Over the centuries, paper money has provided a number of conveniences, even in times and places more accustomed to precious metal-backed money. Unfortunately, in several different eras, issuances of paper money without gold backing caused trouble. Examples are numerous and include settings like France during the Mississippi Bubble or colonial America during the War of Independence. So, until relatively recently in the long history of money, it was considered a crucial safeguard to ensure that all paper notes were backed by and convertible into precious metals.
Yet, during a financial crisis, such convertibility can become either impossible or undesirable to sustain. Indeed, insofar as fear is endless, all paper money can be withdrawn from circulation and much of the financial system brought down for the sake of convertibility. To prevent this, when it was faced with a bank run during the French Revolution, the Bank of England suspended convertibility of its notes into gold. The experience had its successes and failures and debates over these were some of the most important in the history of paper money. One camp, that of the ‘anti-bullionists’, argued that paper money could be safely used without inflation or depreciation.
Convertibility
The French Revolution forced Britain to suspend the convertibility of paper banknotes into gold. Prior to this suspension, which would last twenty-four years, one pound sterling in Bank of England notes was exchangeable for 123.25 grains, or a little less than eight grams, of twenty-two carat gold. Per another way, the Bullion Office of the Bank of England would exchange sterling banknotes for gold at the rate of £3 17s 6d (three pounds, seventeen shillings, sixpence) per troy ounce.
Across the country, relatively few people held Bank of England notes. Prior to the suspension, paper Bank of England notes only circulated around London and its immediate environs and in denominations no smaller than the relatively large sum of £10. Elsewhere, paper money was issued by smaller banks, over two hundred of them in total, commonly called the ‘country banks’. They issued notes in denominations as small as £5 but this was a months’ wages for even a modest skilled worker. Everywhere, people used coins for small ordinary purchases.
In any case, because notes could be converted into gold, or in the case of the country banks, into Bank of England notes which were in turn redeemable for gold, the gold reserves underpinning the system could fluctuate. From 1795 to 1797, gold stocks in Britain were being drawn down. The reasons were several: Britain had been increasing military spending during the Wars of the French Revolution, the balance of trade worsened with poor harvests, and the French were also withdrawing deposits or drawing on credit from Britain as the French paper money, the assignats, lost their value.
The gold standard was finally suspended after an ultimately failed French invasion at Fishguard in Wales caused a financial panic. There were bank runs as people converted banknotes for gold. Banknotes were a more common form of bank liability than deposits at this time but bank deposits were presumably being withdrawn too. As the country banks’ notes were redeemed, they or their customers converted any Bank of England notes they held into gold to satisfy redemptions; this put pressure on the Bank of England’s own reserves.
In February 1797, the Bank of England was given permission to suspend convertibility of banknotes for gold and this was later codified with the Bank Restriction Act. Thereafter, gold came to trade at a premium to banknotes in the open market.
Bank of England Notes
The balance sheet of the Bank of England, in commercial paper and advances to the government, grew for the remainder of the war. It increased from £14.1 million in 1798 to £41.4 million in 1815. As its assets grew, so too did the Bank of England’s profits, drawing scrutiny. Printing more banknotes to discount more bills made the Bank more money but could cause inflation and depreciate the value of the paper money which people now held in larger quantities.
During this period, paper money came to be used in smaller denominations; whereas the smallest denomination was £10 before suspension for Bank of England notes and £5 for those of country banks, new £1 notes were introduced. To solve a shortage of small coins, the Bank of England also began to issue five-shilling silver tokens. These were tokens issued by the Bank of England rather than normal coins issued by the Mint and this constituted another form of money controlled by the Bank.
Bullion Committee
Perhaps because of the banknote issuance and perhaps because of the war or other factors, prices were erratic. One price index produced by Arthur D. Gayer, W.W. Rostow, and Anna J. Schwartz long after these events, in 1953, show that prices jumped 50% by 1801 then fell significantly between 1801 and 1803 and then began increasing again.
Perhaps enabled somewhat by the inflation and availability of money, speculative episodes were not extinguished by the war. In 1808-09, there was a speculative boom driven by the opening up of South America to British trade during the Peninsular War. Meanwhile prices kept rising. This inflation hurt the fortunes of creditors since the value of their interest and principal payments were reduced over time. In the early 19th century, there were many more such creditors to the state as the expensive wars against Napoleon’s France dragged on.
All through this period, the pound traded at a continuing discount to gold and in the absence of inflation statistics, people fixated on this as a sign of a depreciating money. A Bullion Committee was established by the House of Commons to investigate the difference in value between banknotes and gold. By this point, the price of a troy ounce of gold had risen to 90 shillings rather than the old rate of 77.5 or, put another way, each one-pound note could now buy just 107 grains of 22 carat gold rather than the old 123.25, a 13-14% depreciation.
The Banking School
Against considerable scrutiny, the Bank of England defended its conduct before the Bullion Committee. The Bank denied that it was overissuing banknotes, driving down the value of banknotes compared to gold or causing prices to rise. Of course, overissuing banknotes would cause them to depreciate but the Bank denied that its activity constituted an over issuance of paper money. The ‘banking school’, as this side of the debate came to be known, sought to disassociate issuances of paper money and inflation though they did not, of course, insist that paper money could not be inflationary. They insisted though that the rising price of bullion was caused by other factors.
