Saturday, November 24, 2007

The Quantity Theory and the Constitution

Money is probably the second-most divisive issue in American history. A useful tool for interpreting some of the historical battles over it is the quantity theory of money. The main implication of the theory is that more rapid growth of the money supply leads to higher inflation. Inflation (particularly if unanticipated) tends to benefit borrowers by reducing the real value of debts, while hurting creditors. This can explain, for example, why the populists of the late 19th century represented the interests of indebted farmers by campaigning for adding silver (in addition to gold) to the money supply.

It may also help understand the motives behind the Constitution itself. From the Washington Post's review of "Unruly Americans and the Origins of the Constitution" by Woody Holton:
He contends that the Founders were primarily concerned with the very democratic, revolutionary state legislatures' "excessive indulgence to debtors and taxpayers," above all by printing paper money, which made the United States an investor's nightmare. Well-heeled "Federalists" -- which included most of the Founders -- dismissed paper money as a way to allow lazy, luxury-loving people with the 18th-century equivalent of serious credit card debt to cheat their creditors...

After 1783, Holton explains, the states faced colossal war debts on which the interest alone required more revenue than the colonies collected before independence. Most states resorted to regressive "direct taxes" on real estate and polls (only adult men). The main beneficiaries were speculators who had purchased government-issued IOUs from soldiers and war suppliers for a fraction of their official worth, then collected 6 percent interest on the full face value, yielding as much as a 30 percent annual return...

To add to the problem, a severe trade deficit in the mid-1780s drained the country's gold and silver. The resulting deflation made it harder to pay private debts, which became, in real terms, larger than the original loans. Delinquents could see their farms auctioned off, then spend time in debtors' prison. The rural population did not submit quietly. Throughout the country, farmers resisted tax collectors, forced courts to close (or burned them down) to prevent foreclosures and demanded paper money and tax relief.

Circumstances called for (in modern terms) a loosening of the money supply, and Holton argues that paper money was a reasonable response. Seven states printed currency (though only three made it legal tender for all debts), and every state provided some tax or debtor relief. The goal was to let people pay their taxes and encourage economic development, but the paper currency lost value in a few states, particularly Rhode Island, which tried to force creditors to accept it. To defenders of fiscal responsibility, Rhode Island showed what too much democracy produced: a situation in which only a fool would lend money to anyone.

Article I, section 8 of the Constitution gives to Congress the power to coin money, and section 10 specifically forbids States from doing so.

Sounds like an interesting book to read over break...

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