Bank of England
Read this section about the Bank of England and the three-layered monetary system England developed.
Another revolt against an unfavored monarchy preceded the
Bank of England's creation. The Glorious Revolution of 1688
replaced the Catholic monarch James II with his Protestant
daughter Mary and her Dutch husband, William of Orange.
Although not a full transition from monarchy to republic
like in the Netherlands, the Glorious Revolution in England
significantly shifted power away from the monarchy toward
Parliament. English jealously of and admiration for Dutch
representative government and financial prowess led to a
comprehensive overhaul, modernization, and centralization
of the English financial system.
Nothing about the money market was centralized in
England in those days. Goldsmiths fulfilled all the major roles
of banking and mirrored a lot of the activity of Antwerp's first
money market traders. English goldsmiths issued deposits,
circulated notes, and discounted bills. The need to finance a
war eventually drove the English crown to replace this decentralized system by capturing the role of sole actor between
the first and second layer of money.
The English navy had freshly suffered a crushing defeat at the hands of the French and in its effort to rebuild, the government borrowed money by issuing debt. In 1694, the Bank of England (BoE was created with the express purpose to purchase these new government bonds, and the next great central bank was born. The government and BoE drew from the privileged lending precedent set by the VOC and Bank of Amsterdam and utilized the issuance of second-layer money.
The Bank of England was additionally tasked with taking custody of precious metal, issuing deposits, effecting
transfers between depositors, and circulating notes as cash.
Most importantly, the BoE discounted bills of exchange and
increased liquidity in the London money market. Unlike
Amsterdam's monopoly on second-layer money, London was
more friendly to competing versions of paper money, and the
BoE's willingness and ability to discount bills when liquidity was needed the most would eventually set it apart as the
archetype of central banking today.
The Gold Standard
Pound sterling has been the currency denomination of
England since 1158 when King Henry introduced a silver coin
of 92.5% purity.
The currency represented a weight in silver until England started minting a gold coin in 1663 called
guinea, which was named after the part of West Africa from
which the gold was mined. The guinea subjected the pound
to the plaguing complications of bimetallism when both the
guinea and the English silver coin called shilling carried official values in pounds. But shortly after the creation of the
Bank of England, English mathematician and physicist Sir
Isaac Newton as Master of the Mint permanently altered
the course of bimetallism around the world by setting a new
exchange rate between gold guineas and silver shillings in
1717. Newton studied the fl ow of gold and silver throughout
Europe and the exchange rates set forth in other countries'
bimetallic standards, specifically France, the Netherlands,
and Germany. He used his findings to determine a new
exchange rate between gold and silver he thought to be
more representative of each metal's intrinsic value. The new
exchange rate made it profitable for arbitrageurs to export
silver and import gold, and before long silver stopped being
used as money in England. Newton's alteration, whether premeditated or accidental, eventually brought the world under
one money pyramid with only gold at the top.
Although silver was driven from usage in England
shortly after Newton's alteration, it took over a century for a
full gold standard, with which the pound became valued only
in gold, to become law. England's gold standard reverberated throughout the world and eventually pulled every major
country's currency into the same sphere. Figure 7 shows a
layered interpretation of the international gold standard
around the beginning of the twentieth century.
The Third Layer of Money
Up until now, we have extensively examined the relationship between the first and second layer of money and the financial actors that have come between them, but now we must add another layer to our framework for understanding monetary systems. Bills of exchange, from earlier examples of money pyramids, were second-layer monetary instruments that were promises to pay first-layer gold. During the Bank of England era, however, bills were promises not to pay gold but to pay pounds and therefore existed on the third layer of money. In this book we'll use the term "private sector" to describe banks, businesses, and entrepreneurs that are non-government entities. In Figure 8, we can see the private sector issues promises to pay second-layer money, placing it one layer below the Bank of England in the hierarchy of balance sheets. Liabilities of the private sector therefore exist on the third layer of money. In Figure 9, the traditional balance sheet representation is also included to orient you to the new three-layer model. Third-layer money isn't necessarily subject to more abuse than second-layer money, but it is in fact further away from the safety of a counterparty-free asset like gold coins. For example, if an Englishwoman feared her bank to be in a jeopardized financial position and wanted gold coins instead of third-layer bank deposits, she would require two transactions. She'd have to convert her deposits into BoE notes before converting those notes into gold. If she owned second-layer BoE notes, she would transact only once to secure the desired gold coins.
