SEIGNIORAGE, LEGAL TENDER, AND THE DEMAND NOTES OF 1861

I. INTRODUCTION Shortly after the onset of hostilities at Fort Sumter, the Lincoln administration asked Congress to authorize the first large-scale issue of federal paper currency. Officially labeled as United States Notes, they were popularly known as the Demand Notes of 1861. The administration's action is unremarkable. The extraordinary revenue requirements of long and costly wars are often met, in part, by issuing paper money. More surprising (and not widely recognized) is that this initial issue of paper money carried provisions that largely prevented it from yielding sustainable revenue (seigniorage). These provisions were largely omitted for the successor currency to the 1861 Notes (also known as United States Notes, but popularly as Greenbacks). As a result, its seigniorage potential was greater (although seigniorage was limited by other provisions). In modern software jargon, the Greenbacks might be viewed as 1861 Notes version 2.0: a version better suited to sustain a flow of seigniorage. However, the government was unable to replace the latter with the former very quickly, resulting in an extended period during which two paper currencies with different properties circulated side by side both with each other and with gold coin. This somewhat untidy situation provides an interesting (and heretofore underexploited) experiment for economists. These alternative monies circulated widely with market-determined exchange rates for a substantial period during which the amounts of both paper currencies in circulation greatly increased before the 1861 Notes were removed from circulation. We have collected daily data on these exchange rates and report them as differing gold premiums for the competing paper monies. Below, these data are exploited to calculate the seigniorage cost of the various provisions of the 1861 Notes and to provide evidence on alternative theories of expectations formation during this period. Our paper has three sections. The first presents a more extensive discussion than has been previously available of the 1861 Notes. In the second, a simple analytical framework is used to demonstrate and, where possible, estimate the seigniorage costs of the provisions attached to these notes. The third section analyzes the market relationship between gold and the simultaneously circulating 1861 Notes and Greenbacks prior to the (all but complete) retirement of the former in 1863. The paper concludes with a summary. II. THE DEMAND NOTES OF 1861 The major focus of this paper is on the Demand Notes of 1861, the first large-scale federal experiment with paper money. (1) We concentrate on these notes for two reasons. First, little has been written about them. Mitchell (1902), in his pioneering work on Civil War finance, devotes only 7 pages to them while devoting 17 pages to fractional currency and minor coins during the war. In addition, most of his discussion concerns the period prior to suspension. More recently, Calomiris (1988a, 1988b, 1992) makes reference to the 1861 Notes, but only as a part of his discussion of Greenbacks. Second, the paradox of issuing largely seigniorage-free paper money to help finance a war has not been well recognized and, hence, largely unexplained. This conflict between means and ends is interesting in its own right and illuminates some of what is puzzling in the sequence of monetary events over the first half of the Civil War. As a part of our discussion of the 1861 Notes, we challenge or extend the existing literature in three ways. First, we demonstrate that the conclusion of Studenski and Krooss (1963, 141, 144) that these notes were only used by the government to pay salaries and, hence, in their words, were a "pseudomoney" is mistaken. Examination of the financial press of the day suggests that these notes were not only popular but also circulated widely as money. A convincing claim can be made that they were indeed a national currency. …