The Mystery Of Banking

by Murray N. Rothbard

  If it were true that the State could be trusted always only to issue notes to the amount of its specie holdings, a State-controlled note issue would be the best system, but as things were, a far nearer approach to the ideal system was to be expected from free banks, who for reasons of self-interest would aim at the fulfillment of their obligations.16

  Henri Cernuschi desired 100 percent specie money. He declared that the important question was not monopoly note issue versus free banking, but whether or not bank notes should be issued at all. His answer was no, since “they had the effect of despoiling the holders of metallic money by depreciating its value.” All bank notes, all fiduciary media, should be eliminated. An important follower of Cernuschi’s in France was Victor Modeste, whom Vera Smith erroneously dismisses as having “the same attitude” as Cernuschi’s. Actually, Modeste did not adopt the free-banking policy conclusion of his mentor. In the first place, Modeste was a dedicated libertarian who frankly declared that the state is “the master ... the obstacle, the enemy” and whose announced goal was to replace all government by “self-government.” Like Cernuschi and Mises, Modeste agreed that freely competitive banking was far better than administrative state control or regulation of banks. And like Mises a half-century later (and like most American currency men at the time), Modeste realized that demand deposits, like bank notes beyond 100 percent reserves, are illicit, fraudulent, and inflationary as well as being generators of the business cycle. Demand deposits, like bank notes, constitute “false money.” But Modeste’s policy conclusion was different. His answer was to point out that “false” demand liabilities that pretend to be but cannot be converted into gold are in reality tantamount to fraud and embezzlement. Modeste concludes that false titles and values, such as false claims to gold under fractional-reserve banking, are at all times

  equivalent to theft; that theft in all its forms everywhere deserves its penalties ... that every bank administrator ... must be warned that to pass as value where there is no value ... to subscribe to an engagement that cannot be accomplished ... are criminal acts which should be relieved under the criminal law.17

  The answer to fraud, then, is not administrative regulation, but prohibition of tort and fraud under general law.18

  For Great Britain, an important case of currency men not discussed by Smith are the famous laissez-faire advocates of the Manchester school. Hobbled by his artificial categories, Professor White can only react to them in total confusion. Thus, John Benjamin Smith, the powerful president of the Manchester Chamber of Commerce, reported to the chamber in 1840 that the economic and financial crisis of 1839 had been caused by the Bank of England’s contraction, following inexorably upon its own earlier “undue expansion of the currency.” Simply because Smith condemned Bank of England policy, White chides Marion Daugherty for putting J.B. Smith into the ranks of the currency school rather than the free bankers. But then, only four pages later, White laments the parliamentary testimony during the same year of Smith and Richard Cobden as revealing “the developing tendency for adherents of laissez-faire, who wished to free the currency from discretionary management, to look not to free banking but to restricting the right of issue to a rigidly rule-bound state bank as the solution.” So what were Smith, Cobden, and the Manchesterites? Were they free bankers (p. 71) or—in the same year—currency men (p. 75), or what? But how could they have been currency men, since White has defined the latter as people who want total power to accrue to the Bank of England? White avoids this question by simply not listing Smith or Cobden in his table of currency-banking-free-banking school adherents (p. 135).19

  White might have avoided confusion if he had not, as in the case of Scottish banking, apparently failed to consult Frank W. Fetter’s Development of British Monetary Orthodoxy, although the book is indeed listed in his bibliography. Fetter notes that Smith, in his parliamentary testimony, clearly enunciates the currency principle. Smith, he points out, was concerned about the fluctuations of the commercial banks as well as of the Bank of England and flatly declared his own currency school objective: “it is desirable in any change in our existing system to approximate as nearly as possible to the operation of a metallic currency; it is desirable also to divest the plan of all mystery, and to make it so plain and simple that it may be easily understood by all.”20 Smith’s proposed solution was the scheme derived from Ricardo, of creating a national bank for purposes of issuing 100 percent reserve bank notes.

  The same course was taken, in his testimony, by Richard Cobden, the great leader of the Manchester laissez-faire movement. Attacking the Bank of England and any idea of discretionary control over the currency, whether by the Bank or by private commercial banks, Cobden declared:

  I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency. ... I would never contemplate any remedial measure, which left it to the discretion of individuals to regulate the amount of currency by any principle or standard whatever.21

  In short, the fervent desire of Richard Cobden, along with other Manchesterians and most other currency school writers, was to remove government or bank manipulation of money altogether and to leave its workings solely to the free-market forces of gold or silver. Whether or not Cobden’s proposed solution of a state-run bank was the proper one, no one can deny the fervor of his laissez-faire views or his desire to apply them to the difficult and complex case of money and banking.

