Private Issues (3): Prices and Panics

In part one of this series, karthikraoa observed that the year-over-year growth of M3 money is very high, around 20%. In reply, David Andolfatto pointed out that "Most of M3 is private money creation." He said "the stock of base money is tiny relative to M3."

I pointed out that this bigger quantity of money "must have much more to do with inflation than base money does," and concluded "that the blame for inflation lies more with private money than with base." David rejected my conclusion, suggesting that "the US 'free' banking era 1836-63" was an era that showed my conclusion wrong.

In part two, I referenced Warren Mosler's observation that "The gold standard was established in the U. S. in 1834." Thus we were indeed on a gold standard during the free banking era, as I imagined in part one. The link to gold during that time prevented monetary imbalances from working themselves out through inflation. Some other route had to be found to relieve the economy's internal pressures.


Based on annual values from Measuringworth, a plot of consumer prices during the free banking era:

The spike at the right is associated with the U.S. Civil War. Apart from that spike, the entire period looks to average out around the CPI level 8, or 8% of the price level of 1982-84. Not really any inflation during this period.

At the left, the CPI peaks in 1837 and falls for half a dozen years. Then it rises a bit and peaks in 1847. Then it is flat until 1853, rises a bit, and peaks again in 1857. A peak every ten years.

In Appendix B of Charles Kindleberger's Manias, Panics, and Crashes -- "A Stylized Outline of Financial Crises" -- several crises are listed for the United States, including speculative peaks in September 1837 and August 1857.

Wikipedia's Economic History of the United States notes that "President Andrew Jackson ... opposed paper money and demanded the government be paid in gold and silver coins. The Panic of 1837 stopped business growth for three years."

At the time, base money was gold and silver coins.

Wikipedia's Panic of 1857 reports that "The Panic of 1857 was a financial panic in the United States caused by the declining international economy and overexpansion of the domestic economy. Beginning in September 1857, the financial downturn did not last long; however, a proper recovery was not seen until the American Civil War."

"Overexpansion" of private-issue money.

There was also a Panic of 1847, in England. This article quotes Jesus Huerta de Soto: "As of 1840 credit expansion resumed in the United Kingdom and spread throughout France and the United States..."

Credit expansion, relative to the growth of base money.

The excerpt from de Soto includes this statement:

It is interesting to note that on July 19, 1844, under the auspices of Peel, England had adopted the Bank Charter Act, which represented the triumph of Ricardo’s Currency School and prohibited the issuance of bills not backed 100 percent by gold. Nevertheless this provision was not established in relation to deposits and loans, the volume of which increased five-fold in only two years, which explains the spread of speculation and the severity of the crisis which erupted in 1846.

The Act limited base money but not private-issue money.

The 100% backing established in Britain at that time did not apply to all forms of money creation. Therefore, it was a loophole that encouraged expansion of the unregulated forms. It encouraged the five-fold increase de Soto observed.

A five-fold increase in the monetary imbalance.

After the Bank Charter Act, only the Bank of England was authorized to issue bank notes -- to print money -- and those notes had to be backed 100% by gold. So printing money was strictly limited by the Act.

But the Act exempted demand deposits -- checking account money -- from the 100% backing, and left open the door to unlimited increase of private-issue money.


In the United States during the Free Banking era, the proliferation of private money typically ended not in inflation, but in crisis.

Economists today say that the business cycle was more frequent and more severe in the 19th century than it is today. They pat themselves on the back and attribute the difference to the wisdom of their policies. I say the difference arises from the fact that we are no longer on gold.

Policy had no control over gold. The growth of base money depended essentially on chance. Today the Fed can create a little inflation here and there...

I'm not saying it's the perfect policy. I'm pointing out the difference.

...and by doing so, relieve some internal pressures in the economy. The Fed's ability to increase the quantity of money works like the steam-release valve of a pressure-cooker. When we were on gold, the steam-release valve was stuck closed. Since inflation was not an option, the internal pressure had to find other outlets. Thus the more frequent and more severe crises of the 19th century.