Will the Republic be Redeemed? Part Two
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The evolution of the role of the Federal Reserve as the U.S. central bank and how paper money came to be accepted as legal tender with a stable value, exchangeable into gold, can be traced to the first half of the 19th century.
From February 27, 1797 until May 1, 1821, England came perilously close to adopting the barbarous system of open deposit and exchange that the Americans had adopted six years earlier with its creation of the Bank of the United States. The U.S. Constitution and the Congressional laws establishing the Bank of the United States had allowed prices in dollars to be subject to continuous discounting against every means of payment. This anarchy of monetary exchange was not “the discount” that Dutch finance had brought to England as part of the Glorious Revolution. Bank note issuers in the New World were using the same discount mechanism that the Bank of England and other European note issuers had developed; for issuing their own notes in exchange for the borrower’s private bills of credit, they would charge a fee. The bill of credit would be valued in the exchange at a discount from its declared amount. The newly created American banks had gone far beyond that conventional discounting of private debt paper against officially licensed note issues. The Bank of the United States and the state-chartered banks were discounting all exchanges of both foreign and domestic paper currency, notes and coin, even the notes of the country’s new central bank. Nothing was automatically guaranteed by law to have the fixed value of its par denomination.
Parliament’s emergency Bank Restriction Act had escaped that folly; the Bank of England would not be obligated to exchange the notes for coin, but the Bank of England’s demand notes would continue to be lawfully valued at their stated denominations. As with the notes of the Federal Reserve Banks – current American legal tender – it was a criminal offense in 18th and 19th century England for anyone to refuse receipt of a Bank of England note as official currency and full and complete legal payment. However, during the quarter century when the Bank of England did not pay out gold coin for notes, the people in England had followed the Americans in using international pricing to create implied discounts for payments using the notes for which English law prohibited valuations at anything other than par. The English had become arbitrageurs of the pound sterling by calculating the differences between domestic prices for goods and services and those paid abroad and settled in gold and silver coin or bullion.
For many in Parliament and Congress the infuriating part of the colonials’ new system was its direct incorporation of discounting into banking operations that remained under a specie standard. There had been no suspension of exchange in the United States in 1797. American banks had complete freedom to discount their own note issues even as they remained legally required to exchange their demand notes for coin if the holder presented them to the issuer for payment. The American banks could offer fractional and post-dated IOUs that were not subject to any requirement of redemption and discount notes received on deposit, including their own and those of the Bank of the United States. Even as their laws insisted to the world that only coin was legal tender, the Americans practiced complete financial anarchy. Their system had no central financial authority that could exercise absolute sovereign power in defining the value of money; yet their phantom currency was freely exchanged in ever greater volumes.
A few financial heretics in England had asked why it remained necessary for the Bank of England’s notes to be exempt from discounting. If the American system worked and England had not only survived but gained financial power while in suspension, why not return to the gold standard and allow open deposit and discount? Henry Boase raised that question in 1811: If “the Bank were obliged to pay, that is to sell, bullion at the market price, (t)he convertibility of their notes into gold, or silver, at the will of the holder, would be thereby secured.” The answer from the majority in Parliament was that Boase and his fellow anti-bullionists failed to understand how a sovereign financial system must work. The point of having a central bank was to allow a country to escape having its credit determined by its reserves of precious metals. The goal was to have specie measured by the national currency, not the other way round. Throughout the 18th century the United Kingdom had been able to win both the trade and real wars against France by establishing the pound sterling as the denomination in which international money – weights of gold – was accounted. Even as the Royal Mint remained incapable of producing a pound sterling coin or any other coins in sufficient volume, the Bank of England had replaced the Bank of Amsterdam as the financial institution that set the price for the international unit of account. If the price of gold bullion and coin was to return to a fixed amount of pounds sterling, Parliament had to return the Bank of England to full redemption without allowing any American discounting.
Promising once again to exchange paper for coin on demand was not necessary to preserve the value of the Bank of England’s notes; their status as legal tender was already a certainty. Even without the promise of exchange, the law guaranteed that the bank’s printed pieces of paper were real money in England. The purpose of restoring the absolute equivalence of notes and coin was to establish once again that the world price of bullion was fixed by the Bank of England’s exchange rate. By setting the precious metal’s price in the denominations of the United Kingdom’s central bank notes, Parliament was also fixing the terms for the country’s foreign exchange and the interest payments on its own debts. The Bank of England would maintain a steady discount for the direct exchanges of its notes, and there would be no discounting at all against international currency. Under the certainties of a steady loan discount and a fixed value for foreign exchange, Manchester mill owners could lock in profit margins a year in advance. They could make their promises to pay a set price for next year’s cotton shipments that the cotton brokers and plantation owners in the American South were happy to accept because they, too, would know exactly what their net incomes would be. Neither party had to ask what the future price of English bank notes would be against the U.S. dollar.
The prices for cotton, cloth, iron and corn would change, of course; but no English or foreign buyer or seller would need to question the future value of the monetary unit of account. Even the sellers of gold – the international money – could accept, as a fact of commercial life, that an international price was a denomination set in pounds sterling. One did not need David Ricardo’s currency board to maintain gold’s fixed price by buying and selling bullion. Bullion would take the Bank of England’s price because, measured against the fluctuating supplies of gold from the new mines and existing inventory, the fixed quantity of the Bank of England’s note issues would make the paper pound the means of payment that was always in short supply. In a world that accepted a fixed price of gold measured by the Bank of England’s official paper, England’s debts would be sold both at home and abroad as the safest financial investments in the world. And, indeed, they were as long as the world wanted its credit in pounds.
Alexander Hamilton’s hope had been that the United States would emulate and eventually replace the United Kingdom and the world would come to price things in dollars. He assumed that the Bank of the United States would have to begin life following the path that England had taken. The Bank of the United States would be the New World’s goldsmith; all its paper would be warehouse receipts that were 100% guaranteed by bullion and coin reserves. As a believer in gold above all else, Thomas Jefferson was not even willing to go that far towards acknowledging the place of credit in the world. He wanted the United States to have an absolute gold standard without having any banks at all.
To both men’s shock and disappointment, this was not the financial system that Thomas Willing and George Washington would establish. Under their system of open exchange and discount there would be no sovereign protections against the unceasing fluctuation of bid and ask. Whether it was a pound or a dollar, if the monetary unit of account was a physical quantity of a precious metal, its price would fluctuate. Whether the promise of redemption was removed or restored, the supplies and demands for payment versus credit would fluctuate; so would the world’s supplies and demands for the metal. Since there was no way of escaping the anarchy of ever-changing expectation, the United States did not need to establish a fixed dollar price for gold; it only had to avoid thinking that its government’s sovereignty could give it a permanent exemption from clearing its own promises to pay. The Constitution had given Congress the unlimited powers to tax, borrow and spend; as commander-in-chief, Washington knew better than anyone, those powers were necessary if the country was to be able to defend itself in war. Congress could be allowed to have those unlimited powers because the Constitution had imposed the one necessary restraint: money must be coined. It was not necessary for national and state treasuries to avoid the use of the same credit extensions that the people used in their private dealings. It was only necessary that the citizens and foreigners have the same freedom of financial choice in dealing with the government that they had with each other. As debtors they could pay their taxes and other obligations to the government using either money or the government’s own IOUs. As creditors they must have the choice of demanding payment in coin at par or debt paper at the current open market discount.
What they saw when they looked at Wall Street horrified Jefferson and Madison. Financial value had become entirely a matter of negotiation. The application of Washington and Willing’s rules for banks and currency had discarded all possibility of American money being a store of value. Hamilton’s new federal bonds were being turned over each day in frenzies of buying and selling that seemed to be related only to gossip, rumor and wild hypothesis. They were not investments at all. They were the mechanism traders used for speculations about anything and everything, and they could be paid for in promises as well as money. The trades in Treasury securities had to be cleared in gold, but the risk seemed to be only with the buyers whose counterparties failed to deliver. The bond owners as sellers had a guaranteed secondary market among the importers and representatives of European shippers who were responsible for the payment of import tariffs. For those taxes, Treasury securities were always as good as gold. In the market for the national debt, gold and the credit dollar priced each other; and neither held to any fixed value. The dollar was the denomination for the coins produced by the Spanish and the U.S. Mint and, at the same moment, a unit of credit.
Instead of restraining issues of bank notes to guarantee absolute equivalence between coin and official paper, the Bank of the United States allowed the broadest possible distribution of bank notes. The state-chartered American banks issued fractional currency notes, post notes, and debt paper notes priced below par for future redemption at face value. They produced and exchange varieties of notes and exchange promises to pay in transactions whose structures have survived today in the arrangements made each day in the present U.S. Treasury market. In minting 270 grains of standard gold as a coin with the image of an American eagle, the U.S. Mint was creating the country’s “real” money; but there was nothing in law or custom to restrain people from wanting 50-cent bank notes as a premium for accepting currency of the same denomination. Nor, among the parties themselves, was there any idea that someone was being cheated. Yet, even in an age when coin was scarce and denominated paper plentiful, it was possible for some politicians to think that the market was morally obligated to insist that bank’s denominated bills of exchange have the same price as coins with the same face value. In their minds, a proper political economy had to sustain the financial theology of par.
