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Steven Russell

Steven Russellis an economistat the Federal Reserve Bank otSt Louis. Lynn Dietrich provided research assistance.

The U.S. Currency System:A Historical Perspective

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HE USE OF CURRENCY in transactions is aregular part of our daily lives and a basic featureof our economic system. The importance ofcurrency derives both from its obvious role indaily transactions and from the somewhat moresubtle role of the currency system as the basis forour monetary and financial systems. The currencysystem is so fundamental to economic activity thatwe tend to give it little thought. Few of us wouldhave an easy time imagining what alternativesystems might be like or why they might bedesirable. Indeed, it seems likely that most of us, ifpressed, would offer the opinion that the presentcurrency system is the only one that is feasible—orat least, the only one that is desirable.

This article has three purposes. The first is todefine the term “currency” and explain the specialimportance of currency and the currency systemto our economy. The second is to describe the U.S.currency system—the system that governs theforms, uses and roles of currency in the modernUnited States. This description will be preceded bya catalog of the forms currency has taken at vari-ous points in the past, so that the modern U.S.system emerges as a set of selections from a menuof choices provided by history. This procedure isintended to suggest that alternative menu selec-tions were possible—that the currency systemwhich actually evolved in the United States is notthe only one that could have evolved. The article’sthird and most ambitious purpose is to present abrief hut comprehensive account of the historical

development of the U.S. currency system. Thisaccount focuses on the period before and duringthe Civil War.1 Its primary goal is to provide thereader with historical context that may improvehis understanding of the modern currency system.

The historical account has a second purpose,however, The development of the U.S. currencysystem is often characterized as a process of slowbut steady advancement: older institutions andpractices, having failed to meet the demands oftheir times, were replaced by more efficientsuccessors. This“gradual progress” characteriza-tion implies that the modern currency systemmeets the needs of our economy more efficientlythan could any of the alternatives suggested byhistory. The historical account is intended to helpdetermine whether this characterization is valid,and whether relative efficiency conclusionsshould he based on it.

WHAT IS CURRENCY?

One approach to defining currency is to contrastit with something whose definition is closelyrelated, but more familiar: money. Most peoplehave been exposed at some point to an economist’sdefinition of money; it usually reads somethinglike “things that serve as media of exchange” or“things that function as means of payment.” Whileall currency is money, all money is not currency.Currency can he defined as money which circu-

1U.S. monetary history from the end of the Civil War throughmodern times has been chronicled quite extensively, notablyby Friedman and Schwartz (1963). In addition, most of the key

decisions that determined the basic form of the U.S. currencysystem were arguably made before 1865.

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Coin Currency

example, commodities such as wampum (coloredbeads), tobacco, wheat and rice were used ascurrency at different places and times,4 Gold andsilver, the “precious metals,” had attractiveproperties— portability, malleability and dur-ability—which ultimately made them the curren-cies of choice in most early economnies.

lates, or passes from hand to hand. (“Circulation”was once commonly used as a synonym forcurrency.)

Formally, a type of money can be said to circu-late if it usually passes in exchange from oneperson to another without third-party verification.

One easy way to illustrate the difference betweencirculating and non-circulating money is tocontrast dollar bills, which circulate, with checks,which do not.2 A dollar bill may pass from one

person to another many times in different transac-tions. ‘the only people involved in each transactionare the buyer and seller. Transactions using

checks require more complex arrangements. It isunusual for a check, written by one person inpayment to another, to be offered in payment to athird person. Instead, the second person usuallydeposits the check in a bank account. His bank andthe first person’s bank then conduct a “clearing”transaction which, if successfully completed, vali-dates the payment.’

In the modern United States, only dollar billsand coins, issued by agencies of the federal

government, fit the definition of currency. Earlierin our history (amid that of many other nations) thenumber of alternative types of currency waslarger, and included items issued by private

organizations. The next section presents a briefcatalog of some of the varieties of currency thathave existed in the past.

WHAT FORMS CAN CURRENCY TAKE?

As the volume of transactions involving gold andsilver increased, people began to divide thesemetals into pieces of readily recognizable size andshape, called coins. The earliest coin-producingfacilities (mints) seem to have been privately oper-ated.5 In most countries, however, the govern-ment eventually took over coin production.

The rationale behind the government takeovermay well have included the belief that govern-ment-issued coins would be more uniform, andmore reliable, than their privately issued counter-parts. Early governments, however, could haveresolved problems of diversity and fraud byregulating private mints and inspecting privatecoins, in essentially the same way that govern-ments have long regulated and inspected otherindustries.°A more compelling reason for govern-ment coin monopolies, however, was the desire toearn revenue from seigniorage—from periodicallyshortweighting or debasing the currency.7 Unlessa government had a coinage monopoly, its attemptsto earn substantial revenues from seignioragewould have been frustrated as the public aban-doned its coins in favor of those minted by itsprivate competitors.

The prevalence of government currencymonopolies gave rise to the twin concepts of a

The earliest forms of currency were commodi-ties (widely traded goods). In colonial America, for

‘Strictly speaking, economists think of the accounts againstwhich checks are drawn (the demand deposits) as money,rather than the checks themselves.

‘Typically, a person who is offered a newly written check inpayment (the second party) will ask the check-writer (the firstparty) to present identification and will record information

from the identification presented - The second party willdeposit the check in his bank account. His bank will “clear”the check by sending it to the bank against which it is drawn,and demanding payment in cash. The two banks are the“third parties” which are actually involved in most transac-

tions using checks. The clearing transaction is necessary toverify that the check is drawn on an account that containssufficient funds, If the check “bounces,” it has failed theverification test. The amount of the check will not be creditedto the second party’s account, and he will use the information

• from the check-writer’s ID to pursue him for some alternativeform of payment. [The reason the second party will rarely tryto pass the check along to a third party is that the third party isunlikely to accept it, (If you doubt this, try passing such a“third-party check” at your local grocery store.) A third party

typically has no easy way of obtaining reliable identificationfrom the (absent) first party.]

4For an extended discussion of the role of commodity moneyinthe colonies, see Nettels (1934), chapter VIII.

5Feavearyear (1963) describes early English currency asfollows: “At the beginning of the eighth century the currencyconsisted of small silvercoins varying in design according tothe fancy of the individual moneyer.’ (p. 7)

6Adam Smith (177611937) points out that before coins evolved,governments often stamped ingots of precious metal to certifytheir purity (pp. 24-25).

~Acoin is said to have been “shortweighted” if it is mintedwith less than its official metallic weight, but represented ashaving exactly that weight. A coin is said to have been“debased” if it is minted as a mixture of genuine monetarymetal and common scrap metal, but represented as puremonetary metal. These fraudulent practices were sometimespracticed by private mints as well. For a discussion of govern-ment seigniorage motives, see Timberlake (1991), pp. 3-5,50-5 1.

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national currency and a national monetary unit.Typically, a government would define a basicmonetary unit as a fixed quantity of gold or silver.It would then mint coins in denominations thatwere multiples or fractions of this unit and werescaled appropriately in size and weight.

Most nations had an extended period duringwhich government-issued coins were the onlyform of currency. One problem with these pure-coin currency systems was that they had difficultyhandling transactions of widely differing scales. If,for example, coins were denominated so that asingle coin of moderate weight could be used topurchase an inexpensive item (say, an apple), thenthe coins necessary to purchase an expensive item(say, a carriage) were necessarily quite heavy. Onecommon way in which governments tried to solvethis problem was by establishing bimetallic coinagesystems. In these systems coins of low valuecontained a relatively inexpensive metal (typicallysilver~,while larger-value coins were composed ofa more expensive metal (typically gold). ‘I’he twotypes of coins were referred to collectively asspecie.

The U.S. experience with specie currency illus-trates most of the concepts just described. ‘theU.S. Constitution gave Congress the power to“coin money, and regulate the value thereof—aprovision which has been universally interpretedas prohibiting the states either from minting coinsdirectly or from authorizing private parties to doso.8 Shortly after the Constitution was ratified,Congress enacted legislation that defined the basicmonetary unit, the dollar, as either a fixed weightof gold or a (different) fixed weight of silver. Thefederal government then opened a mint thatproduced dollar coins in accordance with thesedefinitions. The mint also produced silver “quar-ters” containing one-fourth the amount of silver ina silver dollar, five-dollar gold pieces containing fivetimes the amount of gold in a gold dollar, and so on.’The U.S. Mint continued to produce full-bodied goldcoins until the early 1930s, and full-bodied silvercoins until the mid-1960s. (A full-bodied coin con-tains a quantity of metal whose market value isequal to the face value of the coin.)

As the magnitude of economic activity increased,the weight of the gold coins necessary for a majorpurchase, or even the quantity that a relativelyivealthy person might desire to have on hand,became unmanageably large. Coins also tended towear away or have their edges clipped. After afew years, coins of the same denomination couldbe significantly different in size.bo These problemsmade coins increasingly unsatisfactory, even forrelatively small-scale transactions.

Bills of Exchange

An obvious solution to the “weight problems” ofthe coin currency system was to find or createlightweight objects that, while not made of coinsthemselves, had known values in terms of coins.Objects like this already existed: they were promis-sory notes—contracts between borrowers andlenders calling for the repayment of fixed sums (incoin) at fixed future dates.

One special type of promissory note, the bill ofexchange, was readily adapted for use as currency.Bills of exchange grew out of commercial transac-tions in which merchants would arrange topurchase goods from other merchants for deliveryat fixed future dates (for example, in 90 days).Often the seller could not afford to produce and/ordeliver the goods unless he received immediatepayment, while the buyer was reluctant to pay forthe goods before receiving delivery. One solutionto this problem was an exchange of contracts. Theseller would contract to deliver the goods at thedate in question, while the buyer would contractto pay the purchase price at the delivery date. ‘thelatter contract took the form of a conventionalpromissory note.

This exchange of contracts may not seem tohave addressed the seller’s immediate problem: toobtain the currency needed to finance the produc-tion and/or transport of his goods. Suppose,however, that the seller, armed with his promis-sory note, sought topurchase materials from asupplier. He could then write out another creditinstrument—a bill of exchange—calling on themerchant who had issued the promissory note topay the supplier the purchase price of the ma-terials, plus an allowance for interest, in 90

5US. Constitution, Article I, Section 8. 10For a description of the clipping problem in pre-eighteenth9See Huntington and Mawhinney (1910), pp. 474-79. Gold century England, see Feavearyear (1963), pp. 5-6, anddollar coins were not actually minted until 1849- See Macaulay (1877), volume V, pp. 85-93.Carothers (1930), pp. 105,109, and Huntington andMawhinney (1910), pp. 508-09.

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that, if he did not have occasion to pass it along, hecould redeem it when it came due.”

Although bills of exchange became an importantadjunct to coin currency, a number of problemslimited their usefulness. Since they were typicallydrawn in fairly large denominations (of the sortappropriate for trade hetween merchants), theywere not well suited for small-scale transactions.And, as the volume of trade in a given regionincreased, it became less and less likely that aperson proffered a bill would be familiar, eitherpersonally or by reputation, with the merchantagainst whom it was drawn, Consequently, disho-nored bills became a more serious problem, andpeople became hesitant to accept them in payment.A less fundamental, but still annoying, problemwas that whenever a bill changed hands, interesthad to be calculated and deducted from its facevalue. ‘this fairly involved calculation requiredconsideration of both the remaining term on thebill and the market rate of interest.

Bank Notes

Thetransactions problems with bills of exchangecreated opportunities for private entrepreneurs toprofit by providing paper currency in more con-venient forms. Suppose an enterprising merchantwith a good reputation sold small bills of exchangein return for specie and used the proceeds to buylarge bills with the same maturity dates. ‘theproceeds of the large bills would then provide afund out of which the small bills could beredeemed. Because small bills were much moreconvenient for exchange purposes than large bills,they were slightly more valuable, per dollar offace value, to their holders.” As a result, smallbills could be sold at smaller percentage discounts(lower interest rates) than large bills. It followedthat the total purchase price of the large billsnecessary to cover a given face value of small billswas smaller than the total sale price of the smallbills. This difference in total prices representedthe merchant’s profits.

days. This process was called drawing a bill; theoriginal goods seller was called the drawer and theissuer of the promissory note the drawee, The

drawee would accept (agree to cover) the bill as

long as its value was less than that of the promis-sory note. He would indicate his acceptance byendorsing the bill.”

By accepting the bill, the supplier was, in effect,lending the seller the value of the materials the

latter had “purchased.” The supplier, however,usually did not expect to hold the bill until it camedue. Instead, he planned to pass it along to some-

one from whom he wished to purchase goods; thisperson might pass it along to someone else, and soon, until the bill matured. The last person in thechain would demand payment from the drawee.

In between, the bill served as paper currency.”Notice that drawing a bill was analogous to

writing a check, with the drawee of the billplaying the same role as that of a bank on which acheck is drawn. It seems to follow that bills of

exchange should not have circulated, for preciselythe same reasons that modern checks do notcirculate. There was a basic difference between a

bill of exchange and a modern personal check,however. Because no one would accept a billunless it was endorsed by the relevant drawee, thequestion of “bad checks”—checks written by

individuals with insufficient funds—did not arise.Stated differently, an accepted bill was purely aliability of the drawee; a person offered a bill in

payment did not need to be concerned about thecreditworthiness of the drawer.”