  Let me now return to Professor White’s cherished free-banking writers and to his unfortunate conflation of the very different hard-money and soft-money camps. The currency school and the free bankers were both launched upon the advent of the severe financial crisis of 1825, which, as usual, was preceded by a boom fueled by bank credit. The crisis brought the widespread realization that the simple return to the gold standard, as effected in 1821, was not enough and that something more had to be done to eliminate the instability of the banking system.22

  Among four leading free-banking advocates of the 1820s and early 1830s—Robert Mushet, Sir John Sinclair, Sir Henry Brooke Parnell, and George Poulett Scrope—Professor White sees little difference. And yet they were split into two very different camps. The earlier writers, Mushet and Parnell, were hard money men. Mushet, a long-time pro-gold-standard “bullionist” and clerk at the Royal Mint, set forth a currency-principle type of business cycle theory in 1826, pointing out that the Bank of England had generated an inflationary boom, which later had to be reversed into a contractionary depression. Mushet’s aim was to arrive at the equivalent of a purely metallic currency, but he believed that free rather than central banking was a better way to achieve it. Once again, White’s treatment muddies the waters. While admitting that Mushet took a currency school approach toward purely metallic money, White still chooses to criticize Daugherty for classifying Mushet with the currency school, since he opted for a free—rather than a central—banking method to achieve currency goals (p. 62n). The more prominent Parnell was also a veteran bullionist writer and Member of Parliament, who took a position very similar to Mushet’s.23

  Sir John Sinclair and George Poulett Scrope, however, were horses of a very different color. White admits that Sinclair was not a pure free-banking man, but he characteristically underplays Sinclair’s fervent lifelong views as being concerned with “preventing deflation” and calls Sinclair a “tireless promoter of agricultural interests” (p. 60 and 60n). In truth, Sinclair, a Scottish nobleman and agriculturist, was, all his life, a determined and fanatical zealot on behalf of monetary inflation and government spending. As soon as the pro-gold-standard, anti-fiat paper Bullion Committee Report was issued in 1810, Sir John wrote to Prime Minister Spencer Perceval urging the government to reprint his own three-volume proinflationist
work, History of the Public Revenues of the British (1785–90), as part of the vital task of rebutting the Bullion Committee. “You know my sentiments regarding the importance of paper Circulation,” Sinclair wrote the Prime Minister, “which is in fact the basis of our prosperity.” In fact, Sinclair’s Observations on the Report of the Bullion Committee, published in September 1810, was the very first of many pamphlet attacks on the Bullion Report, most of them orchestrated by the British government.

  When Britain went back to the gold standard in 1819–21, Sinclair, joining with the proinflationist and pro-fiat money Birmingham school, was one of the most energetic and bitter critics of resumption of specie payments. It is no wonder that Frank Fetter should depict Sinclair’s lifelong enthusiasm: “that more money was the answer to all economic problems.”24 It is also no wonder that Sinclair should have admired the Scottish “free” banking system and opposed the currency principle. But one would have thought that Professor White would feel uncomfortable with Sinclair as his ally.

  Another of Professor White’s dubious heroes is George Poulett Scrope. While Scrope is also characterized as not a pure or mainstream free-banking man, his analysis is taken very seriously by White and is discussed numerous times. And he is mentioned prominently in White’s table as a leading free banker. Scrope’s inveterate inflationary bent is handled most gently by White: “Like Sinclair, he [Scrope] placed higher priority on combating deflation” (p. 82 n). In fact, Scrope not only battled against the return to the gold standard in 1819–21, he was also the leading theorist of the fortunately small band of writers in Britain who were ardent underconsumptionists and proto-Keynesians. In his Principles of Political Economy (written in 1833, the same year as his major pro-free-banking tract), Scrope declared that any decline in consumption in favor of a “general increase in the propensity to save” would necessarily and “proportionately diminish the demand as compared with the supply, and occasion a general glut”.

  Let us now turn to the final stage of the currency school-banking school-free-banking controversy. The financial crisis of 1838–39 touched off an intensified desire to reform the banking system, and the controversy culminated with the Peel Acts of 1844 and 1845.

  Take, for example, one of Professor White’s major heroes, James William Gilbart. Every historian except White has included Gilbart among the members of the banking school. Why does not Professor White? Despite White’s assurance, for example, that the free-banking school was even more fervent than the currency school in attributing the cause of the business cycle to monetary inflation, Gilbart held, typically of the banking school, that bank notes simply expand and contract according to the “wants of trade” and that, therefore, issue of such notes, being matched by the production of goods, could not raise prices. Furthermore, the active causal flow goes from “trade” to prices to the “requirement” for more bank notes to flow into circulation.

  Thus said Gilbart:

  If there is an increase of trade without an increase of prices, I consider that more notes will be required to circulate that increased quantity of commodities; if there is an increase of commodities and an increase of prices also, of course, you would require a still greater amount of notes.25

  In short, whether prices rise or not, the supply of money must always increase! Putting aside the question of who the “you” is supposed to be in this quote, this is simply rank inflationism of the banking school variety. In fact, of course no increase of money is “required” in either case. The genuine causal chain is the other way round, from increased bank notes to increased prices, and also to increased money value of the goods being produced.

