Fiscal and Monetary Policy and Inflation:
The Confederate States 1861-1865
Sargent and Wallace (1981) presented an overlapping generations model where a fiscal authority dominates a monetary authority by imposing a deficit stream which must necessarily be financed by the Central Bank or Treasury. This hypothetical world seems to fit the situation that existed in the Confederate States during the Civil War with the U.S. from 1861-1865. During this period, the Confederate States experienced the only documented case of hyperinflation in the history of the United States. Literature on the subject tends to focus on mistakes of monetary policy and attributes the inflation to problems of money supply and velocity. The policies of the Confederate Congress, however, strongly influenced the actions of the treasury, and had direct implications for the establishment of conditions conducive to hyperinflation.
This paper discusses the actions of the Confederate Treasury given the situation that it was placed in, and examines whether or not the monetary authority could have acted differently so as not to have incurred or exacerbated the high inflation of the period. I conclude that it might have been possible to finance the war along a much lower inflationary path, but prejudices, short-sightedness, and inabilities of the Confederate Congress severely limited the policy options available to Secretary of the Treasury Memminger, thus all but guaranteeing a hyperinflation.
This paper begins with a discussion of the Sargent and Wallace paper and the conclusions which they reached regarding the ability of a monetary authority to control inflation given the regime described above. The next section provides a historical review of the deficits and finances of the Confederacy. An analysis is made with references to the monetary view espoused by Lerner (1955) and also more recent work by Burdekin and Langdana (1993) which utilizes the Sargent and Wallace framework to analyze the Confederate program. Criticism of the Confederate government is tempered somewhat by alternative sources of inflationary pressure such as adverse war news, and changes in the structure of imports.
The Sargent and Wallace Paradigm
In their 1981 paper "Some Unpleasant Monetarist Arithmetic", Sargent and Wallace looked at the effectiveness of monetary policy under a regime where a fiscal authority arbitrarily sets a stream of deficits. The monetary authority is eventually forced to finance the debt through seigniorage. Their analysis gives some interesting results. They determine that it may not be possible for the monetary authority to generate seigniorage sufficient to cover the debt if the sequence of deficits is either "too big" or "too long". Additionally, they find that the ability of the monetary authority to control inflation, given these deficits, is drastically reduced.
In order to control inflation, a policy of tight money is usually prescribed. Sargent and Wallace find that it is possible, under the regime that they describe for tight money to have little effect now, and result in higher inflation later. One of their simulations even reveals a case where tight money leads to higher inflation both now and in the future. With all of this in mind, we can proceed to examine the record of spending and finance of the Confederate Government.
War spending and finance in the Confederacy
The key elements that must be considered when analyzing the programs of Secretary Memminger are the levels of expenditure and deficits of the government, and the institutions and beliefs within the legislature that had direct consequences for the Treasury's ability to finance spending. When looking at the early revenue and spending flows, it is important to note that the general belief, in both the North and the South, was that the war was only going to last for 90 days (Lerner p. 163). Therefore, thoughts of long term finance probably were not considered. Below is a graph of real and nominal government expenditure (Data from Memminger in Budekin and Langdana, p. 355).
Except for a six month period between late 1863 and early 1864, nominal government expenditure was rising at an accelerating pace, though it is evident from the graph that much of the acceleration was likely due to rising prices. The real value of expenditure was relatively flat, so it would seem that the government had little choice but to increase nominal spending in the face of high inflation. Before exonerating the Confederate Congress for its galloping spending, a question of causality must be raised. While increasing spending was partially due to rising prices, rising prices were likely a consequence of war expenditure injecting large sums of money into the economy.
With the deficit stream given, it remained with Secretary Memminger to come up with the money to finance it all. There are a limited number of policy options available for generating revenue. Primarily, governments can either tax, issue interest bearing debt, or resort to printing additional currency. While all of these were used, worsening conditions of the Confederate economy would render the first two options fairly obsolete, thereby forcing seigniorage as the only policy capable of supporting continued expenditure.
