Legal Tender & Sound Money

Congressman Ron Paul (R-Texas), perhaps the only person in Washington I actually have a positive admiration for, has recently introduced a new monetary bill that those Catholics of the Distributist persuasion might find very interesting. On December 9th he proposed the Free Competition in Currency Act, which would repeal the legal tender laws on the books in the United States, allowing citizens of the United States to accept other mediums of exchange besides the United States dollar, thereby giving people the power to reject the dollar in favor of other currencies if the dollar proves to be too weak.

Paul put this bill before Congress once before, in December 2007, but has again reintroduced it as part of his on-going efforts to promote "sound money" in the United States (has anybody read his new book, End the Fed, by the way?). The bill has just be reintroduced; Sessions of Congress last two years, and at the end of each session all proposed bills and resolutions that haven't passed are cleared from the books, which means they have to be reintroduced again if a Rep wants to pursue them. You can read the full text of the bill here; it is only one page, which is a very nice change of pace compared to some other bills we've seen coming out of Washington lately.

Legal tender laws mean that a government compels its citizens by law to accept a certain currency as the medium of exchange in all transactions. In the United States, our legal tender is the United States dollar, which must be accepted as a valid currency for all debts public and private. If you owe somebody money, whether the gas station clerk or your mortgage company, they must accept payment in United States dollars (there are a few exceptions - see here).

We take this as a given in the United States today, but it was not always so, and the rise in "legal tender" laws corresponds directly to the degree that paper currency is accepted in place of precious metals. If we look back to the Middle Ages, currency was always in coin; and since the coin derived its value not from which kingdom minted it but from the content of precious metal it held, one silver coin from Byzantium was just as good as a silver coin of equal weight and content from Florence or England. Thus it was that an Spanish merchant doing business in Calais, France might use Greek numismata for exchange, or the King of England might have his treasury in Italian florins or Dutch guilders. These coins would circulate freely around the local and national economies, as all were equally recognized as currency because of their gold or silver content.

This multiplicity of currencies left the merchant free to reject debased or worthless currencies. It was not unknown in the Middle Ages (and the ancient world) for rulers to shave their coins or debase them with other less valuable metals. So long as other currencies were circulating around in addition to these debased coins, merchants had a choice to accept or not accept the debased "official" coinage, since there were always alternate mediums of exchange to turn to.

The problem begins when governments begin to turn to paper money as an alternative to precious metals, of which there is only a limited supply (and hence, precious metals can't be relied upon to fund enormously expensive and wasteful imperialist ventures). In America this grew out of the Civil War and the need for the federal government to find some means of financing the enormous costs of shouldering the war. This prompted Lincoln to enact the Legal Tender Act of 1862, which replaced the gold-backed Greenbacks with a note backed only by treasury securities; i.e., a fiat currency not backed by anything.

Why would merchants or anyone in business accept a currency not backed by anything, especially when there was still gold and silver going around? The easy answer is that they won't, which is why they had to be compelled to by the arm of the government in the Legal Tender Act of 1862, which guaranteed that creditors would have to take the bills. In his speech introducing the Free Competition in Currency Act, Congressman Paul said:

Historically, legal tender laws have been used by governments to force their citizens to accept debased and devalued currency. Gresham’s Law describes this phenomenon, which can be summed up in one phrase: bad money drives out good money. An emperor, a king, or a dictator might mint coins with half an ounce of gold and force merchants, under pain of death, to accept them as though they contained one ounce of gold. Each ounce of the king’s gold could now be minted into two coins instead of one, so the king now had twice as much “money” to spend on building castles and raising armies...

This was certainly what happened during the Civil War when Americans were forced to accept first Greenbacks and then Legal Tender notes as currency. After the war, some wanted the legal tender system to be permanent; others argued it was only a necessity of the war and should be stopped. The constitutionality of the United States government printing paper money was challenged and in 1870 Hepburn v. Griswold, the Supreme Court ruled that parts of the Legal Tender Act violated the Constitution. As debates over paper money raged, concurrent with the silver controversy going on at the time, the Court eventually overturned the 1871 ruling and declared the printing of paper money and the establishment of a national currency Constitutional in Juilliard v. Greenman (1884). From thereon out, silver and gold were incrementally removed from circulation, culminating in the 1933 ban on private ownership of gold.

Examples of the "Greenback" Demand Notes printed by Lincoln during the Civil War

Of course, since 1913 we have been on the Federal Reserve note, which is backed by absolutely nothing, which is plainly admitted on the website of the United States Dept. of Treasury:

Federal Reserve notes are not redeemable in gold, silver or any other commodity, and receive no backing by anything (source).

