The Rationale of Central Banking and the Free Banking Alternative

It was in note issuing, then, that the earliest banking problems arose, and it was here that Governments threatened most strongly to establish monopolies under the system of concession by charter. When banking was in its infancy, doubtless many mistakes were made,
*4 and there was some justification for a Government’s interfering at least to prevent fraudulent operations. And it is very relevant here to point out that when banking was making its first experiments, industry and trade were only just being weaned from mediaeval protectionism, and it took at least a century for the new system to organise a commercial code for large-scale enterprise. The practical non-existence of company law in general before the nineteenth century was especially serious in spheres touching the currency of a country: what damage could be done was likely to have particularly widespread effects, since the whole population dealt in money. But it must be admitted that it is almost certain that by far the most powerful reason leading to the maintenance of Government intervention in the banking sphere, at a time when it was on the decline in other industries, was that power over the issue of paper money, whether such power is direct or indirect, is an exceedingly welcome weapon in the armoury of State finance.

As deposit banking became, from about the ‘thirties of last century onwards, more important relatively to the issue of notes, the dispute that had arisen about monopolies in the note-issuing business tended correspondingly to diminish in importance, although it could not fall entirely out of the discussion because of the intimate connection between the two branches of the banking business. Deposits must always have at the back of them a sufficient reserve of currency, and therefore the total amount of currency must be a major factor in the determination of the total volume of deposits that can be created through the lending operations of the banks. Thus, if a central banking authority controls the issue of notes, it also controls, though less rigidly, the volume of credit.

Assuming that a paper currency is a desirable adjunct to a country’s commercial development, we may conceive three alternative ways in which its issue may be undertaken:

a) It may be subject to the exclusive control of the State;

b) It may be delegated to the control of a single private institution;

c) It may be left to the free competition of a large number of banks of issue.

The system of a single private institution may take various forms. It may be entirely independent of the State, or the latter may exercise control over it either by taking a share in its capital and thus enforcing its will through its representatives on the directorate, or by subjecting it to the dictates, in matters of general policy, of a Minister of Finance. Even when the system is nominally free from State control, however, history shows that virtually such a right will be very difficult for the bank to maintain.

Also the plural system may vary in the nature of the legal framework within which it functions. There have been advocates of a free system who have favoured certain special regulations; others have assumed that the general clauses of a well-devised company law would be sufficient.

Again we should distinguish the case where a single controlling institution has an absolute monopoly from the case where it is the centre of a so-called mixed system in which it certainly holds the major power, but in which its monopoly is to some extent qualified by the existence of a number of other institutions exercising some of the same functions inside narrower limitations.

We can roughly summarise the course of events and swings of policy in the evolution of banks of issue before 1875 under four phases. The first was a preliminary period when banks were only just beginning to emerge, and they were theoretically at liberty to form freely even if it was only because they were not yet obtrusive enough to catch the eye of the legislative authority. In the second period, monopoly, either absolute or to some extent qualified, was dominant. The third phase was characterised by plurality and increasing liberty, but by no means complete freedom. The fourth witnesses the return to restrictions and monopoly, either absolute or along the lines of a mixed system, with centralisation of control.

This scheme is more or less representative, with differences as to dates, of the course of events in England, France and Prussia. Scotland and America fall outside it.

Let us now turn to the more detailed account of the historical facts of banking development that are relevant to our topic. We commence with England, which produced what later became a model for many other countries.

The origins of banking in the modern sense are to be found in about the middle of the seventeenth century, when merchants took to depositing their balances of coin and bullion with the goldsmiths. The goldsmiths then began offering interest on deposits, since they could re-lend them at higher rates, and the receipts they gave in acknowledgment of the deposits began to circulate as money. There thus arose a number of small private firms, all having equal rights, and carrying on the issue of notes unrestricted and free from Government control.

The second period in English banking, dating from the foundation of the Bank of England in 1694, was ushered in by an event of a rather fortuitous political nature. Charles II had had to rely to a very large extent for his financial needs on loans from the London bankers. He ran heavily into debt and in 1672 suspended Exchequer payments and therefore the repayment of bankers’ advances. The King’s credit was thereby ruined for several decades to come, and it was to provide a substitute for the sources of accommodation thus destroyed that William III and his Government fell in with the scheme of a financier by the name of Patterson for the foundation of an institution to be known as the Governor and Company of the Bank of England. Its establishment was described by the Tunnage Act, among the many clauses of which its incorporation looked an absurdly minor event, as being “for the better raising and paying into the Exchequer of the sum of £1,200,000.”

