Misunderstanding Money Creation
It should come as no surprise, then, that Bagehot assumed — in common with the framers of the Bank Charter Act of 1844 — that banks of deposit are the only legitimate form of banking institution. He did not even consider any role for banks of issue (which take the lion's share of the credit for the economic development of Great Britain and the United States in the 19th century) in his analysis of the London financial markets in Lombard Street.
In the view espoused by Bagehot, the central bank of a country is not an institution designed and intended to provide commerce, industry, and agriculture with liquidity. Instead, the central bank is the State's principal source of financing and means whereby the State can support and maintain the financial elite. Thus, in a disastrous reversal, the central banks of the world often end up acting as deposit banks and quasi-issue banks for the private sector through the inherently unsound implementation of fractional reserve banking, and issue banks for the State, monetizing government deficits and imposing increasing burdens of debt on future generations.
The bottom line is that Bagehot's analysis in both The English Constitution and Lombard Street institutionalized false assumptions at the most basic level of the economic common good. This provided John Maynard Keynes in the next generation with much of the justification he needed for his economic theories. The worst of these assumptions is, as we might expect, the widespread — and erroneous — belief that existing accumulations of savings are absolutely required to finance capital formation. Running a close second is the idea that specie — gold and silver — constitutes the only "real" money. Everything else is considered a "substitute," legitimate only when the State itself issues it, and not otherwise. This is because only the State's monopoly over the instruments of coercion can force people to accept something as gold that is not, in fact, gold, or constitutes an effective ownership claim by the State on all that money can buy.
Combined, these two assumptions ensure that only those who are currently wealthy, that is, with accumulated stores of gold or State-mandated gold substitutes, have the ability to finance capital formation. They thereby maintain a virtual monopoly of ownership over the means of production, and fulfill Marx's observation that capital breeds capital, and, "vampire-like, only lives by sucking living labour, and lives the more, the more labour it sucks." (Capital, 257.)
The Socialization of Capitalism
In Bagehot's system, the trend is even more insidious. Productive capital is left at the mercy of providers of financial capital (the State in the person of the central bank). The "vampire" is the State itself, which thereby effectively claims ownership of everything in the economy. This necessarily sacrifices the economic wellbeing and financial security of the country to maintain the moneyed elite of Wall Street and "the City," and meet transient political goals. This sucks the life out of the productive sector, and the State money power becomes increasingly powerful as the productive sector weakens. The country becomes dependent on foreign investment and captive markets that only colonies can ensure. When these two factors are missing or inadequate, "stagflation" takes over as the State increases the money supply without linking it to increased productive capacity to meet increased deficits. This drives up prices just as production — and thus incomes — are declining.
If gold and State purchase orders are the only "real" money, and only an increase in "real" money can provide the financing for economic growth, the country needs a constant inflow of gold or a never-ending increase in government debt; a strictly enforced policy of mercantilism. Mercantilism, in turn, relies on a captive source of raw materials and markets to ensure a positive balance of payments in the form of specie: colonies — which leads to the justification for empire and the maintenance of a financial elite. (Helfferich, op. cit., 193, 428.)
Nor does this change when a country organized along these lines goes off the gold standard and substitutes government debt paper as the backing of the currency, ensuring a permanent floating debt that ultimately puts the State at the mercy of foreign creditors. The private sector is still "starved" for liquidity, which must come from somewhere, either the carefully restricted flow of funds through commercial financial institutions employing fractional reserve banking (a monetary tool difficult to regulate effectively and inherently unsound), retained earnings achieved by diversion of consumption income into reinvestment, increased foreign investment, or the maintenance of a colonial empire in one form or another.
Of these sources of financing, the most transient and least amenable to domestic control are, of course, foreign investment and a colonial or quasi-colonial empire. In order to maintain the wealth and privilege of its financial and political elite, a country is loaded with a first and second mortgage. First and most obvious is the debt that is pushed into the future to meet current State spending deficits. The second is the economic thralldom imposed on the private sector in the form of debt and equity investments in the country's productive capacity that originate from outside the country.
Interest Fixing is Price Fixing
Inevitably, in the absence of colonies dependent on the mother country, the central bank is forced to manipulate interest rates in order to bring in foreign exchange and investment. From being the financial center of an empire, this method of financing turns the mother country itself into a dependent on foreign suppliers of financial capital. As Henry C. Adams noted,
The facts disclosed permit one to understand how deficit financiering, carried so far as to result in an interchange of capital and credit between peoples of varying grades of political advancement, must endanger the autonomy of weaker states unable to meet their debt-payments. Provided only that the interests involved are of sufficient importance to make diplomatic interference worth the while, the claims allowed by international law will certainly be urged against the delinquent states, and the citizens of such states may regard themselves fortunate if they succeed in maintaining their political integrity. (Henry C. Adams, Public Debts, An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 28-29.)Thus, in support of a "free market," the State imposes price controls through the central bank on the single most important input to production in a monetary economy, the cost of financial capital, and sells its sovereignty to the highest bidder. This is an excellent bargain for the financial markets, which make a profit every time financial capital is transferred, regardless of the source of the money. It is not, however, a very good deal for those engaged in production, propertyless workers, or even the State itself, which finds both its political as well as economic independence undermined.