It is true that bills were occasionally dishonoredby their drawees, just as modern banks occasion-ally fail.” As long as the bills were drawn against

well-known merchants with established reputa-tions in commerce, however, failures were un-common. Consequently a person who accepted abill in payment could be reasonably confident

‘15ee Clough and Cole (1941), pp. 77-78.

“In England, bills of exchange played a prominent role as

means of payment during the seventeenth and eighteenthcenturies; see Feavearyear (1963), pp. 160-62. In severalEnglish districts, they retained this role well into thenineteenth century; see Clapham (1944). II, pp. 90-91,97-98,

Viner (1937), p. 123, and Feavearyear (1963), p. 165.“It is worth noting that while it is usually difficult to negotiate athird-party check drawn on an individual’s bank account, acheck drawn on the account of a government agency orprominent local corporation may be easy to negotiate.

“The existence of federal deposit insurance prevents small-scale personal depositors from being endangered by bankfailures, Before 1935, however, this was not true,

“Contemporary criminals sometimes forged merchants’acceptances, just as modern criminals sometimes forgechecks, The severity of penalties for forgery limited the scaleof this problem, however.

‘5For a careful description of the logic behind this statement,see Wallace (1983).

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The merchant had now become a banker, andthe institution he operated a bank ofissue—afinancial intermediary whose liabilities consistedprimarily of paper currency.’7 The small billscame to be known as bank notes.

The merchant could increase his profits fromnote issue by reducing the risk that he woulddefault on his notes. This would reduce the “riskpremium” that small billholders demanded, andenable him to sell the bills at smaller discounts.One strategy for accomplishing this was to diver-sify his large bill portfolio as extensively aspossible. Another was to provide, or to obtainfrom investors, some capital to act as a cushionagainst defaults on the large bills.

A basic problem with the scheme just describedwas that the time and effort necessary to computethe appropriate discount on a bank note wasusually large relative to the face value of the note.This reduced the usefulness of notes in transac-tions and discouraged people from purchasingthem.’8 One way to solve this problem was to issuenotes with characteristics so appealing that theirholders would be willing to forgo interest onthem. How could this be accomplished?

Since we have assumed (perhaps too quickly)that proper diversification and capitalization madethe risk on bank notes negligible, the need forinterest on them arose purely out of their holders’time preference—their desire to be compensatedfor giving up their money (in this case, their speciecurrency) for fixed periods. Suppose, however,that a merchant promised to redeem his notes ondemand (at any time) instead of at a fixed futuredate. Since the purchaser of such notes couldreclaim his specie whenever he chose, he wouldnot be giving it up for any fixed period, and wouldhave no reason to demand interest, The bills couldthen be sold atpar (undiscounted).

How could a merchant make such a convertibilitycommitment credible? Clearly, he would need tohold back some of the (specie) proceeds of his notesales for use as reserves. These reserves would nothave to be large, however, because as long as note-holders were confident that they could redeem

their notes, there was no particular reason whythey would do so. After all, the holders had boughtthe notes because they were more convenient forexchange purposes than specie.

Notice that there is some circularity in the argu-ment just presented. Convertibility, it asserts, wasnecessary to prevent noteholders from demandingcompensation for giving up their specie, whichthey had been holding for use as money. But thesepeople had exchanged their specie for notesprecisely because the notes were a more conven-ient form of money! This paradox makes it seempossible that convertibility is not really necessary;indeed, there are both historical and theoreticalreasons for suspecting that it may not be. In prac-tice, however, the vast majority of private banksof issue have attached convertibility commitmentsto their notes.’°The Bank of England, for example,began circulating convertible notes shortly after itreceived a royal charter in 1695. These notes be-came the principal paper currency of the relativelydeveloped region surrounding London (the“Metropolis”).” 20

Government Paper Currency

Governments eventually acquired a role in thepaper currency system by regulating the issuanceof private paper currency, and/or by issuing papercurrency directly. The motives for this decisionwere essentially the same as those which drovegovernments to acquire a monopoly over coinage:some combination of a desire to improve effi-ciency by facilitating the development of uniformand reliable paper money, and a desire to earnrevenue by regulating or replacing the privatebanking system. This revenue has been earned ina variety of ways. In some cases, governmentshave earned substantial sums by granting privateinstitutions the right to issue paper currency inreturn for some kind of financial consideration.(See, for example, the discussion of the establish-ment of the Bank of England which appearsbelow.) In other cases, revenue has been earnedthrough direct currency seigniorage, in which thegovernment issues paper currency to purchasegoods and services, or through indirect seig-

‘7For a description of banks that dealt in bills of exchange, seeFeavearyear (1 963), pp. 162-65.

‘°White(1987) provides an analysis of the transactionsproblems associated with interest-bearing currency.

‘9Calomiris and Kahn (1991) construct a formal model in whichnote- or deposit-holders can use redemption demands as adevice for preventing bank frauding by forcing a preemptive

liquidation. Incomplete information problems make it impos-sible for these agents to detect fraud without a liquidation.While this model is not reasonable in every historical context,it represents a first step toward explaining the prevalence ofconvertibility.

‘°Forthe early history of the Bank of England, see Clapham(1944), volume I.

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niorage, in which the government issues papercurrency to purchase and retire its own bonds.

Government paper currency can take a varietyof forms. The earliest form of government papercurrency—and until quite recently, the mostcommon form—was representative currency. Agovernment currency is said to be “representa-tive” if it is issued under a convertibility commit-ment; that is, a government promise to redeem thecurrency in specie, at par and on demand. Rep-resentative currencies are the government-issuedanalogues to private, convertible bank notes.While they have usually been issued by govern-ment-organized “central banks,” they havesometimes been issued directly by the govern-ment. The United States, for instance, had directlyissued representative currency during 1879-1913

(the U.S. notes, or “greenbacks,” which wereissued by the Treasury) and representativecurrency issued by a central bank during 1914-1933(the Federal Reserve notes, which were issued bythe Federal Reserve Banks).”

Governments have also issued currency that isnot convertible into specie, or anything else. Thistype of currency is often referred to as fiat cur-rency.’2 During the Civil War, both the Union andthe Confederacy issued fiat currency to financepart of their military purchases. The Unioncurrency was the greenback mentioned above.Modern U-S. currency is also fiat in nature.Federal Reserve notes (our dollar bills) have notbeen convertible for domestic holders since 1933;since 1971, they have not been convertible for anyholders whatsoever. The Federal Reserve Banks

21The greenbacks were first issued in 1863, but were notconvertibleuntil 1879. Federal Reserve notes were convert-ible for domestic holders from the establishment of theFederal Reserve System in 1914 until March 1933. Theyremained convertible for certain foreign holders until 1971,

22A distinction is sometimes made between inconvertiblegovernment currencies that are issued in purchase of assets(and so form the liabilities side of a “balanced” balancesheet), and currencies which are issued in purchase of goodsand/or services, Currencies of the former type are referred toas f/duc/ary. Many economists believe that currencies derivemuch of their value from the assets which back them.Descriptions of this view appear in Smith (1 985b) and Russell(1989a). It suggests that fiduciary currencies maybe lesslikely to decline in value (that is, to depreciate) than fiatcurrencies,

“Strictly speaking, the Federal Reserve System pays for theTreasury securities it purchases by issuing claims on theFederal Reserve Banks, These claims can be redeemed incurrency—Federal Reserve notes—which can be held by thegeneral public as cash balances, or by commercial banks asreserves, Alternatively, the claims can be converted intodemand deposits at the Federal Reserve Banks, which can

issue most of these notes in purchase of U.S.Treasury securities.’3

WHAT IS A CURRENCY SYSTEM?

A nation’s currency system can be defined as theset of laws, conventions and practices that deter-mine the form and role of currency in the nation’seconomy. A complete description of a nation’scurrency system would provide answers to ques-tions like: “What things does the economy of thisnation use as currency?”, “What sorts of institu-tions (private andlor government) are permitted toissue currency under the nation’s laws?”, “Whatrole (if any) does the nation’s government play indefining the economy’s currency unit, or in pre-serving its value?”, and “What is the nature of therelationship between the nation’s currency systemand its monetary and financial systems?”

HOW DOES THE U.S. CURRENCY

SYSTEM WORK?

This section will provide a brief summary of thehistory and legal framework of the U.S. currencysystem. It will focus on a pair of legal restrictionsthat play a critical role in shaping the system.These restrictions would be prime candidates forrevision or repeal if the system were to be reform-ed or deregulated.

As previously noted, the U.S. Constitution gaveCongress exclusive power to define a nationalmonetary unit and produce coined currency. Inaddition, the states were explicitly prohibitedfrom issuing paper currency directly.” The

also be used by commercial banks as reserves. The decisionconcerning how the claims are divided between thesecompeting uses is made by the private sector.

At present, currency held by the public, or as reserves,accounts for about 85 percent of total claims on the FederalReserve Banks, while U.S. Treasury securities account forabout 75 percent of their total assets, In addition, theeconomic implications of the scheme for paying for thesesecurities just described are identical to those of an alterna-tive scheme under which the System paid for Treasury securi-ties with newly issued Federal Reserve notes, and the privatesectordecided how much of this currency to retain and howmuch to deposit with the Reserve Banks.

The Federal Reserve Act prohibits the System frompurchasing newly issued Treasury securities—an action thatwould amount to issuing currency (and/or Reserve Bankdeposits) to finance government purchases. lSee the defini-tion of “indirect currency seigniorage” presented earlier inthis section.]

24Article I, Section 10 of the U.S. Constitution denies the statesthe power to “emit Bills of Credit:” this was almost universallyunderstood to prohibit them from issuing their own currency.

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Constitution was silent, however, on two ques-tions that ultimately became controversial: Does

the federal government have the right to issuepaper currency? Do either the federal govern-ment or the states have the right to authorizeprivate institutions to issue paper currency—dothey have the right, that is, to grant charters toprivate banks?

Shortly after the Constitution was ratified, thestates began to charter private banks of issue.” In1791, and again in 1816, the federal governmentchartered a single private bank—the Bank of theUnited States. For the next three-quarters of acentury, the bulk of the paper currency that circu-lated in the U.S. was issued by state banks; virtu-ally all of the remainder was issued by the United

States Bank. The rights of the federal governmentand the states to charter private banks were even-tually affirmed (in separate decisions) by the U.S.Supreme Court.”

In 1865, Congress imposed a tax on note issue bystate banks that was high enough to make theactivity unprofitable. This action, which came oneyear after Congress had established a system offederally chartered banks of issue called theNational Banking System, was evidently intendedto put an end to state banking.27 Another wartime

innovation was the issuance, beginning in 1862, of“greenbacks.” For the next 50 years, the U.S. stock

of paper currency consisted almost entirely ofnational bank notes and greenbacks.”

The Civil War produced a dramatic expansion ofthe federal government’s role in, and powers over,the U.S. monetary system. In the years immedi-ately following the war, the right of the federalgovernment to play this role, and to exercise theseexpanded powers, was affirmed in a series of

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Supreme Court decisions. The war converted apolitical system in which the monetary powers offederal government were sharply circumscribedinto one inwhich they were virtually unlimited.

Almost half a century later, the federal govern-ment’s monetary powers were wieldedin dramaticfashion when Congress passed the Federal Re-serve Act of 1913. This legislation established 12“Federal Reserve Banks” that collectively constitu-ted a “central bank” for the United States.’9 TheReserve Banks issued a new form of representativepaper currency called“Federal Reserve notes.”These notes became the basis for the U.S.currency system.

During the first two decades followingthepassage of the Federal Reserve Act, the nationalbanks retained the right to issue limited quantitiesof notes. In 1935, however, the national banks’issue rights expired; Congress declined to renewthem, and made provisions for the gradual retire-ment of all national bank notes still outstanding.~0Since 1935, the Federal Reserve Banks have beenthe only U.S. organizations authorized to issuepaper currency on a regular basis.”

The result of this historical process can besummarized as the first of two basic legal restric-tions which govern the U.S. currency system: thefederal government has a legal monopolyover theissuance of currency, whether in coin or paperform.

The second basic legal restriction involves therelationship between currency, which is nowexclusively federally issued, and “money” of othersorts, which continues to be provided by theprivate sector. Privately issued money is re-quired to be convertible (redeemable at par and on

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“For an exhaustive list of banks chartered by the states prior to1837, see Fenstermaker(1965).

“Key decisions upholding the right of the states to charterbanks are Cra/g v. Missouri (1830) and Br/scoe v. the Bank ofthe Commonwealth of Kentucky (1837). Key decisionsregarding the right of the federal government to charter banksare McCulloch V. Mary/and(1819) and Farmers andMechanics Bank v. Dear/rig (1875).

“State banking survived because it proved possible for manystate banks to convert to pure deposit banking, which was nottaxed prohibitively.

“Theywere eventually supplemented by substantial quantitiesof silvercertificates, andby minor quantities of federal govern-

ment currency of other sorts. See Friedman and Schwartz(1963). pp. 124-34, and Timberlake (1978), chapter 10.