The early history of the Bank was a series of exchanges of favours between a needy Government and an accommodating corporation. In the first instance, the Bank was founded with a capital amounting to £1,200,000. This same sum was immediately lent to the Government and in return the Bank was authorised to issue notes to the same amount.
*5 This sudden issue of so many notes produced all the usual accompaniments of a currency inflation. In 1697 the Government renewed and extended the privileges of the Bank, allowing it to increase its capital and therefore its note issue, and also giving it the monopoly of the possession of the Government balances by ordering that henceforth all sums due to the Government must be paid through the Bank, a provision that added considerably to its prestige. Further, it was also provided that no other bank should ever establish itself by the method of acquiring a special Act of Parliament. Lastly, the Act stated that no act of the Governor and Company of the Bank of England was to subject or make liable to forfeiture the particular private and personal property of any member of the corporation, a clause which bestowed on it the privilege of limited liability. This was a favour which was to be denied to all other banking associations for another one and a half centuries.

It was just about this time that the new type of business entity known as the joint stock company was taking hold, and it was therefore an obvious step in the reinforcement of the Bank’s already privileged position to endow it with some sort of monopoly in this particular type of organisation, which was in so many respects superior to the old forms of business association. Accordingly, when in 1709 the Bank’s charter was renewed, besides allowing it to raise its capital in return for a loan to the Government, the relevant Act specified that no firms of more than six partners might issue notes payable at demand or at any time less than six months. This effectively excluded joint stock firms from the note-issuing business, and, since banking in those days was held to be practically synonymous with note issue, from banking business altogether. More than a century was to pass before the application of the prohibition to banking business other than the issue of notes was to be called into question.

In 1713 the charter was further renewed, again in return for a loan to the Government, and as the resources for the loan were to be obtained by raising additional capital, the Bank gained at the same time the right to an increase in its note issue. The 1742 renewal reaffirmed its privileges of “exclusive banking business,” and was again accompanied by the now customary loan transaction, this time a loan without interest. After 1751 the Bank was entrusted with the administration of the National Debt. In return for the 1764 renewal of its charter the Bank paid the Government a fee of £110,000. There was another renewal and another loan in 1781 and the same in 1800. In short, between 1694 and the beginning of the nineteenth century the Treasury had benefited no less than seven times by the successive renewals of the charter of the Bank of England,
*6 and this, quite apart from the short-term accommodation given by the Bank in the ordinary course of its daily transactions.

The result of the accumulation of an array of privileges was to give the Bank of England a position of prestige and influence in the financial world such as to cause small private banks to experience difficulties in continuing to compete in the same lines of business, and in London the majority of private note issues had been abandoned by about 1780. A further effect was that the smaller banks began to adopt the practice of keeping balances with the Bank of England, which was thus already beginning to acquire the characteristics of a Central Bank.

The period 1797-1819 is interesting from our point of view, not only because it provides an outstanding example of the force of Government pressure on the Bank, but also because the ultimate consequences of the Government’s policy towards the Bank were to add to the latter’s influential position in the country’s banking system. Soon after the outbreak of the French War, Pitt had to ask for advances from the Bank. Now the Bank Act of 1694 had forbidden it to make advances to the Government without the express authorisation of Parliament. For a long time small amounts had nevertheless been advanced on Treasury Bills made payable at the Bank. The legality of this practice had been regarded as doubtful; so in 1793 the Bank applied to the Government for a Bill indemnifying it against liability for the loans it had made in the past and giving it legal authority to continue such transactions in the future, on the condition, however, that they should be kept below a certain figure. Pitt lost no time in getting the Bill through Parliament, but very usefully neglected to insert the limiting clause, so that the Bank became henceforth virtually compelled to comply with Government requirements to any amount. By 1795 these borrowings had become so excessive as to affect the foreign exchanges and seriously endanger the Bank’s reserve position, and the Bank directors appealed to the Government asking Pitt to keep down his demands on the Bank, and at the same time it contracted discounts to private customers. What Pitt did, however, was to take all possible steps to facilitate the Bank’s lending to the Government. The old dislike of small notes was thrown to the winds:
*7 £5 notes were issued for the first time in 1795, and £1 and £2 notes were issued in 1797 in order to provide small currency in conjunction with another measure of that year, namely, the suspension of the payment in cash of the Bank’s notes. This suspension of cash payments was procured by the Government by Act of Parliament in order to meet a critical situation in which the Bank was faced by a “run” at a time when it already had an extremely weak reserve position. The Government’s action amounted to a legalisation of the bankruptcy of the Bank, and it created a precedent which led the public in future always to expect the Government to come to the aid of the Bank in difficult circumstances.

