Different Types of Banks
Before we can begin, however, we must briefly define our terms. This is necessary due to the fact that the terms, while in common use, have very fluid meanings. How these terms are understood often depends more on political needs than financial or economic factors. Consequently there are no standard definitions, and the terms "national bank" and "central bank" are often used interchangeably. For convenience, we will use the following definitions.
A "band of deposit" or deposit bank is what most people think of as a bank. A bank of deposit is defined as a financial institution that takes deposits and makes loans. It functions as an intermediary between savers and borrowers, facilitating the process and, in general, making the market work more efficiently by putting "idle" funds to work.
In contrast, a "commercial bank" is a financial institution that takes deposits, makes loans, and issues promissory notes. As a type of bank of issue or bank of circulation (the terms are usually considered interchangeable), a commercial bank can create money. When done correctly, the money created by a commercial bank, whether in the form of banknotes, demand deposits, or bills of exchange, is backed by the present value of existing or future marketable goods and services.
A "national bank" is a financial institution that, in its purest form, serves as a bank of deposit for the State. In this capacity it regulates the national currency and sets the standard of value. A national bank may also function as a commercial bank with the power to create money for private sector industry, commerce, and agriculture, but should be prohibited from creating money for the State. Allowing the State to create money, either directly by issuing treasury bills and notes, or indirectly, by selling its debt paper to a commercial, national, or central bank circumvents the controls imposed on the State by direct taxation and the required consent of the governed, substituting the "hidden tax" of inflation.
A "central bank" is a "bank for banks." A "true" central bank functions as a national bank with respect to the regulation of the national currency and the standard of value, and as a bank of issue for commercial banks. A central bank differs from a national bank in that a central bank has the power to create money specifically for other banks. A central bank may also function as a commercial bank and serve private sector businesses directly, but this tends to obscure its special character as a bank for banks, and inserts a conflict of interest. In common with a national bank, a central bank should be prohibited from creating money for the State, although serving as a depository for State funds is a legitimate and necessary function of a central bank.
The Founding of the Bank
The ostensible reason for the establishment of the Bank of England, as with previous banks with a national character, was to facilitate trading in bills of exchange. The difference was that the Bank of England was established as a bank for bankers — the essence of a central bank.
The Bank of England was capitalized in the usual way. It was organized as a joint-stock company with the subscribers paying in accumulated savings in the form of specie, that is, gold and silver coin and bullion. With its power to discount and rediscount bills of exchange, however, the Bank — if successful — would make the mercantile classes almost completely independent of the executive ("the Crown") and thus put that wealthy financial elite in total control of the country. The problem, however, was that in order to obtain a royal charter, the organizers had to placate the new king, William of Orange.
William had come to the throne as the result of the "Glorious Revolution" of 1688. He was still widely regarded by many of his new subjects as a usurper. Further, William was fully aware that he was king only at the sufferance of the increasingly powerful commercial classes who controlled the House of Commons. These, by and large, had gained their fortunes in the new society created out of the wreckage of Henry VIII Tudor's break with the Catholic Church.
Consequently, the State in the person of William was, as had become usual in England and throughout the rest of the world, in continual need of money. With the Stuarts, the parliament had learned the tremendous power associated with controlling the purse strings. The House of Commons meant to keep the king on a short rein — with the threat of a short reign, if necessary.
The Slavery of Savings
Before the Bank of England was founded, virtually all new capital formation had to be financed out of existing accumulations of savings. This is a slow and laborious process, requiring cutting consumption. This, paradoxically, slows the process of capital formation even further by reducing effective demand in the economy, and is believed (erroneously) to require concentrated ownership of the means of production in order to finance new capital. (Vide Moulton, The Formation of Capital, loc cit.)
Further, savings were inevitably in the form of gold and silver coin. The mint right was a long-established monopoly of the Crown. It was, however, a monopoly exercised under the watchful eye of a parliament that feared — rightly — even this truncated power to create money in the hands of the executive. Charles I Stuart had, after all, managed to carry on a long and devastating war half a century before by being able to coin money. Henry VIII Tudor had almost ruined the country by using his royal prerogative of striking coins and his near-legendary debasement of the currency to control England and Ireland politically and economically.
