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Monday, September 20, 2010

Say's Law of Markets, Part X: The Man Who Would Be King

From a "Just Third Way" perspective, there was a tremendous difference between Great Britain and the United States throughout most of the 19th century. In Great Britain, ownership of the means of production was becoming increasingly concentrated due to the method of financing new capital formation, while in the United States ownership of the means of production was becoming increasingly widespread due to the western frontier. Both of these had a significant on the perceived validity of Say's Law of Markets and the real bills doctrine, especially in that ownership of the means of production, whether labor or capital, is essential to their proper functioning.

Cotton is King

Obviously this is a general observation. Great Britain was becoming increasingly industrialized and thus dependent on the wage system, while the United States remained largely agrarian until approximately 1890. There were (and remain) however, large areas of Great Britain based on agriculture and relatively small ownership of the means of production, just as in the United States from about 1820 on there were areas in the United States in which industrialization and its social and economic effects reflected conditions similar to that which prevailed in Great Britain. By and large, however, it is not inaccurate to state that Great Britain in the 19th century was predominantly industrial, while the United States was predominantly agricultural.

This was, in fact, the theme of David Christy's 1855 opus, Cotton is King, the book that, even more than Uncle Tom's Cabin, caused and contributed to the ferocity of the American Civil War. Christy's thesis was that the economic health of Anglo-American civilization depended on American agricultural products, chiefly cotton, supplied as raw materials for the industrialized British economy. That sector of American agriculture that produced commodities for export presumably required slave labor. This was because of the theory that "factory farming" on the scale necessary to support both economies could not be carried out by free labor, which was allegedly unsuited to both the climate and the type of labor needed for the cultivation of cotton. Thus, Christy's thesis was that the prosperity of both the United States and Great Britain — and, in a vast "ripple effect," that of the entire world — depended absolutely on the slave cultivation of American agricultural commodities. As he summed up his argument,
KING COTTON cares not whether he employs slaves or freemen. It is the cotton, not the slaves, upon which his throne is based. Let freemen do his work as well, and he will not object to the change. Thus far the experiments in this respect have failed, and they will not soon be renewed. The efforts of his most powerful ally, Great Britain, to promote that object, have already cost her people many hundreds of millions of dollars; with total failure as a reward for her zeal. One-sixth of the colored people of the United States are free; but they shun the cotton regions, and have been instructed to detest emigration to Liberia. Their improvement has not been such as was anticipated; and their more rapid advancement cannot be expected, while they remain in the country. The free colored people of the West Indies, can no longer be relied on to furnish tropical products, for they are fast sinking into savage indolence. His MAJESTY, KING COTTON, therefore, is forced to continue the employment of his slaves; and, by their toil, is riding on, conquering and to conquer! He receives no check from the cries of the oppressed, while the citizens of the world are dragging forward his chariot, and shouting aloud his praise! (David Christy, Cotton is King. New York: Derby and Jackson, 1856, 186-187.)
This was reflected in the financial systems of each country. When human labor is the predominant means of production, it really doesn't matter if ownership of the non-human means of production is concentrated. Whether land or other capital, the non-human means of production remains unproductive until labor can be applied to it. An owner can do nothing until and unless he or she works directly with his or her capital, or hires someone else to do the work. Given that human labor is responsible for virtually all production, direct ownership of other means of production becomes effectively economically irrelevant, as Adam Smith observed. (The Theory of Moral Sentiments, op. cit., IV.1.10.)

That being the case, the price of labor is relatively high because there is no substitute for it. Further, it doesn't matter if the financial powers-that-be believe that new capital formation can only be financed out of existing accumulations of savings, or, through the operation of Say's Law of Markets and the real bills doctrine it is possible to monetize the present value of existing and future marketable goods and services and finance new capital formation out of future savings. Both the rate of savings by cutting consumption, and the rate of new capital formation by any other means are slow enough so that the rate of savings and the rate of capital formation seem to be related. It doesn't really matter to which theory you adhere. Absent technological advances, labor remains the predominant factor of production, and the rate of new capital formation has little noticeable effect on economic growth.

We'll address the effect of technology on the demand for labor a little later. Right now we are interested in the effect of the belief that slave labor was an economic necessity had on the Civil War — and that the war had on the financial system that was evolving to meet the new conditions brought about by the Industrial Revolution.

