Thursday, July 16, 2015

Solving the Greek Debt Crisis, IX: Return to “Sound Money”

Yesterday we looked at how Hjalmar Schacht, the “Old Wizard” with the unlikely middle name of “Horace Greeley” (no, really — he was born in New York City while his parents briefly lived there), stabilized the German currency in the 1920s, putting an end to the hyperinflation that followed World War I.  Of course, on the downside, this laid the foundation of the German resurgence that in less than a decade took the country from absolute zero to nearly conquering the world, but that’s a different issue.  The point to keep in mind is that it is possible to turn even a complete economic basket case completely around in less than a decade.

Charles A. Conant, "hard money" advocate.
Greece does not have to demonetize its national currency, however, or shift to another currency (although that could be beneficial if done properly) because the Euro currency union is — for the time being — not the immediate problem.  It’s a serious problem, of course, but not one that must be dealt with right now.  It should be, of course, but it doesn’t have to be — and that’s all a politician needs to hear to do nothing.

What Greece needs to do, however, is shift from debt backing for its Euros and private sector money supply (mortgages and bills of exchange), to asset backing — and it can be done, because it has been done, and without causing massive disruption in the economy.  Like Greece needs any more disruption. . . .

We can take as our model the program adopted by the United States in 1913 with the passage of the Federal Reserve Act — as it was originally designed, not as it is being (mis)used today.  To understand that, though, we need a little history as background.

Salmon P. Chase, the man who would be president.
Briefly, during the Civil War Abraham Lincoln’s Secretary of the Treasury, Salmon P. Chase, decided to finance the Union war effort using debt instead of raising taxes.  Charles A. Conant, a leading "banking principle" authority, hinted that Chase wanted to be president, and thus didn’t want to be identified with raising taxes.  That is also, by the way, why Chase had his picture put on the first issue of $1 United States Notes: he wanted people familiar with his face so they'd vote for him (Congress forced him to change the design).  Chase got away with debt financing, though, because Lincoln seems not to have given a damn where the money came from as long as it came.  Saving the Union and, later, freeing the slaves was more important than bad monetary and fiscal policy.

Consequently, “hard” money — gold, silver, and even copper nickel coinage — disappeared from circulation, replaced with private tokens and postage stamps for small change, and inflated greenbacks (United States Notes backed by government debt) for larger transactions.  By the end of the war, one dollar in gold was worth a minimum of $2.64 in paper, and the credit rating of the federal government had fallen drastically in the European markets.

A $1 National Bank Note (issued only until 1878)
Unfortunately, the at-first-official and, later, unofficial policy of deflation following the war to restore parity of the gold and paper currencies (i.e., making a paper dollar and the gold dollar pass at par, meaning having the same value) resulted in a lowering of prices and a shrinking pool of past savings for farmers and small businessmen.  At the same time, the rich industrialists and commercial interests could obtain all the money they wanted or needed by issuing bills of exchange based on future savings and either using them directly (merchants or trade acceptances) or discounting them at the new National Banks that also served as commercial banks.

Ironically, the National Bank Notes intended to replace the debt-backed United States Notes were also debt-backed.  Their only advantage was that the amount that could be issued was strictly regulated.  Interestingly, the $1 and $2 National Bank Notes were only issued until 1878, when $1 Silver Certificates and Treasury Notes of 1890, and $1 and $2 United States Notes replaced them.

William Jennings Bryan: "No cross of gold!"
Making matters worse was the falling price of silver relative to gold.  Because of falling prices for wheat and other agricultural products, farmers had to produce (for example) two bushels of wheat to pay back a loan that only bought one bushel of wheat.  As a result, the Populists led by William Jennings Bryan, “the Great Commoner,” began demanding “free silver.”

“Free silver” did not mean that everybody could get silver for free.  It meant that as much silver as people brought to the mint would be coined and pass into the economy as money.  It also meant inflation because the amount of silver in a silver dollar (or any other coin struck in silver) was worth much less than a dollar due to massive production and the falling price of silver.  Inflation would mean that farmers and small businessmen could get out of debt much easier by repaying with cheap silver instead of expensive gold — recall how France was able to leverage the fall in the price of silver to reduce the real value of the indemnity it paid to Prussia in the early 1870s.

The government refused to allow free silver, but did purchase a lot of silver to try and get the price up.  The government issued bonds, the bonds were used to back the Treasury Notes of 1890, The Treasury Notes of 1890 were used to purchase the silver, the silver was coined into silver dollars, the silver dollars were deposited in the U.S. Treasury, and the U.S. Treasury issued silver certificates to circulate instead of the silver dollars.  Thus, for every silver dollar in the Treasury, there was more than $1 in circulation.  The inflation did not, however, offset the falling price level, because the falling price level was due more to increased productivity of the new capital instruments than to deflation of the Greenback currency.

A $100 "Yellow Back" Gold Certificate, Series 1882.
The United States thus had three separate debt-backed paper currencies all circulating at the same time, the United States Notes (“Greenbacks”), the National Bank Notes, and the Treasury Notes of 1890.  In addition, there were Silver Certificates (backed with silver dollars with less than $1 in silver in each one) and Gold Certificates ("Yellow Backs"), as well as the bronze, copper-nickel, and silver token (effectively debt-backed) currency, and the full-value gold currency.

A $20 Treasury Note of 1890
This meant that the U.S. federal government had seven official currencies, three of which were 100% debt-backed, two that were partially debt-backed, and two that were asset-backed.  The U.S. private sector, however, had two unofficial “currencies”: mortgages and bills of exchange, both of which were asset-backed.  The money supply in the United States therefore consisted of nine different kinds of money — but only the rich could get asset-backed money when they needed it by issuing bills of exchange.  Everybody else had to make do with a fixed amount of currency that never seemed sufficient to meet the needs of ordinary people.

"Double Eagle" of 1894: $20 gold ("baggy", i.e., scratches).
The problem seemed insoluble.  To have a stable money supply the reserve currency (the debt-backed National Bank Notes) had to be convertible into an asset on demand.  This meant the quantity of National Bank Notes had to be strictly regulated to avoid inflation, and the government had to avoid going into too much debt, or there wouldn’t be enough gold to meet the demand for convertibility of the reserve currency.

At the same time, because people believed the currency had to be backed by debt, the government simply had to have some debt outstanding . . . which was manageable as long as the politicians didn’t start cranking up the printing presses to cover deficits or to be able to spend to meet political goals . . . the same problem Greece faces today.

On Monday we’ll look at how the United States solved this dilemma . . . even if it didn’t stick to it for more than a couple of years. . . .


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