The Origins of Government Paper Money
[This article is excerpted from A History of Money and Banking in the United States (2002). An MP3 audio file of this article, read by Matthew Mezinskis, is available for download.]
Apart from medieval China, which invented both paper and printing centuries before the West, the world had never seen government paper money until the colonial government of Massachusetts emitted a fiat paper issue in 1690.1 2
Massachusetts was accustomed to launching plunder expeditions against the prosperous French colony in Quebec. Generally, the expeditions were successful, and would return to Boston, sell their booty, and pay off the soldiers with the proceeds. 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 ripe for mutiny, so the Massachusetts government looked around in concern for a way to pay the soldiers. It tried to borrow £3,000–£4,000 from Boston merchants, but evidently the Massachusetts credit rating was not the best.
Finally, Massachusetts decided in December 1690 to print £7,000 in paper notes and to use them to pay the soldiers. Suspecting that the public would not accept irredeemable paper, the government made a twofold pledge when it issued the notes: that it would redeem them in gold or silver out of tax revenue in a few years and that absolutely no further paper notes would be issued. Characteristically, however, both parts of the pledge went quickly by the board: the issue limit disappeared in a few months, and all the bills continued unredeemed for nearly 40 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 of new money to repay all of its outstanding debt, again pledging falsely that this would be the absolute final note issue.
But Massachusetts found that the increase in the supply of money, coupled with a fall in the demand for paper because of growing lack of confidence in future redemption in specie, led to a rapid depreciation of new money in relation to specie. Indeed, within a year after the initial issue, the new paper pound had depreciated on the market by 40 percent against specie.
By 1692, the government moved against this market evaluation by use of force, making the paper money compulsory legal tender for all debts at par with specie, and by granting a premium of 5 percent on all payment of debts to the government made in paper notes. This legal-tender law had the unwanted effect of Gresham's law: the disappearance of specie circulation in the colony. In addition, the expanding paper issues drove up prices and hampered exports from the colony. In this way, the specie "shortage" became the creature rather than the cause of the fiat-paper issues. Thus, in 1690, before the orgy of paper issues began, £200,000 of silver money was available in New England; by 1711, however, with Connecticut and Rhode Island having followed suit in paper money issue, £240,000 of paper money had been issued in New England but the silver had almost disappeared from circulation.
Ironically, then, Massachusetts's and her sister colonies' issue of paper money created rather than solved any "scarcity of money." The new paper drove out the old specie. The consequent driving up of prices and depreciation of paper scarcely relieved any alleged money scarcity among the public. But since the paper was issued to finance government expenditures and pay public debts, the government, not the public, benefited from the fiat issue.
After Massachusetts had emitted another huge issue of £500,000 in 1711 to pay for another failed expedition against Quebec, not only was the remainder of the silver driven from circulation, but, despite the legal-tender law, the paper pound depreciated 30 percent against silver. Massachusetts pounds, officially 7 shillings to the silver ounce, had now fallen on the market to 9 shillings per ounce. Depreciation proceeded in this and other colonies despite fierce governmental attempts to outlaw it, backed by fines, imprisonment, and total confiscation of property for the high crime of not accepting the paper at par.
Faced with a further "shortage of money" due to the money issues, Massachusetts decided to press on; in 1716, it formed a government "land bank" and issued £100,000 in notes to be loaned on real estate in the various counties of the province.
Prices rose so dramatically that the tide of opinion in Massachusetts began to turn against paper, as writers pointed out that the result of issues was a doubling of prices in the past 20 years, depreciation of paper, and the disappearance of Spanish silver through the operation of Gresham's law. From then on, Massachusetts, pressured by the British Crown, tried intermittently to reduce the bills in circulation and return to a specie currency, but was hampered by its assumed obligations to honor the paper notes at par of its sister New England colonies.
In 1744, another losing expedition against the French led Massachusetts to issue an enormous amount of paper money over the next several years. From 1744 to 1748, paper money in circulation expanded from £300,000 to £2.5 million, and the depreciation in Massachusetts was such that silver had risen on the market to 60 shillings an ounce, ten times the price at the beginning of an era of paper money in 1690.
By 1740, every colony but Virginia had followed suit in fiat-paper-money issues, and Virginia succumbed in the late 1750s in trying to finance part of the French and Indian War against the French. Similar consequences — dramatic inflation, shortage of specie, massive depreciation despite compulsory par laws — ensued in each colony. Thus, along with Massachusetts's depreciation of 11-to-1 of its notes against specie compared to the original par, Connecticut's notes had sunk to 9-to-1 and the Carolinas' at 10-to-1 in 1740, and the paper of virulently inflationist Rhode Island to 23-to-1 against specie. Even the least-inflated paper, that of Pennsylvania, had suffered an appreciation of specie to 80 percent over par.
