The Cash Nexus: Money and Politics in Modern History, 1700-2000

by Niall Ferguson

  In France, by contrast, public banking was discredited for two generations by the disastrous bubble generated by John Law’s Banque Royale (see below). The Caisse d’Escompte established in 1776 was designed to discount commercial bills and did not begin lending to the government – at first covertly, then openly – until 1787.22 It too was short-lived: Necker’s efforts to convert it into a national bank were thwarted by opponents of a new ‘plutocracy’ (notably Mirabeau and the comte de Custine), and in 1793 it was suppressed along with all joint-stock companies. ‘We have nothing to gain from making ourselves English, bankers and financiers,’ declared the baron de Batz; a very erroneous judgement.23 It was not until 1800, after a brief period of ‘free banking’, that the Banque de France was founded by supporters of Napoleon Bonaparte’s coup of 18 Brumaire. Unlike the Bank of England, the Banque de France was partly owned by the government, which acquired shares in it in return for depositing its new Sinking Fund.24 As Napoleon himself declared in 1806, three years after the Banque had been granted its monopoly on Parisian banknote issue: ‘The Banque does not solely belong to its shareholders; it also belongs to the state which granted it the privilege of creating money.’25

  The evolution of public banks was only part of a Dutch financial revolution in the seventeenth century. It was not only that the debt of Holland, the wealthiest of the United Provinces, grew rapidly. It was also the fact that it took the form of life and redeemable annuities, providing the merchant élite of the United Provinces with an investment that was secure, yet easily marketable. At the same time, a new kind of security developed in the form of shares in the chartered trading monopoly known as the Dutch East India Company (Vereenigte Oost-Indische Compagnie), a semi-private vehicle for Dutch commercial and colonial expansion.26 These innovations crossed the Channel when William III, Stadholder of the Netherlands, became king of England and Wales after the Glorious Revolution.27

  The cost of the ensuing War of the League of Augsburg soon required the application of Dutch financial techniques in England; but with important modifications. While sales of life annuities and lottery tickets proved disappointing in 1693, the issue of £1.2 million of special bonds paying a guaranteed 8 per cent was fully subscribed the following year. The subscribers were attracted by the fact that specific taxes had been earmarked to pay the interest on the bonds, and by the right the subscribers acquired to incorporate themselves as a new ‘Bank of England’ with an effective monopoly on government borrowing. The new institution redeemed Exchequer ‘tallies’ and allowed the Treasury to issue Bank ‘sealed bills’ instead, as well as accepting government credit notes as deposits or as subscriptions to new public loans, of which there was a steady, war-induced stream from 1702 until 1713. The Bank in turn issued shares of its own. This was only the first of a series of flotations by monopoly companies: the New East India Company (1698), the United East India Company (1708) and the South Sea Company (1711) soon followed. As a result of these issues, London was soon outstripping Amsterdam in terms of the range of tradable assets available to investors. But it is important to bear in mind how much of the business of this nascent stock market was still the government’s. The South Sea Company was set up primarily in response to the strain of war finance, with the aim of funding some £9 million of short-term government obligations. The company accepted these at face value in exchange for its shares, and then swapped the short-term debts for new 6 per cent government annuities. By the time of the Peace of Utrecht (1713), the total government debt was divided in approximately equal shares between annuities, lottery stake money and loans funded by the Bank and the South Sea Company. Four years later, much of the lottery money was ‘consolidated’ into – in other words, exchanged for – a new 5 per cent stock managed by the Bank.28

  It was the experiments with these companies – including the traumatic experience of the South Sea Bubble (see below) – which ultimately produced an asset ideally suited to the needs of government. In the short run, the capital gains of shares in the South Sea and other trading companies made them far more attractive than government-issued annuities, and investors rushed to exchange them for company stock when this was offered by the South Sea Act of March 1720. However, the collapse of the South Sea Bubble revealed to investors the sad fact that share prices can go down as far as they can go up: much further in either direction than is likely with a fixed-interest-bearing bond. To bail out the many investors who had exchanged annuities for South Sea shares, the Company converted the shares into annuities, initially paying 5 per cent (later falling by stages to 3 per cent). The South Sea annuity was followed by the first Three Per Cent Bank Annuity in 1726, a redeemable bond secured on economies in the Civil List. After the Consolidating Act of 1751 the government itself could issue what became known as the ‘consol’, the forerunner of the modern ‘gilt’.29

  BONDS, BANKS AND BUBBLES

  The birth of the consol marks the beginning of the history of modern public debt.30 Whereas many of the annuities of the pre-1720 period had been irredeemable and relatively illiquid, consols were liquid, redeemable at par but otherwise perpetual. In other words, an investor who bought consols could be confident of receiving the specified percentage of his nominal capital, paid twice yearly, for ever, or until he wished to sell. The risk that the selling price would be far below what he had initially invested certainly existed, but it soon became apparent that it was a significantly smaller risk than for any similar asset. Consols became a byword for financial security, the benchmark against which all other investments’ riskiness came to be measured. And from the government’s point of view, the credibility of consols meant that, in a crisis, much larger sums could be raised by selling them than by raising taxation, without incurring a crippling interest burden in the future. Though there were later innovations – such as the introduction by the Younger Pitt of a sinking fund, which required annual payments for amortization of the debt – consols reigned supreme as the key component of the national debt until the time of the First World War. True, consols were never the sole debt instrument the government could issue. Particularly in times of crisis, short-term Exchequer bills – loosely modelled on the commercial bills which financed an increasing amount of British trade – could also be sold to the public or to institutions. But the mass of new debt issued henceforth took the form of consols. On average, less than 4 per cent of the total debt between 1801 and 1914 was ‘unfunded’, that is short-term.31

