Paper Money - Credit and Banking

Paper Money, Credit, and Banking

The great economic achievements of the Dutch in the Fifteenth and Sixteenth Centuries were a source of envy to many com­mercially minded Englishmen. Very humanly, their minds tried to ferret out some explanation of the prosperity of the Dutch, perhaps for the intellectual satisfaction they might get but more probably in the hope of achieving that high standard of living customary among the Dutch merchants. It is not strange that many of them located the source of the Dutch commercial success in the fact that a bank was operated successfully in Amsterdam, while none as yet had been started in England. Sir William Petty and Sir Dudley North, Seventeenth Century writers, both advo­cated the formation of a bank in England which might issue credit. It is clear that the ideas of these early writers were vague on what banks could and could not do. North's idea was that a bank should be created to lend money to the government; and as a matter of fact that was the chief reason for chartering the Bank of England. Banks served as repositories for coin which could be put out at interest, but the ideas of note issue and com­mercial credit were scarcely known, even on the continent, in the Seventeenth Century.

The banks at Amsterdam and at Hamburg were really not banks in the modern sense of the word. They were places where money could be exchanged into currency of recognized and standard value. Because of the variety of coins circulating in Europe at the time, and because the weight and fineness of the metal coins varied so much from that which was claimed by the state issuing them, some reliable method of testing and exchange was essential to the conduct of trade. The increasing amount of commerce passing through Amsterdam and Hamburg made these cities the natural places for the establishment of exchange banks. They weighed and assayed the coin which traders brought them; in exchange, they gave coins of certified weight and fineness or certificates of deposit. Banks of this type needed no capital of their own, since they exchanged value for value and were re­warded by the small charge they made for the service they ren­dered. English authorities of this period confused cause and ef­fect. They felt that the bank was responsible for the growth in trade, and consequently they advocated the establishment of a bank in London. Strangely enough, in their appraisal of the bank of Amsterdam, the English merchants had their eye not so much on the principal function of the bank—which was the ex­change of currency—but on a practice which was at first con­sidered quite secondary.

When the Amsterdam Exchange Bank was established in 1609, traders were allowed to deposit money in the bank to be withdrawn at any time by the depositor. The rules of the bank required that large payments of several hun­dred dollars or more be made by the transference of accounts from one firm to another within the bank. A small charge was made for the transference of accounts. Such transfers of accounts were later called "bank money." As one authority ex­pressed it, the function of the bank was "the local manufacture of international coinage." According to the laws under which the bank operated, the bank was required to keep on hand one hundred percent of the coin deposited. Violations were fre­quent, however, in the later years of the bank's history. Loans were made to the Dutch East India Company and to the city of Amsterdam, and although these obligations were finally met the bank was forced to close in 1820 for failure to meet its obliga­tions.

Banks created primarily for the purpose of accepting deposits and making loans were organized in the commercial city of Venice as early as the Fourteenth Century. These private banks were required by the laws of Venice to hold coin as security for their depositors. Public banks were established during the next two centuries to accept deposits from citizens, make loans—es­pecially to the government—and to issue bank notes on govern­ment authority.

When the Bank of England was founded in 1694 it was de­signed to create a market for government loans. It accepted money from private citizens which it immediately loaned to the government. The time was one of financial instability. With new monarchs on the throne (William and Mary, 1688) and part of the population disgruntled at the change, it was not easy to secure money for public purposes. One is not surprised to note the close connection between the admiration that English commercial interests had for the Dutch, the enthroning of mon­archs with considerable Dutch sympathy, and the establishment of the Bank of England by the descendants of James Houblon, a Flemish refugee who came to England to escape the perse­cutions of the Spanish Duke of Alva.

The Bank of England was the first bank in England to have government authorization, and it was the first of national im­portance; but private banking activity had been carried on for a century and more before by the goldsmiths of England and Scot­land, some of whose names are still attached to private banks now operating. The goldsmith accepted money for deposit and paid interest at a stated percent. Their guarantees of security, easy withdrawal, and interest brought forth abundant money which heretofore had been hoarded or lent at interest on personal se­curity. Members of the royal family, Cromwell, and other promi­nent persons were known to have had dealings with them prin­cipally as borrowers.

