Yellowbacks out West and greenbacks back East: social-choice dimensions of monetary reform.

• Author: Greenfield, Robert L.

1. Introduction

   Oftentimes, in the wake of political developments, monetary questions follow. Should the European Economic Community force adoption of a single money? Or can the job of designating Europe's money be left to the market? Has the rapid dissolution of the Soviet Union left a monetary vacuum? If so, what will fill it? Economists find themselves being pressed to answer these questions and others like them.

   In the 1970s, Friedrich A. Hayek [18] proposed safeguarding against governmental inflationary abuses by giving private issuers of money full scope to operate. Under Hayek's scheme, each issuer could adopt a distinct unit of account, and the various units would fluctuate freely against one another. Profit incentives would restrain overissue, because people would not hold units lacking purchasing-power stability. A unit's stable purchasing power would strengthen the demand for that unit, enabling the issuer to have more loans outstanding and earning interest. Even if one unit should come to dominate, the threat of potential competition would check inflationary tendencies.

   Sympathy for Hayek's scheme might well lead to recommending that questions of monetary reform be left to the market. Benjamin Klein [21], Milton Friedman and Anna J. Schwartz [16], and Lawrence H. White [29], however, have expressed skepticism about competition as an agent of monetary reform. "So far," Friedman and Schwartz [16, 46] caution, "neither Hayek's belief that privately produced constant purchasing power moneys would become dominant nor Klein's and our skepticism has any direct empirical basis, but derive rather from an interpretation of historical experience under very different monetary conditions than those Hayek proposes."

   There now exists, of course, as Friedman and Schwartz note, a large and growing literature on "free banking." The historical studies that we have seen, however, examine banks issuing money convertible into an established base money - gold or silver coins or else fiat money. Thus, the free banking literature does not speak directly to Hayek's proposing free competition in the supply of base money.

   "Some direct evidence," Friedman and Schwartz continue, "may emerge in the near future because of developments within the present system...." They cite the 1974 repeal of the prohibition against privately owning, buying, and selling gold. "In principle," they explain [16, 47], "it has been possible since then for individuals in private dealings to use gold as a medium of exchange. And there have been some minor stirrings. The Gold Standard Corporation in Kansas City provides facilities for deposits denominated in gold and for the transfer of such deposits among persons by check. However, this is a warehousing operation - a 100 percent reserve bank, as it were - rather than a private currency denominated in gold and issued on a fractional reserve basis. Unfortunately, there are currently legal obstacles to any developments that would enable gold to be used not only as a store of value or part of an asset portfolio but as a medium of circulation. Hence, the current situation provides little evidence on what would occur if those obstacles were removed."

   This paper explores a neglected, American-reconstruction-era experiment that directly tests the feasibility of monetary reform through competition in base moneys. The experiment, which the day's leading financiers and politicians gave their support, had two sides. In the East, the yellow-back dollar, a new, gold-denominated and fractional-reserve currency, challenged the greenback dollar, the entrenched fiat currency. Out West, however, challenger and incumbent exchanged positions. There, the greenback dollar, or, equivalently, the banknote denominated in the greenback dollar and backed by fractional reserves of it, challenged the entrenched gold currency. In both cases, furthermore, the challenger had legal-tender-like properties, making for experimental conditions of a kind that economists rarely see.

2. A Tipping Model of Acceptance and Rejection

   To account for the experiment's results - yellowbacks out West and greenbacks back East - we begin with some basic questions. How does a business decide in which money to post prices? How does a worker decide in which money to request wages? How does a person decide in which money to hold transactions balances? Numerous considerations come into play, including the expected bullion value of each money, its legal-tender status, its denominational structure, and the policies that banks and trade associations urge. The position that political parties take representing debtors, creditors, or even producers of monetary metals come into play, too.

   The greatest influence that any individual decision maker feels, however, comes from what everyone else does. If most people use a particular money, then everyone else has good reason to use it. If, however, most people refuse to use a particular money, then no one else has much reason to use it. Only two outcomes, general acceptance or general refusal, therefore, are "Schelling points," and the monetary system will normally tip toward one Schelling point or the other [27].

   Figure 1 illustrates the tipping tendency. Net benefits accruing to any firm because it posts prices in greenbacks increase as the percentage of all firms posting prices in greenbacks increases - and similarly for posting prices in gold. The greenback has a clear advantage. Even if, to start, fifty percent of all firms post prices in greenbacks, then all firms see that the benefits of posting prices in greenbacks exceed the benefits of posting prices in gold. The system tips to the right; everyone posts greenback prices, everyone receives greenback wages, and everyone holds greenback transactions balances. Tipping toward gold could occur, though it would require that, to start, sufficiently more than fifty percent of all firms posted gold prices.

   David Laitin [22, 295-96] employs the tipping model to examine regional language conflicts, focusing on cases in which local political pressures cause the system to tip against using the language that the central government prefers. Perhaps even more effectively with money than with language, however, a self-reinforcing selection process narrows the field. Two parties can converse in whatever language they agree to use. The chain of commerce, however, includes links that extend beyond the two parties involved in any particular transaction. The seller in one transaction, for example, expecting to become the buyer in some later transaction, has to take the second seller's medium-of-exchange preference into account.

   A neutral observer might consider the actual Schelling equilibrium the inferior outcome. In terms of long-run price stability, for example, the greenback equilibrium might seem inferior to the gold equilibrium. But once greenbacks become generally accepted, as they had back East, no individual has an incentive to change. Only much altered external pressures, which in Figure 1 means shifts that put the gold-benefits curve everywhere above the greenback-benefits curve, could push the monetary system back, past its initial tipping point. Bearing in mind, then, the social-choice dimensions of monetary reform, we turn to the history of the national gold banks.

3. John Sherman and the National Gold Banks

   Usually, monetary historians remember the act of July 12, 1870, as the act that raised the authorized quantity of national banknotes from $300 to $354 million to address currency shortages in the Midwest, West, and South (3, 18; 15, 21, n. 7; 28, 94-96). But the act did something else, too. It authorized establishing a second class of national bank - the national gold bank.

   Although historians have neglected the gold-bank provision of the act, Senate finance committee chairman John Sherman, who steered the bill through Congress, took the provision quite seriously. "We have assurances," Sherman [10, 700] said on January 24, 1870, when he brought the currency bill out of the finance committee and to the Senate floor, "that banks will be organized under this system at once on the Pacific coast, thus unlocking . . . a portion of the gold that must necessarily be used now for the ordinary channels of circulation."(1)

   California seemed to offer a fertile environment for the national gold banks. After banks and the government had suspended convertibility in 1861 and even after the government had issued legal tender notes, Californians stuck with gold.(2) And though ignored since 1864, the statute that had codified the state's 1850 constitutional language prohibiting corporate commercial banking had just been officially deemed "obsolete" [1, 22]. Though California's aversion to banks had softened, its aversion to "national" banks, which kept their notes convertible into the greenback, had not.(3) In 1870, the country as a whole had 1,612 national banks, but California had none.

   "In the city of New York," Sherman [10, 700] continued, "there is now a commerce going on of over six hundred million dollars, all of which is carried on the gold basis; and so great is the necessity for paper money to represent this gold business that they actually deposit $50,000,000 of gold coin in the Treasury of the United States, and receive gold notes without interest, merely to facilitate the ordinary transaction of . . . this business.

   "So in the cities of Charleston and New Orleans, where cotton is measured by the gold standard, they can very readily use these coin notes. . . . These banks will furnish to the people a sure currency based on coin, payable in coin, having all the requisites that is possible to have to provide the best national currency."

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