THE Global Justice Movement Website

THE Global Justice Movement Website
This is the "Global Justice Movement" (dot org) we refer to in the title of this blog.

Wednesday, September 2, 2009

Some Thoughts on Money, Part IV: Background of the Great Gold Gabfest

In Great Britain in the 18th century, there were both banks of issue and banks of deposit. To confuse matters, however, not only did most people then tend to think of all banks as banks of deposit, today's economists and other experts also have a strong tendency to make the same mistaken assumption. In addition, people thought — and still think — that banknotes were supposed to be backed 100% by gold. If not, there was some kind of fraud involved.

What really backed the banknotes, of course, were the loans made by the bank that represented actual assets with a defined value in terms of gold. That is, a bank of issue might make a loan for £1,000, and take a lien on a factory, mine, or a farm worth £2,000. This would give the bank's notes or demand deposits "double" security. It wasn't too unusual for a banknote with a face value of, say, £1, to pass for more than £1 in gold if the public was aware that the bank that issued the note had a reputation for taking only good security for the loans it made. Of course, if a bank had a bad reputation, the banknotes it issued might be worth much less than the face value of the note in gold. (Of course, this example ignores the fact that banknotes with a face value of less than £5 were prohibited in England after 1765.)

Typically, however, banks of issue would not stop at backing their banknotes and demand deposits with liens on items of present value, but also back a portion of each banknote or demand deposit with gold as well as other assets. Thus, a conservative bank of issue's banknotes and demand deposits might be backed 200% with assets other than gold, plus 25% in gold, making each £1 it issued "worth" £2, 5s (a "shilling" was 1/20 of a pound, so 5 shillings or 5s was 25% of £1). Most checks and banknotes, however, were not redeemed in gold, but by settling the debt by means of which the money was created in the first place. Before the first clearinghouse was established in England in 1773, this was done through direct inter-bank transfers, large banks, or a consortium of banks filling the same function that clearinghouses later filled. In the 18th century, this was primarily banknotes as well as the checks that constitute the bulk of the business of today's clearinghouses.

Unfortunately, in the laissez faire atmosphere of the 18th century (that is, laissez faire when it suited the plutocracy to be left alone, i.e., until they needed the State to enforce some demand or other), there seems to have been an underhanded financial trick that large banks used to play on smaller, independent banks. If we understand Adam Smith's analysis in The Wealth of Nations (1776) correctly, larger banks or financial consortiums would sometimes take or create the opportunity to destroy a smaller rival. Large banks would hold back banknotes issued by an independent small bank until they had accumulated more than the independent bank was believed to have in gold reserves.

These banknotes would be presented all at one time and, instead of being used to settle or purchase the independent bank's outstanding loans (the basis on which the banknotes had been issued), would be used to demand gold. The independent bank would thereby be forced into bankruptcy, and the larger bank(s) would pick up the independent bank's outstanding loans for a fraction of their true value. This sort of thing also happened in Europe and, later, in the United States under the state banking system that was in place prior to the National Bank Act of 1864. Even as late as the early 20th century J. P. Morgan used a variation of this "liquidity duel" to cause a run on the Knickerbocker Trust by suspending the Knickerbocker's clearinghouse privileges, thereby precipitating the "Panic of 1907."

In Scotland, under the "free banking system," banks were allowed to suspend convertibility of their banknotes into gold on a temporary basis, in part to prevent this from happening. Naturally, this did not sit well with the financial powers-that-were in London who did not like such interference in "free trade." Therefore, even a temporary suspension of convertibility of banknotes into gold was outlawed in 1765, which also prohibited the issuance of banknotes below £1. In England, this was raised to £5 a few years later, although kept at the lower denomination in Scotland.

Then came the French Revolution. In 1797 a rumor swept through England that the French had landed an invasion force, and people rushed to their banks to withdraw all their funds in gold. Reserves got so low that the government permitted the Bank of England temporarily to suspend payment of its banknotes into gold. The temporary measure lasted for more than two decades, and convertibility was not restored until 1821.