A harsh 17th century for England seemed to be over when James II. Was crowned at 1688, finishing it in peaceful times. However, subsequent struggles of James and his Protestant sister Mary and her husband William ended in replacement on throne and a civil war, bringing high costs to the island country, depleting the treasury markedly.
As this was an imminent problem, Lord of the Treasury had to find a way how to solve this issue. That time, a Scotsman William Paterson came with an idea that his financial group could provide assistance in this case. Due to insufficient number of small investors, providing their funds to cover the national debt, Paterson offered the possibility to buy this debt and gain the privilege to issue banknotes on this basis. Parliament approved this new entity, giving it its name, the “Bank of England,” while William, impressed by this new plan, took part therein.
Paterson, seeing the potential and popularity among the royal family member, requested the notes of the Bank of England (BOE) to become a legal tender, however, this was too soon to be accepted. Nevertheless, the BOE gained the right to manage government deposits and issue its own notes.
As expected, the bank issued £760,000 in banknotes, while almost all of them were used for buying the government debt. However, the logic of economy could not be overlooked and the inflation occurred soon. The Bank of England experienced first bank run, and so the first suspension of convertibility of banknotes for gold had to be put in place in 1696. This reaction was seen in the United States as well, hurting the confidence in free banking system.
Suspension of convertibility lasted for 2 years. All the banknotes were covered only by poor £36,000.00 in the treasury, losing 20% of their value in comparison with specie.
Even more, the competition between whigs and tories continued, when the tory members were almost able to set up a competitive bank, the National Land Bank. Although the bank has never been established, whigs pushed more on their Bank of England project and forced the acceptation of its banknotes (even under the death punishment) together with the impossibility to set up a similar institution. Furthermore, the Bank of England kept government balances and all the payments to the government went through the bank. Its banknotes did not bear interest and it was made a tender for all payments to/from govt However, in 1708, the BOE became the only institution within the United Kingdom that could issue banknotes.
South Sea Bubble and other competitors
Nevertheless, in 1711, during the War of Spanish Succession, Robert Harley came with another original idea, popular at the royal court, establishing the South Sea Company, a real competition for the BOE and even more popular institution for couple of years, buying the national debt (reaching even 50%). After first financial struggles, South Sea Company got boost from the asiento right, trading with slaves from Africa, transporting and selling them to America. But the increasing costs and shares on profit brought it to financial troubles again. After a gigantic restructuralization, the company bought large portion of the national debt, making a profit on margin between the face value of its banknotes and the market value (face value was £100, while the market value exceeded even £1,000 in summer). Following a subsequent selloff, the truth came out, strengthening the bearish pressure even more, bringing the company down and reveal the so-called South Sea Bubble (for the entire story about South Sea Bubble, click here).
Naturally, this was the fact that contributed to the Bank of England’s dominance within the U.K. territory. Over the next decades, the bank only confirmed its position, albeit facing some bank runs, e.g. during the times of civil war with Charles at 1745.
Over the second half of the 18th century, the Bank of England extended its monetary base, while its banknotes were widely used by the other banks as their capital for the purpose of the issue of further banknotes. Around 400 entities came to the existence during this time on such basis.
Napoleonic wars caused a massive wave of suspension of banknotes’ convertibility for specie, while even the Bank of England had to participate to secure its position (in 1797) due to significantly increasing costs related to the war. This suspension lasted for 24 years and the BOE bank became the legal tender de iure. From £11 million of issued banknotes, at the end of the war, British economy saw total of £24 million issued.
Because of the above-mentioned rules, plus the limitation of competitors in 65 miles outside of London, the Bank of England improved its position within the centre of the English banking system, while the other, land banks could hardly pose any competition to its status due to their territorial, legal limitations as well as the quality of customers. Moreover, they could keep their reserves only in the Bank of England.
Free Banking in Scotland
Legal requirements left the English banks weak, participating at the edge of the English financial pyramid, while the Scottish banking system was able to produce certain number of banks that issued banknotes, convertible between each other, thus making the system more stable and lacking the pyramidal scheme.
However, the Parliament in London watched this situation with certain suspicion and decided to prohibit Scottish banknotes’. Nevertheless, inhabitants of the Northern England were accepting Scottish banknotes for some time, so they signed a petition against such prohibition.
To read more about the Free Scottish Banking, click here.
Despite the fact that Robert Peel was a neoricardian economist and his aim was to stop the cycles of inflation caused by uncontrolled monetary expansion and resulting in economy contraction and bank runs or collapses.
Therefore, in 1844, Peel proposed following legal amendments to the system:
- Any new issue of banknotes must be covered by a new acquisition of gold or silver
- No other bank should be established that could issue banknotes
- An average new issue must never exceed the existing one
- Any fusion or acquisition of a bank causes its loss of the right of issue
These proposed points were successful in eliminating the land banks as they needed to acquire further gold reserves to issue notes, strengthening the position of the central bank.
Moreover, Peel did not realize that giving the monopoly to one bank means that it will be misused by the state, what was the fact later on. Even more, the Currency School, the Peel was part of, did not grasp the detail that deposits are part of the monetary offer as well, with the possibility to cause inflation as the banknotes. Land banks, struggling to save their existence and to avoid the prohibition of partial reserves, came with the idea of deposits on demand. This caused the Peel’s Act to be suspended for couple of times.
An interesting fact about this Peel’s failure was that Scottish banks did not even protest. This system, introduced by Peel, was observed by deposits on demand, however, the existing Scottish banks were glad to avoid any new subjects entering the market they controlled. Albeit destroying the free Scottish banking, it helped to preserve the conditions and strengthen the existing banking entities.
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