{"id":13834,"date":"2011-03-17T17:59:58","date_gmt":"2011-03-17T06:59:58","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=13834"},"modified":"2011-03-17T17:59:58","modified_gmt":"2011-03-17T06:59:58","slug":"printing-money-does-not-cause-inflation","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=13834","title":{"rendered":"Printing money does not cause inflation"},"content":{"rendered":"

\t\t\t\tA number of readers have written to me asking me to explain why the US government (and any sovereign government) should not learn the lesson of the inflation that was caused by the spending policies of the Confederacy during the 1860s in the US. They have tied this query variously in with the rising budget deficits, the quantitative easing policies of the Bank of England and the US Federal Reserve Bank, and more recently the “injection of liquidity” by the Bank of Japan as a reaction to their devastating crisis. The proposition presented is simple – the Confederacy funded their War effort increasingly by printing paper notes (and ratifying counterfeit notes from the North) and saw runaway inflation as a result. This blog examines that point. What you will learn is that the experience of the Confederate states during the Civil War does not provide an case against the use of fiscal policy or the proposition that sovereign governments should run deficits without issuing debt. The fact is that “printing paper notes” does not cause inflation per se<\/em>. It might under certain circumstances. Those circumstances were in evidence in the Civil Wars years in America.
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\nIt just happens that the topic was covered in a recent New York Times feature (March 14, 2011) – Money for Nothing<\/a> by Ben Tarnoff.<\/p>\n

The article focuses on the events that followed the establishment of the ephemeral “Southern nation”, which began with the secession of South Carolina in December 1860. Six other southern states had joined the rebellion by February 1861.<\/p>\n

On February 8, 1861, the Provisional Constitution<\/a> for the Confederate States of America was agreed unanimously. It was based on the existing US Constitution with some key differences not germane to our interest here.<\/p>\n

On February 18, 1861, Jefferson Davis becomes the provisional president of the Confederate States of America.<\/p>\n

Article I, Section 6 of the provisional Constitution gave the new “country” the rights of a sovereign government with currency issuing authority – with the relevant clauses being:<\/p>\n

\n(1) The Congress shall have power to lay and collect taxes, duties, imposts, and excises for the revenue necessary to pay the debts and carry on the Government of the Confederacy, and all duties, imposts, and excises shall be uniform throughout the States of the Confederacy.<\/p>\n

(2) To borrow money on the credit of the Confederacy … <\/p>\n

(5) To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures.\n<\/p><\/blockquote>\n

On April 12, 1861 the new “country” attacks Fort Sumter and the Civil War formally begins – it was all down hill from there for the South.<\/p>\n

Earlier (March 9, 1861), as Tarnoff notes:<\/p>\n

\n… the congressmen passed a bill that gave the Confederate treasury the power to print notes. The amount they authorized was relatively small: only $1 million. In the coming months, however, that number would increase dramatically. Over time, Confederate paper currency would outgrow its modest origins in Montgomery and become the South’s single most important source of revenue – the financial fuel without which the machinery of its government would cease to function. It would both help and hinder the Confederate war effort, sustaining the South in the short term at the cost of future disaster.\n<\/p><\/blockquote>\n

So the Confederacy in a few short months had established themselves as a sovereign government with monopoly powers to issue the currency and tax in that currency (thus generating a demand for it). The problem which emerged, however, was that unlike the Union states which could enforce its taxing powers, the Southern government had great trouble raising revenue from taxation.<\/p>\n

Its public spending was more substantially matched by printing currency notes than in the Northern states. A definitive research work on the public finances of the era is the book by Donald R. Stabile and Jeffrey A. Cantor (1991) The Public Debt of the United States: An Historical Perspective 1775-1990<\/em>, Praeger: New York.<\/p>\n

While it established a currency-issuing monopoly the Confederacy had to immediately use that power to fight a war with its northern neighbours. Wars always challenge the inflation barrier because of the supply-side constraints that emerge as a nation gears for and then prosecutes the war effort. Rationing of real goods and services (that is, a non-market allocative system) is a typically used device to overcome the supply shortages.<\/p>\n

A famous reference about this period is the work by Eugene M. Lerner (1954) ‘The Monetary and Fiscal Programs of the Confederate Government, 1861-65’, Journal of Political Economy<\/em>, Vol. 62, No. 6, pp.506-522.<\/p>\n

