Wednesday, October 18, 2017

An example of tax-driven money during the greenback era

Cartoon from 1864 poking fun at politicians and greenbacks (source and explanation)

During the greenback era, the Union government issued irredeemable paper money to help pay for its war against the Confederates. What many people don't realize is that there were actually two different strains of greenbacks—those printed before March 1862 and those printed after. Although these two strains had only slightly different properties, they were not fungible with each other and would go on to have drastically different values in the marketplace. Looking at the respective properties of each type gives some insights a thorny problem: why do colored bits of paper money have value?

One classic explanation for the value of fiat money is so-called 'tax-backing.' If the government stipulates that taxes must be paid using government-issued chits of paper, then that will be sufficient to give those chits a positive value. Back in 1910 economist Philip Wicksteed was one of the first economists to champion this explanation:
The Government, then, levying taxes upon the community, may say: "I shall take from you, in proportion to your resources, as a tribute to public expenses, the value of so much gold. You may pay it to me in actual metallic gold or you may pay it to me in anything which I choose to accept in lieu of the gold. If you do not give it me I shall take it from you, in gold or any other such articles as I can find, and which would serve my purpose, to the value of the gold. But if you can give me a piece of paper, of my own issue, to the face value of the gold that I am entitled to claim of you, I will accept that in payment." Now, as these demands of the Government are recurrent, there will always be a set of persons to whom the Government paper stamped with a unit weight of gold is actually equivalent to that weight of gold itself, because it will secure immunity from requisitions to the exact extent to which the gold would secure it. - The Common Sense of Political Economy, Book II Ch 7
The idea that a tax obligation can be the basis of money, or what Randall Wray has termed twintopt, is at the core of modern monetary theory, or MMT.

Let's see how the tax backing theory holds up during the greenback period. To set the context, South Carolina had seceded from the Union in December 1860, soon followed by ten other states. Hostilities between the Union and newly-formed Confederate states began in April 1861. To help fund the Union side of the war effort, an initial $50 million issue of greenbacks was authorized in July. This was to be the first government paper money emitted since the Second Bank of the United States had been wound up.

The act ruled that these notes were to be redeemable on demand in gold, a promise that was also inscribed on the face of each note (see below). They thus earned the nickname demand notes. This promise meant that, at the outset at least, their price could not deviate from par since any movement above or below their gold value would be arbitraged away. When redemption was rescinded a few months later on December 30, 1861, demand notes began to trade at a 1-2% discount to their face value in gold.

The second vintage of greenbacks, known as legal tender notes, was authorized two months later by the Legal Tender Act of February 25, 1862. This act provided for an issue of $150 million, much larger than the first vintage. One novelty is that the second batch of notes was declared legal tender, which meant that a creditor could not refuse to receive them at par in discharge of a debt. The legal tender property was extended to demand notes in March 1862. The second vintage of notes was also irredeemable, putting them on the same basis as the demand notes, which became irredeemable at the end of 1861.

What distinguished legal tender notes from demand notes? As the tweet above shows, the two vintages had visible differences—unlike demand notes, legal tender note did not have the promise to redeem on demand printed on their face. Demand notes also had an extra promise inscribed on them: "receivable in payment of all public dues". What this meant in practice is that the government accepted demand notes in payment for all taxes, including customs dues, whereas legal tender notes were only receivable in a narrow range of internal revenue taxes—and not for customs dues—which at the time made up the majority of Union tax revenues.

Receivability for customs dues was an important point of departure between demand notes and legal tender notes. Duties were priced in gold and could also be discharged with gold coins. So if an importer was on the hook for $x in custom duties, they could certainly scrounge up $x in gold coin to get rid of the obligation, but $x in demand notes would be sufficient to "secure immunity" from the tax. Not so with legal tender notes.

A given importer might only need a small portion of the demand notes in his possession to pay customs duties. Anything above that amount would be worth less than their face value to him, since gold—not demand notes—was necessary to buy goods internationally. However, if that importer could find other importers who were themselves under obligation to pay customs duties, and who would therefore value his remaining stash of demand notes for their tax receivability, then he might sell them his remaining demand notes at a price quite close to the value of gold coins.

So all that was needed to have irredeemable demand notes trade near the value of gold was a permanent market of tax payers who demanded those notes, and a flow of new notes that did not exceed the rate of drainage provided by the tax outlet. After all, if the supply of notes overwhelmed the amount of tax that needed to be paid, then notes would accumulate in importers pockets with no one willing to bid for them. Once everyone's taxes had all been paid up, demand notes would trade at a discount to gold coins. 