Ironically, Christy was a former newspaper editor and an agent of the American Colonization Society in Ohio. (Joseph Dorfman, The Economic Mind in American Civilization, Volume II. New York: The Viking Press, 1953, 955.) The goal of the American Colonization Society was to abolish slavery gradually, shipping the former slaves to Africa, starting with the blacks who were already free, for they were shiftless and debased. (Ibid., 956.) The policy changed during the 1830s for reasons that are not particularly clear, although it may have had something to do with the invention of the cotton gin in 1796. Cotton production expanded rapidly from 0.75 million bales in 1830, to over 3.2 million in 1850. In light of this, Cotton is King met with an enthusiastic response from slave owners and anyone whose economic wellbeing depended on King Cotton:
Southerners were overjoyed at this defense. On the eve of the Civil War, a later edition of Christy's essay with the subtitle: Or, Slavery in the Light of Political Economy, was included in a joint volume of pro-slavery arguments to supersede a similar earlier volume. The abolitionists, by destroying in effect colonization in Africa, were the cause of the prosperity and power of slavery in the United States, Christy declared. The institution cannot be controlled by moral or physical force, but is entirely subject to the laws of political economy. Therefore returning free blacks to tropical countries to supply tropical products to commerce, and not domestic insurrection, should be advocated by honest critics of slavery, for slave labor must continue as long as free labor abstains from supplying the demand of commerce for cotton. (Ibid.)
Banking Before the Civil War

Regardless of Christy's enthusiasm for his subject and the dogmatic belief that he instilled in many of his readers as to the irresistible might of King Cotton, the United States did, barely five years after the publication of Cotton is King, go to war, with slavery being the direct cause. War being an expensive proposition, one of the first subjects to come up before Salmon P. Chase, Abraham Lincoln's Secretary of the Treasury, was how to finance the war effort. As he had presidential aspirations, and in ignorance of the real nature of money and credit as developed in Say's Law and the real bills doctrine, Chase decided it was more politically prudent — and far more popular — to finance the war by borrowing rather than raising taxes.

Lacking a central bank, the federal government could not simply issue securities and sell them to the central bank, which would create the money to purchase the bonds, as was the practice in England. Instead of a central bank, the United States most often used a "Sub-Treasury" system from 1833 to 1913. When Roger Taney removed federal deposits from the Second Bank of the United States under Andrew Jackson's instructions, he deposited the money in a number of state banks. These were called "pet banks" because most of them were chosen due to the fact that their officers supported Jackson and were friends of the administration — an extension of the usual "spoils system" into the realm of finance. (Conant, op. cit., 355.) The official requirements imposed on the pet banks were:
• They were to give security in certain cases,

• No small denomination notes were to be issued,

• One third of each bank's reserves were to be in specie, that is, in the form of gold and silver instead of loan paper representing liens on commercial, industrial, and agricultural assets, and

• Banks holding federal deposits were to honor each other's notes and drafts. (Ibid., 355-356.)
This arrangement lasted for four years, until the Specie Circular caused the Panic of 1837 and a virtual disappearance of gold and silver from circulation. Banks suspended specie payments and the pet banks were forced to deliver federal funds in the form of $25 million worth of bank notes. This put an end to Taney's proposal to use state banks as federal depositories, (Ibid., 356.) which would have enabled the Treasury Department to gain powerful allies through the judicious distribution of favors in the selection of the banks.

In response to the Panic, Martin Van Buren recommended the establishment of an "independent treasury system" in his State of the Union address. Federal funds should be kept exclusively by public officers, and nothing but gold and silver should be accepted in payments to the federal government. When the recommendation was enacted in 1840, the law specified that 25% of what was due to the federal government was to be paid immediately in gold and silver, with an additional 25% each year until all accounts were settled. (Ibid.)

Even though federal funds were thereby supposed to be in the custody of public officials, most of them assumed the personal responsibility of depositing the funds in private banks. With the success of William Henry Harrison and the Whigs, the legislation authorizing the independent treasury system was repealed. Subsequently, two bills reestablishing a fourth national bank passed Congress, but President Tyler vetoed both of them. (Ibid.)

Until 1846, public officials either deposited federal funds in various state institutions, or kept them in their own custody at their own discretion. At that time, Congress again implemented the independent treasury system. State banks were thereby authorized to purchase government bonds by printing currency, keeping the government securities as reserves in lieu of gold and silver. Even though the issues of the state banks that participated in the independent treasury system (also known as the Sub-Treasury System) were thus backed by government bonds, the federal government still refused to accept them in payment of all obligations (except for duties on imports, interest on the public debt, and, after June 3, 1864, in redemption of the national currency), demanding gold and silver. (Ibid., 356-357)

As can be seen, the "Sub-Treasury System" differs from the current operation of the Federal Reserve System only by the fact that the banks involved were privately owned and operated, instead of being "owned" by the member banks of the system and controlled by Congress. They were thus under the control of a slightly larger elite than is currently the case, but the results were essentially the same for the relatively low level of federal financial activity prior to the 20th century.