“The text of the act appears in the Annual Reportof theFederal Reserve System for 1914.

“See Friedman and Schwartz (1963), p. 442.“In principle, Congress retains the right to authorize the

Treasury to issue paper currency directly. It has declined todo so, however, since the establishment of the FederalReserve System.

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demand) in government currency.” In practice,privately issued money consists of deposits at

commercial banks and thrift institutions that arepotentially convenient as media of exchange—i.e.,that are readily transferable (checkable) and avail-able in small denominations. The government

requires that these deposits be convertible, andthey are referred to as “demand deposits.”

If demand deposits are to be convertible intogovernment currency, they must be denominatedin the same units, and have the same market valueper unit, as government currency. Consequently,the convertibility restriction, combined with thegovernment’s currency monopoly, imposes acommon denominational and value standard on allU.S. money. The denominational standard is ofcourse the “dollar,” the basic unit of governmentcurrency; the value standard is the purchasingpower of a dollar (or any fixed number of dollars)of this currency.

It is worth noting that governments usuallyattempt to enhance the acceptability of theircurrency by making it legal tender. Legal tenderlaws either require or strongly encourage peopleto accept government currency in payment ofnominal debts—debts denominated in nationalcurrency units. In the United States, both coinsminted by the Treasury and Federal Reserve notes

are legal tender.

HOW DID THE MODERN U.S.

CURRENCY SYSTEM DEVELOP?

Science has been slow to admit the different explan-awry world of history into its domain—andourinterpretations have been impoverished by thisomission. Science has also fended to denigratehistory, when forced to a confrontation, by regard-ing any invocation ofcontingency as less elegant orless meanin~ulthan explanations based directly ontimeless “laws of nature.”

—Stephen Jay Gould (t989).

“During the earliest decades of U.S. banking history, theconvertibility requirement was largely implicit. Early in thenineteenth century, however, states began to pass legislationwhich explicitly imposed convertibility on the banks—or,alternatively, to include convertibility requirements in bankcharters, The federally chartered United States Banks hadconvertibility requirements in their charters, Convertibilityrequirements were standard features of state charters issuedunder the “Free Banking” laws of 1836-63. The federal

English Origins

Synopsis: The origins of the modern U.S. cur-rency system can be traced in large part to Eng-land. Many important features of the U.S. cur-rency system were based on English models. Theearly history of paper currency in England wasdominated by the government’s need for specierevenues to finance its foreign wars. This needcaused the government to establish two princi-ples—Bank of England monopoly, and strict specieconvertibility—as the basis for England’s system ofpaper currency. ‘these principles had a profoundeffect on the evolution of paper currency andbanking in the United Kingdom, and later in theUnited States.

In England, the notion of organized note issueseems to have arisen during the latter part of theseventeenth century. At the time, England hadhad a government-monopoly coin currencysystem for several centuries, and had begun to

develop a paper currency system based on bills ofexchange.” During the last decade of the seven-

teenth century several groups of entrepreneursrecognized an opportunity to profit by providing amore convenient paper currency. Each of thesegroups sought royal charters for banks of issue.

Horsefield (1960) singles out four groups forspecial study. One of them, led by William Paterson,proposed a bank which would lend convertiblenotes on commercial security. The new bankwas called the Bank of England. It received acharter in 1695, and has operated continuouslysince; it is now the central bank of the UnitedKingdom. ‘4

Three other groups, led by Hugh Chamberlen,John Briscoe, and John Asgill and Nicholas Bar’hon,respectively, proposed “land banks” which wouldlend inconvertible notes on the security of landand other real property. The land banks of Briscoeand Asgill-Barhon actually operated for a shorttime during 1695-96. In the latter year, they wereconsolidated pursuant to a scheme to secure aroyal charter by raising £z,ooo,ooo in specie to helent to the British government, which was des-

charters issued during the late nineteenth century, under theNational Banking Act, also included convertibilityrequirements.

~ a description of early English monetary history, see Feav-earyear (1963), chapters l-IV.

‘4The definitive history of the Bank of England has been writtenby SirJohn Clapham (1944, two volumes).

Ia

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perate for funds. The charter of this “NationalLand Bank” required that it raise half of thespecie loan prior to beginning operation. Whenit proved unable to do this, the charter lapsedand the scheme fell apart.’5

The fear that a public accustomed to coin cur-rency would not accept inconvertible notes cer-tainly played a role in the collapse of the Na-tional Land Bank and other land bank schemes.Nevertheless, even Horsefield (1960), who isgenerally unsympathetic to the concept of landbanking, points out that “the major cause ofthese events was an accident of time.” TheBank of England, which had obtained its charterby means of a similar commitment to providespecie, had drained the capital market of funds.This problem was exacerbated by the onsetof a commercial crisis, which forced the Bankof England to suspend specie convertibility ofits notes.”

In 1697 the Bank of England obtained, inreturn for a further extension of credit to thegovernment, a formal commitment that Parlia-ment would authorize no other banks so longas the Bank existed. Its urgent desire for thiscommitment suggests that it continued toregard land banking as a viable competitivethreat. Clapham (1944) writes that “the GeneralCourt [the directors of the Bank of England]wanted no more Land Banks.”38 In 1708, inreturn for further loan commitments, the mo-nopoly grant was “reenacted and made moreprecise.” Parliament explicitly prohibited anyfirm consisting of more than six partners fromissuing notes in England.” ‘thereafter Englishnote issue was dominated by the Bank of En-gland. The small “country banks’ operated in

“See Horsefield (1960), chapters 14-16, and Clapham (1944),volume I, pp. 33-34.

“Horsefield (1960), p. 246.

“Ibid., pp. 246-47.

“Clapham (1944), vol.1, p.47.

“See Clapham (1944), p. 65, and Feavearyear (1963), pp. 167-68.40During 1797-1821 (the era of the Napoleonic Wars), the Bank

of England suspended specie payments. Although its noteswere not officially legal tender, they became so operationally.Specie virtually disappeared from circulation, most paymentswere made in Bank of England notes, and other Englishbanks redeemed their notes in Bank of England notes. SeeFeavearyear(1963), pp. 182-85, and Viner(1937), p.l54.

41Macaulay (1 B77) provides a colorful and illuminating para-graph describing this relationship (IV, pp. 551-2).

4’Clapham (1944), describing the Bank’s first summer,observes that “what the government—like the Bank—most

its shadow, and evolved along strictly convertiblelines.~°

The development of the British currency sys-tem can be properly understood only in thecontext of the symbiotic relationship betweenthe British government and the Bank of En-gland.41 The Bank regarded its paper currencymonopoly as critical to its profitability, and waswilling to make large financial concessions tothe British government in order to protect andextend it. The British government, on the otherhand, was willing to grant the Bank a monopolybecause it needed the Bank’s financial assist-ance—in particular, to help it obtain specie tofinance foreign wars.4’ Under the circum-stances, it was profoundly in the interest ofboth parties for government liabilities to beidentified as closely as possible with Bank liabili-ties, and for Bank liabilities to be identified asclosely as possible with specie.~’The simplestand most certain way to achieve this was forthe Bank to lend extensively to the governmentand make its notes strictly convertible.’~

In Scotland the situation was quite different.The convertible, commercial Bank of Scotlandwas chartered by the Scottish Parliament in1695. This bank, unlike the Bank of England,was statutorily uninvolved in governmentfinance. It was granted a 21-year note issue mo-nopoly (which was not renewed). In 1705, bothHugh Chamberlen, who had now moved toScotland, and John Law, who was later toachieve monetary infamy in France, proposedland banks for Scotland. Both proposals wererejected because they involved notes that werelegal tender—a status Parliament was unwilling

wanted in the summer of 1696 was not a circulation of notesbut cash, hard cash for the Army in Flanders” (vol. I, p. 39).

4’Clapham (1944) points out that under the Act of 1697, whichformalized the Bank’s monopoly, “forgery ofthe Bank’s noteswas to be punished with death, the penalty for clipping orcoining the King’s money. Bank notes were not yet the King’smoney, but they were getting near to it.” (vol. 1, p. 50). InOctober of 1698, he writes, the English Treasury agreed to“‘receivesuch bills of theBank of England commonly calledBank Bills ... provided the said bills are not at any discount.’The time was getting nearer when the Bank would circulatetheExchequer Bills for the Treasury, cash them on demand,accept them as deposits, make generous advances on theirsecurity, and even pay a dividend on them.” (vol.1, p.56; myemphasis). And in 1710, iust two years after it had acted tofurther strengthen the Bank’s monopoly status, the BritishParliament passed an Act” ‘for engaging and obliging theBank of England . -. to exchange all Exchequer bills for readymoney on demand.’ “(vol.1, p.67).

‘4Santoni (1984) asserts that “the Bank’s contract with itscustomers to redeem its notes at a fixed price in terms of gold

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was a voluntary arrangement” (p. 15). He justifies this asser-tion by noting that the gold standard was not imposed byBritish law until 1821, more than a century after the Bank wasfounded. While this is certainly true, it is also true that untilthe early nineteenth century much of British bank regulationwas implicit rather than explicit. One illustrative exampleinvolves the monopoly status of the Bank of England. Mosthistorians describe the Bank as having possessed amonopoly over joint-stock (corporate) banking in England.However, the Act of 1708 gave it a monopoly only over joint-stock note issue. Nevertheless, none of the deposit banks inEngland attempted to organize in corporate form. Feav-earyear (1963) explains this by noting that, despite the lack ofan explicit legal prohibition against joint-stock depositbanking, “there can be no question whatever that the inten-tion was to give the Bank of England a monopoly of joint-stockbanking, and that had any other institution of more than sixpartners attempted to carry on banking in England in anymanner whatever at any time during the first half of thecentury it would have been suppressed” (pp. 167-68). Simi-larly, despite the lack of an explicit legal requirement thatbank notes be convertible, there can be little question but thatthe intention was that they should be convertible, and thatany attempts by the Bank of England, or any of the Englishcountry banks, to issue inconvertible or semiconvertiblenotes would have been suppressed—just as attempts of thissort by Scottish banks were suppressed (see below).

Santoni also asserts that the establishment of an officialgold standard occurred as a result of “the Bank’s continuousprods to an unwilling government.” He justifies this assertionby noting (1) that the deadlines set by Parliament for resump-

tion were repeatedly postponed, and (2) that the Bankresumed paying specie for small notes in 1817, and Parlia-ment intervened in 1819 to prohibit it from doing so. However,Viner (1937), Clapham (1944), and Feavearyear all report thatthe government’s primary goal in postponing resumption was toavoid embarrassing the Bank. IViner writes that “the govern-ment continued to refuse to obligate the Bank of England toresume cash payments, and both government and Bank wereobviously waiting for the course of events to disclose the auspi-cious occasion for resumption” (p. 172, my emphasis); Feav-earyear notes that “the Government refused to allow the Bank’shand to be forced, and repeatedly extended the term of theRestriction Act” (p. 214).] These authors also describe theresumption attempt cited by Santoni as a failure, and thegovernment prohibition as an attempt to protect the Bank.Finally, both Clapham (1944, vol.2, p. 70) and Feavearyear (pp.221-22) report that the Bank opposed the legislation which actu-ally compelled it to resume specie payments.

45For a history of the early years of Scottish banking, seeCheckland (1975) or White (1984). For a description oftheScottish land bank proposals and their fate, see Horsefield(1960), pp. 175-78, 215-16.

46The option clause has attracted a good deal of academicattention in recent years. See White (1984), pp. 25-30,141-42, Rockoff (1986) and Dowd (1988), for example.

475ee Checkland (1975), pp. 118-21; White (1984), pp. 29-30.The legislation originally proposed ruled out the option clauseonly; it was later amended to rule out any notes not redee-mable on demand.

to grant private liabilities.~’Apparently, thefailure of the English land bank schemes hadcreated a belief that inconvertible notes wouldbe accepted only if they were legal tender. Aswe shall see, this belief was also widespread inthe American colonies—where experience ulti-mately refuted it.

During the eighteenth and early nineteenthcenturies, Scottish banking was considerablymore competitive than English banking. Themajor banks fought bitter “note duels,” present-ing their competitors’ notes for payment in aneffort to drain their specie reserves and forcethem to retrench. One defensive response tothese duels was the issuance by Scottish banksof notes which contained an “option clause—aclause that granted them the right to deferspecie payments for a fixed period in return forlegal interest.~°

Experiments like the option clause might wellhave led to further departures from convertibili-ty in Scotland, where both the public and thegovernment were more comfortable with banksand paper currency than their counterparts inEngland. During the financially troubled yearsof the early I760s, however, the option clauseand other “irregular” Scottish banking practicesattracted unfavorable attention in England(whose Parliament had absorbed that of Scot-

land in 1707). ln 1765 the British Parliament

stepped in with an act prohibiting notes con-taining an option clause, or any other depar-tures from strict convertibility.~’

Colonial Origins

Synopsis: The American colonies experimentedwith a variety of currency systems based oninconvertible notes issued by colonial govern-ments. During the early eighteenth century theBritish government began to regulate these sys-tems. British regulation forced some of the col-onies to hack their notes more carefully, and

eventually prevented all the colonies from mak-ing their notes legal tender. By the end of thecolonial period many of the colonies had deve-loped successful and popular currency systems.These systems were based on inconvertiblenotes which were carefully hacked, and werenot legal tender.