Tax receivability was successful in keeping the value of demand notes close to their gold value. The chart below shows the price of both demand notes and legal tender notes relative to gold through 1862-63.  Demand notes never fell to more than a 10¢ discount relative to gold coin. Calomiris blames this discount on the risk that receivability for customs duties would be revoked by the government before notes had been paid in.

Legal tender notes, however, fell to an ever larger discount relative to both gold coin and demand notes, reaching a 40¢ discount by March 1863. While legal tender notes were receivable for domestic taxes, these taxes did not account for a very large share of government revenues. Nor were these taxes priced in gold. Which meant that, unlike demand notes, legal tender notes were not benchmarked to some real good or price index.

So what, if anything, determined the price of legal tender notes? Here I'll introduce another theory for the value of money; the metallist viewpoint. Rather than tax receivability driving a currency's value, a metallist looks to the currency's intrinsic value. When banknotes are fully redeemable, their intrinsic value is determined by the underlying gold on which the note is a claim, the value of which is set in the market for precious metals in technology and the arts.

In the case of legal tender notes, which were no longer redeemable, the realization of intrinsic value had only been delayed to some future point in time when gold convertibility would be re-adopted. This eventual re-mooring date was in turn a function of the Union government's ability to win the war, among other factors. According to this theory, the steady decline in the gold value of legal tender notes in the chart above can be blamed on the realization by the public that the war would last much longer than most originally thought, pushing the re-mooring date ever further into the future.

While the 1861 issue of demand notes had all been bought back and cancelled by the government by mid-1863, greenbacks remained outstanding even after the war had been won. Their discount to gold continued to widen till July 1864 at which point their price steadily rose. See the chart below. The steady return to par probably can't be explained by the tax-backing theory. Improved odds that the government's fiscal situation would allow it to resume gold convertibility—an event that finally occurred in 1879—is a better explanation. There have been a few interesting accounts written about the value of greenbacks over the full 1862-1879 period, including Wesley Clair Mitchell's A History of the Greenbacks in 1903, but also more recent contributions here (Calomiris), here (Smith & Smith) and here (Willard et al).

In sum, the U.S. government was issuing three non-fungible currencies by 1862. Coins and legal tender notes operated under the principles of a metallic money whereas the third, demand notes, seems to have been a purely tax-driven money as described by Wicksteed. So what about a modern dollar note? Is a Federal Reserve note like an 1861 demand note and mostly tax-driven, or like legal-tender notes and operating on a metallic basis?

I'm not entirely sure, but my guess is that it is a messy combination of both. When it comes to money, I'm not a believer in any one theory. Although the odds of a future return to the old 1972 gold redemption rule of 0.024 ounces per dollar is non-existent, the metallic explanation for the dollar's value continues to be relevant. Instead of redeeming currency with fixed amounts of metal as in days of yore, modern central banks repurchase notes with financial assets held in their vault in a manner that is consistent with hitting an inflation target. This is very much like 1800s-style metallism, except with an ever-shrinking CPI basket in the place of a fixed amount of gold.   


Wesley Clair Mitchell, A History of the Greenbacks

PS: I recently started a discussion board here. Feel free to bring up topics not covered on my more recent blog posts, suggest posts, or discuss ideas that appear on my Twitter feed. I don't like Twitter for long-form discussion; I'd much rather divert them to the board.

Thursday, October 12, 2017

The ubiquitous Spanish dollar—a photo essay

"The head of a fool on the neck of an ass."

That's how Londoners described the strange silver coin pictured above, which first appeared in Britain in 1797. Due to worries that Napoleon was about to invade the British Isles, a run had developed on the Bank of England. In response, Parliament allowed the Bank to refuse to redeem its notes with gold coins, but this had only resulted in an inconvenient shortage of coins.

To remedy the shortage, the Bank of England decided to open its vault and put its hoard of silver coins into circulation. Complicating matters was the fact that these coins were not native shillings or pennies, but Spanish dollars, otherwise known as eight real pieces. As such, they had to be re-purposed into local currency. The Bank of England accomplished this task by stamping the head of King George III—the fool—on the neck of Charles IV of Spain—the ass—who occupied the obverse side of that era's version of the Spanish dollar. The Bank then declared that all stamped Spanish dollars were to be worth four shillings and nine pence. People flocked to the Bank of England's window to get their hands on the new coins.  

