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Paper Money Troubles
With coins, there is a limit to how much it can be debased. Moreover, there are only so many coins available to debase, especially since suspicious holders of the currency can opt to export or hoard their money. By contrast, nominal claims to the existing stock of goods can be printed at will with paper at, as already mentioned, virtually zero incremental cost. Not surprisingly, then, the history of paper money presents more than a few historical examples that casts the government in an even worse light than its management of coinage. While banknotes go back to seventh-century China and privately issued versions were used during the Renaissance period in Italy, government-issued paper money did not become a force in the Western world until the late seventeenth century in colonial North America. In 1685, the Intendant of New France—now the Canadian province of Quebec—dealt with a shortage of coins by putting his government’s stamp on playing cards, which were redeemable in hard currency once supplies arrived by ship from the mother country.
But the more groundbreaking move toward paper was made in 1690 by the colony of Massachusetts in issuing ?40,000 of bills of credit. Its government would occasionally send a military force to New France on self-financing missions to capture booty. After initially enjoying some successful expeditions, however, the Massachusetts soldiers were eventually rebuffed by the French Canadians. Despite this turn of events, the soldiers still demanded to be paid for their efforts. The governor sought to appease them by coming up with the expedient of paying them in paper carrying the promise of eventual redemption in precious metal specie. Justifying it on the grounds that paper issuance facilitated commerce by making up for the lack of coins, Massachusetts continued using paper money, and all the other colonies—Virginia being the latecomer—followed its example. With many of them, Rhode Island in particular, succumbing to the temptation to print money in lavish quantities, rampant inflation ensued. The paper soon traded at a large discount to the redemption value and Gresham’s law worked to further reduce the circulation of silver and gold. In Massachusetts, a paper shilling that was equivalent to 1/20th of a silver dollar in 1726 had declined 40 % to 1/50th of the latter’s value in 1750. By this same year, the paper shilling in freewheeling Rhode Island had collapsed to 1/150th of the silver dollar, on its way to becoming worthless 20 years later. Responding to pleas from creditors who were losing out in being repaid their loans with devalued money, Britain’s Parliament passed legislation in 1764 banning the issuance of paper as legal tender in all of the 13 colonies.
Keynesian revisionists of this history, such as John Kenneth Galbraith, have tended to downplay the inflationary consequences of America’s initial experiment with paper money. They argue instead that the injection of liquidity which that novel form of currency provided was critical in fueling the colonies’ growth. Among America’s founding fathers, all of whom had recently lived through the paper currency regime, the dominant assessment was decidedly opposite to that. Their views were echoed by William Gouge, about a generation after America’s founding, in his History of Paper Money and Banking: “From this account of the provincial paper money ... the reader may ... learn to estimate properly that provision of the United States Constitution, which forbids any State, ‘to emit bills of credit, pass any laws violating the obligation of contracts, or make any thing but gold and silver legal tender in the payment of debts’”.
The US constitutional provision to which Gouge is referring is Article 1, Sect. 10. If the reader is wondering how something other than gold and silver is now legal tender in the USA, it was not that the Constitution was subsequently amended. The relevant provision mandating precious metal as currency does not apply to the Federal Government. Nonetheless, that requirement is indicative of the belief, prevalent at the launch of America’s republic, that assigning monetary value to mere pieces of paper runs in tension with the principles of democracy. Elucidating the rationale underlying Article 1, Sect. 10 of the Constitution, James Madison wrote of the “pestilent effects of paper money” in No. 44 of The Federalist Papers, and how it undermines “the necessary confidence between man and man; on the necessary confidence in the public councils; on the industry and morals of the people, and on the character of Republican Government”.
