7.5 The crisis of 1839 and the escalation of the currency school controversy

A mild boom in 1837 and 1838 was followed by another economic crisis towards the end of 1838 and during 1839. Bankruptcies and bank runs ensued, and the Bank of England's gold reserve fell from £9.8 million in December 1838 to an extremely low £2.4 million by September 1839. Not only that; but in the teeth of shrinking reserves, the bank, instead of following anything like its own Palmer rule, let alone the more rigorous currency principle, expanded credit still further, thus precipitating an even greater drain of gold from the bank. By July and August 1839, the chancellor of the Exchequer was beginning to contemplate another restriction, another suspension of specie payment on behalf of the bank. The bank was saved only by massive credits from the Bank of France and from Hamburg.

Clearly, the banking situation was becoming intolerable, and something had to be done. Parliament appointed a select committee on banks of issue on 1840 and again in 1841, and massive hearings were held on the question. Disputes in parliamentary testimony and pamphlet controversy were redoubled, and were made more urgent by Horsley Palmer's concession that the bank was finding it almost impossible to adhere to his rule.

Several other groups now arose to challenge the growing currency school consensus. The free banking adherents took a lead from the currency school in lashing out at the Bank of England's responsibility for inflation and for the business cycle. But the force of their opposition to the bank was vitiated by their uniform apologia for the country and joint-stock banks. While it is true that those banks were largely governed by the actions of the bank, it was egregious for them to claim that the private banks were totally passive and blameless in the entire process. The free banking school was particularly discredited by the fact that virtually all of its spokesmen – with the exception of Sir Henry Parnell, who died in 1842, in the middle of the controversy -were themselves joint-stock or country bankers, so that the special pleading in their stance was all too evident. If this group had confined their advocacy of free banking to the largely political point that the bank would inevitably be more inflationary and dangerous than competitive banking, they would have been far more persuasive. But such restraint is not the usual practice of special pleaders.

The only distinguished economist to take up the free banking cause was Samuel Bailey, the subjective value theorist. But Bailey had founded and was now chairman of the Sheffield Banking Company, and his fervent apologia was all too suspect. Bailey, indeed, was one of the worst offenders in insisting on the passivity of the country and joint-stock banks, and in attacking the very idea that there is something wrong with worrying about changes in the quantity of the money supply. By assuring his readers that competitive banking would always provide ‘nice adjustment of the currency to the wants of the people’, Bailey overlooked the fundamental Ricardian truth that there is never any social value to increasing the money supply, once the commodity is established, and that inflationary increases in bank credit take place as a process of fraudulent issue of fake warehouse receipts to standard money.

Another school of thought arising in this period was the banking school, at this early point consisting solely of one prominent man, Thomas Tooke. Tooke (1774–1858) was by now an elderly merchant in the Russian trade who, born the son of a chaplain, had started working in St Petersburg at the age of 15, and had become a partner in a mercantile firm in London. Long interested in economic matters, Tooke had been one of the founders of the Political Economy Club, and continued to attend meetings of the club until his death. In the bullion controversy, Tooke was a staunch bullionist, and he strongly supported the resumption of specie payments in 1819. At best, however, Tooke was a confused and inchoate thinker, and whatever theoretical acumen he had was apparently warped beyond repair by decades of immersion in his life-work, a four-volume History of Prices and of the State of the Circulation from 1792, published from 1838 to 1848.²⁰ Inductive play with his statistics was able to convince Tooke, for example, as early as his 1838 volumes, first that high and rising prices during the Napoleonic periods were solely due to bad harvests, lowering the supply of farm products, as well as obstructions of foreign trade, while, second, falling prices after the war were caused by better harvests and the resumption of trade. Having concluded that, Tooke was able to press on, in his third volume of the History of Prices in 1840, and in his parliamentary testimony the same year, to launch the banking school with the absurd proposition – to quote from a crystal-clear formulation of Tooke four years later – that: ‘the prices of commodities do not depend upon the quantity of money indicated by the amount of bank notes, nor upon the amount of the whole of the circulating medium: but that, on the contrary, the amount of the circulating medium is the consequence of prices’.

