The Triumph of the Currency School
As we have seen, however, the stated purpose of the Bank of England was undermined from the start when the government borrowed the Bank's capitalization, replacing the gold and silver with government securities. The effect was to transform that portion of the Bank's reserves from assets to debts. Money and credit became viewed as commodities, a change in understanding from money and credit as the medium of exchange and the store of value.
Much of the monetary confusion rampant in the 18th century can probably be traced to this change in understanding. Previously there had been problems over the centuries with maintaining convertibility between gold and silver as the ratio of gold to silver changed. To this was now added the various paper currencies. A commercial bank's notes would not necessarily pass at par with gold or silver. Sometimes a bank's note would pass at a premium or a discount in terms of gold and silver, being worth more or less than the face value of the note when exchanged for specie. It was even possible at times that a banknote would, say, pass at a premium in terms of gold, but a discount in terms of silver. Viewing money and credit as a commodity, it could have a different value depending on whether you were measuring in terms of gold, silver, or the hundreds of individual commercial banks, each with its own paper currency.
Even the establishment of the Bank of England did not really help the situation. All it did was reduce the number of commodities in terms of which the money supply was measured to three: 1) Gold, 2) Silver, and 3) Bank of England notes. Bank of England notes were made the standard for paper currency by making the individual issues of commercial banks convertible either into gold directly on demand at the bank that issued the note, or by making the individual bank's notes convertible into Bank of England notes, which were convertible into gold on demand.
Money Manipulation and Social Disorder
The Currency Crisis of 1797 "solved" the problem of the difference in value between the paper currency and gold by ignoring it, making the "paper pound" subsidiary to gold, and passing at a discount to the guinea and, later, the sovereign. Great Britain solved the problem of the differential between gold and silver by demonetizing silver with the "New Coinage" of 1816, making silver subsidiary to gold. After 1816, despite the fact that silver coins contained substantially less than the face value in terms of gold, each coin was redeemable at the face value in gold.
The problem was then what to do about the paper currency. Within the Currency School paradigm, the only answer was to deflate the paper currency, thereby raising its value in terms of gold until the value of the paper pound and the sovereign (the gold pound) were equal. This caused a great deal of distress among the poor and the farmers and small businessmen. Prices fell. Many people found themselves having to repay loans of "cheap money" with extremely "dear money," e.g., a farmer would have to grow three bushels of wheat to repay a loan worth only one bushel of wheat when the loan was made.
All of this would have been impossible under a financial system operated under the principles of the Banking School. Had the money supply been tied directly through private property to the production of marketable goods and services through the operation of the real bills doctrine, prices would have reflected the actual "real" value of the goods and services in terms of whatever commodity had been selected as the standard of value, in this case, gold. There would be no question of inflation or deflation.
This is because the money supply, linked as it would have been directly to the present value of existing and future marketable goods and services, would have expanded and contracted with increases and decreases in the present value of existing and future marketable goods and services in the economy. The result would have been a stable price level, affected only by actual increases or decreases in marketable goods and services relative to the real demand for them.
The Bank Charter Act of 1844
The motives of the Bank Charter Act of 1844 were good. The goal was to get a handle on the unrestricted issue of notes by the Bank of England and, through that body, control inflation and guard against deflation. Unfortunately, the means by which this was accomplished was to embed the erroneous principles of the Currency School into law, and discredit (at least in legal and academic circles) Say's Law and the real bills doctrine.
Andrew Jackson's Specie Circular of 1836 had caused a depression in the United States and a recession in England. According to Sir Robert Peel, this was due to the drain of gold out of the Bank of England for transfer to investments in America. This was, however, only half true. The "investment" was to trade overvalued gold for undervalued silver, thereby making a speculative profit off the arbitrage between the two metals. The gold drained out of England was replaced with silver drained from the United States.
As we have seen, however, Great Britain was now on the gold standard. The export of gold and its replacement with silver resulted in a serious deflation of the money supply, which caused the recession.
This was because the Bank of England refused to increase the amount of paper in order to make up for the dearth of gold. Fortunately, the country banks were still able to supply the economy outside London with sufficient liquidity by discounting bills of exchange and issuing banknotes to purchase the bills. London, however, was the financial center, so a decrease in the money supply that was limited to London, served by the Bank of England, meant a recession instead of a full-blown depression.
Conditions in England resulted in the Whigs being voted out of power, and in the installation of Sir Robert Peel as Prime Minister. As a result of the economic situation, there had been a complete rejection of the real bills doctrine among politicians. Subsequent historians have accused these "public men" of having "only a rudimentary knowledge of political economy." (Conant, op. cit., 119.) Regardless of such individuals' expertise or lack thereof in the science of finance, the presumed discrediting of the real bills doctrine became embedded in "mainstream" economics. This is in spite of the inherent contradiction involved in rejecting the real bills doctrine and accepting the quantity theory of money.
This, then (at least in broad strokes) was the situation that led up to the Bank Charter Act of 1844 (7 & 8 Vict. c. 32). The basic tenet of the Currency School, led by Sir Robert Peel, Lord Overstone, and Colonel Torrens was that "money" is a commodity instead of a symbol of the present value of other commodities. Money, which is thus restricted to officially issued coin and banknotes, represents unconsumed past production accumulated in the form of savings. Issuing banknotes is thus, in and of itself, the primary cause of inflation. As Charles Conant described the situation,
This doctrine embodies the ideas that bank-notes are a form of currency entirely distinct from other commercial paper and forms of credit; that an expansion of bank-note issues, even when redeemable in coin on demand, is a potent cause of commercial crises; and that the way to prevent crises is to place fixed limits upon bank-note issues. (Conant, op. cit., 119-120.)The three main provisions of the Act were to 1) separate the issue department from the banking department, 2) prohibit issues of banknotes by institutions other than the Bank of England, (Scotland was exempted) and 3) limit the issue of banknotes to £14 million backed by government bonds plus an unlimited amount if backed 100% by gold coin or bullion. (Conant, op. cit., 121.)
The Legal End of Commercial Banking
The separation of the issue department from the banking department was, from the perspective of the Banking School, a disaster. It transformed the Bank of England from a central bank of issue, into a bank of deposit by taking away its power to issue promissory notes in the form of banknotes to discount and rediscount bills of exchange. Henceforth, all discounting and rediscounting of private sector commercial paper would be financed out of the Bank's capitalization and deposits.
That was the theory, anyway. The Act left a loophole, however, large enough to keep the economy running. The framers of the Act failed to define demand deposits or anything other than coin and Bank of England notes as "money." The Bank of England and the other commercial banks around the country could still issue promissory notes to back demand deposits. This is why, to this day, the use of personal and business checks is more common in the United States and Great Britain than in other countries.
Private sector money consisting of bills of exchange and demand deposits backed by discounted and rediscounted bills of exchange (a check is actually a form of bill of exchange, as is a promissory note) thus continued to be asset-backed. This was, in fact, how both Great Britain and the United States financed their phenomenal economic growth in the 19th century. Had the formation of new capital depended on existing accumulations of savings to supply the financing, economic growth would have ground to a complete halt, and quite probably regressed dramatically.
An Inelastic Currency
The provisions of the Bank Charter Act of 1844 limited the paper currency to £14 million, with any increase coming from an increase in the supply of gold. Not surprisingly, there were periodic currency crises, caused primarily by a shortage of small denomination banknotes when insufficient gold was brought into the country. The "Issue Department" of the Bank of England was, to all intents and purposes, a branch of the government, as Lord Overstone claimed. (Lord Overstone, The Evidence Given By Lord Overstone on Bank Acts. London: Longman, Brown & Co., 1858, 143.) Instead of being a bank of issue for the private sector and a bank of deposit for the State (as originally intended), the Bank of England was now exactly the opposite: a bank of deposit for the private sector, and a bank of issue for the State.
Economic and financial stability thereby required that the amount of money be strictly limited. This is because in the Currency School paradigm, money is purely a commodity. The difference between the cost of the currency and the face value (contrary to the rights of private property and common sense) represents not a liability on which the issuer of the currency has to make good, but a profit. (Ibid., 151.) All Bank of England banknotes not backed by gold were to be backed by government debt. The only question was how much debt could the economy absorb without causing too much inflation. The Act set this amount at £14 million, prohibited all banks except the Bank of England from issuing banknotes, and all subsequent debate centered on whether this was too much, or not enough.
Prohibiting any financial institution except the Bank of England from issuing banknotes had the advantage of imposing a single uniform currency on the country. The problem was that another commercial bank could only purchase banknotes from the Bank of England if it needed cash to meet its transactions demand. The banknotes could not be obtained by discounting commercial paper directly, for the notes by law now had to be backed either by gold or government securities.
Instead, a commercial bank would either purchase Bank of England notes out of its reserves — meaning gold — or sell commercial paper to the Bank of England banking department, which would create a demand deposit to purchase the paper. The commercial bank would then turn around and write a check to the Bank of England issue department to purchase banknotes or gold — a sleight-of-hand that preserved the outward forms of deposit banking in order to carry out issue banking within a system that didn't recognize it.
Limiting the issue of banknotes to £14 million also had a disastrous effect on the perception of the role of credit and how it operates. Credit was now officially and legally construed as something extended exclusively out of existing accumulations of savings — a commodity. Creating money by extending credit for financially feasible capital projects that paid for themselves out of future earnings — the real bills doctrine — became an alien concept, far outside the scope of official or academic recognition. The real bills doctrine did not fit into the erroneous idea of credit as being solely based on existing accumulations of savings, so it was now considered "discredited." As one authority described the logical outcome of this mindset,
The principle of issuing notes covered by other securities than coin, within the safe maximum limit of the amount which can be kept permanently in circulation, is a simple and intelligible banking principle, and indeed the principle upon which modern banking is founded. The declared purpose of the act — "to cause our mixed circulation of coin and bank-notes to expand and contract, as it would have expanded and contracted under similar circumstances had it consisted exclusively of coin," — also seemed simple and intelligible to those who ignored the existence of credit and the domestic causes which made a larger circulation desirable at some periods than at others. The Act of 1844 proposed substantially to destroy the bank-note as an instrument of credit and make it a mere certificate of coin, leaving to other forms of commercial paper the functions which the bank-note had in part performed. (Conant, op. cit., 122.)Thus, the chief effect of the Bank Charter Act of 1844 was to convince people that "money" consisted exclusively of existing accumulations of unconsumed production, eliminating any idea of the present value of a future stream of income.
The Banking School Responds
The views of the "Currency School" did not pass unopposed, however. A year after the passage of the Act, John Fullarton wrote a mocking and acerbic critique of the beliefs of the powers that had pushed through the Act, Regulation of Currencies of the Bank of England. (London: John Murray, 1845.) Fullarton's main point of attack was the belief of the Currency School that only gold or Bank of England banknotes fully convertible into gold or backed by government debt paper constituted "real" money.
As far as Fullarton was concerned, the term "money" signified anything by means of which "transactions of purchase and sale may be conveniently and economically adjusted, without any interchange whatever of actual value, whether intrinsic or factitious." (Ibid., 29) This definition includes gold and silver coin. This is because gold and silver coins are not — as money — exchanged to convey the actual precious metal, but to transfer claims on the value of the goods and services that the medium of exchange is used to purchase. That is, consistent with the legal definition of money down to the present day, money is anything that can be used in settlement of a debt.
Fullarton then pointed out that the belief that only gold and Bank of England banknotes were "real" money was the cause of a serious embarrassment for adherents of the Currency School. If "money" conveys value irrespective of the material of which it is made, and thus banknotes are included in the Currency School's definition of "money," then,
you cannot, therefore, include the bank-note under the generic designation of money, without finding yourself immediately embarrassed by the claims of bills of exchange, bankers' cheques, and a variety of other typifications of the same principle of credit, all of which being more or less competent to perform, and, in point of fact, performing the functions of money, and some of them on a scale of vast extent, have primâ facie just the same pretensions to be rated as money which bank-notes have. (Ibid.)Of almost greater importance to this clarification of the concept of money and its relation to credit, however, was a remark Fullarton threw out in passing to make a different point altogether. He stated, "Wise men have pronounced, that movements of price or exchange are determined solely by the quantity of 'money' in circulation." (Ibid., 32.)
Whether he meant to or not, Fullarton thereby revealed how understanding of the quantity theory of money had decayed since the days of Henry Thornton. In the standard formula, M x V = P x Q, focusing solely on M, the quantity of money in circulation (and by extension V, the velocity of money), and the effect that changes in the money supply have on the price level, P, the supply of marketable goods and services produced, Q, becomes regarded as a de facto constant. Eventually, instead of being recognized as the chief variable from which all the others are ultimately derived, Q is disregarded altogether except as a way to make the equation balance.
It is difficult to overestimate the effect that this narrow view of the quantity theory of money has had, particularly with respect to the real bills doctrine, and thus the whole theory underlying banks of issue and central banks. By ignoring the critical link private property between the money supply and the quantity of marketable goods and services produced and sold, production becomes first a given, then irrelevant. Holding Q as a given or a constant necessarily leads to the conclusion that all new money issued — regardless whether it is paper or even gold and silver — is automatically inflationary.
As a result, the real bills doctrine — that holds that new money can be created without inflation if backed by the present value of existing or future assets — is presumably discredited, precisely as we read in modern economics texts, when it is mentioned at all. Consequently, the idea that money can be created at will if backed by the present value of existing and future inventories of marketable goods and services is treated as an irrational fantasy. Financing of capital becomes locked into dependence on existing accumulations of savings, for anything else must be an illusion.
What became the three main schools of economic thought — the Keynesian, Monetarist, and Austrian — trapped themselves into endless arguments about the best way to deal with money and credit within the system dictated by the Currency School, all the while ignoring the real issue: what is money? By using an incorrect definition of money, all three schools were forced either to reject or redefine Say's Law of Markets, and reject the real bills doctrine, evidently without even realizing that the real bills doctrine is simply the application of Say's Law. It is as if an Abolitionist and a slave owner argued endlessly over the treatment of slaves versus the treatment of free workers (which they did), or the economic necessity of slavery (vide Christy, infra), yet never once debating whether slavery was moral.