Twice now, on this forum back in 2013, and on Twitter more recently (see here and here), I’ve taken Yale economics professor Gary Gorton’s publications to task for misrepresenting the historical record of private currency systems. In particular, I’ve criticized him for claiming, on the basis of evidence drawn exclusively from the United States, that private currency systems suffer from inherent and insoluble shortcomings. Pointing to other, successful private currency episodes, I’ve said that, had Gorton bothered to consider them, besides having to revise his verdict, he’d also gain a better understanding of just why the U.S. arrangements weren’t better.
Little good did those complaints do, for Gorton is still at it, with another working paper committing the very same offense. The paper, coauthored with Chase P. Ross of the Federal Reserve Board and Sharon Y. Ross of the U.S. Treasury, is called “Making Money.” Like Gorton’s September 2021 working paper, written with Jeffery Zhang, it turns the supposedly inherent drawbacks of historical banknote currencies into an argument against stablecoins and in favor of central bank digital currency.
No Questions Asked
Gorton, Ross, and Ross (henceforth “GR&R”) base their argument on the claim that the bedrock of any successful economy is “NQA” money, where NQA stands for “No Questions Asked.” NQA money is money that people accept “without reservation or costly due diligence.” They define the variable d as the “distance” of a money from the NQA ideal. A money with d = 0 is NQA; one with d > 0 is not. The higher the value of d, the less convenient a money is until, at some point, it’s no longer able to serve as money at all.
Most antebellum banknotes were NQA provided that they didn’t venture far from the banks that issued them. But as the distance between them and those banks grew, their “distance” from NQA tended to grow as well. That difference was reflected in discounts merchants and note-brokers applied to notes offered them, which they deducted from the notes’ face or “par” values. An NQA currency would instead be accepted at par nationwide.
GR&R devote a big chunk of their paper to building a formal model of the determinants of d and using historical banknote discount data to estimate it. Not surprisingly, they find that antebellum banknotes generally fell well short of the NQA ideal. They also argue that, although those banknotes tended to get closer to NQA over time, thanks mainly to railroads and the telegraph, they would never have gotten there. GR&R regard these results as evidence that competitively supplied commercial banknotes can never be top-notch money.
There are serious problems with GR&R’s appraisal of antebellum banknote currency, most of which have to do with things that GR&R never mention about it. They never mention barriers to branch banking, which made U.S. banknote discounts much higher than they might have been. And they never mention clearinghouses, the appearance and multiplication of which might eventually have eliminated note discounts even despite “unit” banks. I don’t mean to suggest that GR&R are unaware of unit banking and clearinghouses and how they mattered. On the contrary: Gorton has himself drawn attention to these things elsewhere. But this only makes their absence from GR&R’s paper that much harder to excuse.
GR&R’s misleading treatment of the U.S. case is bad enough. But things get worse in their very last paragraph, where they generalize from that case. Although they allow that “It is an open question whether private forms of money can reduce their distance to NQA to zero,” GR&R insist, not merely that this never happened in the antebellum U.S. banknote market, and that it would never have happened had the federal government not taken charge of things, but that it has never happened anywhere:
We are unaware of any examples of widely circulating private money that is NQA, d = o, without government backing, either implicit or explicit. …Historically, money that is NQA is a public good that only the government can supply.
There is, so to speak, a great deal of “distance” between that last, sweeping statement and the very limited evidence GR&R consider. It should be discounted accordingly; and we need only glance at the records of some non-U.S. banknote systems to determine that it’s about as sound as a Michigan shinplaster.
A World of Private Currencies
GR&R realize that many nations besides the United States once relied upon numerous commercial banks for their paper currency or, to put it their way, that “private debt often circulated as money.” They refer to a work by Kurt Schuler reporting on “about 60 instances” of competitive banknote (“free banking”) systems “across many countries.”