By 1837, coin was no longer scarce in the United States, and the Treasury no longer paid its bills and deposited its tariff collections in a central bank. The charters for both the first and second Banks of the United States had expired, and the country had no national debt to offer either for speculation or for investment. Andrew Jackson had paid it all off. His vice president, Martin Van Buren had been able to win the 1836 election for president by reminding the voters what Jackson’s Democratic Party had done to return the United States to its proper Constitutional origins. Thanks to the Jackson administration, the American political economy had been restored to the form and practice intended by George Washington and the other founders. Old Hickory and the Little Magician had even been able to improve on the founders’ legacy. There would be an independent Treasury that would receive and hold all payments to the government, and all those payments would be in coin. The issue of small change bank notes had been abolished. The Jackson administration had imposed its terms for distributing states the federal Treasury’s surplus left over after payment of outstanding debt. For a bank to be qualified to receive and hold funds on behalf of a state or territory, all issues and exchanges of notes in denominations under $5 would be discontinued. It was time for the United States to put aside the legacy of wildcat finance. Farmers selling sacks of onions for bank scrip no longer needed to be part of the banking system. The mint now had the production capacity to supply small change in all denominations. People could pay cash; they had no need of retail credit.
When the state-chartered banks and Congress and the president agreed that the best thing for the country was to tear up everyone’s 19th century equivalent of a credit card, there were still a few people alive who could remember how Thomas Willing had managed to create national solvency out of open deposit and discount. Unfortunately, the survivors were the very people who were least inclined to remember how they and the country had made fortunes out of nothing but credit. John Jacob Astor was not about to share recollections of using his wife’s $300 dowry to start the American Fur Company any more than modern entrepreneurs are eager to disclose the details of how they used personal credit cards for start-up capital. Astor’s banker Albert Gallatin had been Treasurer of the United States and had argued unsuccessfully for the renewals of both national banks’ charters. But Gallatin’s idea of a banking system for the country was like Nicholas Biddle’s idea of a proper bank; it should be an institution that lectured the public against “speculation, improvidence, and debt.” That the respectably educated opposed such continued private credit growth was understandable. Henry Clay and the new Whig Party saw the continuing growth of retail-sized loans and deposits with the state-chartered banks as a challenge to Congress’ ability to direct American investment. But why should the party of the populists – Andrew Jackson’s Democrats – choose to restrict people’s access to credit by banishing all small denomination note issues? Why include in the terms of the Circular and the Distribution Act a prohibition against banks issuing notes and handling accounts that dealt with retail denominations? Thanks to fractional bank notes, even the poor had begun to enjoy the privileges of financial liquidity. Why should getting the federal government out of debt require the common people to lose their access to credit?
Neither Thomas Willing nor George Washington has seen any need for the federal government to impose fiscal righteousness on popular dealings in small change credit money. They had been content to have contract alone set the prices and terms for private financial exchange. They had even accepted the ambiguity of laws that could define people as property and at the same time allow slaves to have bank accounts in which they were able to save towards the purchase of their own freedom. By 1838, it was no longer possible to tolerate a banking system that allowed such paradoxical conduct. If the fluctuations of exchange were an unavoidable necessity of finance, the law must take care to protect ordinary citizens from the dangers of the open market. To allow banks and their customers to engage in continuous and open-ended exchange of notes as small as paper pennies was to allow fundamentally immoral practices to become embedded in daily life. If the poor were to continue to have credit, they should not also be free to set their own terms. The rates of discount should be limited by usury laws; if poor people were to continue to deal in credit, their exchanges should be limited to the saving and lending of coined money. America would join England in having a proper financial system.
William Gouge, in The Curse of Paper Money and Banking or a Short History of Banking in the United States of America – An Account of its Ruinous Effects on Landowners, Farmers, Traders and on All the Industrious Classes of the Community, wrote the following:
England, in prohibiting the issue of all notes of a less denomination than 24 dollars, has begun to retrace her steps. In the United States we are far behind England in this respect, yet Bank notes may 50 years hence (in 1883) be found only in the cabinets of the curious. The penny notes which were issued by the Bank of North America about the year 1790 are already regarded as rarities by the virtuosi. Banking, it must be admitted, is deeply interwoven with all the business interests and operations and even the rights of society public and private. But so was the feudal system, which had an effect in the Middle Ages similar to that which the paper system has in modern times. Like the feudal system, the paper system divides the community into distinct classes and impresses its stamp on morals. In the progress of society, it may be as necessary to pass through the one as it was to pass through the other, but the feudal system is giving way in Europe to enlightened reason and it may at least be hoped that the paper system will not last forever in America.
Stefan Jovanovich manages the portfolio for The NJT Company, Inc., a family office based in Nevada.