The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
The United States has, throughout much of its history, been committed to a multiple-issuer monetary system, and the monetary union created in 1789 was of this type. We previously demonstrated (RSW 1993) that the framers of the Constitution were well aware of a seigniorage incentive problem that exists in multiple-issuer monetary unions, as such a problem had been observed at various times before 1789. This problem derives from the fact that any issuer in a multiple-issuer monetary union can collect seigniorage from other members of the union, and the member with the fastest growing money supply will ultimately collect most of the seigniorage revenue in the system. Thus, one problem confronting the United States in 1789 was the construction of a multiple issuer monetary union in a way that addressed the seigniorage incentive problem.
We argue here that the solution arrived at was to allow each state to charter, if it so chose, note-issuing banks. We think it was generally held that these banks would redeem their notes for specie on demand, establishing a fixed exchange rate (indeed one with convertible currencies) system. Moreover, if banks were forced to redeem their notes on demand, then they had no discretion about the number of their notes outstanding. Thus, while it was possible to collect seigniorage revenue, no bank had any control over the amount of seigniorage it could collect.
The system established by the Constitution was not very successful in either eliminating exchange rate fluctuations between different kinds of notes or in avoiding seigniorage incentive problems. Until the National Banking System was established, the United States did not possess a uniform currency. Discounts on various kinds of notes fluctuated substantially through time and across locations. Nor was the seigniorage incentive problem avoided. Indeed, we will see that this problem arose even between different branches of the Second Bank, which was itself - as originally conceived - a multiple issuer system.
Why did the attempt at a monetary union represented by the Constitution fail in this way? We will argue that one reason was that the system that existed prior to the National Banking System left note-holders bearing the costs of note redemption. Thus discounts or premia could emerge between bank notes and specie reflecting the costs of note redemption. It was only in 1874, when note redemption costs were borne entirely by note-issuers rather than note-holders, that a uniform currency was achieved. Moreover, adequate mechanisms for preventing suspensions of convertibility (of notes) failed to exist until the National Banking system was established. The implication was that the methods for imposing discipline on the seigniorage incentive problem were flawed until about the same time.
Most authors take the view that, if the individual members of a multiple issuer monetary union are "small," the necessity of maintaining a fixed exchange rate among the currencies removes their discretion regarding how much money they issue. We have previously argued (RSW 1993), however, that if the currencies in a multiple issuer monetary union are perfectly substitutable - which we take to be the intent of forming such a union - this is not the case. If each issuer in such a system is not otherwise restrained, each issuer has complete discretion over how much they issue.
This discretion gives rise to what we term a seigniorage incentive problem. This problem derives from the fact that any issuer in a multiple issuer monetary union can collect seigniorage from other members of the union, and the member with the fastest growing money supply will ultimately collect most of the seigniorage revenue in the system. If one or more members of a monetary union takes advantage of this ability, thereby taxing the other members of the union, those members have an incentive to retaliate. Retaliation could take the form of all issuers in the union increasing their attempts to collect seigniorage, or of members in the union raising barriers against the use of the currencies of offending issuers. The former kind of action will tend to reduce the benefits of a monetary union because of excessive inflation, while the latter tends to defeat the purpose of monetary unification.
How did this system provide a fixed exchange rate between the notes of various banks, and how did it address the seigniorage incentive problem? If it had been the case - as we believe was conceived in 1789 - that all banks redeemed their notes for specie on demand then, subject to some qualifications we will state, there presumably would have existed a fixed exchange rate system (indeed one with convertible currencies). Moreover, if banks were forced to redeem their notes on demand, then they had no discretion about the number of their notes outstanding. Thus, while it was possible to collect seigniorage revenue, no bank had any control over the amount of seigniorage it could collect. The absence of any discretion on this dimension prevented the existence of a seigniorage incentive problem.