We cannot here enter upon a discussion of the contribution of causes other than the Government borrowings, to the Bank’s difficulties before 1797. Let it suffice to remark that the expansion of credit that the Bank was forced to undertake under Government pressure must, besides having been itself a cause, also have weakened the Bank’s capacity to deal with these other causes, since the method of dealing with an outflow of specie, from whatever cause it arises, must be a contraction of credit.

Throughout the period of the rapid depreciation of the pound after 1800, when there were phenomenal increases in bank credits for war finance, Bank of England notes had for all practical purposes the character of legal tender currency. They were not officially so declared prior to 1812, but since they were taken in all Government payments, and perhaps partly out of patriotic motives, they were usually accepted at par. Finally in 1812 the Government declared them to be legal tender for all payments. These events had important effects on the position of Bank of England notes in the country. The country banks began to look on them as backing for their own note issues, and in many parts of the country they took their place in the local circulation for the first time. Another effect of the war experiences was to give the impetus to the first detailed discussion of banking and currency, ushered in by the report of the Bullion Committee, and continued with unlagging vigour till well over the turn of the half century.

There is no doubt that the release of the Bank from its obligation to pay in cash proved very profitable to it. The Bank’s interest in the suspension was stressed by several later observers. Gallatin remarks
*8 that its declared dividends rose from 7 percent to 10 percent, besides £13,000,000 of extraordinary profits, and Horn writes
*9 that on the morrow of its resumption of cash payments its shares fell 16 percent.

The return to more or less normal conditions in 1819 brought with it, already, a tendency to regard the Bank of England as a regulating institution holding some special position of duty in the currency and credit system of the country, and, indeed, the Bank directors made a representation to Parliament protesting against what they regarded as an attempt to establish a system which would place upon them the responsibility “for supporting the whole National Currency.”
*10

Despite the fact that the Bank of England note ceased to be legal tender, the country banks tried to keep their customers to the habit of taking Bank of England notes in lieu of gold, and there was by this time very little gold left in the provinces. The country banks still needed gold to cash their own small notes, since the Bank did not issue notes below £5, but in case of extra strain, the Bank’s stock of gold in London had already become practically the sole source of supply. Furthermore, the country banks were coming to expect the Bank to lend to them in times of stress. At such times when the notes of country bankers lost their acceptability, the public showed no hesitation in taking the notes of the Bank of England, and these served just as well as gold coin to meet an internal drain of cash. In the 1825 crisis the Bank was at first hesitant about assisting the country banks, but after a week or so turned round and lent freely to them. It assisted not only with gold but also with the re-issue of the £1 notes that had been in circulation in the restriction period, since £5 notes were unsuitable as everyday currency for small transactions.

The blame for the 1825 crisis was laid on the country banks and their issues of small notes. There were at this time between seven and eight hundred of these banks in existence, and between 1810 and 1825 about one hundred and fifty of them had become bankrupt. There emerged an agitation in favour of allowing joint stock banks, other than the Bank of England, to set up, on the grounds that the present private concerns of not more than six partners were too small to be solid and that joint stock companies would be much stronger and more stable. It was pointed out that not only were small groups of inexperienced traders allowed to go freely into the banking business, but that under the existing law it was
only these who could do so, and that if concerns with greater financial backing could set up, they would drive out the bad firms. The prime mover in the campaign for joint stock banking was Thomas Joplin, whose pamphlet of 1822
*11 called attention to the great success of the Scotch system, and who was later to take a leading part in the foundation of the National Provincial. The Bank of England opposed the proposals relentlessly and countered them by suggesting that it should set up branches itself in the provinces. Lord Liverpool and his colleagues replied that the proposal of the Bank for establishing branches would not be sufficient to provide for the needs of the country. Incidentally, Liverpool,
*12 in trying to persuade the Bank that an improvement in the country circulation would be to its own advantage, hinted at the growing tendency for the Bank of England to become the centre of a single gold reserve, the sole depository for gold in times of favourable exchanges and the sole resort for obtaining it in the opposite circumstances.