Conditions in early colonial America dif-fered from those in England even moreprofoundly than did conditions in Scotland. Inthe colonies, the most pressing monetaryproblem was a specie shortage: the quantityof specie the colonists were able to retainseems to have been insufficient to meet their

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needs for a medium of exchange.~’During thelGSOs, the Massachusetts Bay Colony attemptedto allay the shortage by operating its own mint(which produced the renowned “Pine Tree Shill-ings”). The British government viewed this ac-tion as usurping a royal prerogative, however,and forced Massachusetts to close the mint.~’The colonies also experimented with commoditycurrencies of different types; these includedwampum (Indian beads), rice and tobacco.’°

Despite the public’s need for more convenientmeans of payment, the introduction of a newform of government paper currency was moti-vated in the first instance by the fiscal exigen-cies of a colonial government. In 1696, theMassachusetts legislature experienced greatdifficulty financing an expedition against theFrench in Canada. It decided to issue “bills ofcredit” in the form of paper currency to use topurchase supplies. These bills were neither con-vertible nor ultimately redeemable in specie;they could, however, be used to defray futuretax liabilities. This financing expedient provedquite successful, and the colony used it repeat-edly during the ensuing 50 years. Within a veryfew years, other colonies began to adopt thepractice—first in New England, and later else-where. By 1730 or so, bills of credit had becomethe principal currency of the American colonies.”

The earliest colonial bills were issued, likethese Massachusetts bills, in anticipation of fu-ture taxes. After a few years, however, certaincolonies began experimenting with bills thatwere issued on loan. Typically the issuing colo-ny would pass laws providing that relativelysmall sums in new bills could be lent to individ-uals who were able to provide land or othersorts of property as collateral. (Often theseloans were mortgage loans and were intendedin part to encourage the colonists to settle andimprove land.) These “loan office” or “land bank”

issues became increasingly popular during thefirst half of the eighteenth century.”

As previously indicated, the legislation auth-orizing the emission of tax anticipation or loanoffice bills was typically accompanied by legisla-tion providing for their eventual retirement—either by imposing future taxes which the billscould be used to pay, or setting out the termsaccording to which the loans would be securedand repaid. The legislators clearly believed thatit was these retirement commitments that con-veyed value to the bills.” Unfortunately, therewere often great political and financial incen-tives for the colonies to violate these commit-ments by declining to levy or collect the futuretaxes, by declining to collect the loan payments,or by stretching out the period over which loanscould be repaid. When these things happened,the bills would often depreciate in value relativeto specie and goods.’~The extent of the depreci-ation was typically measured by the discount onpaper currency relative to specie currency; thatis, by the difference, in percent, between unity(one) and a fraction equal to a given quantity ofspecie currency divided by the quantity ofpaper currency it could be sold for in the openmarket. If it took 50 shillings in paper currencyto purchase 40 shillings in specie currency, forinstance, then the discount on paper currencywas 20 percent. During the early decades of theeighteenth century, many colonial currencies ex-perienced significant depreciation. In some cases,the depreciation was quite severe.55

Currency depreciation became particularly con-troversial because most colonies gave their billsof credit the status of legal tender. Legal tenderlaws compelled creditors to accept bills at facevalue in payment of debts. If, for example, a loanagreement called for a repayment of 500 shillingsat the end of five years, the lender could beforced to accept 500 shillings in bills of credit,

48For discussions of the specie shortage, see Nettels (1934),pp. 202-207, and Brook (1975), pp. 1-9.

49See Felt (1839), Bullock (1900), Chapter III, Breckinridge(1903), pp. 55-56 and Nettels (1934). p. 276.

‘°Noneof these experiments proved particularly satisfactory.For a description of colonial experiments with commoditycurrency see Nettels (1934), chapter VIII, and Brock (1975),pp. 9-16.

“For an encyclopedic account of colonial currency history priorto 1764, see Brook (1975).

‘2For discussions of colonial land banking, see Davis (1900),Kemmerer (1939), Thayer (1953), Billias (1959), Brook (1975)and Smith (1984), among others.

5’Nettels (1934) writes that “In the opinion of the colonists, theprincipal factor affecting the specie value of their paper wasthe provision made for redeeming it from tax revenues”(pp. 257-58).

‘4For analyses of the link between backing and depreciation,see Smith (1984, 1985a, l9BSb) and Russell (1988).

55Data on the specie prices of the currencies of variousdifferent colonies are presented by Brook (1975) and Smith(1984, 1985a, 1985b), among others.

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even though he might prefer specie. The pen-alties for refusing to accept bills were relativelyharsh: the creditor might forfeit the entireamount of the debt or, in some cases, a multiplethereof.”

The original idea behind legal tender laws wasto protect borrowers, and to reduce the fre-quency of lawsuits, by providing a method ofrepayment which was beyond legal challenge.’~When unexpected depreciation occured, how-ever, legal tender laws tended to benefit debtofs(by reducing the real value of their obligations)at creditors’ expense. This made them popularwith farmers and other debtors, and unpopularwith creditor interests.

The creditor interests included a number ofBritish merchants who did business with thecolonies. Many of these merchants were well-connected in Great Britain; their complaints,which were seconded by those of indigenousmerchants and creditors, received sympatheticattention from the British colonial administration,and eventually from the British Parliament. After1730, the colonial administration began to issueregulations eliminating or restricting the right ofparticular colonies to issue new bills or (more fre-quently) to make them legal tender. As the prob-lem of depreciation worsened, however, Parlia-ment considered comprehensive legislation. TheCurrency Act of 1751 deprived the New Englandcolonies of the right to issue legal tender bills andgreatly restricted their powers to issue paper cur-rency of any description. In 1764, a second Cur-rency Act extended the legal tender prohibitionto all the colonies.”

“See Bullock (1900), p. 131, Nettels, (1934), p.265, andRussell (1988), pp. 47-48.

‘7See Breckinridge (1903), p. 52, and Hurst (1973), p. 40. West(1978) stresses the role of colonial paper currency inproviding a “means of settlement,” but does not mentionlegal tender laws explicitly.

“Even before the blanket legal tender prohibition, the Britishgovernment had intervened to prevent particular coloniesfrom making their currencies legal tender. It also intervenedto force some of the colonies to back their legal tender curren-cies more carefully with future tax receipts, and to preventothersfrom issuing currency on loan. See Davis (1900, vol. Iand II), Ferguson (1953), Ernst (1973), Brook (1975), Smith(1984,1 985b) and Russell (1988).

For the history of the Currency Acts, see Davis (1900),Greene and Jellison (1961), Ernst (1973), Brook (1975), Smith(1985) and Russell (1988).

“In 1767, Ben Franklin wrote that “On the whole, no methodhas hitherto been formed to establish a medium of trade, inlieu of money, equal, in all its advantages, to bills of credit,funded on sufficient taxes for discharging it, or on land secu-rity . -. and in the mean time made a GENERAL LEGALTENDER.” lFranklin (1971), p. 354; his emphasis.] Ferguson

Many colonies responded to the legal tenderprohibitions by issuing non-legal tender bills ofcredit. Although many contemporary analysts be-lieved that giving the bills legal tender status wasessential to preserve their value, this does notseem to have been the case in practice.” Thenon-tender bills remained quite stable in value—far more stable, in many cases, than their legaltender predecessors. This was particularly strik-ing because many non-tender issues took theform of land banks—a mode of issue the Britishregarded as particularly prone to depreciation.’°During the decade prior to the Revolution, thecolonies appeared to be moving toward a systemof non-legal tender land bank currency.”

Revolution and Reorganization

Synopsis: The Revolution completely disruptedthe evolution of the American currency system.The Continental Congress was forced to financewartime expenditures by money creation—a policywhich led to a virtual hyperinflation. ‘The war,and the depression that followed it, producedfinancial problems for both state governmentsand the general public. One symptom of theseproblems was large public and private debts—many of which were held by the domestic prop-ertied classes. This situation, combined with mem-ories of the recent inflation, created fears amongthe members of these classes that popularlyelected state governments would adopt monetarypolicies designed to partially repudiate these debts.Representatives of the propertied classes domi-nated the Constitutional convention. They moved

(1953) writes that “The restraining act of 1764 ... prohibitedlegal tender laws and required that existing legal tendercurrencies be sunk at their expiration dates. Many coloniesprotested, in the belief that the legal tender feature was anessential prop to their currency. Experience was to show,however, that the restriction did not materially impair theworkings of the currency system” (p. 177).

seFordiscussions of the strong performance of nontenderpaper currency, see Ernst (1973), Smith (1 984b) and Russell(1988),

“See Ferguson (1953), pp. 177-180. Inconvertible governmentcurrency which was not legal tender is of special historicalinterest because it was issued under circumstances thatapproximated relatively closely the circumstances underwhich inconvertible private currency might have been issued.This was especially true when, as was frequently the case,thecurrency was issued on loan rather than in anticipation oftaxes. Russell (1988) argues that the success of government,non-legal-tender, inconvertible land banking before the Revo-lution provides indirect evidence that private inconvertiblebanking might have been feasible after the Revolution, had itbeen legally permitted.

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to prevent repudiation by prohibiting the statesfrom issuing their own currency, or from makingprivately issued currency legal tender.

During the Revolutionary War, the ContinentalCongress was the American central government,and bore primary responsibility for conductingand coordinating the war effort. It also faced acritical financing problem: under the Articles ofConfederation, it lacked the power to levy taxes.(Colonial opposition to British taxation had beenone of the most important causes of the rebellion.)During the early stages of the Revolutionary War,the Congress attempted to subsist on voluntarycontributions from the colonies. When this sourceof revenue proved insufficient, it began to issuebills of credit—the renowned “continentals”—which were backed by little more than the pioushope that the states would eventually providefunds, or authorize tax levies, to retire them. Thelikelihood of such retirements became ever moredistant as the quantity of continentals increasedand the states supplemented them with their owncurrency issues. Both forms of paper currencybegan to depreciate—at first gradually, and latervery rapidly. By the end of the war, they werevirtually worthless.”

During the brief “critical period” between theend of the war (in 1783) and the tatification of theU.S. Constitution (in 1789), the newly independentstates began to reorganize their finances and con-sider the problem of providing a paper currency.A number of states issued or seriously consideredissuing hills of credit in anticipation of taxes or onloan—much in the manner of the prerevolutionarycolonies.”

Unfortunately, the continental hyperinflationhad fractured the prerevolutionary consensusregarding the usefulness of paper currency.People who had accepted continentals or contin-ental-denominated securities from government orprivate parties were outraged that the states ap-

peared to have no intention of redeeming them atanything close to the values at which they hadtraded during the early years of the war. Indeed,the propertied classes came toview paper currencyas a device by which popularly elected govern-ments sought to permit the common people toescape the burden of their public and privatedebts. (The lengthy trade depression that followedthe end of the war had increased private debtburdens.) Wealthy Americans became terrifiedthat the state legislatures, which wet-c now freefrom British restraint, would reprise the Revolu-tionary experience by issuing large volumes ofinadequately backed legal tender bills—bills whichwould rapidly depreciate, and which could beused to retire debts at a fraction of theirrealvalue.As a result, proposals to issue paper currency thatwould have received consensus support beforethe Revolution now became the subjects of intensepolitical controversy.’4

In Rhode Island, radical populists gained controlof the legislature. They confirmed the worst fearsof the anti-paper money conservatives by issuing alegal tender currency, and then engineering arapid inflation that seemed clearly designed toenable borrowers to escape their debts.” InMassachusetts, an agrarian insurrection (Shay’sRebellion) erupted as a result of the refusal of thelegislature to issue legal tender paper currency.”

As it happened, the Constitution was writtenand ratified during a period of conservativeascendancy— a reaction against excesses of thesort epitomized by events in Massachusetts andRhode Island.” The conservatives desired a “hard”cutrency immune from depreciation. As a result,the framers of the Constitution were not contentmerely to deprive the states of the right to issuelegal tendet bills; instead, they were prohibitedfrom issuing currency of any kind. Specie wasestablished as the new nation’s sole legal tendercurrency—and, in the minds of many, as thenation’s only legitimate currency.

“For a good account of the history of the Continentals, andindeed of Revolutionary War finance, see Ferguson (1961).See also Calomiris (1988).

“For general discussions of currency issues by (incipient)statesduring the critical period, see Nevins (1924), Ferguson(1961), Nettels (1962), Russell (1988) and Schweitzer (1989).

‘4For descriptions of public attitudes toward paper currencyduring the critical period, see Libby (1894), Hammond (1957)and Ferguson (1961).

“Most of the other colonies that issued legal tender bills alsoexperienced serious depreciation—though not on the scale of

Rhode Island, On the other hand, colonies that issuednontender bills experienced little or no depreciation. For adiscussion of this question, see Russell (1988). For descrtp-tions of Rhode Island’s post-revolutionary currency policy, seePhillips (1865), Bates (1898), Nevins (1924) and Ferguson(1961).

“The classic study of Shay’s Rebellion is Taylor (1954).“This point is made by Ferguson (1961), pp. 249-250, Nevins

(1924), p. 537, and Schweitzer (1989), pp. 319-320.

