Monday, March 11, 2013

Strange money: privately-issued $6 and $7 notes

In you were living in Canada between 1870 and 1880 there's a good change that you might have held in your wallet the odd beast that was the private $7 note pictured above. Below is a $6 note issued by Banque Nationale in 1870, a bank that continues to operate in Canada today.

The first striking aspect of the $7 note is that the issuer is Molsons, the very same Molsons that brews one of Canada's best selling beers. Molsons Bank would eventually merge itself with the Bank of Montreal in the 1920s.

Going back a bit in history, the brand name on these notes isn't so unusual. Most Canadians are probably not aware that the entrance of the Bank of Canada into the business of issuing paper money is relatively new. Established in 1935, the BoC has only been a money printer for 78 or so years. Private Canadian chartered banks, on the other hand, began to issue paper banknotes as early as 1819. Until they gave up their right to issue notes in 1935, these banks had been continuously issuing notes for some 125 years. So Molsons notes aren't an anomaly—if anything, they've been the norm up here in Canada, it's the BoC that's a bit weird.

So why would anyone want a $7 note? Why not just carry one $5 and two $1s?

First, we should note that issuing banknotes is a cost-effective way for an institution to fund itself. Why? Notes don't pay out interest. In comparison, bond or deposit funding are pricier funding alternatives since interest must be paid on outstanding obligations. Fierce competition emerged among early Canadian banks to see who could keep their notes in circulation and "enjoy the float". The float refers to seigniorage, or the difference between the cost of maintaining banknotes in circulation and the interest that can be earned by investing note proceeds.

While the Canadian government no doubt wanted to share in this interest-free financing, a proposal by Lord Sydenham in 1841 to end the private issue of notes and monopolize issuance at a central bank never got off the ground. The next effort to move into the business of note issuance did get traction. But rather than establish a monopoly central bank, the Provincial Notes Act of 1866 only allowed for the issuance of $8 million in Province of Canada Notes. These instruments would later come to be known as Dominion notes. Much like US greenbacks, Dominion notes were direct obligations of the government, not of a central bank, and they circulated in competition with the notes of private banks.

Having gained for itself a toe-hold in the banknote issuance business, the Canadian government proceeded to shoehorn its way into a more dominant position. In 1870, the Feds required banks to surrender the issuance of small notes, or any denomination below $4.

Without the ability to issue $1s and $2s, chartered banks could not legally provide the public with hand-to-hand payment media to facilitate transactions that totaled $6, $7, or $11, and made it inconvenient to reach amounts like $26, $32, etc. The response of the Canadian banks was rather cheeky—they decided to print out $6s and $7s ($4 notes already being widely used in Canada). These new denominations allowed a bank to provide its clients with convenient payment media sufficient to total any transaction that clients might incur. An outstanding debt of $26, for instance, could be settled with one $20 note and a $6 note rather than one $10 and four $4s.

In 1880 legislation was passed that raised minimum private denominations to $5 and only permitted multiples of five. Thus ended ten years of oddly-denominated Canadian private notes. From that point on, only $1 and $2 denominated Dominion notes could provide Canadians with the flexibility to meet odd payment amounts.

Canadian $6 and $7 are an early example of regulatory-inspired financial innovation. No doubt the clamping down on private $1s and $2s was justified at the time by an appeal to Adam Smith's Wealth of Nations. While Smith usually advocated the free-banking position, he favored banning notes in denominations below £5. Small denominations were typically used by poorer classes whose ability to monitor notes for credit quality might be less than adequate. Without proper due diligence, wrote Smith, issuers of these notes would be able to overissue and cause credit booms and busts, hurting those least able to afford it.

I don't know what portion of the Canadian government's motivation for pushing into the banknote business emerged from the regulator-as-wise-outsider view and what portion from regulator-as-profit-seeking-monopolist view. But it makes me wonder how much of modern banking regulation is motivated by well-reasoned economic thinking and a genuine Smithian concern for the poor, and how much is motivated by interest groups co-opting the state to provide them with monopoly rents. Perhaps a bit of both. In any case, we shouldn't naively assume that bank regulation will solve all our financial woes.

