The ability of banks to issue money raises some interestingquestions about the nature of money and about the legal aspectsof its issuance in the United States. On these topics I will nowbriefly digress. Money is nothing more than a common numerairewhich reduces the search costs associated with conductingbeneficial trades. Money is also a psychological abstraction.Literally anything can serve in this capacity as long as peopleare willing to accept it as a medium of exchange, if it maintainsits purchasing power reasonably over time, and if it can serve asa convenient unit of measure. An official government edict isnot necessary to create money.
The Constitution contains only two sections dealing withmonetary issues. Section 8 permits Congress to coin money and toregulate its value. Section 10 denies states the right to coinor to print their own money. The framers clearly intended anational monetary system based on coin and for the power toregulate that system to rest only with the federal government.The delegates at the Constitutional convention rejected a clausethat would have given Congress the authority to issue papermoney. They also rejected a measure that would have specificallydenied that ability to the federal government (Hammond, 92).Although the Constitution does not state that the federalgovernment has the power to print paper currency, the SupremeCourt in McCulloch vs Maryland (1819) ruled unanimouslythat theSecond Bank of the United States and the banknotes it issued onbehalf of the federal government were Constitutional.
If the federal government only is permitted to issuemoney,coin or paper, then how could state banks issue money? Statebanks did not coin money, nor did they print any "official"national currency. However, state banks could print bills ofcredit in exchange for specie deposits. These notes would bearthe issuing bank's name and entitle the bearer to the note's facevalue in gold or silver upon presentation to the bank. Statebank notes were a form of representative money; they were notgold or silver, but they represented it. The notes were moreconvenient for conducting large transactions than their speciecounterparts, and, more importantly for the extension of credit,could be produced easily whereas the gold and silver stock of thenation was relatively small and for the most part declining(Hixson, 12-13). The Supreme Court ruled in 1837 in BriscoevsBank of Kentucky that state banks and the notes they issuedwerealso constitutional.
One potential problem with such a system is that banks mayissue notes far in excess of their specie deposits. Customersappeared from time to time wanting to exchange their banknotesfor specie. The banks, of course, made allowances for this bykeeping some of the specie on hand at all times. If thespecie/banknote ratio was too low, even a small unexpectedincrease in the withdrawal rate could force the bank intoinsolvency. Remaining depositors who had not withdrawn theirspecie would be left with worthless banknotes.
The public accounted for this risk of non-redemption bydiscounting the notes of banks that were considered risky. Forexample, a $20 banknote issued by a bank with a reputation ofredemption problems might carry a 5 percent discount off its facevalue. In other words, a local merchant might only give acustomer $19 worth of goods for a $20 note with the differencecompensating the merchant for the risk of accepting the banknote.Discounts on notes among functioning banks ranged from about 95percent for the riskiest banks to zero for banks with a highdegree of public confidence. On the advent of the free bankingera, there were 712 state banks in operation in the UnitedStates, each with its own currency (Kidwell, 59). Imagine thedifficulty for a local merchant in tracking the riskiness andvalue of perhaps dozens of different banknotes in addition to theother concerns of his business.