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Thus the peculiar historical circumstances ofthe post-revolutionary critical period had a pro-found and lasting impact on the nature of the U.S.monetary system. The trauma of the Revolutionmade the currency system controversial, and ulti-mately produced a system very different from therelatively uncontroversial system of late colonialtimes. Indeed, it seems likely that had the coloniesbeen able to escape British domination withoutfighting an expensive war, or had the principalcasus be//urn not been one which required that thewar be financed by means which sowed the seedsof a divisive struggle between classes, the UnitedStates might have begun its existence with a decen-tralized currency system based on (non-legal tend-er?) bills of credit issued by state governments.”

The Constitution was silent on the question ofprivately issued currency. Indeed, dum-ing theyears immediately following its ratification, issu-ance of small-denomination liabilities which mightcirculate as currency (which might “pass current,”to use the contemporary phrase) was regarded asa right of all free persons. By the second decade ofthe nineteenth century, however, the legislaturesof most of the states had acted to eliminate orgreatly restrict that right.” There were at least tworeasons for this. One was the problems caused byirresponsible, or downright fraudulent, privateissues. Another, which was perhaps more compel-ling, was the desire of the state legislatures to re-serve the right of note issue to state-charteredbanks -

The Constitution had also been silent regardingthe right of the states (or the federal government)to charterhanks of issue—perhaps because privatebanking had little history in the colonies. InMassachusetts, the most economically sophisti-cated colony, efforts to organize a private land

“Many historians believe that resentment over British efforts toregulate colonial currency practices played a major role instimulating the Revolution. [See Bullock (1900), pp. 56-59,Davis (1900), vol.1, chapter XXI, vol.2, pp. 256-61,Brock(1975), pp. 561-63, Billias (1959), p.42, and Ernst (1973), pp.359-60, for example.] This makes it seem very ironic that thecurrency restrictions the U.S. Constitution imposed on thestates were generally more restrictive than any the British hadever imposed. [One exception is that the states could charterprivate banks of issue, something the British had prohibitedthe colonies from doing. It is not completely clear that theframers actually intended to authorize state-charteredbanking, however (see below).l

“See Hammond (1957), pp. 27-29, 184-85 and Fenstermaker(1965a), pp. 21-22.

“Both these motives are mentioned by Hammond (1957), pp.27-29, 159-60, 184-85. See also Fenstermaker (1965a), pp.

bank along the lines of public land banks beganlate in the seventeenth century and persistedepisodically for the next five decades. The mercan-tile community was somewhat skeptical of landbanking, however, since it threatened to competewith their own lending activities. [Merchants inthe coastal cities provided a good deal of tradecredit to the merchants and farmers of theinterior.]In addition, the colonial authorities (both adminis-trative and legislative) were reluctant to give uptheir monopoly over paper currency—partly outof fear that a form of money issued outside of offi-cial control might be subject to manipulation, andpartly out of concern that it might reduce poten-tial revenues from seigniorage. Although variousprivate land bank projects received considerablepopular support, they were unable to surmountthis political opposition.”

By 1740, however, the restrictions on colonialissues which had been imposed by the Britishgovernment had become so onerous (land bankissues, in particular, had been entirely pmohibited)that the Massachusetts legislature was willing tocharter a private land bank. While the land bankproject received broad support from the public, itwas vehemently opposed by the colony’s governor(a creature of the British), who viewed it as weak-ening the mother country’s control over the colony’seconomy. The land bank was also opposed byBritish merchants, who saw it as a threat to theirnear monopoly over trade credit. Both groups ap-pealed for relief to Parliament, which responded byenacting legislation prohibiting the establishmentof banking corporations anywhere in the colonies)”

The legislatures of the newly independent statessaw chartered banking as a means by which theycould provide their citizens with paper currencywhile at the same time (in many cases) providing

15-16. The importance of the latter motive is indicated byHammond’s comment that restrictions on unincorporatednote issue were enacted “on the complaint of charteredbanks” (p. 184).

‘1ln 1714 there was a well-organized and determined attempt toorganize a private land bank—an attempt which wassupported by some influential British merchants, andreceived the endorsement of the Board of Trade. The govern-ment of Massachusetts responded by establishing a publicland bank. See Billias (1959), pp. 3-5, Nettels (1934), pp.271-275, Davis (1900), volume I, pp. 56-61,volume II, pp.82-91, Ernst (1973), pp. 27-28, and Metz (1945), chapters 3,4.

“See Billias (1959), Davis (1900), volume II, pp.130-261,Hammond (1957), pp. 24-25. Brock (1975), pp. 123-27, Ernst(1973), pp. 34-35, and Metz (1945), chapter 10.

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themselves with revenue. Of course bank charterswould be more valuable to their holders, and thusissuing charters would be more lucrative for thestates, if the charters conveyed an e,vclusive right toissue paper currency. This accounts for the prohi-bitions against private issues from other sources.”

But what sort of banks should the states charter?While it might seem that the colonies’ extensiveexperience with public land banks should have ledthem, as states, to charter private land banks, theydid not in fact do so. Two factors may help explainthis situation. The first is that the right of the statesto charter banks of any sort was not altogetherclear; indeed, the view that they did not have thisright was widely held.’~Doubts about state charterrights seem to have existed on two levels. Many,and perhaps most, informed Americans believedthat the Constitution established specie as the onlylegitimate form of “money.” The question thenbecame “What is ‘money’?” and, in particular, “Arehank notes ‘money?” A conservative viewwas thatthe categom’y “money” did include bank notes, andindeed paper bills of all descriptions, so that papercurrency in any form was proscribed. A moremoderate view was that bank notes convertible inspeciewere not money, hut merely its “representa-tive,” and thus were not constitutionally prohibi-ted.” ‘T’his view implied that private land bankingconducted along colonial lines, which is to saythrough the issuance of inconvertible notes, in-volved direct creation of money, and was there-fore unconstitutional—even if the bills were notlegal tender.”

A second possible reason why the states did notopt for some form of land banking was that, given

their British-imposed lack of experience withprivate banking, their only models for bankcharters were those of British banks—whichmeant, for all intents and purposes, the charter ofthe Bank of England. Indeed, the charters of manyof the earliest state banks were virtual carboncopies of the Bank of England’s charter. Theattractiveness of the British model may have beenenhanced when, shortly after the Constitutionwas ratified, the Federal government decided toseek a charter for a single “National Bank” along

the lines of the Bank of England. This institutionwas called the “Bank of the United States,” andwas established in 1791 with a 20-year charter.‘rhough the U.S. Bank was basically a privateorganization, the Feder’al government held aminority interest, and the Bank was expected to

provide a variety of financial services for thegovernment in addition to its private lendingactivities.” The early state banks seem to havebeen intended as state versions of the U.S. Bank.This is reflected in the fact that until the charter ofthe U.S. Bank expired in 1811, most states char-tered just one or, at most, a handful of banks.”

The failure of the first U.S. Bank to secure a newchartet was due to a combination of doubts aboutits constitutionality, suspicion of its power, anddiscomfort with the fact that much of its stockwas foreign-owned.” The demise of the bank

coincided with a period of national economicexpansion associated partly with the impact ofthe Napoleonic Wars on commodity prices, andpartly with the settlement of the western(trans-Appalachian) region. Across the UnitedStates, and particularly in the new statesand

“The motives (and actions) of the states in this regard weresimilar to those of any license-granting monopolist. Thestrategy was evidently based on the British example. Duringthe eighteenth century, the British government had repeat-edly extracted largepayments. or loans on favorable terms,from the Bank of England in return for extending or strength-ening its monopoly on note issue- A distinctively Americanvariant of this strategy was for a state government to require abank’s organizers to cede the state an equity interest inreturn for granting the bank a charter. Sometimes the interestwas ceded gratis, and sometimes merely on favorable terms.This practice was particularly common in the southeasternstates. In several of these states bank dividends accountedfor a substantial portion of state government revenues. [SeeFenstermaker (1 965a), pp. 17-20. For a thorough analysis ofthe importance of dividends from bank stock in state govern-ment finance during this period, see Sylla, Legler and Wallis(1987).]

‘4For a general description of the nature and source of doubtsabout the constitutionality of state banks see Hammond

(1957), pp. 103-13, 564-71,and Hurst (1973), pp. 11-12,141 -45.

“See Hammond (1957), pp.61,105-06, Gallatin (1879), pp.254-55, (1879), p. 379, Bancroft(1831), p.40.

“The relatively radical view that private or even public landbanking was consistent with the Constitution, so long as thestates did not try to make the notes of such institutions legaltender (or even, perhaps. if they did), did not become popularuntil the economically troubled period following the Panic of1819.

“Forthe history of the first U.S. Bank, see Holdsworth (1910).“For information concerning state banks chartered before

1819, see Fenstermaker (1965b).“See Hammond (1957), pp. 209-26, and Holdsworth (1910).

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territoriesofthe West and South, banks werechartered in large numbers.” These newbanksdiffered from the established banks in one crit-ical respect: they were organized primarily toprovide credit to farmers.”

Economic Depression and ItsConsequences

Synopsis: The lengthy and severe depressionthat followed the Panic of 1819 placed great strainson the U.S. banking and currency system. Thecrisis exposedabasicinconsistency between twogoals of the developing banking system: specieconvertibility of bank currency, on one hand, andliberal extension of farm credit, on the other.Many of the southern and western states, in whichfarmerspredominated, responded by experi-menting with systems in which banks issued in-convertible notes. While some of these systemswere clearly not viable, others appear to havehad promise. The federally chartered Bank of theUnited States intervened to put an end to all ofthem, however.

At this point in U.S. history, a conflict arose be-tween the needs of economic development and thedevotion to “hard money” which gi-ew out of theRevolution. Economists since the time of Adam Smithhad understood that banks which issued convertiblenotes, and thus were vulnerable to i-uns, could notsafely lend to farmers: farm loans were typically longtertn, illiquid and relatively risky.” The need forfarm credit was sufficiently great, and public under-standing of banking sufficiently slight, however, thatthe legislatures of the southern and western states

“At the time, the western region included western Pennsyl-vania, Ohio, Kentucky, Tennessee, Indiana, Illinois andMissouri. (The following account applies most closely tothe experience of the last five states listed.) The southernregion included Virginia, North Carolina, South Carolina,Georgia and Alabama. (The following account applies mostclosely to the experience of North Carolina, South Carolinaand Georgia.)

For information concerning state banks chartered before1837 see Fenstermaker (1965a).

“For a discussion of the development of agricultural (andother types of long-term) banking see Hammond (1934),Hammond (1957), pp. 676-80, and Redlich (1951), vol. 1,pp. 11-13, 44-45.

“Many farm loans were seasonal loans to finance plantingor harvesting the crop. Variation in weather conditions andcrop prices could make such loans quite risky, and bycontemporary commercial standards they were relativelylong term. However, a good deal of farm credit involvedmuch longer-term loans to finance the purchase andlorclearing of land, the purchase of equipment (and in theSouth, slaves), etc. Most loans for these purposes were“accommodation loans.” An accommodation loan did not

permitted (and indeed encouraged) their banks tofinance large quantities of farm credit by issuingconvertible notes.”

The collapse in agricultural prices which occurredduring 1818-19 (and led to the Panic of 1819) madethe two mandates of the southern and westernbanks—prompt specie redemption of notes, andliberal extension of farm credit—impossible to recon-cile.” The price collapse produced widespread loandefaults and runs on banks. Since agricultural loanswere impossible either to collect or to sell in a shorttime, the runs could he stopped only by suspendingspeciepayrnents—b~refusing to redeem bank notesin specie on demand. Even after the runs subsided,however, the defaults represented tremendous lossesfor the stockholders of banks that wet-c willing, orcould be compelled, to honor their convertibilitycommitments. Indeed, a lam’ge numbem’ of westernbanks had become insolvent.” The managers of thesouthern and western banks responded by decliningto resume payments, and theij notes continued toti-ade at substantial discounts in the open mam’ket.‘I’he holders of these notes were forced, in effect, tohear some of the financial losses associated with thel’anic -

The governments of the western and southernstates responded to this situation in very differentways. Most western states had banking systemscomposed of large numbers of relatively small banks.Since the losses associated with the price collapseand Panic were particularly heavy in the West, mostwestern banks were insolvent, or nearly so; theirnotes were trading far below pam’. Many westernersviewed the events of 1818-19 as a conspiracY on thepart of the “monied interests” to ruin them and seize

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have a fixed term; the borrower was expected to pay an“installment” equal to a fixed fraction of the principal (typi-cally, 10 percent) every 90 days. In practice, installmentscould be deferred andlor reduced, so that the lifespan ofan accommodation loan could greatly exceed the term im-plied by these conditions. Crop loans might also be ex-tended as accommodation loans, with the presumptionthat they would be fully repaid at the end of the season.Very often adverse circumstances made this impossible,however. See Fenstermaker (1965a), pp. 47-49, Redlich(1951), volume I, p. Il, Holder (1937), pp. 119-22, andRussell (1989a), pp. 69-73.

“See Hammond (1957), pp. 178-83, Redlich (1951), pp.9-12.

