Suppressing Asset Price Inflation: The Confederate Experience, 1861–1865

I. INTRODUCTION The absorption of Treasury notes by the funding process is progressing favorably, and will counteract the tendency to a further depreciation of our currency arising from the heavy issues since the 1st of January last. --Richmond Dispatch, 15 April 1863 During the Civil War commodity prices rose in the Confederacy while the gold value of Confederate currency and bonds declined. The rate of asset price inflation lagged behind commodity price inflation, however, and there was a greater than 2:1 divergence at the time of two Confederate financial reforms aimed at encouraging exchanges of currency into bonds. These exchanges raised the demand for bonds and boosted bond prices while supporting the gold value of the currency as the supply of money was reduced. But the period between the announcement and implementation of these reforms saw upward surges in commodity prices with no matching depreciation in the value of the currency against gold. This suggests that the reforms may have channeled inflationary pressures into commodity markets and that an examination of both asset and commodity markets is needed to assess the effectiveness of Confederate monetary policy. Just as Bernanke and Gertler (1999) criticize the Bank of Japan for focusing on asset price inflatio n at the expense of the general price level in the 1989-97 period so too may Confederate monetary policy have been directed too much toward stabilizing asset markets with less favorable consequences for the prices of other goods and services. The bursts of commodity price inflation after the reforms were announced suggest that individuals exchanged money for goods as well as for bonds in the run up to the deadline. A real balance effect seems to have operated whereby decreased demand for the old money created excess cash balances that were translated at least in part into an excess demand for goods. Even after the financial reforms reduced the total money supply, the initial surges in commodity price inflation were never fully reversed. There was, in fact, a boost to wealth holdings when the reforms took effect insofar as the stocks of money being retired were exchanged for bonds at par--even though these bonds were then trading at a premium. In this way consumption expenditures may well have been fueled by the gains on the bonds when the exchange occurred. Despite uncertainty as to the relative weights that should be attached to bond holdings and money balances as components of private sector net financial assets, as discussed, for example, by Pa tinkin (1965, 289-90), the changes in the level and market value of bond holdings surely cannot be ignored in the Confederate case. This is especially so given the existence of a ready market for the bonds received with no restrictions on reselling. From the outset, Confederate currency and bond markets were linked by the fact that note holders enjoyed an imbedded call option on Confederate government bonds. Noninterest-bearing Confederate Treasury notes were issued with the proviso that holders could, at their pleasure, exchange these notes for 8% government bonds at par. This call option would naturally become increasingly valuable if the bonds rose above par and implied that noteholders would be able to participate fully in any bond market rally even while keeping their funds in the form of highly liquid currency. The 8% bonds issued under the 1861 $100 million loan (authorized by the act of 19 August 1861 with a minimum denomination of $100) generally traded at or below par during 1862, however. With no deadline for the exercise of the option, there was no incentive for holders of Confederate Treasury notes to actually convert their money into bonds at that time. In an attempt to induce--and ultimately force--early conversion of money into bonds the government instituted three funding acts that limited the time period over which. Treasury notes could be exchanged for the higher-yielding 8% bonds. …