by David Orrell
Europeans had also known about the possibility of paper currency since the times of Marco Polo, and the idea had been anonymously pumped in 1650 in a British pamphlet called The Key to Wealth, or, a New Way for Improving of Trade: Lawfull, Easie, Safe and Effectual. It therefore seems strange that paper banknotes were not adopted as money until the end of the seventeenth century, even though they were obviously much cheaper to make than coins. The reason, perhaps, is that during this period money was viewed both economically and psychologically not as a virtual instrument of exchange, as in the Middle Ages, but in terms of bullion. The moment that New World gold and silver began flowing into Spain, the dual nature of money had flipped from its virtual head to its bodily tail, and paper didn’t have the same physical appeal as coins. Mercantilism was about stockpiling material wealth, and when Colbert said that “it is simply, and solely, the abundance of money within a state that makes the difference in its grandeur and power,” he was not talking about the ability to print paper.
While the idea had already been floated a number of times, the use of state-sponsored banknotes in Europe properly dates to the creation of the Bank of England in 1694. After military defeat by France in the Battle of Beachy Head, King William III found himself in urgent need of £1.2 million to rebuild the navy. The first idea—a state lottery known as the Million Adventure—did not do the trick. The second idea was to start a bank, along the same lines as state banks like the ones in Holland (William was born Dutch) and Sweden, but with a twist: it would be a public–private partnership, with the funds coming from businessmen. The bank would give the government a permanent loan of gold in return for notes against this debt. The bank would therefore operate like a goldsmith, but on a much larger scale. It would receive 8 percent interest in perpetuity on the original loan, plus a service charge of £4,000 per year, plus whatever it could make from banking services.26 The subscription was sold out within twelve days to forty London and Edinburgh merchants. It was a huge success for the government and so much easier than raising taxes.
Nothing in the Bank of England’s original charter mentioned banknotes, but they turned out to be the most important part of the enterprise. Like other banks, the new corporation gave notes in return for deposits and also lent them out at interest. Such notes, which were handwritten by a cashier, included a promise to pay the bearer the sum of the note on demand, so anyone could redeem them in full or in part (in which case the note was suitably endorsed) for metal coins. Supported as they were by royal approval, they soon began to circulate as money.27
As mentioned in chapter 1, new inventions often result from a collision between existing technologies and cultural practices. The founding of the Bank of England represented a melding of the financial technology of the banking network with the power of the state. The new money system of bills and notes was certified, like a coin, by the sovereign’s stamp. There was therefore a transfer between the sovereign and the private system of credibility for cash. For the first time, private businessmen were directly involved in issuing and controlling the government’s money. Instead of acting as a check on the state’s power, as described by Steuart, they now had their hands on the controls.
The bank was originally sited in a small office in Walbrook in the City of London, the square mile of the financial district, which lies within the remains of the walls surrounding the Roman town of Londinium. Archaeologists later discovered on that site the remains of a Roman temple of Mithras, the god of contracts (the bank moved to its current location in Threadneedle Street in 1734). Perhaps the contract between the government and the newly formed corporation had the god’s blessing, because it was certainly fortuitous for all concerned. The effort to rebuild the navy had knock-on effects on the rest of the economy and set the newly revitalized country on its way to becoming the dominant power for the next century and a half, with the largest empire in history. England ruled the waves—and driving it, like the core of a nuclear-powered submarine, was the quantum power of money.
Intrinsic Value
The Bank of England was the first independent central bank and, as discussed later, served as a template for other central banks around the world. While the development of paper money would eventually reshape the world financial system, it didn’t seem to represent much of a revolution at the time. The reason was that banknotes were just a receipt, a pointer to something else, and it was understood that the real money—the gold bars and coins—existed in a vault somewhere. The banking system has since been described as “perhaps the most astounding piece of sleight of hand that was ever invented,” and certainly this move appears to have tricked the audience.28 (The exact size of the reserves, which consisted of both bullion and government securities, was kept deliberately vague by the corporation. When later questioned on this point by a royal commission, Lord Cunliffe said the reserves were “very, very considerable.” Asked to expand on that, he said he would be “very, very reluctant” to do so.)29
A much more serious matter, in the minds of intellectuals, politicians, and the public alike, was the so-called silver crisis. As discussed earlier, a feature of coin money is that if the face value of a coin falls below the market price of the metal it is made of, then it will tend to be melted down or sold abroad as bullion. England at the time operated under a bimetallic regime, with both low-denomination silver and high-denomination gold coins that could be exchanged at a set rate. This meant that the Royal Mint in the Tower of London had to maintain a tricky balance between the market rates of the two metals and the formal exchange rate, since otherwise it would open up arbitrage opportunities. For several decades, the face value of silver coins had tended to dip a few percent below the metal value—with the result that there weren’t enough silver coins to go round.
