Interest-bearing currency and legal restrictions theory: lessons from the Southern Confederacy.

• Jurisdiction: United States
• Date: 22 September 2002
• Author: Burdekin, Richard C.K

Instances of interest-bearing currency are relatively rare. The Southern Confederacy issued both interest-bearing and non-interest-beating notes during the Civil War. The two types of notes apparently circulated alongside one another with the interest-bearing currency generally commanding the premium implied by legal restrictions theory. Government-imposed restrictions on banks prevented the non-interest-bearing notes from being driven out of circulation. The Southern experience appears to be consistent with the legal restrictions theory of money and suggests a potential role for interest-bearing currency as a circulating medium.

The Role of Interest-Bearing Currency

I would ... suggest the expediency of issuing notes ... of two kinds: one of a small denomination, without interest, say tens and fives, and denominations of twenties and upwards, at 8 per cent. per annum. It is believed that those bearing this interest will, as soon as the crop begins to come in, be relieved from circulation as a sort of savings fund.... If the Secretary of the Treasury be authorized to try the market with these issues experience will determine to what extent they may be used. --Confederate Secretary of Treasury Memminger (1861) (1)

U.S. government bonds have no more default risk than Federal Reserve notes and yet bondholders receive interest payments while holders of Federal Reserve notes do not. Why then do so many choose the non-interest-bearing notes? According to Wallace (1983) non-interest-bearing currency would be dominated by interest-bearing assets save for legal restrictions that interfere with the free circulation of interest-bearing alternatives. Government bonds, for example, are issued only in relatively large denominations and are not legal tender. Absent legal restrictions, Wallace (1983) argues that non-interest-bearing currency could exist side-by-side with other government obligations that pay interest only when the rate of return on the interest-bearing obligations is driven down to zero (or near zero). There are very few examples of interest-bearing currency with which to test the implications of legal restrictions theory, however. Indeed, the very absence of interest-beating currency has itself been taken as evidence against legal restrictions theory.

For example, White (1987) emphasizes that, even though there were apparently no legal restrictions prohibiting bank-note-issuing Scottish banks from offering interest on their notes over the 17161844 period, no interest-bearing notes were actually issued. According to legal restrictions theory, non-interest-bearing notes would be dominated by alternative interest-bearing assets like the high-quality commercial bills and government bonds that were available at the time. Friedman (1969: 39) argues that, in the absence of legal restrictions, competition among banks would force them to pay interest on currency--albeit at a rate below that paid on deposits because of the additional costs of paying the interest on the circulating currency. Thus, a Scottish note-issuing bank of the free banking era should have been "forced by competition to pay out to note-holders the anticipated net earnings on its asset portfolio" (White 1987: 450n). (2) The free banking experience in Scotland hardly disproves the idea that interest-bearing currency could afford a private note issuer a competitive advantage in other settings, however. Indeed, Schuler (2001) suggests that one way private banks could effectively compete with government-created money today would be through paying interest on them via a lottery feature.

McCulloch (1986) argues, though, that complete bank deregulation may be required to make interest-bearing currency feasible and cost-effective. A major cost of private note issuance by U.S. banks--before their notes were forcibly phased out under the terms of the 1913 Federal Reserve Act (see Schuler 2001)--had been the government bonds that banks were required to purchase to "back" their notes according to the 1863 National Currency Act. Even under the pre-1863 "free banking" era, banks still had to back their note issues with holdings of approved bonds. In this case, however, banks that were perceived to be riskier had their notes initially discounted by the market. Redemption at par not only allowed banks to prove their ability to honor their notes but also provided an implicit interest return based on the initial discounted price (Gorton 1996). (3)

Schuler (2001), while reviewing the federal government issuance of non-interest-bearing notes (the familiar "greenbacks") during the Civil War, and the attendant restrictions on note issuance by private banks, surprisingly does not consider that this same historical episode is also one of the very few experiences with actual issuance of interest-bearing currency. So, rather than speculate on why interest-bearing currency has failed to appear, there is an opportunity to see how actual issues of interest-bearing currency were received by the public. Such evidence could not only potentially offer some more direct evidence on the propositions of legal restrictions theory but also yield insights into whether private banks could have anything to gain from issuing interest-bearing currency.

It is true that existing work on the experience of the North during the Civil War suggests that interest-bearing currency was not well received and that it did not have any apparent competitive advantage over its conventional non-interest-bearing counterpart...