The success of this campaign marks the beginning of a third period, a period of increased liberalism in English banking. By the 1826 Act joint stock banks were permitted to establish outside a sixty-five mile radius from London and the Bank of England was authorised to set up branches. The presumed evil of small notes was met by an Act of the same year prohibiting the issue of notes of lower denomination than £5.

By this time it had become obvious that banking business did not consist solely in the issue of notes; nor was this necessarily the main department of banking. Another branch of banking had taken root and was awaiting further development: deposits subject to draft by check were already an important feature of the commercial world. The urgency of the demand for the free right to issue notes therefore subsided into the now more important need for greater freedom in the establishment of deposit banks. It was decided that the charter rights of the Bank did not include any monopoly of deposit banking, and in 1833 the Act for the renewal of the Bank Charter accorded the permission for joint stock banks, not issuing notes payable to bearer on demand, to set up in London. The first bank to set up under the new provisions was the London and Westminster, followed by the London Joint Stock Bank, the Union Bank of London, and the London and County Bank.
*13

The 1833 Act also made Bank of England notes legal tender (except by the Bank) for sums above £5 so long as they should maintain their convertibility.
*14 The result of this was to strengthen the tendency towards making the metallic reserve a single reserve system in the hands of the Bank of England. Gold still had to be kept on hand at all ordinary times for making payments below £5, but in times of extra heavy demands, especially in times of panic, the country banks paid out Bank of England notes when their own notes were presented, or their deposits withdrawn, and the ultimate demand for gold fell on the Bank of England. From this it was not a very far or unnatural step for the banks to adopt the practice of keeping the greater part of their reserves in the form of balances at the Bank to which they looked to get Bank notes whenever necessary. In this way the Bank became the holder not only of the
gold reserve of the whole country, but also of the
banking (cash) reserve.

Between 1826 and 1836 about a hundred joint stock banks of issue had been founded, and of these about seventy had been formed during the last three years, and it was on these that the Opponents of a freer banking system blamed the crises of 1836 and 1839. Criticism came especially from Horsley Palmer, then Governor of the Bank of England,
*15 and the question was again raised of the relations between movements in the country bank-note circulation and the Bank of England note circulation. The 1832 Parliamentary Committee
*16 had been unable to reach any definite conclusion as to whether or not the country issues usually followed movements in the Bank of England issues. Palmer now contended that prior to 1836 the Bank of England had followed up any tendency to an outflow of specie with a contraction of its circulation, but that what should have been the influence of this policy had been rendered nugatory by the imprudent credit facilities and low money rates occasioned by the issues of the joint stock banks. He claimed that between 1834 and 1836 the issues of the joint stock and private banks in the country had together increased by 25 percent, and that this had led to a continuous export of bullion until the Bank had finally been obliged to raise its discount rate, an event which had caused the stringency on the money market in 1836.

It was also his opinion that banking provision had been adequate under the system of private banks existing prior to 1826, and that in face of this it was dangerous to encourage the formation of additional joint stock banks. He thought the merit of the private banks had been grossly understated. �Nearly eighty private banks suspended their payments in 1825,” he says, “yet no stronger proof could be afforded of the really substantial state of the country banks at that time than that a very small proportion (it is believed not ten) proceeded to bankruptcy.” Palmer’s allegations evoked a somewhat ironic reply from Loyd,
*17 who failed, he said, to find in the Bank’s accounts sufficient evidence of Palmer’s contention that the Bank had, during the years under discussion, kept its securities constant and contracted its circulation when specie diminished. He found rather that the reverse had been the case, and he very much doubted whether the joint stock banks had the power to extend their issues for any length of time should the Bank of England carry out a “regular, steady and undeviating course of contraction.” Loyd was claiming that the central issuer, whose notes were now looked upon as reserve money by the joint stock banks, had both the power and the duty to control the action of those banks, while the Bank directors still refused to accept that responsibility. Loyd and his followers considered at the same time that the indirect power of control of the Bank of England was insufficient because the Country note issuers were late in following up contractions by the Bank of England.
*18

