Future Taxation and Paper Money Expansion in the Revolutionary War

Benjamin Franklin advocated paper money and monetary expansion in his essay "A Modest Inquiry into the Nature and Necessity of a Paper Currency." John H. Wood in the Chicago Fed's Economic Perspectives tells that Franklin advocated inflation but that:

"Afterwards, however, in that most candid of autobiographies, Franklin suggested that his motives might not have been altogether altruistic.

"'My Friends [in the Assembly], who conceiv'd I had been of some service, thought fit to reward me by employing me in printing the money; a very profitable jobb and a great help to me.'

"This monopoly, which Franklin retained until 1764, must certainly have been 'a great help'to the struggling young printer. He was also heavily in debt, another reason to favor a monetary expansion. Forty years later, however, Franklin, grown prosperous and now a creditor, observed that, "I now think there are limits beyond which the quantity [of currency] may be hurtful."

In an article that appeared in The Journal of Economic History (Vol. 48, No. 1 (Mar., 1988), pp. 47-68) Charles W. Calomiris notes that not only Franklin but also a number of the Federalists, to include Madison, Hamilton, John Adams, Gouverneur Morris and Robert Morris also supported paper money expansion in the mid 18th century. In fact, although paper money was invented in China, its modern application was invented in America. The British discouraged acquisition of gold specie in America, and many contemporary observers believed that there was a shortage of money.

Calomiris notes that in 1729, at the age of twenty-three, Franklin wrote "A Modest Inquiry into the Nature and Necessity of a Paper Currency,":

"a polemic supporting the creation of land banks in Pennsylvania. Franklin argued that the expansion of properly backed paper currency could have a lasting real effect on the aggregate stock of money and the extent of trade. Franklin focused on the favorable developmental consequences for a capital-poor, land-rich economy of being able to substitute paper for exportable specie. Franklin expounded on the virtues of multiple deposit expansion in Europe and the great saving enjoyed through fractional reserve banking and consequent reductions in specie hold-ings. The mortgage-backed currency issued by land banks, he reasoned, would be even more efficient because it would not direct any real resources to production

"Franklin argues that abundant money leads to lower interest rates, greater production, immigration, and special- ization by enhancing the rapid settlement of debts and by insuring that traders will always be able to purchase the bundle of goods they desire. Furthermore, in a currency-scarce economy, merchants who deal in foreign goods often are forced to pay wages and debts in kind from inventories, and thereby promote the consumption of foreign goods to the detriment of local commerce. In this context, land-backed paper money has a developmental "bootstrapping" role in moving the economy beyond a critical initial threshold which allows exchange and specialization to thrive...

"Franklin addressed opponents of land banks who claimed that an increase in money always led to inflation. He maintained that credible land-backed money would not be inflationary, in part because its creation corresponded to the earmarking of a set of real assets which backed it. The importance of backing in determining the value of money was extended by analogy to the government's use of its assets (future taxes) as a means of redeeming and giving value to its debts, including currency."

However, "Adam Smith argued that the demand for money-like debt depended not only on the backing of money, but on the sufficiency of the supply of competing liquid claims in the economy as a whole. He allowed money demand, as well as land or tax backing, to influence the value of money-like claims through the liquidity premium money enjoys." Smith did not look favorably upon paper money expansion.

Calomiris notes (pp. 47-8):

“Whether the colonies suffered a scarcity of money has been a topic of debate among economic historians. Throughout eighteenth-century America there were a wide variety of circulating media- foreign coins and bills, a trivial number of domestic coins, and private, colonial, state and continental notes. Specie import cost was inflated before the Revolutionary War by mercantilistic prohibitions and duties intended to encourage the flow of specie from the colonies to Britain... Colonial bills were restricted in supply by prohibitions and limitations originating in Britain, as well as by local government prohibitions of private paper issues and local limits on emissions of legal-tender currency. Parliament enacted its prohibitions at the behest of British and colonial creditors who saw in paper money a means to reduce the value of hard-currency debt. Some colonials complained that government regulations and government unwillingness to supply sufficient paper bills caused unnec- essary monetary scarcity” (pp. 47-8).

Like Pennsylvania, New York experimented with paper money inflation. Calomiris quotes New York's Governor Hunter (p. 48):

"I do affirm that since the circulation of these bills, the trade of this place has increased at least above a half of what it was."

"The currency stock valued in real terms at roughly 8 million Spanish milled dollars was viewed as a severe shortage in 1775, and the trebling of real balances from 1775 to 1776 due to state and continental note issues confirms the earlier potential for growth in real money balances" (p. 48)

"Pelatiah Webster's estimate of total specie and bills in America at the beginning of 1775 is $10 million (specie equivalent)." From May 1775 to November 1776 the states, acting individually, issued $18 million in currency to help finance the Revolutionary War but:

"The greatest source of increase in liquidity during the early war years, however, was the bills first authorized by the Continental Congress in May 1775. By the end of 1776, Congress had issued $25 million in continentals for which it received $21 million in specie value."

"The value of the promise to redeem continentals depended crucially on the ability and willingness of Congress to tax. Under the Articles of Confederation, however, only states had taxation authority, while both Congress and states could issue money and other debt. The redemption of continentals required the completion of the following chain of events: the war had to be won, Congress had to want to redeem its currency, the states had to be willing to transfer resources to Congress or to vest it with the power to tax, and the public had to be sufficiently wealthy and willing to be taxed" (p. 60)

"To contemporaries it was clear that the difference between the state and continental bills was the expected value of each for extinguishing taxes" (p. 61)

Ultimately "It's not worth a continental" became a popular expression as the federal Continental was redeemed at 2 cents on the dollar. Calomiris argues that where taxation was used to repay notes that served as paper money, extending the money supply was not inflationary. But where there was no backing of the paper money with increased taxation it was.

He goes on to quote Benjamin Franklin (p. 63):

“The general effect of the depreciation among the inhabitants of the States has been this, that it has operated as a gradual tax upon them, and every man has paid his share of the tax according to the time he retained any of the money in his hands, and to the depreciation within that time. Thus it has proved a tax on money, a kind of property very difficult to be taxed in any other mode; and it has fallen more equally than many other taxes, as those people paid most, who, being richest, had most money passing through their hands.”

In effect, Franklin is arguing for holding hard assets (land, gold, inventory, Lexuses) rather than cash.

Calomiris offers an interesting concluding observation:

"The financial legacy of the American Revolution was distrust of government money which, when combined with the struggle over private bank chartering privileges, contributed to the prolonged inadequacy of financial institutions in the United States. Critics of government monetary control cited the revolutionary experience as proof that governments could not be trusted to repay their monetary obligations. Such bitter opposition to government bill issues led to the prohibition of state bill issues by the Constitution. Federal powers regarding paper money creation were left deliberately vague by the framers as a compromise between those who advocated absolute prohibition and those who saw the advantage of occasional issues. While a small amount of government currency was issued during the War of 1812, only the financial exigencies produced by the Civil War led the government once again to create a substantial supply of paper money. The somewhat credible commitment to resume specie backing of greenbacks limited their depreciation, and the achievement of resumption in 1879 set the stage for a permanent government role in supplying paper money. Thus the displacement of the post-Revolution for a discussion of the constitutional debate over federal monetary powers."