In order to address the claims made by typical mainstream layman and economist alike, we must first briefly outline how the modern American monetary system came about.
Prior to the establishment of the United States, this geographic area was settled by scattered groups of primarily English and Spaniards. As will occur in any location, the choice medium of exchange arises as a function of scarcity and demand. For the early colonials, this ranged from beaver pelts and corn in the northern areas to fish and tobacco in the south. As the region began to grow, gold and silver coins were imported and used frequently in the cities and for foreign trade.
I must stress that many different foreign coins were freely circulating in early America. Although it seems patently obvious to some, the fact that a mass of gold or silver is equivalent without regard to the minting stamp seems to escape many of those who are insistent upon government control of money. In point of fact, foreign coins were readily accepted throughout all of America until Congress outlawed the use of foreign coins in 1857.
With exception to ancient China (see the great book “Paper Money – A Cycle in Cathay” by Gordon Tullock), the first government issued fiat paper money originated in Massachusetts. The reason was due, of all things, to a failed raid on Canada. For many years, Massachusetts had been sending soldiers into Quebec to plunder as much riches as they could carry and then sell off all the booty in Boston, with a portion of the proceeds used to pay the soldiers (or pirates, if you prefer). Quebec eventually garnered enough defenses to repel the raid and the soldiers returned to Boston in an obviously foul mood demanding payment for their services. Ill-content soldiers are prime victims of mutiny and discord, so Massachusetts attempted to borrow money to pay them off, but their credit rating was apparently too low for the available creditors. Therefore, the government printed £7,000 in paper notes. Along with the paper, the government promised to redeem them in the future in either gold or silver from tax revenue and that not another single paper note would be issued.
As is typical of government promises, both quickly went the way of the dodo. Within a few short months the paper money supply increased another £40,000 while ultimately taking some 40 years to redeem the paper.
Following in lock-step with the laws of economics, the risk and lack in quality of the paper money led to depreciation. The Massachusetts government attempted to force the acceptance of the fiat money on par with specie, but ultimately effected the disappearance of specie. Additionally, the rapid expansion of paper money had the result of price inflation and dramatically reduced exports. Thus, while many modern economists claim that the so-called “money shortage” is reason enough for the introduction of fiat paper money, it was actually the introduction of fiat paper money which created the money shortage to begin with.
By the late 1750s, every colony in America had begun issuing fiat paper money and the price of silver had increased tenfold. In every case, after new paper money was released into the economy, an inflationary boom eventually followed by a deflationary depression resulted.
Finally, King George prohibited the further issuance of paper money in the colonies and required the redemption of all outstanding obligations. As is typical of today’s naysayers, opponents of specie money predicted that foreign trade would come to a standstill, prices would skyrocket, and a “shortage of money” would result. In reality, after a brief adjustment period, the resumption of specie money resulted in an increase in trade and lower prices.
The next period of paper money was during the Revolutionary War. While not accompanied by a promise of specie redemption, the infamous Continental was supposed to be retired in seven years and replaced through future taxation. Of course, politicians being what they are, this apparently limitless new form of revenue expanded rapidly. Beginning with a paltry $6 million in 1775, the Congress eventually issued more than $225 million of the next five years. As a consequence, by 1781 the Continentals were trading on the market at a virtually worthless ratio of 168:1. As will likely occur with modern U.S. Dollars, the Continental was allowed to sink into worthlessness without burdening the economy with redemption.
Thus emerges the first central bank in 1782, the Bank of North America. This bank was the first fractional reserve bank in the United States as well as being a privately owned and monopolistic bank. The federal charter allowed it to issue notes receivable for all taxes and duties owed to the government at par with specie. Lack of confidence likely due to the previous bad experiences with paper money resulted in failure by the end of the following year.
The Coinage Act of 1792 made the mistake of establishing a bimetallic standard for the U.S. Dollar. This Act defined the dollar as both 371.25 grains of pure silver and 24.75 grains of pure gold; thus, a fixed ratio of 15:1. Gresham’s Law tells us that when competing monies are artificially fixed at legal ratios, the overvalued money will drive out the undervalued money. Or in other words, the least valuable money will remain in circulation while the more valuable money will remain in “hoarding”. By 1810, gold coins all but disappeared from circulation.