Also influencing people’s monetary thinking at the time was the Mississippi scheme of 1716-1720. Indeed, this affair would resonate up until the early twentieth century in providing a cautionary warning against all proposals to institute a paper money regime. The leading character behind the Mississippi scheme was John Law, the Scottish-born author of a notable work on economic and monetary theory, but also a womanizing, bon vivant with a penchant for gambling. Having moved to London from his Scottish homeland, Law was drawn into a duel with Edward Wilson because of a dalliance with Elizabeth Villiers (the future Countess of Orkney). He killed Wilson and, consequently, was charged with murder—an allegation that was subsequently reduced to manslaughter upon conviction. While Wilson’s family appealed the case, Law managed to escape to Holland for a while, then returned to Scotland in an unsuccessful attempt to secure a pardon and convince politicians there to implement his economic ideas, before resuming his sojourn in Continental Europe, where he traveled from one city to another, studying the subject of finance by day and cavorting with Europe’s aristocratic elite in casinos by night. Among the individuals he befriended, while in Paris, was the Duke of Orleans, who would go on to assume power as the Regent of France during the minority of King Louis XV. The Duke was left with the herculean task of dealing with a gargantuan public debt bequeathed by Louis XIV, the result of the Sun King’s extravagant court and, more so, France’s numerous wars. Eager for potential solutions, and previously impressed by the financial expertise of his old gambling companion, the Duke deferred to Law when the latter presented himself at the court to pitch what came to be known as his “system”.
As complicated as Law’s system eventually turned out to be, the core idea behind it was rather simple: the economy needs more money in circulation than a precious metal standard can typically provide. “Domestick Trade”, Law wrote, “depends on the Money. A greater Quantity employes more People than a lesser Quantity. A limited Sum can only set a number of People to Work proportion’d to it, and ‘tis with little success Laws are made, for Employing the Poor or Idle in Countries where Money is scarce”. If this scarcity is ever to be overcome, money has to consist in something that, at the very least, retained its value over time. Otherwise, Law argued, people would lack confidence in it and it would not circulate sufficiently. Silver, the precious metal which Law focused upon, could not satisfy this requirement, being perpetually subject to increases in production that lowered its unit value. But land, precisely because it has a fixed supply, offers a more solid foundation for maintaining the value of a monetary unit. Obviously, parcels of land cannot be exchanged in ordinary transactions, so something must be employed to represent it—paper money was Law’s candidate for this role. No longer constrained by the vagaries of silver mining, paper money stood out to him as a more elastic currency that could be readily increased to meet the needs of the economy.
Fig. 2.2 Quantity of notes issued by Banque Royale, 1718-1720. Source: Larry Neal
Accordingly, Law’s first move in 1716 after winning the support of the Duke of Orleans was to establish the Banque Generale, a financial institution authorized to issue notes backed by the value of French land. The injection of liquidity worked to revive the economy, while furnishing the French government a currency that, by declaring it legal tender, it could borrow from the bank in order to pay its creditors. Law’s standing raised by this success, his bank was granted a royal charter in 1718 and suitably renamed as the Banque Royale. This entity soon merged with the Compagnie des Indes, or the Mississippi Company as it subsequently came to be called, whose most widely touted line of business consisted in its monopoly over trade in Louisiana. At the time, this was not the middling sized US state that we know today, but rather a French colony stretching down the middle portion of North America all the way from the lower Great Lakes to the Gulf of Mexico. Law was forced to hype Louisiana’s commercial promise because the government was treating the Banque Royale as a money-printing machine, heavily borrowing its notes to fund its outlays, in the process raising the supply of those notes well beyond what could be redeemed in specie (Fig. 2.2).
Law’s original idea of buttressing paper money with land turned out to be unworkable, it being cumbersome to specify and provide a tract of land in exchange for notes. His notes ended up being guaranteed by the monarch’s pledge to convert them into precious metal. To avoid a wave of such redemptions, confidence in the notes had to be maintained by keeping the Mississippi Company’s share price high—very much like a modern bank must pay heed to its share price in order to forestall any anxiety on the part of its bondholders and depositors.
Given Law’s reputation as a financial genius, the shares initially boomed, nay exploded upward. Demand was so strong that several share offerings were made without adversely impacting the price. Helping fuel demand was that the manufactured notes borrowed by the government were spent on goods and services, money which was then used by its recipients to buy Mississippi Company shares. The Banque Royale was also offering margin on stock purchases, that is, loans collateralized by the value of the shares.