If you have access to JSTOR the article can be located HERE<\/a>.<\/p>\n

Lerner notes that Milton Friedman considered the Civil War to:<\/p>\n

\n… provide precisely the kind of evidence that we would like to get by ‘critical’ experiments if we could conduct them …\n<\/p><\/blockquote>\n

Mainstream economists have used the Civil War period as a demonstration of their case against budget deficits.<\/p>\n

The Southern government tried to exercise their tax authority by collecting in-kind taxes from farmers and businesses. They were easily avoided who as Lerner says:<\/p>\n

\n… sold their goods (or hid them) before collection time …\n<\/p><\/blockquote>\n

There were other problems with the in-kind impost including rotting, damage and theft of the goods.<\/p>\n

I liked Lerner’s account of the way the farmers would avoid the “impressments” who were lying in wait as the farmers went to market:<\/p>\n

\nFrequently, impressment agents waited along well-traveled roads and seized the goods of unlucky farmers who happened along, instead of leaving the highways and impressing more equitably the goods of all producers. Farmers who anticipated impressment soon stopped bringing their goods to market and were discouraged from producing more than enough for their own immediate needs.\n<\/p><\/blockquote>\n

So not a very sensible revenue-raising strategy.<\/p>\n

Lerner notes that:<\/p>\n

\nUp to October, 1864, almost 60 per cent of all the money received by the Confederacy had come from the printing press. Less than 5 per cent of its revenue came from taxes. Approximately 30 per cent came from bonds sold to banks, institutions, and private persons and 5 per cent from miscellaneous sources.\n<\/p><\/blockquote>\n

Lerner reports on a struggle between the Southern nation’s first Treasury Secretary one Christopher Gustavus Memminger and the politicians. The New York Times article noted above has some nice narrative description of Memminger. He wanted to raise property taxes but the Congress declined to support the suggestion.<\/p>\n

For those with access to the University of North Carolina you can read all of C.G. Memminger Papers<\/a> at the library there.<\/p>\n

The New York Times article says that:<\/p>\n

\nMemminger wanted slave-owners to bear the brunt of the taxes … After much foot-dragging, the legislators finally complied in August. They didn’t tax one kind of property more than another, however. Instead, they adopted a uniform rate – of one-half of one percent.<\/p>\n

The tax turned out to be a fiasco. Sentiment against it ran high, contributing to delays in collection and resistance among the states.\n<\/p><\/blockquote>\n

Lerner provided the answer to this impasse in his 1954 article. The Southern states were not only hostile to centralisation and that was one of the reasons for the secession, but more pragmatically they:<\/p>\n

\n… believed that large tax payments were not necessary. Cotton was to be king; England would soon recognize the new nation and intervene actively; the Yankees would not fight; and military battles would go well for the South.\n<\/p><\/blockquote>\n

The early stages of the War reinforced these expectations.<\/p>\n

Memminger is often held out by the mainstream as being aware that printing too much currency is inflationary. There is a famous quotation in Lerner’s article that is repeatedly used to make this case:<\/p>\n

\nSecretary Memminger saw two immediate and indispensable benefits from levying taxes payable in government notes. First, taxes created a demand for the paper issued by the government and gave it value. Since all taxpayers needed the paper, they were willing to exchange goods for it, and the notes circulated as money. Second, to the extent that taxation raised revenue, it reduced the number of new notes that had to be issued. Memminger’s numerous public statements during the war show that he clearly realized that increasing a country’s stock of money much faster than its real income leads to runaway prices. They also show that he believed that a strong tax program lessens the possibility of inflation.\n<\/p><\/blockquote>\n

My colleague Randy Wray in his “Understanding Modern Money” book provides his view on this quote. He says that “it is clear that Memminger’s understanding went far beyond” the simple quantity theory of money approach – too much money chasing too few goods.<\/p>\n

Randy Wray says that Memminger understood that the nation needed “to impose sufficient tax liabilities to create a demand for the notes so that goods and services would be offered at relatively stable prices”.<\/p>\n

I won’t try to interpret what Memminger understood at the time. There is an additional point however. There has to be the capacity as well as the willingness to supply real goods and services in return for government spending. I will come back to that point soon.<\/p>\n

