Inflation (Part II)

<< Read More: Inflation (Part I)

At one point in the history of the United States, gold and silver coins were money. I use the term money since it satisfies the criteria defined in Part I of this article series. For reasons of practicality and safety, these coins could be stored in depositories issuing certificates redeemable for the coins. The depositories also charged a fee for storage. The depository served a warehouse function and the certificates were the warehouse receipt. The depository collected a storage fee for their services and the certificates were widely accepted as money. It was a reasonable arrangement. These certificates were deemed “as good as gold” and served as payment for goods and services and for repayment of debt. The certificates satisfied the criteria of money. Whoever presented certificates at the depository was entitled to the stated amount of gold or silver on the certificate. 

The owners of these depositories recognized that at any point in time, the amount of gold/silver on deposit was more than adequate to pay the certificate bearers. This condition is perfectly logical since as long as the certificate users had confidence in the existence of gold/silver in the depository, there was no need to withdraw the physical metal. The owners of the depositories used this to their advantage. They began to issue certificates well in excess of gold and silver deposits. Since these depositories issued certificates with interest consideration, it became profitable for the depositories to continue their issuance. This additional issuance is another example of what we call inflation. A greater amount of money (the certificates) pursued the same amount of goods and services in the economy relative to the existing wealth in the economy. As a result, our store of wealth criteria for money was altered since each outstanding certificate had less purchasing power than before. Additionally, the person given these extra certificates had not provided any wealth (gold/silver) in the transaction with the depository. The depository acquired no material item produced by human effort.

Important milestones emerged with these depositories. First, inflation appeared – meaning an increase in the supply of certificates relative to the supply of wealth (gold/silver) held in deposit. Secondly, a “fractional reserve” system was established where the depository lent a greater amount than was actually present in storage. Lastly, and perhaps most importantly, credit was created without sufficient wealth (gold/silver) backing it.

During the American Revolutionary War, the fledgling country needed vast sums of money to fight the British. One method of acquiring this money was to tax the people. Since taxes are usually unpopular, the country created money called the Continental Dollar. This money was credit extended to the people for goods and services. The colonists provided goods and services to the government to fight the war and the government paid the people with Continentals. The Continentals were redeemable for Spanish milled dollars, which themselves represented a stated amount of gold/silver. Since no additional wealth in the form of gold/silver appeared in the colonies to back the new Continentals, instant inflation occurred. We know this is inflation since the supply of money (Continentals) increased relative to the supply of wealth (gold/silver).

Six years after the Continentals came into existence it took $16,800 in Continentals to acquire $100 of wealth (gold/silver). During those six years would you rather own Continentals or wealth? Anyone realizing what was occurring with the purchasing power of a Continental would rid themselves of it (before it lost value) instead of gold/silver for transactions. This gives rise to something known as Gresham’s Law. 

Gresham's Law - Bad money drives out the good money.

The “bad” money was the Continental and the “good” money was the Spanish dollar.The Continental was the hot potato that nobody wanted while the Spanish milled dollar and coins were not circulated. Eventually the Continental ceased to exist and the episode gave rise to the term “not worth a Continental."

The Founding Fathers recognized Gresham’s Law and understood inflation.Article I Section 10 of the Constitution says,

No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.

Note the specification of gold and silver coin for the purposes of tender to pay debt.

The eruption of the Civil War necessitated the creation of US Notes. During the war, the government chose to borrow by issuing Notes (not redeemable in gold). In exchange for the Notes, the public provided goods and services. The public could use the Notes to pay for their taxes. The Notes were also considered legal tender for payment of public and private debts. Returning all the Notes to the Government for tax payment represented goods/services exchanged for taxes. 

While the Notes circulated as money, they did not satisfy my definition of money since it was not a direct store or representation of wealth. Since the Notes circulated as legal tender, their effect was inflationary. 

Debasement of money occurred in the Civil War and Revolutionary War eras. The common theme in both cases was war. War is an extraordinary event requiring extraordinary effort on the part of the public. In order for a war effort to be fought, tremendous resources must be marshaled away from regular consumption towards fighting an enemy. In order to prosecute a war, a government must either raise taxes or borrow. Since taxation is rarely popular, borrowing is the alternative. I make the point about war borrowing since for a portion of our history war was the reason for incurring public debt. Quite different today, eh?