  The British system differed from the two principal continental alternatives – the Dutch and the French – because the institutions of debt management co-existed with a centralized, bureaucratic system of tax collection, a transparent process of parliamentary budget-making and a nascent central bank – though it should be noted that the maintenance of the convertibility of paper banknotes into gold was an important but not an indispensable part of the system. When the Bank of England was forced to suspend ‘cash payments’ between February 1797 and May 1821, the effect was not fatal to the system.32 In addition, the system benefited from the development of a large and liberally regulated financial market capable of trading not only government bonds but also a range of private sector financial assets.33 Alongside the market for consols, there flourished markets for private sector bonds and early equities, as well as (at the nearby Royal Exchange) the discount market for commercial bills, to say nothing of the various commodity and insurance markets. Peacetime expansion of private sector asset markets deepened and widened the capital market, increasing its capacity to absorb government debt in the event of war.

  Of all the great powers, France had the greatest difficulty in evolving a stable system of public debt management: a distinct disadvantage for a power which ran a deficit in every year between 1610 and 1800 apart from the nine years between 1662 and 1671.34 This was not for want of trying. Under Louis XIV, Jean-Baptiste Colbert had laboured mightily to raise tax revenues and to establish in the form of the caisse des emprunts an institution of modern debt management
. It was abolished after his death.35 In 1718 the Scotsman John Law set out to modernize French borrowing – which under Louis XIV had relied increasingly on innumerable short-term loans (often little more than paper ‘IOUs’) from tax farmers, accountants and contractors36 – by combining the best of the Dutch and British systems. Boldly, Law sought to unite the functions which had been carried out separately in Britain by the Bank of England and the South Sea Company. His Banque Générale was rechartered as the Banque Royale and, in return for exchanging its own stock for the existing government debt, gained the right to issue banknotes. However, from the outset the Banque Royale’s fortunes were inseparable from those of the Compagnie d’Occident, which had been granted monopolies on French trade with the Caribbean and the exploitation of the drainage of the Mississippi river basin. A quarter of the Banque Royale’s capital was held as shares in the Compagnie d’Occident; the boards of the two entities also overlapped; and Law himself was a director of the Compagnie. There was a confusion of priorities, in which the stability of the currency came at best third.

  In May 1719 Law merged the Compagnie d’Occident with two other trading companies to form the Compagnie des Indes, then used issues of new Banque Royale banknotes to chase up the prices of the new company’s shares. He then proceeded to take over the royal tobacco monopoly and the United General Farms, the corporation of the principal tax farmers. Between August and December 1719, shares in the Compagnie des Indes soared from around 3,000 livres each to over 10,000 livres. At the zenith of his ‘system’, Law accepted the office of Comptroller-General and merged the Banque Royale and the Compagnie des Indes. It was too much. The combination of monetary inflation and the interest-rate cap on new loans which Law himself imposed burst the bubble, and in June the Compagnie des Indes share-price plummeted back below 6,000 livres. By September the shares were ‘almost worthless’; in October the notes of the Banque Royale ceased to be legal tender; and in December Law fled France.

  The collapse of Law’s schemes, it is generally agreed, more or less ‘demolished the existing credit structure in France’.37 It is worth pausing to ask why the same thing did not happen in England, which also had its South Sea ‘Bubble’. The price of South Sea shares had in fact experienced a not dissimilar rise and fall: from 128 on 1 January 1720 to 950 on 1 July, slumping to 775 two months later and touching just 170 on 14 October.38 The average price in 1722 was just 92.39 Yet the institutional damage was much less in England. In France both the Compagnie des Indes and the Banque Royale were dissolved. Moreover, a very large part of the assets and cash Law had created – which had an estimated face value of some 4 billion livres – was simply repudiated: only 1.6 billion were recognized by the liquidating commission know as the Visa, and these were converted into government bonds paying just 2 or 2.5 per cent interest.40 In England, by contrast, the Bank of England and the pound – the value of which had been fixed in gold only three years before – remained intact, while holders of South Sea stock came off with tolerable losses.41 The authorities recognized that the Company was too big to fail: its debts were partly taken over by parliament, while £4.2 million of its nominal capital (which totalled over £38 million) was bought for cash by the Bank of England and converted into bonds paying 5 per cent. In 1723 – by which time the Company’s shares were back above par – half of its capital was converted into bonds. Those who had exchanged life annuities (which often yielded as much as 14 per cent) for South Sea shares were undoubtedly worse off; as were those who had speculatively bought shares during the Bubble. But the scale of losses was far smaller than in France, where many investors and creditors lost everything.

