As we saw in yesterday’s posting, governments were not able to control the currency for political purposes to any appreciable degree until they were able to hijack the institution of the central bank. Even then, their power over the money supply was generally limited by two factors which tended to subject the value of the currency to the forces of the market, rather than the force of politicians’ arguments.
One, the belief that the money supply consisted entirely of cash — that is, coin and banknotes — or cash substitutes, such as demand deposits (checking accounts). By ignoring the effect of the greater part of the money supply, governments simply could not predict (or understand) any financial effect that their limited definitions imposed on them.
|Historically, non-cash transactions far outnumber cash ones.|
Two, there was the fixed economic doctrine, only departed from with extreme caution and after presumably careful consideration, that whatever backed the currency, it must be redeemable in or convertible to gold or silver. Only in this way could the faith and credit of the government — and its currency — be maintained, and stability ensured.
Regardless how much a politician wanted to spend, if his demands got beyond what the experts considered “safe” — i.e., what could be spared out of reserves of precious metal without running the risk of having people lose confidence in the government . . . and the government’s money. For without money, no government could function, and the politicians would be out of their jobs.
|Manzikert: Bureaucrats betrayed the army and the Empire.|
Unfortunately, with the new idea of the State that came out of the French Revolution and the Napoleonic Wars, governments — especially the new republics in Central and South America — came to believe that government debt that represented a vague promise to pay out of anticipated future tax collections was somehow not only as good as private sector debt that represented claims on specific assets, it was actually better. The idea grew up that government debt was, in fact, the only legitimate backing for a currency.
The fact that this is exactly what the politicians and bureaucrats wanted everybody to believe was just a coincidence. . . .
|Jemima the Great saves England with a pitchfork, 1797|
Naturally, anyone who had savings in a bank wanted the money out of the bank and safe in hand — and he wanted it in gold. Anyone who had banknotes also wanted gold he could trust instead of bits of paper that might not be worth anything once the French took and burned London and started rampaging up and down the country.
Before long gold reserves had dropped so low that the Bank of England requested — or was ordered, depending on your source — to stop payment in gold as an emergency measure. It was not expected to last more than a couple of weeks at most, just until the panic passed and people’s fears were calmed.
The temporary suspension of convertibility lasted until 1821. In addition to allowing the government to carry on the struggle against Napoleon without raising taxes too much, debt money not tied to anything other than government debt encouraged further concentration of ownership of capital, this time the new technology of the Industrial Revolution.
|From 1797 to 1821 the Paper Pound was not "good as gold."|
Still, the banks continued to create new money in the form of promissory notes and demand deposits backed by private sector assets. At the same time, government policy and economic theory convinced people that all the new money was really past savings controlled by the rich, or purchasing power magically created by government. With control over money and credit in the hands of the already wealthy and the politicians, ownership became even more concentrated than before.
There was another development that came out of the suspension of convertibility of banknotes into gold. Government debt changed from being one type of backing for the currency, to the preferred backing for the currency, and in the minds of some experts, the only legitimate backing for the currency.
|Panic of 1825|
Then came the defaults of the sovereign debt of the Central and South American republics, triggering the Panic of 1825. Stock and bond prices plunged, and a significant number of old and reputable banks in the City of London were in serious trouble.
Ironically, one of these was the bank founded by Henry Thornton, the “Father of Central Banking,” whose treatise, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802) contained numerous warnings about the dangers of dealing in “fictitious bills,” i.e., financial instruments with no specific assets behind them, of which government debt was considered the worst, aside from actual fraud. Not heeding his father’s warnings, Thornton’s son got the bank he inherited into a great deal of trouble.
Even more ironically, despite the fact that it was the issuance of unbacked government debt that inflated the money supply — and is credited with starting the modern business cycle of “boom and bust” — many of the experts (and all of the politicians) blamed the lack of control by government, and the unregulated (by government as opposed to the market) monetization of private sector assets by commercial banks for the financial disaster.#30#