If this was the intention, why did the Constitution require states to charter note-issuing banks, while not allowing them to issue notes themselves? We believe that this was part of a mechanism to enforce the redeemability of notes. In particular, a note-holder of a private bank could sue for redemption if necessary, while the holder of a state-issued bill of credit could not sue the state for redemption without its consent. Thus the system of note issue through private banks left note-holders with recourse to the courts if redemption were ever refused, a recourse that would not have existed with states issuing notes directly. And indeed, Dewey (1910) argues that it was often necessary to resort to this recourse.
In spite of this, the seigniorage incentive problem does not appear to have taken on a major significance over this period. Perhaps its absence accounts for the lack of concern with banks that were failing to redeem.
It is also true that, during this period, note-holders bore the entire cost of redeeming notes when notes were redeemable. As we have argued, this would permit the emergence of discounts even under full redeemability, and discounts on the notes of state banks were, in fact, observed. A uniform currency had not yet been obtained.
We have argued that having a system with multiple issuers of a uniform currency gives rise to a seigniorage incentive problem. The SBUS was itself subject to this problem in two forms. First it was, along with the state banks, part of a multiple issuer system, and it was therefore in a position to raise seigniorage at the expense of the rest of the system. (And indeed, a common charge against the SBUS was that it aggrandized its profits at the expense of state banks.) However, the SBUS was subject to the same control mechanism as the rest of the system, namely redemption of its notes.
More subtly, though, the SBUS was - in and of itself - a multiple issuer system. Each branch, at the inception of the Bank, could issue notes which were redeemed in Philadelphia. Moreover, many branches (including Baltimore and some southern and western branches) were not (early on) redeeming their own notes. As a result, a serious seigniorage incentive problem arose within the SBUS itself. Branches whose note issues were growing most rapidly gained capital at the expense of the rest of the SBUS.
In 1818 it was viewed as necessary to limit the seigniorage incentive problem operating within the SBUS. Two actions were taken: redemption of branch notes at other branches was limited, and many southern and western branches were ordered to cease note issues. There were two results. First, for many holders of SBUS notes, redemption costs rose. Accordingly, discounts on the notes of other branches appeared in Philadelphia. Second, in many areas only state bank notes circulated, and these were generally less uniform than SBUS notes. As a consequence, currency uniformity was not attained.
This problem manifested itself almost immediately with general suspension. Several states already had wholly state owned banks. Once they were not subject to note redemption, their note issues could be expanded. Laws were passed to prevent these notes from being refused in payments, and strategic issues arose about forcing out-of-state-residents to accept notes issued (in effect) by the state. Such issues had been viewed as a serious problem under the Articles of Confederation (RSW 1993), as they were again during the panic.
This episode illustrates the limited enforcement mechanisms available against the seigniorage incentive problem in the absence of full redemption. Despite the Constitutional prohibition of state issues of bills of credit, note issues by wholly state owned (nonredeeming) banks were deemed Constitutional in a variety of cases even when the state had "guaranteed" the note issues.
Biddle also adopted a new policy for addressing the seigniorage incentive problem that existed between branches of the SBUS. Branch notes were issued by buying inland bills of exchange. As these were presented in New York and Philadelphia they constituted claims on the branch of issue, and this prevented note issues from transferring capital between branches.
Biddle's policies reduced the general range of bank note discounts to their most limited level of the ante-bellum period. Nevertheless, it did not altogether eliminate discounts on notes, and indeed there were small discounts on the notes of SBUS branches. Such discounts presumably allowed Andrew Jackson to charge, in his message vetoing renewal of the SBUS charter, that the SBUS had failed to create a uniform currency.
Before 1874, however, redemption costs between banks were born by the redeeming bank. As a result, it was possible for discounts to be observed on national bank notes in inter-bank transactions (Friedman and Schwartz 1963). This problem was remedied in 1874: thereafter the costs of note redemption were born by the issuing bank, and discounts on national bank notes were eliminated completely.
It continued to be the case, of course, that note redemption was the means of controlling seigniorage incentive problems, and mechanisms for eliminating the suspension of note convertibility were put in place. Thus it was not until 1874 that the United States had a system in place for maintaining a completely uniform currency and for managing the seigniorage incentive problem associated with a multiple issuer system.