The Bank Charter Act of 1844 did this by imposing a strict limit on the amount of currency that could be backed by government debt (£14 million, adjusted at various times), and mandated that the rest of the currency must be backed by gold or be gold, that is, the currency was either paper banknotes representing gold bullion in the Bank of England, or gold coin itself.
In this, the Currency School made two fatal errors. The first is obvious: "money" consists of much more than gold coin and banknotes. As John Fullarton pointed out in 1845 (and other economists before and since), "money" is anything that can be used in settlement of a debt. The "circulation" of a country therefore is not restricted to gold coin and paper banknotes backed by State claims on somebody else's gold, but of demand deposits ("checking accounts"), bills of exchange, commercial paper, bills of lading — anything, in short, that is accepted in the channels of commerce in settlement of a debt.
The second fatal error of the Currency School is less obvious, but still serious. That is, a fixed or inflexible currency is hardly adequate to the needs of a modern or developing industrial or commercial economy. Consequently, the British government went through periodic "currency crises" even after the passage of the Bank Charter Act of 1844. They finally gave up after 1914, going off the gold standard domestically, and backing the currency completely with government debt.
This leads us into a third error, and one that the Currency School tried to avoid by mandating a legal limit to the amount of currency that could be backed by government debt. That is the fact that governments are rarely able to keep their hands off the printing presses, and will, if given the opportunity, create more money than can be backed by the present value of future tax collections. This is because the State spends money to achieve political, not economic ends — and the art of politics often involves garnering as much of the public revenue for your own constituents as possible, while letting someone else's constituents pay for it.
Various expedients have been tried to inhibit or prevent the State from inflating the currency in this manner. The problem is that if there is a loophole, however small, the politicians will find a way through it, as they did in the United States in 1917 when a way was found to circumvent the prohibition against monetizing government deficits found in the Federal Reserve Act of 1913. This was the origin of the so-called "open market operations."
Thus, almost a century after the Federal Reserve Act of 1913 was enacted to break up concentrated control over money and credit and provide a flexible currency backed by hard assets to meet the needs of industry, commerce, and agriculture, the U. S. currency is backed almost entirely by government debt, with a small amount of legally-mandated gold to back the United States Notes that nobody ever sees anymore.
The problem with backing the currency with government debt is two-fold. One, as we already noted, the State can rarely resist the temptation to monetize deficits. Going into debt is much easier and certainly more politically expedient than raising taxes. Taxes are immediately unpopular, while debt only becomes unpopular when it has to be repaid, or when the effects of unrestrained government spending begin to be felt throughout the economy.
Two, again as we have noted, when the currency is backed by government debt, the money supply is determined by political considerations, not the needs of industry, commerce, and agriculture. Any politician that can come up with a "good" reason for printing more money can, with relative ease, obtain funding in that manner rather than through the accountable method of raising taxes.
