The Free Market 24, no. 4 (April 2004)
With a Republican president running sky-high debts, unleashing wars, imposing protectionist trade edicts, and risking the nation’s financial future, sometimes it feels like the 19th century all over again, specifically the year 1861 and following. The 1860 election of Abraham Lincoln sparked a secession movement in the southern states. In December, South Carolina seceded, and other Deep South states soon followed. Interstate commerce was disrupted, and many northeastern banks suspended specie payments. The atmosphere was one of grave political and economic crisis. Many feared war; many feared the unknown.
From December through most of the first half of 1861 (the months previous to the war), the business community prepared to weather the coming storm. Banks contracted their loans and increased reserves. Merchants and traders retrenched, and manufacturers deferred new capital investments. Everyone reduced debt and expenses. As a consequence, prices fell, imports slowed, exports boomed, and specie flowed into the country.
These developments, wrote William Graham Sumner, represented a real opportunity for the government to fund its war without resorting to inflationary finance. The business community and the banks had done their part; it was now up to the government. The Lincoln administration hesitated as to which choice to make, but it eventually chose inflation and extravagance.
The Lincoln administration feared to rely primarily or even significantly upon taxation as a means to pay for the northern union’s invasion of the southern confederacy. Americans had never yet paid for a war by paying more taxes, not even as colonists of Britain; so there was no precedent. Besides, Americans were averse to taxation for any purpose and had not paid internal taxes since the mid-1810s.
In addition, at least half of the northern public was either opposed to the war or would give it only a grudging and highly conditional support. Raising taxes significantly would surely increase the vehemence of anti-war sentiment and push those who were undecided or apathetic to favor an armistice. Nevertheless, some taxes would have to be raised, if only to maintain the credit of the bonds.
Treasury Secretary Salmon Chase could not expect to raise much revenue by increasing tariff rates. Even before Lincoln took office, the Republican Congress had passed the Morrill Tariff (March 2, 1861). Its purpose was to exclude foreign manufactures, not raise revenue. This tariff represented a major regression in both liberty and economic thought. By it and subsequent revisions, average rates on dutiable imports rose from 19 percent in 1860 to 54 percent by late 1865.
Chase proceeded cautiously, but every year he recommended new taxes. By the end of the war, Americans were paying higher taxes than they had ever paid before—even as colonists of Britain—and more than most of the nations of Europe. In 1860, Americans paid $53 million in taxes, all in the form of import duties; in 1865, they paid $295 million. In August 1861, Congress passed a property tax to be apportioned among the states, and an income tax. In the first year, the property tax raised $20 million, the income tax nothing.
In 1862, the property tax was repealed, and the income tax brought in only $2.7 million, so Chase recommended excise taxes (enacted in July 1862). These were the first internal taxes laid since the War of 1812.
It would be tedious to list even a sample of the things that were taxed by the Internal Revenue Act of 1862. Suffice it to say that the general principle was to tax everything. Congressman James Blaine praised it as “one of the most searching [and] comprehensive systems of taxation ever devised by any government.”
In June 1864, Congress raised the duties still more. That year was the first in the history of the republic in which revenue derived from internal taxes exceeded that collected from the tariff. By the end of the war, the income tax had raised $55 million, customs $305 million, and the internal revenue duties $352 million. However, these substantial sums amounted to only 21 percent of the expenses of the war, the other 79 percent having to be borrowed.
Inflation in 1861
Inflation was moderate in 1861. Secretary Chase issued $33 million in demand notes, which were made receivable for all government dues and then reissued, and which the banks were pressured to receive on deposit and redeem in coin. In addition, he floated a $150 million bond issue in the form of three-year, 7.3 percent treasury notes. Chase insisted that the subscriptions be made in gold or in treasury notes.
As the banking system of the time was a fractional reserve one, with a mixed currency of gold dollars, fractional silver coins, bank notes, and demand deposits, the massive transfer of gold to the government, plus the addition of $33 million in convertible government paper currency, drained bank reserves. As a result, the banks suspended specie payments in December, 1861.
This suspension was unprecedented in that it was not preceded by a financial panic or a sudden demand for coin. The banks were under no necessity to suspend, but they did so because of what they anticipated would happen in 1862. Confederate military victories in the summer of 1861 had dispelled the initial expectation of a short war. The banks now rightly expected heavy bond issues and more government paper currency. The results of the suspension were predictable. Gold coins ceased to circulate, and gold rose to a one or two percent premium against paper.
The Legal Tender Act of February 1862
The Republicans were heirs of the soft-money tradition of Hamilton, Clay, and the Whigs, so they predictably turned to currency inflation to fund their expanding war. In 1862, they proposed a massive legal tender paper issue. Only a handful of hard-money northern Democrats remained in Congress to contest the measure. According to Sumner, “the spirit of the debate was that of panic.” Republicans thrust aside economic objections as theoretical nonsense and dismissed historical warnings as irrelevant to American conditions.
When the catastrophe of the Continental dollar during the American Revolution or the assignats of the French Revolution was cited, Republicans responded by impugning the patriotism of the skeptics. One Republican congressman indignantly asked why the government should have to demean itself by having to “go into the streets to borrow money.” Another intoned, “I prefer to assert the power and dignity of the government by the issue of its own notes.” Thaddeus Stevens of Pennsylvania, a longtime abolitionist and a leading Radical Republican, even made the astonishing and ignorant claim that making the government notes legal tender would prevent any depreciation in its value.
