Chapter VI: Central Banking

We have seen how fractional reserve banking is unworkable, even if it is not considered fraud, in a free banking system, due to the threat of a possible loss of confidence (inevitable after a credit expansion), and the threat from competition.

 

The history of Central Banking is the gradual removal of these free banking limits, permitting fractional reserve banking on a wide scale.  Every modern bank practices fractional reserve banking, and can do so by being a member of a banking cartel, led by the Central Bank.  It is an extremely beneficial arrangement for these member banks, which is why bankers led the drive for the creation of central banks in the first place, and why every bank supports their national central bank.  Those bankers who control the central bank itself have enormous power over the member banks and over entire economies.  By controlling the money supply, central bankers can controls nations.  

 

The bankers themselves also have a very cozy relationship with government.  In return for the monopoly privilege from government, the central bank offers to finance government deficit spending.  The central bankers promise to buy government securities, by creating new money, so that government has new, powerful weapon of taxation: the inflation tax.  The government benefits considerably by being able to spend new money as they please, without the need for a more visible, and loathed, form of taxation.  In doing so the government misdirects capital in the economy towards its own interests such as wars.  The biggest losers will be those people who are late to receive the money, or those who do not receive it at all.

 

We shall now examine the history of central banking, and how the free market limits to fractional reserve banking were gradually removed.

1. The Bank of England (1694-1844)

 

The Bank of England was created in 1694.  The 1690s were a difficult time for the English government; the country had seen four decades of revolution, civil war and civil strife.  Much of it was due to heavy taxation that the government levied on its population in order to pay for expansion of the British Empire.  The government did not want stop the expansion of the Empire.  On the contrary, they wanted to raise even more money so that they could conquer the French Empire.  Afraid of revolution if they raise taxes, and unable to get credit from other nations due to previously defaulting on loans, the government looked for other options.

 

One way the English government could have financed their planned wars would have been to create money out of thin air.  They could have issued English Government Notes.  But this was not customary (most notes had names of banks written on them), and they are patently nothing more than claims to future taxes.  The government felt that the people would not fall for that scam.

 

At that moment, a syndicate of bankers approached the government with the idea that they, the bankers, could set up a special bank which, by government privilege, would be allowed to practice fractional reserve banking, and it would lend its newly created money to governments.  In return, the government would sell the Central Bank government debt, claims to future taxation.  The government would also pay the bankers interest on the government debt held by the Central Bank (which they bought with un-backed Bank of England notes).  Additionally, the government would use the Central Bank for all transactions – it would be government’s official accounts holder.  Proceeds of taxation (gold) would now go directly into the government’s account at the Bank.  The cozy relationship between the central bank and the government was established.

 

In 1694, the syndicate was given a charter to create the new “Bank of England”.  The original charter lasted until 1705.  They started by issuing the huge sum of £1.2 million in Bank of England Notes, with only a fraction of it (precisely £760,000, 63%) backed up by real gold, the rest created out of thin air – fake certificates for gold that was not in the Banks reserves.  The first run of central banking did not last long.  After less than two years, there were £765,000 worth of outstanding notes, backed up by only £36,000 in gold.  A loss of confidence in the bank notes had led to a run on the Bank, as people demanded redemption in gold (“specie payments”).  Unable to redeem all the notes, the new Bank was bankrupt already.

 

The government however, willing their new inflationary-tool to work, allowed the Bank to suspend the redemption of bank notes, but continue its operations.  The government promised that the Bank would not fail (they said that it was backed up the credit of the State), and all Bank Notes would be redeemed in gold eventually.  Specie payments were suspended for two years while the Bank of England was re-capitalized.  £1 million worth of gold was injected into the Bank through private financing (the wealthy syndicate of bankers running the corporation).  A quarter of million new bank notes were issues, and the Bank was finally able to resume specie payments; it now had 100% reserves.  Anxious holders of Bank of England notes could now redeem them in gold, and confidence was restored in the Bank.  The Bank’s charter was extended until 1710.

 

Soon, the Bank was back into the business of fractional reserve banking – issuing Notes that were not backed by the £1 million worth of gold in stock – and lending to the English government, collecting interest payments on debt they had acquired by creating money out of thin air.  The syndicate of bankers that owned the Bank felt sure that people would confidently use Bank of England notes in future and not run on the bank again.  After all, they had been told, and indeed seen for themselves, that the Bank of England is “too big to fail” and, in the case of a run, the government will ensure that all Notes are eventually redeemed.  Note that it did not matter to the bankers if the government was permanently in debt and never paid the bankers back; the bankers were happy enough collecting interest payments on the debt, so from their perspective, the higher the government was in debt to them, the better.