  Because of Law’s failure and the drastic way it was dealt with, France remained locked in a system in which private credit was restricted to the ‘information network’ provided by an élite of public notaries,42 while public credit increasingly depended on the old forms of short-term loan (‘assignations’, ‘anticipations’ and ‘rescriptions’)43 and the sale of offices. For, as we have already seen, the money invested in offices was not so different from the money invested in the British national debt, except that the interest was paid in the form of salaries. In 1660 Colbert estimated the value of the capital invested in offices by some 46,000 office-holders at 419 million livres; when the Revolution finally liquidated the system, the compensation paid to office-holders was almost twice that sum.44 By the middle of the eighteenth century it was clear that the sale of offices was no longer the solution to the ancien régime’s fiscal problems, but a fundamental part of them, since office-holders were one of the most powerful interest groups opposed to root and branch fiscal reform. In their search for new sources of revenue after 1750, ministers turned to life annuities (rentes viagères), which increasingly took the place of sales of office as the crown’s readiest source of funds. However, a rising proportion of these were sold at a flat rate without regard to the ages of the purchasers.45 Between 1777 and 1781 Necker borrowed some 520 million livres by this and other means, but for terms seldom exceeding twenty years.46 His successors Calonne and Brienne could not equal this and, despite the forcible registration of new loans in the parlement of Paris in November 1787, royal finances became increasingly dependent on renewing the short-term anticipations of future tax revenue, which now amounted to some 240 million livres. When the government attempted to over-ride the parlement’s demand that the Estates General be convened, ‘the government’s usual creditors refused to lend’. In August 1788 Brienne was forced to suspend payments, even on long-term rentes. It was this debt crisis which obliged the government to summon the Estates General.47

  Only after another great financial collapse – that caused by the Revolution – were steps taken to remodel French finance in something like the British image. Henceforth government borrowing took the form of issues of rentes perpetuelles bearing interest of 5 or 3 per cent. The rente now became a standardized, liquid security like the consol. They were not bearer bonds (i.e. freely transferable between buyers and sellers): the names of rentiers were inscribed in the Grand Livre de la Dette Publique.48 By contrast, the coupons of a bearer bond could be clipped off and exchanged for cash when interest was due by whoever possessed them.

  The contrast with the financial system which developed in the other great revolutionary regime of the age is striking. Under the influence of Alexander Hamilton, the United States acquired a system of public debt that resembled in essentials that of Britain – though its federal fiscal system was much more like the Dutch. As early as 1779–80, Hamilton outlined a plan to ‘accomplish the restoration of paper credit, and establish a permanent fund for the future exigencies of government … select[ing] what is good in [Law’s] plan and any others that have gone before us, avoiding their defects and excesses’.49 In 1789 he successfully funded the old debt of the bankrupt Confederation, converting them into new 6 per cent federal bonds (‘Hamilton 6s’), redeemable at par like consols. And two years later he overcame the opposition of Thomas Jefferson and others to establish the Bank of the United States, modelling its charter on that of the Bank of England and issuing Bank shares (‘the hot … initial public offering of mid-1791’), just as had been done in England a hundred years before. As is well known, Hamilton’s central bank subsequently fell victim to political opposition, which culminated in President Andrew Jackson’s 1832 veto of the bill to recharter the Second Bank of the United States. And Hamilton’s intention to give the dollar a metallic basis was undermined by the tendency of silver to drain away to Latin America. For most of the nineteenth century America had ‘free banking’ and paper money, with up to 1,600 banks issuing as many as 10,000 different kinds of banknote (though until the Civil War the link to silver was maintained, at least in theory). Only in 1863 were steps taken to reduce the number of note-issuing banks and to create a standardized national banknote; only in 1879 was the dollar restored to a metallic exchange rate, though which metal remained controversial; and only in 1913 was a central bank finally created in
the form of the Federal Reserve. Nevertheless, the British-style national debt which Hamilton had created did survive. Indeed, in many ways the American financial system went further than the British in encouraging private sector issues of securities to deepen and widen the capital market.50

  For reasons to be discussed in Chapter 10, the nineteenth century saw the global spread of the British system of public debt, just as the institutions of parliamentary budget-making, bureaucratic tax collection and metallic (increasingly gold) currency were also widely copied. The consol became the model for long-term bonds, and indeed the benchmark against which their performance was conventionally measured (though some countries preferred to issue bonds with specified if remote maturities). The Bank of England was imitated, though with significant national variations, in Finland (1811), Holland (1814), Norway and Austria (1816), Denmark (1818), Portugal (1846), Belgium (1850), Spain, Germany and Bulgaria in the 1870s, Japan, Romania and Serbia in the 1880s, and Italy in 1893.51 Where there continued to be diversity was in the structures of commercial banking systems. For example, the American National Banking Act of 1864 restricted branching by national banks and currency could only issued if government bonds were held by the issuing bank.52 The German banking system, with its industry-financing ‘universal’ banks was different again.53