To be fair to Tooke and his banking school colleagues, they did not mean -or profess to mean – to apply this old fallacy to inconvertible currency, as their anti-bullionist forbears had done, but only to convertible currency. But this did not make their analysis or conclusion one whit less absurd. The masterful critique by Torrens deserves to be quoted at some length: Torrens first points out that Tooke has ‘the deserved reputation, which even he himself cannot destroy’ of having shown by ‘an extensive induction from existing and from historical facts... that the value of everything declines as its quantity is increased in relation to the demand’. But then, Torrens notes, Tooke ‘turns his back upon himself by affirming that the value of money does not decline, as its quantity is increased in relation to the demand’. Or at least he affirms this for a convertible money standard. But Torrens concludes incisively that the effects of an increase are the same, for convertible or inconvertible currency. The only difference is that there are limits to increases imposed by a convertible currency. Thus: ‘Mr. Tooke falls into the misconception of imagining that the limitation to a further decline of value which convertibility imposes, prevents the previous existence of the decline which it subsequently arrests.’ Like Adam Smith, the banking school was blithely assuming that the adjustments and restraints of redeemability were instantaneous, and therefore that no problems would be created in the actual processes of the real world.

A particular rapier thrust against Tooke by Torrens four years later cannot be resisted: ‘Throughout interminable pages of inconsistent affirmation [in the multi-volume History of Prices], he reiterates the inference, that the value of commodities has fluctuated in relation to money and that, therefore, the value of money has not fluctuated in relation to commodities’.

The corollary proposition of the banking school, taken from the anti-bullionists and now brought again to the fore by Tooke, is that the Bank of England cannot increase the supply of money (as Tooke put it starkly, ‘The Bank of England has not the Power to add to the Circulation’). Even applying this claim only to convertible currency, as the banking school did, it is difficult to hold such a manifest absurdity at length. In practice, therefore, Tooke and the other banking school adherents usually modified this blunt statement to apply only to bank notes issued in loans to private borrowers, and not to purchases of government securities. To the question: what's the difference?, the main contribution to Tooke's doctrine was made in 1844 by John Fullarton: namely, that notes issued in purchase of government securities are ‘paid away’ and remain permanently in circulation, thus adding to the quantity of money, whereas bank notes ‘are only lent and are returnable to the issuers’²¹ and presumably therefore do not add to the money supply. This was what Fullarton dubbed the ‘principle of reflux’ of notes returning to the banks. Once again, the incisive refutation came from Colonel Torrens, who pointed out that to carry any weight, the ‘vaunted principle of reflux’ requires instantaneous repayment of all loans: ‘Allow any interval to elapse between the loan and the repayment and no regularity of reflux can prevent redundancy from being increased to any conceivable extent.’²²

The same, as well as many other, strictures apply to a variant of Fullarton's and others in the banking school, which, again stemming from the anti-bullionists, held that banks can never over-issue notes provided that their notes are only issued in the course of making short-term, self-liquidating loans matched by inventories of goods in process – the so-called ‘real bills’ doctrine.

Torrens's role in the currency vs banking controversy has a fascinating reverse symmetry with the path taken by Tooke. Whereas Torrens began as an anti-bullionist and apologist for the Bank of England, and now ended as a currency schoolman and opponent of bank credit inflation, Tooke began as a solid bullionist yet ended his days as a pro-bank, anti-bullionist.

Among the various grave inconsistencies in the banking school approach, one particularly stands out: if it is true that banks can do no wrong (at least in a convertible currency), that they cannot over-issue notes or over-expand credit, and that even if they did it could have no effect in raising prices or causing a business cycle, then why not adopt free banking? