Back in the late seventeenth century, the first true central bank was established, the venerable Bank of England, “the Old Lady of Threadneedle Street,” as it is more or less fondly known. Usually it is less these days as the Old Lady, along with virtually every other central bank in the world, gets ever-further away from its mission.
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| Founding the Bank of England, 1694 |
And that mission? To provide adequate liquidity or “accommodation” for industry, agriculture and commerce. No, not financing government. That was not the original intent. Central banks got into the financing government game as the result of what might be termed an accident of history.
It seems that when the “merchant adventurers” who organized the Bank of England as a commercial bank for commercial banks, they needed a royal charter in order to do business. And that could only come from parliament, to be signed into law by the king.
It so happens, however, that the government of King William of Orange was (as seems to be chronic with kings and queens and governments) a bit short of cash. Make that a lot short of cash. Parliament found out about the £1.2 million in specie (gold and silver) contributed — “subscribed” — to the bank’s coffers to serve as reserves to meet the bank’s obligations for which there were no offsetting balances.
Parliament offered the organizers of the Bank of England a deal they didn’t dare refuse if they wanted to operate legally — or at all. The government would grant the bank a twenty-year charter on condition that the bank sell its £1.2 million in gold and silver to the government in exchange for “government stock” (debt paper, a.k.a., bills of credit).
Okay, technically the bank purchased the “government stock” with its £1.2 million in specie, but let’s not dress it up any. In reality, the government bought gold and silver and paid for it with pieces of paper that were worth whatever the government said they were worth.
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| "The New Coinage" of 1816 |
Over time, it got worse. Handling the government’s debt gradually became the bank’s most important business when it wasn’t even supposed to have anything to do with government. As a result, England went through a century and a half of currency crises and financial panics, including the Panic of 1825, that kicked off the modern business cycle. And that less than a decade after the “New Coinage” was supposed to solve England’s financial problems for good.
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| Bank Charter Act of 1844 |
Then came the Bank Charter Act of 1844. Since its founding, the Bank of England had managed to retain some semblance of its original mission, viz., providing the private sector with sufficient liquidity to finance industry, agriculture, and commerce.
In 1844, however, the new bank charter forbade the monetization of private sector “real bills,” and limited the amount of currency that could be supplied backed by government debt. The rest of the money supply would presumably be supplied by the importation of gold.
There was a loophole for the rich, though. Commercial banks backed up by the Bank of England could still create money by accepting bills of exchange and mortgages (no, not home mortgages) and creating demand deposits. In some circles today, the debate continues as to whether demand deposits — checking accounts — are “real” money, or just a “money substitute,” but that is not important for our discussion today.
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| The Economic Dilemma puts you . . . well . . . |
What is important is that new capital formation became irrevocably linked to the myth of past savings. That is, the belief that the only way to finance new capital formation is to cut consumption and accumulate money savings, or borrow from someone who has accumulated money savings.
Thus was born “the economic dilemma.” This can be stated most simply in this way:
· If you save to invest in new capital, demand falls to the point where the new capital isn’t needed because there is not enough demand.
· If, however, you spend instead of saving, there is enough demand to justify financing new capital . . . but not enough savings to finance it!
That is, if you assume that all savings must come from restricting consumption in the past.
If, however, you rethink saving and realize that savings can also come from increasing production in the future, the so-called economic dilemma solves itself. Instead of turning unconsumed production from the past into money to finance new capital, you turn not-yet-produced consumption in the future into money.
This is, in fact, what commercial and central banks were invented to do: create money backed by future production, and cancel the money once the new capital becomes productive and the goods and services produced are sold and consumed.
It was not to finance government or any other type of non-productive spending.
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