It is clear that a significant role of taxation – and a central proposition of Modern Monetary Theory (MMT) – is to create a demand for the currency. In a fiat currency system, taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities. <\/p>\n

The orthodox conception is that taxation provides revenue to the government which it requires in order to spend. In fact, the reverse is the truth. Government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending.<\/p>\n

It follows that the imposition of the taxation liability creates a demand for the government currency in the non-government sector which allows the government to pursue its economic and social policy program.<\/p>\n

This insight allows us to see another dimension of taxation which is lost in orthodox analysis. Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the non-government sector.<\/p>\n

The unemployed or idle non-government resources can then be utilised through demand injections via government spending which amounts to a transfer of real goods and services from the non-government to the government sector.<\/p>\n

In turn, this transfer facilitates the government’s socio-economics program. While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities.<\/p>\n

Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue. Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes.<\/p>\n

In my reading of Memmminger’s documents I have never found this level of understanding expressed. But he clearly did realise that “taxes created a demand for the paper issued by the government and gave it value” (as Lerner notes) so it is possible that he did think in the way that Randy Wray describes.<\/p>\n

At any rate, the ability to collect the tax revenue was severely constrained by a myriad of factors.<\/p>\n

The New York Times article said that:<\/p>\n

\nRelatively little revenue came into Memminger’s coffers … The Confederacy had been founded on the principle of the sovereignty of the states; any attempt by the central government to assert itself, even to support a war fought for its survival, would be met with mistrust.\n<\/p><\/blockquote>\n

This antipathy to taxation and the inefficiency of the Southern tax collection system is very well described in Lerner’s article cited above. He reports that:<\/p>\n

\nSixty-one million dollars entered the Treasury in the first year of the war, and $1.2 billions by September 30, 1863. Absolutely nothing came from property taxes in the first year, and only $20.8 millions by September 30, 1863. The property tax accounted for only 1.7 per cent of the total revenue received.\n<\/p><\/blockquote>\n

The first point then is that the Confederacy is not an ideal example to use when challenging the basic precepts of MMT. Yes, it did form a government with a provisional constitution giving it taxing and currency-issuing powers as outlined above.<\/p>\n

But, the essential characteristic of a modern monetary state (that is, a sovereign government) is that its tax borders are not porous. They must be able to effectively enforce the law which requires all tax liabilities to the state being extinguished in the currency of issue. It is one thing to invoke a law (based on a constitution) giving the state those rights but another thing to effectively enforce the rights.<\/p>\n

Lerner says that for many reasons – poor design, recalcitrant member states, invasion from the North etc:<\/p>\n

\n… it became impossible for the South to collect large amounts of revenue through taxation.\n<\/p><\/blockquote>\n

It would be wrong to think the problem was a lack of revenue. The problem was that the tax system could not be used as an effective vehicle to transfer private resources into the public domain in return for government spending.<\/p>\n

Further, it seemed that the tax system undermined the supply of real goods and services.<\/p>\n

Lerner recounts that Memminger’s:<\/p>\n

\nThe Secretary’s real alternatives for raising revenue were floating bonds or printing money. He, therefore, recommended that Congress authorize an 8 per cent bond issue of $50 million payable “in any resource which can be made available.” On May 16, 1861, Congress authorized bonds to be sold for “specie, military stores, or for the proceeds of sales of raw products and manufactured articles.\n<\/p><\/blockquote>\n

Which meant that the farmers would provide the loan funds upon sale of their produce (for example).<\/p>\n

The problem was – as the NYT’s article notes – that as the war proceeded unexpected difficulties arose. Lerner wrote:<\/p>\n

\nAt harvest time, however, the market for exported goods was smaller than had been expected. Southern ports were blockaded. Trading with the enemy was discouraged. A grand design forcing Europe to recognize the Confederacy was afoot, and southerners themselves prevented the export of King Cotton. Consequently, the price of cotton was almost 25 per cent lower in September than it had been in June when the pledges were made. Since the general price index for all commodities rose 27 per cent during this period, the real income of the cotton planters fell sharply. Many who planned to buy bonds when they sold their crops became discontented and, instead of buying bonds, demanded immediate government aid.\n<\/p><\/blockquote>\n

