Mercantilism and Inflation
[This article is excerpted from An Austrian Perspective on the History of Economic Thought, vol. 1, Economic Thought Before Adam Smith. An MP3 audio file of this article, read by Jeff Riggenbach, is available for download.]
The postmedieval state acquired most of its eagerly sought revenues by taxation. But the state has always been attracted by the idea of creating its own money in addition to plundering directly the wealth of its subjects. Before the invention of paper money, however, the state was limited in money creation to occasional debasements of the coinage, of which it had long managed to secure a compulsory monopoly. For debasement was a one-shot process, and could not be used, as the state would always like, to create money continually and feed it into state coffers for use in building palaces, pyramids, and other consumption goods for the state apparatus and its power elite.
The highly inflationary instrument of government paper money was first discovered in the Western world in French Quebec in 1685. Monsieur Meules, the governing intendant of Quebec, pressed as usual for funds, decided to augment them by dividing some playing cards into quarters, marking them with various denominations of French currency, and then using them to pay for wages and materials. This card money, later redeemed in actual specie, soon became repeatedly issued paper tickets.
The first more familiar form of government paper began five years later, in 1690, in the British colony of Massachusetts. Massachusetts had sent soldiers on one of their customary plunder expeditions against prosperous French Quebec, but this time had been beaten back. The disgruntled Massachusetts soldiery was even more irritated by the fact that their pay had always come out of their individual shares of French booty sold at auction, but that now there was no money for them to collect.
The Massachusetts government, beset by demands for payment of their salary by a mutinous soldiery, was not able to borrow the money from Boston merchants, who shrewdly considered its credit rating unworthy. Finally, Massachusetts hit upon the expedient of issuing 7,000 pounds in paper notes, supposed to be redeemable in specie in a few years. Inevitably, the few years began to stretch out on the horizon, and the government, delighted with this newfound way of acquiring seemingly costless revenue, poured on the printing presses and quickly issued 40,000 more paper pounds. Fatefully, paper money had been born.
It was to be two decades before the French government, under the influence of the fanatically inflationist Scottish theoretician John Law, turned on the taps of paper-money inflation at home. The English government turned instead to a more subtle device for accomplishing the same objective: the creation of a new institution in history — a central bank.
The key to English history in the 17th and 18th centuries is the perpetual wars in which the English state was continually engaged. Wars meant gigantic financial requirements for the Crown. Before the advent of the central bank and government paper, any government not willing to tax the country for the full cost of war relied on an ever more extensive public debt. But if the public debt continues to rise, and taxes are not increased, something has to give, and the piper must be paid.
Before the 17th century, loans were generally made by banks, and "banks" were institutions in which capitalists lent out funds that they had saved. There was no deposit banking; merchants who wanted a safe place to keep their surplus gold deposited it in the King's Mint in the Tower of London — an institution accustomed to storing gold. This habit, however, proved highly costly, for King Charles I, needing money shortly before the outbreak of the civil war in 1638, simply confiscated the huge sum of 200,000 pounds in gold stored at the mint — announcing it to be a "loan" from the depositors. Understandably shaken by their experience, merchants began depositing their gold in the coffers of private goldsmiths, who were also accustomed to the storing and safekeeping of precious metals. Soon, goldsmiths' notes began to function as private bank notes, the product of deposit banking.
The Restoration government soon needed to raise a great deal of money for wars with the Dutch. Taxes were greatly increased, and the Crown borrowed extensively from the goldsmiths. In late 1671, King Charles II asked the bankers for further large loans to finance a new fleet. Upon the goldsmiths' refusal, the king proclaimed, on 5 January 1672, a "stop of the Exchequer," that is, a willful refusal to pay any interest or principal on much of the outstanding public debt. Some of the "stopped" debt was owed by the government to suppliers and pensioners, but the vast bulk was held by the victimized goldsmiths. Indeed, of the total stopped debt of 1.21 million pounds, 1.17 million was owned by the goldsmiths.
Five years later, in 1677, the Crown grudgingly began paying interest on the stopped debt. But by the time of the eviction of James II in 1688, only a little over 6 years of interest had been paid out of the 12 years' debt. Furthermore, the interest was paid at the arbitrary rate of 6 percent, even though the king had originally contracted to pay interest at rates ranging from 8 to 10 percent.