A further extension of the goldsmiths' banking activities came when the certificates of deposit were accepted in payment for financial obligations. These deposit receipts, at first merely the holder's evidence for his deposit and his right to withdraw the amount stated, soon began to circulate as currency. As long as the reputation of the bank and the depositor were good, people had no fear of accepting deposit slips instead of cash. This issue of certificates was followed by the issuance of notes, and then in 1781 by a book of checks. The right to issue notes was so much a part of private banking that legislation in the time of Queen Anne prohibiting this practice was believed to be an effective means of eliminating any but the smallest private banks.

The immediate effect of the organization of the Bank of Eng­land was the stabilization of public finance, but the long run effect was a serious inflation of currency and credit. Specie dis­appeared, the mint closed because no one brought bullion to be coined, and devaluation of the currency was advocated. John Locke opposed devaluation, and in his essay, Further Considera­tions Concerning Raising the Value of Money, he argued for a sound money policy. He believed it unjust to deprive blameless men of one-fifth of their estates and income. Many men, he said, would be glad to give a much larger proportion of their estates if they were assured the nation would benefit; but to take from some men and give to others less deserving (the debtors) did not help the state at all. Furthermore, the function of government was to preserve contracts; how could the government require that some pay less than their contract and others receive less. Such a policy was no more just than requiring men to pay more than they had contracted to pay. Lastly, he believed, devaluation would undermine public confidence in the government and de­fraud not only the king but also the church, the universities, and the hospitals.

Locke's arguments were persuasive, especially to the class of landowners who continued to exercise control over the govern­ment. A period of deflation set in, but the hardship which the advocates of devaluation had foreseen never materialized. What might have happened eventually will never be known, for a wave of speculation founded upon colonial enterprises- overtook both England and France and brought on a banking crisis in both countries in 1720.

The name of John Law (1671-1729) is closely identified with this period of speculation, inflation, and subsequent financial crisis especially in France. Law was the son of a banker, one of the goldsmiths who originated banking practices in Scotland; and by tradition and training he became an authority if not a genius in economic matters. His ideas were coldly received both in Scot­land and England. Because of certain personal misfortunes of a social nature while living in London, he was exiled from Eng­land and forced to spend the rest of his life on the Continent. The financial difficulties of France following the extravagant reign of Louis XIV gave Law his opportunity, and in an amazingly short time he had established institutions to put his ideas into practice. Law's principal work, Money and Trade Considered, with a Proposal for Supplying the Nation with Money, was written in 1705, as a plan to relieve Scotland of a severe financial panic following the failure of the Darien expedition. The plan was never seriously considered in Scotland, but it embodied the basic ideas which Law held on wealth, money, credit and banking, and to which he gave practical expression in France in 1716. Law denied the general contention of Mercantilism that money was wealth; he held that wealth in terms of goods did depend upon trade, and both employment and trade depended upon the quantity of money in circulation. Furthermore, he added, credit had all the beneficial effects of money. The quantity of specie need not be increased; but merely by the device of creating a bank, credit could be expanded. The bank which Law proposed was to issue notes backed by land. Credit expansion and note issue would be under rigid control, since the bank would be a state agency and the commission controlling it composed of govern­ment officials. The most daring part of the proposal was that foreign trade and public finance would be managed through one gigantic corporation, controlled by the state in the interests of the people, and carrying on business through the issue of an abundant supply of paper currency.

The story of Law's experiments in France reads like an economic fairy tale. During his exile he supported himself in luxury mainly through financial speculation and gambling. The chaotic finan­cial situation in which Louis XIV left France on his death baffled the best financial experts of the time. A declaration of national bankruptcy was seriously considered. When an acquaintance of Law's, the Duke of Orleans, became Regent, Law was given an opportunity to submit a plan to stabilize the nation's finances. Opposed by the financial oligarchy in Paris, the plan was tenta­tively accepted by the Regent. The first step was the establish­ment of La Banque Generate under the immediate direction of Law. The capital of the bank consisted of shares of stock paid for in 4 installments, 1/4 in cash and 3/4 in the then nearly worthless paper notes of the French state. The privilege of note issue was granted to the new bank, the notes being redeemable in metal by weight on sight. Thus far the plan was a success. The fact that the bank was willing to accept the existing government notes raised the credit of the government; the bank's own notes became a most desirable medium of exchange since they had a fixed value in metal. The use of the notes for industrial transactions in the provinces, and the decree making the notes acceptable in pay­ment of taxes created such a demand for the notes that new issues soon followed. It must be remembered that Law saw no diffi­culty in an unlimited issue of paper currency as long as there was a demand for it and as long as there was good security for it. An excess quantity of paper currency never worried him.