That the Spanish dollar temporarily became part of England's circulating media of exchange was due to its ubiquity—in its heyday the Spanish dollar, like today's U.S. dollar, was everywhere. After discovering huge amounts of silver in the new world, the Spaniards had set up a mint in Mexico City in 1536 to produce large quantities of silver coins. Mints in Potosi (Bolivia), Lima (Peru), and elsewhere soon followed. It is estimated that some four-fifths of the world's silver produced between 1493 and 1850 came from Spanish America, almost all of it in the form of Spanish dollars! 

Although their design changed over the centuries, by the 1700s the Spanish dollar—easily identified by the two "pillars of Hercules" on the reverse side of the coin—had become known and accepted all over the world. As the map above shows, the two pillars refer to the Rock of Gibraltar in Spain and its counterpart on the Moroccan side of the narrow strait separating Africa from Europe.

In addition to England, the Spanish dollar shows up in the Caribbean islands where it made up a major part of the local coinage. To provide small change, locals cut dollars up into pieces. Below, an 1806 dollar used in Guadeloupe has had its centre carved out of it and stamped with the letter "G". Earmarking of coins was done to prevent exportation and restrict usage within borders. In this way, local currencies were literally piggybacked into existence off of the ubiquitous Spanish dollar.

Source: The Spanish Dollar as Adapted for Currency in Our West Indian Colonies

In the next image, a Trinidadian version of the dollar has been carved up like a pizza. The half piece has been countermarked with a "6", the third with a "4", and the sixth with a "2". These numbers refer to the number of bits or bitts the piece was worth, the bit being a local accounting unit. By marking the letters "TR" on each dollar to indicate Trinidad, the Spanish dollar has been forked to create a second currency.

Spanish dollar marked with TR for Trinidad

All possible methods of cutting up Spanish dollars were used. Here's a 1797 dollar from Saint Lucia that has been cut up lengthwise, like a loaf of bread, with "SLucie" being countermarked on each section.

Saint Lucia Spanish dollar

The Spanish dollar also made a notable appearance on the opposite side of the globe. In 1813, the colony of Australia minted its first currency, the so-called holey dollar. To deal with a shortage of coins, the governor of New South Wales imported thousands of Spanish dollars. A convicted forger was contracted to cut the centre from each one, countermarking each of the resulting pieces with the name of the colony and its nominal value in shillings and pence. As in the case of the Caribbean Islands, this mutilation of the dollar was an attempt to render them useless outside of the colony. The outer ring was rated at five shillings and the centre—the dump—at fifteen pence, or one shilling and three pence. 

The Spanish dollar, which would become the Mexican dollar after Mexico won its independence from Spain, was also popular in China. Merchants and professional money exchangers, or shroffs, would test a coin to verify its silver content. According to James Gullberg, they went about this by balancing the coin on their finger and tapping it. If it rang, it was legitimate. The theory goes that once the coin had passed their purity test, a shroff would stamp that coin with his own peculiar chopmark—a Chinese character, an emblem, symbol, or a pseudo character. (I discussed this practice in more depth here). The more chops a Spanish dollar had, the better its quality—even after it had been chopped beyond recognition.

1807 Spanish dollar with chopmarks

Pictured above is a chopped Spanish dollar from 1807. According to Gullberg, Chinese merchants preferred the Carolus IIII dollar, which was issued between 1772-1810. They referred to it as four work, the IIII resembling the Chinese character for going to work. The influence of the Spanish/Mexican dollar continued even into the 19th century: the banknote below, issued in 1912 by the Sino-Belgian Bank, is redeemable in Mexican dollars.

Moving back west, the Spanish/Mexican dollar had a key role to play in the North American economy up to the mid-1800s. In both Canada and the U.S., the unit of account function of money was separated from the medium of exchange function. Early colonists kept prices in pounds, shillings, and pence unit of account, but Spanish dollars and their subdivisions were used to transact business. Because of the long distance from England, there simply weren't enough shillings and pennies to make do.

Even though a local U.S. dollar coin—which was modeled off of the Spanish dollar—had been minted as early as 1794, the Spanish version remained by far the most popular form of coinage in the U.S. The presence of the Spanish dollar was even enshrined in American law, the coins having been declared legal tender in 1793. Many people have even speculated that the famous dollar sign, $, has been bastardized from the symbol for peso.