The Bank and its advocates argued that so long as the Bank of England was issuing banknotes to discount bills that arose from genuine trade, so-called ‘real bills’, then its emission of notes would not depreciate the paper money because they were matching the pace of economic activity. As the population and agricultural and manufacturing output grew, so would the volume of currency in circulation in the same proportion as output. Thus, the increase in the supply of money would be matched by the enlarged demand for money and the currency would not depreciate.
One of the arguments in favor of the Bank’s position was made by John Hill in a series of letters to one of the members of the Bullion Committee. Beyond the above, he argued that some of the banknote issuances of the Bank of England were merely offsetting outflows of gold from Britain and, at least this portion of the banknote issuance not actually increasing the money supply at all. Thus, the paper money supply, even if it outpaced economic activity by a limited margin may not have actually increased the aggregate money supply. Another figure, the soldier turned economist Robert Torrens, pointed out that new issuance of money supporting the discounting of bills would encourage more productive activity and create economies of scale, increasing the supply of goods and reducing prices.
Hill and fellow defenders of the paper banknotes also believed that interest rates would keep money creation in check. Even if too much paper money was created, the excess money would drive prospective rates of return in the market lower and at some point, this would fall below the Bank’s discount rate making further borrowing undesirable. At that point, there would be little incentive to keep discounting bills at the Bank of England and the money supply would contract. There would also be liquidations from traders caught between high interest costs relative to returns on their trading, again checking the price rises.
More data from the period has been tabulated and allows modern debate about what happened in the period 1797-1810 to be more informed by data than the Bullion Committee itself was. Indeed, over short periods of time in this era, the Bank of England’s note issuance seemed to have no effect on the price of bullion in terms of paper money. Sometimes, the discount on paper banknotes and the premium on gold worsened in periods when banknotes in circulation were actually decreasing, not increasing!
Nonetheless, over the long term, both prices and the money supply clearly rose. Still, the ‘banking school’ or ‘anti-bullionists’ as they were also known, instead attributed the discount of banknotes to other factors, generally attributing it to the balance of payments. There were several factors reducing demand for Bank of England notes as compared to gold. These factors included the distribution of subsidies and the proceeds of loans to British allies in the Napoleonic Wars which were converted into foreign money, poor harvests in Britain which increased imports of foreign grain, reductions in exports to America because of the latter’s embargo, and higher interest rates on the Continent than in Britain, encouraging more selling of the pound and purchases of foreign money.
In essence, the banking school believed the balance of payments and supply shocks were causing banknotes to depreciate. Indeed, for short time horizons, subsequent research showed a closer correlation between the balance of payments and the value of the paper pound than between banknote issuance and the value of the paper money. Of course, this is not to say printing money does not put pressure on the currency but on any given day, week, month, or year, there are probably more immediately relevant factors.
Regardless, besides merely defending its record, the banking school also made an affirmative argument for an inconvertible paper money. Convertibility, Robert Torrens pointed out, would limit money issuance to a level below what the needs of trade required, creating an artificial scarcity that would slow the economy. So, even if one conceded that an inconvertible money ‘could’ create an excess of money, a convertible money ‘would’ create a deficit. Further, he argued that convertibility into gold was a chief cause of bank failures as banks needed to guess how much gold they must keep on hand at all times and banks were naturally disincentivized to keep too much idle gold on hand.
Lesson
Here was only one side of the argument. Part II will summarize the arguments against the banking school. In the meantime, it is surprising enough that paper money had so many defenders in the face of the usual concerns about it and actual evidence of some problems. While the experience of Britain may have left something to be desired, it was not accepted as a failure universally, nowhere near it. Clearly, substantial thought was given to how to safely issue paper money and regulate its quantity. Bullionists would deride the ‘real bills’ doctrine as an insufficient safeguard but the concept had a century of life left in it. Indeed, debates about money that were being had in the early 20th century reflected a lot of the debate in early 19th century Britain.
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Read part II of this post and about how the Battle of Fishguard led to the suspension of the gold standard in Britain and how this was received by caricaturists. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
Further Reading
1. Canaan, Edwin. “The Paper Pound of 1797-1821.” Journal Of The Royal Statistical Society, vol. 83, no. 2, P.S. King and Son, 1919, p. 284.
2. Hendrickson, Joshua R. “The Bullionist Controversy: Theory and New Evidence.” Journal of Money Credit and Banking, vol. 50, no. 1, Jan. 2018, pp. 203–41.
3. Kindleberger, Charles P. A Financial History of Western Europe. George Allen and Unwin, 1985.
4. Laidler, David. “The Bullionist Controversy.” Money, New Palgrave, Macmillan Press, 1989, pp. 60–71.
5. O’Brien, D. P. Foundations of Monetary Economics. Pickering and Chatto (Publishers) Ltd, 1994.
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