“For descriptions of and data on the price collapse. seeCole (1938), Berry (1943), Smith (1953) and Russell(1989c).

“A list of the banks which failed during or shortly after thePanic can be compiled from information presented by Fen-stermaker (1965a). Berry (1943) provides information con-cerning bank failures in Ohio during this period.II

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their property. The banks, they believed, hadbeen agents of this conspiracy. Consequently,the western legislatures moved to revoke theircharters anchor to force them to liquidate. Pri-vate banks were replaced by monolithic, state-managed organizations called “Banks of the State”or “relief banks.” They were supposed to lendinconvertible notes which would be given quasi.legal tender status by their states.”

The history of the relief banks was brief, con-troversial, and generally undistinguished. Sincetheir mandate was to lend liberally to financiallydistressed farmers, the market value of theirloan portfolios was low relative to the nominalvalue of their outstanding notes. This circum-stance was reflected in the deep discounts onthe notes.” The lending standards of the tllinoisrelief bank were so lax, and its efforts at collec-tion so ineffectual, that its notes soon becamevirtually worthless.”

Both the legislation that created the reliefbanks and the “stay laws” which made theirnotes quasi-legal tender were of doubtful con-stitutionality. These laws were challenged vig’orously in state and federal courts. In Kentucky,Tennessee and Missouri, these challenges ulti-mately led to the demise of the relief banks.

Some of the federal court challenges were or-chestrated by the second Bank of the UnitedStates. In 1816, Congress had responded to fi-nancial problems created by the War of 1812by chartering a second U.S. Bank. The newbank was (again) a private institution, thoughthe federal government held a sizable minorityinterest. ‘the term of its charter was 20 years.”

The U.S. Bank’s charter required its notes tobe strictly convertible. The Bank’s managementbelieved that it could circulate convertible notesin the west and south only if the notes of its lo-cal competitors were also convertible. The man-agement also believed that acquiring a largelocal circulation was essential if the Bank were

to earn a profit on its southern and westernoperations, or effectively perform its duties asthe payments agent of the federal government.”The Bank consequently made strenuous effortsto force the western banks to return to thespecie standard. This policy allowed it to extendthe scope of its activities in the West, whilestriking a pose as the defender of sound curren-cy. In the meantime, bitter political controversyover the redistributive implications of the activi-ties of the Banks of the State greatly reducedtheir effectiveness.”

In many ways, the relief banks were directdescendants of the public land banks that hadbeen quite successful, and had enjoyed consen~sus public support, during the years precedingthe Revolution. Unfortunately, the extraordinari-ly adverse economic circumstances which ledthe western states to circumvent the Constitu-tion by creating these institutions also served toensure their ultimate demise. The relief bankswere created by the state legislatures for thepurpose of relieving the financial plight of theirconstituents, rather than to provide a soundcurrency, or to earn revenue (which is to sayprofits) for the states.” This mandate, combinedwith the depth of the agrarian distress, made itimpossible for the banks’ managers to resistmaking too many loans to troubled farmers—who were already burdened with debt andwhose ability to repay was very doubtful. Thesame circumstances led the states to supplementthe relief bank legislation with stay laws andrelated provisions. These provisions made thebanks extremely controversial, earning them theenmity of creditor interests in general and thepowerful United States Bank in particular.

The failure of the relief bank experiment hadan effect on public attitudes toward monetaryissues that was reminiscent of public reaction tothe Revolutionary hyperinflation. People becameincreasingly suspicious of banks and paper’ cur-

“The best available account of the Panic and its aftermathis Rothbard (1962).

The legislatures of these states enacted “stay laws”which provided that foreclosures and other legal actionsfor the collection of delinquent debts (“executions,” to usethe contemporary description) could be delayed for longperiods—typically a year or more—unless the creditors inquestion were willing to accept Bank of the State notes atpar. See Rothbard (1962), chapters II, Ill.

~ on the discounts on the notes of the Kentucky reliefbank are available from Berry (1943) and Sumner (1896).Fenstermaker (1965a) presents somewhat less complete in-formation on the discounts on other relief bank currencies.

“See Rothbard (1962), pp. 41-42, 80-83; see also Dowrie(1913).

“See Catterall (1902), chapter I.“See Catterall (1902), pp. 96-99. Redlich (1951), pp. 109-10,

124, 128-29, 440-44, Temin (1969), p. 49, and Fraas(1974).

“For accounts of the demise of the relief systems, seeRothbard (1962), Chapter Ill, Hammond (1957). pp.282-285, and Sumner 0896).

“See Fenstermaker (1965a), pp. 26~27,Rothbard (1962),pp. Bl~B3.85-86, 102-03, and Sumner (1896).

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rency, and increasingly enamored with “hardmoney—specie, or bank notes rigidly convert-ible into specie. The demise of the relief banksalso gave the Bank of the United Slates a virtualmonopoly over banking in much of the West.

The southern states tried a different—and ini-tially, at least, more promising—experimentwith inconvertible banking. The southern banks,unlike their western counterparts, were largebut few in number; frequently, they operatedbranches across their respective states. Thesouthern state governments held large minorityinterests in these banks. Since the dividends onthe shares provided an important source ofstate revenue, the state legislatures had nodesire to see the banks close down.” In addi-tion, since the financial distress that accompa~nied the Panic was less severe in the South thanin the West, the popular outcry against thebanks was somewhat less strident there. Finally,because of their large size and branch systems,the banks of the region were more effectivelydiversified than their western counterparts, andrequirements imposed by their charters hadkept them relatively highly capitalized.

When the southern banks suspended the con-vertibility of their notes, the governments of thesouthern states did not force them to liquidate,or even to close down. Instead, the banks werepermitted, and often encouraged, to continue todo business—lending, collecting on loans, andconducting other financial transactions, allthrough the medium of their now-inconvertible

“See note 73 above.“’For a description of banking in North Carolina after the

suspension, see Russell (19B9a).“Note discount data for North and South Carolina state banks

during 1817-1 829 are provided by Russell (19B9a). Fenster-maker (1 965a) provides less complete data for all thesouthern states.

“For expressions of this view see Gouge (1833), Sumner(1896) and Klein (1974).

“Before thesuspensions, the notes of southern state bankshad traded at or near par with specie; afterwards, they tradedat variable discounts. Thus it seems clear that the suspen-sions exposed noteholders to risks they had not previouslyborne. The author believes that after the suspensions, themarket priced bank notes in much the same manner asmodern mutual fund shares. This sort of pricing schemewould have linked the value of a bank’s notes to the value ofits assets—a link which was absent under convertibility. [SeeRussell (I9B9b,c).l Other theories of inconvertible noteprtcing have broadly similar implications, however. The mostpopular alternative theory is that the notes of a suspendedbank were priced as risky titles to future specie, payable ifand when the issuing bank resumed payments. Since thestate of a bank’s portfolio was probably the biggest singlefactor influencing the prospect that it would be able to re-

notes.”’ These notes dropped to variable discounts(against specie) in the open market. Variation inthese discounts seem to have reflected changingmarket conditions—much like the variation inmodern national currency exchange rates.”

Economic historians have usually viewed thesuspensions as irregular events completely in-consistent with the maintenance of monetaryand financial stability.” There are good practi-cal and theoretical arguments against this view,however. On a practical level, the banks stayedin business, and continued to supply badly neededcurrency and credit, despite the depressed condi-tions created by the collapse in prices and thefinancial panic. This situation stands in markedcontrast to that of the West. There, the bankingsystem collapsed, and a scarcity of currencyand credit threatened to bring economic activityto a standstill.

On a theoretical level, the suspensions shiftedsome of the burden of the banks’ portfolio riskfrom shareholders to noteholders.” The pricecollapse and panic had revealed the true extentof the risks the banks faced, and had exacer-bated the already acute scarcity of financialcapital—particularly concentrated financial capi-tal—in the relatively undeveloped southernstates.” Under these circumstances, it seemsdoubtful that current or future bank shareholderswould have been willing to continue to bear allof the banks’ portfolio risk—particularly in lightof the heavy losses that a prompt return tospecie pa~rnentswould have imposed.”

sume, this theory also implies that the holders of inconvertiblebank notes were bearing portfolio risk. And because all of theportfolio risk had to be borne by the holders of the banks’liabilities, any risk borne by noteholders reduced the riskbornby shareholders (and vice-versa).

Another alternative theory is that bank notes traded at adiscount during suspension because holders’ inability toconvert them into specie temporarily reduced their useful-ness, relative to specie, as media of exchange. Advocates ofthis theory typically view suspensions as a sort of “safetyvalve” protecting fractional reserve banking systems oper-ating under /a/ssez-faire—operating without, that is, govern-ment deposit insurance and/or a government lender of lastresort. For expressionsof this view see Friedman andSchwartz (1963), pp. 163-68, 324-32, and Dwyer and Gilbert(1989).

“The charters of contemporary banks specified minimumdenominations for shares which were usually well out ofreach of the common people. The rationale behind theseminima is not entirely clear. See Russell (1989a), pp. 35-36.

“The North Carolina banks, in particular, decided to closedown when specie payments were finally imposed on them in1828-1829. See Russell (1989a), pp. 25-32, 78-80, Holder(1937), pp. 250-51, and Flanagan (1934).

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A case can be made that the post-Panic suspen-sions began a process which, had it been allowedto proceed unhindered, might have enabled theSouth to develop an alternative banking systemwhich was peculiarly suited to its distinctive needs.Because the southern economy was dominated byagriculture, banks could be useful to southerneconomic development only if they were able tomake farm loans in large volumes. Farm loans,however, were relatively risky—and under con-vertibility, these risks were borne almost exclu-sively by bank stockholders. These stockholdershad both the opportunity and the means to lendoutside the South, and could be induced to takethese large risks only in return for high averagerates of return. Such rates would have made bankcredit too expensive for many farmers—and usurylaws might have prevented the banks from chargingthem in any case. One solution to this problem wasthe development of an alternative banking systemwhich could bring the diffuse financial capital ofthe common people into the risk-bearing process.Inconvertible private banking seems to have hadthe potential to provide such a system.”

Unfortunately for the southern banks, both thefederal government and its financial agent, theBank of the United States, regarded the suspen-sions with almost unalloyed hostility. The U.S.‘treasury Department was deeply (and somewhatirrationally, under the cir-cumstances) committedto fiscal arrangements under which payments tothe federal government (for taxes, land purchases,etc.) were made exclusively in par currency.”Southerners, however, were used to makinggovernment payments in local (bank) currency,which was no longer trading at par. The Bank ofthe United States, which was charged with the

responsibility of receiving and clearing the pay-ments, found itself wedged very uncomfortably inbetween. If the Bank accepted discounted statebank notes at par for government payments, theTreasury would insist that it clear them at par,and the Bank would take large exchange losses. Ifit did not accept state bank notes at all, it would atthe very least offend the people of the South—aregion where it greatly desired to extend its busi-ness—and might well materially increase theireconomic troubles. The Bank would also offendthe Treasury, its patron, which wished to ensurethat federal payments could be made in currencyreadily available to the public.” Finally, if theBank accepted state bank notes at their marketrates of discount, it would be accepting a situationwhich, it believed, prevented it from operatingprofitably and effectively in the region.”

The Bank’s problems would have been solved ifthe southern banks had resumed specie paymentspromptly after the Panic. When they did not, itlaunched a campaign to force them to do so. Itcontinued to accept discounted state bank notes inpayment of federal debts and, when it had accu-mulated them in large quantities, presented themat the counters of the state banks for payment.When the southern banks refused to pay, the U.S.Bank filed suit against them in federal court.”’

While the suspensions had no formal legal validi-ty—in principle, each bank note was redeemable atpar and on demand, and a hank which declined toredeem its notes had defaulted on its debts—theywere implicitly (and sometimes explicifly) toleratedby state legislatures and courts. The U.S. Bank, how-ever, was in a position to sue infederal courts, whichprovided the state banks no such protection.”

“This argument is presented in detail in Russell (1989a,b).

“It seems likely that the exchange problems described herecould have been avoided if the Treasury had been willingto accept and disburse state bank notes at their marketrates of discount. A similar situation had arisen after thegeneral suspension, of specie payments which occurred inAugust of 1814, near the end of the War of 1812. Duringthe months after the suspension, the Treasury neededfunds to service debt held by residents of New England.New England was the only region of the United States inwhich the banks had not suspended specie payments, soNew England bank notes were trading at par with specie.Unfortunately, most of the federal government’s revenuewas received in the mid-Atlantic region. The mid-Atlanticbanks had suspended, and their notes were trading wellbelow par. The Treasury insisted on accepting local cur-rency at par in payments to the federal government, andon disbursing such currency only where it would be ac-cepted at par. This forced it into temporary default on itsdebt service payments, despite its large balances of mid-Atlantic bank notes. See Catterall (1902),pp. 4-7, and Ban-croft (1831), pp. 47-49.

“2For a general description of the U.S. Bank’s problems asa federal collection and clearing agent, see Catterall(1902). For accounts of its disputes with the banks of Ge-orgia and North Carolina, see Govan (1937), Heath (1954),Holder (1937) and Russell (1989a). These accounts arebased on correspondence between the U.S. Bank, theTreasury Department, and the state banks that is recordedin the American State Papers, Finance, Volume 4.