The goldsmiths were even more intensively thwarted by the new government of William and Mary, ushered in by the Glorious Revolution of 1688. The new regime simply refused to pay any interest or principal on the stopped debt. The hapless creditors took the case to court, but while the judges agreed in principle with the creditors' case, their decision was overruled by the Lord Keeper, who candidly argued that the government's financial problems must take precedence over justice and property right.
The upshot of the "stop" was that the House of Commons settled the affair in 1701, decreeing that half of the capital sum of the debt be simply wiped out — and that interest on the other half begin to be paid at the end of 1705, at the remarkable rate of 3 percent. Even that low rate was later cut to 2.5 percent.
The consequences of this declaration of bankruptcy by the king were as could be predicted: public credit was severely impaired, and financial disaster struck for the goldsmiths, whose notes were no longer acceptable to the public, and for their depositors. Most of the leading goldsmith-creditors went bankrupt by the 1680s, and many ended their lives in debtors' prison. Private deposit banking had received a crippling blow, a blow which would only be overcome by the creation of a central bank.
The stop of the exchequer, then, coming only two decades after the confiscation of the gold at the Mint, managed virtually to destroy at one blow private-deposit banking and the government's credit. But endless wars with France were now looming, and where would government get the money to finance them?1
Salvation came in the form of a group of promoters, headed by the Scot William Paterson. Paterson approached a special committee of the House of Commons formed in early 1693 to study the problem of raising funds, and proposed a remarkable new scheme. In return for a set of important special privileges from the state, Paterson and his group would form the Bank of England, which would issue new notes, most of which would be used to finance the government's deficit. In short, since there were not enough private savers willing to finance the deficit, Paterson and company were graciously willing to buy interest-bearing government bonds, to be paid for by newly created bank notes, carrying a raft of special privileges with them. As soon as Parliament duly chartered the Bank of England in 1694, King William himself and various MPs rushed to become shareholders of this new money-creating bonanza.
William Paterson urged the English government to grant Bank of England notes legal-tender power, but this was going too far, even for the British Crown. But Parliament did give the bank the advantage of holding deposits of all government funds.
The new institution of government-privileged central banking soon demonstrated its inflationary power. The Bank of England quickly issued the enormous sum of 760,000 pounds, most of which were used to buy government debt. This issue had an immediate and substantial inflationary impact, and in two short years, the Bank of England was insolvent after a bank run, an insolvency gleefully abetted by its competitors, the private goldsmiths, who were happy to return to it the swollen Bank of England notes for redemption of specie.
At this point, the English government made a fateful decision: in May 1696, it simply allowed the bank to "suspend specie payment." In short, it allowed the bank to refuse indefinitely to pay its contractual obligations to redeem its notes in gold, while at the same time continuing blithely in operation, issuing notes and enforcing payments upon its own debtors. The bank resumed specie payments two years later, but this act set a precedent for British and American banking from that point on. Whenever the bank inflated itself into financial trouble, the government stood ready to allow it to suspend specie payments. During the last wars with France, in the late 18th and early 19th century, the bank was allowed to suspend payments for two decades.
The same year, 1696, the Bank of England had another scare: the specter of competition. A Tory financial group tried to establish a national land bank, to compete with the Whig-dominated central bank. The attempt failed, but the Bank of England moved quickly to induce Parliament, in 1697, to pass a law prohibiting any new corporate bank from being established in England. Any new bank would have to be either proprietary or owned by a partnership, thereby severely limiting the extent of competition with the bank.
Furthermore, counterfeiting of Bank of England notes was now made punishable by death. In 1708, Parliament followed up this set of privileges by another crucial one: it now became unlawful for any corporate bank other than the Bank of England, and for any bank partnership over six persons, to issue notes. And, moreover, incorporated banks and partnerships over six were also prohibited from making any short-term loans. The Bank of England now only had to compete with tiny banks.
Thus, by the end of the 17th century, the states of western Europe, particularly England and France, had discovered a grand new route toward the aggrandizement of state power: revenue through inflationary creation of paper money, either by government or, more subtly, by a privileged, monopolistic, central bank.
In England, private banks of deposit were inspired to proliferate (especially checking accounts) under this umbrella, and the government was at last able to expand the public debt to fight its endless wars; during the French war of 1702–13, for example it was able to finance 31 percent of its budget via public debt.
- 1. Of the 66 years from 1688 to 1756, fully 34, or more than half, were spent in wars with France. Later wars, such as 1756–1763, 1777–1783, and 1794–1814, were even more spectacular, so that of the 124 years from 1688 to 1814, no less than 67 were spent by England in wars with the "French threat."