According to the Currency School, "money" means only coin, and banknotes backed by government debt. Demand deposits were added later when the use of checks as money became impossible to ignore. Bills of exchange and other negotiable bills and notes were not included in the definition, any more than commodities used in direct exchanges.
Adam Smith's understanding was thus that money is the medium of exchange, and can be (and is) created by any two or more parties to a transaction, without necessarily the involvement of the banking system or the State. That of the Currency School was — and remains — that money is a medium of exchange. The State alone decides what constitutes money, and determines the allowable terms of all contracts. The question is how this state of affairs came about.
A New Economic Theory
In 1797, people in England, afraid that the French were invading England in support of a rebellion in Ireland, began converting their Bank of England banknotes into gold. This drained the Bank of England of its reserves. Sir William Pitt ordered the Bank of England as a temporary measure to stop paying out gold. (Edwin Cannan, "Introduction," The Paper Pound of 1797-1821, The Bullion Report, 8th June 1810, Second Edition. London: P. S. King & Son, Ltd., 1925, x-xiii.) Convertibility was not resumed until 1821. (Ibid., xxix-xxxiv.) The inflation that followed was blamed not on increased prices due to the Napoleonic Wars, poor harvests, restriction on grain imports that benefited wealthy landowners at the expense of the poor (55 Geo. 3 c. 26), or the civil unrest that plagued England as the country was transformed from a rural economy to the most industrialized in the world, but to the use of paper money.
Compounding the problem was the publication of the Reverend Thomas Malthus's Essay on Population in 1798, the year following "the last invasion of England." Malthus's declarations were and continue to be used to "prove" the dogma that financing capital formation is presumed impossible without the use of existing accumulations of savings. In what passes for logic and reason in the modern age, the dogma that financing capital formation is presumed impossible without the use of existing accumulations of savings is still used to "prove" Malthus's theories. Not surprisingly, the theories and tenets of both Malthus and the Currency School are based on false notions of scarcity, both reject Say's Law of Markets, and both are inherently elitist, based on distorted versions of human nature and the natural moral law.
Malthus stated two "postulates," neither of which he bothered to prove. One, "The power of population is indefinitely greater than the power in the earth to produce subsistence for man. Population, when unchecked, increases in a geometrical ratio. Subsistence increases only in an arithmetical ratio. A slight acquaintance with numbers will show the immensity of the first power in comparison with the second." (Thomas Malthus, Essay on Population (1798), Chapter I.)
Two, "in all societies, even those that are most vicious, the tendency to a virtuous attachment is so strong that there is a constant effort towards an increase of population. This constant effort as constantly tends to subject the lower classes of the society to distress and to prevent any great permanent amelioration of their condition." (Ibid., Chapter II.)
In other words, because the earth cannot possibly produce enough for everybody, and because humanity is unable to control its urges, overpopulation and starvation are inevitable. Unfortunately, even though Malthus's theories have been disproved, economists have failed to grasp the true import of the "slavery of [past] savings" and their unquestioning acceptance of false notions of scarcity.
The New Theory and Money
Consequently, reinforced by the unquestioned and widespread acceptance of Malthus's theories, the adherents of the Currency School had two basic tenets. One, they refused to recognize as "money" anything other than gold coin and bullion, Bank of England banknotes backed by gold (silver was "demonetized" in 1816), or Bank of England banknotes backed by a strictly limited amount of government debt. (Milton Friedman, "The Monetary Theory and Policy of Henry Simons," The Journal of Law & Economics, Volume X, October 1967, 2.) Reliance on existing accumulations of savings and, especially, a too-narrow definition of money appear to be an example of Aristotle's "small error" that leads ultimately to huge errors. John Fullarton pointed out the injudiciousness of making such an arbitrary determination of the amount of currency needed in the economy in his 1845 book, On the Regulation of Currencies of the Bank of England. (John Fullarton, On the Regulation of Currencies of the Bank of England. London: John Murray, 1845, 3-4.)
Later, near the end of the 19th century, adherents of the Currency School finally admitted that demand deposits ("checking accounts") could be recognized as "money." (Ibid., 29.) This gives us today's definition of "M1": coin, currency, and demand deposits — the smaller part of the money supply. Many economists and policymakers, however, still have problems with anything other than M1 as "money."
Two, adherents of the Currency School believed that all issues of paper money in excess of gold or silver backing are automatically inflationary. (Anna J. Schwartz, "Banking School, Currency School, Free Banking School," The New Palgrave: Money, op. cit., 42-43.) This comes from the fixed (and erroneous) belief that money is first created, then the money is invested in new capital formation.