  Professor White may not be alive to this distinction because he, too, is a follower of the “needs of trade” (or “wants of trade”) rationale for bank credit inflation. White’s favorable discussion of the needs-of-trade doctrine (pp. 122–26) makes clear that he himself is indeed a variant of banking-school inflationist. Unfortunately, White seems to think all this to be consonant with the “Humean-Ricardian” devotion to a purely metallic currency (p. 124). For one thing, White does not seem to realize that David Hume, in contrast to his banking-school friend Adam Smith, believed in 100 percent specie reserve banking.

  While Professor White, in the previous quote from Gilbart, cites his Parliamentary testimony in 1841, he omits the crucial interchange between Gilbart and Sir Robert Peel. In his testimony, Gilbart declared not only that country bank notes increase solely in response to the wants of trade and, therefore, that they could never be overissued. He also claimed—in keeping with the tenets of the banking school—that even the Bank of England could never overissue notes so long as it only discounted commercial loans! So much for Professor White’s claims of Gilbart’s alleged devotion to free banking! There followed some fascinating and revealing colloquies between Peel and the alleged free banker (i.e., pro-free-banking, pro-gold-standard) James Gilbart. Peel sharply continued his questioning: “Do you think, then, that the legitimate demands of commerce may always be trusted to, as a safe test of the amount of circulation under all circumstances?” To which Gilbart admitted: “I think they may.” (Note: nothing was said about exempting the Bank of England from such trust.)

  Peel then asked the critical question. The banking school (followed by Professor White) claimed to be devoted to the gold standard, so that the “needs of trade” justification for bank credit would not apply to inconvertible fiat currency. But Peel, suspicious of the banking school’s devotion to gold, then asked: In the bank restriction [fiat money] days, “do you think that the legitimate demands of commerce constituted a test that might be safely relied upon?” Gilbart evasively replied: “That is a period of which I have no personal knowledge”—a particularly disingenuous reply from a man who had written The History and Principles of Banking (1834). Indeed, Gilbart proceeded to throw in the towel on the gold standard: “I think the legitimate demands of commerce, even then, would be a sufficient guide to go by.” When Peel pressed Gilbart further on that point, the latter began to back and fill, changing and rechanging his views, finally once more falling back on his lack of personal experience during the period.26

  Peel was certainly right in being suspicious of the banking school’s devotion to the gold standard—whether or not Professor White was later to reclassify them as free bankers. In addition to Gilbart’s revelations, Gilbart’s fellow official at the London &c Westminster Bank, J.W. Bosanquet, kept urging bank suspensions of specie payment whenever times became difficult. And in his popular tract of 1844, On the Regulation of Currencies, John Fullarton—a banker in India by then retired in England and a key leader of the banking school—gave the game away. Wrote Fullarton:

  And, much as I fear I am disgracing myself by the avowal, I have no hesitation in professing my own adhesion to the decried doctrine of the old Bank Directors of 1810, “that so long as a bank issues its notes only on the discount of good bills, at not more than sixty days’ date, it cannot go wrong in issuing as many as the public will receive from it.27

  Fullarton was referring, of course, to the old antibullionist position that so long as any bank, even under an inconvertible currency, sticks to short-term real bills, it cannot cause an inflation or a business-cycle boom. It is no wonder that Peel suspected all opponents of the currency principle to be crypto-Birmingham men.28

  The only distinguished economist to take up the free-banking cause is another one of Professor White’s favorites: Samuel Bailey, who had indeed demolished Ricardian value theory in behalf of subjective utility during the 1820s. Now, in the late 1830s and early 1840s, Bailey entered the lists in behalf of free banking. Unfortunately, Bailey was one of the worst offenders in insisting on the absolute passivity of the British country and joint-stock banks as well as in attacking the very idea that there might be something worrisome about changes in the supply of money. By assuring his readers that competitive banking would always provide a “nice adjustment of the currency to the wants of the people,” Bail
ey overlooked the fundamental Ricardian truth that there is never any social value in increasing the supply of money, as well as the insight that bank credit entails a fraudulent issue of warehouse receipts to nonexistent goods.

  Finally, Professor White ruefully admits that when it came to the crunch—the Peel Acts of 1844 and 1845 establishing a Bank of England monopoly of note issue and eliminating the “free” banking system of Scotland—his free-banking heroes were nowhere to be found in opposition. White concedes that their support of Peel’s acts was purchased by the grant of cartelization. In short, in exchange for Bank of England monopoly on note issue, the existing English and Scottish banks were “grandfathered” into place; they could keep their existing circulation of notes, while no new competitors were allowed to enter into the lucrative note-issuing business. Thus, White concedes: