The Mystery Of Banking

by Murray N. Rothbard

  XII.

  THE ORIGINS OF CENTRAL BANKING

  1. THE BANK OF ENGLAND

  How did this momentous and fateful institution of central banking appear and take hold in the modern world? Fittingly, the institution began in late seventeenth century England, as a crooked deal between a near-bankrupt government and a corrupt clique of financial promoters.

  Banking in England, in the 1690s, consisted of scriveners— loan bankers who loaned out borrowed money, and goldsmiths, who had accepted gold on deposit and were beginning to make loans. The harrowing and expensive Civil Wars had finally concluded, in 1688, with the deposition of James II and the installation of William and Mary on the throne of Great Britain. The Tory party, which had been in favor, now lost its dominance, and was replaced by the Whig party of noble landlords and merchant companies enjoying monopoly privileges from the government. Whig foreign policy was mercantilist and imperialist, with colonies sought and grabbed for the greater glory of the Crown, trading advantages, investments in raw material, and markets for shipping and exports. England’s great rival was the mighty French Empire, and England set out in a successful half-century-long effort to attack and eventually conquer that rival empire.

  A policy of war and militarism is expensive, and the British government found, in the 1690s, that it was short of money and its credit poor. It seemed impossible after a half-century of civil wars and a poor record of repayment for the government to tap sufficient savings by inducing people to buy its bonds. The British government would have loved to levy higher taxes, but England had just emerged from a half-century of civil wars, much of which had been waged over the king’s attempt to extend his taxing power. The taxing route was therefore politically unfeasible.

  A committee of the House of Commons was therefore formed in early 1693 to figure out how to raise money for the war effort. There came to the committee the ambitious Scottish promoter, William Paterson, who, on behalf of his financial group, proposed a remarkable new scheme to Parliament. In return for a set of important special privileges from the State, Paterson and his clique would form the Bank of England, which would issue new notes, much of which would be used to finance the English deficit. In short, since there were not enough private savers willing to finance the deficit, Paterson and his group were graciously willing to buy government bonds, provided they could do so with newly-created out-of-thin-air bank notes carrying a raft of special privileges with them. This was a splendid deal for Paterson and company, and the government benefited from the flimflam of a seemingly legitimate bank’s financing their debts. (Remember that the device of open government paper money had only just been invented in Massachusetts in 1690.) As soon as the Bank of England was chartered by Parliament in 1694, King William himself and various members of Parliament rushed to become shareholders of the new money factory they had just created.

  From the beginning, the Bank of England invested itself, aided and abetted by the government, with an impressive aura of mystery—to enhance its prestige and the public’s confidence in its operations. As one historian perceptively writes:

  From 27 July 1694, when the books were opened with the words “Laus Deo in London,” the Bank was surrounded with an aura of prestige and mystery which has never entirely evaporated—a sense that it was not as other businesses, yet as businesslike as any. It was like some great ship, with its watch of directors always on duty during its business hours, and its studied display of operational efficiency. The un-English title of “director,” the Italianate contraction “Compa” on its notes, were deliberate touches of the exotic and modern, showing those who handled the new currency or dealt with the Bank that, though this was something new in England, it had borrowed its tradition from the glorious banks of Genoa and Amsterdam. And although the Bank had grown from, and continued as the preserve of, a particular business syndicate who as a group and as individuals had many other interests, it bred and drew a particular type of man, capable of sustaining its gravity.1

  William Paterson urged that the English government grant his Bank notes legal tender power, which would have meant that everyone would be compelled to accept them in payment of money debt, much as Bank of England or Federal Reserve notes are legal tender today. The British government refused, believing that this was going too far, but Parliament did give the new Bank the advantage of holding all government deposits, as well as the power to issue new notes to pay for the government debt.

  The Bank of England promptly issued the enormous sum of £760,000, most of which was used to buy government debt. This had an immediate and considerable inflationary effect, and in the short span of two years, the Bank of England was insolvent after a bank run, an insolvency gleefully abetted by its competitors, the private goldsmiths, who were happy to return to it the swollen Bank of England notes for redemption in specie.

  It was at this point that a fateful decision was made, one which set a grave and mischievous precedent for both British and American banking. In May 1696, the English government simply allowed the Bank of England to “suspend specie payment”—that is, to refuse to pay its contractual obligations of redeeming its notes in gold—yet to continue in operation, issuing notes and enforcing payments upon its own debtors. The Bank of England suspended specie payment, and its notes promptly fell to a 20 percent discount against specie, since no one knew if the Bank would ever resume payment in gold.

  The straits of the Bank of England were shown in an account submitted at the end of 1696, when its notes outstanding were £765,000, backed by only £36,000 in cash. In those days, few noteholders were willing to sit still and hold notes when there was such a low fraction of cash.

  Specie payments resumed two years later, but the rest of the early history of the Bank of England was a shameful record of periodic suspensions of specie payment, despite an ever-increasing set of special privileges conferred upon it by the British government.

  In 1696, for example, the Whig magnates who ran the Bank of England had a scare: the specter of competition. The Tories tried to establish a competing National Land Bank, and almost succeeded in doing so. As one historian writes, “Free trade in banking seemed a possibility. Bank of England stock fell on the market.”2

  Though the Land Bank failed, the Bank of England moved quickly. The following year, it induced Parliament to pass a law prohibiting any new corporate bank from being established in England. Furthermore, counterfeiting of Bank of England notes was now made punishable by death. As Sir John Clapham, in his sycophantic history of the Bank of England, put it, “Bank notes were not yet King’s money, but they were getting near to it.”3

  In 1708, Parliament followed up this privilege with a further one: It was now unlawful for any corporate body other than the Bank of England to issue demand notes, and added a similar prohibition for any partnership of more than six persons. Not only could such bodies not issue notes redeemable on demand, but they also could not make short-term loans under six months. In this way, the Bank of England was enormously privileged by Parliament by being the only corporation or even moderately sized institution allowed to issue bank notes; its only competitors could now be very small banks with fewer than seven partners.

  Despite these provisions, the Bank soon suffered the competition of powerful Tory-connected rivals, launched during a brief Tory ascendancy during the reign of Queen Anne. The South Sea Company, created in 1711 and headed by Prime Minister Robert Harley, was a formidable rival to the Bank, but it collapsed nine years later after a bout of inflationary monetary expansion and stock speculation. In the wake of the South Sea collapse, the Bank of England was itself subject to a bank run and was again allowed to suspend specie payments indefinitely. Still, the ignominious end of the “South Sea Bubble” left the Bank of England striding like a colossus, unchallenged, over the English banking system.4

  A similar run on the Bank of England was precipitated in 1745, by the rising of Bonnie Prince Charlie in Scotland, and once more the Bank was permitted to susp
end payments for a while.

  During the late eighteenth century, the Bank of England’s policy of monetary expansion formed the base of a pyramid for a flood of small, private partnerships in note issue banks. These “country banks” increasingly used Bank of England notes as reserves and pyramided their own notes on top of them. By 1793, there were nearly 400 fractional reserve banks of issue in England. Inflationary financing of the lengthy, generations-long wars with France, beginning in the 1790s, led to the suspension of specie payment by one-third of English banks in 1793, followed by the Bank of England’s suspension of specie payments in 1797. That suspension was joined in by the other banks, who then had to redeem their obligations in Bank of England notes.

