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Economic Review Federal Reserve Bank of Dallas July 1986  1  The Abrogation of Gold Clauses in 1933 and Its Relation to Current Controversies in Monetary Economics Steven L. Green  In 1933, the u.s. government nullified "gold clauses" in existing bonds and contracts. When the United States abandoned the gold standard earlier that year, many outstanding obligations-including those of the government itselfcontained clauses offering creditors the option of demanding payment in gold rather than currency. Such clauses were intended to prOVide creditors protection against devaluation of the dollar relative to gold. This article surveys the gold clause abrogation episode from a historical perspective and relates its lessons to several current controversies in monetary economics. An important implication developed is that the contracts of private citizens, either with each other or with the government itself, cannot be written in such a way as to absolutely preclude subsequent governmental interference with their execution. For this reason, assumptions about the permissibility and permanence of contracts are potentially important factors in economic analysis. 19  Deregulation and Monetary Reform Gerald P. O'Driscoll, Jr.  Major features of modern monetary systems are the product of evolutionary forces. Nonetheless, some analysts have argued that important facets of the payments system, such as the circulation of non-interest-bearing currency, are the product of legal restrictions. The argument implies that market forces would radically alter the payments mechanism. Recently, certain of these analysts have proposed hastening the evolutionary process by implementation of their vision of our monetary future, which entails a payments system without circulating money (currency). This article both criticizes the vision and questions the means proposed to implement it. The article concludes that currency would reemerge spontaneously.  This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)  The Abrogation of Gold Clauses in 1933 and Its Relation to Current Controversies in Monetary Economics Steven L. Green Assistant Professor of Economics  Vanderbilt University Visiting Scholar  Federal Reserve Bank of Dallas  One of the more interesting episodes in American monetary history is the abrogation of gold clauses by Congress in 1933. Gold clauses were provisions in contracts, most often long-term bonds, giving creditors the right to demand payment in gold coin of a specific weight and fineness.' The standard of weight and fineness was usually that prevailing when the obligation was issued. With a few exceptions, gold clauses in bonds applied to both principal and interest. These clauses were very prevalent in debt obligations in the early 1930s, as they were included in all outstanding U.S. Treasury bonds and in a large fraction of state, municipal, and corporate bonds. In 1933, President Roosevelt and the Congress effectively took the United States off the gold standard, at least with respect to domestic transactions. In the same year, Congress passed a resolution declaring that gold clauses, including those in obligations of the U.S. Treasury, were "against public policy." As a result of this action, contracts explicitly allowing the creditor to demand payment in gold Economic Review - July 1986  were legally satisfied with the tender of unbacked paper money. The constitutionality of this action was effectively upheld by the Supreme Court in 1935. This paper provides a detailed discussion of the decision of Congress to abrogate gold clauses and the Supreme Court approval of that decision. To place the decision in historical perspective, an outline of the relevant legal aspects of u.s. monetary history is also included. This episode is also relevant to several current issues in the monetary economics literature. First, the legal restrictions theory of the demand for money views such restrictions as an important influence on monetary matters.2 In most of this literature, however, the discussion of specific restrictions is cursory at best. This paper, therefore, can be viewed as background information about the history of restrictions on the ability of individuals to enter into certain The author would like to thank John Van Huyck for helpful comments on an earlier draft of this paper.  kinds of contracts designed to protect against the effects of debasement. Second, economists have long been puzzled by the absence of widespread indexation practices in moderate inflation economies.) There is some debate as to whether the legislation abrogating gold clauses rendered all indexation arrangements unenforceable, and these arguments are reviewed in light of the historical discussion of the abrogation episode. Third, the recent literature reflects considerable interest in changes in monetary standards. 4 This paper is thus useful in providing a relatively thorough discussion of the legal aspects of monetary standard changes in 1933. Fourth, the abrogation of gold clauses in government bonds is an example of a government explicitly breaking a promise made to its constituents. As a result, the abrogation episode is relevant to the time inconsistency literature, which explores the incentives of governments to promise one thing and do another. 5 The gold clause episode and its history suggest that, as interpreted, the Constitution of the United States imposes no effective limitation on the monetary powers of the federal government. This observation raises fundamental questions regarding the source of limitations on the exercise of power by governments. Specifically, why is it that governmental powers-at least in democracies- seem to be effectively and explicitly limited in some areas (freedom of speech, search and seizure, etc.) but not in others, especially the monetary area? What is special about money that results in its control being almost universally ceded to governments by their constituents? Monetary phenomena will probably never be completely understood until the extent of governmental control over money is rationalized. The first section of the discussion provides an overview of the legal aspects of American monetary history, with particular attention paid to the use of gold clauses in public and private obligations. The legal development of the monetary system during the Civil War is emphasized because the events of that time bear special relevance to the abrogation of gold clauses in 1933. The second section explores the abrogation episode in detail. Included are discussions of the extent of, and motivations for, gold clause usage; the arguments for and against the abrogation legislation made at the time; the Supreme Court opinions upholding the abrogation; and interpretations of the event by scholars with the benefit of hindsight. The third section briefly relates to the recent literature the events described in the previous sections. The paper concludes with some observations about the lessons of the gold clause abrogation episode, particularly concerning the abil2  ity to contract freely and the associated implications for economists' views about policy effectiveness. Gold clauses and their place in U.S. monetary history  Since the early days of coinage, the fear of debasement has been a prominent concern of those engaging in monetary transactions. 6 Accordingly, attempts by transactors to ensure payment in coins of an established specie content are virtually as old as money itself. The tension between the desire of governments to debase coinage and of those using the coinage to protect themselves against debasement effects has been present therefore at least since the Middle Ages. International legal history prior to the founding of the United States abounds with legislative and judicial restrictions on the use of gold clauses. Hence, governmental powers have very often been employed to frustrate the efforts of economic agents to insulate themselves from the effects of debasement. Early U.S. monetary history. Before and during the War of Independence, the U.S. monetary system was very decentralized? Each of the colonies had its own monetary legislation, and there were several experiments with unbacked paper money that ended in inflation. These paper money experiments were partly the result of a gold shortage resulting from British mercantilism. The Revolutionary War was financed by issues of the infamous Continental currency, which became essentially worthless after the war because of its abundance. The Constitution gave the new federal government the right to coin money and regulate its value. It specifically denied states the right to designate something other than gold or silver as legal tender but was very vague about federal powers in this area. 8 In fact, the framers considered inserting specific limitations to the federal power in this area (specifically, making the issue of unbacked paper money unconstitutional), but ultimately they chose not to do so. The apparently persuasive argument was that such a limitation could be harmful in emergency situations such as wars. In 1792, Congress defined the dollar as legal tender. 9 The dollar was the denomination of a Spanish coin that circulated widely in the colonies and did not, like some other widely circulating coins, have the disadvantage of a link to the British crown. Legal tender quality was given to both silver and gold coin at a 15:1 ratio. This statute did not abolish the monetary systems of the states, and accounting in terms of colonial money persisted locally for several years. The initial monetary role of the federal government was essentially that of underwriting an assaying office that coined privately held gold and silver and thereby certified its weight and fineness. Federal Reserve Bank of Dallas  The fact that the dollar was defined as a fixed weight of either gold or silver during this era gave rise to the operation of Gresham's law whenever the market value of one metal in terms of the other deviated from the ratio set by the government. The version of Gresham's law most applicable in the present context states that when the relative price of two metals is fixed, the metal that is undervalued by official prices relative to market prices will become the dominant circulating money, and the overvalued metal will be withdrawn from circulation. The basic idea is that if an individual could melt down ten (overvalued) gold dollars and sell the resulting bullion for more than ten (undervalued) silver dollars, he or she would be irrational to use gold dollars at par value in exchange. When declines in the value of silver relative to gold began shortly after the Coinage Act of 1792, gold coins (including foreign coins) gradually began to leave the country. Between 1792 and 1834, the United States dollar was essentially a silver dollar, with a very limited monetary role for gold . On 28 June 1834, the gold content of the dollar was reduced approximately 6 percent. The silver-gold ratio in the definition of the dollar was thereby raised to 16:1. This action, together with discoveries of gold in California and Australia, made gold the relatively more abundant metal, and silver dollars were accordingly withdrawn from circulation to some extent.'o The period between 1792 and 1860 was one of considerable tension between the states and the federal government over monetary matters. Important questions included the relative powers of the federal and state governments, either directly or indirectly through chartered private banks, to issue bank notes. Court decisions wavered on this and other important issues. More generally, however, constitutional development during this period involved expanding federal powers relative to those of the states, a legacy of the broad construction of the necessary and proper clause by Chief Justice Marshall. This development, together with a precedent from English law to be discussed below, meant that money power would eventually be vested in the federal government, with the Constitution (as interpreted by the Supreme Court) providing no explicit limitations on its use. Monetary events during the Civil War and the first gold clause cases. The outbreak of the Civil War generated tremendous fiscal pressure on the Union government." The convertibility of national bank notes was suspended, and Congress authorized the first of three issues of legal tender Treasury notes (called "greenbacks'~ in February 1862 under the supervision of Treasury Secretary Salmon P. Chase (whose portrait later graced the $10,000 bill). By the end of Economic Review- July 1986  the war, some $450 million of the notes had been authorized. Of interest is the fact that Congress apparently preferred to issue legal tender notes rather than sell bonds at less than par, insisting on this policy with the reluctant acquiescence of Treasury Secretary Chase. The most significant aspect of this issuance was the legal tender status assigned to unbacked notes. The authority of Congress to do this was immediately challenged in the courts. As the so-called "legal tender cases" were working their way up to the Supreme Court, the chief justice's seat was vacated. President Lincoln appointed Treasury Secretary Chase to the position in anticipation of his upholding the constitutionality of an action that Chase himself had supervised. Although an initial decision in which Chase wrote the majority opinion ruled that the greenback issuance was unconstitutional, the legal tender quality of the unbacked paper was ultimately affirmed .12 In retrospect, these decisions effectively removed any explicit restriction on the monetary powers of the federal government that might have existed. The flurry of legal activity associated with the greenback issue included several cases relating to the use of commodity clauses in private debt obligations. Although gold clauses are by far the most prevalent kind of commodity clauses across time and across countries, some evidence exists that silver clauses were incorporated into some obligations in the United States after the California gold rush.13 This reliance on silver no doubt reflected its relatively stable value in the face of declines in, and uncertainty about, the value of gold. Apparently, however, contracts containing gold clauses also were entered into prior to the Civil War.'4 Finally, a later lower court opinion noted that it was a "common custom" at the time to write contracts calling for payment "in specie" because of uncertainty about the value of state bank notes.'5 Specie presumably referred to whichever monetary metal (gold or silver) was readily available in coined form. There seems to be no available data that might give more specific inSight into the fraction of outstanding contracts that contained such clauses during this era. The treatment of these clauses in the courts in the face of legal tender legislation is significant. State courts for the most part found the exercise of such clauses inconsistent with the legal tender acts. Somewhat surprisingly, however, the Supreme Court chose to overturn the state court decisions, ruling that the operation of contracts calling for payment in gold had not been explicitly forbidden by Congress and hence should be enforced.'6 The key point, then, was that Congress had not chosen to render the clauses unenforceable, and whether Congress actually had the 3  power to do so was not at issue. This decision predated Judge Chase's opinion declaring the legal tender laws unconstitutional, and even though his legal tender decision was reversed less than two years later, his gold clause opinion retained the force of law for many years. Civil War financial policy of the Union Government. Another interesting aspect of the Civil War was the policy of the Union toward its interest-bearing debt. 17 At the close of the Civil War, the Union had $2 billion in interest-bearing debt, and many bonds were set to mature very shortly. Most of these bonds had been purchased by citizens with greenbacks. Although several laws had authorized the issue of such bonds, many were ambiguous as to whether the principal, or the interest, or both were ultimately to be paid in gold. An important subset of the bond issues, the socalled "5-20s"-20-year tax-exempt securities bearing 6-percent interest in gold and callable after five years-represented about $800 million of the Union debt at the end of the war. Nothing in the laws authorizing the 5-20s said anything about whether the principal would be repaid in gold or in greenbacks, however. Many buyers were given to understand by Jay Cooke and Co., the agent hired by the government to sell the bonds to the public, that the government would in fact pay principal and interest in gold. The issue of how to service and repay the debt-in greenbacks or in gold-dominated political discussion in the years after the war. In the election of 1868, the Republican platform denounced "repudiation" (meaning repayment in anything other than gold), while the Democrats advocated repayment in greenbacks (unless the bonds expressly stipulated coin payment). With the election of Grant and the Republicans, the Public Credit Act of 1869 was passed. This act authorized the refunding of Civil War debt then coming due with new debt specifically calling for payment, both principal and interest, in coin. Since the mid-1830s, gold had been undervalued relative to silver and was therefore the dominant monetary metal. Hence, the terms "specie" and "coin" were generally taken to refer to gold. Shortly after the passage of the Public Credit Act, however, the scarcity of silver relative to gold began to decrease, and a monetary role for silver as well as for gold became a possible outcome of the planned resumption. As a result, there came to be some ambigUity about the meaning of the term "in coin" as it was used in the Public Credit Act. In the Coinage Act of February 12, 1873 (later termed the "Crime of '73"), Congress defined the dollar exclusively in terms of gold and thus eliminated any potential monetary role of silver. The combined implication of this act and the Public Credit Act was therefore that specie 4  resumption would involve only gold and that bonds would be repaid in gold. Interestingly, despite the uncertainty about whether Civil War bonds would be serviced and/or repaid in gold, the Union apparently never resorted to greenbacks for this purpose. That is, virtually all payments were in fact made in gold. This would not have been possible without the refunding in 1869 that pushed principal payments back several years. But the refunding, of course, presumably would have involved higher interest rates without the explicit promise to repay in coin. From resumption to the Depression. In 1875, Congress passed a law mandating the resumption of specie payments at prewar parity by 1879, leaving the details of how to effect resumption up to the Treasury.18 Because of a combination of good policy and good luck, the resumption came off as scheduled. Apparently, though gold clauses were not prevalent during the greenback era, they became more popular once specie payments were resumed. 