7.8 Tragedy in triumph for the currency school: the aftermath

As the Jacksonians and other currency counterparts in the US might have predicted, the currency school harboured a tragic flaw, an Achilles' heel that laid them low and turned their triumph into ashes: the neglect of bank deposits as a coordinate part of the money supply. And so, no sooner had Peel's Act been passed, when the Bank of England, happily ensconced in its briar patch of monopoly, central control, and note restriction but deposit freedom, began to expand its loans and deposits ad libitum. At the end of 1844, bank discounts had been £2.1 million and total bank credit £21.8 million. By the end of February 1846, however, bank credit expansion had been so intense that its discounts totalled £13.1 million and total credits £35.8 million. In short, in only a little over a year, total bank credits had risen by 64 per cent, and discounts by a phenomenal 424 per cent. This expansion was aided by the bank's drastically reducing its discount rate from 4 per cent to 2V2 per cent, not only a huge quantitative reduction, but also a lowering of the rate from its traditional ‘penalty rate’ above the market, to the market interest rate, thereby greatly stimulating borrowing from the bank by banks and other debtors.

Notes of the Bank of England increased only mildly during this period; the huge rise, as we might expect, took place in bank deposits. In September, 1844, bank deposits totalled £12.2 million; by the end of February, 1846, they had doubled to £24.9 million. In the course of this enormous expansion, bank gold reserves fell sharply.

Most of this expanded bank credit poured into a speculative mania of investing in questionable new domestic railroads. In the years 1845 and 1846, over £180 million of new railroad construction was authorized, about double the total of the entire previous decade. Looking back on the period a few years later, The Economist referred to the ‘mad scenes’ of 1845 and 1846, and to

the folly, the avarice, the insufferable arrogance, the headlong, desperate, and unprincipled gambling and jobbing, which disgraced nobility and aristocracy, polluted senators and senate houses, contaminated merchants, manufacturers, and traders of all kinds, and threw a chilling blight for a time over honest plod and fair industry.

The bank tried feebly to stem the tide during the first half of 1846, but no sooner did bank reserves increase, than the bank, which had raised its discount rate to 3 ¹/₂ per cent in November 1845, dropped it back to 3 per cent the following August. Bank reserves then resumed their steep decline, falling from £10 million in August 1846, a ratio of specie to notes and bank deposits of 58 per cent, to only £3.0 million in April 1847, a ratio of only 20 per cent.

Again, the bank tried to check the tide it had created and continued to generate, but too little and too late. Interest rates rose with the inflationary boom, so that an increase of the bank discount rate to 4 per cent in January 1847 left the rate still under the market, and between 9 January and 10 April, total bank credits rose by £4.5 million and discounts by £3.8 million.

By April 1847, the Bank of England, as well as the entire financial and economic system, was in deep crisis: it increased its rate to 5 per cent, but market rates were now up to 7 per cent. Rejecting efforts by a minority of bank directors to raise the rate to 7 per cent, or even to 6, the bank made things much worse by keeping its rate at 5 and then rationing credit, suddenly cutting off discounts, calling in loans, and refusing to increase loans regardless of the credit quality of the borrower. The bank's refusal to raise rates and instead discriminate in favour of certain borrowers did not, however, save the commercial bank owned by the bank's own governor, W.R. Robinson, from stopping payments in July, or the bank of two other directors from going under in September.

The bank's sudden contraction, cessation of loans and credit rationing caused a severe business and financial panic in April and May of 1847. This drastic therapy finally eased the bank's own condition by the end of May, with the gold outflow temporarily reversing. By the beginning of July, the bank's reserves had doubled from £3.0 million to £6.0 million, a reserve ratio to deposits of 32 per cent. But no sooner had the pressure eased than the bank began to expand again, in the meanwhile making things worse by keeping its discount rate below the market and indulging in selective credit rationing. In September, the second great crisis of 1847 broke, and mercantile failures spread throughout September and October. Thomas Tooke lamented that ‘These mercantile failures, in number and in the amount of property involved in them, were unprecedented in the commercial history of this country’. In October, the banks began to break, and bank runs began to spread through the provinces. As a result, the frightened banks began to contract their credit and deposits drastically, in order to increase greatly their percentage of reserves. The reserves of the Bank of England were down sharply once again, to less than 14 per cent of deposits. At that point, the Bank of England threw in the towel, and, for the first of many crises, requested the government to suspend the 100 per cent gold reserve restriction on notes imposed by Peel's Act. Delegations from Liverpool and the North, London private bankers, and members from Scotland also pressed hard for suspension of Peel's Act. The country bank organ, Circular to Bankers, charged that the London bankers were considering breaking the Bank of England by redeeming all their deposits. One wonders, in that case, how the commercial banks themselves could have avoided being broken in turn. At that point, the government predictably, and, for the first of many crises, itself threw in the towel by suspending the Peel Act provision of 100 per cent gold reserve restrictions on the issue of Bank of England notes.

The government saved the fractional-reserve system by obediently suspending Peel's Act on 25 October, thereby of course saving the day for the banks and alleviating the immediate crisis – at the expense of, in effect, giving up the currency principle and any attempt to tie the monetary and banking system directly to, and to the same extent as, the behaviour of gold. From then on, Great Britain, and eventually the rest of the world, was stuck with a fractional-reserve banking system issuing demand deposits, pyramiding on top of a central bank monopolizing the issue of notes and centralizing the nation's gold, and generating an endless round of boom-bust cycles of inflation and recession. Furthermore, with gold essentially centralized into the reserves of the central banks, it became easy for all these nations, even though allegedly committed to the gold standard, to go off that standard and on to fiat paper whenever any crisis – such as World War I – presented an alleged need for the rapid inflation of money to finance the war effort.

The heart and soul of the currency principle was a rigid tie of Bank of England note issue to 100 per cent gold reserve; but if this restriction was to be suspended whenever banks or businesses got into trouble, then the currency principle lay in shambles. As the prominent London banker George Carr Glynn correctly prophesied after the 1847 suspension, the public would expect another suspension in every future crisis. And sure enough, that is precisely what happened. In response to the 1847 crisis, there were committees of parliamentary inquiry in 1847 and 1848. The suspension of Peel's Act during the crisis of 1857 was easier, and while there were parliamentary committees in 1857 and 1858, there was, in contrast to the 1847 crisis, no debate on the floor of Parliament. And the suspension of Peel's Act in 1866 was considered so routine that there was not even the bother of a parliamentary committee of inquiry.

It is therefore remarkable that, from the time of the first suspension in 1847, the currency school, without exception, defended the suspension of Peel's Act, giving no sign of realizing that they were thereby abandoning their entire doctrine.³⁹ For not only did suspension in crises weaken the point of the Act, but also the knowledge that suspension would come to the rescue in any crisis emboldened the bank and banking system to expand credit as if the restrictions of Peel's Act did not exist at all. As a result, all that was left of the currency principle was the monopolization of notes by the Bank of England.