  This time, the suspension of specie payments by the Bank lasted 24 years, until 1821, after the end of the wars with France. During that period, the Bank of England’s notes, in fact though not in law, served as legal money for England, and after 1812 until the end of the period, was de jure legal tender as well. As might be expected, this period proved to be a bonanza for inflationary bank credit and for creation of new, unsound banks. In 1797, there were 280 country banks in England and Wales. By 1813, the total number of banks was over 900. These banks pyramided on top of a swiftly rising total of Bank of England notes. Total bank notes outstanding in 1797 were £11 million. By 1816, the total had more than doubled, to £24 million.5

  The fiat money period proved a bonanza for the Bank of England as well. The Bank’s profits zoomed, and when specie payments finally resumed, Bank stocks fell by a substantial 16 percent.6

  In 1826, banking was liberalized in England, since all corporations and partnerships were now permitted to issue demand notes; however, the effect of the liberalization was minuscule, since the new freedom was restricted to outside a 65-mile radius from London. Furthermore, in contrast to the Bank of England, the new bank corporations were subjected to unlimited liability. Thus, the monopoly of the Bank was kept inside London and its environs, limiting competition to country banking.

  In 1833, banking was liberalized further, but only slightly: deposit but not note issue corporate banking was allowed within London. More significantly, however, the Bank of England now received the permanent privilege of its notes functioning as legal tender. Furthermore, country banks, which previously were required to redeem their notes in specie, now had the option of redeeming them in Bank of England notes. These actions strengthened the Bank’s position immeasurably and from that point on, it functioned as a full central bank, since country banks now took to keeping virtually all of their reserves at the Bank of England, demanding cash, or gold, from the Bank as necessary.

  2. FREE BANKING IN SCOTLAND

  After the founding of the Bank of England, English banking, during the eighteenth and first half of the nineteenth centuries, was riven by inflation, periodic crises and panics, and numerous—and in one case, lengthy—suspensions of specie payment. In contrast, neighboring Scottish banking, not subject to Bank of England control and, indeed, living in a regime of free banking, enjoyed a far more peaceful and crisis-free existence. Yet the Scottish experience has been curiously neglected by economists and historians. As the leading student of the Scottish free banking system concludes:

  Scotland, an industrialized nation with highly developed monetary, credit, and banking institutions, enjoyed remarkable macroeconomic stability through the eighteenth and early nineteenth centuries. During this time, Scotland had no monetary policy, no central bank, and virtually no political regulation of the banking industry. Entry was completely free and the right of note-issue universal. If the conjunction of these facts seems curious by today’s light, it is because central banking has come to be taken for granted in this century, while the theory of competitive banking and note-issue has been neglected.7

  Scotland enjoyed a developing, freely competitive banking system from 1727 to 1845. During that period, Scottish bank notes were never legal tender, yet they circulated freely throughout the country. Individual banks were kept from overissue by a flourishing note exchange clearinghouse system. Since each bank was forced to toe the mark by being called upon for redemption, each bank would ordinarily accept each other’s notes.8

  Whereas English country banks were kept weak and unreliable by their limitation to partnerships of six or fewer, free Scottish banks were allowed to be corporate and grew large and nationwide, and therefore enjoyed much more public confidence. An important evidence of the relative soundness of Scottish banks is that Scottish notes circulated widely in the northern counties of England, while English bank notes never traveled northward across the border. Thus, in 1826, the citizens of the northern English counties of Cumberland and Westmoreland petitioned Parliament against a proposed outlawing of their use of Scottish bank notes. The petition noted that Scotland’s freedom from the six-partner restriction “gave a degree of strength to the issuers of notes, and of confidence to the receivers of them, which several banks established in our counties have not been able to command. The natural consequence has been, that Scotch notes have formed the greater part of our circulating medium.” The petitioners added that, with one exception, they had never suffered any losses from accepting Scottish notes for the past 50 years, “while in the same period the failures of banks in the north of England have been unfortunately numerous, and have occasioned the most ruinous losses to many who were little able to sustain them.”9

