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The legal framework by which paper money and coins came to be accepted for use in private transactions and international trade was established in the 18th century by George Washington and Alexander Hamilton.
When President Washington brought together his cabinet for its first meeting on November 26, 1791, Alexander Hamilton put forward what is now universally accepted as the American law for money and public credit. The central bank shall be the depository for the government’s collection of taxes and the customer of first and last resort for the government’s sales of its debt. The paper currency issued by the central bank, along with secondary coinage, shall be defined by the law as legal tender.
In his presentation, Hamilton added a condition that is no longer considered necessary: To avoid the inflation and corruption caused by war spending, the central bank promises to redeem its bank notes on demand for coins. Hamilton offered the example of the Bank of England as evidence of the wisdom of such a plan. Through central-reserve banking, both the country and the government’s needs for capital would be answered, as they had been in the United Kingdom. Using foreign and domestic coins held as a reserve, the Bank of the United States would be able to put into circulation the amount of legal tender that the country needed. (Hamilton did not formally offer the now standard description of the money multiplier; but he hardly needed to. As users of merchant and state-chartered and private banks’ bills of exchange, Americans were already thoroughly familiar with paper as payment.)
After listening carefully and requesting position papers from each member of his cabinet, Washington said “yes” to Hamilton’s idea of a nationally-chartered bank, but “no” to everything else. As Hamilton hoped, the wealthy, both at home and abroad, would invest a portion of their money savings in the national debt. Investors would accept American federal debt as “safe” investments because its interest was reliably paid in the international money of gold. The Bank of the United States would accept the federal government’s deposits of its tax collections. The Bank would issue its own notes and bills of exchange.
But neither the Congress nor the Bank would issue paper legal tender. The national bank’s responsibility would be to maintain the country’s ability to meet its foreign exchange obligations. It would not be gathering up the nation’s savings and making them available to Congress to pay for public improvements. It would not even be allowed to lend against real estate. At the same time, the states had independent authority to issue charters for banks within their range of their own sovereignties. Those state-chartered and private banks would be able to issue bank notes in even the smallest denominations. (This was in stark contrast to the Bank of England, whose notes specifically excluded anything we might consider to be “small change”.) As Marcello De Cecco observed, Washington’s rejection of conventional central banking and acceptance, for the states, of the Scottish model of “free” banking, was establishing a unique financial system. The United States was allowing independent banks to be established almost at will, without a central government overseer. Each town would have a bank that could issue notes to its borrowers without first getting the approval of a central bank.
In most states banks would be free to mirror the Scottish banks and set their own specie reserve requirements. Extensions of credit would not have to wait for the collection of coins from the deposit of private savings; banks would create their deposits through the loans to their customers. Bank-issued notes would circulate locally and regionally as unredeemable bills of exchange; their use as a medium of exchange would come through private parties’ voluntary acceptance of them as payment.
Public land had to be purchased with coin; but the warrants and other title claims issued to the war veterans by the states and Congress could be exchanged for private bank notes and bills of credit. Even as the net supply of the official national money grew slowly, after the principal and interest owed on the federal debt was paid, the national economy grew wonderfully through independent banks providing the mortgages and direct loans financing the acquisition of American real estate. Credit paper would be the means by which commerce was done, even at the level of petty cash.
Throughout the 18th century the “developed” European economies and their colonies had been desperately short of the coins that we would consider small change. That shortage would, if anything, grow worse even as the American economy took off. Coins in small denominations became even less available, not because of Gresham’s law, but because the volume of commerce continued to outstrip the ability of the mint offices to produce minor currency. The deficit would be made up through the printing of local bank notes.
Under the plan Washington approved, as put into practice by Thomas Willing, the president of the Bank of the United States, Hamilton’s ideas were being turned on their head. Hamilton had expected the sovereign authority of the national government to be sufficient to allow the law to turn paper into coin. After all, even as the first Bank of the United States began receiving deposits of foreign coins received in payment of tariffs and excise taxes (the mint had not yet begun operation), trades in its own stock were being cleared using the Bank’s own notes. The Treasury of the United States was paying for its own 20% ownership of the Bank’s stock by taking out a loan from the Bank and then tendering the Bank’s own bill of exchange as payment. Why then, Hamilton and others asked, should governments be prohibited from using the leverage of fractional reserve banking? Why should the magic money multiplier operate for private credit but not for the government of the United States and state governments?
The answer, for Washington, Willing and G. Morris (who was in France dealing with Congress’ largest and most insistent creditor), was simple. The state and private banks, like everyone dealing in commercial exchange, had to protect their reputations. Cash money, in a credit economy, would only be used for final payments between parties who had no immediate plans for further dealings. But, precisely because it was rarely needed, any failure to provide it by a bank would be horribly expensive, if not fatal. The bank would find its notes being discounted or rejected; and it would lose even its borrowers. No one would want to pledge land or scarce specie as security for bank notes that could not be exchanged.
