7.2 The emergence of the currency principle

The prohibition of small notes, however, scarcely tackled the main problem. The first to go beyond this minor aspect of banking and go straight to the heart of the matter was a brilliant and influential thinker who has remained as little known to historians as he was obscure in his own day. It is with justice that Lionel Robbins has wittily referred to James Pennington (1777–1862) as the ‘Mycroft Holmes’ of the later monetary controversy of the classical period.³

James Pennington was born into a prominent Quaker family in the town of Kendal, in Westmorland; his father, William, was a bookseller, printer and architect, who eventually became mayor of Kendal. Graduating from a first-rate Quaker school at Kendal, Pennington moved to London. Little is known of his personal life thereafter, except that he lived in Clapham, and that he and his large family of seven children were parishioners, and James a trustee, of the famous Clapham Anglican parish church, obviously abandoning the Quakerism of his youth. Apart from that, we know that he was a merchant, ‘gentleman’ and accountant, and briefly became a member of the board of control for India in 1832. From then on, retired from commerce, he would be consulted repeatedly in technical financial matters by the government.

In the wake of the great banking crisis of December 1825, London was agog with discussions of money and banking, the august Political Economy Club dealing with this topic in its meetings of 9 January and 6 February, 1826. At the latter occasion, Pennington was present as a guest and, stimulated by the discussion, he sat down to write a memorandum on the subject to the powerful president of the board of trade, the liberal Tory William Huskisson. Huskisson did not request the memo, but he was known to be receptive to intelligent memoranda on crucial topics, and this method of promoting his views may have been suggested to Pennington by his longtime friend, and one of the original founders of the Political Economy Club, the merchant and economist Thomas Tooke. In this first memo to Huskisson on 13 February ‘On the Private Banking Establishments of the Metropolis’, Pennington outlined with crystal clarity how private banks, by expanding loans, create demand deposits which function as part of the money supply. Walter Boyd and others had pointed this out, but Pennington's exposition was unmatched in its lucidity and, when published as an appendix to Tooke's Letter to Grenville (1829), greatly influenced the banking controversies of the era. Unfortunately, the Letter did not sufficiently influence Pennington's own camp, the currency school, who stubbornly and tragically failed to realize that bank demand deposits formed part of the supply of money, equivalent to bank notes.

Without any encouragement from Huskisson, Pennington followed up his first memorandum with another, a year later (16 May 1827) on ‘Observations on the Coinage’. After explaining the technical procedures of the gold standard, Pennington detailed the dangers to gold of the existence of a paper currency, and then added a tantalizing hint: ‘It is possible to regulate an extensive paper circulation... to render its contraction and expansion... subject to the same Law as that which determines the expansion and contraction of a currency wholly and exclusively metallic’. Here was the first indication in Great Britain of the ‘Currency Principle’: that more than simple gold redeemability was needed to transform bank money into a mere surrogate of gold.

William Huskisson finally sat up and took notice, writing to Pennington that:

I perceive that towards the end of your Paper on Coinage, you state an opinion that means may be found of preventing those alternations of excitement and depression which have been attended with such alarming consequences to this Country. This, for a long time, has appeared to me to be one of the most important matters which can engage the attention...[T]he too great facility of expansion at one time, and the too rapid contraction of paper credit... at another, is unquestionably an evil of the greatest magnitude.

In short, bank credit and paper money were perceived by Huskisson as responsible for the business cycle; what, then, could be done about it? He urged Pennington to elaborate on his tantalizing suggestion.