The problem was exacerbated by the widespread practice of “clipping” coins—that is, removing a tiny amount of the valuable metal from the edges, to be melted down and sold. The coins that remained in circulation were therefore often but fragments of their former selves, with many containing only half their original silver. Merchants began to discount such coins, valuing them on weight rather than stamp, which resulted in inflation. Money was losing its most basic property, which was that market value should be designated by the stamp. By 1694, the economy was in serious trouble. The government therefore decided to issue new coins, but was unsure whether to restore them to their former level of silver or keep them at the new lower level. The latter option was favored by mercantilist economists, who argued that a cheaper coin would result in a low exchange rate. This in turn would make goods cheaper to produce relative to those of other countries, and thus maximize exports.
On the other side of the debate was the philosopher John Locke. In his Two Treatises on Government (1689),30 he argued that the role of the state was to protect the rights and freedoms of its citizens. One of the key rights was property rights, which Locke believed are generated when people mix their labor with the material world. For example, an apple on a tree is of no use to anyone; but by picking it, a worker mixes his or her labor with the apple, thus giving it value: “His labour hath taken it out of the hands of nature … and hath thereby appropriated it to himself.” Money was a way of crystallizing these gains and a means of asserting and guaranteeing one’s freedom.
Locke’s work therefore countered the mercantilist idea that the economy was at the service of the state. It also provided political justification for the sanctity of private property and the accumulation of money, and later served as one of the main influences on the Constitution of the new American government. Above all, it meant that the government should protect the integrity of the money in people’s pockets, not try to dilute it or allow it to be debased by coin-clipping thieves or force people to exchange their old coins for new, smaller versions. According to the rational, scientific, materialistic perspective of the Enlightenment, it made sense that the value of a coin should be determined by its physical qualities, that is, its precious metal c
ontent rather than the sovereign’s stamp, which after all was just a stamp. The answer to the question “What is money?” was a set weight of metal. Money’s “intrinsic value” was measured by its precious metal content, and you could no more change it than you could “lengthen a foot by dividing it into Fifteen parts, instead of Twelve.”
Locke therefore won the argument over the silver coins, and they were restored to their former level of content, but this time with milled edges to discourage clipping. Instead of a flexible exchange rate, the worth of money would be firmly tethered to the price of metal. An unexpected result, however, was that people hoarded the new silver coins and spent the old ones. This is an example of “Gresham’s law,” known to Copernicus, Oresme, and others, which states that “bad money drives out good.”31 (Here “good” can refer to either metal weight or even the appearance of a currency—shiny new coins with a nice design are preferred to old, beaten-up ones.)32 The shortage of money, coupled with the inflexibility of the monetary standard, created a deflationary disaster that was only alleviated as paper money and cheaper-denomination coins slowly became available for everyday transactions. Perhaps the stamp was worth something after all.
The Alchemist
Locke was acting as an adviser for none other than Isaac Newton, who had career-shifted from physics into a position as warden (later master) of the Mint. The job was intended as a sinecure—Newton had recently suffered a mental breakdown, perhaps caused by mercury poisoning from his alchemical experiments (the same problem suffered by many New World slaves, only this time self-inflicted). But Newton took his role seriously, devoting a surprising amount of energy to chasing down clippers and counterfeiters, a number of whom were sent to their deaths. He was also inadvertently responsible for putting England, and eventually much of the world, onto the gold standard.
The guinea coin—named for the region of West Africa where the material was sourced—was the country’s first gold coin to be struck by machine instead of by hand. It weighed about ¼ ounce of gold, bore an image of a small elephant (the logo of the Africa Company), and was originally worth 1 pound sterling, equal to 20 silver shillings. However, the actual market exchange rate tended to be somewhat higher. In 1717, Newton announced in a report that in England, “a pound weight of fine gold is worth fifteen pounds weight six ounces seventeen pennyweight & five grains of fine silver, reckoning a Guinea at 1£. 1s. 6d. in silver money” (1 pound, 1 shilling, and 6 pence). He calculated the European price ratio to be a little different, so for purposes of harmonization Newton recommended that the price of a guinea be set to 1 pound and 1 shilling, or 21 shillings. The Treasury therefore issued an order announcing that to be the official exchange rate.
This number 21, which fixed the relationship between gold and silver coins, was the monetary equivalent of a fundamental physical constant. As discussed in chapter 2, though, the concept of real-world value is fuzzy and uncertain, tends to vary with time and place, and has ways of confounding exact calculation. Because Newton’s ratio—in the eyes of merchants and traders around the world—still slightly favored gold over silver, gold coins were used to buy silver coins, and these were melted down and exported to places like India, where the British East India Company did a roaring trade. In a kind of reverse Gresham’s law, if money is underrated, it tends to leave, like a jealous lover. (A similar problem can occur when one country tries to peg its currency against that of another—not everyone may respect the peg.)