A House Divided

Although the different currencies, lacking a single regulatory agency, did not necessarily pass at par, even though all were backed by debt of the same government, the system worked more or less reasonably well until the Civil War put a serious strain on the nation's financial system. As Charles Conant described the situation,
The United States at the outbreak of the Civil War were conducting their financial operations through the independent Treasury. The notes of the State banks formed a large part of the medium of exchange in private transactions, but only specie was accepted in payments to the government. The aid of the banks was not sought in handling funds, in making transfers, in placing loans, or in paying interest. This at least was the theory of the independent Treasury, although in fact the absence of proper depositaries led many public officers to deposit their funds temporarily in the banks at their own risk. (Ibid., 397)
When the war started, Salmon P. Chase immediately realized that the federal government could not prosecute the war without the aid of the banking system — not if he wanted to adhere to his decision to finance the war by borrowing instead of through taxation. One fact that might confuse today's monetary theorists and the myth of "Lincoln Money" (for which, allegedly, the 16th president was assassinated) is that Lincoln seems to have left the question of financing entirely to Chase, "Honest Abe" being more concerned with holding the Union together by any means necessary.

Consequently, Chase held a conference in New York City on August 9, 1861, to which he invited representatives of the major banks in New York, Philadelphia, and Boston. They agreed to loan the federal government $150 million in gold, secured by three-year bonds bearing 7.3% interest. The bonds were to be redeemed with the proceeds of other bonds sold to the public. This loan has been credited with putting the Union war effort on a more or less solid footing, and committing the financial industry of the North to the war. (Ibid., 397-398)

A few days before the New York City conference, Congress had authorized the deposit of federal funds in specie-paying banks, a move that probably influenced the willingness of the bankers to loan money to the federal government. The banks naturally assumed that Congress's action authorized them to use all the instruments of modern banking in furtherance of their new client's interests, such as banknotes, checks, and drafts, allowing them to keep the actual gold for the loan they had just agreed to make safely in their vaults to back the paper. After getting the bankers to agree to advance the $150 million, however, Chase declared that Congress intended no such thing. Instead, the loan proceeds would be handed over to the government in coin. The bankers were, as might be imagined, outraged at Chase's stunt. Nevertheless, they finally agreed to his terms in order not to harm the war effort and damage the public credit. (Ibid., 398)

It was not sufficient. Consequently, Congress authorized additional loans, especially non-interest bearing notes in denominations of less than $50. These were to be payable on demand by the assistant treasurers of New York, Philadelphia, and Boston. As Conant described the situation,
These notes were not made legal tender and Secretary Chase, in recommending them, declared that "The greatest care will, however, be requisite to prevent the degradation of such issues into an irredeemable paper currency, than which no more certainly fatal expedient for impoverishing the masses and discrediting the government of any country can well be devised." Notwithstanding this brave language, the Treasury began to issue the new notes early in August [1861]. They were very reluctantly accepted as currency and the banks refused to receive them except as special deposits. The new notes threatened to bring infinite disorder into the currency system by the element of inflation which they involved. The banks filed a prompt protest against thus trifling with the circulating medium while they were straining their resources to withdraw capital from active industry and divert it to the uses of the government. The Secretary intimated that he would suspend the issue of such notes until other resources were exhausted, but that he did not regard it as proper to pledge himself openly not to exercise a power conferred by law. (Ibid., 399)
Reassured, the banks began sending the $150 million in gold to the federal government in $5 million increments. The Treasury at once began trying to sell the 7.3% bonds to repay the banks, but only managed to raise a little under $25 million. Consequently, the banks themselves purchased the rest of the notes in order to sell them over time to the public. In effect, the Treasury had engaged in a transaction that bears a striking resemblance to today's "open market operations" of the Federal Reserve. (Ibid., 399-400) The public's confidence in the private banks remained high, and they began to purchase the bonds.

Some fears were expressed that the gold entering circulation through federal government expenditures would find its way into banks in the west to replace the obligations issued by states now in secession, and thereby be lost to circulation. Before that could happen, however, Chase began issuing notes directly from the Treasury again, violating his pledge that he would not authorize additional issues of such notes until all other resources had been exhausted. (Ibid., 400)

"Lincoln Money"

Around this circumstance grew the myth of "Lincoln Money." As Gertrude M. Coogan creatively edited the above events in her book, Money Creators,
He [Lincoln] decided to eliminate the secret money power by establishing a system of money such as the Constitution had provided. He had not studied "finance," but his robust common sense revealed to him that the source of any nation's wealth resides in the natural resources and the work carried on in the nation.

