Naturally the establishment of a State-supported monopoly created serious problems. Concentration of power, especially financial power, is rarely (if ever) a good thing for anyone, especially for ordinary people who thereby are cut off from the means of acquiring and possessing private property in the means of production.
The first reaction against the Bank of England did not, however, come from the common people. Relatively few of them had sufficient existing ownership to worry about such things. Those that did have a modicum of wealth tended to avoid banks, even to finance capital acquisitions or improvements. True, the Bank of England was the first major establishment intended to function in accordance with the real bills doctrine and create money as necessary backed by the present value of existing and future marketable goods and services. Popular understanding of money and credit, however, was still linked seemingly irrevocably to existing accumulations of savings. Existing savings are, by definition, a monopoly of the currently wealthy. Consequently, banks, capital finance, lending, money creation — these were esoteric matters, best left to the financial and political elite.
The Business of Lending
Lending for both consumption and productive purposes had, for centuries, been in the hands of the goldsmiths. It was common throughout the Middle Ages for people with savings to deposit their coin or valuable objects with the local goldsmith for safekeeping. This was logical, for the goldsmiths had the best security around. Their business success depended on their ability to safeguard small items of high value.
This made the goldsmiths the obvious people to resort to when a loan was needed. During the Middle Ages, of course, most loans were not made for productive purposes, but for consumption. Charging interest on these loans was (and remains) a serious sin under the name "usury" in the three major religions and most of the others. This is because the money is not used for a productive purpose, and, consequently, there is no profit to share — the original meaning of "interest," derived from "ownership interest."
Nevertheless, lending for consumption at interest was tolerated, though not considered moral. We don't need to go into the complex rationale here, other than to say that usury is wrong not because taking a profit is wrong, but because taking a profit when no profit is generated is wrong. Taking a profit is therefore not "objectively evil," and can be tolerated at times when there are no actual profits if the good that results outweighs the unintended evil of making an unjust profit.
There was, however, a growing incidence of lending for productive purposes as England changed from producing marketable goods and services for domestic use, to producing goods for export. This had begun on a large scale in the reign of Henry VII Tudor, when the "staple," that is, the annual production of wool, became an important export. Consequently, the rising "New Men" were those who dealt primarily in wool and related areas of commerce. Large tracts of land were cleared of the subsistence farmers and herders who had lived there for centuries, sometimes millennia, and used for sheepherding. As St. Thomas More later quipped in Utopia, England thereby became the only country on earth where sheep ate men.
Developing the staple, building the financial and commercial infrastructure — all of this took money. While the practice of discounting and rediscounting bills of exchange drawn on the present value of the annual staple to be realized in the future had been growing rapidly, a great deal of lending was still out of existing accumulations of savings. Loans made out of existing accumulations of savings remained largely the business of the goldsmiths until the establishment of the Bank of England.
The Reaction of the Goldsmiths
Not surprisingly, in view of the special privileges granted to the Bank of England, the goldsmiths quickly became desperate. Because of the money creation powers and economies of scale of the new Bank, the only business that would be left open to them was high-risk loans made to borrowers who did not qualify for a loan from the Bank of England or one of the affiliated "country banks." They therefore gave their support to a proposal that, even had it succeeded, would have been disastrous.
This was the proposal for a "land bank" brought before parliament by Hugh Chamberlain the year after the founding of the Bank of England. The idea was to establish a bank that would issue notes backed by the value of land, up to one hundred times the annual rental of the land, and "in some unexplained way" provide the State with funds. (Conant, op. cit., 85.)
Except for the odd provision that the State would somehow receive funds (probably a subtle way of offering a bribe), the theory of a land bank is relatively sound. The currency is backed with something with a defined present value. It has the disadvantage, however, of tying the amount of circulating media to an asset that does not increase and decrease in tandem with the marketable goods and services available for purchase in the economy. This means automatic deflation if the economy grows at all, and inflation if the economy contracts. Tying the money supply to a commodity in fixed supply is thus a recipe for economic stagnation. This, of course, is simply the ultimate outcome of tying money to something other than the present value of existing and future marketable goods and services. The same thing happens with gold, silver, or any other commodity.
The other problem with the land bank scheme was that the proposed issue of notes was grossly in excess of the present value of the land. Typically, even the best land at that time sold for twenty times the annual rental at most, and frequently less. That is, the present value of the land was calculated by multiplying the annual anticipated rent revenue by some factor reflecting the true value of the land. In essence, the proposal was to inflate the currency, giving a bribe to the State for the privilege of robbing the people through the transference of purchasing power that necessarily results from inflation. The first bribe was to guarantee the State an advance of more than £2.5 million at 7% interest, to be secured by a special tax on salt.
