The basic genius of bond notes (Part II)

THE confidence of the Reserve Bank of Zimbabwe (RBZ) in the likely success of bond notes is explicable.

It seems to be grounded in United States Civil War monetary history. There is a striking similarity between bond notes and United States Notes, mockingly nicknamed greenbacks because they were printed in green on one side.

The original greenbacks (a debt instrument) issued when the US did not have a central bank, are not the current US dollar paper notes issued by the US Federal Reserve commonly circulating today.

Greenbacks were first issued in 1862 following the passage in the US Congress of the First Legal Tender Act. In 1861 the American Civil War had broken out after some states seceded from the Union. Hit hard by a fall in tax revenues, the US government,then led by the slavery-abolition activist President Abraham Lincoln could not finance the war which was taking longer than anticipated. Banks told the US government they could lend at 36% interest. Lincoln balked.

A Congressman and businessman from Buffalo named Elbridge Gerry Spaulding came to the rescue.He tendered what was at the time a hare-brained idea. Spaulding urged Congress to milk its constitutional authority to fund war to empower the US Treasury to print and issue paper notes which would be accepted in settling all public and private debts. Though crafted as a temporary measure, it was a very radical idea for two reasons.

First, the US constitution provided for coining of money, not printing paper money. Spaulding was asking the government to turn debt contracts (Treasury notes) into currency! Suggesting that government permit Treasury to issue notes at zero interest and turn a traditional debt instrument into currency was a shocking and cheeky financial novelty. The US constitution stated that anyone debasing money should be hanged!

The thinking behind the US notes is debatably the same reasoning guiding our bond notes. Our RBZ governor John Mangudya stated in his Mid-Term Monetary Policy Statement that bond notes were a zero coupon debt instrument. That statement simply means bond notes are borrowing paper for which Treasury pays no interest. Echoes of US Notes are hard to miss here. The genius of bond notes, it seems, is rented from the economic history of the US.

The First Legal Tender Act cleverly excluded customs duties from being payable in greenbacks — importers could only settle their customs duties in gold and silver (commodity money). Another shrewd provision was that the US notes could be used to settle government special loans called bonds with interest at a rate of 6%. Simply put, if government issued a bond (long-term borrowing paper instrument); youlentin gold and silver, not in US notes. The thinking is similar to bond notes incentives — you cannot get incentives in hard US dollars but in bond notes injected through the Real-Time Gross Settlement (RTGS) system of payment.

Second, it had been the practice for US banks before the formation of the US central bank to offer paper notes as proof that banks held gold and silver coins of equivalent value in their vaults — a person could redeem coins by presenting bank notes. These paper notes are what is called representative money.

Spaulding’s Legal Tender bill was radical in that US notes could not be redeemed for gold and silver. Technically, we say the US notes were not convertible. These US notes would be backed simply by faith in the government that at some point in time the notes would eventually be converted to gold and silver.

We can draw similarities concerning the convertibility of our bond notes.

The US notes by default were pegged at par with gold. Though the US Legal Tender Act did not make this explicit, the fact that the US notes were decreed to settle all public and private debts meant that their value was assumed to be at par with gold. In the case of bond notes, there is an explicitly decreed parity between 1 bond note and US$1. The history of the value of the US notes against gold shows that between 1862 and 1878 the notes traded at a discount to gold. The value of US notes fell to an all-time nadir: US$1 note worth just 35 cents in gold.

In fact, each time it looked like the Union was being defeated by the secessionists, the US note fell against gold.

In 1879 when the US government made US notes convertible to gold, the value of US notes traded at par with gold. The government waited for people to come and exchange their US notes for gold. Few came because the market had come to regard US notes to be just as good as gold.

There is a lesson here from history worth repeating. The history of the US notes points towards the likelihood that if bond notes are not convertible into what backs them (hard US dollar) they will be discounted. I think it is a huge mistake to assume that since bond coins have not been discounted to date bond notes will also not be discounted.

Here is the difference. Bond coins have been convertible — they are practically as good as the US dollar. Should bond notes become the dominant mode of exchange circulating, no matter how carefully they are drip-fed (governor Mangudya’s parlance), they are likely to be discounted if they cannot be freely exchanged for US dollars. History testifies that economic and not political means dictated the value of US notes.

There are other salient similarities and differences between bond notes and US notes.

For starters, the very idea and specific language of legal tender used in Statutory Instrument 133 of 2016 has its origins in the very First Legal Tender Act of the US passed in February 1862.

The US notes, like bond notes, are creatures of decree. They are legal tender, meaning that by force of diktat they cannot be refused when presented as payment for goods and services. The difference in how bond notes and US notes respective pieces of legislation were enacted is that bond notes were not debated in parliament whereas US notes were subject to robust debates in the US Congress.

This links us to another important difference. The First Legal Tender Act set the ceiling of US notes that could be printed at US$150 million. Our bond notes have been given a ceiling of US$200 million. There are nuanced differences here. The US notes limit was legally binding. Our US$200 million limit is not legally binding since it is not mentioned in Statutory Instrument 133 of 2016 which declared bond notes legal tender.

When the war funding need escalated, the US Congress passed the Second and Third Legal Tender Acts to increase the limit of US notes by US$150 million apiece. If bond notes “succeed”, will their limit be revised upwards?

Our Treasury and the RBZ seem to be banking on the history of US notes to be on their side. That history is both for and against our monetary and fiscal authorities.

Chulu is a management consultant and classic grounded theory researcher. He has published research in an international peer-reviewed academic journal.