In consequence, ownership of the means of production was highly concentrated in England, even at the dawn of the 18th century. The common people had largely been stripped of ownership of land as a result of the Reformation, and ownership concentrated in the hands of the aristocracy. The rising commercial classes, which had gained great economic as well as political power during the Civil War, already controlled most of the non-agricultural trade in the country. An institution like the Bank of England, with its discount power and thus control over the means of acquiring and possessing private property in the means of production, would concentrate ownership of the growing commercial interests even further in fewer and fewer hands. This would mean the virtual negation of the power of the Crown.
Reasserting Royal Power
As noted, however, William had one arrow in his otherwise empty quiver. Organizing as a corporation could only be carried out with explicit royal approval. It was, after all, the creation of an "artificial person," and thus required what amounts to a grant of citizenship — personality — in order to have a social and legal identity. In order to obtain its charter, the bank had to agree to lend the full amount of its capitalization immediately to the Crown. In exchange, the bank received "government stock," as the floating debt of the State was then termed.
There were not a few advantages to this arrangement. Bank of England notes were thereby backed not primarily by the value of the commercial paper that private merchants and bankers brought to the bank for discounting, or even gold and silver coin and bullion, but by the full faith and credit of the English Crown. The Bank of England thereby acquired the character of a national bank, rather than remaining a purely private venture. The Bank of England would henceforth be the chief agent for handling the financial business of the English (to be known about a decade later as the British) government.
Plus, by backing the note issues of the Bank of England with government debt and making it the chief agent of the government, the notes of all other commercial banks that rediscounted their bills at the Bank of England would pass at par with those of the Bank of England. This, in effect, established a common paper currency throughout England. Parity with the gold and silver coinage was to be maintained by requiring that the banknotes be convertible on demand into gold.
How to Debauch a Currency and Destroy Liberty
Unfortunately, the disadvantages of this arrangement were even greater. It is a fundamental principle of internal control in a business that functions must be separated, e.g., those who authorize the disbursement of funds must not be the ones who actually have custody of the funds and make disbursements. Backing the note issues of the Bank of England with government debt tied private and public interests together in a sort of proto military-industrial complex. This eventually led to the elitist anti-democratic ideas expressed by Walter Bagehot in The English Constitution (1867).
In addition, giving a commercial bank the power to create money for non-productive purposes — especially for the State, which has a monopoly on the instruments of coercion — is the same as permitting the State to raise money at will, bypassing the taxation and appropriations process. This is extremely dangerous, for it gives the State enormous power by avoiding the normal checks and balances built into the system. As Henry C. Adams observed,
As self-government was secured through a struggle for mastery over the public purse, so must it be maintained through the exercise by the people of complete control over public expenditure. Money is the vital principle of the body politic; the public treasury is the heart of the state; control over public supplies means control over public affairs. Any method of procedure, therefore, by which a public servant can veil the true meaning of his acts, or which allows the government to enter upon any great enterprise without bringing the fact fairly to the knowledge of the public, must work against the realization of the constitutional idea. This is exactly the state of affairs introduced by a free use of public credit. Under ordinary circumstances, popular attention can not be drawn to public acts, except they touch the pocket of the voters through an increase in taxes; and it follows that a government whose expenditures are met by resort to loans may, for a time, administer affairs independently of those who must finally settle the account. (Henry C. Adams, Public Debts, An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 22-23.)Allowing the State to finance its operations without being directly accountable to the citizens through taxation is one of the surest ways to establish and maintain tyranny — to say nothing of effectively abolishing private property. Money and credit are the primary means to acquire and possess private property in the means of production. Money is also a claim on the present value of all existing and future marketable goods and services in the economy — which ordinarily must back all money and be directly linked to it through the institution of private property in the means of production that generate marketable goods and services. Ownership of the means of production is, in turn, the chief protection for life, liberty, and all other fundamental human rights.
Formerly, the only thing holding back the power of the State to inflate the currency was access to the supply of precious metal and how fast the government dared to decrease the amount of gold and silver in the coinage. With the addition of paper money, the inflation rate could proceed at a much faster rate. Now that money can be created electronically, of course, there is no effective limit to the rate at which the currency can be inflated. One witness to this is the increasingly wild swings in the stock market in recent years as money is created virtually at will for speculation and gambling on the secondary markets and to finance massive government spending.
