Use of Interest-Bearing Currency in the Civil War: The Experience below the Mason-Dixon Line

By Makinen, Gail E.; Woodward, G. Thomas | Journal of Money, Credit & Banking, February 1999 | Go to article overview

Use of Interest-Bearing Currency in the Civil War: The Experience below the Mason-Dixon Line


Makinen, Gail E., Woodward, G. Thomas, Journal of Money, Credit & Banking


The legal restrictions theory of the demand for money (henceforth, LR) posits that interest-bearing notes are as suitable for circulation in exchange as non-interest-bearing notes.(1) For any level of asset quality (that is, risk of default), interest-bearing notes and non-interest-bearing notes, according to LR, should be equally useful transactions media. The use of non-interest-bearing notes, therefore, is not explained by their unique or inherent suitability for exchange purposes, but by institutional restrictions imposed by the government.(2) If not for the legal and regulatory roadblocks imposed, interest-bearing notes would be used in exchange, and consequently could not exist in equilibrium with non-interest-bearing notes. The interest-bearing notes would dominate non-interest-bearing notes in rate of return, and thus always be preferred by transactors; the non-interest-bearing notes--which bear only the implicit return resulting from their use as a transactions medium--could not be kept in circulation. This paper examines the case of interest-bearing notes in the Confederate States of America which were not legal tender, but which were said to circulate.

ALTERNATIVES TO THE LEGAL RESTRICTIONS THEORY

In posing an alternative to LR, researchers have advanced two possible explanations for why non-interest-bearing notes might be inherently superior transactions media. White (1987) suggests transactions costs as an explanation: for small purchases, the interest earned by using an interest-bearing note would not be enough to justify the time it would take to calculate its present value. Malkinen and Woodward (1986) suggest that interest rate risk inherent in interest-bearing notes would make them unsuitable for circulation.(3)

Makinen and Woodward found that in France during the period 1915-1926, small-denomination bearer securities well suited to the requirements of LR did not circulate. White points to the free banking period in Scotland as an environment in which--if LR were correct--interest-bearing notes should have evolved, but did not.

Gherity (1993) provides examples of circulating interest-beating notes in the U.S. North during the Civil War. But the episode fails to bear out the conclusions of LR because the notes circulated side-by-side with non-interest-bearing notes. He suggests that this phenomenon could be reconciled with White's transactions cost hypothesis: interest-bearing notes could be convenient to use if the interest were simply ignored. But as the coupon drop approached, the interest foregone on them would mount, and they would be withdrawn from circulation--behavior that was characteristic of the Civil War notes he references.

Woodward (1995) maintains that the circulation behavior of some of the notes cited by Gherity is explained by their legal tender status (at par). The present values of the notes when valued as financial assets were below their face value right after the coupon drop, and above it later. When the notes below par were valued as financial assets, they were forced on merchants and creditors as legal tender. When above par, they were held as investments. Hence, the experience could not be used to discriminate between the transactions cost and interest rate risk explanations. In the case of Civil War instruments that were not legal tender, Woodward produces some evidence that they were still forced on some creditors, and that in any case their circulation was very limited; he conjectures that they were passed in exchange by necessity rather than virtue, but observes that some of their behavior in exchange is irreconcilable with any of the theories.

THE CONFEDERATE EXPERIMENT

The Confederate States of America issued three interest-bearing notes that were said to circulate. The noteworthy aspect of the Southern episode is that neither the CSA's interest-bearing notes nor its non-interest-beating notes were made legal tender. …

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