Changing the Definition
Another important change that came out of the tenets of the Currency School was a transmutation of the basic definition of money itself. It is not obvious, and to many people it sounds the same as saying that money is a medium of exchange — but there is an important difference. That is, many economists now define money primarily as "purchasing power," (Vide, e.g., John Maynard Keynes, A Treatise on Money, Volume I: The Pure Theory of Money. New York: Harcourt, Brace and Company, 1930, 3; Bennett T. McCallum and Marvin S. Goodfriend, "Demand for Money: Theoretical Studies," The New Palgrave: Money, op. cit., 118.) essentially a purchase order issued by the State. "Purchasing power," however, is different from "medium of exchange."
Money is the medium of exchange, that is, anything that can be used in settlement of a debt. Because money is the medium of exchange, money has purchasing power as an inherent aspect of its ability to carry out its function as the medium of exchange. Confusing the fact that money is the medium of exchange with the fact that money has purchasing power leads directly into what we might call "monetary positivism." "Monetary positivism" is a term we just invented to describe the fallacy that "money" is whatever the State or some other authority says it is — and can only be what the State or some other authority says it is.
The problems associated with the wrong definition of money, and thus the wrong principles of money, credit, and banking are extremely serious. A central bank run in accordance with wrong principles almost inevitably concentrates ownership of the means of production, and promotes the use of "bad" credit over "good" credit. Most often this results from the State hijacking the central bank in order to finance deficits without the unpopular expedient of raising taxes, or money creation backed by debt to stimulate consumer demand. This is always a temptation, despite the extreme danger that deficit financing by governments.
Effect on Economic Growth
A central bank that has been diverted from its primary purpose of providing a sound medium of exchange and adequate liquidity for the economy thus represents a serious danger to individual human dignity and personal sovereignty. Further, a central bank that does not conform to the real bills doctrine in accordance with the work of Henry Thornton and Harold Moulton will necessarily assume the necessity of existing accumulations of savings to finance capital formation. This, in turn, leads almost inevitably to permitting the State to manipulate money and credit for political ends. Credit will thereby (and incorrectly) be considered as necessarily limited to the amount of existing wealth (which, being a monopoly of the rich by definition, concentrates ownership even further) and thus act as a brake on critical economic growth.
Worse, "available" credit (a meaningless concept under the real bills doctrine) will be diverted from "good" uses (that is, investment in capital that generates its own repayment) into "bad" uses — speculation, consumption, and government spending. Thus a central bank run on principles that are not consistent with central banking theory can be (again, in that limited sense) almost worse than no central bank at all, becoming, as William Leggett, an early 19th century political commentator, pointed out, at best the lesser of two evils. (William Leggett, "The Natural System," The Plain Dealer, August 19, 1837. Reprinted as Democratick Editorials: Essays in Jacksonian Political Economy by William Leggett, Compiled, Edited, and with a Foreword by Lawrence H. White. Indianapolis, Indiana: Liberty Fund, Inc., 1984, 177.) That is why the British "Bank Charter Act of 1844" under the government of Sir Robert Peel was, although presented as a reform and an advance of the financial system, actually a great step backwards.
Background of the Bank Charter Act of 1844
The motives behind the Bank Charter Act of 1844 were good. The goal was to get a handle on the unrestricted issue of notes by the Bank of England and, through that body, control inflation. Unfortunately, the means chosen to limit the issue of bank notes was to jettison the real bills doctrine. The Act effectively removed bills and notes backed by private sector assets — the larger part of the real money supply — from the official definition of money.
Andrew Jackson's Specie Circular of 1836 had caused a depression in the United States and a recession in England. According to Sir Robert Peel, this was due to the drain of gold out of the Bank of England for transfer to investments in America. This was, however, only half true. The "investment" was to trade overvalued gold for undervalued silver, thereby making a speculative profit off the arbitrage between the two metals. The gold drained out of England was replaced with silver drained from the United States.
Unfortunately, Great Britain (unlike the United States) was on the gold standard and had been since 1816 with the advent of the "New Coinage." Silver was only a monetary metal by courtesy. It was used solely for what was to all intents and purposes a token subsidiary coinage. The export of gold and replacement with silver resulted in a serious deflation of the money supply, which caused the recession.
This was because the Bank of England, contrary to Thornton's analysis, refused to increase the amount of paper in order to make up for the dearth of gold. Fortunately, the country banks were still able to supply the economy outside London with sufficient liquidity in the form of bills of exchange and demand deposits. London, however, was the financial center, so a decrease in the money supply that was limited to London, served by the Bank of England, meant a recession instead of a full-blown depression, as was the case in the United States, where the Specie Circular disrupted banking and commerce throughout the country.