The pledges were the bond commitments.<\/p>\n

The NYT’s artile says that the “Southern economy was agricultural, illiquid … The South did have “white gold” – cotton. But the cotton trade fell sharply with the Union naval blockade, proclaimed by Lincoln in April 1861. A self-imposed embargo, devised by Southern leaders in an effort to force Britain to support the Confederacy, further curtailed cotton exports”.<\/p>\n

The obvious fact that emerged (and there is a very interesting discussion of the to and fro with respect to the bond issuance in Lerner) was that the Confederacy had unpaid bills piling up.<\/p>\n

Lerner says:<\/p>\n

\nUnpaid bills began accumulating on Secretary Memminger’s desk before revenue could be raised through tax collections or bond sales. Printing notes was the most expedient way of meeting these obligations, and on March 9, 1861, Congress authorized the issue of treasury notes “for such sum or sums as the exigencies of the public service may require, but not to exceed at any one time one million of dollars.” During the next four years the Treasury printed over fifteen hundred times this amount.\n<\/p><\/blockquote>\n

The NYT’s article notes that “(p)aper money had several advantages. It didn’t infringe on the sovereignty of the states. It provided a way to avoid taxes and to compensate for the Confederacy’s lack of capital … And it spared the South the more painful task of building a sound financing structure – a task that might require difficult decisions about the Confederate system’s shortcomings”.<\/p>\n

The NYTs article concludes that:<\/p>\n

\nThe value these notes generated couldn’t be sustained forever, though. As their quantity grew, so would inflation. As paper came to shoulder the bulk of the Confederacy’s costs, its inevitable depreciation greatly undermined the Southern effort. The war couldn’t be funded on faith alone. It required real revenue, something the deliberately decentralized Confederacy wasn’t designed to deliver.\n<\/p><\/blockquote>\n

It is clear that inflation accelerated in this period (in both the North and the South) – and was particulary robust in the South.<\/p>\n

But this conclusion misses the essential point. It was not a lack of revenue that caused the inflation. It was the inability to control aggregate demand through spending and taxation that was the problem.<\/p>\n

Confused? It is a subtle but important distinction.<\/p>\n

As explained above, the levying of the taxes would normally generate a demand for the currency of issue which would manifest in the form of a supply of real goods and services to the state from the private sector in return for spending (to get the currency to pay the taxes). This has nothing to do with the Confederacy needing revenue to spend.<\/p>\n

They constitutionally gave themselves the right to spend by establishing a fiat currency monetary system. But having an infinite capacity to spend is only part of the capacity to exercise appropriate fiscal policy interventions (which might include prosecuting a war effort).<\/p>\n

However, to elicit that supply of real goods and services, the government must be able to effectively impose the tax obligations. It is clear that the Confederacy was unable to do that.<\/p>\n

The problem was further compounded because even if they could have imposed the obligation effectively there was also the impact of the War on the capacity of the Southern states to produce real goods and services.<\/p>\n

It wasn’t the printing of the currency notes that was the problem. It was the fact that there were not enough real goods and services available for sale in relation to the rate of growth of nominal spending (on the war effort) that was the problem.<\/p>\n

There were additional issues – such as counterfeit notes pushed into the Southern economy by the North and ultimately accepted by the Confederacy as legitimate tender.<\/p>\n

But the supply problems were endemic.<\/p>\n

When we teach macroeconomics the development of understandings of both the demand-side (spending) and the supply-side (output) is important. The pre-Keynesian macroeconomics largely considered the demand-side to be reactive (Say’s Law) to supply. This was consistent with the denial that an economy could oversupply and thus experience a demand-deficient slump.<\/p>\n

You will be familiar with the regular statements that “printing money” causes it to lose value – which is another way of saying causes inflation.<\/p>\n

Once you understand the components of aggregate demand (spending) – household consumption, private investment, government spending, and net exports (exports minus imports) – the question to explore is how will the economy react to that nominal spending (that is, money value).<\/p>\n

So statements like increased budget deficits or an expansion of money will cause inflation have to be analysed in terms of how the supply-side of the economy responds to the increased nominal demand.<\/p>\n

Any nominal demand acceleration coming up against a supply constraint will be inflationary – it is not a unique characteristic of public spending.<\/p>\n

To explore that question you need to know how the supply-side of the economy responds. There are only three options when the economy receives an increase in nominal aggregate demand (spending):<\/p>\n