The Future of Central Banking:
A Lesson from United States History

Bennett T. McCallum

Carnegie Mellon University

Prepared for the 17th international conference of the Institute for
Monetary and Economic Studies, Bank of Japan, May 26-27, 2010.

1. Introduction
I’m going to begin by reviewing a crucial episode in U.S. monetaryhistory together with resulting decisions by the U.S. Supreme Court. Thisis an unlikely topic for a conference on the future of central banking, but isin fact highly relevant. In developing that argument I will refer to a paper
given at the BOJ conference last year by Goodfriend in which he promotes
an analytical classification for thinking about monetary policy (JME,2010). Following this discussion, I will conclude by outlining a way of
conducting monetary policy that is inspired by metallic standards of thepast—thus illustrating the connection between today’s policy issues and1

the monetary arrangements of previous centuries.
Let’s review what the Constitution says about monetary arrangements:(i) “The Congress shall have power ... to borrow money on the credit of
the United States, ..., to coin money, regulate the value thereof, and offoreign coin, and fix the standard of weights and measures” [Art I, Sec 8].
(ii) “No state shall ... coin money; emit bills of credit; make any thing but
gold and silver coin a tender in payment of debts ...” [Art I, Sec 10].
From these it seems clear that the vision embodied in the Constitution wasthat the nation’s arrangements would feature a strict metallic standard—with gold or silver as the standard commodity, or, gold-silver bimetallism.
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There is no mention of money in the amendments, so a basic question is:
how were these provisions overturned so as to result in today’s fiat-money
system with FR notes as legal tender and no trace of a metallic standard?
2. Greenbacks
Fiat money made its first appearance after adoption of the Constitution,in the Civil War of 1861-65, with issues of the infamous “Greenbacks” in
1862, 1863, and 1864. Total Greenback emission was $450 million, whichalone represented a near-doubling of money supply relative to 1860. The
context for the first issue was that in late 1861 matters were going badly
for the U.S. government as militarily the Southern forces were holding3their own, and financially the U.S. was having major problems. Bothorthodox and unorthodox schemes had been attempted, and still the Northwas finding it extremely difficult to raise funds needed for the war(Mitchell, 1903). Additional taxation would be unpopular and borrowing
was viewed as likely to require “prohibitively high” rates of interest. So
the Treasury Secty, Salmon P. Chase—of whom we shall hear more—andan energetic committee chairman, Rep. Elbridge G. Spaulding, devised aplan of issuing fiat paper money, the “Greenbacks.” These were legal
tender notes, non-redeemable, non-expiring, and non-interest-bearing.

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Spaulding wrote the legislative bill and led its passage, which met withmuch opposition in the House. He argued that haste was necessary; thatthe government would “be out of means to pay the daily expenses in about
thirty days, and the committee do not see any other way to get along till
we can get the tax bills ready....”. [Not true]
In the debate, constitutionality of Greenback issues was questioned bymany as their characteristics were similar to those of the “bills of credit”
specifically prohibited by the Const. Unfortunately, at least for the sake ofclarity, this prohibition applies to the states but not—at least not
explicitly—to the Congress. Resulting ambiguity enabled the Greenback
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proponents to argue that their issue was justified by the Constitution’s
grant to the Congress of the power “... to make all laws which shall benecessary and proper for carrying into execution the foregoing powers,
and all other powers vested by this Constitution in the Government of theUnited States ...” [Art I, Sec 8]. Strong counter-arguments were made in1862 that the Greenback issues would be only “helpful” to the govt’s
conduct of the war, not necessary, and the bill barely squeezed throughCongress. But it was signed by President Lincoln on Feb. 25, 1862, andthe first issue took place in April. At the time, Sec Chase expressed misgivings about making notes legal tender—see Mitchell (1903, pp. 68-74).
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3. Legal Tender Cases in the Supreme Court
If the Greenback issue had been only temporary, the nation might havereturned after the war to a metallic standard, as in many other cases. That
was not to happen, however, because of “… congressional inaction(failing to repeal the laws quickly and return to a specie standard) andSupreme Court approval once the laws were tested.”
It was natural that no challenges to the constitutionality of the Greenbacks would arise until after the War. The first case to make it to theSupreme Court was Hepburn v. Griswold, in 1869. The lender, who had
made a loan (in dollars) before issuance of the Greenbacks, went to court
8when the borrower attempted to make repayment in Greenbacks. By thistime, remarkably, Chase had become Chief Justice (of Supreme Court). In
fact, he was part of 4-3 majority who ruled that the Legal Tender Act of1862—for which he was largely responsible—was unconstitutional!
That was not the end of the story. On the very day on which thisruling was made public, President Grant announced the appointment of
two new justices to the Court, both of whom had made rulings that showedthat they supported the validity of the legal tender laws. So, when anotherlegal-tender case made it to the Court in 1871, the 1869 ruling wasoverturned and the legal-tender laws ruled to be consistent with the9Constitution. (Chase voted in the minority, again judging the laws to beunconstitutional.) This ruling, in Knox v. Lee (1871), was upheld in later
cases (1872 and 1884).
It is interesting to consider whether Grant’s appointment of two
Greenback-favorable members to the Court should be considered as a
successful “packing,” and thereby as a predecessor of Roosevent’s
infamous attempt in 1937. It turns out that Grant’s actions were lessobjectionable. {The main reason is that the Court had been temporarily
below its previous number of justices, as the result of a congressional actof July 1866 (brought about to avoid Court appointments by President
10Johnson, who had been impeached in 1868 but acquitted). The act
enlarging the Court to nine justices had been passed in 1869, possibly withan eye to overturning the expected ruling in Hepburn case. See Hepburn(1935), Dunne (1960), Ratner (1935).}
4. Supreme Court Decisions and Future Monetary Policy
But what does all of this have to do with current and future monetary
policy? The point is that the Supreme Court arguments in favor ofGreenback constitutionality were based largely on a crucial confusion
between monetary and fiscal policy. In particular, “the power to borrowmoney” is a fiscal, not a monetary provision. It gives Congress the right11