But GR&R must not have read Schuler’s paper carefully, for otherwise they wouldn’t have gotten its title wrong: it’s “The world history of free banking,” not “The world of free banking.” More importantly, they wouldn’t have overlooked the passage in it saying that “The notes that free banks issued generally circulated at par nationwide” (my emphasis). Nor can they have read many of the other essays included in the volume in which Schuler’s survey appears—a book, edited by Kevin Dowd, called The Experience of Free Banking. Had they done that, they’d have discovered several cases supporting Schuler’s claim, and contradicting their opposite assertion.
Scotland’s NQA Banknotes
Dowd’s book is far from being the only source to draw attention to past NQA banknote systems. GR&R might just as easily have learned about several of them from other readily-available sources.
That Gorton is aware of one of these other sources—Lawrence White’s book on the Scottish banking system—is clear from his having written a review essay concerning it back in 1985. Unfortunately, that essay suggests that he also didn’t read White’s book with great care, for although White makes it perfectly clear that Scottish banks’ nationwide branch networks, among other factors, kept Scottish banknotes at par everywhere north of the Tweed, Gorton somehow concluded that “In Scotland…notes traded at par or at a uniform discount reflecting transportation costs of redemption” (my emphasis). It seems from this that he was already slipping into the unfortunate habit of assuming that what happened to banknotes in the antebellum United States must have happened to them everywhere.
But even if he’d never read White’s book, Gorton should have learned the truth about Scottish banknotes from a work that’s read by every economist worth his salt: The Wealth of Nations. In it, the great Adam Smith has something to say, not just about the Scottish case, but about the general feasibility of what GR&R call private debt-based NQA money:
A paper money payable in bank notes, issued by people of undoubted credit, payable upon demand without any conditions, and in fact always readily paid as soon as presented is, in every respect, equal in value to gold and silver money; since gold and silver money can be had for it. Whatever is either bought or sold for such paper, must necessarily be bought and sold as cheap as it could have been for gold and silver.
Although Smith makes a general point, he does so with the Scottish banknote system in mind. Remarkably, that system was already NQA by 1776—long before any bank even existed in what later became the United States. In fact, Smith’s suggestion that Scottish banknotes were as good as precious metal is an understatement: so far as most of his fellow Scots were concerned, they were better. “The whole kingdom of Scotland,” George Chalmers observed in his 1811 Considerations on Commerce, “prefers Bank notes to golden guineas.” To this day, Scottish commercial banknotes, which have never been legal tender, let alone compulsory tender, have never fallen out of favor with the Scottish public.
Sweden’s Enskilda Bank Currency
Another NQA private currency system that GR&R should have known about operated for almost six decades in Sweden. Although it hasn’t gotten as much attention as Scotland’s free banking system, the Swedish case is one of several considered in this 2018 Bank of Canada working paper by Ben Fung, Scott Henry, and Warren E. Weber. Like Gorton’s own recent working papers, the Fung, Hendry, and Weber paper tries to draw lessons about stablecoins from past private currency episodes. At least one of its co-authors, Warren Weber, is also well known to Gorton, who has written with him on the subject of antebellum banknote discounts. It’s therefore hard to understand how GR&R managed to overlook it.
Like Gorton and his various co-authors, Fung, Hendry, and Weber believe that government intervention is usually needed to achieve a uniform, NQA currency: I address their claim that this was the case in Canada later in this post. But unlike Gorton and company, they recognize two exceptions. One is New England’s Suffolk System, which kept all New England banknotes at par throughout that region between 1825 and 1858. The other is Sweden between 1846 and 1904, when numerous private “enskilda” banks shared the right to issue banknotes with the Riksbank, which had been founded by Sweden’s Parliament in 1668. The enskilda banknotes were withdrawn in 1904, when the government awarded the Riksbank a currency monopoly. That happened despite an official commission of inquiry’s finding that enskilda banknotes, besides being trouble-free, had played an important part in funding the country’s growing economy.” More recent research by Lars Sandberg and Andres Ögren, among others, supports this assessment.*
“Although enskilda bank notes did not start out as a uniform currency,” Fung et al. write, “they became one over time without government intervention.” As happened in Scotland (and as Larry White and I argue tends to happen in any competitive note issue system), Sweden’s enskilda banks gradually agreed to routinely accept each other’s notes at par. That step, which dates back to 1846, and the establishment of a central banknote clearing system by the Stockholms Enskilda Bank a decade later, sufficed to allow enskilda banks’ notes to circulate with No Questions Asked. At last, in 1869 the Riksbank, finding it was doing itself no favors by holding out, also agreed, reluctantly, to accept enskilda bank notes at par. So much for government having to take the initiative to make a nation’s currency uniform.
