A romp through history
First there was the Spanish silver dollar
In colonial times, they used it as de facto money, as did many other places. Other specie was also commonly accepted. But the Spanish silver dollar was the most widely used coin in the colonies. It maintained a reputation as the most honest coin in the world from the 16th century to the 19th.
The early years also saw commodity money, beaver fur, wampum, fish, corn, rice and, most of all, tobacco.
Of course, as an outpost of the British empire, the official money was the British pound, based on a silver standard. Britain also coined gold, regulating its weight to silver ratio, effectively a bimetallic standard.
England also prohibited the colonies from minting coinage. Exporting of English coins was also prohibited – but that did not stop the colonies from obtaining them from other countries.
Fiat money raises its head
Massachusetts, in 1690, needing money to pay its soldiers for a raid on Quebec gone bad, could not raise the funds from Boston merchants. The quick fix was the issue of £7,000 of paper notes, with a promise to redeem in specie accrued from taxation. A year later, they printed £40,000 ‘for the ‘last time’.
No surprise, then, that the paper currency had depreciated by 40% against real money. The government’s answer was to enact a legal tender law.
The unintended but inevitable consequence was one more iteration of Gresham’s Law – Bad money drives out good.
Specie disappeared from the colony. Prices went up, exports declined.
Proving that no idea cannot be repeated, by 1711, Connecticut and Rhode Island had also issued paper money. In the two decades, about 20% more paper had been issued than the silver coinage, which had all but vanished from circulation.
Governmental response? Fines, confiscation of property (asset forfeiture is not new!) and imprisonment were the answers to people refusing fiat at par.
By 1750, all colonies had issued fiat paper, initiating an inflationary boom, followed by deflationary bust. Parliament had attempted to pull the colonies back to hard money and in 1764 required the retirement of paper. The usual doomsayers expected an “absence of money” and ruination of trade. The return of sound money actually enhanced trade, lower prices, more exports and inflow of specie.
As an amusing aside, Maryland issued new fiat in 1733 and distributed almost half of it to the people, to assure its acceptance. They didn’t have helicopters then but surely established the fallacy. Of course, the depreciation was quick.
Private banking in the colonies
The few that appeared in the early days did not last long, for various reasons. For instance, the Massachusetts Land Bank of 1740 issued irredeemible paper notes, and lending on real estate. Within six months, the public was refusing the fiat and Parliament outlawed it.
One wonders at the persistence of inflationary money. For the indebted, typically wealthy businessmen and land owners, a borrowed paper pound today can be paid back with interest in the same paper of less value tomorrow.
Money During the Revolution
When a war needs to be financed and the total money supply of the rebel colonies is but $12,000,000 (est.) the quick answer is more fiat! Thus, the irredeemable Continental was born. Initially promised to be retired in seven years by taxes from the states, the first issue in June, 1775, of $2 million had grown to $6 million by the end of the year. In five years, another $225 million had been added of fiat paper.
“Not worth a Continental” proved correct – by 1781, one silver dollar was worth 168 fiat paper notes.
Even worse, various states had issued their own paper money. A total of 210 million more depreciated dollars swelled the money supply.
When the Continental was not accepted by anyone, the Continental Army supplied itself by ‘paying’ with federal certificates, like it or not. Fortunately, when the dust settled, the state and federal governments rescinded taxing the citizens and all fiat vanished into oblivion.
Not precisely money were the Continental Congress issuance of ‘loan certificates’, some $600 million. Issued to pay for merchant supplies, these certificates became a type of currency but depreciated, one silver dollar worth 24 certificate dollars. Some were liquidated at depreciated rates but most became the federal debt.
This need not have happened, as natural attrition could have taken its course.
But no, Robert Morris, wealthy Philadelphia merchant – who had been Minister of Finance to the Continental Congress – had a plan: make the debt at par value to be repaid, principal and interest. This supported his advocacy for the taxing ability of Congress, a notion the Articles of Confederation had not allowed. A younger Alexander Hamilton had been his aide …
Morris introduced a bill to create the first commercial bank which also effectively would be a privately owned central bank. This scheme was chartered on December 31, 1781 by the Congress of the Confederation.
