The invention of central banking

Stranger — Sun, 22 Mar 2009 06:37:44 GMT

This is the history of the first central bank, the Bank of England, as told by Murray Rothbard in The History of Economic Thought and reproduced here for the convenience of newer students, and to give them an idea of the enormity of the struggle that has to be fought to restore capitalism and end the financial cycle.

The key to English history in the seventeenth and eighteenth centuries is the perpetual wars in which the English state was continually engaged. Wars meant gigantic financial requirements for the Crown. Before the advent of the central bank and government paper, any government not willing to tax the country for the full cost of war relied on an ever more extensive public debt. But if the public debt continues to rise, and taxes are not increased, something has to give, and the piper must be paid.

Before the seventeenth century, loans were generally made by banks, and 'banks' were institutions in which capitalists lent out funds that they had saved. There was no deposit banking; merchants who wanted a safe place to keep their surplus gold deposited them in the King's Mint in the Tower of London - an institution accustomed to storing gold. This habit, however, proved highly costly, for King Charles I, needing money shortly before the outbreak of the civil war in 1638, simply confiscated the huge sum of 200 000 pounds in gold stored at the Mint - announcing it to be a 'loan' from the depositors. Understandably shaken by their experience, merchants began depositing their gold in the coffers of private goldsmiths, who were also accustomed to the storing and safe keeping of precious metals. Soon, goldsmiths' notes began to function as private bank notes, the product of deposit banking.

The Restoration government soon needed to raise a great deal of money for wars with the Dutch. Taxes were greatly increased, and the Crown borrowed extensively from the goldsmiths. In late 1671, King Charles II asked the bankers for further large loans to finance a new fleet. Upon the goldsmiths' refusal, the king proclaimed, on 5 January 1672, a 'stop of the Exchequer', that is, a wilful refusal to pay any interest or principal on much of the outstanding public debt. Some of the 'stopped' debt was owed by the government to suppliers and pensioners, but the vast bulk was held by the victimized goldsmiths. Indeed, of the total stopped debt of 1.21 million pounds, 1.17 million was owned by the goldsmiths.

Five years later, in 1677, the Crown grudgingly began paying interest on the stopped debt. But by the time of the eviction of James II in 1688, only a little over six years of interest had been paid out of the 12 years' debt. Furthermore, the interest was paid at the arbitrary rate of 6 per cent, even though the king had originally contracted to pay interest at rates ranging from 8 to 10 per cent.

The goldsmiths were even more intensively thwarted by the new government of William and Mary, ushered in by the Glorious Revolution of 1688. The new regime simply refused to pay any interest or principal on the stopped debt. The hapless creditors took the case to court, but while the judges agreed in principle with the creditors' case, their decision was overruled by the Lord Keeper, who candidly argued that the government's financial problems must take precedence over justice and property right.

The upshot of the 'stop' was that the House of Commons settled the affair in 1701, decreeing that half of the capital sum of the debt be simply wiped out; and that interest on the other half begin to be paid at the end of 1705, at the remarkable rate of 3 per cent. Even that low rate was later cut to two-anda- half.

The consequences of this declaration of bankruptcy by the king were as could be predicted: public credit was severely impaired, and financial disaster struck for the goldsmiths, whose notes were no longer acceptable to the public, and for their depositors. Most of the leading goldsmith-ereditors went bankrupt by the 1680s, and many ended their lives in debtors' prison. Private deposit banking had received a crippling blow, a blow which would only be overcome by the creation of a central bank.

The stop of the Exchequer, then, coming only two decades after the confiscation of the gold at the Mint, managed virtually to destroy at one blow private deposit banking and the government's credit. But endless wars with France were now looming, and where would government get the money to finance them?9

Salvation came in the form of a group of promoters, headed by the Scot, William Paterson. Paterson approached a special committee of the House of Commons formed in eady 1693 to study the problem of raising funds, and proposed a remarkable new scheme. In return for a set of important special privileges from the state, Paterson and his group would form the Bank of England, which would issue new notes, most of which would be used to finance the government's deficit. In short, since there were not enough private savers willing to finance the deficit, Paterson and company were graciously willing to buy interest-bearing government bonds, to be paid for by newly created bank notes, carrying a raft of special privileges with them. As soon as Parliament duly chartered the Bank of England in 1694, King William himself and various MPs rushed to become shareholders of this new moneycreating bonanza.

William Paterson urged the English government to grant Bank of England notes legal tender power, but this was going too far, even for the British Crown. But Parliament did give the bank the advantage of holding deposits of all government funds.

The new institution of government-privileged central banking soon demonstrated its inflationary power. The Bank of England quickly issued the enormous sum of 760 000 pounds, most of which were used to buy government debt. This issue had an immediate and substantial inflationary impact, and in two short years, the Bank of England was insolvent after a bank run, an insolvency gleefully abetted by its competitors, the private goldsmiths, who were happy to return to it the swollen Bank of England notes for redemption of specie.

At this point, the English government made a fateful decision: in May 1696, it simply allowed the bank to 'suspend specie payment'. In short, it allowed the bank to refuse indefinitely to pay its contractual obligations to redeem its notes in gold, while at the same time continuing blithely in operation, issuing notes and enforcing payments upon its own debtors. The bank resumed specie payments two years later, but this act set a precedent for British and American banking from that point on. Whenever the bank inflated itself into financial trouble, the government stood ready to allow it to suspend specie payments. During the last wars with France, in the late eighteenth and early nineteenth century, the bank was allowed to suspend payments for two decades.

The same year, 1696, the Bank of England had another scare: the spectre of competition. A Tory financial group tried to establish a national land bank, to compete with the Whig-dominated central bank. The attempt failed, but the Bank of England moved quickly to induce Parliament, in 1697, to pass a law prohibiting any new corporate bank from being established in England. Any new bank would have to be either proprietary or owned by a partnership, thereby severely limiting the extent of competition with the bank. Furthermore, counterfeiting of Bank of England notes was now made punishable by death. In 1708, Parliament followed up this set of privileges by another crucial one: it now became unlawful for any corporate bank other than the Bank of England, and for any bank partnership over six persons, to issue notes. And, moreover, incorporated banks and partnerships over six were also prohibited from making any short-term loans. The Bank of England now only had to compete with tiny banks.

Thus, by the end of the seventeenth century, the states of western Europe, particularly England and France, had discovered a grand new route towards the aggrandizement of state power: revenue through inflationary creation of paper money, either by government or, more subtly, by a privileged, monopolistic, central bank. In England, private banks of deposit were inspired to proliferate (especially checking accounts) under this umbrella, and the government was at last able to expand the public debt to fight its endless wars; during the French war of 1702-13, for example it was able to finance 31 per cent of its budget via public debt.

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The invention of central banking