Most of the discussion after this time centred round these problems of central bank policy and the effectiveness of the control it had over the total circulation and the necessity or lack of necessity for limiting note issues to a predetermined figure. In England the currency and banking controversy tended to overshadow the wider issues of free banking. The two problems were, of course, not entirely independent, and their interconnections will be considered in a later chapter. All that concerns us here is that it is the final victory of the currency school in 1844 which brings us to our fourth period and the decision, at least in practice, in favour of a central banking single reserve system. It was the 1844 Act which ensured the ultimate monopoly of the note issue in the hands of the Bank of England. It provided in the first instance that the Bank of England’s fiduciary issue should be limited to a figure of £14,000,000. The other banks of issue at that time in existence were to be allowed the continuance of the right to issue, but the maximum limit of the issues was fixed in each case at the average figure their issues had reached in the period just preceding the Act, and their rights were to lapse altogether if they amalgamated with, or were absorbed by, another bank, or if they voluntarily renounced their rights, and the Bank of England was to acquire such rights to the extent of two-thirds of the authorised issues of the banks concerned. No new bank could acquire rights of issue.

Horsley Palmer now invoked the position of the Bank as, what Bagehot later christened, the “lender of last resort” as grounds for opposing Peel’s Act.
*19 It would, he said, put the Bank in a very difficult position for rendering aid to the market in times like 1825, 1836 and 1839. Peel’s hope that his measure would render such situations much less likely to occur was, as events proved, to be unfulfilled. The 1847, 1857 and 1866 crises showed the Government always ready, on the only occasions when it was necessary, to exempt the Bank from the provisions of the Bank Act, and the Opinion was naturally expressed in some quarters that the clause of the Act, limiting the fiduciary issue of the Bank, was a mere paper provision having no practical application, since the Bank of England could always rely on the Government to legalise a breach of it every time it got into a difficult position. The relations between the Bank and the Government were, in fact, a tradition too long established for either the Bank, or the public, or the Government, to envisage anything other than full Government support to the Bank in time of stress. It had always been a privileged and protected institution, and it was in the interests not only of the Bank but also of the Government that it should remain so.

The Bank directors were extremely loath to recognise the delicacy of the Bank’s position in a system which, as the result of a long series of Government manipulations, had made it the controlling element in the country’s credit structure. It was the nature of this responsibility that Bagehot was analysing in his “Lombard Street.”

Looking at the 1844 Act from our position of superior knowledge of what were to be the features of later banking development, in particular the amalgamations of the last quarter of the nineteenth century, it is impossible to ignore the anomaly of the situation in which this Act left the provincial note-issuing banks. Since they were prohibited from acquiring by purchase or absorption the circulation of other banks of issue, there was a tendency towards the preservation of the smaller banks, even when it would have been more economical for them to combine, because it might happen that the profits to be obtained from the retention of the note issue were estimated to be greater than those to be obtained by joining a larger concern. Secondly, joint stock banks which engaged in the note-issuing business were excluded from the London market and had to pay correspondents to pay out their notes in London. A striking case in point in this respect was the National Provincial Bank. This had been founded, not like the London and Westminster Bank as a London bank without note issue under the 1833 Act, but under the 1825 Act as a joint stock bank issuing notes. Thus, although this bank had a head office in London from which the general administration of all its branches was conducted, it was excluded from carrying on any banking business whatsoever in the metropolis. It was these anomalies that Gladstone sought to remove in the Country Note Issues Bill he introduced in 1865. In return for the removal of the disadvantages mentioned above, those banks choosing to take advantage of its provisions (it was to be a permissive Act only) were to pay a tax of £1 percent on their authorised circulation, and the Government was, besides, to have the right to terminate their issues altogether after a period of fifteen years. Hankey and Goschen got this clause of the Bill amended so as not merely to empower the Government to terminate the issues of such banks after fifteen years but to compel it so to do. It was thus to become an instrument for getting rid of the country circulation altogether, but Gladstone so worded the preamble as not to preclude entirely negotiations for a renewal of the term. The Bill failed to pass, however, and in 1866 the National Provincial, probably the bank most concerned, started a banking business in London at the price of sacrificing its right to issue notes. From this time onwards the joint stock banks concentrated their efforts on deposit business.

The theoretical discussion lingered on a few years longer, largely as the reflection of developments abroad.