Whatever the effect in the former colonies, the conditions in England resulted in the Whigs being voted out of power, and in the installation of Sir Robert Peel as Prime Minister. As a result of the economic situation, there had been a complete rejection of the real bills doctrine among politicians. Subsequent historians have accused these "public men" of having "only a rudimentary knowledge of political economy." (Conant, op. cit., 119.) Regardless of such individuals' expertise or lack thereof in the science of finance, the presumed discrediting of the real bills doctrine became embedded in "mainstream" economics. This is in spite of the inherent contradiction involved in rejecting the real bills doctrine and accepting the quantity theory of money.
Worse, this contradictory approach to central banking and bank of issue theory has determined the monetary and fiscal policy of virtually every government on the globe today — with the consequence that such economic disasters as the present "meltdown" become not only possible, but inevitable. Further, rejection of the real bills doctrine locks economic and social development into a false reliance on existing accumulations of savings to finance capital formation. This, in turn, concentrates ownership of the means of production in fewer and fewer hands, thereby diverting capital income from consumption to reinvestment, making the problem even worse.
This, then (at least in broad strokes) was the situation that led up to the Bank Charter Act of 1844 (7 & 8 Vict. c. 32). The basic tenet of the "British Currency School," led by Sir Robert Peel, Lord Overstone, and Colonel Torrens was that issuing bank notes was, in and of itself, the primary cause of inflation.
The Bank Charter Act of 1844
Thus, in a basic contradiction that rivals the rejection of the real bills doctrine, commercial paper, demand deposits, and other credit instruments are not considered "money." "Money" is either gold, paper backed by gold, or paper backed with a strictly limited amount of government debt paper. This last is somehow, in an extreme distortion of the thought of Henry Thornton, construed as being "good as gold." (Ibid., 120.) Whatever the intent, the long-term consequence of the Act was to divorce money from the present value of existing and future production in the minds of public officials and academic economists, and on that shaky basis to "discredit" the real bills doctrine.
The three main provisions of the Act were to 1) separate the issue department from the banking department, 2) prohibit issues of bank notes by institutions other than the Bank of England, and 3) limit the issue of bank notes to £14 million backed by government bonds plus an unlimited amount if backed 100% by gold coin or bullion. (Conant, op. cit., 121.)
The separation of the issue department from the banking department was a vague step in the right direction. This, however, was only in the sense that it was an extremely tenuous recognition that there should be a separation of function to provide some kind of built-in system of checks and balances. The problem was that the Bank of England continued to operate both as an ordinary commercial bank, and as a central bank. This meant that there was not a true separation of function consistent with clear-cut definition of the different institutions' specialized roles.
Further, the failure to accept the fact that demand deposits and other credit instruments are just as much "money" as paper bank notes and gold coin made the separation effectively meaningless. If the Bank of England and the other commercial banks throughout Great Britain could not print bank notes, they could always create demand deposits. The effect, then, was to expand the use of checks and demand deposits when the supply of gold and bank notes proved insufficient.
Prohibiting any financial institution except the Bank of England from issuing bank notes had the advantage of imposing a single uniform currency on the country. The problem was that another commercial bank could only purchase bank notes from the Bank of England if it needed cash to meet its transactions demand. The bank notes could not be obtained by discounting commercial paper directly, for the notes by law now had to be backed either by gold or government securities.
Instead, a commercial bank would either purchase Bank of England notes out of its reserves — meaning gold — or sell commercial paper to the Bank of England banking department, which would create a demand deposit to purchase the paper. The commercial bank would then turn around and write a check to the Bank of England issue department to purchase bank notes or gold. The shift to checks comes as no surprise under these conditions.
Limiting the issue of bank notes to £14 million had a disastrous effect on the perception of the role of credit and how it operates. Credit was now officially and legally construed as something extended exclusively out of existing accumulations of savings. Creating money by extending credit for financially feasible capital projects that paid for themselves out of future earnings — the real bills doctrine — became an alien concept, far outside the scope of official or academic recognition. The real bills doctrine did not fit into the erroneous idea of credit as being solely based on existing accumulations of savings, so it was now considered "discredited."