The Bank of North America
opened on January 7, 1782, not surprisingly headed by Robert Morris.
He deposited gold and silver coin of his own wealth, not enough to meet the charter requirements. Fortunately, and still also ‘treasurer’ of the Confederation, he undertook ‘loans’ from France and the Netherlands, of enough gold and silver to satisfy.
The Bank of North America was also set up as a fractional reserve operation and a monopoly to issue paper money. The first deposit account was the government itself, to which he loaned $1.2 million.
It only took a year of excess issuing of paper money – and depreciation – for people to lose confidence. Outside of Philadephia, their notes depreciated. Complaints of foreign influence and favoritism, and unfair practices added fuel to the fire.
The Bank of New York and Massachusetts Bank in Boston arrived in 1784.
Morris lost the central bank role in 1785 and ultimately became a private commercial bank with a charter from the state of Pennsylvania in 1787 .
A new nation, a new money
Custom is powerful – the term ‘dollar’ borne by the Spanish silver coin became the base unit of American money. The Continental Congress decided this in 1785, although the first American coinage was not struck until 1893.
Having had numerous bad experiences with unsupported fiat paper, the framers opted for a monetary system of intrinsic value. Enshrined in the Constitution:
- Article 1, Section 8
- 1. Coins; Weights; Measures
To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures;
Also, Section 10 .1 unconditionally prohibited states from coining money … [nor] make anything but gold and silver coin a tender in payment of debts …
In 1791, Secretary of the Treasury Alexander Hamilton submitted a Report on the Establishment of a Mint”. A year later, Congress passed the Coinage Act of 1792. This established the composition of gold and silver coins at a fixed ratio of 15-to-1, asserted both were legal tender, with the silver dollar and $10 gold eagle as the basic coinage.
Hamilton thought bimetallism a good idea at the time. Keeping both metals active should have increased the supply of money. Alas, Gresham’s Law prevailed – Mexican silver mining increased enough by 1810 to undervalue gold and gold coins virtually disappeared from American usage from then through 1834.
The fixed ratio in the Constitution had not taken into account market variations of the two metals.
The First Bank of the United States
Even before the ‘Mint Report’, Hamilton, who had always wanted a central bank, produced the “Report on a National Bank”. Congress chartered The First Bank of the United States in February 1791 for twenty years.
Hamilton’s real agenda was to initiate the role of paper money, claiming a scarcity of specie.
Showing that continuity and experience is important, Philadelphian Thomas Willing, who had been president of the Bank of North America, was appointed president of this new enterprise. Hamilton had planned a private institution but with the fig leaf of the government owning 20% of the shares.
The new bank’s notes were redeemable on demand and also acceptable for paying taxes. In practice, the operation was fractional reserve banking. Having issued millions of bank notes, and investing heavily in the government itself, the initial $2 million of capital was outmatched by the over $6 million of notes.
Needless to say, monetary inflation unleashed a 72% rise in prices within five years. Eighteen new banks arose in this period.
Enter a Constitutional crisis. In this corner we have Hamilton and the Federalists; adversaries, the Jeffersonian faction. Ultimately, McCulloch v. Maryland before the Supreme Court was ruled in favor of the Hamilton interpretation, ‘implied powers’.
But where did the money come from? a child of the 21st century might ask. All she’s known is Federal Reserve notes, and unlikely to have ever seen a silver certificate,
The real money, of course, was the gold and silver coins made by the mint. State banks were chartered and, in the fractional-reserve mode, were required to keep a certain amount of gold and silver on hand to redeem their paper notes when customers wanted real money.
By 1811, there were 117 state banks. Their combined reserve ratio had fallen to 0.23 due to expansion of easy credit. The recharter bill in Congress that year failed by one vote in the House and one in the Senate.
By 1815, the number of state banks had about doubled. So had their issue of unsupported paper. When New England banks demanded in 1814 that the other banks redeem their notes, the U.S. Government recognized those banks were insolvent in real money terms and allowed them to waive the contractual requirement.
The War of 1812 had been a factor in bank expansion and loose credit and now, de facto fiat paper, which lasted until early 1817.
The Second Bank of the United States
Third time lucky?