In May, 1861, Secretary Memminger recommended that a property tax be levied to provide no more than $15 million during the coming fiscal year (Lerner p. 163). While a sum of $10 million was eventually approved, the mood of the Confederate States was highly opposed to large taxation by the centralized government. The entire issue of secession from the Union had centered on State's rights and a rejection of strong central government. With that in mind, there could be little wonder that Memminger had a difficult time collecting taxes.
Due to the Confederate Congress lacking its own agents to collect the taxes, the States were charged with raising the revenue quotas assigned to them. Not wanting to actually enforce the property tax, many states "floated bond issues to raise the money. Many of these securities were purchased by banks, and the stock of money expanded." (Lerner p. 165). Increasing the money supply was certainly not Memminger's intention when he introduced his tax bill. While the end result of bringing revenue to the government was achieved to some degree, the expanded money stock must have placed upwards pressure on prices. Also, while revenue flows from the property tax (regardless of whether it was collected with a property tax) were steady at first, as the war endured the tax became increasingly difficult to collect. It ended up accounting for only about 5% of all revenue (Lerner p. 165).
Along the same lines as taxation, another important failure of revenue raising by the Confederacy was the miserable contribution of tariffs and export duties. Even though the Union had imposed a blockade of shipping to and from the Confederacy, about 60% still got through at the height of the blockade (Ekelund and Thonton, p. 895). Despite the relative ineffectiveness of the blockade, tariffs and export duties made very little impact on revenue. A large contributor to this failure was an embargo on cotton export imposed in 1861 by the Confederacy in an attempt to draw the European powers into the conflict. An interesting side note is given by Pollard (1866) cited in Burdekin and Langdana (1993).
For one year after the war commenced, the blockade was so slight that the whole of cotton might have been shipped to Europe, and there sold at two shillings sterling a pound, giving the government, purchasing at twenty cents, a clear profit of six hundred millions of dollars! We may even suppose one-fifth of this captured by the enemy, and we would still have had a balance in our favor, which would have enabled us to have drained every bank in Europe of its specie! Or if we had drawn for this sum as we needed it, our treasury notes would have been equal to gold, and confidence in our currency would have been unshaken and universal.
While Pollard's estimates were probably optimistic, the potential for large revenue gains from the sale of cotton was quite substantial and might have prevented the debt crisis that the Confederacy would later face.
The impotency of taxation having been addressed, the record of Confederate bonds is looked at next. The first issue of $50 million dollars was approved in May 1861. Demand for the bonds was high and an additional $50 million issue immediately followed (Lerner p. 166). Much of these issues were sold on the credit of pledges from planters who promised to buy the bonds following harvests at the end of the summer. The cotton embargo and a subsequent fallout of prices in the market for cotton, however, prevented many farmers from living up to their pledges. Between May 2 and November 16 of 1861, the treasury reported only $18 million in receipts from bond issues (Memminger in Burdekin and Langdana, p. 354)
The interest rate on the first bond issue was 8%, but subsequent issues carried rates as low as 4% (Burdekin and Langdana, p. 361). Intuitively, and from experience with other historical episodes of high inflation, we would have expected interest rates to increase as inflation rose. The decline in rates is a product of Memminger's determination not to default on the debt, and to be able to pay in coin as prescribed by law. Since tax revenues were so low, he could not have serviced the debt in this manner at high interest rates.
Given these low rates compared to rapid rise of prices in the economy, the return on bonds soon became negative. The negative return, and the fact that higher returns could be earned in private investments created a situation where virtually the only reason for purchasing the bond issues was out of a sense of patriotism for the Confederacy.
Whatever their reasons, southerners continued to buy the bonds, and the Treasury had to become increasingly concerned with servicing the debt.
Ball (1991) heavily criticizes several aspects of Confederate debt management policy. In particular, he looks at the poor judgment of Memminger in his structuring of the maturity of the various bond issues.
