2. The Peel Act Structure (1844-1922)

 

The system had enabled the bankers to achieve their second objective, the removal on the market limits to fractional reserve banking.  The formal structure of a central bank, acting as cartel manager for commercial banks practicing fractional reserve banking, was formalized in 1844 with the Peel Act.

 

The Peel Act granted the Bank of England an absolute monopoly on bank notes.  These notes became legal tender, and must be accepted in the payment of debts.  Now, no commercial bank was allowed to create bank notes (which could circulate as money substitutes), only deposit slips, containing the name of their depositor.  This meant that, in order to acquire Bank notes demanded by the public, the banks had to keep a reserve account at the central bank.  This eliminated the threat of outsiders entering the industry and operating an honest bank, which may threaten the stability of the fractional reserve banking cartel.  They had finally created a closed banking system. 

 

If an outsider did enter the market, he would be invited into the cartel and invited to practice fractional reserve banking, which had now been officially legalized by government.  This way, the central bank could ensure that all banks expand and contract together, as they would all have – by mutual agreement – the same “reserve requirement” – say 10%.  A bank was free to keep a higher reserve, but there was no reason for them to do so – they would not be maximizing their profits.  A 100% reserve bank would not be granted an account at the central bank, and hence could not operate to any extent, and its profits would be minute compared to the profits of the banks in the cartel.  Up against such a system, 100% reserve banking became a thing of the past.

 

Now, as well being the main creditor of government debt, the central bank had enormous power over the money supply.  The post-Peel Act banking system was organized as two inverted pyramids:

• At the bottom was the Bank of England, which had, say, £100 million worth of gold in its vault.  It practiced fractional reserve banking.  With a 10% fraction, there would be £1 billion worth of Notes in circulation. 
• But the process did not stop there, for now each of the commercial banks could practice fractional reserve banking as well.  With £1 billion worth of “reserves” (now just Bank notes) in their vaults, they could multiply the money again, so the total amount of Notes in circulation was £10 billion (£1 billion in the vaults of commercial banks). 

 

The Bank of England could control the whole system, by changing the reserve requirements, or by simply setting an interest rate for the cost of borrowing Notes from the bank (which a commercial bank will do if gets low on reserves).  By adjusting their interest rate, they could ensure that banks will do likewise, so the economy can be expanded or contracted at will by the Bank of England.  This increased power to inflate created much more serious business cycles than happened before the structure was formally created in 1844.  Business cycles work to the benefit of those who create them – the controllers of the money supply.  By buying stocks when they are low, then creating a credit boom, they can be sold at exaggerated profits.  When the economy busts, those very same stocks can be bought back again a fraction of the price.

 

For the rest of the 19^th century, the banking system functioned mostly as planned.  Faith in the redeemability of Bank of England notes ensured their continued use.  The early receivers of the newly created money disproportionately benefited at the expense of the late receivers of the new money, including foreign trading partners.  The central bank, the commercial banks, and their labor and landowners, benefited the most.  The government also benefited enormously.  Over the longer term, everyone suffers from decreased productivity for satisfying consumer wants.

 

The Central Bank meanwhile positioned itself as the “lender of last resort”.  That is, if any commercial banks go bankrupt, the central bank will provide emergency funds to prevent a collapse of the system.  This greatly increased confidence in the Notes and the banking system in general.