19 The minimal use of gold clauses prior to 1879 may indicate that given the apparently credible commitment of the government to eventually resume specie payments at prewar parity, the widespread expectation (fully realized in actuality) was that the greenback would appreciate against gold. Hence, there was little reason to expect depreciation and to write such protection into contracts. Once specie payments were resumed, however, the likelihood of devaluation was greater, and some people thus began including gold clauses in debt obligations once again. The deflation of the 1880s and 1890s created an alliance of green backers with silver advocates resulting in the silver agitation, a movement calling for the monetization of silver and unlimited coinage of silver at a ratio of 16:1 with gold. This agitation generated extreme uncertainty about the monetary standard. Though only part of the long-term bonds issued after resumption included gold clauses, that portion likely was increased by the silver agitation. In addition, the use of such clauses probably affected a wider range of obligations, including nonmarketable debt agreements such as mortgages and also, perhaps, short-term agreements. The defeat of William Jennings Bryan in the election of 1896, as the candidate advocating a monetary role for silver, signaled a significant reduction in uncertainty about the monetary standard. Gold clauses did not become an important issue again until 1933. It seems likely that gold clauses may have been continued 'out of habit because their inclusion was essentially costless. The interest-bearing public d~bt was very small prior to World War I, but substantial issues of "Liberty Bonds" helped Federal Reserve Bank of Dallas  finance the war effort. The total public debt rose from $1.2 billion in 1916 ($12 per capita) to $25.5 billion in 1919 ($243 per capita). All of these bonds contained gold clauses by congressional mandate. The Depression and its aftermath. After the prosperity (accompanied by signs of financial stress) of the 1920s, the stock market crash in 1929 signaled the onset of the Great Depression.20 In 1931, Great Britain-also suffering from depression- broke the link between the pound and gold. Roosevelt, after winning the election of 1932, took office in 1933 in the face of a massive wave of bank failures and a collapsing economy. In 1933, some 4,004 banks with total deposits of $3.6 billion were closed either permanently or temporarily. (Total bank deposits in 1933 were $27.1 billion.) Upon taking office, President Roosevelt took several initiatives that significantly changed the U.S. monetary system. The first step, and perhaps the most widely remembered, was the Bank Holiday. More relevant to our purposes, however, was Roosevelt's decision to nationalize private gold holdings in exchange for government paper in March 1933 at the then official price of $20.67 per troy ounce. In the Thomas Amendment to the Agricultural Adjustment Act, Congress declared that unbacked paper money was legal tender. Congress passed Joint Resolution No. 10, and the President approved it on 5 June 1933, declaring gold clauses in debt obligations to be "against public policy": . . . IElvery provision contained in or made with respect to any obligation which purports to give the obligee a right to require payment in gold or a particular kind of coin or currency, or in an amount in money of the United States measured thereby, is declared to be against public policy; and no such provision shall be contained in or made with respect to any obligation hereafter incurred. Every obligation, heretofore or hereafter incurred, whether or not any such provision is contained therein or made with respect thereto, shall be discharged upon payment, dollar for dollar, in any coin or currency which at the time of payment is legal tender for public and private debts. Any such provision contained in any law authorizing obligations to be issued by or under authority of the United States, is hereby repealed, but the repeal of any such provision shall not invalidate any other provision or authority contained in the law. 21 It may be recalled that the legal tender acts passed in the Civil War were not accompanied by legislation abrogating commodity clauses in general or gold clauses in particular, Economic Review - July 1986  and the Supreme Court chose to enforce such clauses in the absence of legislation to the contrary. In January 1934, Congress passed the Gold Reserve Act that, among other things, mandated a decrease in the gold content of the dollar by not less than 50 percent and not more than 60 percent. President Roosevelt immediately obliged the Congress by redUCing the gold content to 59.06 percent of its former weight. This, in effect, raised the official price to $35 per troy ounce from $20.67. Suits challenging the constitutionality of the gold clause abrogation were immediately filed, and the Supreme Court handed down decisions in February 1935. By a 5-4 vote, the actions of Congress were effectively upheld. Effective 1 January 1936, the consent to sue the government over monetary claims was withdrawn. The withdrawal of consent to sue made gold clauses a moot issue for about forty years. In 1974, Congress again legalized the private ownership of gold. Courts ruled, however, that this law did not by implication repeal the prohibition on gold clauses. 22 A 1976 Tennessee court ruled that the Joint Resolution had outlawed indexing the principal of a loan to the consumer price index and raised the question of whether all indexation arrangements were illegal. 23 In 1977, Congress made the latter issue moot when it expliCitly legalized gold clauses in obligations entered into after 28 October 1977. The courts, however, continued to refuse to enforce gold clauses in agreements entered into prior to that date. 24 This legislation by implication legalized all indexation arrangements in contracts signed after the effective date. The gold clause abrogation episode in detail The above section has placed the gold clause abrogation episode in historical perspective. The decision of Congress to abrogate gold clauses in 1933 and the effective affirmation of that decision by the Supreme Court will now be considered in detail. The prevalence of gold clauses in 1933. By all accounts, the use of gold clauses in debt obligations was very wide25 spread at the time of the abrogation legislation in 1933. Most figures cited at the time fluctuate around the $100-billion-dollar mark as the par value of all obligations containing gold clauses, with estimates ranging from $75 billion to $125 billion. This included all of the $18 billion of outstanding interest-bearing federal debt. In addition, $10 billion in currency, redeemable in gold by the federal government, was outstanding. With the total public and private debt in 1933 at $168.5 billion, more than half of all outstanding debt obligations probably contained gold clauses. One lower court opinion maintained that enforce5  ment of gold clauses would add more than $80 billion to the principal of debt obligations, a figure that compares to an estimated total national wealth of $330.5 billion in 1933. Additional evidence of the prevalence of gold clauses is the list of railroad bond yields compiled by Macaulay.26 Of the 31 bonds for which yields were reported for 1933, only 2 did not contain gold clauses. One was issued in 1885, maturing in 2361, and the other was issued in 1908, maturing in 1958. Whether or how often contracting parties included gold clauses in obligations with the specific and conscious intent of protecting the value of the obligation against depreciation is difficult to judge from the historical record. At the time of the abrogation, some observers contended that no such intent was present, but rather that the inclusion of gold clauses was done out of habit-a legacy, perhaps, of the silver agitation-with no direct basis in the fear of depreciation: It is a sort of fetish of antiquity that they [public and private bonds] carry the gold clause. As a matter of fact, we know that practically they are never paid in gold, nobody expects them to be paid in gold, and they would have sold just as readily if the gold clause had not been in them. 27 According to comments recorded in In re Missouri Pacific Railway Co.,  the term "payable in gold coin of the United States of the present standard of weight and fineness" is a sonorous and mouth-filling phrase and indubitably it adds a dignity and a glamour of richness to all bonds, particularly to those which the maker had not and never had the remotest intention of ever paying in anything. 28 Given the nationalization of gold holdings, exactly how gold clauses would have been honored-either voluntarily or if they had not been abrogated-is not obvious. Explicit payment in gold was impossible, or at least illegal. Because no domestic market was determining the price of gold, payments of paper dollars could not be indexed to the domestic value of gold. One possibility, later attempted in a suit against the government, would have been indexing payment in paper currency to the official price of gold set by the government for international transactions. Regardless of the intent of including gold clauses in obligations, it would have imposed a significant burden on already strapped debtors if debts had been scaled upward proportionately to the higher official gold price. A 60-percent rise in debt would have compounded an already 6  difficult problem. A general picture of the problem can be inferred from noting that the wholesale price index (1929 = 100) fell from 95.1 in October 1929 to 60.2 in March 1933. Even more remarkable is the decline in farm prices (August 1909-July 1914 = 100) from 149 in October 1929 to 55 in March 1933. National income in 1933 was only 51.4 percent of the 1929 level. 29 Debts incurred prior to the onset of deflation imposed a greater and greater burden as prices and incomes fell while nominal debt-service demands were unchanged. An obvious question is whether or how much bonds with gold clauses sold at a premium relative to bonds without gold clauses. The yield data from the 1920s and 1930s unfortunately were not detailed enough for definitive statements about the premium on bonds with gold clauses. Because gold clauses were so widespread, it is hard to find yields on bonds without them. Nevertheless, Chart 1 indicates that yields on Treasury bonds- all of which contained gold clauses-did not rise appreciably, either at the time of the abrogation legislation in 1933 or when the Supreme Court decisions were handed down in 1935. In fact, yields declined generally during the entire period from 1931 to 1939. While this fact might be taken to imply that gold clauses had no market value during this period-perhaps because the abrogation was anticipated, the implicit ceteris paribus assumption in such a judgment is contrary to a realistic assessment of the determinants of yields. 30 It may be recalled that U.S. Treasury obligations issued to finance the Civil War contained implicit gold clauses. Friedman and Schwartz discuss whether these gold clauses in Union bonds had any value. Despite the fact that all interest payments on these obligations were made in gold, Friedman and Schwartz contend that the market initially priced the bonds as if they would be serviced and repaid in greenbacks: ... [Dluring the war and for some time thereafter there was little confidence that the government would in fact pay principal and interest in gold . . . . The bonds were being treated as if they were predominantly paper bonds. ... Since current interest coupons were being paid in gold, investors must surely have had different expectations for coupon payments in the near future and for coupon and principal payments in the distant future. 31 Thus, at least initially, market participants did not trust the "indexing" component of the government bonds, probably because the commitment to pay in gold was not explicit. The fact that the government did service this debt in gold Federal Reserve Bank of Dallas  Chart 1  Bond Yields, 1919-1939 (Monthly Averages)  PERCENT  PERCENT  12 r--,---,---,--- ,---r--.---,---, ---, ---r--.---.---,---.---.--,---,---,---,---,--. 12  10  ~--~--~--~~~~~~--~---4---4---4---4---4--- 1 --1-4---4---4---+---+---+---+-~  10  9  r-~--~---+---+--_r--~--+---+---~--~~--~--~\ I --+!j-_r--~--;_--+---r---r_~  9  r-lDLr'\ ~0 I n : :=:rv=:~=:"'V=:=:=":1\=:1=:=:==~-,,- '- - ---rIV V l~--l-"---+--+-~_/j.,=:: 8  :\.I \~,  ~)  /~  \  2 .1 '~~ l -.h  /"'v-  r  5  CORPORA TE Baa ,) ~~  ~~I r-V - ~  I"" CdRPORATE AaafA _ I I I \, ." - I~~" I );r~~'+--V;\ , -'J\+-.j------A:I~ --=----tlj-d-t--r,v-Y-''\:J;:;  P1""  I ~- ~-+ I I-~) ~ d luwh~ l"j~~~ ~h~ I A ~ 1' -V7·~ I -~ \l! .....::1'-\.7.~ ~  4 3  U,S, GOVERNMENT PARTIALLY TAX EXEMPT  2  ~ \j  \  , -  /'  I  I  I  HIGH-GRADE MUNICIPAL BO NDS I STANDARD AND POOR'S CORP .  •  \..~-;-~  I  ~  STATE AND LOCAL GOVERNMENT Aaa  : =============~IM~ T"~l 1922  1924  1926  1928  1930  1932  1934  1936  7  6  5  4 3  'i\.\ I'  r--4--~--4---~-4--~--4---~-4--~--4---~~~~~~~~-;--~--~--~~  1920  8  2 1  o  1938  SOURCE : Board o f Govern ors, Fed eral Reserv e System , Div ision of Research and Stati stics , H isto rical Supplement o f Federal Reserve Chart Book on Financial and Bus iness Statistics (Was hington , D C, September 1959), 44  Economic Review - July 1986  7  meant that the effective return to its holders in terms of greenbacks fluctuated with the greenback price of gold. As payment in gold became more certain with the election of Grant in 1868 and the Public Credit Act of 1869, however, yields began to reflect the anticipation of gold payments. In this one instance, then, the market assumed the government would resort to payment in unbacked paper in the absence of specific evidence to the contrary. Legislative history. 'From a historical standpoint, legislative interference with gold clauses has occurred for centuries.32 In an ordinance of 1429, foreign merchants in England were forbidden the right to demand payment in gold coin or to refuse payment in silver. In Venice, a statute abrogating gold clauses was enacted in 1517. Several countries abrogated gold clauses shortly after World War I, and a large number of countries joined the United States in passing abrogation legislation in the 1930s. That such legislation is so prevalent historically-and especially that so many countries enacted such legislation in the 1930s- strongly suggests that a common set of underlying principles may explain these actions. Had the abrogation legislation of 1933 in the United States been unique, it could be be attributed more easily to historical accident, perhaps because of the whims of those making policy. Almost immediately after the discussion of legal tender issues that ultimately led to passage of the Thomas Amendment to the Agricultural Adjustment Act in March 1933, the question of how to deal with gold clauses was raised in Congress. A key position in the congressional debate was as follows. Those favoring the measure essentially supported the arguments in the committee reports. The essence of this position was that the enforcement of gold clauses would interfere with the power of Congress to regulate the value of money and provide for a uniform currency: The occasion for the declaration in the resolution that the gold clauses are contrary to public policy arises out of the experiences of the present emergency. These gold clauses render ineffective the power of the Government to create a currency and determine the value thereof. If the gold clause applied to a very limited number of contracts and security issues, it would be a matter of no particular consequence, but in this country virtually all obligations, almost as a matter of routine, contain the gold clause. In the light of this situation two phenomena which have developed during the present emergency make the enforcement of the gold clauses incompatible with the public interest. The first is the tendency which has developed internally to hoard gold; the second is the tendency 8  for capital to leave the country. Under these circumstances no currency system, whether based upon gold or any other foundation, can meet the requirements of a situation in which many billions of dollars of securities are expressed in a particular form of the circulating medium, particularly when it is the medium upon which the entire credit and currency structure rests. 33 [Empahsis added] This report ignores the obvious counterexample of the greenback experience, when different kinds of currency circulated side by side and the enforcement of gold clauses by the courts apparently produced no serious disruptions in the economy. At the very least, a defense of the abrogation would seem to have demanded explicit delineation of the differences between the then-current situation and the circumstances surrounding financial policy during the Civil War. Much of the congressional debate related to the propriety of abrogating gold clauses in the obligations of the government itself-to the effect of whether such action was "repudiation" that could not be legally justified. Many senators viewed the resolution as immoral, breaking a sacred covenant between the government and its creditors.34 Those senators in favor of the measure, however, maintained that creditors would be paid in something of equivalent value and hence that the resolution was in no sense immoral or inappropriate.35 Ultimately, the ability of the government to undertake these actions rested on the view of sovereignty. A congressional committee report foreshadowed the position of the government to be taken in subsequent suits challenging the constitutionality of the action: Nor does the fact that outstanding obligations of the Government are expressed as payable in gold coin impose a limitation, under the circumstances obtaining, upon the exercise of the powers conferred by the Constitution. The Government cannot, by contract or otherwise, divest itself of its sovereign power. All contracts of the Government are made in the light of this inalienable power to legislate as the public interest may demand. It is too well settled to admit of controversy that contracts or provisions of contracts, even though not inconsistent with public policy when made, may subsequently become contrary to public policy, as authoritatively announced by the legislative branch of the Government, and that, in such event, they become invalid and unenforceable. 36 Even after the Joint Resolution was passed, gold clauses were not explicitly illegal. Those signing contracts with gold Federal Reserve Bank 01 Dallas  clauses were not breaking the law. Instead, the courts simply refused to enforce them. This did not prevent the party losing as a result of gold price movements from voluntarily affirming the agreement, but there is no evidence to this effect. 37 Moreover, the courts continued to uphold all other provisions of contracts containing gold clauses, with the single exception that they could be satisfied by payment in any legal tender of the United States. Finally, the debate over the Joint Resolution reveals that a vote was taken in subcommittee to limit the resolution to obligations entered into after the date of passage of the bil1. 