Response to the Act
Thus, the chief effect of the Bank Charter Act of 1844 was to convince people that "money" consisted exclusively of existing accumulations of savings, not the present value of a future stream of income. The views of the "Currency School" did not pass unopposed, however. A year after the passage of the Act, John Fullarton wrote a mocking and acerbic critique of the beliefs of the powers that had pushed through the Act, Regulation of Currencies of the Bank of England. (John Fullarton, On the Regulation of Currencies; Being an Examination of the Principles, on Which It is Proposed to Restrict, Within Certain Fixed Limits, the Future Issues on Credit of The Bank of England, and of the Other Banking Establishments Throughout the Country. London: John Murray, 1845.)
Fullarton's main point of attack was the belief of the Currency School that only gold or Bank of England bank notes fully convertible into gold or backed by government debt paper constituted "real" money. As far as Fullarton was concerned, the term "money" signified anything by means of which "transactions of purchase and sale may be conveniently and economically adjusted, without any interchange whatever of actual value, whether intrinsic or factitious." (Ibid., 29.) This definition includes gold and silver coin. This is because gold and silver coins are not — as money — exchanged to convey the actual precious metal, but to transfer claims on the value of the marketable goods and services that the medium of exchange is used to purchase.
Fullarton then pointed out that the belief that only gold and Bank of England bank notes were "real" money was the cause of a serious embarrassment for adherents of the Currency School. If "money" conveys value irrespective of the material of which it is made, and banknotes are included in the Currency School's definition of "money," then,
you cannot, therefore, include the bank-note under the generic designation of money, without finding yourself immediately embarrassed by the claims of bills of exchange, bankers' cheques, and a variety of other typifications of the same principle of credit, all of which being more or less competent to perform, and, in point of fact, performing the functions of money, and some of them on a scale of vast extent, have primâ facie just the same pretensions to be rated as money which bank-notes have. (Ibid.)Quantity Theory of Money
Of almost greater importance to this clarification of the concept of money and its relation to credit, however, is a remark Fullarton throws out in passing to make a different point altogether. He mentions that "Wise men have pronounced, that movements of price or exchange are determined solely by the quantity of 'money' in circulation." (Ibid., 32.) Whether he meant to or not, Fullarton thereby reveals how understanding of the quantity theory of money had decayed since the days of Henry Thornton. In the standard formula, M x V = P x Q, focusing solely on M, the quantity of money in circulation (and by extension V, the velocity of money), and the effect that changes in the money supply has on the price level, P, the supply of marketable goods and services produced, Q, becomes regarded as a de facto constant. Eventually, instead of being recognized as the chief variable from which all the others are ultimately derived, Q is disregarded altogether except as a way to make the equation balance.
It is difficult to overestimate the effect that this narrow view of the quantity theory of money has had, particularly with respect to the real bills doctrine, and thus the whole theory underlying banks of issue and central banks. By ignoring the critical link between the money supply and the quantity of marketable goods and services produced and sold, production becomes first a given, then irrelevant. Holding Q as a given or a constant necessarily leads to the conclusion that all new money issued — regardless whether it is paper or even gold and silver — is automatically inflationary.
As a result, the real bills doctrine — that holds that new money can be created without inflation if backed by actual assets or the present value of future assets — is presumably discredited, precisely as we read in modern economics texts, when it is mentioned at all. Consequently, the idea that money can be created at will if backed by existing inventories of marketable goods and services or the present value of marketable goods and services to be produced in the future, is treated as an irrational fantasy. Financing of capital becomes locked into dependence on existing accumulations of savings, for anything else must be an illusion.
Effect on Personal Sovereignty
Worse than the mis-definition of money, however, was the fact that this happened at a time when it was becoming critical that the working classes had to gain access to some means whereby they could become owners, at least in part, of the means of production in order to supplement or replace their labor incomes. By the powers-that-be assuming that only existing accumulations of savings could be used to finance capital formation, however, and even embodying that assumption into law with the Bank Charter Act of 1844, the growing proletarian (i.e., propertyless) working classes were locked into permanent bondage to the wage system, and complete dependency on their employers, "a yoke little better than slavery itself." (Pope Leo XIII, Rerum Novarum ("On Capital and Labor"), 1891, § 3.)
The long-term political effect of the Act was to shift the power over the purse strings from parliament to the Bank of England. This transferred power from the elected (more or less) representatives of the people — the political elite — to the economic elite. In consequence, a few years later Walter Bagehot was to claim that not only were the economic elite the true rulers of the British Empire, they were the legitimate and rightful rulers due to their economic preeminence. A common currency was established, more or less sound as long as the government kept borrowing within bearable limits, but at the cost of a virtual loss of economic and political sovereignty of ordinary people.