  In contrast to the English banking system, the Scottish, in its 120 years of freedom from regulation, never evolved into a central banking structure marked by a pyramiding of commercial banks on top of a single repository of cash and bank reserves. On the contrary, each bank maintained its own specie reserves, and was responsible for its own solvency. The English “one-reserve system,” in contrast, was not the product of natural market evolution. On the contrary, it was the result, as Bagehot put it, “of an accumulation of legal privileges on a single bank.” Bagehot concluded that “the natural system—that which would have sprung up if Government had left banking alone—is that of many banks of equal or not altogether unequal size.” Bagehot, writing in the mid-nineteenth century, cited Scotland as an example of freedom of banking where there was “no single bank with any sort of pre-dominance.”10

  Moreover, Scottish banking, in contrast to English, was notably freer of bank failures, and performed much better and more stably during bank crises and economic contractions. Thus, while English banks failed widely during the panic of 1837, a contemporary writer noted the difference in the Scottish picture: “While England, during the past year, has suffered in almost every branch of her national industry, Scotland has passed comparatively uninjured through the late monetary crisis.”11

  3. THE PEELITE CRACKDOWN, 1844–1845

  In 1844, Sir Robert Peel, a classical liberal who served as Prime Minister of Great Britain, put through a fundamental reform of the English banking system (followed the next year by imposing the same reform upon Scotland). Peel’s Act is a fascinating example of the ironies and pitfalls of even the most well-meaning politico-economic reform. For Sir Robert Peel was profoundly influenced by the neo-Ricardian British economists known as the Currency School, who put forth a caustic and trenchant analysis of fractional reserve banking and central banking similar to that of the present book. The Currency School was the first group of economists to show how expansion of bank credit and bank notes generated inflations and business cycle booms, paving the way for the inevitable contraction and attendant collapse of business and banks. Furthermore, the Currency School showed clearly how the Central Bank, in England’s case the Bank of England, had generated and perpetrated these inflations and contractions, and how it had borne the primary responsibility for unsound money and for booms and busts.

  What, then, did the Currency School propose, and Sir Robert Peel adopt? In a praiseworthy attempt to end fractional reserve banking and institute 100 percent money, the Peelites unfortunately decided to put absolute monetary power in the ha
nds of the very central bank whose pernicious influence they had done so much to expose. In attempting to eliminate fractional reserve banking, the Peelites ironically and tragically put the fox in charge of the proverbial chicken coop.

  Specifically, Peel’s Act of 1844 provided (a) that all further issues of bank notes by the Bank of England must be backed 100 percent by new acquisitions of gold or silver12; (b) that no new bank of issue (issuing bank notes) could be established; (c) that the average note issue of each existing country bank could be no greater than the existing amount of issue; and (d) that banks would lose their note issue rights if they were merged into or bought by another bank, these rights being largely transferred to the Bank of England. Provisions (b), (c), and (d) effectively eliminated the country banks as issuers of bank notes, for they could not issue any more (even if backed by gold or silver) than had existed in 1844. Thereby the effective monopoly of bank note issue was placed into the not very clean hands of the Bank of England. The quasi-monopoly of note issue by the Bank had now been transformed into a total legally enforceable monopoly. (In 1844, the Bank of England note circulation totaled £21 million; total country bank note circulation was £8.6 million, issued by 277 small country banks.)

  By these provisions, the Peelites attempted to establish one bank in England—the Bank of England—and then to keep it limited to essentially a 100 percent receiver of deposits. In that way, fractional reserve banking, inflationary booms, and the business cycle were supposed to be eliminated. Unfortunately, Peel and the Currency School overlooked two crucial points. First, they did not realize that a monopoly bank privileged by the State could not, in practice, be held to a restrictive 100 percent rule. Monopoly power, once created and sustained by the State, will be used and therefore abused. Second, the Peelites overlooked an important contribution to monetary theory by such American Currency School economists as Daniel Raymond and William M. Gouge: that demand deposits are fully as much part of the money supply as bank notes. The British Currency School stubbornly insisted that demand deposits were purely nonmonetary credit, and therefore looked with complacency on its issue. Fractional reserve banking, according to these theorists, was only pernicious for bank notes; issue of demand deposits was not inflationary and was not part of the supply of money.