38 This proposal was defeated. Congress apparently considered that interference with existing debt obligations was of prime importance. Supreme Court opinions. After passage of the Joint Resolution, lawsuits soon challenged its constitutionality.39 Historically, judiCial disapproval of clauses designed to protect creditors from debasement occurred as early as the sixteenth century in Europe. An important British precedent was the so-called "case of the mixed moneys," which related to a royal decree lowering the bullion content of coin minted explicitly (and exclusively) for use in Ireland. The suit was filed by an Irish merchant who had contracted prior to the decree to purchase a certain quantity of goods for one hundred pounds in English sterling when his creditor refused to take payment in the debased money. The court ruled for the debtor on the ground that the power of the crown over coinage superseded provisions in pre-existing private contracts. Five suits have collectively become known as the "gold clause cases."40 In Norman v. Baltimore and Ohio Railroad Co. (294) U.S. 240 [1935]), the holder of a bond containing a gold clause sued for coin payment. Nortz v. United States (294 U.S. 317 [1935]) was a suit to recover the bullion value of gold coin previously depOSited with the Treasury and rejecting the postdevaluation paper money settlement. In Perry v. United States (294 U.S. 330 [1935]), the holder of a Liberty Bond issued by the U.S. Treasury sued for payment in gold coin rather than in paper money. The two other cases were decided as part of the Norman case. The court recognized a distinction between suits involving two private parties as opposed to suits involving the federal government. For obligations involving two private parties, the court upheld the constitutionality of the abrogation by a 5-4 vote. The majority reasoned that the government does all kinds of things to jeopardize the operation of private contracts, including declaring war, levying tariffs, and so on. Private contracts thus cannot inhibit the exercise of constitutional government powers-specifically, the power of Congress to coin money and regulate its value. Economic Review - July 1986  The exact nature of the interference of gold clauses with this power is not clear from the opinions. The primary argument developed as follows: It requires no acute analysis or profound economic inquiry to disclose the dislocation of the domestic economy which would be caused by such a disparity of conditions in which, it is insisted, those debtors under gold clauses should be required to pay one dollar and sixty-nine cents in currency while respectively receiving their taxes, rates, charges, and prices on the basis of one dollar of that currency.41 Exactly how such dislocation implies that the coinage provision gave Congress the power to abrogate gold clauses is not apparent from the opinion. Regarding obligations of the government containing gold clauses, the issue at hand was not whether the government actions could interfere with contracts between two private citizens but rather whether the government could renege, ex post, on an agreement it had made at an earlier point in time. In Perry v. United States, the court ruled that Joint Resolution No. 10 could not be applied constitutionally to interest-bearing government debt containing gold clauses-that government obligations were in fact different from private ones. The government could not make a tangible commitment one period and explicitly rescind that commitment at a later date. The following are selections from the majority opinion, written by Chief Justice Charles Evans Hughes: The argument in favor of the Joint Resolution, as applied to government bonds, is in substance that the government cannot by contract restrict the exercise of a sovereign power. But the right to make binding obligations is a competence attaching to sovereignty .... In the United States, sovereignty resides in the people who act through the organs established by the Constitution. . .. The Congress as the instrumentality of sovereignty is endowed with certain powers to be exerted on behalf of the people in the manner and with the effect the Constitution ordains. The Congress cannot invoke the sovereign power of the people to override their will as thus declared. The powers conferred upon the Congress are harmonious. The Constitution gives to the Congress the power to borrow money on the credit of the United States, an unqualified power, a power vital to the government,-upon which in an extremity its very life may depend. The binding quality of the promise of the United States is of the essence of the credit which is so pledged. Having this 9  power to authorize the issue of definite obligations for the payment of money borrowed, the Congress has not been vested with authority to alter or destroy those obligations. The fact that the United States may not be sued without its consent is a matter of procedure which does not affect the legal and binding character of its contracts. While the Congress is under no duty to provide remedies through the courts, the contractual obligation still exists and, despite infirmities of procedure, remains binding upon the conscience of the sovereign .... We conclude that the joint Resolution of june 5, 1933, in so far as it attempted to override the obligation created by the bond in suit, went beyond the congressional power. 42 The court therefore determined that the government cannot constitutionally renege on its agreements with private citizens. But the question of constitutionality is separate from the question of damages. The bondholder was asking for damages measured by the increase in the official price of gold (the price set by the government for use in international transactions, which had been raised from $20.67 to $35 per ounce in january 1934), demanding more than one paper dollar for every gold dollar promised by the bond. The court held that the bondholder was entitled to no compensation for damages. In early 1933, the government outlawed the ownership of gold. Hence, even if the bondholder had been paid his coupon in gold on the date in question (24 May 1934), he would have had to turn in the gold and receive a like number of paper dollars. He was, however, already in possession of an equivalent number of paper dollars that the government had tendered in payment of the coupon. He had, therefore, suffered no damages as a result of the abrogation. By similar reasoning, the majority held in Nortz v. United States that the holder of a gold certificate was not entitled to damages as a result of joint Resolution No. 10. The court thus ruled that while the government cannot explicitly repudiate its commitments, it can pass other laws that have essentially the same impact. Despite the eloquent discussion of the meaning of sovereignty, the effect of the opinions was virtually identical to a ruling that the joint Resolution was constitutional when applied to government obligations. In a concurring opinion, justice (later Chief justice) Harlan F. Stone emphasized the unquestioned power of Congress to grant and withdraw the consent to sue rather than the somewhat nebulous application of the power to coin money and regulate its value. His perspective was sup10  ported when, as noted above, Congress removed the consent to sue on monetary claims effective 1 january 1936. The four-member minority, in an opinion relating to all the gold clause cases, argued that the resolution amounted to an unconstitutional confiscation of property rights. Regarding gold clauses in government obligations to the private sector and the refusal of the majority to award damages because of the demonetization of gold, justice james C. MCReynolds wrote the following: ... [We] conclude that, if given effect, the enactments here challenged will bring about confiscation of property rights and repudiation of national obligations. . .. just men regard repudiation and spoilation by their sovereign with abhorrence; but we are asked to affirm that the Constitution has granted power to accomplish both. . .. Valid contracts to repay money borrowed cannot be destroyed by exercising power under the coinage resolution. . ' . For the Government to say, we have violated our contract but have escaped the consequences through our own statute, would be monstrous. In matters of contractual obligation the Government cannot legislate so as to excuse itself. ... Can the government, obliged as though a private person to observe the terms of its contracts, destroy them by legislative changes in the currency and by statutes forbidding one to hold the thing which it has agreed to deliver? If an individual should undertake to annul or lessen his obligation by secreting or manipulating his assets with the intent to place them beyond the reach of creditors, the attempt would be denounced as fraudulent, wholly ineffective. 43 Although very eloquent, MCReynolds' reasoning here is inconsistent with most of legal history. Explicit limitations on the monetary power of governments have not been widespread. In the light of history, then, it is somewhat surprising that the decision was so c1ose. 44 Perhaps the animosity of the court toward New Deal reforms in general was one reason for its nearly reaching a decision almost without precedent. Motivations behind the policy actions of 1933. The policy actions in 1933 that demonetized gold and abrogated gold clauses reflected a large number of influences during economic chaos. 45 Nevertheless, scholars concerned with the period have identified three relatively simple motivations for the policy actions: (1) the desire to reverse the deflation of the early 1930s, (2) the desire to redistribute wealth from creditors to debtors, and (3) the desire of the Treasury to capture completely the capital gains on gold implied by devaluation. These motivations are not necessarily indeFederal Reserve Bank of Dallas  pendent of one another, differing instead in which concern received prirnary emphasis. The fall in the wholesale price index from 1929 to 1933 was noted above. Roosevelt's goal, which was widely embraced, was to raise prices. One rationale for this goal may have been the perception that prices behaved procyclically, and hence that higher prices would somehow induce higher real income. Roosevelt was drawn to policies that would raise prices directly, such as devaluation and its implications for the prices of imported goods. Exactly why the abrogation of gold clauses was essential to this goal was never made clear by proponents of the policy. Another effect of inflation would have been to reduce the real value of nominal debt service. The enforcement of gold clauses by scaling payments upward according to the increase in the official price of gold, however, would have significantly increased real debt burdens, because the general price level did not rise proportionately with the official gold price. As a result, the abrogation of gold clauses in private contracts prevented a redistribution of wealth from debtors to creditors. The goal of providing relief to debtors was prominent in the mind of one senator, who offered the following forecast as to the effects of the joint Resolution: "It will be my task to show that if the amendment shall prevail it has the potentialities as follows: It may transfer from one class to another class in these United States value to the extent of almost $200,000,000,000. This value will be transferred, first, from those who own the bank deposits. Secondly, this value will be transferred from those who own bonds and fixed investments.,,46  If Congress had desired to redistribute wealth from private creditors to private debtors, it could have specifically excluded government obligations. The fact that they did not would suggest that the above motives may not tell the entire story. An alternative story, suggested by james Buchanan and Nicholas Tideman, attributes a revenue motive to the government. 47 By confiscating private gold holdings, the government put itself in a position to realize an enormous capital gain (almost $3 billion) from the devaluation and deny that capital gain to private gold owners. Considerations of equity may have demanded that those holding claims to future gold flows (in the form of obligations with gold clauses) also not be allowed the realization of a windfall from the devaluation. While this argument has some appeal, the subsequent actions of the government do not make it very convincing. Of the capital gain, $2 billion was appropriated to the financing of the foreign exchange stabilization fund set up in Economic Review -  July 1986  the Gold Reserve Act of 1934, and $640 million went toward the retirement of national bank notes. In 1945, the United States paid its share of World Bank and International Monetary Fund (lMF) capital out of this profit. As Buchanan and Tideman noted, this policy had the somewhat ironic implication that it cut off one mechanism- wealth effects in the form of capital gains to gold owners-whereby a devaluation leads to higher aggregate demand and, presumably, to higher prices. The Treasury chose not to spend the windfall to the extent that private agents might have. Of course, the cushion provided by the capital gain may have enabled the Treasury to engage in the deficit financing associated with the New Deal more boldly than would have otherwise been the case. Finally, one obvious potential explanation for the policy actions of 1933 is not applicable. In many cases, the decision of a government to suspend specie payments and/or to devalue reflects declining gold reserves. Even though worsening terms of trade had caused balance of payments deficits that resulted in the United States losing one-fifth of its monetary gold stock between September 1931 and july 1932, it still held more gold in March 1933 than it did in 1929. It seems highly unlikely, then, that concern about gold outflows was the primary motivation for the policies in early 1933. Relation to current research issues Legal restrictions theory. Several recent papers have explored the role of legal restrictions in the development of monetary systems. Usually such discussions cite bank reserve requirements and the prohibition of smalldenomination interest-bearing notes as the most important legal restrictions. 48 This paper has provided a relatively detailed overview of legal restrictions from the standpoint of the ability, or lack thereof, of private agents to circumvent legal tender laws via contractual arrangements and thereby protect themselves from the effects of debasement. The gold clause episode strongly suggests that there are no effective constitutional constraints on the monetary powers of the federal government in the United States. The positive observation that the monetary powers of the U.S. government do not appear to be subject to explicit limitations, however, does not make positive models of laissez faire monetary systems irrelevant. Nor does it render normative arguments in favor of such limitations fruitless. History does suggest, however, that such arguments have for the most part not been very persuasive. Governmental powers in a sense always rest on the consent of the governed. If the underlying political economy so dictated, society could probably restrict governmental 11  monetary powers to any desired extent. From a positive standpoint, monetary powers are not limited because people probably do not strongly desire it. More precisely, the current perception, and the historical one, must be that the costs of such limitations exceed the benefits. It may be the case, however, that this perception could eventually be changed by recent research on the properties of laissez faire monetary systems and the benefits of constitutional restraints on the monetary power. Such research could possibly influence the evolution of the underlying political economy enough to result in effective limitations on the monetary powers of government. The effects of uncertainty about the ability to contract in terms of something other than a monetary unit whose value can be manipulated by the government seems to be a subject worthy of further study. SpeCifically, it might be the case that this threat of abrogation prevents agents from entering into certain contracts, resulting in a welfare loss relative to a situation where all trades are possible. From a broader perspective, the role of government in inducing such a loss would then need to be explained. The current literature takes as a maintained hypothesis that legal restrictions in the monetary realm are permissible from a public choice standpoint. By contrast, some explicit guaranties of other rights to the people (such as freedom of speech) do exist. While this is certainly a defensible research strategy, stepping back and asking the more fundamental question- of why restrictions are permissible in some areas but not in others-might lead to important inSights. Indexing. Economists have long been puzzled as to why indexation arrangements are not more prevalent in moderate inflation economies. McCulloch has recently contended that the failure of u.s. corporations to issue indexed bonds was due to the fact that the joint Resolution of 1933 made indexation illegal. 49 SpeCifically, the opinion of a Tennessee court in 1974 cited the joint Resolution in disallowing the indexation of principal on a bank loan.50 McCulloch has pointed out that the threat of disallowance, finally realized in 1974, was an effective deterrent to the issue of indexed bonds between 1933 and 1977. Kelly, in a comment on McCulloch's paper, contended that firms do not issue indexed bonds because they can achieve the effects of such issuance in other ways.51 McCulloch's interpretation of the implications of the joint Resolution for the legality of tying payments to a price index is at odds with the conventional wisdom of legal scholars that such practices were not deemed to be against public policy. One explanation they offer for the failure of corporations to issue indexed bonds involved questions about the 12  negotiability of such instruments. 