Of course, neither paper money nor electronic money is inherently any more inflationary than gold, silver, or any other medium. The key to a stable currency or money supply that is neither inflationary nor deflationary — an "elastic currency" — is to tie all money creation to the present value of existing and future marketable goods and services with private property.
The problem is when the State — or anyone or anything else — gains control over or access to money and credit in any way that allows money creation without a preexisting private property right in something that has a definable and secure present value. When the State gains access to the money creation powers of the banking system, accountability to the citizens diminishes and sometimes disappears altogether. This lays the groundwork for tyranny as well as effective socialism. It is, to all intents and purposes, taxation without representation.
The Privileges of the Bank of England
On the strength of its massive loan to the State, the Bank of England not only had the benefit of certain inherent advantages, but comparative advantages over the goldsmiths. The goldsmiths had previously enjoyed a virtual monopoly on lending. They were, however, deposit bankers, meaning that they could not lend out more than they took in. They were also forced by economies of scale and the scarcity of existing accumulations of savings to charge high interest on loans.
It didn't help that many of the goldsmiths were Jewish. Jews had been expelled from England in 1295. They had, however, been permitted back into the country a generation or so before the founding of the Bank of England. This was after the Jews of Amsterdam, anxious to participate in the economic growth and development of England, managed to scrape together a bribe large enough to satisfy Oliver Cromwell, then Lord Protector of the Commonwealth.
In contrast, the Bank of England was an enterprise initiated by the "best" men in England. These were descendants (culturally and mentally, if not physically) of the class that had controlled England since the Tudors had tossed out the Plantagenents late in the 15th century. Walter Bagehot was later to assert in his classic The English Constitution (1867) that the mercantile classes were the real rulers of England — an assertion borne out by the rapid rise of the Bank of England.
Nevertheless, the Bank of England could not have attained its eminence without the protection of the State. Because of its special position, the Bank had three privileges denied to other financial institutions. These privileges allowed the Bank to reduce its charges far below those of its competition, the London goldsmiths, and virtually eliminate all rivals. The Bank,
• Received all government balances (i.e., was the official agent for the State's financial business),Discounting bills of exchange was by this time a common practice, and these circulated as a form of currency, albeit frequently only from business to business. Bills of exchange did not provide a common circulating medium for the country, especially as they were inevitably in large denominations. The Bank of England was, in fact, established in order to facilitate the rediscounting of bills of exchange.
• Had limited liability, and (most important)
• Had the power to issue banknotes against the government debt, thereby permitting the Bank to make loans in excess of its deposits.
Commercial Banking with a Difference
The issue of banknotes made the Bank of England something more than an ordinary commercial bank. By providing a common circulating medium for the country in the form of banknotes backed by the State debt, the Bank of England became the first true bank of issue or circulation. (Charles Conant, A History of Modern Banks of Issue. New York: The Adelphi Company, 1927, 84.)
This was a problem on two counts. One, the soundness of the banknotes was based (as today) on the credit-worthiness of the government instead of the productive capacity of private sector assets. As we have seen in recent years, as well as many times throughout history, basing a currency on the faith and credit of the government whose debt stands behind the currency destabilizes the currency whenever the government gets into trouble, whether politically or economically.
Two, backing the currency with government debt essentially gives the State the key to the money machine. Consistent with the disproved principles of the British Currency School, this also convinces many people that government debt is the only proper backing for the currency. This, of course, makes no sense, given the definition of money as the medium of exchange: anything that can be used in settlement of a debt. A private property right is essential if money is to have a stable and secure value, or even if it is to serve its proper function.
Using government debt to back the currency or any other part of the money supply effectively abolishes private property to that extent. It also gives the State virtually complete control over the economy — at least that part of it involving consumers and day-to-day transactions in the public market, as opposed to what is today known as "B2B" — "Business to Business." In general, at least until the State takes over control of business, the private sector can continue to create its own money. This is in the form of bills of exchange that circulate within the business community, usually without ever seeing the inside of a bank.
All of these dangers are avoided, or at least minimized if the State is forbidden to create money, or have the commercial, national, or central banking system create money on its behalf. Had the Bank of England backed its banknotes with properly vetted and collateralized private sector bills of exchange, the circulating medium would have been backed not by the vagaries of State monetary and fiscal policy — always at the mercy of political interests instead of the needs of commerce — but would have had existing productive private sector assets behind them instead of the State's ability to collect taxes at some unspecified date in the future.