Lincoln knew that the way to finance the Civil War was to have the United States Government itself issue non-cancellable United States currency but to issue it only in such amounts as corresponded with the nation's ability to produce the actual physical things needed to conduct the war. Lincoln made one issue of $150,000,000 of United States currency. But when the time came to issue more, to pay for war materials, the international financiers had succeeded in ruling Congress. The new issue of United States currency carried a restricting clause; "it was not legal tender for the payment of taxes or import duties." This restricted these United States notes and since they were not good for all purposes for which money was used, it was not in reality full legal tender. This move prevented Lincoln from financing the Civil War in an honest constitutional manner. (Gertrude M. Coogan, Money Creators: Who Creates Money? Who Should Create It? Palmdale, California: Omni Christian Publications, 1998, 215-216.)
This story is repeated with similar detail and the same distorted facts (e.g., the $150 million "currency" was in the form of 7.3% bonds made over to the commercial banks in exchange for gold coin) over and over in many different sources, such as Rev. Charles E. Coughlin's (Rev. Charles E. Coughlin, Money! Questions and Answers. No publisher or date given, 100-101.) Wickliffe B. Vennard, Sr. (Wickliffe B. Vennard, Sr., The Federal Reserve Hoax: The Age of Deception. Palmdale, California: Omni Publications, (ND), 77.) and Dr. R.E. Search (Dr. R.E. Search, Lincoln Money Martyred. Palmdale, California: Omni Publications, Inc., 1989.) A glance at the bibliographies of the volumes in question reveals that they all rely on each other for their facts and verification, and none have gone to original sources. Two of the "Lincoln Money" dogmas are particularly egregious, as they contradict explicit statements and actions taken by Secretary Chase:
• United States Notes were intended to be an unredeemable, non-interest bearing floating debt of the United States government (on the contrary, Chase clearly stated that, "The greatest care will, however, be requisite to prevent the degradation of such issues into an irredeemable paper currency, than which no more certainly fatal expedient for impoverishing the masses and discrediting the government of any country can well be devised." As for interest, "Of the amount raised by taxation . . . $9,000,000 was to pay the interest on the new debt." (Conant, op. cit., 403.)), and

• The United States government did not issue bonds or take out loans to back the notes (on the contrary, reference the three-year 7.3% bonds floated with the express intention of exchanging the securities for $150 million in gold from the commercial banks).
In any event, the "United States Notes" did not circulate to any great extent when first introduced, being used primarily to obtain gold from the reserves of the private banks. In essence, the federal government was insisting on issuing paper that it refused to redeem in specie, yet at the same time forcing private banks to redeem federal issues in gold and silver. That is, private banks were being forced to make good on government paper obligations in specie — obligations for which the government refused to give anything but more paper in exchange.

Chase's transactions took on the aspect of a swindle, which probably accounts for the outrage of the private bankers who ended up with vaults full of government paper in exchange for their gold and silver reserves. The federal government issued $150 million in 7.3% bonds in exchange for gold. This was a serious drain on the specie reserves of the private banks, as well as a serious attack on private property, the basis of sound money. The federal government then issued another $150 million in bonds in the form of non-interest bearing paper money ("United States Notes") to raise money intended to redeem the original 7.3% bonds given to the private banks in exchange for gold.

Gold Disappears

We have not, however, been able to find any evidence that the money raised by the United States Notes were actually used to establish a sinking fund to retire the 7.3% bonds. Instead, it appears that the government spent the United States Notes to meet additional war expenditures, and the public exchanged the United States Notes for more gold at the private banks.

As a result, in the three-week period between December 7 and December 28, 1861, the precious metal reserves of the private banks in New York City alone (already seriously depleted as a result of the $150 million loan in gold to the federal government) fell from more than $42 million to less than $30 million. (Ibid., 400) If redemption of the United States Notes continued at that rate, the remaining reserves of gold and silver would be completely exhausted in six weeks.

The bankers had an emergency meeting with Chase in which they pointed out that his actions would cause gold to pass at a premium, and that all paper currency, whether issued by state banks or directly by the U.S. Treasury, would be inflated by his increased issues of United States Notes. Chase refused to consider putting a stop to issuing currency backed only by the government's vague promise to redeem the notes at some unspecified date. In consequence, the banks felt forced to suspend redemption of the United States Notes in gold and silver. The suspension went into effect Monday, December 31, 1861. (Ibid.) Gold, silver, even the new copper-nickel cents disappeared almost immediately from circulation.