The economic rationale for legal tender paper money was made by Senator John Sherman of Ohio (the brother of General Sherman). His arguments were all disguised forms of the argument from necessity. The government needed money right away. The banks had exhausted their capital in buying bonds. There was not enough money in the country to fund the bonds. Gold and silver coin had ceased to circulate. Interest rates were too high. The issue of legal tender notes was a mere temporary expedient, and it could do no harm. What these arguments really meant was that Sherman wanted to command the full productive resources of the country for the war, and as the public was not willing to make the requisite sacrifice, they had to be coerced.
When Democrats pointed out, correctly, that the Constitution conferred no power to make government paper legal tender, and no one before 1861 had ever suggested it had such a power, Sherman replied that the necessity and righteousness of the cause overruled the Constitution. For him, the end justified the means. “As a member of this body, I am armed with high powers for a holy purpose, and I am authorized—nay, required—to vote for the laws necessary and proper for executing these high powers, and to accomplish that purpose.”
The Legal Tender Act authorized the issue of $150 million in government currency and a bond issue of $500 million. The notes, soon known as “Greenbacks,” were made legal tender for all private debts, receivable by the government for taxes and land sales (but not import duties), and were fundable into the bonds. The bonds bore 6 percent interest and were payable in 20 years, but redeemable after five. The Republican Senate had very cleverly added two specie amendments. One required import duties to be paid in gold, and the other that the interest on the bonds be paid out in gold. The protectionist Republicans were determined to preserve the restrictive character of the tariff by mandating that duties be paid in gold, instead of in a depreciated paper currency. And they believed that a gold dividend would enhance the value of the bond.
The consequences of the legal tender law and emission of irredeemable notes were such as any economist would have expected. First, it destroyed American credit abroad. Foreigners dumped their holdings of American bonds and would not buy the war bonds. Second, it drove specie out of the country, much of it going to pay for the augmented imports incident to an inflated currency. Third, they depreciated. Fourth, the Treasury printed more. In July 1862, Congress approved a second issue of $150 million notes, and then a third issue of $100 million in January 1863 (increased by $50 million in March).
Altogether, in four years, the government issued $480 million in legal tender notes, $43 million in fractional currency, and $60 million in demand notes. Of this sum, all but $75 million was outstanding in 1865. According to Rothbard, the total money supply (currency plus deposits and coin) rose from $745 million in 1860 to $1.7 billion in 1865, an increase of 128 percent, or 18 percent per annum.
From a base of 100 in 1860, prices rose to 217 in 1865, an increase of 117 percent, or 23 percent per annum. Not surprisingly, wages did not keep up. They rose only 43 percent in five years. Soldiers had it even worse. Their monthly pay remained $13 for the first three years of the war, and Congress did not raise it until May, 1864, and then by only $3 a month. The advance in prices increased both government expenditures and debt.
One of the effects of Greenback depreciation was to effect a massive redistribution of wealth. Soldiers and skilled laborers experienced a dramatic fall in income while government contractors made huge profits. Those who had surplus funds could afford to speculate with them, and thus make a profit off the rising and fluctuating prices incident to an inflationary period. They could also buy large quantities of government bonds.
Borrowing Phony Money
By the end of 1862, Chase had sold only $23.7 million in bonds out of the $500 million authorized in February. The reason? Chase had refused to sell the bonds below par. The Republican Congress ensured that this would not happen again in the great loan act of March, 1863. It authorized the Treasury Department to issue $900 million in a bewildering variety of short and long-term notes and bonds, at different rates of interest. It required the secretary to sell the bonds at market value but to accept for their purchase the depreciated Greenbacks at par. That meant a creditor could purchase a 5/20 federal bond, that paid 6 percent annual interest in gold, with a currency worth only 65 cents on the dollar. As the currency continued to depreciate into 1864, this windfall would increase still more (by July, a creditor could purchase a bond with a currency worth only 39 cents in gold).
Not surprisingly, by December 1863, Chase had sold $400 million of the previous year’s 5/20 bonds, and $75 million of the 1863 bonds. Chase came to see the wisdom of accepting depreciated paper at par. An additional factor that increased the desirability and value of the bonds was the passage of the National Banking Act, in February 1863, for it required the national banks to buy bonds to back their notes. They could issue no more notes than the par value of the bond holdings.
An interesting measure of whether people lent their money to the government out of patriotism or greed is to contrast the percentage of all loans that were short-term versus long-term by year. In 1861–62, 85 percent of all loans were short-term (three years or less). In 1862–63, 71 percent of all loans were short-term. Only after Northern victories at Vicksburg and Gettysburg in the summer of 1863 seemed to ensure the defeat of the Confederacy did long-term loans surpass short-term ones.
After the war, the great question was: should the country return to hard money and correct at once the imbalances and malinvestments wrought by four years of inflation and war, or should it continue with soft money and attempt to perpetuate the wartime boom. The majority of Republicans again opted for inflation. Thus, the inflationary boom, inaugurated by the war and the Greenback, continued unabated until the panic of 1873 brought it to a close.
After the war, many Democrats wanted to pay off the debt in the depreciated Greenback. It was known as the Ohio Idea. While this was just, it was not wise, as it perpetuated inflation and set a precedent of quasi-repudiation through inflation. The Democrats made it their major issue in the 1868 presidential campaign, and made its author, Senator Pendleton of Ohio, their vice presidential candidate.
The Republicans now posed as the party of hard money and sound credit, and painted the Democrats as the party of inflation and repudiation. The Republican victory led to the passage of the Public Credit Act of 1869 mandating that government bonds be redeemed in gold.
Historian H.A. Scott Trask is an adjunct scholar of the Mises Institute (hstrask@highstream.net).