A government was under no comparable discipline. The financial terms for American governments had to be cash on the barrel head because they were exempt from all judicial remedies. Judgments against the United States of America did not have to be settled at all because they could not be secured in the first place. The government of the United States had sovereign immunity, and there was no possibility that it would ever surrender that absolute legal insulation.
There was every reason to expect the state governments to have equal absolute safety. In Chisholm v. Georgia (1793) the Supreme Court had attempted to assert its own absolute judicial supremacy by finding that the state of Georgia was just another defendant who could be brought before a federal judge. The political response was thorough and complete rejection of that principle and the instant passage of the 11th Amendment, granting states legal immunity. Under the Constitution, the states would be just as free as the federal government from being sued by ordinary citizens.
This fact of law and politics meant that governments would never join the people in having direct liability for their mistakes and extravagances. No one, either in the Constitutional Convention, the Cabinet or the first Congress, had suggested that the government should surrender its sovereignty. Many, like Hamilton and John Adams, thought it was the natural order of things: Kings and queens were immune from earthly judgment and Congress, the president and the courts themselves should enjoy the same privilege. Even Madison, Randolph and Jefferson, as believers in a continuing revolution, took it for granted that Congress and the president, like the National Convention in France, held absolute legal immunity as the sovereign authority. If no Congress, president, state governor and legislature, Parliament, king or revolutionary assembly would ever be subject to legal discipline, then they were in a permanently different realm from even the wealthiest private parties and corporations.
To allow Congress to charter a central bank of issue would give the federal government both the legal immunity it already had and a permanent exemption from the Constitution’s limits on its financial authority. People could use whatever credit paper they chose because they always had to settle accounts between each other or risk legal judgment. The two sovereign governments – the states and the United States – could not use credit paper as legal tender because they were exempt from all competitive restraint. Coin had to be the only money because that was the only way that governments and the people’s ability to use credit could balance the governments’ monopoly exemption from commercial liability. For the same reason, people had to be able to sue the Bank of the United States. Therefore, it had to be privately-owned and its note issues could not carry the immunity of sovereign authority.
In short, the scarcity of gold and silver coins had to be embraced, not evaded. Coin had to be the legal tender because only money could be paid by private citizens in settlement of court judgments and payment of taxes. To allow people to choose the private money they preferred would leave the government with the same empty sovereignty that the Congress had under the Confederation. To allow the government to be able to define public money used as legal tender would leave the citizens at the mercy of Congress’ unlimited powers to tax and spend. Like the emperors of Rome, Congress could clip the coins it issued or use ink and paper to pay the government’s debts and then require a different, better payment for taxes.
To thrive, the country had to accept the inherent tension between an open credit system and national money, whose supply was not under any political or commercial control. The lawyers could not be allowed to establish legal substitutions no matter how much they wished. If a bank or state or even the federal government was unable to settle its accounts in coin, then they would have to suspend or even default. The Constitution had created coin as money because that was the only practical restraint possible for a sovereign authority. Money had to be limited to a physical form that was – compared to words and pictures printed on paper – fundamentally scarce no matter what new discoveries of specie were made; and the law had to be, as it already was in the Constitution, unambiguously clear that even the lawmakers and judges would find no room for maneuver. Legal tender must have a physical scarcity that could not be argued away, even by Daniel Webster. This was the only restriction that could be effectively imposed equally on both the government and the people.
It was also the only one that would support foreign trade and exchange. There was, under the Washington plan, one exception to the general rule that state and federal government tax collections and payments would only be in cash. Bank of the United States notes, account balances and bills of exchange could be accepted in payment of import tariffs. Yet this seeming exception was, in fact, a shared acknowledgement between Americans and their foreign counterparties that only gold could serve as international money. Exporters to the United States chose to ship their goods to American ports F.O.B. because they could acquire U.S. Treasury debt in local currencies and bank credits in London and Amsterdam and have the interest due credited to their accounts with either the Bank of the United States or its European correspondents. That allowed them to avoid paying the premiums for either shipping gold to the United States with their goods or having their U.S. customers search for scarce coins. By allowing foreigners to keep their gold through these credit swaps, the Bank of the United States was supporting both its own reputation and the United States government’s credit.
A decade after the signing of the Treaty of Paris, foreign property owners, including American Tories who had fled to Canada, the United Kingdom and the Caribbean colonies, were having their property claim lawsuits proceed to final judgment. Americans, with their appalling credit history, had already proven that their lawyers’ words about money were just that – words. The only hope for the new government’s to establish international credit was for U.S. currency to be weights and measures of precious metal that were instantly convertible into sterling, guilder, franc and peso coins. Foreign banks and merchant creditors knew that American courts would satisfy judgments in international money. Claimants, lenders and commercial creditors would accept the Bank of the United States’ own promises to pay precisely because the Bank was scrupulous about hedging its own liabilities.
Its word was good because the Bank would never presume that a paper currency defined by the legislators of the United States or a central bank of their creation could be accepted as the equivalent of international money.
Stefan Jovanovich manages the portfolio for The NJT Company, Inc., a family office based in Nevada.
Read more articles by Stefan Jovanovich