52 Sec. 3 of the Uniform Commercial Code, which relates to commercial paper, requires that for an instrument to be negotiable, it must call for payment of a "sum certain." Under this provision, indexed instruments are definitely not negotiable. Sec. 8, on the other hand, gives a relatively general definition of a "security" and then declares all securities to be negotiable. Moreover, if there is any ambiguity as to whether an instrument is governed by sec. 3 or sec. 8, sec. 8 is given precedence. On balance, it seems to be the case that, as the law is currently written, indexed bonds would be negotiable if an organized market for them developed. Whether this has always been the case is an open question. If indexed bonds were not negotiable, it might explain why firms have chosen to mimic the effects of indexing in the "other ways" suggested by Kelly. (It should be noted that bonds with gold clauses were negotiable because they did call for payment of a certain sum, although the sum was expressed in a particular kind of money,) In many instances, however, indexation arrangements have been enforced. Examples include modern economies with chronic inflation, such as Israel and Brazil. Indexed contracts are probably permissible as long as they shift the burden of debasement in a politically acceptable way (i.e., not Significantly at odds with the underlying political economy). Certain contingencies, such as wars or depreSSions, might make the implied distribution unacceptable, which would in turn lead to abrogation. The possible occurrence of such contingencies may prevent the imposition of explicit limitations on the debasement and abrogation powers. Changing monetary standards. The tendency of many monetary economists studying the implications of different monetary standards has been to view changes in standards as once-and-for-all events. As a result, analysis of the effects of such changes has generally neglected the implications of uncertainty about the standard that might still persist even after it has been changed. In an important paper, however, Flood and Garber develop a model that emphasizes the fact that commodity standards are temporary in nature: Even a well-designed commodity-money scheme is a foolproof inflation guard only when the scheme's permanence is guaranteed. Permanence may possibly be guaranteed by an underlying political economy that abhors inflation, but merely the enactment of a new ephemeral rule does not ensure permanence. 53  The history of the gold clause abrogation episode provides considerable support for this perspective, but one interestFederal Reserve Bank of Dallas  ing implication of this perspective is the complication that it poses for normative arguments. For example, one might consider an economist whose positive models of hypothetical monetary systems have led him to conclude-based on some normative criteria-that a particular monetary system is preferred over all others. His models, however, would all incorporate assumptions about the degree of permanence of a system. One common assumption is that once the new system is adopted, people believe it will be permanently maintained. For his positive analysis to be strictly applicable, the economist's normative arguments must thus be strong enough to change the underlying political economy sufficiently for the system to be adopted permanently. Without such permanence, the favorable features of the newly adopted system might never be fully realized. The time inconsistency problem. Several recent contributions explore the implications of the assumed inability of the private sector to explicitly constrain government behavior. 54 These papers analyze a noncooperative game between private agents and the policymaker when the policymaker is assumed to receive some benefit from "fooling" private agents. An intertemporal policy plan is time inconsistent if while optimal when announced, it is dominated by another policy at some point in the future. The most popular example of time inconsistency involves money growth and inflation determination in a fiat money regime. The monetary authority perceives some benefit (lower real debt service costs, for example) to creating surprise inflation when private agents expect the exogenously specified optimal inflation rate. Because the policymaker by assumption cannot be effectively prevented from creating surprises, private agents in equilibrium adopt expectations of inflation that are high enough to remove the incentive to create a surprise. They are able to do this because anticipated inflation by assumption poses increasing marginal disutility to the policymaker. Inflation is therefore higher than would be the case if a binding rule could be externally imposed on the monetary authority. The gold clause abrogation episode is relevant to the issues addressed in the time inconsistency literature because it is an example of a government making an explicit promise in one period (to honor demands for payment of interest and principal in gold) and breaking that promise in a later period. The time inconsistency literature generally assumes a fiat money regime in which the policymaker's opportunity set is a continuum of money growth rates. Breaking that promise, however, took the form of changing the monetary standard, which is a discrete event. One implication of this discreteness is that considerations of reputation and crediEconomic Review - July 1986  bility must be carefully addressed, and doing so properly is likely to be a major theoretical exercise. Nevertheless, this literature does raise certain questions about the gold clause abrogation episode. Most importantly, was the abrogation anticipated by private agents? That is, could private agents have developed a model of government behavior that suggested abrogation was the optimal policy? The failure of government bond yields to move during the episode raises the intriguing possibility that the policy actions may have in fact been accurately anticipated, but the weakness of the evidence makes such an interpretation quite speculative. In an important extension of the time inconsistency literature, Barro and Gordon address issues of reputation and credibility in a model of monetary policy determination under a fiat standard. 55 The central feature of their model is that the policymaker not only perceives benefits to cheating today as in the conventional time inconsistency model but also suffers a cost in terms of lost reputation that will make it harder to cheat in the future. This occurs because cheating today means that private agents will be less likely than before to believe future announcements of, say, disinflationary polices. If concern about future outcomes is a strong enough influence on policymaker behavior and if cheating today results in the loss of reputation long enough, these reputational considerations can act to "enforce" an outcome that resembles one associated with an externally imposed rule binding the conduct of the monetary authority. In a fiat money regime, it is conceivable that the policymaker can "invest" in reputation by following policies of low money growth even if it has "cheated" in the recent past. Put another way, the reputation costs of "cheating" in a fiat money regime may not be all that great. The continuum of policy choices makes this possible. In the context of changing monetary standards, however, the credibility cost is very high. Switching back and forth from commodity to fiat standards is conSiderably more difficult than increasing and decreasing growth rates of fiat money. Hence, modeling the reputational costs of abandoning a commodity standard is a very subtle exercise. As a result, the time inconsistency literature at its current stage of development is probably not directly applicable to the gold clause abrogation episode. Moreover, the benefits and costs to the government of the policies undertaken in 1933- both from the standpoint of those making policy at the time and in the light of historical record-are difficult to characterize with precision. The Civil War financial policy of the Union government is another intriguing episode with respect to questions of rep13  utation and monetary standard changes. Although the government abandoned the gold standard as a "necessary" aspect of wartime finance, the belief that it would ultimately resume specie payments at par was apparently widespread. Foreigners invested heavily in greenback-denominated securities in the apparent belief that the greenback would appreciate against gold, as was justified by subsequent experience. In fact, throughout history most paper money issues have been associated with wars, with a return to some kind of commodity standard by the victor following the war. As Friedman has recently emphasized, however, the present fiat money system has not followed this pattern. 56 Further study into the comparative aspects of the Civil War experience relative to the Depression experience could provide some insight into this issue. Such a study might usefully employ the perspective of Grossman and Van Huyck, who maintain that sovereign agents (i.e., agents whose agreements are subject to no outside enforcement authority) break explicit agreements only when conditions render the action "excusable" (i.e., upon the realization of a contingency that is at least implicitly understood by the contracting parties).57 In the absence of such contingencies, the maintenance of such agreements is in the long-term best interest of the agent. From this perspective, something about the Depression must have made the abrogation of gold clauses excusable, while such conditions did not prevail during and after the Civil War. More generally, however, the arguments above raise the following question: If limitations on monetary powers of governments would really yield unambiguously favorable results, then why do they not exist? The answer to this question will probably not be forthcoming until the public choice mechanism linking preferences of individuals and binding constitutional restraints on government actions is better understood.  Concluding comments This paper has provided a detailed examination of the decision of Congress to abrogate gold clauses in public and private contracts in 1933. It has supplemented discussion of this episode with a selective history of the legal aspects of U.S. money and the use of gold and silver clauses in private and public contracts. The direct implication of this episode was that private agents could not protect the value of contractual payments from changes in the value of the monetary unit by contracting in terms of gold. Moreover, the abrogation legislation and the subsequent judiCial approval of it is by no means unique to the United States of the 1930s 14  as examples of such actions abound across other countries and throughout history. More generally, this episode firmly established that the contracts of private citizens, either with each other or with the government, cannot be written in such a way as to absolutely preclude subsequent governmental interference with their execution. Contracts cannot inhibit what is deemed by the Supreme Court to be the legitimate exercise of a constitutional power by the federal government, and the interpretation of what is "legitimate" obviously can change over time. Conceivably, any contract could eventually be deemed to be at odds with the Supreme Court's prevailing notion of the public interest, and rational individuals should take this uncertainty into account when signing agreements. While this history therefore supports the idea that legal restrictions can be an important influence on monetary pheonomena, it begs the more fundamental question of the source of explicit restrictions on governmental powers. SpeCifically, what is speCial about money that has precluded the effective imposition of meaningful explicit restrictions on the use of governmental money power? The power of governments in general to debase their currencies is firmly established. An important part of that power is the ability to prevent private agents from taking actions to insulate themselves from the effects of such a policy. Many economic models assume, however, that private agents are free to undertake transactions that offset the effects of policy actions. In some models, for example, activist stabilization policies are neutral with respect to real variables such as output and employment. Given that the government has the power to invalidate contracts that could neutralize the wealth effects of debasement, however, it could also have broader powers to effectively disallow private actions that would neutralize, or at least mitigate against, the effects of a wide range of policies. This is a point that raises interesting possibilities for the views of economists about the effectiveness of policy actions.  1. An example of a typical gold clause may be found in Russell L. Post and Charles H. Willard, "The Power of Congress to Nullify Gold Clauses," Harvard Law Review 46 (June 1933): 1225 n. 1. A good general reference discussing gold clauses and their usage is Arthur Nussbaum, Money in the Law (Chicago: The Foundation Press, Inc., 1939), 304-305 . The detailed documentation of the use of gold clauses in 1933 is given in the notes later at the point of detailed discussion in the text. 1. For example, see Neil Wallace, "A Legal Restrictions Theory of the Demand for 'Money' and the Role of Monetary Policy," Quarterly Review, Federal Reserve Bank of Minneapolis, Winter 1983,1-7. Federal Reserve Bank of Dallas  3.  For example, see Nissan Liviatan and David Levhari, "Risk and the Theory of Indexed Bonds," The American Economic Review 67 (June 1977): 366-75.  4. For example, see Robert P. Flood and Peter M. Garber, "Gold Monetization and Gold Discipline," Journal of Political Economy 92 (February 1984): 90-107. 5.  The seminal paper in the time inconsistency literature is Finn E Kydland and Edward C. Prescott, "Rules Rather than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy 85 (June 1977): 473-91.  6. A good general reference for the use of gold clauses internationally is Money in the Law by Nussbaum, which also contains a detailed treatment of the history of U.S. monetary law. Other references that emphaSize the legal aspects of U.s. monetary history include James Willard Hurst, A Legal History of Money in the United States, 1774-1970 (Lincoln: University of Nebraska Press, 1973); F. A. Mann, The Legal Aspect of Money, 4th ed . (Oxford: Clarendon Press, 1982); and Arthur Kemp, The Legal Qualities of Money (New York: Pageant Press, Inc, 1956). The Kemp book provides a useful discussion of the distinction between "legal tender" and "lawful money," including documentation of the confusion over the meaning of these terms that has been a feature of legislation and court rulings dealing with money in the United States. The facts cited in the introduction to this section were obtained from Nussbaum, Money in the Law, 301-304, 335-76. 7.  Historical material in this subsection was drawn from Nussbaum, Money in the Law, 168-72, 177-79; Gerald T. Dunne, Monetary DecisiOns of the Supreme Court (New Brunswick, N.J.: Rutgers University Press, 1960), 6-10,12-13,23-64; Walter T K. Nugent, Money and American Society 1865-1880 (New York: The Free Press, 1968), 7-8  12. In Hepburn V. Griswold, 75 U.s. (8 Wall J, 603 (1870), the court ruled by a 4-3 vote that the legal tender legislation passed during the Civil War did not apply to contracts- even those calling only for payment of a nominal sum-that were made prior to the passage of the law See Dunne, Monetary Decisions, 71-76, for a discussion of this case. In the majority opinion, Justice Chase issued the following thinly veiled apology for his actions as Treasury Secretary: "Some who were strongly averse to making government notes a legal tender felt themselves constrained to acquiesce in the views of the advocates of the measure. Not a few who . . . acquiesced in that view, have, since the return of peace, and under the influence of the calmer time, reconsidered their conclusions' (Dunne, Monetary Decisions, 74). The later cases included Knox V. Lee and Parker v Davis, 79 U.S. (12 Wall.), 457 (1871) . These cases were decided by a court with two new justices whose appointments were sent to the Senate on the very day Hepburn v. Griswold was decided. These two new justices sided with the dissenters in Hepburn V. Griswold to uphold the constitutionality of the legal tender legislation. The majority opinion in these cases was written by Justice William Strong, one of the new appointees. Finally, Julliard v. Greenman, 110 U.S . 421 (1884) established that the authority of Congress to declare unbacked paper legal tender was a general power rather than one that could only be exercised during wartime. (See Dunne, Monetary Decisions, 76-83). 13. Nussbaum, Money in the Law, 303. In Holyoke Water Power Co. v. American Writing Paper Co., Inc., 68 F (2d) 261 (C.C.A. 1st, 1933), the issue was whether a contract calling for payment in silver coin or its equivalent value was invalidated by the legal tender laws. 14. In 8ronson v. Rodes, 74 U.S. (7 Wall.), 229, 258 (1869), the contract in question called for payment in gold coin (see Dunne, Monetary Decisions, 105)  8. The following excerpts from the U.S. Constitution are cited in Dunne, Monetary Decisions, 10: 'The Congress shall have Power . . . To Coin Money, regulate the Value thereof, and of foreign Coin .. : (art. I, sec. 8, cI. 5); and "No State shall . .. coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts . . . (art I, sec. 10, cI. 1).  15. "Prior to the Civil War, it was a common custom to write into obligations for the payment of money, even into promissory notes, the provision that the debt should be payable in specie. The reason for this precaution was that much of the money then in circulation consisted of paper promises to pay, issued by so-called state banks" (see Bronson V. Rodes, 74 U.s. [7 Wall 1, 229, 19 l. Ed 141 [18691, as cited in In re Missouri Pacific Railway Co., 7 F. Supp. 1 at 2, 3 [1934]).  9. The text of this law and many of the others cited in this paper may be found in Laws of the United States Relating to Currency, Finance, and Banking from 1789 to 1896, compo Charles F. Dunbar, rev. ed. (Boston: Ginn and Co., 1897), 227-29.  16. Nussbaum, Money in the Law, 347-48, cites several relevant state court cases. The Supreme Court case was Bronson v. Rodes, 74 U.s. (7 Wall.), 229 (1869). For a discussion of this decision, see Dunne, Monetary De-  10. There is some debate about whether silver coins strongly dominated gold coins in circulation between 1792 and 1834 and whether gold coins were strongly dominant between lB34 and 1860. See Arthur J Rolnick and Warren E. Weber, "Gresham's law or Gresham's Fallacy?" Journal of Political Economy 94 (February 1986): 185-99, for the less conventional view that Gresham's Law is not strictly applicable to these time periods. For advocacy of Gresham's law, see Nussbaum, Money in the Law, 178-79, and Nugent, Money and American Society, 7-8.  17 Historical material in this subsection was drawn from Nugent, Money and American SOciety, 10-11, 126-27, 182-83; Unger, The Greenback Era, 17; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1970, A Study by the National Bureau of Economic Research, New York (Princeton, N.J.: Princeton University Press, 1971[1963]),27, 45.  11. Historical material in this subsection was drawn from Irwin Unger, The Greenback Era: A Social and Political History of American Finance, 1865-1879 (Princeton, N J: Princeton University Press, 1964), 14-15; Wesley Clair Mitchell, A History of the Greenbacks, with SpeCial Reference to the Economic Consequences of Their Issue: 1862-65, The Decennial Publications of the University of Chicago, 2d ser., vol. 9 (Chicago: The University of Chicago Press, 1903), 68-74; and Dunne, Monetary DeCisions, 70.  Economic Review - July 1986  cisions, 71.  