Even the unreformed Ebenezer Scrooge probably understood money, credit, banking, and finance better than most people today, and certainly better than the monetary mavens of his day. Proving that two wrongs don’t make a right, the experts of Scrooge’s day were responsible for undermining the exclusionary and elitist, but theoretically sound, financial system that existed prior to the British Bank Charter Act 1844 (7 & 8 Vict. c. 32).
This is important because, as we saw in the previous posting on this subject, “money” is in its essence a social tool that allows me to trade what I produce for what you produce, to the benefit of both of us. In theory, anyone who can produce can create money, and “uncreate” money by making good on the promises he makes by delivering what was promised.
If the money system is managed that way — i.e., creating money as needed and cancelling it when it is not — there need be no inflation nor deflation, and the currency can be uniform, stable, and asset-backed. Commercial (mercantile) and central banks were invented to do precisely that, in fact. How they got into money creation for government is an accident of history, although some prefer to think of it as a conspiracy. The truth is actually much more interesting (and, duh, truthful).
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| Is this a Bank Holiday? |
We could speculate forever on what any fictional character would have done had he been as smart as we are or willing to become our creature rather than that of the original author. We speculate, however, that Scrooge, who first saw the light of day and was visited by the spirits late in 1843, would have looked askance at the British Bank Charter Act of 1844, which changed the entire “philosophy” of money with which he would have been familiar.
That requires more than a little explanation. For about half a century before the publication of A Christmas Carol, two different concepts or philosophies of money struggled for ascendancy. Both had been around from the dawn of civilization, but things hadn’t really heated up until the coming of the Man of Destiny and the need to finance the type of total war that came with the Napoleonic Era.
The British government needed money fast to stop the Little Corporal, and because the tax and ownership base of society had been eroding for the prior three centuries or so (and accelerated greatly with the Industrial Revolution), had little chance of being able to raise it through taxation. Instead, they decided to use the old standby, borrowing . . . but with a significant twist. To understand the twist, however, requires a little backstory.
A century or so before the Napoleonic Wars, a group of “merchant adventurers” got organized to implement a brilliant idea — a bank for banks! Under commercial or mercantile banking theory, a commercial bank can create money if there is something of value to back it. A borrower brings a proposal to a commercial bank in the form of an offered contract. This can either be a contract based on goods or some form of wealth in the borrower’s possession that he wants to turn into money, or a project that he reasonably expects to generate the cash needed to repay a loan, should the bank agree to make the loan.
If everything checks out and the borrower has collateral (other wealth that can be seized if the borrower cannot or doesn’t repay the loan), the commercial bank issues a promissory note to “accept” (buy) the offered contract. These days the promissory note is used to back a demand deposit (checking account), but in the old days a bank could actually have some banknotes (now you know why they’re called that) printed up and handed over to the borrower.
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| Napoleonic Era British £1 Note |
The demand deposit or the banknotes were not created out of nothing, of course. They could only be created (if a demand deposit) or issued/reissued (if banknotes) when backed by a promissory note which was backed by a contract called a bill of exchange or mortgage. Banknotes issued by the bank that were brought to the bank and deposited in someone’s account were considered to be still in circulation and could be used by the bank in daily transactions.
Banknotes issued by the bank that were brought to the bank to repay the principal on a loan made by the bank were cancelled or put into a special holding account (sort of like treasury stock) to be reissued only when the bank made another loan (why print up new banknotes when the old ones are still serviceable?). The amount of the repayment consisting of interest on the loan or the discount (what some erroneously call “imputed interest”) represented the bank’s revenue and was not cancelled or put into the special holding account even if it was in the form of notes issued by the bank.
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| Williamandmary, needed cash. |
That’s the theory, anyway. Unfortunately, back when the Bank of England was established, it required a royal charter that could only be granted by parliament and then only if given the royal assent . . . and the government of William and Mary was in desperate need of cash, as usurping governments usually are.
The merchant adventurers who organized the Bank of England had collected £1.2 million in specie (a fancy way of saying “gold and silver”) to capitalize the project and provide adequate reserves. The British government wanted the cash and agreed to charter the Bank if the Bank would “lend” (a nice word for “allow funds to be extorted semi-legally”) the cash, with the loan secured by “government stock,” i.e., government bonds. To provide reserves, the Bank was permitted to issue banknotes backed by the government debt.
At least the government debt held by the Bank of England represented actual hard assets that the government owed the Bank. If push came to shove, the Bank could meet its obligations by selling the government debt to someone, who thereby became the creditor of the government.
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| "Did you get my good side?" |
The problem was that it legitimated using government debt as an acceptable backing for the currency. In the minds of many people today, government debt is the only allowable backing for the currency, an idea that came in with the Bank Charter Act of 1844, as we will explain presently.
Now comes the real twist that has wreaked utter havoc on the global financial system down to the present day. As we noted above, the British government needed a lot of money very quickly to finance the war against Napoléon Buonaparte. Since it had used government debt before to raise money, why not do so again? Consequently, parliament authorized massive borrowing to finance the war effort.
Slight problem: there are two kinds of government debt, corresponding to the two types of money. And the two types of money? There is “past savings money” representing existing assets in the possession of the issuer, the contracts for which are called “mortgages.” The banknotes backed by the government stock representing the £1.2 million “borrowed” from the Bank of England by the British government (okay, the English government; it wouldn’t be the British government until the Acts of Union in 1707) in 1694 was this type of government debt. It came from borrowing existing or past savings.
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| Irving Fisher |
There is also “future savings money” representing the present value of assets that the issuer reasonably expects to have in his possession when the contract is presented for redemption or fulfillment but are not yet in his possession. The contracts for future savings money are called “bills of exchange.”* When emitted (not “issued”) by a government, bills of exchange are called “bills of credit” and are backed by the future savings represented by the taxes that the government hopes to collect in the future.
In other words, bills of credit do not represent savings at all, because the tax monies that back them are not in the possession of the government and may never actually materialize. Bills of credit are also called “anticipation notes” because by emitting them a government is anticipating future tax revenues, i.e., living beyond its means by creating money out of thin air, a procedure that a century or so later the economist Irving Fisher would call “legal counterfeiting.” It was this type of debt that the British government used to finance the Napoleonic Wars and help convince people that only government debt could back the money supply.
* Explanatory note: most people today understand “bill of exchange” as a “bill of foreign exchange,” which is not a true bill of exchange at all but a type of bank draft that nowadays doesn’t even have to be dealing in foreign exchange! Depending on the context, then, “bill of exchange” may refer to either a future savings contract, or a past savings contract.
Of course, there is more to the story than financing the Napoleonic Wars, as we will see in the next posting on this subject.
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