As we have seen, the love of an inflationary policy and subsequent depreciation of fiat recurs repeatedly. At this point in time, 232 banks played that game. Rather than bring them to heel, yet another ‘central bank’, the Second Bank of the United States began operation in January, 1817.
Similar to the predecessor, with one-fifth of the shares of this private bank owned by the federal government, this Second Bank enabled the state banks with immediate issuance of easy credit. Its bank notes were redeemable in specie and the notes were effective legal by way of being accepted by the federal government for the paying of taxes.
In practice, however, irredeemable state bank notes continued to circulate and attempts by the Second Bank to ask for specie was countered by ‘hardship’.
In two-and-a-half years of operation the Second Bank held $2.36 million in specie against an issuance of $19.2 million increase of the national money supply. Repeated fraud at two of its branches and no control of distant state banks, continuing their easy credit inflationary policy, led to the Panic of 1819-21. Unintended consequences of loose money reaped the inevitable crisis: rising unemployment, bank failures, mortgages foreclosed, investment, particularly in the western states all but ceased, and trade diminished.
Property values fell as much as half in some areas. The first urban poverty crisis saw debtor’s prison for some; soup kitchens; an estimated one million jobless; charity drives for clothes, shoes, and food; perhaps one-third of the national population of 9 million disadvantaged. Almost everyone blamed the banks. The southrons criticized protective tariffs. They and those of the western states complained about the Second Bank’s money tighterning.
One popular refrain was the ‘high cost of government’ and people demanded reduced state and federal budgets.
The outcome of economic depression led to the development of a new Democratic Party in the mid 1820s. Elderly Thomas Jefferson was onboard for the agenda of restoring sound money, minimal government-backed economics, paying off the national debt, and ultimately anticipating the ending of fraction-reserve banking. Others included Martin van Buren, old-line Virginians, Thomas Hart Benton of Missouri and Andrew Jackson.
Jackson won the election of 1828 and the first step was to attack the Second Bank, considered the initial source of inflation.
“Old Hickory” had won the presidency with a significant popular vote, a true man of the people. In his annual message to Congress in 1829, he declared his intentions toward the Second Bank. The battle lines were drawn. Nichola Biddle, head of the bank, and his attorneys Henry Clay and Daniel Webster, pushed a confrontation in 1831 to derail Jackson’s re-election campaign.
By insisting on an early re-charter, and getting a passing vote in Congress, followed by Jackson’s veto, their plan failed when Congress would not pass said bill over the veto.
Jackson had told Martin van Buren, “The bank is trying to kill me but I will kill it.”
The 1832 election confirmed Jackson’s position with another strong popular vote. It was the people and their president against the bank.
The Second Bank, having been structured like its predecessor, had the 20% public Treasury deposits there in. In 1833, Jackson removed the government money and spread it around to a number of private banks. His adversaries claimed this would produce inflation. The facts are, however, the record of the Second Bank repeated earlier excesses. Biddle’s Second Bank had already created more than enough inflation: the total money supply had nearly doubled in only a few years.
Although wholesale prices had remained relatively steady, this is explained by rising productivity.
Biddle’s Second Bank, having lost its mojo, ended up in 1836 getting a charter from the state of Pennsylvania.
In his second term, Jackson did fail in the goal of ending fractional-reserve banking. Even more significant, however, is that he paid off the national debt. Remember, the debt of the states after the Revolutionary War had become part of that national debt – and had been growing. The amounts due were withdrawn from the Second Bank and pro-rata distributed to the respective states.
A Generation of Monetary Experimentation
Martin van Buren succeeded Jackson in the presidency, and continued their agenda. He proposed an Independent Treasury early in 1837. although it did not pass until 1840. This sound money plan lasted until the Civil War.
The plan as accepted then made the national Treasury totally independent of the banks – it held specie in its own vaults for payment of trade debts and so on. A legal tender clause mandating specie payment was also included; public opinion against this was bipartisan. People always like easy money … and this was one of the reasons van Buren became a one-term president.
The expansion of the money supply in the 1830s stalled due to several factors. The Bank of England, confronted with inflation and the outflow of gold, raised interest rates, tightening its money supply. The resulting credit crunch impacted on American cotton exports; also, export of silver to China (due to that country’s shift to buying opium – a story for another day) dropped.