Simultaneously, the First Bank of the United States was established at Hamilton’s urging in order to combat the alleged “scarcity” of specie. The ensuing rapid increase in credit and paper money promptly resulted in price inflation. Within the twenty-year span of the First Bank, 113 new banks were formed which collectively increased the supply of money and credit by more than fourfold.
The First Bank’s charter expired in 1811, but the War of 1812 had a devastating effect on the money supply. The number of banks nearly doubled by the end of the war, piling new paper money and credit upon specie to the point of a nearly 6:1 ratio across the nation. However, this ratio was only around 2:1 in New England banks which generally refrained from inflating credit while Virginia and South Carolina approached a ratio of 19:1. This had the effect of subsidizing northern manufactured goods with inflated paper in the south and was likely a contributing factor to the Civil War.
Most alarmingly, the federal government allowed banks to suspend payment of specie (i.e. refuse redemption of paper money for gold or silver) for over two years beginning in 1814. Further suspensions occurred in 1819, 1837, 1839, and 1857. These blatant violations of property rights represented the golden key for bankers and planted the seed which eventually resulted in our modern monetary system.
The importance of everything explained to this point is the refutation of the common claim of a “failure of free banking”. Free banking can only occur in an environment in which banks are treated no differently than any other business. That is, a failure to conform to contractual obligations results in insolvency and the liquidation of assets to pay for debts incurred. For an excellent explanation of free banking, refer to “The Rationale of Central Banking” by Vera Smith:
Prior to the establishment of the United States, this geographic area was settled by scattered groups of primarily English and Spaniards. As will occur in any location, the choice medium of exchange arises as a function of scarcity and demand. For the early colonials, this ranged from beaver pelts and corn in the northern areas to fish and tobacco in the south. As the region began to grow, gold and silver coins were imported and used frequently in the cities and for foreign trade.
I must stress that many different foreign coins were freely circulating in early America. Although it seems patently obvious to some, the fact that a mass of gold or silver is equivalent without regard to the minting stamp seems to escape many of those who are insistent upon government control of money. In point of fact, foreign coins were readily accepted throughout all of America until Congress outlawed the use of foreign coins in 1857.
With exception to ancient China (see the great book “Paper Money – A Cycle in Cathay” by Gordon Tullock), the first government issued fiat paper money originated in Massachusetts. The reason was due, of all things, to a failed raid on Canada. For many years, Massachusetts had been sending soldiers into Quebec to plunder as much riches as they could carry and then sell off all the booty in Boston, with a portion of the proceeds used to pay the soldiers (or pirates, if you prefer). Quebec eventually garnered enough defenses to repel the raid and the soldiers returned to Boston in an obviously foul mood demanding payment for their services. Ill-content soldiers are prime victims of mutiny and discord, so Massachusetts attempted to borrow money to pay them off, but their credit rating was apparently too low for the available creditors. Therefore, the government printed £7,000 in paper notes. Along with the paper, the government promised to redeem them in the future in either gold or silver from tax revenue and that not another single paper note would be issued.
As is typical of government promises, both quickly went the way of the dodo. Within a few short months the paper money supply increased another £40,000 while ultimately taking some 40 years to redeem the paper.
Following in lock-step with the laws of economics, the risk and lack in quality of the paper money led to depreciation. The Massachusetts government attempted to force the acceptance of the fiat money on par with specie, but ultimately effected the disappearance of specie. Additionally, the rapid expansion of paper money had the result of price inflation and dramatically reduced exports. Thus, while many modern economists claim that the so-called “money shortage” is reason enough for the introduction of fiat paper money, it was actually the introduction of fiat paper money which created the money shortage to begin with.
By the late 1750s, every colony in America had begun issuing fiat paper money and the price of silver had increased tenfold. In every case, after new paper money was released into the economy, an inflationary boom eventually followed by a deflationary depression resulted.
Finally, King George prohibited the further issuance of paper money in the colonies and required the redemption of all outstanding obligations. As is typical of today’s naysayers, opponents of specie money predicted that foreign trade would come to a standstill, prices would skyrocket, and a “shortage of money” would result. In reality, after a brief adjustment period, the resumption of specie money resulted in an increase in trade and lower prices.