The upshot was an ironic one: while James Pennington's third memorandum, in reply, ‘On the management of the Bank of England’, 23 June, was the first fateful elaboration of the justly famous currency principle, it was scarcely action-oriented enough to suit the minister. At any rate, monetary matters faded temporarily, and Huskisson himself resigned his post the following year, to die three years later. But Pennington's memorandum, nevertheless, was very important, for it declared that to make bank paper currency stable and tied to gold, it must be regulated to conform to the movements of the gold supply. If the Bank of England were the monopoly issuer of notes, Pennington prophetically counselled, it would be easy for it to control the total supply; in lieu of that, the private banks, London and country, could in some way be totally and immediately controlled by the bank. In either case, the bank could then be compelled to keep its securities (i.e. its earning assets) fixed in total amount; if so, its note issues would move in the same direction, and to the same extent, as its stock of gold. While the bank would not have 100 per cent gold reserves to its notes, the legally fixed gap between them would mean that bank notes (and by extension, the total money supply) would move in the same way and to the same extent as the gold supply – thus arriving at the equivalent of 100 per cent specie money for all further operations of the bank. Here was the seed of Peel's great Act of 1844, the embodiment of the currency principle.

But Huskisson could not seize on this point, because of Pennington's hesitations and qualifications; in particular, Pennington, of all people, knew full well that bank deposits are just as much creatures of bank credit as bank notes, and that to ‘regulate them [deposits] properly will be no easy task’.

It becomes a mystery that Pennington, the founder of the currency principle, should have been so alert to bank deposits' role as money, while the currency school concentrated with such fierce insistence on bank notes alone. They applied this variant of 100 per cent gold money to notes exclusively, leaving deposits to go unchecked and unregulated on their own. Some historians speculate that the currency school made the conscious decision to avoid applying their principle to deposits, because of an alleged difficulty in practical application, and because they believed that note-holders – presumably being a broader or less wealthy section of the population – were more likely to cash in for gold than deposit-holders.⁴ If so, then this ‘practical’ decision to forget about deposits proved, in the long run, to be the height of impracticality – indeed, fatal to the currency, or 100 per cent gold, cause. For Peel's Act's prohibitions on further fractional-reserve note issue simply induced the banking system, led by the Bank of England, to shift their inflationary and expansionary attentions to deposits alone – a condition that still prevails throughout the world.

Currency school myopia on demand deposits scarcely extended to their cousins in the United States. On the contrary, such 100 per cent gold leaders and Jacksonian theorists as Condy Raguet, Amos Kendall and the magnificent Jacksonian William M. Gouge of Philadelphia (1796—1863), were perfectly aware of deposits' equivalent role to notes in the issue of bank money. A Philadelphia editor, Gouge became a treasury official in the 1830s, and remained there from that point on. Gouge held firmly that deposits are in all cases equal to notes, that they may be created by bank lending, and that they have the same inflationary effect on prices as bank notes. He called for a return to the 100 per cent gold reserves backing the deposits of the original banks of Hamburg and Amsterdam. Gouge was also the main theoretician of the Van Buren-Polk independent treasury system, in which the federal government would separate itself totally from banking, first by keeping no deposits in any banks, spending its funds directly in specie, and second, by accepting in taxes only specie and no bank notes or deposits. In that way, the American banking system would be free, not only of a central bank (as ensured by President Jackson in the early 1830s), but also of any link to or support by the federal government.⁵

Other influential expressions of the currency principle emerged from the panic of 1825. The highly influential Sir Henry Drummond (1786–1860)⁶, banker and MP, in the fourth edition (1826) of his Elementary Propositions on the Currency, was driven by the crisis to the realization that mere specie convertibility was not enough to avoid boom-bust crises in money and in prices. He therefore concluded that the quantity of paper money should be kept constant, so that variations in the money supply would only reflect changes in the stock of specie. In the same year, Richard Page, writing as ‘Daniel Hardcastle’, state the currency principle in crystal-clear form: ‘That only is a sound and well-regulated state of things, when no greater numerical amount of paper is in circulation than would have circulated of the precious metals if no paper had existed’ ⁷

After the crisis of 1825, then, a consensus began to form, beginning with James Pennington and spreading through knowledgeable circles in Britain, that the gold standard is not enough; and that bank credit must not be allowed to expand unduly. At the ultimate pole were the currency school, who believed that commercial banks must be restricted to 100 per cent of gold, at least for any further note issues. Most of the school unfortunately left demand deposits out of their reckoning as not part of the money supply. Other established leaders, such as bank governor John Horsley Palmer, developed the far more qualified view advocating more control by the Bank of England: bank money should pyramid on top of a fixed ratio of reserves to liabilities maintained by the Bank of England.