The success of the bank earned the immediate confidence of the Regent, consequently Law's request for permission to carry out the other parts of his program was met with approval. The Mississippi trading area was not prospering under the manage­ment of an incompetent speculator. Law took over the franchise and set up the Compagnie de la Louisiane ou d'Occident (Company of Louisiana or the West). Its capital was raised by the sale of shares payable part in cash and part in notes of indebtedness of the French state. The same confidence did not exist in the new company as had obtained for the bank. Consequently, the price of the shares fell below par. Law remedied this by agree­ing as director of the bank, now an official state bank named La Banque Royale, to redeem the shares at par with notes guar­anteed by the king. The favorable effect on the shares was im­mediate; their price rose on the exchange to above par. Law's next move was to unite the companies engaged in foreign trade into a single company, La Compagnie des Indes (The Com­pany of the Indies), under his own direction. Without going into further detail, confidence in Law and the renewed vigor of business enterprise caused every new issue of shares to be grabbed up immediately at fantastic prices. To meet the demand for money caused by the accompanying price rise, the bank issued more paper currency.

Finally, the more intelligent investors real­ized that the earnings of the companies were too meagre at this early date to pay a dividend commensurate with the price of the shares, and they began to sell. With the dictatorial power over French financial matters which he now held, Law introduced measures to check the falling price of shares and the rising price of metal and property. He declared a 40% dividend on the shares, he forbade the use of diamonds and the manufacture of gold and silver plate. A virtual embargo was placed upon coin. But the shares still fell. Then Law made his most daring effort to check the downward trend. He ordered the bank to buy and sell the shares of the various trading companies at a fixed price, payable in bank notes. The loss of confidence which at first only affected the companies now extended to the bank and to the paper currency. The latter soon became as worthless as the shares. Law was driven from France and the bank notes were incor­porated into the debt of France, the total of which was subse­quently reduced by more than half. Much abuse has been heaped on the head of Law for his mismanagement of French finances. Mature judgment seems to indicate that while on the whole his plan was admirable it was spoiled first by a fundamental miscon­ception—that paper money could be issued in unlimited quan­tity—and, secondly, by a foolish gamble—ordering the bank to buy the discredited shares at a fixed price. Except for the latter action, the bank might have been saved and the credit structure of France maintained. It is not an exaggeration to say that Law's four years of experimentation with his "Mississippi Scheme" stands as one of the most exciting periods in financial history.

While John Law was learning through bitter experience the fallacies of some of his economic ideas, a similar course of events was being pursued in England. In 1711 the South Sea Company was incorporated. This was the first move in a scheme originated supposedly by Daniel Defoe to reduce the government's debt and stimulate foreign trade. The South Sea Company agreed to pay the government several million pounds to be applied to the national debt in return for a monopoly on trading rights in South America and the Pacific Islands. The money paid to the govern­ment was to be raised by the sale of stock. In spite of trouble aris­ing with Spain, the scheme was successful in its early stages and a more ambitious plan was submitted to government officials. Under the new arrangement the South Sea Company would take over the entire national debt of over fifty-one million pounds on which it would receive 5% annually. It was the plan of the directors to contact the holders of government certificates of in­debtedness and persuade them to exchange the government bonds for shares in the South Sea Company. Stimulated by the confi­dence of the French in the experiments of John Law, the shares of the company were not only readily accepted by the holders of government bonds, but their price on the exchange began to ap­preciate rapidly. Within six months the stock had risen from 1281/2 to 1000. Companies imitating the plan and organization of the South Sea Company began to appear, and speculation was wild. Then came word of the panic in France, and a similar loss of confidence began in England. The price of shares fell rapidly as insiders, sensing the situation, unloaded huge quantities of stock on the market. By December not only the South Sea Com­pany stock but securities of sound companies such as the Bank of England and the East India Company went down rapidly, and Parliament was forced to take action. Investigation of the com­pany showed both fraud and bribery and. the leaders of the com­pany were brought to trial and imprisoned. Those who had ex­changed government obligations for the South Sea Company asked the government to guarantee them their original invest­ment, but while not completely neglected they received only half of what was due them before the panic.