Roger W. Weiss said:Here was a silver standard ... in the absence of institutions of the central government intervening in the silver market, and in the absence of either a public or private central bank adjusting domestic credit or managing a reserve of specie or foreign exchange with which to stabilize exchange rates. The market ... kept exchange rates remarkably close to the legislated par. ... What is most remarkable in this context is the continuity of the specie system through the seventeenth and eighteenth centuries.
The next period of paper money was during the Revolutionary War. While not accompanied by a promise of specie redemption, the infamous Continental was supposed to be retired in seven years and replaced through future taxation. Of course, politicians being what they are, this apparently limitless new form of revenue expanded rapidly. Beginning with a paltry $6 million in 1775, the Congress eventually issued more than $225 million of the next five years. As a consequence, by 1781 the Continentals were trading on the market at a virtually worthless ratio of 168:1. As will likely occur with modern U.S. Dollars, the Continental was allowed to sink into worthlessness without burdening the economy with redemption.
Thus emerges the first central bank in 1782, the Bank of North America. This bank was the first fractional reserve bank in the United States as well as being a privately owned and monopolistic bank. The federal charter allowed it to issue notes receivable for all taxes and duties owed to the government at par with specie. Lack of confidence likely due to the previous bad experiences with paper money resulted in failure by the end of the following year.
The Coinage Act of 1792 made the mistake of establishing a bimetallic standard for the U.S. Dollar. This Act defined the dollar as both 371.25 grains of pure silver and 24.75 grains of pure gold; thus, a fixed ratio of 15:1. Gresham’s Law tells us that when competing monies are artificially fixed at legal ratios, the overvalued money will drive out the undervalued money. Or in other words, the least valuable money will remain in circulation while the more valuable money will remain in “hoarding”. By 1810, gold coins all but disappeared from circulation.
Simultaneously, the First Bank of the United States was established at Hamilton’s urging in order to combat the alleged “scarcity” of specie. The ensuing rapid increase in credit and paper money promptly resulted in price inflation. Within the twenty-year span of the First Bank, 113 new banks were formed which collectively increased the supply of money and credit by more than fourfold.
The First Bank’s charter expired in 1811, but the War of 1812 had a devastating effect on the money supply. The number of banks nearly doubled by the end of the war, piling new paper money and credit upon specie to the point of a nearly 6:1 ratio across the nation. However, this ratio was only around 2:1 in New England banks which generally refrained from inflating credit while Virginia and South Carolina approached a ratio of 19:1. This had the effect of subsidizing northern manufactured goods with inflated paper in the south and was likely a contributing factor to the Civil War.
Most alarmingly, the federal government allowed banks to suspend payment of specie (i.e. refuse redemption of paper money for gold or silver) for over two years beginning in 1814. Further suspensions occurred in 1819, 1837, 1839, and 1857. These blatant violations of property rights represented the golden key for bankers and planted the seed which eventually resulted in our modern monetary system.
The importance of everything explained to this point is the refutation of the common claim of a “failure of free banking”. Free banking can only occur in an environment in which banks are treated no differently than any other business. That is, a failure to conform to contractual obligations results in insolvency and the liquidation of assets to pay for debts incurred. For an excellent explanation of free banking, refer to “The Rationale of Central Banking” by Vera Smith:
“Free banking” is a regime where note-issuing banks are allowed to set up in the same way as any other type of business enterprise, so long as they comply with the general company law. The requirement for their establishment is not special conditional authorization from a government authority, but the ability to raise sufficient capital, and public confidence, to gain acceptance for their notes and ensure the profitability of the undertaking. Under such a system all banks would not only be allowed the same rights, but would also be subjected to the same responsibilities as other business enterprises. If they failed to meet their obligations they would be declared bankrupt and put into liquidation, and their assets used to meet the claims of their creditors, in which case the shareholders would lose the whole or part of their capital, and the penalty for failure would be paid, at least for the most part, by those responsible for the policy of the bank. Notes issued under this system would be “promises to pay,” and such obligations must be met on demand in the generally accepted medium which we will assume to be gold. No bank would have the right to call on the government or on any other institution for special help in time of need. ... A general abandonment of the gold standard is inconceivable under these conditions, and with a strict interpretation of the bankruptcy laws any bank suspending payments would at once be put into the hands of a receiver.