But if bank credit was to be confined to movements of gold, and thereby to end the threat of inflation and the business cycle, by what mechanism was this to be accomplished? In most cases, and certainly among virtually all adherents of the currency school, the answer was to be the Bank of England itself: the very institution which bullionists and their successors had long seen to be the central agent of inflation and credit expansion. The idea was that the bank would either ride herd over the private banks, or, in the developing consensus, to assume a monopoly over all issue of bank notes — leaving banks to issue demand deposits in a way that tied them inexorably to the Bank of England. In short, the modern banking system, with all its deep inflationary flaws, was what was envisioned and brought forth by the currency school. In the name of ultra-hard money, they unwittingly imposed upon Great Britain, and later the world, the modern, centralized inflationary, fractional-reserve and central bank-dominated banking system. The theory was that the bank would control the private banks through monopoly of note issue and other measures, while the government would rigidly control the bank itself.

The other main instrument of bank control over private banks was to centralize gold in the hands of the bank, and to make Bank of England notes legal tender for all citizens and banks. In that way, the banks would be induced to surrender their gold to the Bank, and to happily pyramid their loans and deposits on top of their bank reserves. Their demand deposits at the bank could always be cashed in for legal tender currency. In short, as this proposed structure came to be established in Britain and then elsewhere, the world was saddled with the modern banking system.

It is still a mystery how men so keenly aware and critical of the cartellizing and inflationary role of the Bank of England should have proposed centralizing control into the hands of the very same bank, and all in the name of stopping inflation and tying the monetary system closely and one-to-one to gold. It was truly putting the fox in charge of the proverbial chicken coop. A minority of currency men, it is true, favoured another variant, first recommended by the spiritual father of the currency school, David Ricardo himself. Already, at the end of his 1816 pamphlet on Economical and Scarce Currency, Ricardo had hinted at this solution, influenced by an unpublished proposal of J.B. Say in 1814. In his last, posthumous work, published in 1824, The Plan for the Establishment of a National Bank, Ricardo put forward and elaborated the new plan: the appointment of a government board to be in charge of a national note issue monopoly, with the Bank of England essentially confined to credit and deposit banking. The idea was that since the bank could not be trusted to be in charge of monopoly note issue, that function should be trusted to the central government. But, surely, here was even more of a fox, if not a wolf, to be placed in command. Government is just as much, if not more, inclined toward monetary and credit inflation as any private central bank. Government can always use inflation to finance the deficits it desires and to subsidize credit to its political allies.

There were other far more effective ways to restrict bank credit expansion. During the Jackson-Van Buren era in the United States (approximately 1828–40s), which roughly coincided with the period of the currency-banking school controversies in Britain, the programme of the hard-money Jacksonian movement was far more thoroughgoing, and ultimately far more realistic, than their spiritual cousins of the currency school. Both groups aimed at achieving hard money, tied very closely to specie, in order to end inflation and the boom-bust cycle. But, instead of maintaining and strengthening the central bank, the Jacksonians, far more logically, made it their first order of business to destroy it. The next step, for Gouge, Kendall, Raguet and their followers, who included Presidents Jackson and Van Buren, was to separate the federal government totally from money, by establishing an independent treasury system, passed by the Van Buren administration in 1840, repealed by the Whigs, and then permanently re-established by the Jacksonian Polk administration in 1846. The idea of the independent treasury was, first for the treasury to keep its own funds, without depositing them in any banks; and second, for the treasury to accept in taxes and other fees only specie, and not even notes of specie-redeeming banks. In that way, the federal government would give no encouragement whatever to the circulation of bank notes or deposits. Another plank in the Van Buren programme, considered but never passed, as being too hard-hitting, was a federal bankruptcy law which would have forced any bank to close its doors whenever it failed to meet its contractual obligations to redeem its notes or deposits in specie on demand. Other parts of the Jacksonian programme were state enforcement of bankruptcy the moment a bank should fail to pay in specie, and even the outlawing of all fractional-reserve banking as inherently fraudulent, as promising something that could not possibly be fulfilled: instantaneous redemption of all demand liabilities in specie.⁸