“See note 90 above.“’Govan (1937) and Russell (l9B9a) describe federal court

suits filed by the U.S. Bank against state banks in Georgiaand North Carolina, respectively.

“See Hammond (1957), pp. 283-84, and Russell (1989a),pp. 42-43. The efforts of various southern and westernstates (notably Georgia) to evade adverse federal court de-cisions concerning the U.S. Bank were ultimately rejectedby the U.S. Supreme Court. See Catterall (1902), pp. 88-91,Govan (1937), and Hammond (1957), pp. 263-68, 272-73.

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The efforts of the U.S. Bank slowly forced thebanks of the various southern states to resumepayments: Virginia and South Carolina in 1823,Georgia in 1825, Alabama in 1827 and North Caro-lina in 1823. In view of the conventional wisdomregarding suspensions, it should come as no sur-prise that most economic historians have regardedthe Bank’s resumption campaign as virtuous andconstructive; the Bank is lauded, in particular, forhaving created a “uniform national currency.”Southern farmers, and other southerners whoselivelihood was based, directly or indirectly, onfarming—groups which collectively comprised thebulk of the region’s population—had less reason tosing the Bank’s praises. ‘the cost of resumption wasthat state banking systems (or those portions ofthem which survived) became reluctant to lend tofarmers. Since there were few alternative sourcesof credit available, farm loans became substan-tially more difficult to obtain.” It should thus beequally unsurprising that, just a few years later,the southern states were in the forefront of theopposition to the Bank’s efforts to secure a newcharter.”

A Bank War and the Rise of FreeBanking

Synopsis: The political controversy that led tothe demise of the Bank of the United States had aprofound effect on public attitudes toward thebanking and currency system. The Americanpublic became suspicious of any hint of monopolypower in banking and of any link between thefederal government and private banks. It alsobecame increasingly devoted to the concept ofhard money. One outgrowth of these attitudeswas that many states adopted laws providing for“Free Banking.” Free banking laws encouragedentry into banking, and resulted in the establish-ment of large numbers of banks. The free bankswere heavily regulated, however; their notes wereto be carefully secured, and strictly convertible.Other results of changed public attitudes were the“Specie Circular” and the “Independent Treasury.”The federal government became reluctant to accept

“See in particular Catterall (1902), Redlich (1951), Ham-mond (1957) and Temin (1969).

“For the case of North Carolina, see Russell (1989a), pp.71-74. In 1828, Georgia established the Central Bank, astate-owned institution designed to extend long-term loansto farmers and planters. Heath (1954) ascribes this deci-sion to a shortage of long-term commercial bank creditthat developed during the 1820s.

bank currency in payment, and attempted toconduct its financial operations without the aid ofbanks.

The election of 1828 transferred control overthe federal administration from the Whigs, led bydefeated President John Quincy Adams of Mas-sachusetts, to the Democrats, led by President-elect Andrew Jackson of Tennessee. The Demo-crats regarded themselves as the party of the com-mon (and thus largely agricultural) people; theyhad long been advocates of competitive, decentral-ized state banking and opponents of the Banks ofthe United States. The party also contained a hardmoney faction which was deeply suspicious ofbanking of any kind. Jackson himself seems tohave had somewhat ambiguous feelings towardbanking. On one hand, many of his principaladvisors were men who had defended the reliefbanks and bitterly resented the damage the U.S.Bank had done to the banks and people of thewestern states. Some of these men tvere now con-nected with the state banks, and thus tended toformulate policies which favored their interestsvls-a-vis those of the U.S. Bank. On the other hand,Jackson is said to have been personally opposed tobanking and paper currency of any sort; late in hisadministration he took actions that greatly in-creased the problems of the state bankingsystems.”

Jackson’s State of the Union message in 1829came out against the recharter of the UnitedStates Bank. (The Bank’s charter did not expireuntil 1836, but its friends in Congress had begunto agitate for an early recharter act.) Jacksonargued that the Bank’s constitutionality wasdoubtful, and that its concentrated financialpower was inconsistent with the tenets ofrepresentative democracy. Jackson’s messagemarks the beginning of the “Bank War,” a periodof five years or so during which the Whigs (whocontrolled Congress) attempted to defend theBank against the increasingly vituperative attacksof the Democratic administration. During thisperiod, the ‘Bank question” became the singlebiggest issue in national politics. The Democrats

“Catterall (1902), pp. 164-65, 235, Hoyt (1960) and Wilburn(1967), pp. 7-11, 17-19, descrtbe southern support for theBank War.

“For descriptions of Jackson’s attitude toward banking ingeneral, and the United States Bank in particular, see Cat-terall (1902), pp. 182-85, Schlesinger (1953), pp. 76-78,Redlich (1951), pp. 162-71, Hammond (1957), pp. 346-50,and Temin (1969), chapter 2.

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simultaneously exploited and encouraged publicfeeling against the banks so as to build up theirpolitical power base at the Whigs’ expense. AfterJackson was re-elected in 1832 the issue came to ahead; Congress passed legislation rechartering theBank, Jackson vetoed the legislation, and Congressfailed (narrowly) to override his veto. The secondU.S. Bank effectively ceased to exist as a nationalinstitution when its federal charter expired in1836; its relationship with the federal governmenthad been severed, and its power thus greatlyreduced, two years earlier.”

The demise of the U.S. Bank raised two impor-tant questions: how should the federal govern-ment administer its financial affairs, and howshould the states regulate their banking systems?The first question arose because the U.S. Bank hadacted as the financial agent for the U.S. Treasury—in other words, as the federal government’s bank.The second arose because the U.S. Bank no longerexisted to regulate the state banks and, in particu-lar, to enforce specie payments. By the second halfof the 1830s, Jacksonian hard-money notions hadbecome so pervasive that few people were pre-pared to accept a return to relatively laissez-faire banking, or to a currency which mightcome to consist largely of inconvertible banknotes. The effect of the Jackson Administra-tion’s anti-U.S. Bank campaign on a financiallyunsophisticated public had been to exacerbateits doubts about and suspicion of all banks andall paper currency.”

The Jackson and Van Buren Administrations[Martin Van Buren, who was elected president in1836, had been Jackson’s vice presidentl respondedto the first problem with two policy initiatives.The first was an executive order called the SpecieCircular, issued in 1838, shortly before Jacksonleft office. This order directed the U.S. Treasuryto accept no currency other than specie in pay-ment of debts to the federal government.” Thesecond policy initiative was the Independent Trea-sury Act, a product of the Van Buren Administra-

tion. This Act withdrew the U.S. government’scash deposits from the large state banks (some-times called pet banks) where they had been placed

after the demise of the U.S. Bank. Henceforth, theTreasury would act as its own banker. The neteffect of these two actions was profoundly anti-banking. The federal government would no longerdeal with the state banks, or encourage (or evenrecognize) their note circulation.”

The states’ response to the problem of bankregulation reflected two features of public atti-tudes towards banking which had grown out ofthe Bank War: suspicion of concentrated financialpower, and preference for “hard money.” Underthe bank chartering system that existed in moststates prior to the late 1830s, the issuance of acharter required a special act of the state legisla-ture. The process of securing legislative assentwas lengthy, cumbersome, uncertain and occa-sionally corrupt; in addition, banks that alreadypossessed charters generally lobbied vigorouslyagainst the issuance of new ones. The upshot wasthat most states had a relatively small number ofbanks, and that these banks possessed, or werebelieved to possess, considerable market power.”4

The “free” in the free banking laws reflected thedesire to reform the chartering process in thedirection of free entry. Each state would formu-late a standardized charter, and any individual orgroup which was able and willing to meet theterms of this charter could organize a bank in thatstate. The free banks would be regulated by thestate auditor, or by a state banking agency createdfor that purpose; the legislature would be involvedonly indirectly. This system was intended togreatly increase the number of state banks.”

There is another sense in which the term “freebanking” is a misnomer, however. Free bankingwas not in any sense laissez-faire or unregulatedbanking. The standardized charters imposednumerous and relatively stringent restrictions onthe banks’ capitalization and reserves, the condi-

“For accounts of the Bank War, see Catterall (1902), Ham-mond (1957) and Schlesinger (1953), among many others.

“‘Foradescription of the Loco Focos (formally, the EqualRights Party), a party of antibanking radicals which aroseduring the Bank War and was ultimately instrumental in therise of Free Banking and the Independent Treasury, seeRedlich (1951), pp. 188-90, Hammond (1957), pp. 493-99,and Schlesinger (1953), chapters XV-XVI.

“For analyses of the motivation behind, and/or the impact of,the Specie Circular, see Hammond (1957), pp. 455-57,Schlesinger (1953), pp. 129-31,Smith (1953), p. 185, Temin

(1969), pp. 120-28, Timberlake (1960) and Timberlake (1978),chapters.

‘“For discussions of the role of the Independent Treasury seeHammond (1957), pp. 542-45, Taus (1943) and Timberlake(1978), chapter 6.

“4See Hammond (1963), pp. 7-B, (1957), pp. 577-80, Redlich(1951), pp. 188-90, and Schlesinger (1953), p. 286.

“For discussions of the rationale behind Free Banking seeRedlich (1951), pp. 187-204, and Hammond (1957), pp.572-80.

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tions under which they could issue notes, and thetypes of assets they could hold. These restrictionswere designed, in the “hard money” spirit, to ensurethat the banks’ notes would alwaysbe convertibleon demand, and that they would be relativelyimmune from losses associated with declines inthe value of the banks’ assets. One restriction wasso common that it has come to be regarded ascharacteristic of free banking: the notes of thefree banks had to be 100 percent backed by hold-ings of state or federal government securities.”

Free banking experienced some problems, espe-cially during its early years. It seems in particularto have been characterized by a relatively highrate of bank failures. These failures, and a fewnotorious instances of fraud, have given the sys-tem a bad reputation among historians.” Therewere also many complaints that the need to keeptrack of the market values of the many differenttypes of bank notes in circulation—some of whichwere counterfeit or issued by failed or insolventbanks—materially reduced the effectiveness ofbank currency as a medium of exchange.”

Recent research has revealed that the losses tonoteholders associated with free bank failureswere actually quite small on average.” Ironicallyenough, many of the losses and failures that didoccur were caused by defaults on state govern-ment bonds, which were widespread during the1840s and 1850s.” Entrepreneurs responded tothe diversity of bank currencies by publishing“bank note reporters” in which the value ofdifferent bank currencies were recorded, insol-vent banks identified, and the appearance ofcommon counterfeits described.” The systemworked well enough that, until the Civil Warbroke out, there seems to have been little politicalsupport for any federally dominated alternative.Additional evidence that contemporary legislators

viewed free banking as viable is provided by thefact that new states continued to adopt freebanking laws through the early 1860s. Rockoff(1975) notes that “on the eve of the Civil War overhalf the states, including the most populous states,had free banking laws.”

The Civil War and the Demise ofState Bank Currency

Synopsis: The changes in the American cur-rency system produced by the Civil War werealmost as profound as those produced by the Rev-olutionary War. When the Civil War began, theU.S. had a relatively decentralized system in which

paper currency was issued by state-chartered and-regulated banks; the federal government had norole in the provision of paper money and thereseemed little prospect that it would acquire one.When the war ended, the nation had a relativelycentralized system in which paper currency wasissued by federally chartered and regulated banks;it was no longer possible for state banks to issuepaper money. In addition, the federal governmenthad acquired and used the power to issue papermoney and to make it legal tender. This huge,rapid transformation was possible for two rea-sons. First, the war produced a dramatic shift inthe balance of power between the major politicalparties, and between state and federal govern-ments. Second, the war produced an unprece-dented need for federal government revenue.

The demise of free banking, and more broadlyof the system of decentralized, state-regulatedprovision of currency, was caused less by anyproblems this system may have experienced thanby the outbreak of the U.S. Civil War. This extra-ordinary political event created a pair of peculiarcircumstances which helped determine the future

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“See Rockoff (1975), pp. 2, 81-87, and Rolnick and Weber(1984), (1988).

“For unsympathetic descriptions of the record of FreeBanking, or references to such descriptions, see Cagan(1963), pp. 19-21, Friedman (1960), p.6, Hammond (1957),pp. 723, 741-42, (1963), Rockoff (1975), pp. i-u, and Rolnickand Weber (1983).

“See Cagan (1963), pp. 19-20, Hammond (1957), pp. 722-23,(1963), p. 14, and Rockoff (1975), pp. 26-29.

“Rockoff (1975) and Rolnick and Weber (1983, 1988) use datadrawn from state auditors’ reports to provide careful esti-mates of the costs of free bank failures. Rockoff estimatesthat the total losses endured by free bank noteholders from1836 through 1860 were less than $2 million—about the cost,

in 1860, of a single year of 2 percent inflation. The estimatesprovided by Rolnick and Weber are slightly higher (see their1983 paper, p. 1089). Cagan (1963), by contrast, reports withapparent endorsement an estimate by Jay Cooke that thelosses were $50 million per year. Cagan’s use of this esti-mate in his influential article served to reinforce the conven-tional view that free banking was a national disaster.

‘2’See Rockoff (1975) and Rolnick and Weber(1982,1983,1984,1985,1988).