Fung et al. are by no means unique in drawing attention to Sweden’s uniform banknote currency. We free bankers have long known about it, thanks mainly to Lars Junung’s pioneering work, a recent version of which is here. The Stockholm School’s Erik Lakomaa has also written a very good 2007 article about it. Summing up the enskilda banks’ efforts, Jonung says that they
displayed considerable ingenuity in promoting the circulation of their note issues. They were able to adjust or circumvent obstacles to the adoption of their notes by the public. They were more efficient than the Riksbank in adapting to the demands of the public, most prominently in supplying notes of low denominations. Through many branch offices, the stock of private notes expanded rapidly and became larger than the volume of Riksbank notes within less than four decades after the establishment of the first enskilda bank.
Jonung adds that, although the Riksbank never offered aid to any enskilda bank, none ever failed to fully redeem its notes at par.
Canada, Yet Again
Sweden takes up less than 174,000 square miles. Scotland is still smaller, with just over 30,000. Both also have extensive coastlines that allowed for low-cost transportation in the days before railroads or good highways. Achieving a uniform, par-value currency system based solely or mainly on competitively-supplied banknotes in those two countries was relatively easy. The same can be said of antebellum New England, with its 72,000 square miles, where the Suffolk System established an NQA private banknote system as early as 1824.
But could such a system ever have been achieved for the entire United States, with its 3.7 million square miles of territory? I believe it could have; and that Canada’s private banknote system proved it. But Feng and his co-authors say otherwise. They claim that, in Canada as in the United States, instead of always circulating at par, Canada’s commercial banknotes “regularly traded at discounts outside their local area,” and that it took government intervention to rid the system of those discounts. Fung et al. develop these claims further in a separate paper addressing the Canadian case.
Even allowing that it took government intervention to turn Canada’s commercial banknotes into a fully-fledged, d = 0, NQA money, the fact that intervention sufficed itself contradicts GR&R’s claim that “money that is NQA is a public good that only the government can supply.” But was government intervention really crucial? All authorities agree with Fung et al. that the notes of Canada’s chartered banks only became NQA following the passage of the 1890 Bank Act. According to Charles Conant, for instance,
The bank-note circulation of Canada, under the operation of the redemption fund and the complementary requirements, has, in the language of Mr. Breckenridge, “ acquired a thoroughly national character ; since 1890 it has circulated from one end of the country to the other, never causing loss to the holder, yet keeping unimpaired the qualities for which, in its less perfect state, Canadians had again and again refused to give it up (p. 465).
Among other steps, the 1890 Act required every chartered bank to
make such arrangements as are necessary to ensure the circulation at par in any and every part of Canada, of all notes issued or reissued by it and intended for circulation; and towards this purpose the bank shall establish agencies for the redemption and payment of its notes at the cities of Halifax, St. John, Charlottetown, Montreal, Toronto, Winnipeg, and Victoria, and at such other places as are, from time to time, designated by the Treasury Board.
But to jump to the conclusion that Canada’s banknotes wouldn’t have become NQA money without the 1890 legislation is to engage in post hoc ergo propter hoc reasoning. In truth, by 1890 the notes of Canada’s chartered banks were already on the verge of becoming NQA money. Because Canada’s banks, unlike their U.S. counterparts at the time, enjoyed unlimited freedom to branch, most already had branches throughout the country, including ones in all its leading cities, as well as in some U.S. cities. Thanks to these branches, banknote discounts were already vanishing. As I noted in the first of a 2017 series of posts I wrote in response to Fung et al.’s study of the Canadian case, the exceptions consisted of “slight” discounts placed on notes from some Nova Scotia and New Brunswick banks in Toronto and Montreal, and equally slight discounts placed on those of some Toronto and Montreal banks in the Northwest.
Considering how sparsely populated many parts of Canada were, even compared to remote parts of the United States, and the small size of its railroad network (in 1880, Canada had fewer than 9,000 miles of railroad, as compared to more than ten-times that mileage in the United States), this near-elimination of Canadian banknote discounts was itself a remarkable achievement. But it was far from exhausting the private sector’s capabilities. Canada’s first coast-to-coast railroad, the Canadian Pacific, was only finished in 1885—seventeen years after the driving of the golden spike. That development, and the rapid settlement of the northwest that followed (which made it more profitable for banks to establish branches there), alone would have gone far to rid the country of remaining banknote discounts whether the government stepped in or not.
Another factor that would have contributed to the same outcome was the establishment of clearinghouses, first in Halifax in 1887, and then in Montreal in 1889. That others would eventually have been established without any government encouragement seems highly likely. (As it happened, clearinghouses were established in Hamilton and Toronto in 1891, in Winnipeg in 1893, and in St. John, New Brunswick, in 1896.)
Finally, the 1890 reforms themselves, far from being a clear case of government having to force private currency issuers to take steps they weren’t willing to take on their own, appear to have been largely inspired by Canada’s chartered banks themselves. To quote the second number of my 2017 essay series:
The 1890 reform…was also the bankers’ idea. According to Breckenridge, in December 1888 one of them sent a circular letter to all the others, noting the complaints about banknotes not always being current, and outlining plans for keeping them at par “however far they might be from the place of issue.” The circular also proposed the establishment of “a safety fund, contributed from all the banks, whereby to ensure prompt and full redemption to the holders of notes of a suspended bank.”
What’s more, most of the banks completed arrangements to carry out the circulars’ first proposal within a year of its receipt, that is, before the new Bank Act was passed, making pairwise agreements to redeem each other’s notes in their separate neighborhoods. According to Breckenridge, “this simple device quite prevented the discount for geographical reasons” (p. 321). The actual legislation, in other words, amounted to little more than an official endorsement of voluntary arrangements already in place when it passed.
It was, presumably, with these facts in mind that L. Carroll Root (p. 323) bemoaned “the tendency of United States financiers and statesmen to place extraordinary stress upon providing for elaborate redemption facilities,” while noting that Canada’s experience proved “that legislation in this regard was delightfully immaterial.” U.S. experience, on the other hand, “demonstrated how completely a thoroughly good system which has developed without the aid of law has been petrified by attempting to assist it.”
I trust that these three examples suffice to establish that, despite what Gorton, Ross, and Ross claim, NQA banknote systems have existed in the past. It follows that private NQA paper currency is perfectly possible. It might still be true, of course, that private NQA digital currency isn’t possible. But if I were you, I wouldn’t take Gary Gorton’s word for it.
*While many have characterized the Swedish arrangement as an instance of free banking, Ögren rejects that characterization on the grounds that enskilda banks treated Riksbank notes as base money. “To argue that a free banking system may rest on base money issued by a monetary authority,” he says, “is inconsistent with free banking theory.” I beg to differ. In fact, in The Theory of Free Banking (1988), I wrote that free banking could even be consistent with a modern fiat system:
[T]he preceding pages discussed mainly a commodity standard, because this is the type that would most probably have evolved had banking been free all along; but events have been otherwise. For better or worse our monetary system is at present based on a fiat-dollar standard, and the momentum behind any existing standard is an argument for its retention. Existence of a fiat standard is, however, no barrier to the adoption of free banking. As far as banks today are concerned, fiat dollars are base money, which it is their business to receive and to lend and to issue claims upon. For most of the 20th century the only claims allowed (we are as usual considering ones redeemable on demand only) have been checkable deposits. What is proposed, therefore, is that commercial banks be given the right to issue their own notes, redeemable on demand for Federal Reserve Dollars, on the same assets that presently support checkable deposit liabilities.