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Enter the Central Bank

Central Banking began in England, when the Bank of England was chartered in 1694. Other large nations copied this institution over the next two centuries, the role of the Central Bank reaching its now familiar form with the English Peel Act of 1844. The United States was the last major nation to enjoy the dubious blessings of Central Banking, adopting the' Federal Reserve System in 1913.

The Central Bank was privately owned, at least until it was generally nationalized after the mid-twentieth century. But it has always been in close cahoots with the central government. The Central Bank has always had two major roles: (1) to help finance the government's deficit; and (2) to cartelize the private commercial banks in the country, so as to help remove the two great market limits on their expansion of credit, on their propensity to counterfeit: a possible loss of confidence leading to bank runs; and the loss of reserves should any one bank expand its own credit. For cartels on the market, even if they are to each firm's advantage, are very difficult to sustain unless government enforces the cartel. In the area of fractional-reserve banking, the Central Bank can assist cartelization by removing or alleviating these two basic free-market limits on banks' inflationary expansion credit.

It is significant that the Bank of England was launched to help the English government finance a large deficit. Governments everywhere and at all times are short of money, and much more desperately so than individuals or business firms. The reason is simple: unlike private persons or firms, who obtain money by selling needed goods and services to others, governments produce nothing of value and therefore have nothing to sell.10 Governments can only obtain money by grabbing it from others, and therefore they are always on the lookout to find new and ingenious ways of doing the grabbing. Taxation is the standard method; but, at least until the twentieth century, the people were very edgy about taxes, and any increase in a tax or imposition of a new tax was likely to land the government in revolutionary hot water.

After the discovery of printing, it was only a matter of time until governments began to “counterfeit” or to issue paper money as a substitute for gold or silver. Originally the paper was redeemable or supposedly redeemable in those metals, but eventually it was cut off from gold so that the currency unit, the dollar, pound, mark, etc. became names for independent tickets or notes issued by government rather than units of weight of gold or silver. In the Western world, the first government paper money was issued by the British colony of Massachusetts in 1690.11

The 1690s were a particularly difficult time for the English government. The country had just gone through four decades of revolution and civil war, in large part in opposition to high taxes, and the new government scarcely felt secure enough to impose a further bout of higher taxation. And yet, the government had many lands it wished to conquer, especially the mighty French Empire, a feat that would entail a vast increase in expenditures. The path of deficit spending seemed blocked for the English since the government had only recently destroyed its own credit by defaulting on over half of its debt, thereby bankrupting a large number of capitalists in the realm, who had entrusted their savings to the government. Who then would lend anymore money to the English State?

At this difficult juncture, Parliament was approached by a syndicate headed by William Paterson, a Scottish promoter. The syndicate would establish a Bank of England, which would print enough bank notes, supposedly payable in gold or silver, to finance the government deficit. No need to rely on voluntary savings when the money tap could be turned on! In return, the government would keep all of its deposits at the new bank. Opening in July 1694, the Bank of England quickly issued the enormous sum of £760,000, most of which was used to purchase government debt. In less than two years time, the bank's outstanding notes of £765,000 were only backed by £36,000 in cash. A run demanding specie smashed the bank, which was now out of business. But the English government, in the first of many such bailouts, rushed in to allow the Bank of England to “suspend specie payments,” that is, to cease its obligations to pay in specie, while yet being able to force its debtors to pay the bank in full. Specie payments resumed two years later, but from then on, the government allowed the Bank of England to suspend specie payment, while continuing in operation, every time it got into financial difficulties.

The year following the first suspension, in 1697, the Bank of England induced Parliament to prohibit any new corporate bank from being established in England. In other words, no other incorporated bank could enter into competition with the Bank. In addition, counterfeiting Bank of England notes was now made punishable by death. A decade later, the government moved to grant the Bank of England a virtual monopoly on the issue of bank notes. In particular, after 1708, it was unlawful for any corporation other than the Bank of England to issue paper money, and any note issue by bank partnerships of more than six persons was also prohibited.

The modern form of Central Banking was established by the Peel Act of 1844. The Bank of England was granted an absolute monopoly on the issue of all bank notes in England. These notes, in turn, were redeemable in gold. Private commercial banks were only allowed to issue demand deposits. This meant that, in order to acquire cash demanded by the public, the banks had to keep checking accounts at the Bank of England. In effect, bank demand deposits were redeemable in Bank of England notes, which in turn were redeemable in gold. There was a double-inverted pyramid in the banking system. At the bottom pyramid, the Bank of England, engaging in fractional-reserve banking, multiplied fake warehouse receipts to gold—its notes and deposits—on top of its gold reserves. In their turn, in a second inverted pyramid on top of the Bank of England, the private commercial banks pyramided their demand deposits on top of their reserves, or their deposit accounts, at the Bank of England. It is clear that, once Britain went off the gold standard, first during World War I and finally in 1931, the Bank of England notes could serve as the standard fiat money, and the private banks could still pyramid demand deposits on top of their Bank of England reserves. The big difference is that now the gold standard no longer served as any kind of check upon the Central Bank's expansion of its credit, i.e., its counterfeiting of notes and deposits.

Note, too, that with the prohibition of private bank issue of notes, in contrast to demand deposits, for the first time the form of warehouse receipt, whether notes or deposits, made a big difference. If bank customers wish to hold cash, or paper notes, instead of intangible deposits, their banks have to go to the Central Bank and draw down their reserves. As we shall see later in analyzing the Federal Reserve, the result is that a change from demand deposit to note has a contractionary effect on the money supply, whereas a change from note to intangible deposit will have an inflationary effect.

  • 10. A minor exception: when admirably small governments such as Monaco or Liechtenstein issue beautiful stamps to be purchased by collectors. Sometimes, of course, governments will seize and monopolize a service or resource and sell their products (e.g., a forest) or sell the monopoly rights to its production, but these are scarcely exceptions to the eternal coercive search for revenue by government.
  • 11. Printing was first developed in ancient China, and so it should come as no surprise that the first government paper money arrived in mid-eighth century China. See Gordon Tullock, 'Taper Money—A Cycle in Cathay,” Economic History Review 9, no. 3 (1957): 396.