How US moved to a paper currency system? lessons for central banking

Bennett McCallum of CMU writes this fascinating paper on the topic.

He says US constitution mentions monetary arrangements only twice:

Let us begin by reviewing what the Constitution of the United States has to say about monetary arrangements. It is an easy matter to do so because monetary affairs are mentioned only twice in the Constitution, with the two brief provisions being as follows:

(i) “The Congress shall have power … to borrow money on the credit of the United States, …, to coin money, regulate the value thereof, and of foreign coin,  and fix the standard of weights and measures” [Article I, Section 8].

(ii) “No state shall … coin money; emit bills of credit; make any thing but gold and silver coin a tender in payment of debts … [Article I, Section 10].

From these provisions it seems abundantly clear that the vision and presumption embodied in the Constitution was that the nation’s monetary arrangements would feature a strict metallic standard—one with either gold or silver as the standard commodity or,  alternatively, one involving a gold-silver bimetallic system. 

As there is no mention of the monetary standard among the amendments to the Constitution, a fundamental question arises naturally, namely: how were these provisions of the Constitution overturned so as to result in today’s fiat-money arrangement in which Federal Reserve notes serve as legal tender and there is no trace whatsoever of a metallic standard?

He then looks at how greenback came into being.  They were issued to meet war financing needs.

The occasion upon which fiat money made its appearance in the U.S., for the first time since the adoption of the Constitution, was the Civil War of 1861-1865, with three issues of the infamous “Greenbacks” occurring in 1862, 1863, and 1864. The total Greenback emission was $450 million, which alone would have represented a near doubling of the money supply relative to its magnitude in 1860. 

The context for the first of these issues was that in late 1861 matters were not going well for the U.S. government. Militarily the rebellious Southern forces were holding their own (First Battle of Bull Run), and financially the U.S. was finding it difficult to provide its armies with troops and supplies. Both orthodox and unorthodox schemes had been attempted, and still the North was finding it extremely difficult to raise funds needed for prosecution of the war.

Additional taxation of U.S. citizens would be unpopular and borrowing was viewed as likely to require “prohibitively high” rates of interest. Consequently, the Secretary of the Treasury, Salmon P. Chase—of whom we shall hear much more—and an enthusiastic committee chairman, Rep. Elbridge G. Spaulding, devised a plan for finance by issuing fiat paper money, which came to be called “Greenbacks.” These would be legal tender notes, non-redeemable, and non-interest-bearing. Spaulding wrote the legislative bill after which he and Chase led its passage, which met with much opposition in the House of Representatives. 

Spaulding argued that haste was necessary; that the government would “be out of means to pay the daily expenses in about thirty days, and the committee do not see any other way to get along till we can get the tax bills ready….”.

There was huge controversy and criticism as notes not mentioned in constitution but still went on given the needs. What was more interesting was that these notes continued even after the civil war. There were several court cases. By then Salmon P. Chase the Treasury chief who got these greenbacks going became the supreme court chief. He in a a really ironic case, ruled these greenbacks as unconstitutional!!!

And then how then US president appointed two Greenback favoring members to Supreme court and finally greenback was ruled to be consistent with constitution in 1871. Interestingly, no one really objected to this packing of the supreme court (read the reasons in the paper).

Now what are the implications of all this for central banking? Mccullum says though greenback intro was seen as monetary policy action but actually it was a fiscal policy action. And we see the same case now with Fed doing monetary actions but they are more fiscal than monetary:

But what, one might well ask, does all of this have to do with current and future monetary policy arrangements? My answer is that the Supreme Court arguments in favor of Greenback constitutionality relied to a substantial extent on a crucial confusion between monetary and fiscal policy. In particular, note that “the power to borrow money” is a fiscal, not a monetary, provision. Specifically, it gives Congress the right to borrow  —to sell government debt to the public—an activity that does not necessarily entail any change in the outstanding stock of money.

Borrowing” and “lending” are terms that pertain to fiscal actions, not monetary actions; for when the Treasury sells or purchases bonds rather than raising or lowering taxes (in order to finance increased or decreased government expenditures) there is no necessary or implied change in the nation’s quantity (stock) of high-powered money—and no change in the private sector’s holdings when the borrowed funds are immediately spent on (e.g., military) supplies and wages, as was the case in 1862.

But the reasoning expounded by Supreme Court justices in two crucial cases did not recognize this distinction. Instead, they argued as if the quoted power (“to borrow money”) would justify the issue of legal-tender fiat money.

Thus the failure of legislators and justices to recognize the basic distinction between monetary and fiscal policy played a central role in the fundamental and momentous historical change, from metallic to fiat regimes, in U.S. monetary arrangements. But essentially the same failure has been present in much of the recent discussion concerning the financial crisis of 2007-2009, as is revealed in the analysis of Goodfriend (2010), whose argument focuses on this distinction and emphasizes its fundamental importance for central-bank independence.

So what is the way out? Return to the bimetal standard? Nopes because changes in constitution would be impossible to achieve. They could actually use the constitution to improve today’s paper arrangement:

More important, in my opinion, is that we could now do better by recreating the essence of the Constitution’s instructions within the context of today’s paper money arrangements and with an improved monetary policy target. In particular, the provisions of the Constitution were clearly designed to prevent major ongoing changes in the purchasing power of the medium of exchange. Given the absence of publically available data on comprehensive price indices in those days—or even any form of rapid communication among hypothetical statistical offices in different cities—the specification of a fixed metallic standard was the only means known to the authors of providing a semblance of price level stability. 

Given today’s technology, however, near-constancy of the value of the medium of exchange could be provided by governmental specification of a comprehensive price index, rather than the  price of gold, that the monetary authority could keep at a virtually constant level over time by standing ready to buy or sell (via a redemption medium such as Treasury bills) bundles of goods and services specified by the comprehensive index.

For the U.S., for example, Congress could designate a widely-defined price index and assign the Federal Reserve the technical task of keeping the associated inflation rate equal to (or at lease close to) zero.  Indeed, it would be possible for assigned task to be to keep some measure of aggregate nominal spending (such as nominal GDP or final demand) growing steadily at a non-inflationary rate. This would provide the United States with a clear monetary standard, which we do not have at present, and would specify the Fed’s duties in such a way that the Fed would have monetary policy independence, which would then be used in meeting the standard specified, in accordance with the Constitution, by the Congress.

Wow. What insights from US history. Really fascinating stuff..

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