In theory, according to what is now known as the “law of supply and demand,” the market price of gold would fall as it became relatively abundant compared with silver; and Newton predicted that any discrepancy would be erased over time. Instead, what happened was that the market price of silver adjusted to a degree but remained volatile, and the price of gold stayed the same. Perhaps this was because the attractive, machine-produced gold coins were seen as superior to the more shopworn silver currency.33 Or maybe it was just that gold had more gravitational pull over the collective monetary consciousness. Either way, guineas therefore retained their face value of 21 shillings, even though the unit referred to a weight of silver. Newton may not have been able to turn lead into gold through alchemy, but in a sense he turned gold into silver. The result was that the pound sterling switched de facto from a bimetallic standard to a gold standard, with the Mint price of gold set at £3 17s 10½d an ounce (which made a guinea 21 shillings). There it remained, with wartime interruptions, for the next 200 years; a frozen Newtonian accident.34 In 1821, a new coin, the sovereign, was introduced, containing 20/21 of the gold in a guinea, thus making it worth exactly 1 pound sterling.
The inherent and unavoidable tension between money’s material value (tails) and stamp value (heads), which is complicated by bimetallism, later prompted a similar argument in the United States. Thomas Jefferson had recommended that the U.S. currency be based on a bimetallic standard so as to “abridge the quantity of circulating medium.”35 The Coinage Act of 1792 therefore defined a dollar to be 371.25 grains (24.1 grams) of silver, with gold worth fifteen times as much by weight. By the late nineteenth century, however, the country had essentially adopted what was fast becoming the international gold standard. The silver dollar stopped being coined in 1873 (see box 4.1), and the money supply shrank. This self-imposed, deflationary scarcity boosted the wealth of anyone holding gold and led to an intense political debate—with Populist politician William Jennings Bryan famously arguing that its effect was to “crucify mankind upon a cross of gold”—that is believed to have inspired the themes behind L. Frank Baum’s children’s novel The Wonderful Wizard of Oz (1900).
Rich bankers (the Wicked Witches of the East and West) wanted to control the money supply and keep with gold. Indebted farmers (the Scarecrow), who wanted a cheaper silver currency, were not helped by either industrialists (the Tin Woodsman) or fearful politicians (the Cowardly Lion). In real life, the wicked witches won, the country stayed on the yellow brick road, the value of the dollar was still measured in ounces (oz, get it?) of gold until 1971, Dorothy’s silver slippers were turned into ruby slippers for the movie, and the wonderful wizard at the central bank kept his job. The argument ended with the discovery of new supplies of gold in Alaska and Colorado—but the novel/play/film ran and ran.
The Madness of People
The gold standard was Newtonian in the sense that it prescribed an exact mathematical relationship between a currency and a weight in metal. The desire for Enlightenment scientists and philosophers, discussed further in chapter 7, to place the study of money and the economy on a solidly rational and mechanistic footing was no doubt also related to the fact that the economy itself had for a while been showing some rather footloose behavior. Financial innovations such as joint-stock companies and stock exchanges had boosted economic activity but had also magnified the possibility of adverse events, such as everyone losing all their money.
Leaders in this area, as in many other monetary developments, were the Dutch, who in the “tulip mania” of 1637 saw the price of the newly introduced bulb soar to incredible heights before suddenly wilting. The collapse created an economic chill that took some of the shine off what is known as the Dutch golden age, when the country was a dominant power in everything from art to warfare. A number of similar “manias” followed in other countries, with even more disastrous consequences. In England, what became known as the South Sea Bubble was driven by speculation in shares of the South Sea Company—a kind of South American version of the East India Company—which had been granted a monopoly to trade with Spain’s colonies there in exchange for helping to fund the national debt.
The company’s apparent success, which turned it into a competitor to the Bank of England, inspired many others to cash in on the trend for stock market flotations. One person set up a company whose Internet-like prospective famously consisted of “carrying on an undertaking of great advantage, but nobody to know what it is.” Others offered a “wheel of perpetual motion” and a method for
“extracting silver from lead.” In 1720, the South Sea share price soared within a few months from £175 to more than £1,000—despite the fact that not much trade was actually occurring. Directors sold some shares, investors began to suspect a scam, and by the end of September the price had deflated to £135. The ensuing crisis caused a record number of bankruptcies at every level of society. In 1721, the English government passed what became known as the Bubble Act, which forbade the founding of joint-stock companies without a royal charter. This protected the South Sea Company, which had such a charter, but unfortunately did not succeed in making bubbles illegal.