Lessons From America’s First Great Inflations

Lessons From America’s First Great Inflations

Robert E. Wright

New England first experienced significant inflation in the first half of the 1700s, and got out of it by banning fiat paper money, returning to a commodity money standard and forcing fiscal restraint on the region’s governments through the bond market. That does not mean that America must return to gold or adopt a Bitcoin standard to get out of its current inflationary and fiscal messes. Federal Reserve Chairman Paul Volcker proved that raising interest rates to the moon to induce recession can squelch inflation too. Colonial South Carolina also experienced a period of rapid inflation that ended when its government slowed new money issuance until it suffered recession. The colonial New England episode offers a potentially less jarring way out, although the details require some background knowledge to understand.

The money supply of British North America consisted of book credit, country pay, fiat paper bills of credit, and various full-bodied gold, silver, copper, and vellon (copper and silver mixed) coins (collectively known as specie), most of foreign manufacture. Though seemingly chaotic, the colonial payments system worked because economic value was standardized through a duodecimal (base 20) unit of account nominally identical to that used in Great Britain: 20 shillings to the pound, 12 pence in a shilling, and 4 farthings in a pence.

In Britain, the pound sterling was merely a unit of account as there was no pound coin in circulation in the 18th century. Instead, a gold guinea coin rated at £1 and 1 shilling (21 shillings) sterling unit of account circulated. A shilling coin did circulate, conveniently worth a shilling sterling unit of account (.05 pound sterling). In the colonies, British shilling coins were rarely seen, but when they did enter circulation they were worth more than a shilling in the local unit of account. That did not break any of the laws of economics because although colonial units of account nominally and denominationally resembled those of Britain, they were not sterling British pounds, just as Canadian or Australian dollars today are not the same as US dollars.

The colonial units, usually termed the “money” or “currency” of a given colony, were invariably worth less than sterling. So, for example, in the late colonial period a New York merchant needed about £NY170 to buy £stg.100 (1.70 pounds New York currency to buy 1.00 pound sterling), just like a Canadian merchant today needs about 1.25 CAD to buy 1.00 USD. That exchange rate prevailed because New York merchants valued gold and silver coins higher in nominal terms than British merchants did. For example, New Yorkers considered a French guinea (a gold coin) worth 36 shillings in New York’s unit of account, while in England the same coin passed at 21 shillings in Britain’s unit of account. Do a little math (36/21 = 1.71) and the New York-sterling exchange rate makes economic sense.

In domestic transactions, colonists reckoned value in their local unit of account and made economic decisions accordingly. Coins were seldom seen because they were seldom needed. Over the course of a year, a farmer in the Massachusetts countryside might buy 10 shillings (120 pence or £.5 Massachusetts money) worth of booze from a local tavern keeper on credit. The farmer might repay her (yes, her) with labor or farm produce at a market rate. Or, he might tender beef, maize, pork, or other items of “country pay” at a rate decreed by the colonial government. Or, he might tender foreign coins at the rates decreed by the colonial government or, later in the colonial period, by local custom. Or, he might pay off his tab entirely and even establish a credit balance through a combination of those means of payment.

Even in Philadelphia and other colonial port towns, most retail transactions, and of course most wholesale transactions, were done on credit, not cash. Prices were not posted and part of the negotiation process included discussion of the terms of payment, with those offering good coin receiving lower prices than those who promised to pay on “short credit,” and much lower prices than those offering to pay only “on account,” like the Massachusetts farmer mentioned above. But good coins did not abound because their highest valued use was in international payments, not clinking about the colonies.

Ingenious as the colonial “bookkeeping barter” system described above was, it could not raise large sums quickly or efficiently. Private banks attempted to fill the void by issuing paper notes but Imperial and colonial governments squelched them, the latter to monopolize the market with their own paper money, which took three forms: tax anticipation script, loan office bills, and warehouse notes.

Colonists called both loan office bills and tax anticipation script “bills of credit,” though their legal and economic basis differed considerably. Loan office bills were issued to individuals as loans backed by significant collateral, typically improved real estate. In the event of default, the government could seize and sell the collateral. Warehouse notes were also backed by collateral, the deposit of merchantable commodities, typically tobacco, in a government warehouse. (British government bonds backed one issue of bills of credit by the colony of Maryland.) Note that all of those forms of paper money enjoyed flexible legal limits but also hard economic constraints linked to the value of the collateral assets backing the emissions.

Bills of credit issued as tax anticipation script faced a flexible legal limit, but no clear economic one. The issuers promised only to redeem the bills for taxes but were under no obligation to redeem them for specie, or anything else of value. The issuing governments controlled both tax rates and bill redemption periods, which they often extended to keep taxes at a politically palatable, which is to say low, level. (In economic jargon, they suffered a time inconsistency problem.)

In 1690, Massachusetts became the first colony to issue paper bills of credit. They took the form of tax anticipation script because they were needed to finance a military expedition gone bad. By 1710, the other New England colonies (then only Connecticut, New Hampshire, and Rhode Island as Maine was still part of Massachusetts and Vermont remained unincorporated) also began to issue bills of credit to finance yet more wars. Because the eastern part of the region was small enough and economically tied to Boston closely enough to constitute a common currency area, bills of each colony circulated promiscuously across colonial boundaries.