to borrow—to sell government debt to the public—an activity that does
not entail any necessary change in the stock of money, especially when thefunds are immediately spent on military expenses (as in 1862). When theTreasury sells or purchases bonds rather than raising or lowering taxes (inorder to finance increased or decreased government expenditures) there is
no implied change in the stock of HP money, which is basically
Goodfriend’s 2010 criterion for monetary policy.
But the reasoning of Supreme Court justices in two crucial cases did
not recognize this distinction. Instead, they argued as if the quoted power(“to borrow money”) would justify the issue of legal-tender fiat money.
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These cases were Knox v. Lee (1871) and Julliard v. Greenman (1884)—
see Hepburn, Dunne, Timberlake. Also, arguments by congressmen in
1861 in favor of the Greenback issue (Mitchell), and by minority membersin the Court’s 1869 case, had also involved this confusion. In sum, thefailure to distinguish between monetary and fiscal policy actions was amajor contributing factor to the Supreme Court decisions that madepossible the shift of the U.S. monetary standard from a metallic-money toa fiat-money system, a change of fundamental and momentous proportion.
Of course this change was not completed until much later, as convertibility
into gold was maintained from 1879 until 1933 and some remaining
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elements of a metallic system until 1971. But the “legal tender” cases
were necessary preludes to the later steps in the process of demetallization; without them, later actions and rulings would have beendifferent. Now, essentially the same failure has been present in thediscussion of the recent financial crisis, as argued in Goodfriend’s paper,
which emphasizes the implications for central-bank independence.
5. Contemporary Relevance
I have suggested that monetary arrangements in the U.S. have departed
sharply from those specified by the Constitution, and that the change has
been based in crucial ways on invalid reasoning. Does that mean that I
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would favor a return to a metallic standard? In fact, I would not favor an
attempt to return to a gold or silver or bimetallic standard, and only partly
because doing so would be nearly impossible to achieve. More importantis that we could now do better by recreating the essence of theConstitution’s instructions within the context of today’s paper money andwith an improved policy target. The purpose of the constitutional
provisions was to prevent major changes in the purchasing power ofmoney (the MOE). Given the absence of broad price indices in those days,
the specification of a fixed metallic standard was the only way known tothe authors of providing a degree of price level stability. That the “value”
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specified by Art I, Sec 8, was to be adjusted rarely (if ever) was, it seems
clear, implied by the phrases “to coin money” and “regulate the value
thereof” appearing in the same sentence as those pertaining to standards
for weights and measures. Given today’s technology, however, nearconstancy of the value of money could be provided better by specificationof a broad price index, rather than the price of gold, for the system to keep
constant. For the U.S., Congress could designate a broad price index andassign the Fed the technical task of keeping its inflation rate equal to (orclose to) zero. This would provide the U.S. with a monetary standard,
which we do not have at present, and would specify the Fed’s duties in16

such a way that it would have monetary policy independence. This could
then be used in meeting the standard specified—as in the Constitution—bythe Congress.
Obviously, this reasoning could be applied to Japan or other nations
with market economies. In addition, this setup would be entirely in thespirit of the New Keynesian type of monetary policy analysis that hadrepresented something of a “consensus” among researchers before thecrisis of 2007-2009 erupted, in a manner that has demoralized andconfused economists and policymakers in recent years.

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