As the worst example he cites the May 16, 1861 issue. While these bonds had a perfectly reasonable ten year maturation, they were to become fully convertible into treasury notes in July of 1863. These notes were redeemable for coin upon demand. Therefore, if faith in the ability of the treasury to fulfill its debt obligations were to wane, then Memminger would be facing a very serious crisis as people flocked to convert the bonds. Indeed this was the scenario that he faced, and despite attempts to mitigate the damage from this issue, there was little he could do to convince people to continue to hold the notes. As Kentucky Congressman Eli Bruce noted, the value of notes fell because Confederates saw the unrealistic payment terms and doubted the government's intentions to pay its debts (Ball, p. 143). Issuance of debt was ever increasing, and as the war began to draw out for longer than expected, the government's credit declined.
With the money collected in taxes flowing out almost as fast as it came in, and with the declining ability of the government to finance itself by issuing long term debt, the only option which would allow the treasury to cover the expenses of the war was to print money.
Throughout the period, the relatively expedient solution of printing money tended to outpace revenue flows from issuing interest bearing debt and was the main resource for financing the burgeoning deficits of the Confederacy. The original act of Congress which gave Memminger authority to print money required that the sum not exceed $1 million at any one time, however during the next four years the Treasury printed over fifteen hundred times that amount (Lerner p. 168).
The vast sums of currency injected into the economy by the Treasury added to the existing stock, as well as notes issued by banks. Attention is recalled to the State bond issues used to pay tax quotas, a program which resulted in substantial increase to the money stock.
Even if one does not fully believe in the quantity theory for the demand of money, enough theoretical and empirical work exist that have demonstrated the role of money creation in generating inflation. If the demand for money depends on the expected rate of inflation, then it turns out that the current price level depends on current and all anticipated future levels of the money supply (Sargent and Wallace, p. 183). The assumption that money demand does depend on expected inflation seems to be reasonable, especially in the climate of uncertainty generated by the war. Thus, as the government increasingly tended towards seigniorage as the primary method of finance, agents in the economy absorbed this fact in their formation of expectations, resulting in the explosive inflation in the South.
While the role of the expanding money stock has been given a large portion of the blame for perpetuating inflationary expectations, the role of the accelerating government budget deficit has not fully been addressed. With the failure of the Treasury to finance expenditure through issuance of interest bearing debt, and the practical absence of revenue from taxation, it is clear that without some other adjustment to policy, the level of debt would continue to increase without bounds. It is precisely the expectation of a change in policy that ties down the dynamics of inflation (Blanchard and Fischer, p. 517). The mounting deficits imply that the Treasury will at some point have to monetize the debt. The expectations of an increasing money supply are an endogenous function of the deficit stream.
Though the high levels of seigniorage generated under Memminger were indeed the roots of the hyperinflation, it is apparent that there may not have been much else that the Secretary could have done given the dominant position of the government in establishing its deficits. Additionally, the lack of enforcement of the tax bills placed inordinate pressure on the Treasury. The failure to generate significant reserves through taxes had direct implications for the credibility of the government to live up to its obligation to service the debt. A dearth of specie made it all but impossible to service the debt thereby causing the Treasury to attempt to breach the specific terms of its bond contracts on several occasions (a pattern of behavior which only served to reduce the desirability of the securities). Monetization of the debt therefore seems to be the inevitable outcome of a self-fulfilling prophecy implied by the high levels of deficit spending.
Even if Memminger had been able to pursue restriction of the growth of prices through a tight monetary policy, it is questionable whether the final effects of hyperinflation might have been avoided. Within the Sargent and Wallace framework discussed, money creation cannot be avoided given persistent and growing deficits. In fact, tight money now only implies that the monetary policy must loosen the money supply later. According to their analysis, any attempts that Memminger might have made to reduce the growth rate of the money stock initially would likely have led to even higher rates of inflation later.
Alternative sources of inflationary pressure
Primary fault for high inflation having been established, alternative contributors to the hyperinflation are now examined. One possibility examined here involves the composition of goods which the South was importing through the blockade. The other attributes substantial inflationary effect to changes in war news.
Ekelund and Thornton (1992) discuss the changes in imports caused by the Union blockade. They find that as the blockade tightened, ships increasingly shied away from importation of "necessity" goods in favor of "luxury" items. The authors attribute the shift to a change in the relative price of luxury goods. As risk of capture rose, the cost of importation of these goods decreased. Additionally, luxuries had much higher value to bulk ratios which provided further inducement for the blockade runners to substitute away from necessities.
In late 1861 and in 1862, the blockade began to create shortages and higher prices in vital goods and materials (Ekelund and Thornton, p. 893). Even though the incentives for blockade runners ran contrary to the needs of the Confederacy in its bid to sustain the war effort, the government did not attempt to truly restrict the activities of the runners until late in the war. The disruption of needed supplies allowed for those who controlled war materiel to extract high profit margins. While the overall impact in the structural change of imports is difficult to determine, it seems likely that the luxury substitution had significant impact. Indeed the authors of the paper name this the "Rhett Butler" effect, after the blockade runner in Margaret Mitchell's Gone with the Wind. The popularization of the selfish practices of runners gives supportive evidence of the role that imports played in causing shortages and indirectly, inflation.
Another contributor to the inflation was the impact of war news on the price level. Burdekin and Langdana (1993) regressed the changes in prices on variables including the change in the deficit, change in interest rates, and a dummy variable representing significant war news. The dummy was set to equal +1 for good times and -1 for bad times. It gave a coefficient of -0.11, significant at the 1% level. This provides support for news directly affecting the price level, most likely through increases in the velocity of money. However, the authors do point out that the war dummy is broadly defined and could be picking up on the effect on war news for fiscal and monetary actions. The effect of "war news" becomes equivalent to "fiscal news" concerning expected future values of money and debt issue (Burdekin and Langdana, p. 373). The resultant change in prices merely reflects an adjustment to expectations of future money supply.
When viewed through the Sargent and Wallace framework discussed here, the evidence from the Confederate Congress and individual State legislatures leads to the conclusion that large scale monetization of debt was an inevitable policy choice for the Treasury. High deficit spending undertaken to sustain the war effort was not offset by large enough tax collection. The biggest tax in effect was that caused by inflation whose effects injured both the government and the general populace.
Though it is true that Memminger's bond program was not the most carefully constructed, it is debatable whether any program could have credibly endured for very long. The legal obligation to service debt with coin, combined with the dismal performance of the Confederacy's taxation program, severely limited choices for term structure of interest rates. In order to continue to service the debt without default, low interest rates were necessarily maintained. The resulting negative returns prevented finance through the accumulation of interest bearing debt.
Arguably, reduction of expenditure was not a viable option for a government at war. However, a more concerted effort to enforce taxation policies would have greatly reduced the burden on the Treasury. Taxes also serve as a method for arresting the growth of the money stock by reducing the amount of seigniorage necessary, and also by decreasing the amount of money in circulation.
The government's policy of restricting the export of cotton at the onset of the war was another crucial mistake. Instead of using the sales from this valuable commodity to stuff the Confederate war chest, a futile bid to force Europe to take sides resulted in losses for both the government and plantation owners. When exports of cotton finally resumed, the Union blockade was in place, and shippers became more interested in carrying "luxury" goods. The failure of the Confederacy to intervene in the activities of the blockade runners, forcing them to ship needed supplies, resulted in shortages leading directly to higher prices, helping to feed the inflation.
Secretary Memminger appears to be a partial scapegoat for the inflationary woes of the Confederacy. This paper has shown that many of his policies were not taken by choice, but were the consequence of the circumstances which were thrust upon him. Serious blame must be attributed to the Congress and the individual States for the poor execution of taxation. The Confederate hyperinflation is a prime example of the need to coordinate fiscal and monetary policy. When a monetary authority is forced into such an extreme position as that faced by Memminger, there are severe limits as to its ability to finance the large debts imposed on it.
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