18. Historical material in this subsection was drawn from the following sources: Nugent, Money and American Society, 11; Friedman and Schwartz, A Monetary History, 70-85, 91, 107 n. 27, 115; Nussbaum, Money in the Law, 304; U.s. Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Part 2 (Washington, D.C., 1975), 1117; and the Federal Reserve Bulletin 19 (June 1933): 335. 19. In the list of 150 railroad bonds compiled by Frederick R. Macaulay (in Some Theoretical Problems Suggested by the Movements of Interest Rates, 80nd Yields and Stock Prices in the United States since 1856 [New 1S  York: National Bureau of Economic Research, 19381 ), the 32 issued before 1865 were all payable in currency. A bond payable in gold was issued in 1865, but of 24 bonds issued between the end of the Civil War in 1865 and the resumption of specie payments in 1879, only 6 contained gold clauses Fourteen of the 24 bonds issued between 1879 and 1886 contained gold clauses, and only 2 of the remaining 72 bonds (the latest year of issue was 1926) did not contain such clauses (see Macaulay, Movements of Interest Rates, A5-A 16; also, Friedman and Schwartz [in A Monetary History, 71 n 781 cite this evidence in their discussion of interest rate behavior during the Civil War) At a conference on the abrogation of gold clauses, Friedman presumably had the Macaulay data in mind in making the following remarks: "From 1860 to 1879, there were no gold clauses, but gold clauses were put into every bond thereafter Th ey started in 1879 as a result of the experience during the greenback episode, when gold sold freely in terms of greenbacks at a free-market price; the gold clauses said that you were to receive the number of dollars req uired to buy X ounces of gold of such and such weight and fineness , It was in contemplation of a return to such a situation- one in which the U S. would be driven off gold and you would have a free greenback price of gold-that gold clauses were introduced in bonds after 1879 Almost every bond issued by both the private sector and the government from 1879 on had a gold clause, and it's perfectly clear that that was why they did it" (see the comments in Henry G Manne and Roger LeRoy Miller, Gold, Money and the Law [Chicago: Aldine Publishing Co., 19751, 143-44). 20. Historical material in this subsection was drawn from U S. Bureau of the Census, Statistical Abstract of the United States 193961 (Washington, D.C., 1940), 263; Historical Statistics, Part 2,992; Federal Reserve Bulletin 19 (April 1933): 213-17; 19 (May 1933): 166-86,266-71; 20 (February 1934): 63-69; Friedman and Schwartz, A Monetary History, 469; and Dunne, Monetary Decisions, 96 21 The full text of the resolution is reprinted in the Federal Reserve Bulletin 19 (June 1933): 336-38 22. For an example of such a decision, see Feldman v. Great Northern Railway Co " 428 F.5upp. 979 (1977). In this case, the holder of a bond containing a gold clause issued in July 1921 sued for payment in gold 23. Aztec Properties, Inc. v. Union Planter's National Bank, 530 S.W.(2d), 756 (1975): 425 U S. 975 (1976). 24 For example, see Rudolph v. Steinhardt, 721 F 2d 1324 (1983), in which a lease written in 1970 containing a gold clause was declared unenforceable. Moreover, in Southern Capital Corp. v. Southern Pacific Co., 568 F.2d 590 (1978), the holder of a bond with a gold clause issued in March 1927, before the passage of the Joint Resolution of 1933, was ruled not entitled to payment in gold 25. Historical material in this subsection is drawn from the New York Herald Tribune, 13 April 1933, sec. 2, p, 8, col. 1: Nussbaum, Money in the Law, 304-305 n 16-20: In re Missouri Pacilic Railway Co, 7 F.5upp. 1, at 2, 4 (1934); CongreSSional Record 77 (3 June 1933), 4982, 4905; Historical Statistics, Part 1, 255, and Part 2, 989, 993, 1117 26. Macaulay, Movements of Interest Rates . 27. Remarks of Senator Barkley in the Congressional Record, 4892. 28  In re Missouri Pacific Railway Co , 7 F Supp. 1 at 3 (1934).  29. Statistical Abstract, 311 , 315. For a detailed analysis of debt obligations  in the Great Depression, see Albert Gailord Hart, Debts and Recovery, A  16  Study of Changes in the Internal Debt Structure from 1929 to 1937 and  A Program for the Future: The Factual Findings (New York: The Twentieth Century Fund. Inc., 1938). 30. For historical yield data from this period, see Banking and Monetary Statistics (Was hington, D c.: Board of Governors of the Federal Reserve System, 1943), 468-71 . 31 Friedman and Schwartz, A Monetary History, 69-76: the quotation is on p. 73. 32 Historical material in this subsection is drawn from Nussbaum, Money in the Law, 356-61; on pp . 357-58 n 5, he includes a list of legislation, beginning in 1931, In 24 different cou ntries outlawing gold clauses. 33 House Report no 169, 73d Cong., 1st sess. The report is reprinted in the Federal Reserve Bulletin 19 (June 1933): 335-38: the quotation is on p. 335 34 "Mr REED . I think it is much more important to consider this question from the standpoint of national honesty and national honor than it is to split hairs on constitutional construction, and the letter of that charter of our liberties to which we so often refer, and so seldom follow" (see the Congressional Record, 4894): "Mr REED .. We took $500,000,000 of money from the people of the United States on April 23 in the reliance on their part upon our promise to pay in gold coin of the present standard of value, Never did any confidence man or trickster pull off a more dishonorable performance than that, if it was then in mind that we were to repudiate the outstanding promises of the United States to pay in gold or its equivalent" (see the Congressional Record, 4896). 35 "Mr FLETCHER . . We are not depriving anybody of any property or of any value or of any rights they now have, except that we are not proposing to pay in gold absolutely the obligations, but we are giving what is equal to gold, what is as good as gold, and no one can claim that he has lost anything by this kind of transfer" (see the Congressional Record, 4890);  "Mr FLETCHER .. As a matter of fact, there is no repudiation at all here There may be technically a repudiation of the obligation to pay in gold; but if we pay in something that is worth just as much, that is just as valuable for every pu rpose that money can be used for as gold, we have not repudiated anything. Nobody has lost anything. We are actually paying today in dollars a dollar and a half for what we promised to pay a dollar for when our bonds were issued" (see the Congressional Record, 4892).  36. House Report no. 169 (see the quotation in the Federal Reserve Bulletin 19 Uune 19331: 336). 37. Gerald O'Driscoll has pointed out that this is an accepted distinction at commo n law. Although some contracts might be unenforceable for public policy reasons, it is not clear that any contract (absent conspiracy) is illegal at common law An intriguing question is whether reputational forces were ever strong enough to make voluntary adherence to gold clause agreements optimal for creditors In a famous French case (Do-Oelattre v Scouteten, D .P 1870 IV 76; D P. 1873, I 77) heard shortly after notes of the Banque de France were declared legal tender in 1870, the effect of the act on gold clauses in existing contracts was considered. The contract in question called for payment in "gold or silver coin and not in any value or paper money made legal tender in France through laws or decrees which hereby are waived by the debtors in good faith and upon honor . ." (see Nussbaum, Money in the Law, 336) The court held this clause ineffective, and the debtors were al-  Federal Reserve Bank of Dallas  lowed to repay their debt in depreciated bank notes. This particular attempt to use moral pledges to circumvent governmental enforcement was therefore unsuccessful. 38. The following exchange was recorded on 3 june 1933: "Mr. VANDENBERG. Was there a proposal in the committee to limit this proposition to new loans and not to apply it to existing contracts? "Mr. FLETCHER. There was. "Mr. VANDENBERG. What was the vote in the committee on that subject? "Mr. FLETCHER. I do not remember the vote. The proposal was defeated . "Mr. VANDENBERG. Was it defeated by a narrow margin? "Mr. FLETCHER. I think perhaps it might be called a narrow margin . My recollection is there was a majority of 3 or 4. "Mr. VANDENBERG. Has the Senator available the form in which the amendment was offered in the committee? "Mr FLETCHER. No; I have not. Of course, if that sort of amendment were adopted, it would destroy the whole plan. "Mr. VANDENBERG. But it would not destroy the credit of the Governmentl?l. "Mr. FLETCHER. No; and it will not be destroyed anyhow' (see the Congressional Record, 4890).  39. Not surprisingly, the gold clause abrogation induced a flurry of legal commentary such as those by Henry M. Hart, Jr., "The Gold Clause in United States Bonds," Harvard Law Review 48 (May 1935): 1057-99; and John Dickinson, "The Gold Decisions," University of Pennsylvania Law Review 83 (April 1935): 715-25. The material in this subsection also draws on Nussbaum, Money in the Law, 335-38, and Dunne, Monetary Decisions, 107. 40 The majority, concurring, and dissenting opinions are collected in Gold Clauses in Obligations, Sen. doc. no. 21, 74th Cong., 1st sess. (Washington, D.C: Government Printing Office, 1935). 41 . Gold Clauses in Obligations, 14. 42. Gold Clauses in Obligations, 24, 25. 43. Gold Clauses in Obligations, 31-32, 40, 41-42, selected .  44. "It is not going too far to say that on the precedents and from the standpoint of constitutional law, it would have been far more revolutionary for the Supreme Court to have decided against the validity of the recent legislation than as they did decide The decision in the private bond cases was distinctly conservative in the sense of following out the logic of the earlier cases" (Dickinson, "The Gold Decisions," 715). 45. Material in this subsection draws on Kenneth W . Dam, "From the Gold Clause Cases to the Gold Commission: A Half Century of American  Economic Review - July 1986  Monetary Law," University of Chicago Law Review 50 (1983): 510-11, and Margaret G. Myers, A Financial History of the United States (New York: Columbia University Press, 1970), 337. 46. Cited in Gold Clauses in Obligations, 38 n. 3. 47 james M Buchanan and T. Nicholas Tideman, "Gold, Money, and the Law: The Limits of Governmental Monetary Authority," in Manne and Miller, Gold, Money and the Law, 25, 33-34 48 See Wallace, "A Legal Restrictions Theory"; in addition, an important contribution to this literature (as well as containing most of the important references) is Robert L Greenfield and Leland B. Yeager's article, "A Laissez·Faire Approach to Monetary Stability," journal of Money, Credit, and Banking 15 (August 1983): 302-15. 49. j. Huston McCulloch, "The Ban on Indexed Bonds, 1933-77," The American Economic Review 70 (December 1980): 1018-21. 50. Aztec Properties, Inc. v. Union Planter's National Bank, 530 S.W.2d 756 (1975); 425 U.S. 975 (1976). 51 . Willam A Kelly, Jr., "Incentives and Proxies for Indexed Bond Issues: Comment: The American Economic Review 72 (june 1982): 563·65. McCulloch responds to Kelly in "Incentives and Proxies for Indexed Bond Issues: Reply," The American Economic Review 72 (june 1982): 566-68. 52. See Keith S. Rosenn, Law and Inflation (Philadelphia: University of Pennsylvania Press, 1982), 148-50, and the references he cites. This conclusion is supported also by Rita E Hauser, "The Use of Index Clauses in Private Loans: A Comparative Study," The American journal of Comparative Law 7 (1958): 353, 356 McCulloch notes the issue of negotiability (in "The Ban on Indexed Bonds," 1020) but gives it little emphasis. 53. Flood and Garber, "Gold Monetization," 90. 54. See Kydland and Prescott, "Rules Rather Than Discretion," as well as Robert J. Barro and David B. Gordon, "A Positive Theory of Monetary Policy in a Natural Rate Model," journal of Political Economy 91 (August 1983): 589-610. 55. Robert j. Barro and David B Gordon, "Rules, Discretion and Reputation in a Model of Monetary Policy," journal of Monetary Economics 12 (july 1983): 101-21 . 56. Milton Friedman, "Monetary Policy in a Fiat World," Contemporary Policy Issues 4 (january 1986): 1-9 57. Herschel!. Grossman and john B. Van Huyck, "Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation," National Bureau of Economic Research Working Paper no. 1673 (Cambridge, Mass., july 1985).  17  Deregulation and Monetary Reform Gerald P. O'Driscoll,  Jr.  Senior Economist and Policy Advisor Federal Reserve Bank of Dallas  In recent years, deregulation has taken place in a number of economic activities. Deregulation of transportation modes, for instance, has increased freedom of entry and exit by competitors, permitted new services to be offered, and, in the case of air transportation, instituted rate-making freedom on domestic routes. Deregulation of financial services has been less dramatic but nonetheless substantial. The process of registering securities has been simplified, and new financial products have been introduced. In banking, a subset of financial services, noteworthy changes have occurred. Some of the changes in banking have even been dramatic, such as the elimination of interest-rate ceilings on all but certain transaction accounts. Banking deregulation raises the issue of deregulation of the money creation process and, more generally, the question of monetary reform. Specifically, deregulation of deposits and interest rates makes it impossible for central banks to affect money supply growth through disintermediation. With deposits paying market rates of interest, financial intermediaries can acquire all the funds for which they are willing to pay. Some have argued that, as a result, deregulation may result in loss of monetary control. Others have suggested that the freeing up of the liability cr~ation process may lead to a change in the monetary standard itself. Recent analysis of unregulated monetary systems falls into two main classes: free-banking theory and the legal reEconomic Review - July 1986  strictions theory. A free-banking system is one in which individuals need only comply with certain general legal requirements in order to start a bank. The system contrasts with one in which permission to open a bank either requires a specific legislative charter or is subject to the discretion of a chartering agency (for example, the Office of the Comptroller of the Currency). In the United States the first 1 free-banking system was created in New York in 1838. But even banks in free-banking states were subject to branching restrictions and restrictions on the assets they could purchase. These banks could, however, issue deposits and notes subject to regulations on the assets that the liabilities could be used to purchase. The Scottish system came much closer to being an "unregulated" banking system. Both systems were characterized by the absence of any central bank of issue. In modern times, there have been only two major freebanking systems: Scotland before the first Peel Act (1844) and the United States before the National Banking Act (1864). Recent work on the American experience argues that observed cyclical instability in the 19th century reflected real shocks and flawed state banking regulations, rather than inherent instability of free banking. Work on the Scottish system of free banking both confirms the flaws in some American variants and supports the theoretical case for free banking.2 19  The legal restrictions theory constitutes an alternative approach to analyzing unregulated banking. The approach focuses on banks' role in providing accounting and transaction services. Since traditional approaches analyze banks as creators of money, banking deregulation immediately raises the question of the effects of deregulating the money creation process. In fact, the latter is the central issue in the long debates over free banking. In contrast, the legal restrictions theory questions whether money as we know it would exist in an unregulated banking system. The legal restrictions theory concludes that non-interestbearing money would not circulate in an unregulated monetary system. Taken to its logical conclusion, the theory predicts the disappearance of money as a distinctive financial asset. The argument is supported by the benchmark adopted by legal restrictions theorists for analyzing banks. Monetary theory has traditionally modeled banks as creators of money. Legal restrictions theorists view this function as secondary, contingent upon the existence of legal impediments to financial intermediation. They view the essential function of banks as the provision of accounting and transaction services. In an unregulated payments system, only the essential function would remain. Supported by this theory, some authors have argued for reform to bring about a payments system without money. They contend that such a system would be an improvement over the present one. This article examines one such proposal. The major focus of the article is on the coherence and practicality of the reform proposal. In examining these issues, however, the article also analyzes some of the central propositions of the legal restrictions theory. After briefly reviewing the legal restrictions theory and then introducing the proposed reform, I critically analyze the proposal. Two major conclusions are reached. First, I question the coherence of the proposal as well as the suggested methods for implementing the reform. Second, I adduce both demand and supply considerations for why non-interest-bearing money ("currency") would not disappear in an unregulated payments system. If eliminated, as is suggested in the reform proposal, currency will reemerge in a market process. Legal restrictions theory of money  The legal restrictions theory begins by noting the apparent paradox that the very same entity, the u .S. Government, issues some default-free obligations that yield no interest (currency) and others that yield market rates of interest (bondsV Legal restrictions theorists argue that, absent some legal compulsion, individuals would shun the government's non-interest-bearing liabilities and purchase only its 20  interest-bearing obligations.4 One of two outcomes is then possible: either the government would no longer issue currency or the yield on bonds would be driven to zero. In the former case, individuals would presumably utilize government bonds as means of payment. In the latter case, bonds and currency become indistinguishable, leading to a similar result. The logic of the argument is not merely that interestbearing assets are preferred to non-interest-bearing assets (net of risk differences) but that so long as there is any interest-rate differential (net of specified transaction costs), money will be dominated by bonds. In other words, not only does non-interest-bearing money disappear but also any distinction between money and financial assets. This conclusion is incorporated explicitly by John Bryant and Neil Wallace in their work when they make the following assumptions: 5 1. Assets are valued only in terms of their payoff distributions. 