Wednesday, March 29, 2017

Good as Gold, VII: Battling the Banks


In the previous posting in this series — cut short on the Ides of March — we saw how the tenets of the British Currency School became predominant.  We also saw how one branch of it, that which held that government debt is an asset of the issuing government, quickly became public policy . . . if only because it allowed politicians to spend as much money as they could until the public lost confidence in them.
Sir Robert Peel, architect of the 1844 Bank Charter Act.
By 1844 in England the idea that the currency had to be backed either by gold or government debt had taken hold as a matter of public policy.  Thus, when the charter of the Bank of England came up for renewal that year, the struggle became not merely for the Bank’s survival — that was a foregone conclusion — but who would control the creation of money and credit.  Not simply regulate, mind you.  That has always been a function of government.  No, the issue was who would have the power to create money.
As we have seen, the Bank of England was established to ensure that there would always be enough liquidity in the system to carry out commerce.  It was strictly a private sector venture that got sucked into being the chief financing agent for the State by accident: in order to secure its charter, the Bank had to bribe the government with a loan of £1.2 million in gold and silver that the organizers of the Bank had put in to have sufficient reserves for convertibility of credit money into the reserve currency.  Ultimately, this made government debt and gold legally the same for the purposes of bank reserves.
The purpose of bank reserves is, contrary to popular thought, not to back the currency or provide loanable funds for banks, but to convert all other forms of money into the reserve currency on demand.  This ensures that all forms of money have the same value, i.e., a dollar in the form of a check is the same as a dollar in the form of a banknote.
Pre-1844 privately issued British £5 Banknote
Prior to the British Bank Charter Act of 1844 (7 & 8 Vict. c. 32), any commercial bank could expand the money supply by accepting mortgages and bills of exchange and using its promissory notes to back new issues of banknotes.  By tying its note issues to those of the Bank of England, a commercial bank could ensure that its notes would pass a par with those of the Bank and other member banks.  Notes were more acceptable in commerce than personal checks, as notes were a general obligation of a bank, while a check is a personally issued instrument.  A merchant would trust a banknote more than a check.
One of the reforms instituted by the Bank Charter Act of 1844 was to separate the banking function from the note issuing function in the Bank of England, and to end the power to issue banknotes for most banks.  This did two things.  One, it cut the direct link between at least part of the currency and the level of economic activity.  Two, it put the sole power of creating the reserve currency (and thus control over the rate of economic growth) in the hands of the State.
£1 note, pre-1844 asset-backed, post 1844 debt-backed.
Prior to the Bank Charter Act of 1844, if a commercial bank wanted to make loans in excess of the reserve requirement, it could rediscount some of the loans it already had at another commercial bank or the Bank of England to increase its reserves.  The other commercial bank would accept the paper if it had excess reserves, while the Bank of England could use the accepted paper to create more reserve currency.  Either move would allow the commercial bank offering the paper for rediscount to make more loans and have the required amount of reserves on hand.
After Bank Charter Act of 1844, increasing reserves of a commercial bank depended on whether excess reserves existed in other banks — including the Bank of England — or the government was willing to issue more debt to back additional amounts of the reserve currency (or — unlikely — enough gold had flowed into the country at just the right time).  Thus, regardless whether there were financially feasible capital projects in the economy that needed financing, if existing savings did not exist to provide reserves and the government refused to increase its debt, or the inflow of gold was insufficient, the projects would not be financed.
From private sector financing to government funding with a pen stroke.
Not unnaturally, this gave fractional reserve banking a bad name.  Originally nothing more than a form of insurance to maintain public confidence in the currency, fractional reserves became a way for the government to control the rate of economic growth, or restrict who was permitted to use money and credit to finance new capital formation.
Ultimately, the reforms carried out under the Bank Charter Act of 1844 served to concentrate ownership of capital even more than before.  By tying the rate of economic growth — and economic growth — to the supply of existing savings, ownership of virtually all new capital was restricted to the already wealthy, the lucky, or those who figured out how to “game” the system, e.g., finance new capital formation by somehow circumventing the presumed need for existing savings.
As a result, the ability to gain a decent income began increasingly to rely on the ability to force redistribution of existing wealth instead of the capacity to become productive.  Wealth became not only a means of securing one’s own material wellbeing, but of controlling that of others through control of access to money and credit, and thus ownership of capital.
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