Since the currency is not backed by anything, its stability depends solely on the soundness of the American economy, which is linked to the soundness of the government's fiscal policies. When the economy is good and the government policies are friendly to the economic system, then the currency will be strong and the legal tender system tends to work pretty well. However, the real problems arise when the economy takes a dump and the currency goes with it - then people find themselves having to pay debts incurred when the economy was strong with a currency that is weak. This is inflation, a lowering of the purchasing power of the currency as seen in a rise in prices.

This problem is exacerbated when the government itself adds to the inflationary pressures by printing and circulating an extraordinary amount of fiat currency not linked to any real economic growth. At our current state, the American currency is being propped up only by the name and reputation of the United States government; if Egypt or Mexico or Peru or Pakistan tried running up a $14 trillion debt financed by fiat printing, their economies would crumble overnight, as did that of Zimbabwe (see here). Only America's longevity, historically strong economy and (presumed) financial stability are able to keep the value of the dollar up. But the world is starting to call these factors into question, and the dollar is weakening rapidly. If the world ever loses confidence in the American government, the inflationary pressures we have unleashed by printing so much money will catch up with us and we could experience hyperinflation.

Inflation is a uniquely modern problem, at least in its swiftness and degree. Sure there was overall inflation in prices in Europe from 1500 to 1600, but it was gradual and relative to a real supply of specie in European economies coupled with a real increase in the costs of maintaining armies, navies, etc. in the 16th century. But the Middle Ages saw nothing like the inflation of Germany in 1923, or that of Yugoslavia in the 1994, Hungary in 1946 (with a monthly inflation rate of 4.19 x 10 to the 16th power % and prices doubling ever 15 hours) or Zimbabwe in 2008. Those types of crises require a fiat paper currency forced in place by legal tender laws.

Those whose sole source of wealth is in legal tender suffer the hardest blow when inflation hits because they witness the devaluation of their money as it loses its purchasing power. What would we all do if, say in the next year or two, the American economy fails to pick up, US debt spirals out of control as the government attempts more failed stimulus spending into the tens of trillions and foreign markets and countries lose confidence in the US government? What will we do if our currency becomes worthless and inflates at an alarming rate?

But what if there were other legal tender besides the dollar? What if citizens had a right to choose between differing forms of currency, either different currencies altogether or different types of American currency, some perhaps minted privately? What if, when the dollar really begins to tank, there were other alternatives, so that if people came to your store trying to spend their crappy dollars (which you know could devalue again rapidly in a hyperinflationary economy), you were free to reject them in favor of "sound money"? If sound money was allowed to compete with worthless money, the sound money would be preferred every time and the worthless money would be witheld from circulation. This would strengthen the economy, since consumers would not be tied to the worthless legal tender. Ron Paul states:

In the absence of legal tender laws, Gresham’s Law no longer holds. If people are free to reject debased currency, and instead demand sound money, sound money will gradually return to use in society. Merchants would have been free to reject the king’s coin and accept only coins containing full metal weight.

Obviously Paul is referring to a currency in metal competing with a paper currency; his bill also calls for a return to private minting. Since the value of metallic currency was in the metal content itself, there was no reason why private mints could not exist alongside the US government mint in striking these coins - an oz. of silver was an oz. of silver regardless of who minted it.

I can't see any reason why a Distributist shouldn't be open to this concept of having other currencies coexisting alongside our official currency. This was, after all, how most economies in the Middle Ages and the ancient world flourished, which of course were generally much more stable than ours. It would certainly put more power back into the hands of the people and promote localism if certain precious metal coins were struck by regional mints. Yet most Distributist stuff I have read seems to presuppose a single, legal tender currency and focuses mainly on how to manage the currency we have in an equitable and responsible manner. I am not really a Distributist - I am more of a semi-Distributist because I like the ideals of Distributism but have reservations about how it would be implemented, though perhaps these reservations are more due to ignorance than to any positive disagreement.

I am also not in favor of a currency solely tied to the gold standard, either, because inasmuch as there is a limited amount of gold it can be manipulated by hoarding it or flooding the market with it. But I do feel that a mixture of paper currency coupled with precious metals would be ideal, and that the paper currency needs to be tied to growth and value in the real economy, not called up out of nothing.

I am sure Congressman Paul's bill will not pass, just like his Audit the Fed bill will probably be doomed to failure as well (though I pray this is not the case). But it is interesting to think about - for those of you who know more about economics than me, what about this concept of other, perhaps privately issued, currencies circulating around in competition with the dollar?