2. Anticipated payoff distributions are the same as actual payoff distributions. 3. Under laissez-faire, no transaction costs inhibit the operation of markets and, in particular, the law of one price. Taken together, these assumptions lead to the conclusion that in the absence of legal restrictions, interest differentials between money and non money financial assets will be arbitraged away. Since this has not happened, Bryant and Wallace postulate the presence of relevant legal restrictions. Wallace identifies these restrictions as (1) the nonnegotiability of some U.S. Treasury bonds (that is, savings bonds) and (2) the large denomination of other Treasury obligations (for example, Treasury bills). Neither would be a sufficient condition preventing arbitrage. The sufficient condition is that the U.S. Government is a monopolistic provider of currency. In other words, financial intermediation must be restricted. 6 As indicated in the introduction, legal restrictions theorists have adopted a different benchmark for analyzing banks. Banks have traditionally been analyzed as creators of money. The alternative view propounded by legal restrictions theorists emphasizes that banks are financial intermediaries providing accounting and transaction services. The latter function is viewed as fundamental, while the creation of money by banks is viewed as contingent upon existing restrictions and institutions.? This approach to modeling banks rationalizes the separation of the unit of account from the means of payment-a characteristic proposition in the literature and the basis of the policy proposal examined in the next section. Federal Reserve Bank of Dallas  For writers such as Bryant and Wallace, the legal restrictions theory is a modeling strategy. A piece of positive economic analysis, the theory is viewed as containing both explanatory and predictive power. Models applying the theory appear to explain anomalous phenomena, as well as predicting the consequences of completely deregulating banking. More generally, these models are viewed as providing insight into workings of the payments mechanism in a modern economy. Robert Hall apparently was the first to utilize the theory to propose a reform of the payments system. If "money is exactly a creation of regulation,"8 then further doses of deregulation will bring us a nonmonetary payments mechanism. Following Hall, Robert Greenfield and Leland Yeager have proposed a payments system incorporating ideas from the legal restrictions theory. In short, in the hands of Hall and of Greenfield and Yeager, positive economic analysis has been transformed into normative analysis; models of banking have become the basis for banking reform. This article focuses on the Greenfield-Yeager system, which constitutes a far-reaching reform proposal in the tradition of the legal restrictions theory. Moreover, consideration of the proposal highlights the issue of the separability of the means of payment and the unit of account.  Unregulated payments mechanisms This section outlines a recent proposal for implementing an unregulated payments mechanism. (As will be evident, it would be misleading to call the mechanism a monetary system.) In a series of papers, Yeager offers elements of the analytical underpinnings of the proposal. An article coauthored with Greenfield provides the most complete statement of the proposal itself.9 The proposal. Yeager objects to the variability of the purchasing power of money. Our existing monetary standard is the "preposterous dollar," and the unit of account "is whatever value supply and demand fleetingly accord to the dollar of fiat money.,,10 Problems arise because money alone has no market of its own. Maladjustments between the demand for and supply of money (a positive or negative excess demand for money) can only be cleared by costly adjustments in all other goods markets. ll By itself, the fact that money has no market of its own in which to clear an excess demand would not represent a unique problem. The interdependence of all markets ensures that an excess demand in one market "spills over" into others. Goods are connected by an intricate web of complementarities and substitutabilities. In a full generalequilibrium analysis, the demand for each good depends, in principle, on the prices of all other goods. Consequently, a  Economic Review - July 1986  shock to one market affects all other markets. The fact, then, that money has no market of its own is a necessary but not a sufficient condition for macroeconomic problems. Sticky prices cause monetary shocks to produce macroeconomic reverberations. The downward stickiness of prices is both a cause and an effect of the costliness of adjusting to changing demand conditions. Prices and wages respond far from promptly enough to absorb the full impact of imbalances; they are stickysome more so than others-for reasons that make excellent sense from the standpoints of individual price-setters and wage-negotiators. Under these realistic circumstances, failure to keep the quantity of money correctly and steadily managed can have momentous consequences. 12 If the supply of money adjusted automatically to changes in its demand, then Yeager-type macroeconomic problems (that is, those induced by demand shocks) could be avoided even in the presence of price and wage stickiness. Over the long run, commodity standards, like the gold standard, do provide such endogeneity to the money supply. In practice, however, the money supply under gold standards has not been highly elastic in the short run. Similarly, in theory, a perfectly managed fiat money system could accommodate short-run swings in money demand. In practice, however, monetary management has never been up to the task and probably never will be, given the informational requirements. In any case, Yeager believes that financial deregulation may have made monetary control impossible in the future. 13 These considerations lead Greenfield and Yeager to recommend a payments system in which no money exists. In arguing for the system, they exploit the theoretical wedge driven by legal restrictions theorists between money, conceived as a means of payment, and the unit of account, conceived as a social accounting system. Greenfield and Yeager propose implementing a system with a unit of value "defined by a suitable bundle of commodities." They analogize the choice and measurement of a unit of value to the selection of a unit of weight and measurement. The government plays a role "by non coercively offering a definition, just as it does with weights and measures.,,14 Just as the meter is defined physically as 1,650,763.73 wavelengths of the orange-red radiation of krypton 86, so the value unit would be defined physically as the total market value of, say, 50 kg of ammonium nitrate + 40 kg of copper + 35 kg of aluminum + 80 square meters of  21  Development of the Legal Restrictions Theory The modern statement of the legal restrictions theory can be traced to two articles, one by Fischer Black and the other by Eugene Fama.1 Developments and elaborations have been provided by, among others, John Bryant, Robert Hall, and Neil Wallace. 2 Although different facets of the theory are emphasized by the various authors, it can be summarized concisely.J Most generally, the theory connects the existence of certain institutions and financial assets with legal restrictions. Thus, banks and non-interest-bearing money (that is, currency) exist because of restrictions on the creation of liabilities by nonbank financial intermediaries. Wallace's analysis of why currency exists is exemplary. Consolidating the central bank and U.S. Treasury accounts, Wallace identifies what he perceives to be a paradox. The same issuer provides default-free interest-bearing and non-interest-bearing liabilities (bonds and currency). To illustrate the paradox, Wallace considers the following example: Suppose, for example, that we observe butter in one-pound packages selling for $1 per pound and butter in one-hundred-pound packages selling for 25 cents per pound. Is it an adequate explanation of this spread in prices per pound to say that individual households buy one-pound packages because they may not have or want to devote $25 to buying butter and they may not be able to transport or store one-hundred-pound packages? Obviously, such reasons are not adequate if there are sufficiently inexpensive ways to convert large packages into small packages and if there is free entry into the business of converting large packages into small packages.4 Economic theory would predict that, in such circumstances, entrepreneurs would arbitrage between the two markets by purchasing butter in large quantities at 25 cents per pound and reselling it to consumers in 1-pound containers for less than $1. Competition ("free entry") ought to reduce the differential in the two markets to the actual costs of repackaging butter. Returns to retailing butter ought to be no greater than for any similar operations. Mutual funds, banks, and other financial intermediaries constitute the retailers of a competitive financial system. Absent legal restrictions, financial retailers would purchase large-denomination, interest-bearing liabilities of the  22  Treasury ("bonds") and repackage them into denominations small enough to circulate hand to hand as currency. Competition should drive down the yield differential between Treasury bonds and currency . As with butter, the yield differential should reflect only the costs of intermediating between large-denomination bonds and circulating currency.s Citing money market mutual funds, Wallace estimates the cost of intermediating securities like Treasury bills into notes at 1 percent or less. He concludes that in an unregulated system, intermediaries "could operate with a discount that is close to zero and, hence, .. . the upper bound on nominal interest rates on safe securities under laissezfaire would be close to zero."b This conclusion, however, has far-reaching implications for the government's present monopoly on currency creation. Laissez-faire means the absence of legal restrictions that tend, among other things, to enhance the demand for a government's currency. Thus, the imposition of laissez-faire would almost certainly reduce the demand for government currency. It could even reduce it to zero. A zero demand for a government's currency should be interpreted as the abandonment of one monetary unit in favor of another-for example, the abandonment of the dollar in favor of one ounce of gold. Thus, my prediction of the effects of imposing laissez-faire takes the form of an either/or statement: either nominal interest rates go to zero or existing government currency becomes worthless? Wallace's analysis implies not only the disappearance of currency as a distinctive asset but also the blurring of any distinction between bank and nonbank intermediari~s. This is particularly true if banks are viewed as the institution creating a distinctive money. The typical intermediary in the unregulated world of the legal restrictions theory is a generiC institution purchasing diverse assets and issuing diverse liabilities. In certain presentations, such as Wallace's, some of these liabilities circulate the same way today's currency does. In other presentations, such as Black's, there is no distinctive money as we know it. If not money, what do "banks" (financial intermediaries) produce? As is clear in Greenfield and Yeager, banks' particular function would be to produce accounting and trans-  Federal Reserve Bank of Dallas  action services. These services would presumably be needed even in a world without money They constitute the unit-ot-account function that money now comprises (along with the medium-ol-exchange function). The change in the benchmark for analyzing banks reflects a specific assumption characterizing the legal restrictions theory. The assumption really has two parts. First, the medium-at-exchange function and the unit-ofaccount function are not only conceptually distinct but practically separable. Second, it is the latter, not the former, that is crucial for the operation of a developed market economy. Legal restrictions theorists also emphasize that conventional monetary theories are special cases, whose applicability depends on the existence of legal restrictions Since the existence of money as a distinct asset is, as it were, a contingent fact, so too is the applicability of conventional monetary theories. Existing monetary institutions and the relationship between the quantity of a subset of financial assets (namely, money) and key macroeconomic variables (such as th~ price leveD depend on the existence of legal restnctlons. Although I have dated the modern development of the theory from Black's 1970 arLicie, Tyler Cowen and Randall Kroszner argue that the theory has a long history9 They trace the predecessors of Black, Fama, Wallace, and others back at least to the 18th century They view the separability of the unit of account and medium of exchange as the central theoretical proposition in the literature, a judgment with which I concur. Nonetheless, it is useful to restate the theory's conclusions in terms of five propositions (Cowen and Kroszncr find seven): 1. Money would not exist as a distinctive financial asset in the absence of legal restrictions. 2. Conventional monetary theories are applicable only to a specific set of financial institutions. 3. In an unregulated payments system, the provision of accounting and transaction services by banks would have no special effects on prices or macroeconomic activity 4. The provision of accounting and transaction services-not the production of money-·is the benchmark for analyzing banks. 5. The unit of account is separable from the means of payment. Much of the literature involves drawing out further implications of these assumptions. In terms of the Greenfield  Economic Review - July 1986  and Yeager proposal, the fifth assumption is particularly important. If that assumption is questioned, their proposal cannot stand up,  Fischer Black, 'Banking and Interest Rates in a World Without Money: The Effects of Uncontrolled Banking: Journal of Bank Research 1 (Autumn 1970): 8-20; and Eugene F. Fama, "Bankmg in the Theory of Finance,' Journal of Monetary Economics (, (January 1980): 39-57 2  John Bryant and Neil Wallace, 'The Inefficiency of Interestbearing National Debt," Journal of Political Economy 87 (April 19791: 365-81, and "A Suggestion for Further Simplifying the Theory of Money" (Minneapolis, December -1980, Photocopy); Robert E. Hall, 'Explorations in the Gold Standard and Related Policies for Stabilizing the Dollar: in Inflation: Causes and Effects (Chicago: University of Chicago Press for National Bureau of Economic Research, 1982),111-22, and "Monetary Trends in the \';nited States and the United Kingdom: A Review from the Perspective of New Developments in Monetary Economics,' lournal 01 Economic Uterature 20 (December 1982): 1552-56; and Neil Wallace, "A Legal Restrictions Theory of the Demand for 'Money' and the Role of Monetary Policy,' Federal Reserve Bank 01 Minneapolis Quarterly Review, Winter 1983, 1-7  3.  The theory is more fully developed in Gerald P. O'Driscoll, Jr., "Money in a Deregulated Financial System," Economic Review, Federal Reserve Bank of Dallas, May 1985, 1-12, and ·'Money, Deregulation and the Business Cycle,' Federal Reserve Bank of Dallas Research Paper no 8601 (Dallas, January 1986), 1-7  4  • A Legal Restrictions Theory," 2.  5  Adding other kinds of financial assets would complicate matters by bringing in default but would not alter the thrust of Wallace's analysis  b  Wallace, H A Legal Restrictions Theory: 4.  7.  Wallace," A Legal Restrictions Theory," 4.  8  The latter point is argued forcefully in Fama, "Banking in the Theory of Finance," 45-47; see also Wallace, 'A Legal Restrictions Theory,' 4-5. For an earlier criticism of this line of reasoning, see O'Driscoll, "Money, Deregulation and the Business Cycle," 18-26, "Money in a Deregulated Financial System," 6-12, and "Money: Mengers Evolutionary Theory," Federal Reserve Bank of Dallas Research Paper no. 8508 (Dallas, December 1985), 19-24.  9  Tyler Cowen and Randall Kroszner, 'The Development of the 'New Monetary Economics'" (Cambndge, Mass ., December 1985, Photocopy).  23  plywood of a specified grade. .. + definite amounts of still other commodities .... The bundle would be composed of precisely grad able, competitively traded, and industrially important commodities, and in amounts corresponding to their relative importance. Many would be materials used in the production of a wide range of goods so that adopting the bundle as the value unit would come close to stabilizing the general level of prices expressed in that unit. 15 The crucial difference between their proposal and conventional commodity standards is that the commodities constituting the proposed unit of value would neither be stored nor need to be storable. Greenfield and Yeager place great emphasis on this point, which is crucial for understanding their proposal. 16 A commodity standard is characterized by convertibility in fixed proportions between the commodity (for example, gold) and the national currency (for example, the U.S. dollar).17 A composite-commodity standard involves convertibility in fixed proportions between a bundle of commodities and the national currency. Any commodity standard is subject, however, to the risk of devaluation or abandonment initiated by an excessive rate of growth in the national money supply. The reason is that excessive money growth eventually causes the nominal prices of all goods, including the price of the monetary commodity itself, to rise on open markets. If the market price of the monetary commodity is more than negligibly higher on organized markets than the official or conversion price, then the nation's mint simply becomes a source of the commodity at a subsidized price. Monetary reserves would be lost, and if the situation perSisted, it would soon become untenable. One of three things would need to occur to remedy the situation: 1. Contraction or slowing in the growth rate of the money supply; 2. Devaluation of the currency unit; 3. Abandonment of the standard. The first option involves precisely the kind of costly downward price adjustment that Greenfield and Yeager wish to avoid. The second and third choices, however, ratify the change in the purchasing power of the monetary unit. They also involve a partial or complete revision in the monetary standard itself, which is presumably costly. Greenfield and Yeager contend that all such costly adjustment processes are avoided in the proposed system: Part of the beauty of the ... system, in contrast, is that the value unit remains stable in terms of the designated 24  commodity bundle because its value never did depend on direct convertibility into that bundle or any specific commodity. Instead, its value is fixed by definition. It is free of any link to issues of money that might become inflated. 