Even though the Bank of Amsterdam laid the frame-work for central banking, the Bank of England would eventually establish the central banking model for the world. It didn't come easily or from inception. The BoE's initial charter, issued in 1694, only guaranteed it a life of eleven years. When each charter expired, negotiations were held between the BoE and the government. In the negotiations, the government's primary concern was always to finance its spending, and the BoE's motivation was to increase its share price due to the fact that it had private shareholders motivated by profit. The BoE's shares usually appreciated sizably after charter renewals, as each one granted an extension of monetary power.
In the charter renewal of 1742, the BoE cemented its monopoly specifically over note issuance in England. The private sector was no longer allowed to issue second-layer notes that promised to pay the bearer gold on demand, relegating the private sector permanently to the third layer of money. The BoE faced several more charter renewals and legislation changes before finally achieving permanent status in 1844.
Elasticity and Fragility
Let's see how the elasticity of money increases as we travel
lower in layers. On the second layer of money, Bank of
England notes are elastic because they are fractionally
reserved; they are issued in excess of the gold held in the
BoE vault. This elasticity is compounded when the private
sector issues deposits that promise to pay BoE notes, and
those deposits themselves are only fractionally reserved by
said notes. As the pyramid of money grows, lower layers in
the pyramid have the most elasticity but also the most fragility as a by-product. With the backdrop of money elasticity,
we can look at how the Bank of England dealt with financial
panics, or the act of people scrambling up the money pyramid
in order to secure more qualitatively certain forms of money.
Lender of Last Resort
Bank of England notes were demanded as cash because of
their ascribed convertibility to gold coin and the creditworthiness of the sovereign. Nevertheless, the notes were still
second-layer money, and the distinction between BoE notes
and gold became accentuated during a particular financial
crisis. The Panic of 1796, triggered by the bursting of a land
bubble across the Atlantic in the newly formed United States
of America, resulted in a wave of British defaults and eventually a run on the Bank of England's gold deposits. This rush
out of second-layer money into first-layer gold coins would
have utterly depleted the Bank of England of its gold if not
for the Bank Restriction Act of 1797. The act suspended gold
convertibility for all BoE notes, a suspension which lasted for
over two decades. Financial panics like this one were guaranteed in a money pyramid constructed with elasticity and
in a fractionally reserved manner. But the Bank of England
swatted away gold's attempt to provide discipline and sent a
strong message that its second-layer money could stand on
its own. The fact that the BoE's liabilities could stand tall
without convertibility implied that in a crisis, it could use
its power to create second-layer money without undermining
the currency denomination or risk losing its precious metal
The Bank of England had a way to protect its possession of gold, but it also needed a way to face crises starting
in the third layer of money, for example if private sector bills
of exchange suddenly lost liquidity in the money market.
The BoE was willing and able to provide liquidity to the bill
market by actively discounting paper that otherwise would
struggle to find a price floor in crisis. In any such panic, it
had to act as the ultimate backstop in an elastic system if the
currency denomination were to survive.
In 1873, famed British writer and founder of the
Economist magazine Walter Bagehot wrote a seminal book
called Lombard Street: A Description of the Money Market that
demystified how the bill market worked, and how the Bank
of England should be operated in order to ensure it assuages
crises. Bagehot's book is primarily cited for nominating central banks as the "lender of last resort" within a financial system. His solution was for the Bank of England to lend cash
freely against creditworthy bills at punitive yet reasonable
In a panic, the holders of the ultimate Bank reserve should lend to
all that bring good securities quickly, freely, and readily.
Financial crises during the era corresponded with sudden surges in the demand for cash, whereupon those either issuing or holding third-layer money required liquidity in the form of second-layer Bank of England notes. When the demand for cash swelled, Bagehot explained that second- layer money must be created by the central bank in order to satisfy that demand. It should fl ex its power of elasticity while still maintaining discipline in order not to encourage moral hazard, which occurs when a financial institution takes on excessive risk because it anticipates being rescued by the government or central bank if its financial position sours. The BoE would provide liquidity by discounting bills they deemed to be temporarily in need of support, not bills that were destined for default regardless of the financial climate. If elasticity wasn't flexed when needed, a cascade of defaults could ripple through the third layer of money. He concluded that the central bank must ultimately create second-layer money in abundance when the system needs it most, underpinning the modus operandi of central banking ever since. The power to create money came with the responsibility, when necessary, to do whatever it took to preserve the currency denomination. The pound sterling spent the nineteenth century as the world reserve currency as other nations procured it as a savings vehicle due to the British Empire's stature and stability. As the Empire expanded to cover half the Earth's surface, the Bank of England faced the enormous challenge of maintaining a domestic denomination used by participants around the world. Pound sterling wouldn't be the last currency to suffer from this conundrum. Across the Atlantic, the next world reserve currency was waiting in the wings.
Source: Nik Bhatia: Layered Money
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.