With these two major disasters in the background, it is no wonder that the more conservative economists were reluctant to give wholehearted approval to paper money and bank credit dur­ing the century which followed. This period was marked by bitter and continued controversies on the question of money and credit especially as they related to banking practices and government

In the midst of money and banking uncertainty, Ricardo endeavored to outline the function and methods of modern bank­ing, with the hope that a more general understanding of how and why banks operate would ease the mounting tension. In his Pro­posals for an Economical and Secure Currency, he described modern banking practices. He said the real advantage of banking to a community begins only when it employs the capital of others as well as its own. This additional money comes from deposits and the notes which it issues. Most of it is loaned to persons whose trustworthiness is assured, who intend to use the funds for business purposes, although a small part merely remains in the bank awaiting its depositor's decision to withdraw it. On the money loaned, the bank collects interest; some of the money deposited and some of the original capital may be invested in government bonds or other sound obligations which can be converted into cash on short notice. Another important function of the bank, said Ricardo, was the facility it offered in making payments be­tween merchants in near or distant towns, or foreign countries; checking accounts had not developed extensively at the time of Ricardo, but the use of the bank to make payments was wide­spread. Finally, banks could issue notes on the government bonds and specie which they held. The former not only furnished funds to the government but enabled banks to increase the paper money in circulation. The earnings of a bank arise through the interest it collects on loans to the government or individuals, the earnings from investments it makes, and the fees it collects for services. With these earnings the bank pays expenses, interest on deposits, and dividends to the holders of shares in the bank.

This outline taken from Ricardo is a fairly accurate description of conservative banking practices of his time. The simplicity of the description belies the problems and debatable issues in con­nection with it. As a matter of fact, at least two major issues stirred the financial world during Ricardo's lifetime. The first great controversy was between bullionist and anti-bullionist about which something has already been said in the discussion of Ricardo's ideas on money. The uncertain economic situation which could be traced to the almost continuous warfare during the Eighteenth and early Nineteenth Centuries upset the normal banking procedures. Specie payments were suspended in Eng­land; exchange rates were usually unfavorable; country banks failed; and the excessive government demands upon the Bank of England made uncertainty the keynote of the times. The chief point at issue throughout the period was the control of paper currency. Ricardo, Whatley, Malthus, and Thornton were the outstanding bullionists. They contended that the constant de­preciation of currency was due to the over-issue of paper bank notes, and they advocated—in the report of the Bullion Com­mittee which was largely the work of Ricardo—that a return should be made to specie payments, and that the difference in value between specie and bank note reflected the amount of over­issue of the notes. The anti-bullionists' position was presented in speeches and pamphlets by Nicholas Vansittart, Bosanquet, and Trotter. Their argument was that Bank of England statistics did not show that a greater note issue existed in periods when bullion was selling at a premium over paper money; and further, that in the years when large payments in specie were made by the Bank of England to foreign countries the premium of specie over paper was greater.

Hence, the anti-bullionists refused to agree that de­preciation in the value of paper money was due to over-issue. They believed that rather than set rigid limits to the amount of paper money a bank could issue by setting a fixed ratio to the amount of bullion on hand, the bank itself could control the issue simply by restricting issue when the interest rate began to fall. It is sufficient to note that the anti-bullionists' views were accepted until after the Napoleonic Wars, when specie payments were re­sumed. The immediate effect of the resumption was to set in mo­tion a deflationary process which lowered prices and wages but continued fixed incomes and debts at previous levels. Objection to this economic condition was outspoken as it had been of the unstable inflationary period which preceded it.

Thus, the fires of controversy were kept burning. Did devalua­tion and the consequent inflation of currency stimulate business? Was the failure to honor the gold standard a breech of faith on the part of government? Could paper currencies be stable with­out being tied directly to the quantity of metal money on hand? These and other questions challenged the best minds of the times, and much of the best economic writing of the period is in the form of attempts to state an idea or a theory in language practical enough so that it might have a bearing upon the existing mone­tary difficulties. Further, refinement of the points at issue and sharper arguments were used as the currency controversies con­tinued. The currency school advocated strict adherence to a metallic standard for paper money; the banking school believed that both paper money and credit could be regulated without government interference by the economic processes themselves. Nevertheless, government regulation became a fixture even though a specific metallic standard was a fiction rather than a reality.