18 The claim that nonconvertibility is advantageous is examined in the following section. At this juncture, it is important to note that there is a more fundamental reason why there is no link to money in the Greenfield-Yeager system: there is no money. Prices would be quoted, contracts expressed, and financial records kept in the defined unit of account. 19 Greenfield and Yeager have captured Fischer Black's vision of an unregulated financial system: In such a world, it would not be possible to give any reasonable definition of the quantity of money. The payments mechanism in such a world would be very efficient, but money in the usual sense would not exist. 2o For Greenfield and Yeager, as for other writers in this tradition, it is the unit-of-account function of money (not its medium-of-exchange function) that permits the development of a complex market economy. The authors are not very clear, however, about how an accounting system without a medium of exchange would function. (The very distinction depends on the separability of the two functions, itself a controversial proposition.) With no money quantitatively existing, people make payments by transferring other property. To buy a bicycle priced at 100 value units or pay a debt of 100 units, one transfers property having that total value. 21 The authors hypothesize that "financial intermediaries blending the characteristics of present-day banks and mutual funds would presumably develop. People would make payments by writing checks (or doing the equivalent electronically) to transfer the appropriate amountsvalue-unit-worths-of shares of ownership in these funds."22 They envision that funds offering payments services might invest in a wide variety of assets, including securities, real estate, and commodities. Fund shares might even circulate as hand-to-hand currency, but there would be no outside or base money in the system. 23 The authors envision payments occurring in fund shares and other financial liabilities, not in actual commodities. Advantages. Greenfield and Yeager claim five advantages for their system over present monetary arrangements: 24 1. The system offers a unit of account of stable value. Federal Reserve Bank of Dallas  2. The government would come under "fiscal discipline."  3. The competitive aspects of the system would spur financial innovation. 4. The means of payment would not be redeemable in a base money. 5. The unit of account's value would no longer depend on the quantity of a medium of exchange. The first advantage represents the chief goal of the proposal: to "provide a stable unit for pricing, invoicing, accounting, economic calculation, borrowing and lending, and writing contracts reaching into the future." The second advantage derives from the complete divorce of government from the payments system. 25 It is an advantage in their view because the government "would have to borrow on the same basis as any other borrower and could no longer acquire resources by issuing money and otherwise imposing inflationary 'taxation without representation."' It should be noted that the second advantage is a characteristic of any commodity-based monetary system or, indeed, a managed money system constrained by an appropriate rule (such as a monetarist rule for a steady rate of growth in the money supply). In other words, abolishing money is not a necessary condition for attaining this advantage. The third advantage derives from having a competitive payments system, rather than any of the particular characteristics of the Greenfield-Yeager proposal. The fourth advantage is a defining characteristic of the proposed system and can only be addressed in the overall evaluation of the next section. Finally, the fifth advantage is the means by which they propose to accomplish their chief goal, which, again, is captured in the first advantage. The principal issue that must be addressed is determining the worthwhileness of the primary goal of the system. In doing so, one must also analyze whether the means proposed will achieve that goal. Finally, one must consider whether so radical a change in the payments system is necessary to achieve the stated goal. The next section examines these issues. Critical assessment This section analyzes the Greenfield-Yeager proposal, focusing on three issues: the evolution of standards and payments systems, the goal of a unit of account with a stable value, and the separability of the unit of account and the medium of exchange. My conclusions can be summarized as follows. First, Greenfield and Yeager disregard the evolutionary elements present in all monetary systems and are cavalier in their attitude toward the complexities of monetary reform. Second, the authors want to have both a stable unit of account and an unrestricted payments system. They Economic Review - July 1986  ignore, however, arguments adduced by other legal restrictions theorists that question both the value of strict pricelevel stability and its feasibility absent legal restrictions. Third, it is questionable whether the unit of account can be separated from a medium of exchange. Concretely, this implies reemergence of circulating currency. Money-an asset joining the medium of exchange to the unit of account-will evolve in their system for the same reasons it has evolved in virtually every other economy. Only legal restrictions could prevent money's evolution. Unit of account. Greenfield and Yeager want to define the unit of account physically so as to give quantitative precision to the basic unit of value. 26 Moreover, they apparently view the choice of a unit of account as an essentially arbitrary decision. 27 Each viewpoint ignores both the origin and the significance of standards. Standards, be they units of weight, length, or value, have their origin in usage. Like language, they are evolved, not consciously created. 28 In terms of its evolution, we can identify a standard only after it has been used for a sustained period of time. Without a sustained period of observation, we would not know whether a thing or action were "regularly and widely used, available, or supplied.,,29 Further, the degree of precision of a standard tends to be enhanced only with the passage of time. This is certainly true for units of length, like the foot. 3D Similarly, in English at least, spelling standards have only solidified in this century. Indeed, in language, as is true generally, the concept of a "standard" must be dynamic; accepted usage and meaning are continually evolving. Standards are sometimes codified. Even in these cases, however, codification often results from private not governmental action. Time zones represent an illustrative case. 31 Before 1883, every town had its own local time, based on when the sun passed over the meridian of the town. Until the coming of the railroad, this situation was not of great importance. In the 1870s the railroads began organizing to standardize time for their own operating purposes. On October 11,1883, railroads adopted the present system of time zones at the General Time Convention. Railroad clocks and watches were set to the new standard at noon on Sunday, November 18, 1883. In retrospect, it may seem natural that society at large eventually conformed to the operating standard of the dominant intercity transportation mode. The adoption of the railroad time system was the result, however, of innumerable individual, voluntary actions. It certainly did not reflect governmental action, since Congress only passed the Standard Time Act on March 19, 1918. Legislation thereby caught up with (codified) practice. 25  Standards typically emerge, then, from decentralized choices, not centralized ones. Standards are sometimes codified, but codification generally reflects use. Some users of a standard, like scientists, may require greater precision than the public at large. This is the origin of the precise, scientific definition of a meter. The definition, cited by Greenfield and Yeager, represents a spurious precision for most 0f us. For ordinary usage, no one need know the frequency definition to utilize the metric system. More to the point, the "definition" is simply the frequency distance of the meter as it already existed. The meter is 1,650,763.73 wavelengths of the orange-red radiation of krypton 86 because this figure exactly conforms to the length of the already standardized meter (and not the other way around, as Greenfield and Yeager seem to suggest).32 Up to this point, I have emphasized the private origin of standards. What if the government were to offer an alternative standard? In most such cases, either some coercion or subsidization is in fact present (thereby violating the assumption made by Greenfield and Yeager). Even in such cases, government efforts to alter, for example, linguistic standards have been more notable for their failures than for their successes. Policy actions sometimes influence at the margin but seldom determine standards. French governments have failed to maintain the "purity" of the language, and Irish governments have been unable to preserve Gaelic as a living language. In light of this experience, the idea that a governmental suggestion could alter the monetary standard is dubious.33 Even if Greenfield and Yeager's view of standards were not flawed, the analogy they draw is misapplied. Greenfield and Yeager maintain that money is a unit of measurement and, as such, it should have an invariant value just as the meter has an invariant length. 34 It is this assumption that leads them to view the existing monetary standard as "preposterous," because money's value varies with constantly changing demand and supply conditions. Even though it underpins both their analysis and proposal, the assumption is not really examined much less defended . Yet it is in fact dubious. There is only an analogy between a monetary unit as a standard and a unit of length as a standard: they are alike in some respects (for example, both evolved) and unlike in other respects (for example, the latter is invariant and the former is not). Greenfield and Yeager do not ever demonstrate that the similarities are relevant and the differences inconsequential. 35 The differences between the two types of standard are in fact fundamental, the most obvious one also being one of the most important. Money does not, nor did it ever, have 26  a fixed or even unique value. Its value (purchasing power) is inversely related to the exchange rates (prices) of all the goods that money can purchase. To estimate money's value, one must weight prices by the importance of the respective goods in an individual's purchases. In general, each individual purchases goods in different proportions, so that, even at a moment in time, the value of money varies across individuals. This variation is an inherent by-product of individual choice and will persist so long as the money good is an object of individual choice.36 In contrast, an established standard of measurement is the same for everyone. Even more room for variation in money's value enters as time passes, since the value will be affected by every change in the demand and supply conditions for all other goods. What I have just described is, of course, the characteristic of money to which Greenfield and Yeager object. Notice, however, that if this variability in value necessarily characterizes money, then money is not a standard of value in the same sense that a meter is a standard of length. That is, money is not an invariant measure of value. 3? "Standard" is being used equivocally, and the analogy made by Greenfield and Yeager draws its force from this equivocation. The authors could argue that money (or the means of payment) ought to be standard in the same sense that the meter is. Instead of arguing for the position, however, they assume it. They then present a means for achieving a goal without ever having defended the goal. A crucial analytic step in the argument is thus simply miSSing-namely, the justification for the system they propose. Moreoever, if one places any importance on institutions (or standards) as they have evolved and existed through time, the GreenfieldYeager proposal must appear very odd indeed. It would endow a means of payment with a characteristic that it has never had. Modern governments have certainly taken an activist role in monetary matters. The U.S. Government has intervened in many significant ways, the most notable case being the nationalization of private gold holdings in 1933.38 Nonetheless, major features of the monetary system reflect evolutionary forces. The dollar itself was adopted in an evolutionary process by Americans before it ever became the official currency. Though Greenfield and Yeager are quite correct in pointing to the many monetary restrictions and interventions that have occurred, they all but ignore the evolutionary elements present in the current system. They accordingly beg the crucial question by implicitly treating all major features of the current monetary system as the result of policy interventions.39 Moreover, they write as though money were invented, despite the fact that we have long known that "money is not the product of an agreement Federal ReServe Bank of Dallas  on the part of economizing men nor the product of legislative acts. No one invented it.,,40 Price level. Like many other monetary economists, Greenfield and Yeager prefer greater price stability. They believe that adopting an invariant standard of value will yield near-absolute price stability. It is important to note that "price stability" refers to the stability of the price level-an average of prices. Stability of relative prices is impossible and undesirable in a market economy. Changes in relative prices are sensitive indicators of the relative scarcity of goods; economic agents depend on these price Signals for making allocational decisions. What, then, is the case for stabilizing the price level? Given the degree of support for this position among economists, the arguments offered are surprisingly sketchy. We have already seen that the analogy on which Greenfield and Yeager rely- the invariance of a unit of length-breaks down. They do offer the more pragmatic argument of downward inflexibility of prices. Unfortunately, their argument proves too much. Consider the following passage: Elements of price and wage stickiness, though utterly rational from the individual points of view of the decisionmakers involved, do keep downward price and wage adjustments from absorbing the full impact of the reduced willingness to spend associated with efforts to build or maintain cash balances. The rot snowballs, especially if people react to deteriorating business and growing uncertainty by trying to increase their money holdings relative to income and expenditure. 41 The analysis overlooks the fact that nonmonetary factors-real shocks- are also capable of putting downward pressure on prices and wages in sectors of the economy. (The early-1986 fall in energy prices is a dramatic but relevant example.) Surely "the rot snowballs" in such cases too. A model incorporating reasonable lag could generate "deteriorating business and growing uncertainty," at least transitionally, as a consequence of a major real shock. More generally, save in a hyperinflation, some prices are always declining; if the economy cannot sustain downward pressure on key prices, then price stability is no solution. With the price level constant, many individual prices will be failing at any given time. Nothing but a policy of virtually unlimited inflation could prevent this. Milton Friedman has suggested that stabiliZing the general level of prices will diminish the number of price changes that need to be made overall. In this view, there is a given amount of price flexibility in the system, and policymakers ought to avoid placing excessive demands on this price Economic Review - July 1986  flexibili ty 42 Unfortunately, Friedman does not offer an argument showing any direct connection between stabilizing a price level and minimizing the number of relative price changes. Others have argued that stabilizing the price level may cause disequilibrating relative price changes. 43 Since Friedman made his suggestion, an empirical literature has emerged that documents an apparent connection between the rate of change in the price level and the variance of relative prices. 44 The theory underlying this connection is not so well worked out, but, in any case, Friedman obviously did not rely on this literature. Wallace contends that the legal restrictions theory calls into question the welfare argument for price stability: Although widely espoused as a goal, there exist no complete arguments leading to the conclusion that people are on average better off the more stable the price level, given the steps that have to be taken to attain greater stability of the price level. 45 The argument assumes that in an unregulated financial system, private agents can create debt obligations, some of which will circulate as credit money. The variability in the supply of these money substitutes makes price-level control difficult. Only legal restrictions can ensure price-level stability. According to Wallace, then, the absence of legal restrictions is inconsistent with strict price-level control. The Greenfield-Yeager system is susceptible to the Wallace critique. As they explicitly recognize, the funds in their system might issue debt instruments denominated in units of account. 