Financial Markets after Civil War

Two Major Changes

• Move to uniform currency• Creation of Federal Reserve system• Both grew out of problems financing Civil War

Review

• What was money?– Coins– Bank notes issued by state chartered banks

• How is Civil War financed?– Limited ability to borrow

– Europeans unwilling to buy bonds– Excise taxes, tariffs, land sales not enough, so income

taxes– Treasury issues non-interest bearing notes

redeemable in specie

• When the union army looses battles, people redeem notes

• December 30, 1861 government suspends payment in specie

• 1862 Congress proposes new notes, greenbacks, legal tender of payment of debts but non-redeemable for specie– Fiat money

Greenbacks

• Two sets of prices, one in greenbacks, one in gold

• By 1863 money supply had doubled– Increase in use of paper money

• Prices in greenbacks rose, wages may have lagged prices

Gresham’s law

• Bad money drives out good• If you expect greenbacks to depreciate

relative to gold and silver, how can you make money?

• Keep gold and silver to buy more greenbacks latter

• By end of Civil War few coins of any kind in circulation

After Civil War

• What to do with Greenbacks?– Attempt to retire after Civil War leads to deflation– Farmers protest

• Businesses want to go back to convertibility• Too many greenbacks out there to maintain it.• Eventually in 1875, convertibility is resumed

with gold

Silver

• At end of war no silver coins in circulation, mint ratio (16 to 1) was not consistent with price of gold in relation to silver (18 to 1).

• Silver coins dropped in Coinage act of 1873• Farmers who felt prices of farm output were

falling faster than prices of inputs, wanted increase in money supply by monetizing silver.– Williams Jennings Bryan’s famous speech.– http://www.youtube.com/watch?v=HeTkT5-w5RA

Prices are falling

Real Per Capita incomeTrend in per capita income is up, but there are periods of decline which could have been caused by unanticipated deflation.

• “Wizard of Oz” as Monetary Allegory– What color were Dorothy’s shoes in the original

book by L. Frank Baum?

• Who were the Dorothy, Scarecrow, Tin man, Cowardly Lion?– Dorothy represents America, scarecrow the

western farmers, tin man the working man– Cowardly lion is William Jennings Bryan

• Eventually increase in gold supply made the cause unnecessary.

National Banking System

• Attempts to establish national banking system started in 1861– Required banks to buy gov bonds as capital– Not popular, inspite of 2% tax on state bank notes

• National Banking Act of 1864– 5 or more people – Set capital requirement based on population of city

• >50,000 $200,000• 6,000-50,000 $100,000• <6,000 $50,000• 1/3 of capital had to be in gov bonds deposited with controller of

currency• Banks got national bank notes equal to 90% of bonds (had to

accepted as payment at par unlike state banknotes)

• Reserve requirements was 25% for Banks in major cities, 15% for country banks

• What were reserves?– Vault cash- gold and silver– Deposits with National Banks in 12 “reserve cities”

• State banks did not switch– Tax on bank notes increased to 10% – Big decrease in state banks, as a result

Resurgence of State Banks

• Demand deposits (personal check) allow state banks to get around the tax– Legally checks are bills of exchange drawn on the

check writers bank account, payable to the person to whom the check is written

• Number of states banks increase up to to 1914

• Response by government– Reduce capital requirements of national banks– Reduce reserve requirements

• Competition between state and national systems lead to weak banks, more bank failures

• Financial Panic in 1907– Many banks suspend payments– Loss of faith in banking system

Federal Reserve Act of 1914

• Established a Central Bank• Functions

– Clearing house for checks– Preventing bank panics by setting reserve

requirements• Banks deposit reserves with the Fed

– Lender of Last resort by lending to solvent banks caught in panic

• Not designed to rescue failing banks• Problems distinguishing between the two

– Federal Reserve notes become national currency• No more state bank notes

– Open Market operations come later in 1920s• control of money supply not part of the original vision,

goal is to prevent banking panics