 

For the English/British government, the Bank of England was an essential tool for facilitating deficit spending, and stealthy taxation via inflation.  It was in the interest of the government that the Bank of England was successful.  And for that to happen, the Bank of England notes must be considered “as good as gold”, and therefore gold never demanded in exchange for the notes.  So when the Bankers told the government of their scheme to stabilize the Bank of England Notes and ensure they continue in use indefinitely, the government willingly obliged them.

 

Recall the ultimate aims of the Bankers - to set up a central bank that could act both as:

1.      A lender of newly created un-backed money to the British government, which would finance deficit spending.

2.      A cartelizing agent of the private commercial banks of the country.

 

The second part was essential for overcoming problems with fractional reserve banking on a free market.  The first step came in 1697, when the government prohibited any new corporate bank from being established in England, which would compete with the Bank of England.  The government granted a monopoly privilege to the Bank to function as the government’s inflationary lender and account-holder. 

 

With new confidence in Bank of England notes, a large number were issued over the next decade.  In 1708, the government made it unlawful for any corporation to issue bank notes besides the Bank of England, and note issue by bank partnerships of more than six persons was also prohibited.  Bank of England notes came to be widely used in the economy.  Gold was mainly used for small purchases; for bigger transactions, money substitutes were used, and Bank of England notes were fast becoming the most widely used money substitute.  People were starting to believe that the Notes were as good as gold. 

 

In 1707 however, the Bank suffered a run that threatened to destroy it again.  It was saved by wealthy Dukes and other Whig noblemen and politicians, who wanted to see the Bank survive.  The Bank did survive and its charter was extended to 1732, and then to 1742.

 

The Bank was now reaping huge, unearned profits, and easily attracted investment, and was able to increase its stocks of gold.  In 1742, the government demanded a gift from the Bank of £1.6 million, out of its capital of around £10 million.  In exchange, the government would not only renew the charter of the Bank until 1762, it would also make private counterfeiting of Bank of England Notes (which had emerged as a problem), a crime punishable by death.  By the end of the 18^th century, Bank of England notes of £20, then £10, then £5 had been created; the notes were now being used even for relatively small exchanges.

 

The Bank had created enormous benefits for the bankers, who reaped huge unearned profits in interest on the national debt and for holding the accounts of the British treasury.  The government also benefited enormously.  With the cheap and easy central bank credit, the British Empire fought several major wars, including the War of Spanish Succession (1702-13), the War of Austrian Succession (1744-8) and the Nine Years War (1754-63) which assured that it would be the British Empire, not the French, which would be the preeminent global Empire.

 

Via the Bank of England inflation through credit expansion under fractional reserve banking, the British economy was distorted towards production for war and government projects.  The British people were worse off, due to rising prices in general.  The economy suffered from business cycles. 

 

But the biggest losers were not the British people, but the people from British colonies and trading partners with Britain.  Useful goods and services were transferred from them to Britain, where prices were higher.  The trading partners accepted Bank of England notes.  These notes would eventually be used to buy goods back from England, but at higher prices as the Bank notes continued to lose purchasing power.  In many cases, however, international traders with Britain demanded specie payments.  This led to a gradual flow of gold from the Bank to foreign countries.  In 1797, the Bank was running so low on gold that the government once again allowed them to suspend specie payments. 

 

This time it took the Bank much longer to be recapitalized.  Specie payments were not made again until 1821.  But during this time, the notes continued circulating as money (even though they were known to be non-redeemable, fiat paper).  The reason for this was that the people always expected the notes to be redeemable eventually.  The notes became, temporarily, a de facto pure fiat currency.  People came to see gold as unimportant, and antiquated.

 

In 1810, William Cobbett MP stated the following with regard to the banking system:

 

"There is something so consummately ridiculous in the idea of a nation's getting money by paying interest to itself upon its own stock, that the mind of every rational man naturally rejects it. It is, really, something little short of madness to suppose, that a nation can increase its wealth; increase its means of paying others; that it can do this by paying interest to itself. When time is taken to reflect, no rational man will attempt to maintain a proposition so shockingly absurd"