ECON120: Monetary History

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.

Figure 7

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.

Figure 8

Figure 9

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 holdings.

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 interest rates:

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
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