Tuesday, September 29, 2009

Pirates, Paper, and Purchasing Power

In the late 17th century the Massachusetts people every few years would plunder the French in Nova Scotia. Ordinarily the soldiers would win the battles and loot French goods. In Massachusetts these goods would be sold and the soldiers paid from the proceeds. So this colonial army was a pirate army of sorts. In 1690, however, things did not go as planned. The French this time where waiting for them. They built strong forts and repelled the Massachusetts pirates. When the soldiers got back home the government realized it has no means to pay the soldiers. It was already deep in debt and had no specie to pay the solders with. The government, fearing an angry mob of unpaid soldiers, crafted a cleaver solution. Although it had never been done before, the Massachusetts government decided to issue 7000 pounds of paper currency as a substitute for specie. In order to convince the market to accept this currency it first promised it would never print money again. It also promised that the paper currency would be redeemable in specie in a few years. So the paper was backed by the belief that the government could raise future revenue in specie to retire the debt at some future date. It worked; the currency was circulated as a perfect substitute for specie.

The solution was brilliant. Prices only marginally increased due to the increased money supple and the government had avoided disaster. Only a slim bout of price inflation for paying the army was certainly worth the cost. Unfortunately for the holders of this paper currency two months later Massachusetts said that the 7000 pounds did not cover all of its needs. It issued 40000 pounds of additional paper currency to pay off all its debt. It again promised that no more paper would ever be issued. One year after the original issuance the currency had depreciated by 40%. The government continued to issue paper currency and never did redeem the currency for specie. Needless to say it devalued it currency to the point of ruin.

Other colonies soon followed in Massachusetts lead in issuing paper money and later destroying it though the ravages of inflation. The government of Zimbabwe must have thought that colonial Massachusetts monetary policy represented the ultimate form of monetary policy. Post world war one and pre world war two Germany must have been a great student of Massachusetts money policy. Sometimes I wonder about Ben Bernanke.

The unintended consequence here was the devaluing of the currency. The temptation for government to print money when it was complete and utter control of the monetary system is too great for it to resist. This has happened in modern US history too. After world war two the dollar was fixed at 35 dollars to an ounce of gold. During the 1950’s and 1960’s the US government printed additional dollars without increasing the gold reserves. By 1971 foreign holders of dollars had discovered this and where demanding gold in exchange for their dollars. The US gold reserves fell so drastically so fast, and with no way to redeem all the dollars in gold it was forced to abolish the gold standard. We all know that the period right after was marked by high inflation.

So I ask you, is there anything that the US government is doing now that will have drastic unforeseen consequences? Are we wiser than colonial Massachusetts? Is it somehow going to be different this time around?

*The source of information for the colonial money was a speech of Murray N. Rothbard given at the Mises Institute. http://www.youtube.com/watch?v=Wfyp_i7y1t0


  1. Aaron,

    I don't know much about the global currency market. Are there any currencies that are backed by physical assets anymore? You know how in fashion they are always saying "X" is the new "black".

    Maybe in today's global economy "no specie" is the new "specie".

  2. It does appear that the new specie is no specie at all.