Law’s system began to fall apart in 1720, however, when the Prince de Conti requested three wagons of notes to be exchanged for specie. After a complaint from Law, the Regent compelled the Prince to return two- thirds of the specie he had taken out of the bank. That set a few stock traders thinking that something was awry, leading them to convert their notes into gold and silver coins and to send those abroad. Fomenting doubts, too, was the news trickling in from America that Louisiana’s economic prospects were proving far less promising than advertised. As these trends gained momentum, the Mississippi Company shares underwent a spectacular drop, whose implications Law vainly sought to avoid by suspending the redemption rights of his bank’s notes, illegalizing the exportation of coins, and even compelling the public to bring all their precious metals to the bank. Eventually, the Banque Royale’s notes were officially devalued and Law, now a reviled man, had to slip out of France in December 1720. He eventually made his way to Venice where he died a pauper in 1729.
After its revolution 60 years later, the French would go on to suffer yet another debacle with paper money in the aftermath of its 1789 revolution. Echoing Law’s proposal of issuing a currency backed by land, the French National Assembly introduced the assignat, paper bearing a promise to be redeemed by the eventual sale of property which the revolutionary government had confiscated from the church. Being structured as an asset- backed bond, the assignat’s tie to land was given a more practicable form than anything that Law had managed to institute with his Banque Royale notes. The new regime found itself inundated with the giddy expectations that revolutions typically foster. At the same time, it had to manage the national debt bequeathed to it by the old monarchical order, a debt which it had decided against defaulting upon for fear of alienating the bond and money markets. Selling its newly acquired lands all at once to pay off the debt was also out of the question, as that would depress their value. So too, there was the regime uncertainty generated by the revolution and its course, during which the security of property rights was put under question by the confiscations of the very lands buttressing the assignats. In these circumstances, the willingness to buy property with hard currency was less than optimal to execute a successful sale of the lands. Consequently, the revolutionary government took advantage of the fact that the assignats quickly came to be exchanged as money. It seized the chance of adopting a mode of financing that did not require the explicit consent of the people: printing ever more assignats. From an initial run of 400 million livres in 1790, the government over the next five years went on to issue a total of 45.5 billion, the upshot of which is that the French state effectively arrogated an estimated 7 billion livres worth of resources at 1790 prices.55 Obviously, the assignats depreciated tremendously as a result both against gold and the wider array of goods and services (Fig. 2.3).56
This, in turn, ushered a hyperinflationary storm that the revolutionary government sought to quell with price controls and draconian laws requiring people to accept assignats at face value (Fig. 2.4).
Not until Napoleon took over the French state and instituted a gold- based system was monetary order finally restored to the country—not exactly an outcome by which democracy, then in the midst of making its grand reappearance in the world since its prior incarnation in Ancient Greece and Rome, could give a good first impression of its competence to handle monetary affairs.
Thus, at the dawn of liberal democracy in the eighteenth century, the historical record had sufficiently disclosed the fundamental contours of money’s relation to government. While hardly anyone doubted that
John Kenneth Galbraith, Money, 64-66; Florin Aftalion, The French Revolution: An Economic Interpretation, (Cambridge: Cambridge University Press, 1990), 68-85; 181-190.
Fig. 2.3 French assignats priced in gold livres, 1790-1796. Source: Centre for Financial Stability
Fig. 2.4 France cost of living index, 1790-1796. Source: Centre for Financial Stability
government had a necessary role to play in regulating the currency, the political and economic elites of the period mostly acknowledged the pitfalls and dangers of the state’s involvement in the monetary realm. It was widely understood that governments are apt to exploit their monopoly over the definition and creation of money to extract wealth for its own purposes at the expense of the community they are supposed to serve.
Nonetheless, they recognized how the economy could be enlivened by the injection of currency. The Scottish philosopher David Hume, who was widely read at the time, even recommended such injections on a periodic basis as a means of bolstering the economy, foreshadowing Milton Friedman’s call for regular annual percentage increases in the money supply. Still, the advantages of ample money were qualified by the awareness that the addition of liquidity could ultimately escalate out of control by fomenting exorbitant inflation and, as Law’s scheme so clearly evidenced, asset bubbles in the financial markets.
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