A detailed study of the effects of paper money in New Jersey shows how it created a boom-bust economy over the colonial period. When new paper money was injected into the economy, an inflationary boom would result, to be followed by a deflationary depression when the paper money supply contracted.3
At the end of King George's war with France in 1748, Parliament began to pressure the colonies to retire the mass of paper money and return to a specie currency. In 1751, Great Britain prohibited all further issues of legal-tender paper in New England and ordered a move toward redemption of existing issues in specie. Finally, in 1764, Parliament extended the prohibition of new issues to the remainder of the colonies and required the gradual retirement of outstanding notes.
Following the lead of Parliament, the New England colonies, apart from Rhode Island, decided to resume specie payment and retire their paper notes rapidly at the current depreciated market rate. The panicky opponents of specie resumption and monetary contraction made the usual predictions in such a situation: that the result would be a virtual absence of money in New England and the consequent ruination of all trade. Instead, however, after a brief adjustment, the resumption and retirement led to a far more prosperous trade and production — the harder money and lower prices attracting an inflow of specie. In fact, with Massachusetts on specie and Rhode Island still on depreciated paper, the result was that Newport, which had been a flourishing center for West Indian imports for western Massachusetts, lost its trade to Boston and languished in the doldrums.45
In fact, as one student of colonial Massachusetts has pointed out, the return to specie occasioned remarkably little dislocation, recession, or price deflation. Indeed, wheat prices fell by less in Boston than in Philadelphia, which saw no such return to specie in the early 1750s. Foreign-exchange rates, after the resumption of specie, were highly stable, and "the restored specie system operated after 1750 with remarkable stability during the Seven Years War and during the dislocation of international payments in the last years before the Revolution."6
Not being outlawed by government decree, specie remained in circulation throughout the colonial period, even during the operation of paper money. Despite the inflation, booms and busts, and shortages of specie caused by paper issues, the specie system worked well overall:
Here was a silver standard … in the absence of institutions of the central government intervening in the silver market, and in the absence of either a public or private central bank adjusting domestic credit or managing a reserve of specie or foreign exchange with which to stabilize exchange rates. The market … kept exchange rates remarkably close to the legislated par …. What is most remarkable in this context is the continuity of the specie system through the seventeenth and eighteenth centuries.7
Private Bank Notes
In contrast to government paper, private bank notes and deposits, redeemable in specie, had begun in western Europe in Venice in the 14th century. Firms granting credit to consumers and businesses had existed in the ancient world and in medieval Europe, but these were "money lenders" who loaned out their own savings. "Banking" in the sense of lending out the savings of others only began in England with the "scriveners" of the early 17th century. The scriveners were clerks who wrote contracts and bonds and were therefore in a position to learn of mercantile transactions and engage in money lending and borrowing.8
There were, however, no banks of deposit in England until the civil war in the mid-17th century. Merchants had been in the habit of storing their surplus gold in the king's mint for safekeeping. That habit proved to be unfortunate, for when Charles I needed money in 1638, shortly before the outbreak of the civil war, he confiscated the huge sum of £200,000 of gold, calling it a "loan" from the owners. Although the merchants finally got their gold back, they were understandably shaken by the experience, and forsook the mint, depositing their gold instead in the coffers of private goldsmiths, who, like the mint, were accustomed to storing the valuable metal. The warehouse receipts of the goldsmiths soon came to be used as a surrogate for the gold itself. By the end of the civil war, in the 1660s, the goldsmiths fell prey to the temptation to print pseudo warehouse receipts not covered by gold and lend them out; in this way fractional-reserve banking came to England.9
Very few private banks existed in colonial America, and they were short-lived. Most prominent was the Massachusetts Land Bank of 1740, issuing notes and lending them out on real estate. The land bank was launched as an inflationary alternative to government paper, which the royal governor was attempting to restrict. The land bank issued irredeemable notes, and fear of its unsound issue generated a competing private silver bank, which emitted notes redeemable in silver. The land bank promptly issued over £49,000 in irredeemable notes, which depreciated very rapidly. In six months' time the public was almost universally refusing to accept the bank's notes and land-bank sympathizers vainly accepting the notes. The final blow came in 1741, when Parliament, acting at the request of several Massachusetts merchants and the royal governor, outlawed both the land and the silver banks.
One intriguing aspect of both the Massachusetts Land Bank and other inflationary colonial schemes is that they were advocated and lobbied for by some of the wealthiest merchants and land speculators in the respective colonies. Debtors benefit from inflation and creditors lose; realizing this fact, older historians assumed that debtors were largely poor agrarians and creditors were wealthy merchants and that therefore the former were the main sponsors of inflationary nostrums. But, of course, there are no rigid "classes" of debtors and creditors; indeed, wealthy merchants and land speculators are often the heaviest debtors. Later historians have demonstrated that members of the latter group were the major sponsors of inflationary paper money in the colonies.1011
- 1. Government paper redeemable in gold began in the early 9th century, and after three centuries the government escalated to irredeemable fiat paper, with the usual consequences of boom-bust cycles, and runaway inflation. See Gordon Tullock, "Paper Money — A Cycle in Cathay," Economic History Review 9, no. 3 (1957): 393–96.