Those who opposed the monopoly established for the advantage of the Bank of England were quick to offer their support to the land bank. Unfortunately (or, actually, fortunately) they were not quite so ready to offer financial support. As Conant related,
The King was authorized to appoint a body of commissioners to receive subscriptions, half of which were required to be subscribed before August 1, 1696, and the whole before January 1, 1697. Subscriptions did not materialize, however, with such rapidity as expressions of sympathy for the enterprise. The Lords of the Treasury subscribed £5000 on behalf of the King, but the other subscriptions never exceeded £2100, and it is recorded about three years later that Dr. Chamberlain, "sole contriver and manager of the Land Bank, is retired to Holland, on suspicion of debt." (Conant, op. cit., 85.)Before that, however, people began worrying about the rise of a potential rival to the Bank. The value of Bank shares fell. This resulted in a demand that the Bank of England be granted a monopoly not just on government business, but on all commercial banking. The shares recovered after the land bank proposal came to nothing, but other problems were in store.
Dangers of State Control of Money and Credit
The Bank's association with the State was the chief problem it faced. Being forced to implement government monetary and fiscal policy had a definite down side. Decisions tended to be made on political, rather than economic or financial grounds. One of the first instances of this was a "recoinage" ordered for 1696, to be completed by February 1697. This was to replace the "hammered" coinage that still made up the bulk of the currency. Much of this was badly worn, clipped (pieces of metal shaved off), and underweight. New coins of full weight made by machine were to take the place of the worn-out pieces.
As the government's chief financial agent, the Bank found itself presented with vast quantities of inferior coin with a legal tender value sometimes far in excess of the value of the metal, for which it had to pay out full value in good coin. The government sold the new coin to the Bank at face value, but only purchased the old coin from the Bank as bullion. This caused the Bank to suffer a serious financial loss.
Adding to the problem was the fact that the new coins could not be manufactured fast enough to meet demand. Since the lowest denomination note issued by the Bank of England was £20 — an enormous sum of money at the end of the 17th century — most people had to be paid out in new coins when they brought their old coins in for redemption. The goldsmiths, still smarting from their defeat caused by the failure of the land bank scheme, took the opportunity to try a trick that became common later, and eventually led to the formation of clearinghouses as well as stricter government regulation.
A Trick with Fractional Reserves
The goldsmiths attempted something that came straight out of the "dirty tricks" department of classical capitalism. While relatively simple, it requires some explanation and a little background information. The trick relies on the essential difference between a bank of deposit and a commercial bank of issue — and the insistence that banknotes be redeemable on demand in gold and silver, not in the assets that actually back the banknotes.
As we have seen, a bank of deposit is pretty much what it sounds like, and what most people tend to think of as a bank . . . whether or not they are looking at an actual bank of deposit. A bank of deposit takes deposits (obviously), then lends out the deposits to borrowers. The bank charges interest on such loans, some of which is passed through to the depositors. The bank of deposit retains the rest of the interest as its revenue, from which it meets its costs and generates profit for the owners. (George Tucker, The Theory of Money and Banks Investigated. Boston, Massachusetts: Charles C. Little and James Brown, 1839, 160-172.)
Assuming that a country is on the gold standard, the bank of deposit can either lend out the gold that was deposited, or it can keep the gold safe in its vaults and issue a banknote to substitute for the gold. These banknotes circulate as currency, or "current money." If a customer presents a banknote to the bank, the bank will either use the banknote to cancel a debt owed by the customer, or exchange the note for gold out of the bank's reserves.
As noted, the bank of issue is a different creature altogether. The most common type of bank of issue is the commercial bank, that is, a bank intended to facilitate commerce. (Ibid.) A bank of issue converts non-monetary wealth into money. If something has a present value, it can (in theory, anyway) be converted into money. (Ibid.)
A bank of issue (again, in theory) does not need a customer to make a deposit before making a loan. Instead, a borrower comes to the bank and pledges something of value in exchange for a loan. Technically, if the pledge involves real property (i.e., land), the pledge is called a "mortgage." ("Mortgage," Black's Law Dictionary, op. cit.) If the pledge involves anything other than land, it is called a "pawn." ("Pawn," Oxford English Dictionary.) The latter term is nowadays restricted to small loans made on "portable security," that is, items of relatively high value that can be transported easily and used to secure the loan.
The bank of issue creates the money, either in the form of a banknote that circulates as currency, or in the form of a demand deposit on which the borrower issues checks. A check does not usually circulate as currency, but is returned immediately (more or less) to the bank of issue for redemption after a single transaction. Usually the recipient of a check does not take it to the bank on which it was drawn and demand cash, but deposits it in his or her own bank, taking the banknotes issued by that bank or issuing checks.
The recipient's bank presents the check to the bank on which it was drawn in order to settle the account and complete the transaction. Since the original bank and the receiving bank often have thousands, if not millions of such transactions back and forth, very little cash changes hands — or needs to, as the accounts eventually "zero out" (again, in theory). This "zeroing out" is usually done through a clearinghouse, a financial institution designed to facilitate transactions between banks and minimize the movement of actual cash, which can be both unwieldy and unsafe.