“See Hammond (1963), p. 14, Temin (1969), p. 50, andRockoff (1975), pp. 23-25.

“2Rockoff (1975), pp. 2-4.

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evolution of the U.S. currency and banking sys-tem. The first was that it gave the Republicanparty, the political successor of the old Whig party,almost complete control over the federal govern-ment. The majority of the Democratic congress-men and senators were southerners who abandonedtheir seats and defected to the Confederacy at theoutbreak of hostilities. Since the Republicans hadinherited from the Whigs a preference for mone-tary and financial centralization, while the Demo-crats remained the party of decentralization, thedefection of the Democrats greatly increased theprospects for centralizing change in the monetarysystem.

The second determining circumstance was thefederal government’s need for enormous newsources of revenue. Though taxes played somerole in Civil War finance, particularly in the war’slater years, it was clear almost from the beginningthat the bulk of the expenditure burden would bemet by borrowing.” As the war’s cost mounted,however, the federal government began to experi-ence difficulty obtaining the sums required on theopen securities market, and turned for assistanceto the large Eastern banks.”~Unfortunately, thesum required by the government far exceeded thebanks’ aggregate specie holdings; when the specieborrowed by the government failed for variousreason to return to the banks as rapidly as theyhad anticipated, they were forced to suspend spe-cie payments.” The suspension seemed to closeoff the possibility of further bank loans, leavingthe federal government desperate for new sourcesof funds and for new- - ays to increase the demandfor its debt.

One way in which the government might “bor-row” was by issuing paper currency. Early in 1882,at the urging of Secretary of the Tr-easury Salmon

P. Chase, Congress passed the fix-st Legal TenderAct. The Act authorized the Treasury Departmentto issue $300 million in paper currency.” Thiscurrency was not convertible in specie, nor re-deemable in specie at any fixed future date; it was,however, made legal tender in payment of publicand private debts.” Later in the war, consider-able additional quantities of these greenbackswere issued.

The Legal Tender Acts marked the first time in(post-revolutionary) U.S. history that the federalgovernment had issued fiat currency—currencywhich was entirely irredeemable, and was legaltender for private debts. The Constitution did notgive the federal government any explicit right toissue paper currency (fiat or otherwise), or tomake paper currency legal tender; indeed, it con-tained language which was widely interpreted asimplicitly denying the government these rights.”This made the legality of the Acts seem verydoubtful. In the event, however, no attempt tochallenge them managed to reach the SupremeCourt until several years after the Civil War hadended. There ensued one of the more bizarreepisodes in U.S. monetary history. Chase, who wasnow Chief Justice, voted with the court majorityto strike down legislation whose form he had ap-proved, and whose passage he had recommended,when he was Secretary of the Treasury! Thegreenbacks were saved when Congress, whichremained dominated by the Republicans, voted toincrease the number of Supreme Court justices bytwo; President Grant acted quickly to fill the re-sulting vacancies with judges who supported theActs’ constitutionality. The enlarged court voted5-4, with Chase dissenting, to uphold the Acts.”‘I’his decision set a precedent that was later usedto justify further steps on the part of the federalgovernment to regulate or control the currency

“For the government’s reluctance to raise taxes during theearly years of the war, see Mitchell (1903), pp.16-19, p. 37,pp. 72-73.

~ federalgovernment’s financing problems were greatlyexacerbated by its reluctance to sell its securities, which typi-cally returned interest at the rate of 6 percent of face value, ata discount—its reluctance, that is, to borrow at interest ratesin excess of 6 percent. See Mitchell (1903), pp. 48-50, 64-65.

‘2’For accounts of the suspension see Mitchell (1903), pp. 37-43and Hammond (1970), pp. 150-59.

“The provisions of the first and the two subsequent LegalTender Act(s) are summarized by Mitchell (1903), pp. 44-118.

“In 1875, 10 years after the end of the war, Congress enactedlegislation making the greenbacks convertible in specie,according to the prewar definition of the dollar, beginning in1879. This legislation became known, somewhat mislead-

ingly, as the ‘‘Resumption Act.” [The history and provisionsof the Resumption Act are summarized by Friedman andSchwartz (1963), pp. 44-50. See also Timberlake (1978),chapter 8.1

“For discussions of the constitutionality of legal tender federalcurrency, see Breckinridge (1903), pp. 114-37, Mitchell(1903), pp. 51-55, Hurst(1970), pp.182-86, Christainsen(1988), Timberlake (1989), (1991). chapters 8-10.

“See Breckinridge (1903), pp. 127-137, Friedman andSchwartz (1963), pp. 46-47, Mitchell (1903), pp. 71-74, andTimberlake (1989), (1991), chapter 9.

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system—notably, the creation of the FederalReserve System.

The greenbacks marked a change in the U.S.currency system which went beyond governmentissuance of currency. As has already been noted,the fiscal crisis of late 1861 caused the privatebanking system to suspend specie payments. Onearlier occasions when there had been a nationalor regional suspension, most of the survivingbanks had refused to redeem their notes in anyway until they could resume redeeming them inspecie on demand. The fact that the greenbackswere legal tender, however, gave bank debtorsthe legal right to use them to repay their debts.Since greenbacks began trading at substantialdiscounts shortly after they were first issued,moreover, debtors hastened to take advantage ofthis opportunity. The banks consequently felt enti-tled, and indeed compelled, to redeem their notesin greenbacks.”°Thereafter, the banking systemredeemed its notes and deposits almost exclusivelyin legal tender paper currency, regardless ofwhether it was convertible in specie. This ensuredthat goods and assets would be priced in legaltender paper—in other words, that governmentcurrency would replace specie as the nation’s unitof account.

Because neither Congress nor the Administra-tion was willing to risk a repetition of the Revolu-tionary hyperinflation, greenbacks could be usedto finance at most a small portion of the wartimedeficit.” The balance of the deficit had to befinanced by the issuance of conventional, interest-bearing debt.” Secretary Chase responded to thissituation by developing a strategy for monetaryreform which promised to simultaneously achieveboth cur’rency centralization and debt demandenhancement. This program, which was ultimate-ly embodied in the National Banking Act, calledfor the creation of a “National Banking System”(NBS)—a system of private, federally charteredbanks which would he nationally regulated ana-logues of the state-chartered “free banks.” The Actimposed reserve, capital, convertibility and otherrequirements that were generally similar to those

“See Mitchell (1903), pp. 144-49.“The limited financial resources of the southern states made it

difficult for the Confederate government to borrow largesums. As a result, it was forced to cover a very substantialfraction of its deficit through currency creation. This strategyultimately produced a hyperinflation. See Lerner (1956), andTimberlake (1978), pp. 102-03.

“Mitchell (1903), pp.119-al, discusses the reasons the federalgovernment issued no greenbacks from 1863 to the end ofthe Civil War.

imposed on the free banks. These requirementswere to be administered, and the national banksregulated, by a new federal agency called theOffice of the Comptroller of the Currency.” Forthe first time in U.S. history, the federal govern-ment had moved to create a system of privatebanks (rather than a single, centrally administeredprivate bank) under its direct regulatory control.

From the perspective of the currency system,the key features of the National Bank Act involvedthe notes the national banks were to issue. Thesenotes were to be printed by the Treasury Depart-ment and issued to the banks) rather than printedby the banks directly; they were to look entirelyuniform, except for an indication of the identity ofthe issuer. In order to obtain a given value of banknotes, a national bank had to deposit U.S. govern-ment securities of essentially equal value (stategovernment securities would not do) with theComptroller of the Currency. Thus, national banknotes were to be 100 percent backed by U.S. gov-ernment securities.

The requirement that the notes be backed byfederal government securities was designed tocreate a “captive” demand for federal debt on thepart of banks of issue. Since notes were the prin-cipal liabilities of contemporary banks, and sincethe framers of the Act evidently expected most ofthe state banks to apply for federal charters, therewas every reason to expect that the Act wouldforce the banking system to purchase Treasurysecurities in large quantities. This, it was hoped,would materially ease the federal government’sborrowing problems.”

Congress, anticipating heavy demand for nation-al bank notes, included provisions in the Act estab-lishing a maximum quantity which could beissued and allocating this quantity across thevarious regions.” Contrary to expectation, how-ever, during the year or so after the Act was passedthe number of charter applications was small,and the volume of U.S. bonds deposited as notebacking was far lower than anticipated. Congress

“For the history and provisions of the National Banking Act,see Redlich (1951), pp.99-113 and Hammond (1970),chapters 10-11.

“Discussions of the budgetary motivations for the NationalBanking Act can be found in Hammond (1957), p. 725,(1970), pp. 135-36, 286-95, and Mitchell (1903), pp. 37,44-45,103,109,

“5These provisions are summarized by Redlich (1951), p. 118,

I

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responded by amending the Act to impose a puni-tive tax on state bank notes—a tax rate sohigh (10percent) that it made note issue by state banksentirely unprofitable.” This decision eliminatedstate bank notes from circulation, and marked thefinal demise of state currency systems.

Of course, a system under which any currencythat was not issued directly by the federal govern-ment was printed by the federal government, fullybacked by U.S. Treasury securities, and issued inquantities and locations closely regulated by thegovernment, might be said to have differed verylittle from a system under which the federal gov-ernment directly issued all paper currency.”Indeed, it could be argued that the only reallysignificant differences between the NBS and adirect note issue system were that under the NBS,the government (1) had little short-run influenceover the total quantity of notes (which indeedproved relatively unresponsive to short-run influ-ences of any kind), and (2) assigned the responsi-bility for clearing the notes (and thus for ensuringtheir convertibility in specie) to the issuing banks.When 50 years of experience with the systemseemed to suggest that these features were seriousliabilities, the federal government used the broadmonetary powers it had acquired during the CivilWar to establish a system of direct issue—the Fed-eral Reserve System.

CONCLUDING REMARKS

The changes in the U.S. currency system thatresulted from the Legal Tender and National Bank-ing acts stand, along with the monetary clauses ofthe U.S. Constitution, as classic examples of casesin which the basic structure of the system wasstrongly influenced by extraordinary politicalevents with largely non-economic (or at least, non-monetary) causes. If, as we have seen, the Americancolonies could have obtained their independencefrom Great Britain without fighting a long, expensiveand divisive revolutionary war, the monetary his-tory of the next 90 years might have been verydifferent: historical evidence suggests that the

states might have retained the right to issue theirown currencies, and that these currencies mightnot have been convertible in specie. Subsequently,if the American states could have resolved theirsectional disputes without fighting a long, expen-sive and divisive civil war, the monetary history ofthe ensuing 50 years might also have been verydifferent: historical evidence suggests that thestates might have retained the right to charterbanks of issue, and that the federal government’srole in the U.S. currency system might haveremained relatively limited.

It should also be remembered that the federalgovernment chartered the second United StatesBank in response to financial dislocations associatedwith the War of 1812.”’ In the absence of SecondBank opposition, the inconvertible banking sys-tems that arose in the western and southern statesafter the Panic of 1819 might have survived andbecome entrenched; without a Second Bank forthe Jacksonians to fight, the “hard money” prin-ciples of the Free BankingEra might never havebecome popular. Here again a sequence of essen-tially political disputes played a key role in dictat-ing the evolution of U.S. currency arrangements.”

Currency System Evolution: AnAlternative View

As we have seen, U.S. monetary history hasbeen punctuated by a sequence of rather abrupttransitions from one currency system to anotherwith very different features. These transitions areoften interpreted as part of a process of Darwinianadvancement—a process, that is, through whichold and relatively inefficient systems were replacedby new and more efficient successors. The moderncurrency system emerged out of this process asthe most efficient system yet devised.

While this historical interpretation certainlysounds plausible, it is one that we should accept orreject on the basis of evidence concerning the rela-tive efficiency of past and present currency sys-tems. Unfortunately, the prestige of Darwinism

“See Friedman and Schwartz (1963), pp. 18-19, Hammond(1957), pp. 732-34, and Redlich (1951), p. 113.“This point is made by Friedman and Schwartz (1963), p. 21.“5ee note 89 above.“Redlich (1951) comments that had Secretary Chase

promoted the National Banking Act less vigorously, the early

ICivil War suspension also might have led to the developmentof a currency system based on inconvertible bank notes(p.95).

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Ihas become so great that economists tend toreverse the logical process by using the varioussystems’ orders in the historical sequence as thebasis fox’ efficiency comparisons. (If only the fittestsystems survive, then the systems that survived ateach stage must have been the fittest.) The disap-peararice of older systems is regarded as compel-ling evidence that they wem’e less efficient thantheir successors.

The claim that the currency system, if left toitself, tends to progress (slowly) in the direction ofgreater efficiency is not disputed in this article;indeed, several examples of this sort of progres-sion have been presented above. What the articlehas argued is that the U.S. currency system hasnot been left to itself, and that its evolution hasbeen anything but an orderly and inevitableprogression toward economic efficiency. Instead,it has been donunated by political decisions thatwere largely uninfluenced by efficiency consider-ations. Many of these decisions wem’e made inresponse to political pressures of a particularlyurgent sort—pressures gm’owing out of the U.S.government’s (and earlier, the British and/orcolonial governments’) involvement in prolongedand expensive wars.

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