- 2. The only exception was a curious form of paper money issued five years earlier in Quebec, to become known as "card money." The governing intendant of Quebec, Monsieur Mueles, divided some playing cards into quarters, marked them with various monetary denominations, and then issued them to pay for wages and materials sold to the government. He ordered the public to accept the cards as legal tender, and this particular issue was later redeemed in specie sent from France.
- 3. Donald L. Kemmerer, "Paper Money in New Jersey, 1668–1775," New Jersey Historical Society, Proceedings 74 (April 1956): 107–44.
- 4. Before Massachusetts went back to specie, it was committed to accept the notes of the other New England colonies at par. This provided an incentive for Rhode Island to inflate its currency wildly, for this small colony, with considerable purchases to make in Massachusetts, could make these purchases in inflated money at par. Thereby Rhode Island could export its inflation to the larger colony, but make its purchases with the new money before Massachusetts prices could rise in response. In short, Rhode Island could expropriate wealth from Massachusetts and impose the main cost of its inflation on the latter colony.
- 5. If Rhode Island was the most inflationary of the colonies, Maryland's monetary expansion was the most bizarre. In 1733, Maryland's public land bank issued £70,000 of paper notes, of which £30,000 was given away in a fixed amount to each inhabitant of the province. This was done to universalize the circulation of the new notes, and is probably the closest approximation in history of Milton Friedman's "helicopter" model, in which a magical helicopter lavishes new paper money in fixed amounts of proportions to each inhabitant. The result of the measure, of course, was rapid depreciation of new notes. However, the inflationary impact of the notes was greatly lessened by tobacco still being the major money of the new colony. Tobacco was legal tender in Maryland and the paper was not receivable for all taxes.
- 6. Roger W. Weiss, "The Colonial Monetary Standard of Massachusetts," Economic History Review 27 (November 1974): 589.
- 7. Ibid., p. 591.
- 8. During the 16th century, before the rise of the scriveners, most English moneylending was not even conducted by specialized firms, but by wealthy merchants in the clothing and woolen industries, as outlets for their surplus capital. See J. Milnes Holden, The History of Negotiable Instruments in English Law (London: Athlone Press, 1955), pp. 205–06.
- 9. Once again, ancient China pioneered in deposit banking, as well as in fractional-reserve banking. Deposit banking per se began in the 8th century AD, when shops would accept valuables, in return for warehouse receipts, and receive a fee for keeping them safe. After a while, the deposit receipts of these shops began to circulate as money. Finally, after two centuries, the shops began to issue and lend out more receipts than they had on deposit; they had caught on to fractional-reserve banking. Tullock, "Paper Money," p. 396.
- 10. On the Massachusetts Land Bank, see the illuminating study by George Athan Billias, "The Massachusetts Land Bankers of 1740," University of Maine Bulletin 61 (April 1959). On merchant enthusiasm for inflationary banking in Massachusetts, see Herman J. Belz, "Paper Money in Colonial Massachusetts," Essex Institute, Historical Collections 101 (April 1965): 146–63; and Herman J. Belz, "Currency Reform in Colonial Massachusetts, 1749–1750," Essex Institute, Historical Collections 103 (January 1967): 66–84. On the forces favoring colonial inflation in general, see Bray Hammond, Banks and Politics in America (Princeton, N.J.: Princeton University Press, 1957), chap. 1; and Joseph Dorfman, The Economic Mind in American Civilization, 1606–1865 (New York: Viking Press, 1946), p. 142.
- 11. For an excellent biographical essay on colonial money and banking, see Jeffrey Rogers Hummel, "The Monetary History of America to 1789: A Historiographical Essay," Journal of Libertarian Studies 2 (Winter 1978): 373–89. For a summary of colonial monetary experience, see Murray N. Rothbard, Conceived in Liberty, vol. 2, Salutary Neglect, The American Colonies in the First Half of the Eighteenth Century (New Rochelle, N.Y.: Arlington House, 1975), pp. 123–40. A particularly illuminating analysis is in the classic work done by Charles Jesse Bullock, Essays on the Monetary History of the United States (New York: Greenwood Press,  1969), pp. 1–59. Up-to-date data on the period is in Roger W. Weiss, "The Issue of Paper Money in the American Colonies, 1720–1774," Journal of Economic History 30 (December 1970): 770–84.