The Reserve Requirement
In practice, however, there is a role for reserves of currency even with a "pure" bank of issue. Assuming a gold standard, a bank of issue may need gold on hand to reassure the public as to the value of its banknotes and demand deposits. A bank of issue does this by converting its banknotes and demand deposits into gold coin on demand (or into banknotes of the central bank that can be converted into gold) instead of using the banknotes to settle outstanding liabilities of the bank. (Thornton, op. cit., 90-102.)
A bank of issue thereby assumes the character of a bank of deposit, at least in part. The bank has to maintain deposits — reserves — of whatever serves as the legal tender currency in order to self-insure its banknotes and demand deposits. It thereby backs its banknotes and demand deposits both with the loans it made to create the money (which might go bad), and a percentage of its total loans in gold, which is presumed always to be good, despite what history has shown. (Earl J. Hamilton, American Treasure and the Price Revolution in Spain, 1501-1650, Harvard Economic Studies, 43. Cambridge, Massachusetts: Harvard University Press, 1934.)
In Great Britain at the close of the 17th 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 assumption. People thought — and still think — that banknotes were 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.
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), with the note passing at a premium over the face value to reflect the greater confidence in the issuing bank.
Most checks and banknotes emitted by a bank of issue, 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 17th and 18th centuries, this was primarily banknotes as well as the checks that today constitute the bulk of the business of clearinghouses.
The "Bullying Tactic"
Unfortunately, in the laissez faire atmosphere of the 17th and 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 was an underhanded financial trick that large banks used to play on smaller, independent banks. If we correctly understand Adam Smith's analysis in The Wealth of Nations, larger banks or financial consortiums would sometimes take or create the opportunity to destroy a smaller rival. (Adam Smith, The Wealth of Nations, 294.) 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 and other assets 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" (Michael Crook, "A Brief History and Analysis of Scottish Free Banking, 1716-1845") or "bullying trick" ("The Bullionist Controversy," The History of Economic Thought Website.) to cause a run on the Knickerbocker Trust by suspending the Knickerbocker's clearinghouse privileges, thereby precipitating the "Panic of 1907."
In Scotland, banks were allowed to suspend convertibility of their banknotes into gold on a temporary basis, in part to prevent this from happening. (Conant, op. cit., 145.) As described by Smith,
Some years ago the different banking companies of Scotland were in the practice of inserting into their bank notes, what they called an Optional Clause, by which they promised payment to the bearer, either as soon as the note should be presented, or, in the option of the directors, six months after such presentment, together with the legal interest for the said six months. The directors of some of those banks sometimes took advantage of this optional clause, and sometimes threatened those who demanded gold and silver in exchange for a considerable number of their notes, that they would take advantage of it, unless such demanders would content themselves with a part of what they demanded. (Smith, loc. cit.)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 (Conant, op. cit., 146.) . . . unless you were the Bank of England and had a special relationship with the government. Consequently, the goldsmiths began collecting Bank of England notes that bore the promise of redemption in gold.
The War on the Bank of England
Eventually the goldsmith's accumulated approximately £30,000 in banknotes. These were presented for redemption during the week beginning May 4, 1696. As anticipated, this caused a "run" on the Bank — customers demanding to withdraw their accounts in full, in gold and silver, not paper.
The banknotes, however, were not backed by gold and silver, but by government debt. The Bank typically had only sufficient gold and silver on hand to meet the ordinary demand for convertibility into specie. In effect, by presenting the banknotes backed by government debt for conversion into coin, people were demanding that the State make immediate repayment of that portion of the national debt held by the Bank. Nowhere is the essential illogic of backing the currency with government debt more evident, for making good on the banknotes would have required a huge tax increase, payable only in gold and silver . . . which would immediately have set off inflation, possibly even hyperinflation as gold and silver were taken out of circulation and replaced by banknotes.
One of the advantages of being so closely tied to the government now became evident. The directors simply refused to honor the promise given on the face of the banknotes and convert them into specie. An ordinary bank doing the same thing would have been forced into bankruptcy, as became not uncommon during the 18th century. The Bank of England did, however, promise to continue to make redemptions for their current customers . . . as soon as the government made its scheduled £80,000 interest payment on the State debt held by the Bank.
Now one of the disadvantages of being so closely tied to the government became evident. The government failed to make the scheduled payment. The Lords of the Treasury, however, did issue an order that no public notary could "enter a protest" on any bill issued by the Bank for a period of two weeks.
"Entering a protest" is a formal statement by a notary made at the request of the holder of a bill or note that the instrument was presented for payment on the specified day and was refused. The "protest" gives the reasons for refusing to redeem the bill or note and protests against all parties to the instrument (in this case the Bank of England and the government), holding them responsible for all damages resulting from the refusal to honor the bill.
The government, by disallowing all such protest effectively destroyed the private property interest in the bill on the part of the holder in due course. It was also an effective suspension of specie payments that lasted for over a year before the Bank resumed redemption of its notes in gold and silver. The Bank was granted new privileges and its charter extended.