Thus, the British in the 19th century did not acquire an empire "in a fit of abstraction" as has been asserted, any more than the American South seceded from the Union and fought a war to preserve a romantic and cherished way of life that was then "gone with the wind." Both the British Empire and American slavery were believed to be a very necessary support for the financial system and economic security for the power of the wealthy elite.
The "White Man's Burden" was not some kind of duty imposed on England to uplift native races in the colonies, any more than slavery was for the benefit of the black race, although some otherwise very honest and even admirable people believed so in each case. On the contrary, the burden consisted of the loads of gold and silver brought into England from the colonies to expand the money supply for economic development and growth, as well as the immense profits realized from the production of "King Cotton."
John Company
A graphic example will be useful to illustrate the effects of the system Bagehot described in Lombard Street. The inadequate concepts of money, credit, and banking — as well as of basic finance — that obtained in the British Empire were largely responsible for the failure of the intensive effort to develop India in the 1860s.
As a result of the Sepoy Mutiny of 1857, the British East India Company turned over administration of India to the Crown in 1858. Those areas controlled by the company had been run as a private business enterprise, somewhat along the lines that Bagehot believed that the English constitution presumably provided for Great Britain. Not unnaturally, this meant (consistent with Bagehot's orientation and analysis) that the "lower" orders were treated as unintelligent barbarians or children. The job of the company administrators was to take care of them . . . at a considerable profit.
Basic human rights of the native inhabitants were not a consideration. Consequently, whenever the company's private army had an opportunity to add territory to the company's raj (rule), it marched in and set up shop, both figuratively and literally — "John Company" was, after all, primarily a commercial venture.
This would not have been the sort of problem it turned out to be had ownership of the East India Company been vested in the inhabitants of India. As shareholders, they could have participated in the economic and social development of the subcontinent, received dividends, voted for the board of directors, and so on. The British corps of administrators could have had very lucrative management contracts, as well as providing mutually beneficial commercial services that profited both groups.
Instead, ownership of the East India Company was relatively restricted. While the inhabitants of India benefited to the extent that jobs were created (usually), and the civil administration provided by the company was, in general, better, more efficient, and certainly less corrupt than that they had enjoyed under their own rulers, the Indians were still a subject race. Their essential human dignity and personal sovereignty were offended at the most profound level, as was their pride. They were, after all, heirs of a civilization already ancient when the English were painting themselves blue and running around naked in the woods.
The Great Mutiny
While not possibly articulating the situation in those terms, a significant number of the inhabitants, especially native troops in some recently acquired territories, were disaffected in 1857. Certain incidents that could have been handled by treating complaints with respect were bungled and the situation trivialized after an initial overreaction. A prophecy that the company's raj would last for a hundred years (the company's first establishments were made in 1757) began to circulate.
Hindu and Muslim populations, which it was the company's policy to keep at loggerheads, cobbled together a temporary alliance, and northern India went into revolt. Europeans and Eurasians, men, women, and children, were massacred. British imperial troops were rushed to India after being pulled off-station throughout the Empire, and a modicum of peace restored after a bloody civil war. The British were helped not a little by the inability of the Hindu and Muslim troops in revolt to continue working together, and the shame felt by a significant number of the native troops at betraying their salt.
Direct Government of India
Soon after taking over direct administration of India, parliament decided to try and develop India economically. Bagehot made a number of allusions to this effort in Lombard Street, all of them approving. This is not surprising, inasmuch as the development program could have been following Bagehot's blueprint, or it may have been the Indian program that suggested the theories he embodied in The English Constitution and Lombard Street:
• Concentrated ownership of the means of production,The paucity of commercial banking facilities deserves special mention. The East India Company had established a few banks that made limited issues of paper currency, but most commercial transactions were internal company affairs. They thus required little more than bookkeeping entries. Currency — in the form of silver Rupees and their fractional parts issued by the company in the name of the British king or queen — was used chiefly to pay wages and salaries. Banking per se for the public at large was in the hands of village moneylenders.
• Power over India vested in the British House of Commons, (Helfferich, op. cit., 428.)
• Specie (predominantly silver Rupees with a scattering of gold Mohurs — 15 Rupees) (Depending on the price of gold and the political situation, a Mohur varied between 14 to 16 rupees. On September 15, 1899, the Mohur was made equivalent to the British Sovereign, .2354 ounces of gold, at 15 Rupees of 16d English each. (Helfferich, op. cit., 200)) almost the sole currency, (Ibid., 192,)
• An almost non-existent commercial banking system, forcing reliance on the Bank of England, (Ibid. 192, 428,) and
• Little if any of the benefits of development accruing to ordinary Indians.