Less thoroughgoing than the Jacksonian proposals but better than the currency school's reliance on the central bank were the proposals of a free banking group that arose after 1825, calling for elimination of the Bank of England. The free banking proponents, however, were scarcely united in their theoretical outlook or in their goals; some wanted free banking in order to eliminate what they considered to be Bank of England restraint on bank credit expansion; while others wanted it for the opposite reason: to approach the currency school goal of pure specie money.

In the former category, for example, was the veteran inflationist and anti-bullionist, Sir John Sinclair. On the other hand, a particularly important example of the latter, hard-money, category was the long-time bullionist and clerk at the Royal Mint, Robert Mushet. In his substantial book, An Attempt to Explain from Facts the Effect of the Issues of the Bank of England... (1826), Mushet set forth a currency principle type of business cycle theory. The Bank of England, he pointed out, set into motion an expansionary policy that created an inflationary boom, and that later had to be reversed into a contractionary depression. Like the later currency school, Mushet's aim was to arrive at a purely metallic currency or its equivalent, but he saw that free banking rather than central banking was a better way to achieve it. Thus, Mushet hailed the act of 1826, allowing joint-stock banking outside of the environs of London, as an improvement on the previous system, but still leaving intact the ‘main evil’, ‘because they do not take the power from the Bank of England of adding extensively to the currency’. But ‘when the monopoly of the Bank expires [in 1833], and the trade in money is perfectly free, a better order of things may arise’. The better order included stability, a currency not suffering from over-expansion, and an end to the boom-bust cycle.⁹

But by far the most important hard-money free banking advocate was the veteran bullionist Sir Henry Brooke Parnell, a leading MP who had taken the bullionist side in the Irish money question in 1804, was a prominent member of the bullion committee, and had supported resumption in 1819. As early as 1824, Parnell had moved in Parliament for an investigation of the Bank of England's charter. In 1826, he denounced the bank's ‘exclusive and mischievous privilege’. In 1826 and again the following year, Parnell organized a discussion at the Political Economy Club, on the theme, ‘Might not a proper Currency be secured by leaving the business of Banking wholly free from legislative interference?’ He left no doubt that his own answer was, Yes.

Parnell set forth his free banking views in his 1827 tract Observations on Paper Money, Banking, and Overtrading (1827, 2nd ed., 1829). He began, following Mushet, by placing the blame for the panic of 1825 on the Bank of England's over-issues of 1824–25. The problem was that the law had taken away from the bank ‘the great check over abuses in issuing paper money, namely, the competition of rival banks’. Going beyond Mushet, Parnell was not willing to wait for the bank's charter to expire in six years; no, the power of the bank over money, and thereby over prices and the general state of business, was 'so entirely repugnant... that it ought not be tolerated any longer’. Parnell concluded that the remedy was ‘a free system of banking’, and, overlooking a few pages at the end of Mushet's work, proclaimed that he himself was the first man in England to raise the banner of free banking.¹⁰

It is hardly surprising, on the other hand, that George Poulett Scrope, the inveterate underconsumptionist, should also have been an inflationist advocate of free banking in this period. In several books and in an article in the Quarterly Review, heralded by articles of other like-minded men in that leading Tory journal, Scrope called for the legalizing of small bank notes and an end to the London note issue monopoly of the Bank of England. His programme was designed to fit inflationist ends. Thus the competing banks would be able to redeem their notes in bullion rather than coin. The proclaimed goal of this banking programme was, in Scrope's words, to ‘everywhere lower the values of the metals, and with them that of money’.¹¹