Inflation Part II

By: Jim Mosquera | Mon, Apr 7, 2014
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At one point in the history of the United States, gold and silver coins were money. We use the term money since it satisfies the criteria defined in the previous article (medium of exchange, unit of account, direct representation of wealth). 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 (those wanting to withdraw gold/silver). 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 (an early example of credit). This additional issuance is another example of what we call inflation. Thus, a greater amount of money (the certificates) was pursuing the same amount of goods and services. 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.

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. As a parenthetical note, for government to do ANYTHING it must tax - absent taxes, it must borrow. 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 or the equivalent amount of gold/silver (meaning the Spanish dollar represented an 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 them before it lost value instead of gold/silver for transactions. This gives rise to something known as Gresham's Law. The law says that bad money drives out the good money. In this case, the "bad" money was the Continental and the "good" money was the Spanish dollar/gold/silver. The Continental was the hot potato that nobody wanted while the Spanish milled dollar and coins were not circulated in the same manner. 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. As noted earlier when government needs to do anything either taxes are raised or money is borrowed. 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 (lawfully declared money) 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 our definition of money since it was not a direct store or representation of wealth. Since the Notes circulated as legal tender, their effect was inflation. The circulation of the Civil War era Notes is inflation since the supply of money increased without a corresponding increase in wealth (gold/silver).

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 main reason for incurring public debt.

In the ensuing years, the United States functioned with an assortment of paper certificates redeemable for gold/silver. Additionally, gold and silver coins were also used in common transactions. Late in the 19th century and early in the 20th centuries, financial panics and bank runs occurred which gave rise to one of the most significant but least understood events in the 20th century - the creation of the Federal Reserve System.

 


 

Jim Mosquera

Author: Jim Mosquera

Jim Mosquera,
The Sentinel

Jim Mosquera

Jim Mosquera is a Principal at Sentinel Consulting and is the author of E$caping Oz: Protecting your wealth during the financial crisis.

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