When peace returned, a recession ensued and businessmen sought relief in the form of loan office bills lent at low rates of interest. Additionally, Rhode Island soon discovered that it could earn seigniorage rents by serving as a money pump, gleefully exchanging cheaply printed bills of credit for costly goods in Massachusetts, Connecticut, and New Hampshire. Its politicians deftly left the bills in circulation instead of raising taxes to retire them. People in the other New England colonies also were happy to let their bills continue to circulate rather than suffer higher taxes, procrastinating until another war forced them to issue yet more bills of credit. Eventually, bills of credit displaced all the coins in domestic circulation throughout New England’s common currency area.

Unsurprisingly, New England suffered a big bout of inflation, which the colonists perceived as a depreciation of their bills of credit vis-a-vis real money, i.e., gold, silver, or foreign exchange. In other words, it took more than the face value of the bills to purchase a coin of the same nominal rating. Similarly, when merchants purchased foreign exchange, like sterling denominated deposits in Britain, they had to pay more in bills of credit than in coins. When negotiating price, retailers would ask for more in immediate payment in bills of credit than they would for immediate payment in good coin.

The spot market price of silver in Boston is one way to track the depreciation of New England’s bills of exchange. It went from 8 shillings per ounce in 1707 to almost 57 shillings per ounce in 1747. An identical basket of goods composed of a chicken, a goose, a turkey, butter, cheese, eggs, beef, mutton, pork, veal, corn, rye, wheat, milk and beer, candles, and one pair of men’s and women’s shoes cost almost 7.5 times more in bills of credit in 1747 than in 1707. Plagued by thin, rocky soil and rock-headed policies, New England remained the poorest region in British mainland North America.

On their own, the New England colonies could do little to redeem the mass of paper money in circulation. Massachusetts legislator Thomas Hutchinson, however, saw an opportunity to return to a silver standard when Britain promised to reimburse the New England colonies for some of their military expenses. As part of the monetary reforms pushed by Hutchinson and applauded in London, Massachusetts rated the Mexican silver dollar at 6 shillings and established the lawful unit of account in terms of silver at 6 shillings 8 pence per ounce for all contracts entered into after 31 March 1750. Importantly, it also shut down the Rhode Island money pump by making the circulation of the bills of credit of other colonies illegal. A British warship carried 650,000 ounces of silver and some copper coins for small change to Massachusetts in late 1749. Redemption of the colony’s bills in silver was largely completed by June 1751 when the remaining outstanding bills became legal only for payment of taxes. Prodded by Britain and the need to do business in Boston, the other New England colonies soon implemented similar reforms.

Importantly, when British policymakers summoned Massachusetts into the French and Indian War later that decade, instead of issuing bills of credit Massachusetts financed its war effort by selling bonds serviced with silver. Owners of Massachusetts bonds wanted to be repaid, with interest, as promised. So unlike holders of bills of credit, they pressed policymakers for higher taxes and greater expenditure discipline instead of low taxes and a profligate public purse.

At the other end of British mainland North America, South Carolina also fought many wars and began funding them with tax anticipation script in 1703. Although it did not have to contend with a money pump in its midst because its neighbors remained economically stunted throughout the colonial period, South Carolina still managed to inflate away much of the real value of its bills. By 1730, one needed £700 of South Carolina bills of credit to purchase£100stg. A decade later, one needed £810. By slowing the issuance of new bills while the population was expanding thanks to increased international demand for two of its major exports, rice and indigo, however, it managed to appreciate its currency modestly, to £710 by 1849, and lure some specie coins back into domestic circulation. When the commodities markets softened, as they always do, businessmen in South Carolina began to push for a loan office, just as their compatriots in Massachusetts had done a generation earlier. But by the late 1740s, British policymakers were too disgusted by what was going on in New England to assent. In fact, over the next fifteen years, British policymakers would wrest control of monetary policy away from the colonies in ways that sparked the Imperial Crisis that led to revolution and independence.

Ironically, New England’s economy waxed strongly enough after its currency reform to enable it to lead the colonists’ fight for independence. More ironically still, instead of sticking to their increasingly robust capital market and specie standard, New England’s policymakers during the early stages of the American Revolution jettisoned what they had learned and joined the rest of the new states, and the new national government, in the issuance of fiat bills of credit. Only after those rebellious bills became worthless did the nation return to a specie standard and modern capital market instruments. Aided by reforms implemented during George Washington’s first term, that potent combination spurred a long wave of prosperity marked by agricultural, transportation, and industrial revolutions that transformed the New England countryside and made it one of America’s richest and most economically developed regions.

Today, the Federal Reserve and federal government serve as America’s Rhode Island, the money pump that keeps the money supply rising faster than money demand. The longer it waits to act decisively to combat inflation, however, the more it risks having to stop the inflationary spiral by inducing a recession and causing joblessness. Or, it will need to find some other credible mechanism to slow new money growth and returning to some sort of commodity standard, like gold, is a tried-and-true way to do that.

Courtesy: (AIER)

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