With trade affected, the Panic of 1837 ensued but ended by 1838 when Bank of England changed policy. Cotton prices rose again,
Meanwhile, state governments exacerbated the 1838 boom by spendthrift projects – “internal improvements” – due to the distribution of federal money in paying off the national debt.
Not only did they spend the unexpected payout, they borrowed and borrowed for more public works!
No one would be surprised that 1839 ushered in a crisis that lasted four more years of deflation overall. Foolish banks failed, uneconomic state projects died. Polk’s Whig administration, having succeeded Martin van Buren’s, elected to bail out the various states in danger of default.
Default in this era of course, was inability to pay gold and silver on demand from customers losing all confidence in fractional-reserve paper.
The Democratic Party continued to support hard-money principles of the Jacksonian persuasion; the Whigs countered with support for easy credit, especially in states issuing bonds. Banks eagerly bought this government, using it to expand their money supply. This in turn expanded the issue of state bonds, debt! States connived in this quid pro quo by permitting suspension of specie redemption and also legal tender laws accepting bank notes for taxes.
The Whigs were also active in various schemes and were fond of state usury laws, leading to more easy credit. Inflation and speculation grew.
The bimetallism trap
To compound money problems, the gold rush in California and new gold from Russia and Australia upset the gold-silver ratio in 1850. With gold cheaper in the market, silver dollars gained around 4-5 percent of true value and thus virtually vanished into arbitrage land. The only silver coinage left in U.S. Circulation were ‘junk silver’, worn Spanish and Mexican coins.
Congress reacted to the problem in 1853, keeping a Constitutional aspect of bimetallism but with a de facto gold standard and debased silver coinage. The silver quarter-dollar began minting and became popular.
By 1857, Congress outlawed the use of foreign coins. That year also saw a Panic due to the usual suspects, inflating money supply and states waiving specie redeeming.
The Civil War and Beyond
Suppose they gave a war and nobody could afford it? That’s the usual case, examples littered history. Lincoln had precedent for issuing an irredeemable currency, the Greenback. During the War of 1812 period, for two-and-a-half years, state and federal government suspended specie payment.
Banks loved this – they could inflate the money supply like there was no tomorrow.
More significantly, the federal government initiated use of greenbacks by outlaw new issue of state bank notes. And the Treasury offered a $150 million bond issue, expecting the state banks to subscribe and pay in specie – but they did not have the gold. ‘Sauce for the goose’, as it were and the Treasury suspended specie payment on its notes. By February, 1862, the Treasury issued the first Greenbacks. And they were declared legal tender.
From 1861’s federal expense of $66 million to $1.3 billion four years later.
To no one’s surprise, save the government experts, the greenbacks depreciated rapidly. Various interventions were tried, Treasury Secretary Chase even sold $11 million of gold bullion to lower the gold premium of greenbacks. The market barely noticed. Then he attempted a foreign exchange effort to lower the British pound to dollar ratio. Fail.
Like beating a dead horse into glue, the last manuever was to forbid gold futures contracts and regulate brokerage sales of gold and speculation. All Chase’s gold legislation succeeded in doing was to drive the value of the greenback further down, ultimately to forty cents in June, 1864.
Congress repealed this legislative mistake at the end of the month – and Secretary Chase found himself replaced.
During the war years, fiat experimentation even affected coinage. Silver coins left the country for better value elsewhere. The ignominy of a debased bronze penny appeared in 1864 also, all better coins had been exported.
The first federal income tax!
To supplement monetary magic, Lincoln signed on August 5, 1861, the first federal income tax law , the Revenue Act. A flat tax of three percent on annual income over $800 was imposed. The wording was carefully chosen to skirt around the Constitution’s limitation on a direct tax.
Proving that no bad idea cannot be improved, the Revenue Act of 1862 was progressive – three percent at $600 income and five over $10,000. This act also was intended to cease in 1866.
Not content with that, Lincoln also imposed additional sales and excise taxes as well as estate taxes. War is expensive! The income tax was finally repealed in 1872.
Part Two will continue with the inflationary games bankers play. And more.