The suppression of state banknotes: a reconsideration

GEORGE SELGIN [*] It is generally believed that Congress, in imposing a prohibitive 10% tax on state banknotes in 1865, made the public better off by doing away with inferior brands of currency while simultaneously helping finance the Civil War by stimulating bond sales to national banks. In truth, the tax served neither purpose. The true purpose of the 10% tax was not to enhance bond sales or to improve the quality of the currency but to offset the inflationary effects of greenbacks and national banknotes. In the long run, the public might have been better off had state banks retained their right to issue currency. (JEL G21, N21) "Let us have a bank currency that will be recognized in the next town..., a currency that will be recognized in New York, Philadelphia, Boston, New Orleans, Chicago, or any other part of the United States." --Representative John F. Farnsworth (Illinois), April 28, 1864 [Congressional Globe 38th Congress, 1st Session, 1934]. "[I]f the national banks, with the great advantages which they enjoy, cannot compete successfully with the State banks, it simply shows that the latter subserve better the interests of the business community, and should not be destroyed." --Representative Francis Kernan (New York) February 16, 1865 [Congressional Globe 38th Congress, 2d Session, 833]. I. INTRODUCTION During the Civil War, a 10% tax was placed on any issuance of notes of state-chartered or incorporated banks, deliberately forcing state banks out of the paper currency business and making the regulation and issuance of currency a prerogative of the federal government and of federally chartered national banks. This paper reexamines the congressional decision to suppress state banknotes. American monetary historians have conventionally viewed the decision as reflecting (1) "the public's intolerable disgust with an unregulated currency" [Hammond 1957, 11; compare Dunbar 1922, 220] and (2) the government's desire to boost the demand for national bank charters so as to expand the market for its debt [e.g., Hughes and Cain 1998, 373-74; Dowd 1992, 230]. I plan to argue that neither view accounts adequately for the 10% tax. The first view in particular begs important questions that have gone unaddressed: If state banknotes were clearly inferior to national banknotes, why was a prohibitive tax needed to drive them out of circulation? Just how were consumers supposed to benefit from having their choices restricted? I explore several responses to these questions and ultimately conclude that consumers considered some state banknotes to be just as desirable as their national bank counterparts. I argue that the 10% tax served not to overcome any banknote-market failure but to force the withdrawal of relatively high-quality state banknotes. I then proceed to show that the tax was not needed to secure adequate bond sales to national banks. Proponents of the tax were striving not to increase the number of applications for national bank charters but to limit growth in the aggregate money stock. I conclude by suggesting that because state banks of issue could have accommodated market demands that national banks failed to satisfy, consumers might have been better served had state banknotes been allowed to survive. II. THE "CHASE PLAN" When the first shots of the American Civil War were fired at Fort Sumter, the paper currency of the United States consisted of over $200 million in banknotes, issued by nearly 1,500 state-chartered banks. The quality of these banknotes varied according to their issuers' management and regulatory environment. [1] Some banknotes circulated at par only near their source and at fluctuating discounts elsewhere, so that persons carrying notes from state to state risked incurring currency exchange losses of the sort borne by international travelers today. A few were subject to especially heavy discounts or were refused altogether because their issuers' solvency was in question. …