46 If, as is argued below, circulating liabilities ("currency") are likely to be non-interest-bearing, then there is a fatal flaw in the system: In this case, .. . the banks (or funds) would always have an incentive to issue more of these paper Units, in effect using them to purchase interest-bearing assets. Indeed, the incentive to issue additional currency would prevail as long as the (nominal) interest rate on paper assets exceeded zero and the exchange value of Units exceeded the cost of printing paper Units. This, however, is a market force-and apparently a potent one-tending to undermine the scheme. One who believes that market forces are generally more effective than suggestions or expressions of sentiment by the government would then believe that the exchange value of the Unit would be 47 driven far below that of a standard bundle. In other words, a circulating medium of exchange ("currency") would emerge once again in an unregulated pay27  ments system. One could forbid its issuance, but then the system would not be one in which "the government would practice laissez faire toward the medium of exchange and the banking and financial system.,,48 Economic analysis suggests that architects of such a system will soon be faced with the choice of abandoning the scheme or forsaking the commitment to "laissez faire ." Non-interest-bearing money. Legal restrictions theorists believe that key features of our present monetary system have resulted from compulsion not competition. Greenfield and Yeager observe that "our existing system is far from the pure product of ... evolution."49 The observation is unquestionably true but does not address ~hether the features of the system relevant to the debate have evolved f}r are basically the product of intervention. Specifically, would non-interest-bearing currency exist in a completely unregulated payments system? Though Greenfield and Yeager allow for some currency in their system, the issue is both the starting point and the major focus of the legal restrictions theory. Moreover, currency is the most distinctive monetary aggregate; it is least like non money financial assets. Hence, an affirmative answer to the question would at least cast doubt on the broadest conclusion of the legal restrictions theory: namely, money would not exist as a distinct asset in a competitive payments system. On this broader issue, Greenfield and Yeager accept the conclusion of the legal restrictions theorists. Elsewhere, I have developed the theoretical case for noninterest-bearing money in a competitive payments system. Basically, that case derives a nonpecuniary yield from holding money. The source of the yield is the transaction costs saved in utilizing a widely accepted medium of exchange in indirect exchange. In other words, money is more liquid than are nonmoney financial assets.50 This traditional argument addresses the demand for noninterest-bearing money (here, "currency"). Lawrence White has recently analyzed the cost or supply conditions of producing currency. His analysiS strongly suggests the viability of currency even in a highly competitive payments system. White makes a rough calculation of the costs and benefits of paying interest on currency: On a note whose initial value equals two hours' wages, held one week while yielding interest at 5 percent per annum, accumulated interest would amount to less than 7 seconds' wages. If the noteholder's wage rate indicates the opportunity cost of his time, then he will not find it worthwhile to compute and collect interest if to do so twice (once at the receiving end and once at the spending 28  end) takes 7 seconds or more, i.e. if it takes 3.5 seconds or more per note-transfer. To indicate the same pOint less generally, a $20 note held one week at 5 percent interest would yield less than 2 cents. Notes held in cash registers by retailers generally turn over much more rapidly than once a week, of course, so that the threshold denomis1 nation may well be extremely high. White's calculation ignores the cost of any capital equipment necessary to make such speedy calculations. For realistic wage rates, interest rates, and maximum denominations of currency, it is highly plausible that currency will continue to yield no interest. Non-interest-bearing money is the outcome of fundamental market forces, not legal compulSion. Conclusion  The article began by conSidering the development of the legal restrictions theory. The theory constitutes positive economic analYSiS, and the models employing it implement a particular modeling strategy. It is fairly clear that Black believes that the system he outlines would emerge naturally. The same belief appears to characterize the work of Fama and Wallace. Greenfield and Yeager (and Hall) have advocated implementing the alternative payments system as a matter of public policy. Their papers represent a normative economic approach to the issues raised by the legal restrictions theory. This article focused on the public policy proposal as put forth by Greenfield and Yeager. The coherence of their goal was questioned, as were the methods for attaining it. My criticism of that proposal does not directly address the legal restrictions theory as positive economic analysiS. Nevertheless, one strong conclusion derives from both the theory and the policy proposal: the disappearance of money as a distinctive financial asset. This article strongly questions the soundness of the argument for that conclusion. A number of important issues raised by the GreenfieldYeager proposal have necessarily been left unresolved. For instance, Greenfield and Yeager believe that stability in the value of the unit of account can only be achieved in an unregulated payments system. Wallace, however, questions whether price-level control is attainable absent legal restrictions. Moreover, given the need for the restrictions, he questions the deSirability of price-level control. It is not clear that banking deregulation necessarily obviates attainment of macroeconomic goals like price-level stabilization.52 It does seem unlikely, however, that a monetary reform accelerating the move toward an unregulated payments system could increase the degree of control over the Federal Reserve Bank of Dallas  price level. With flaws in the Greenfield-Yeager proposal and continued disagreements among legal restrictions theorists, that remains an open question .  1. 'Under this law any person or group had a right to sta rt a bank. Under the old rule, the privilege of starting a bank had to be granted by special legislative act' (Ross M. Robertson, History of the American Economy, 3d ed. [New York: Harcourt Brace Jovanovich, 1973J, 188n). 2.  3  On the American system, see Hugh Rockoff, "The Free Banking Era: A Reexamination," Journal of Money, Credit, and Banking 6 (May 1974): 141-67; also, Arthur J. Rolnick and Warren E. Weber, "Free Banking, Wildcat Banking, and Shinplasters," Federal Reserve Bank of Minneapolis Quarterly Review, Fall 1982, 10-19, and "The Causes of Free Bank Failures: A Detailed Examination,. Journal of Monetary Economics 14 (November 1984): 267-91. For the Scottish system, see Lawrence H. White, Free Banking in Britain: Theory, Experience, and Debate, 1800-1845 (Cambridge and New York: Cambridge University Press, 1984). In this usage, ' bonds" comprise Treasury bills, notes, and bonds.  4. See Neil Wallace, ' A Legal Restrictions Theory of the pemand for 'Money' and the Role of Monetary Policy," Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1983, 1-7; and John Bryant, "Analyzing Deficit Finance in a Regime of Unbacked Government Paper,' Economic Review, Federal Reserve Bank of Dallas, January 1985, 17-27. 5. John Bryant and Neil Wallace, "A Suggestion for Further Simplifying the Theory of Money' (Minneapolis, December 1980, Photocopy), 1. 6. Wallace, ' A Legal Restrictions Theory," 1-4. 7. Eugene F. Fama, 'Banking in the Theory of Finance,' Journal of Monetary Economics 6 (january 1980): 55; also, his ' Financial Intermediation and Price Level Control,' Journal of Monetary Economics 12 Uuly 1983): 8. 8. Robert E. Hall, 'Monetary Trends in the United States and the United Kingdom: A Review from the Perspective of New Developments in Monetary Economics,' Journal 01 Economic Uterature 20 (December 1982): 1554.  economic perspeC1we, the asymmetry is troubling. This is especially true if adjustment costs reflect infonnation costs or the value of price stability. In either case, prices ought to be sticky in each direction . In 'Essential Properties of the Medium of Exchange: Yeager deals with inflation 10 a footnote, and then only with the special case of suppressed inflation (54n; d . 57 n. 19). 13. "Recent and ongoing financial innovations (money-market funds, sweep accounts, overnight RPs, overnight EurodollarS, highly marketable credit Instruments, cash management devices, and all the rest) are rendering the very concept of money hopelessly fuzzy and the velocity of whatever constitutes money hopelessly unstable and unpredictable. So, anyway, goes a view that 1 cannot confidently dismiss" (Yeager, "Stable Money and Free-Market CurrenCies,' 308). 14. Greenfield and Yeager, "A laissez-Faire Approach,' 305. 15. Greenfield and Yeager, 'A Laissez-Faire Approach,' 305. In this quote, the au thors refer to the fou r commodities constituting the monetary unit advocated by Robert E. Hall in 'Explorations in the Gold Standard and Related Policies for StabiliZing the Dollar' (in In/lallon: Causes and EHec!S IChicago: University of Chicago Press for National Bureau of Economic Research, 1982J, 111-22). Hall dubbed the unit "AN CAP" for its constituent parts: ammonium nitrate, copper, aluminum, and plywood. Some of the differences between the Greenfield-Yeager proposal and Hall's are explained in the text here.  16. According to Greenfield and Yeager, the commodities defining the unit 'would not have to be storable, that is, capable of bemg held as monetary reserves, since the . . . scheme does not require any direct convertibility of obligations into the particular commodities defining the value unit" (.A Lais ez-Faire Approach," 305). The contention that the commodities need not be srorab/e (as opposed to not actually being stored) is surely at odds with the requirement that the commod ity bundle 'would be composed of precisely grad able, competitively traded, and industrially importan t commodities: It is difficult to conceive of a commodity that is at once 'precisely gradable, competitively traded, and industrially important" but not storable. 17. For this comparison, differences among various types of commodity standards can be sloughed over. 18. •A Laissez-Faire Approach," 306.  9.  Leland B. Yeager, 'Essential Properties of the Medium of Exchange,' Kyklos 21, no . 1 (1968): 45-69; reprinted in R. W. Clower, ed., Monetary Theory: Selected Readings (Baltimore: Penguin Books, 1969), 37-60; "What Are Banks?" Atlantic Economic Journal 6 (December 1978): 1-14; 'Sticky Prices or Equilibrium Always?' (Paper presented at the Western Economic Association meetings, San Francisco, 7 July 1981); "Stable Money and Free-Market Currencies,' Cato Journal 3 (Spring 1983): 305-26; and Robert L. Greenfield and Leland B. Yeager, 'A Laissez-Faire Approach to Monetary Stability," Journal 01 Mo ney, Credit, and Banking 15 (August 1983): 302-15.  10. Yeager, ' Stable Money and Free-Market Currencies," 305. 11. The classic statement of this view is in Yeager's 'Essential Properties of the Medium of Exchange: See also his "Stable Money and Free-Market Currencies,' 305-8, and Greenfield and Yeager, "A Laissez-Faire Approach to Monetary Stability,' 309-11 . 12. Greenfield and Yeager, "A Laissez-Faire Approach," 309. As in most such macroeconomic analYSis of price setting, there is an asymmetry in the treatment of upward and downward price adjustments. From a microEconomic Review - July 1986  19. Greenfield and Yeager, ' A Laissez-Faire Approach,' 305. 20. Fischer Black, ' Banking and Interest Rates in a World Without Money: The Effects of Uncontrolled Banking," Journal of Bank Research 1 (Autumn 1970): 9. 21 . Greenfield and Yeager, "A Laissez-Faire Approach," 307. 22. Greenfield and Yeager, "A Laissez-Faire Approach," 307. Their account of the future payments mechanism adds little to Black's prophecy in "Banking and Interest Rates in a World Without Money." 23. Greenfield and Yeager, "A Laissez-Faire Approach,' 307-8. 24. "A Laissez-Faire Approach," 308-11 . The quotations here on the system's advantages are found on those pages. 25. "The government would be forbidden to issue obligations fixed in value in the unit of account and especially suitable as media of exchange" (Greenfield and Yeager, 'A Laissez-Faire Approach," 305). 26. "A Laissez-Faire Approach: 303, 305. 29  27. Greenfield and Yeager, "A Laissez-Faire Approach," 306; d . Yeager, "Stable Money and Free-Market Currencies," 324. 28. For an evolutionary theory of not only institutions but customs and even law, see F. A. Hayek, "The Results of Human Action but Not of Human Design," in Studies in Philosophy, Politics and Economics (New York: Simon and Schuster, Clarion Books, 1969), 96-105, and "Liberalism," in New Studies in Philosophy, Politics, Economics and the History of Ideas (Chicago: University of Chicago Press, 1978), 119-51. 29. Webster's Ninth New Collegiate Dictionary, s v. "standard" (adjective).  30. A "foot" was originally the length of the terminal part of the reigning king's vertebrate leg. 31. This account of the episode is based on Larry Treiman, "Railroad Watches and Time Service," National Railway Bulletin 41, no. 1 (1976): 4. 32. Greenfield and Yeager chose an atypical and complex set of standards, the metric system. The metric system was indeed invented out of whole cloth. The meter was originally and arbitrarily defined as a fraction of the length (crudely measured) between the two poles of the earth. It later attained its more precise definition. The system was potentially useful, however, because of its conformity to customary units of length. (Richard Langlois kindly supplied me the history of this scientific unit of measurement.) 33. See Gerald P. O'Driscoll, Jr., and Mario J. Rizzo, The Economics 01 Time and Ignorance (Oxford and New York: Basil Blackwell, 1985), 195-98. 34. "A Laissez-Faire Approach," 306. 35. They come closesl when lhey observe the following: ' Of course, an analogy is just that and not an identity. There are differences between units of length and value, just as between units of length and weight. The key similarity is that both are defined units whose defonitlons do not change o r SLOp being applicable because of changes in some quantity Or because of other physical or economic events' ('A Laissez-F"ire Ap· proach," 306). Their explication of the differences does not meet the objection being raised here. 36. For a humorous demonstration of this paint, see M. L. Burstein, Money (Cambridge, Mass.: Schenkman Publishing Co., 1963), 11-14; reprinted as "The Index-Number Problem," in R. W. Clower, ed ., Monetary Theory: Selected Readings (Baltimore: Penguin Books, 1969), 61-64. Well-known price indices, like the consu mer price index, certainly can prOVide useful information if properly utilized . Persistent or substantial changes in the indices typically indicate changes on the purcha.slng power of money confronting most individuals. Similarly, policy makers may use changes in the indices as information concerning the effects of recent poiicy actions. 37. The issue is actually an old one in the history of economics, one that was disposed of effectively by David Ricardo in the early 19th century. He examined whether there could be any "invariable standard" or "invariable measure" of value (David Ricardo, On the Principles of Political Economy and Taxation, vol. 1 of The Works and Correspondence of David Ricardo, ed. Piero Sraffa [Cambridge: Cambridge University Press, 1951], 14, 43). He concluded that "of such a measure it is impossible to be possessed" (p. 43). The reasons he gave against a commodity standard's being an invariable measure of value apply also to the unit of account proposed by Greenfield and Yeager. Indeed, at the end of their article, they evidence awareness of some of the problems. See 30  Greenfield and Yeager, •A Laissez-Faire Approach," 313-14. On this issue, see Gerald P. O'Driscoll, Jr., "Money, Deregulation and the Business Cycle," Federal Reserve Bank of Dallas Research Paper no. 8601 (Dallas, January 1986), 14-16 38. See Steven L. Green, 'The Abrogation of Gold Clauses in 1933 and Its Relation to Current Controversies in Monetary Economics," this Economic Review.  39. Greenfield and Yeager correctly observe that ' our existing system is far from the pure product of .• evolution ' (. A Laissez-Fai re Approach,' 303). To justify their proposal within their own lalssez·faire framework, however, they need to demonstrate that the major features of the existlOg monetary system reflect policy Intervention. A5 argued In the text above, some variability in the value of money IS an inherent feature of money. The search for an invariant measure of value is a quixotic quest. (See note 37.) 40. Carl Menger, Principles of Economics, trans. James Dingwall and Bert F. Hoselitz (1871; reprint, New York and London: New York University Press, 1981), 262. 41 . Yeager, 'Stable Money and Free-Market Currencies," 306. 42. According to Milton Friedman: 'Under any conceivab le institutional arrangements, and certainly under those that now prevail In the United States, there is only a limited amount of flexibility in prices and wages. We need to conserve this flexibility to achieve changes in relative prices and wages that are requ ired to adjust to dynamic changes In tastes and technology. We should not diSSipate it simply to achieve changes in the absolute level of prices that erve no economic function' ('The Role of Monetary poncy,' In The Optimum Quantity of Money and Other E5says (Chicago: A1dine Publishing Company, 1969L 106). 43. Hayek argued that the actions necessary to stabilize the price level will generate unsustainable relative price changes. See Friedrich A. Hayek, Prices and Production, 2d ed. (london: George Routledge & Sons, 1935). 44. See, for instance, Michael David Bordo, 'John E. Cairnes on the Effects of the Australian Gold Discoveries, 1851-73: An Ea rly Application of the Methodology of Positive Economics,' History of Polit/cal Economy 7 (Fall 1975): 337-59; "The Effects of Monetary Change on Relative Commodity Prices and the Role of long-Term Contracts: Journa! of Polit/cal Economy 88 (December 1980): 1088-1109; and 'Some Aspects of the Monetary Economics of Richard Cantillon," Journal of Monetary Economics 12 !August 1983): 235·58. Also see Eugene F. Fama and G. William Schwert, ' Inflation, Interest, and Relative Pnees: Journal 01 Business 52 (Ap ril 1979): 183-209; Richard W. Parks, ' Inflation and Relative Price Vanability,' Journal o( Po/icJcal Economy 86 (February 1978): 79-95; and John Spraos, ' Why Innatlon Is Not Relative Price-Neutral for Primary Products,' World Development 5 (August 19771: 707-13. 45 .•A Legal Restrictions Theory,' 6. 46. Greenfield and Yeager, • A laissez-Faire Approach: 307-8. 47. Bennett T. McCallum, "Bank Deregulation, Accounting Systems of Exchange, and the Unit of Account: A Critical Review," CarnegieRochester Conference Series on Public Policy 23 (Autumn 1985): 35-36. The argument brings into sharp relief the efficacy of any noncoercive suggestion by a government. The 'standard bundle" refers to one unit of the composite-commodity bundle (for example, one ANCAP unit in Hall's system). 48. Greenfield and Yeager, "A laissez-Faire Approach,' 303. Federal Reserve Bank of Dallas  49 . •A Laissez-Faire Approach: 303. 50. See Gerald P. O'Driscoll, Jr., "Money in a Deregulated Financial System: Economic Review, Federal Reserve Bank of Dallas, May 1985, 11, an~ the references listed there. The original statement of this view was by Carl Menger; see Gerald P. O'Driscoll, Jr., "Money: Menger's Evolutionary Theory,' Federal Reserve Bank of Dallas Research Paper no. 8508 (Dallas, December 1985). Also see Karl Brunner and Allan H. Meltzer, 'The 'New Monetary Economics: Fiscal Issues, and Unemployment: CarnegieRochester Conference Series on Public Policy 23 (Autumn 1985): 1-4.  Economic Review - july 1986  51 . Lawrence H. White, "Accounting for Non-interest-bearing Currency: A Critique of the 'Legal Restrictions' Theory of Money" (New York, February 1986, Photocopy), 8. White also presents an equilibrium model of competitive note creation with no interest payments; see Free Banking in Britain, 1-22. 52. See the discussion in O'Driscoll, "Money in a Deregulated Financial System:  31  FEDERAL RESERVE BANK OF DALLAS STATION K. DALLAS. TEXAS 75222 ADDRESS CORRECTION REQUESTED  BULK RATE U.S. POSTAGE  PAID PERMIT NO. 151