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4. The Origins of Government Paper Money

Three times before in American history, since the end of the colonial period, Americans had suffered

under an irredeemable fiat money system. Once was during the American Revolution, when, to finance the war

effort, the central government issued vast quantities of paper money, or “Continentals.” So rapidly did they

depreciate in value, in terms of goods and in terms of gold and silver moneys, that long before the end of the

war they had become literally worthless. Hence, the well-known and lasting motto: “Not Worth a Continental.”

The second brief period was during the War of 1812, when the U.S. went off the gold standard by the end of

the war, and returned over two years later. The third was during the Civil War, when the North, as well as the

South, printed greenbacks, irredeemable paper notes, to pay for the war effort. Greenbacks had fallen to half

their value by the end of the war, and it took many struggles and fourteen years for the U.S. to return to the

gold standard.8

During the Revolutionary and Civil War periods, Americans had an important option: they’ could still

use gold and silver coins. As a result, there was not only price inflation in irredeemable paper money; there

was also inflation in the price of gold and silver in relation to paper. Thus, a paper dollar might start as

equivalent to a gold dollar, but, as mammoth numbers of paper dollars were printed by the government, they

depreciated in value, so that one gold dollar would soon be worth two paper dollars, then three, five, and

finally 100 or more paper dollars.

Allowing gold and paper dollars to circulate side-by-side, meant that people could stop using paper

and shift into gold. Also, it became clear to everyone that the cause of inflation was not speculators, workers,

consumer greed, “structural” features or other straw men. For how could such forces be at work only with

paper, and not with gold, money? In short, if a sack of flour [p. 56] was originally worth $3, and is now worth

the same $3 in gold, but $100 in paper, it becomes clear to the least sophisticated that something about paper

is at fault, since workers, speculators, businessmen, greed, and so on, are always at work whether gold or paper is being used.

Printing was first invented in ancient China and so it is not surprising that government paper money

began there as well. It emerged from the government’s seeking a way to avoid physically transporting gold

collected in taxes from the provinces to the capital at Peking. As a result, in the mid-eighth century, provincial

governments began to set up offices in the capital selling paper drafts which could be collected in gold in the

provincial capitals. In 811-812, the central government outlawed the private firms involved in this business and

established its own system of drafts on provincial governments (called “flying money”).9

The first government paper money in the Western world was issued in the British American province

of Massachusetts in 1690.10 Massachusetts was accustomed to engaging in periodic plunder expeditions

against prosperous French Quebec. The successful plunderers would then return to Boston and sell their loot,

paying off the soldiers with the booty thus amassed. This time, however, the expedition was beaten back

decisively, and the soldiers returned to Boston in ill humor, grumbling for their pay. Discontented soldiers are

liable to become unruly, and so the Massachusetts government looked around for a way to pay them off.

It tried to borrow 3 to 4 thousand pounds sterling from Boston merchants, but the Massachusetts

credit rating was evidently not the best. Consequently, Massachusetts decided in December 1690 to print

£7,000 in paper notes, and use them to pay the soldiers. The government was shrewd enough to realize that it

could not simply print irredeemable paper, for no one would have accepted the money, and its value would

have dropped in relation to sterling. It therefore made a twofold [p. 57] pledge when it issued the notes: It

would redeem the notes in gold or silver out of tax revenues in a few years, and that absolutely no further

paper notes would be issued. Characteristically, however, both parts of the pledge quickly went by the board:

the issue limit disappeared in a few months, and the bills continued unredeemed for nearly forty years. As early

as February 1691, the Massachusetts government proclaimed that its issue had fallen “far short,” and so it

proceeded to emit £40,000 more to repay all of its outstanding debt, again pledging falsely that this would be

the absolutely final note issue.

The typical cycle of broken pledges, inflationary paper issues, price increases, depreciation, and

compulsory par and legal tender laws had begun—in colonial America and in the Western world.11

So far, we have seen that M, the supply of money, consists of two elements: (a) the stock of gold

bullion and coin, a supply produced on the market; and (b) government paper tickets issued in the same

denominations—a supply issued and clearly determined by the government. While the production and supply

of gold is therefore “endogenous to” (produced from within) the market, the supply of paper dollars—being

determined by the government—is “exogenous to” (comes from outside) the market. It is an artificial

intervention into the market imposed by government.

It should be noted that, because of its great durability, it is almost impossible for the stock of gold and

silver actually to decline. Government paper money, on the other hand, can decline either (a) if government

retires money out of a budget surplus or (b) if inflation or loss of confidence causes it to depreciate or

disappear from circulation.

We have not yet come to banking, and how that affects the supply of money. But before we do so, let

us examine the demand for money, and see how it is determined, and what affects its height and intensity. [p.

58] [p. 59]