Source: Evolution of the Dollar Mark (1912)

To illustrate the ubiquity of the Spanish dollar in the U.S., below I've included a 6¼ cent note issued in 1816 by Easton and Wilkesbarre Turnpike Company, which built and operated private toll roads. This odd denomination only makes sense if you consider it in the same context as the Spanish dollar. Unlike U.S. dollars, which were divisible by 100 into cents, the Spanish dollar was divisible into 8 reals. A one-real coin, a fairly common unit around that time, would have been worth 12½ cents, and a ½ real coin worth 6¼ cents. So while the turnpike company's decision to issue a 6¼ cent note might seem odd to us today, it was probably meant as a convenience to its users, who would have been more familiar with Spanish coins than any other type of coin.

As for Canada, below is an 1819 $5 bill from the Bank of Upper Canada. To help customers who couldn't read, the bank conveniently printed an image of five Spanish dollars at the bottom of the note.

This 1819 banknote has five Spanish dollars illustrated along its bottom

For a number of reasons, the Mexican dollar was eventually killed off . The U.S. had originally been on a bimetallic standard, but in 1834 the authorities changed the silver-to-gold ratio to 16:1 from 15:1, in the process slightly overvaluing gold. The discover of the yellow metal in California only further pressured the price of gold down relative to silver, exacerbating the legally-imposed undervaluation of silver. As a result, silver coins began to disappear. After all, anyone who had a stash of silver coins would have found it more profitable to melt them down and export them overseas where they traded at their true economic value. The U.S. had effectively flipped onto a gold standard. To compound matters, Spanish dollars lost legal tender status in 1856, which would have further crimped their demand.

As for Asia, several competing coins were created, including the Japanese yen, a near-replica of the Mexican dollar. The U.S. began to produce special trade dollars that were to be used solely in Asian trade (I wrote about the trade dollar here). Further reducing the demand for Mexican silver was the decision by many nations to follow the major western nations and officially adopt gold standards, including Japan in 1897 and the Philippines in 1904.


Even though it was eventually eclipsed, there are still modern day echoes of the old Spanish dollar. The pejorative term two bit is still used in the U.S. as a synonym for cheap or insignificant, as in two-bit thief. One bit was ⅛ of a dollar, or 12.5¢, and two-bits 25¢, so a two-bit thief is a 25¢ thief. Amazingly, the practice of pricing in sixteenths continued on the New York Stock Exchange up till 2001. The Toronto Stock Exchange decimalized in 1996.

Up here in Canada, Quebecers use the word piasse for dollar. I had always assumed that they meant piece, but I recently discovered that the wording actually goes back centuries to piastre, the French word for the Spanish peso. Even more interesting is the vernacular usage of trente-sous (or 30 sous) to mean 25-cents, which I only understood after reading this from Frédéric Farid.
After the '87 market crash, a business man begs for 25¢ (Source)

The story goes like this. In the 18th and 19th Centuries, an English halfpenny was referred to in the colony of Lower Canada (i.e. Quebec) as a sou. The pound-shilling-pence unit of account (£/s/d) was still in use at the time but Spanish dollars were the most common coin in circulation in both Upper and Lower Canada. Dollars were officially rated by the British authorities at $4 for each £1. A quarter Spanish dollar (a two-real coin or 25 cent piece) would therefore be worth £0.0625.

Since an English pound contained 240 pence, that meant a quarter Spanish dollar was worth 15 English pennies, or 30 half-pennies. And given that Quebecers referred to half-pennies as sous, that gave rise to the ongoing practice of referring to 25 cents as 30 sous. When they use this term today, Quebecers are just referring to the archaic exchange rate between Spanish dollars and pence.

Source: La Maison nationale des Patriotes

This odd system of conversion really hits home when you work through the above scrip note emitted by Distillerie St-Denis, printed in 1837.  It is denominated in three different units. Trente-sous appears twice in French and once as XXX, while in the English paragraph near the bottom the £/s/d equivalent of one shilling and three pence, or fifteen English pennies, appears. Finally, a two-real coin, or quarter dollar—the pillars of Hercules side showing—has been emblazoned smack in the centre.

To end things off, you can also see a ghost of the old Spanish dollar in Venezuela's 12½ centimos coin. This coin is an eight of a bolivar—reckoning in terms of eights and sixteenths is a hallmark of the days of the old pillar coin.
Given Venezuela's ongoing hyperinflation, the likely destiny of the 12½ centimos coin is to be nothing more than another two-bit dead coin.

George Selgin, Good Money
A. Piatt Andrew, The End of the Mexican Dollar (link)
J.B. Caldecott. The Spanish Dollar as Adapted for Currency in Our West Indian Colonies (link)