Unfortunately, this state of affairs continued after the Crown took over the administration. When the decision was made to develop India, a commercial banking system does not appear to have been considered. The new royal (later imperial) Government of India began purchasing vast quantities of silver, mostly from the United States, Mexico, and South America (but also draining Europe of silver, especially Germany and Austria), (This played into the hands of the Prussian Chancellor, Otto von Bismarck, who was thereby empowered to manipulate the currency of Austria and the southern German states, by forcing changes back and forth between the gold and silver standard.) to mint into Rupees to finance development. (Helfferich, op. cit., 134, 192.) Minting began in 1862, and the series continued with the date "frozen" until 1874, when the British finally gave up the effort and threw in the towel. (Ibid.)
The Slavery of Past Savings — Yet Again
Many reasons are advanced for the failure to develop India economically. Often these take the form of rather lame excuses, e.g., the Indians were too backward, incapable of learning how to operate a modern economy, too fatalistic, didn't understand private property, etc., etc., etc. — all the usual suspects to excuse reliance on badly structured institutions and lack of respect for human dignity. The five bulleted points above, however, are probably more to the point.
Of most concern to us in this analysis is the reliance on specie instead of advanced financial instruments to form capital. From 1862 through the first half of 1874, the imperial mints at Calcutta, Bombay, and Madras struck a total of 706,912,179 Rupees, all dated 1862, using a total of 243,036,407 ounces of silver. (Numbers of coins struck and the amount of silver used are taken from Krause Publications' Standard Catalogue of World Coins.) This was a little under the estimated total world production during the period, and does not include the silver used for fractional rupees and minor coinage, which also used tons of silver. (Helfferich, op. cit., 134. 190-192.) This was achieved at a cost of approximately £84 million (c. $418 million) at the average price of silver between 1862 and 1874 (during which the price of silver reached historical highs) of $1.719 per ounce.
All of this silver had to be purchased out of existing accumulations of savings (tax collections or State borrowing) before any investment could even take place, thereby adding significantly to the cost of development before any capital was formed capable of generating a single Pie (1/192 of a Rupee) in revenue to repay the debt. This was sterile expenditure producing nothing, as Henry Thornton had pointed out in 1802. A currency expensive to produce, reliance on past savings, and exclusionary financial policies therefore virtually guaranteed that the effort to develop the subcontinent would come to nothing. The amount spent by the Government of India to purchase the material simply to provide the means to carry out transactions — that is, to manufacture the coinage — between 1862 and 1874 is objectively more than the Gross Domestic Product of some modern countries (admittedly, some very small countries; such is inflation and the great increase in government budgets) in today's Dollars, and of itself yielded nothing.
Further, the British managed to time their surrender perfectly to undermine the world market for silver, (Ibid.) the mainstay of most of the economies of Central and South America. This destabilized what little good government the countries of Central and South America enjoyed and shifted many of them away from mining and its ancillary industrial base to agricultural produce — the birth of the "Banana Republic." The market had already suffered a serious shock when German Chancellor Otto von Bismarck discontinued the millennia-old silver standard of Europe as a political move to establish and maintain Prussian supremacy.
This put the new German Empire onto the gold standard and forced the same on its chief political rivals: Austria-Hungary and France, as well as its chief trading partners, Scandinavia and Holland. France's indemnities to Prussia as a result of the 1870 war, paid largely in silver Five Franc pieces (subsequently melted and sold on a declining world market), finished off reliance on silver as the primary monetary metal in Europe.
This forced the price of silver down to previously unheard-of levels. The British abandonment of the attempt to develop India virtually destroyed the market, as China, the sole major remaining market for silver, couldn't possibly absorb booming world production and the existing supplies suddenly thrown on the market.
The Poverty of Past Savings
Ironically, the British stopped using silver just as it became more financially feasible to do so as a means of increasing the money supply, as silver went down from its historical high of $2.939 per ounce in 1864 to $0.970 in 1887. Silver fell to $0.590 in 1897, then to $0.487 in 1902, not getting above $1 again until 1918, when it reached $1.019, hitting a high of $1.336 in 1919 before falling to $0.655 in 1920, then $0.254 in 1932, not getting above $1 again until 1961 when it reached $1.033.
The weakness of the Bagehot's system is graphically illustrated by the fact that the British changed from the venerable "sterling" standard in 1921 when silver was at an all-time low, reducing the silver content of the imperial coinage from 92.5% silver to 50.0%. Half silver is, technically, not considered "silver" at all, but "billon," being at least 50% other metals. The reason? The tax base had eroded to the point where the government could no longer afford purchases of precious metal to waste on the coinage.
Appropriate use of a commercial banking system backed up with a properly run central bank that opened up opportunities for widespread ownership of the means of production would have maximized the possibility of success in the economic development of India in the 1860s. Unfortunately, while some systems have been established along lines consistent with classic banking theory, central banks and banks of issue have generally been subverted to meet political ends as well as serve the special interests of the financial elite. Lombard Street described such a system implemented in one of the most, if not the most important financial centers in the world in the latter half of the 19th century.
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