PS: Many of these facts come from Roeliff Morton Breckenridge's The Canadian Banking System 1817-1890


  1. I can't remember where, but I remember reading that private note-issuance was generally unprofitable, as the interest was used up by printing and handling costs, chasing counterfeiters, etc. Notes were issued mostly for advertising.

    Another thing frequently mentioned in the old days was the question of why any private banker should be trusted for fifty times more than he is worth.

    Both of these factors support the "government as wise outsider" view.

    1. I've read that advertising bit somewhere too. Maybe Larry White?

      In any case, when note issuance isn't being done on a competitive basis it's incredibly profitable... cue many years of Federal Reserve profits.

      In hindsight, anyone who trusted Molsons Bank or Banque Nationale, both private bankers, with x times more than the bank was worth did ok. Both banks are still in existence. Canada had double liability for long time too, so notes were protected not only by the bank's capital but the personal capital of the shareholders.

  2. That's a clever response from the banks. Thanks for posting.

    The denominations we have now are puzzling to me. The $5 bill in particular has pretty poor utility. Having a $3 bill reduces the average number of bills to make change below $10 from 2.78 bills to 2.33 bills. This is assuming that all dollar amounts from 1 to 9 are equally likely; if we assume that small transactions are more common, then $3 bills become even more efficient.

    I've read papers analyzing the most efficient denominations of coins, but never bills, and never taking into account the distribution of cash transaction amounts. It's an interesting topic I'd like to hear more about.

    1. I meant to say "having a $3 bill INSTEAD of a $5 bill".

    2. Interesting. How did you do those calculations?

      Maybe we have an inherent bias to the number five because it looks & feels right? Five fingers. Half of ten. etc. There's a certain symmetry to it that overrides logic.

  3. Kind of an unrelated topic, but the Dominion notes part was interesting and got me thinking.

    (Apologies if I'm butchering theory here...) One criticism of Free Banking seems to be that people are skeptical that a FB system could stave off deflationary spirals (e.g. the Great Depression) or perform the lender of last resort function (i.e. emergency liquidity).

    But isn't that at best an argument for a night-watchman monetary policy? If the Free Banking system were working fine, then the govt could be completely hands off. In the face of an incipient financial crisis, couldn't the govt use something like the Aldrich-Vreeland emergency clearinghouse currency to provide liquidity as necessary?

    1. In a free banking system, the many roles that a central bank serves would be devolved to the market. The provision of liquidity insurance (the lender of last resort role) to banks and the rest of the financial system could be passed to the options market, or the insurance market. The job of clearing payments would be left to private competing clearing houses. Monetary policy, the provision of notes + deposits when demand increases, would be left to competing profit-seeking banks.

    2. "The provision of liquidity insurance could be passed to the options market, or the insurance market."

      Interesting! I hope you can do a post in the future on the details of how this system might work in practice.

  4. "Much like US greenbacks, Dominion notes were direct obligations of the government, not of a central bank"

    Federal Reserve notes are also obligations of the government. Isn't the current Canadian currency an obligation of the Canadian government?

    1. Canadian bank notes are "a first charge on the assets of the Bank," which means the bank ring-fences all of its assets so as to make note holders whole. I haven't found any wording that says the Federal government also stands behind the notes. The Feds are a shareholder of the bank... but that seems to be it.

      What bit of wording tells you that US Federal Reserve notes are obligations of the government?

    2. It's in the US Code:

      "Federal reserve notes, to be issued at the discretion of the Board of Governors of the Federal Reserve System for the purpose of making advances to Federal reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are authorized. The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues."

      "18 USC § 8 - Obligation or other security of the United States defined:

      "The term “obligation or other security of the United States” includes all bonds, certificates of indebtedness, national bank currency, Federal Reserve notes, Federal Reserve bank notes, coupons, United States notes, Treasury notes, gold certificates, silver certificates, fractional notes, certificates of deposit, bills, checks, or drafts for money, drawn by or upon authorized officers of the United States, stamps and other representatives of value, of whatever denomination, issued under any Act of Congress, and canceled United States stamps."

  5. Do you know how I can get my hands on a 7 dollar bill I really want one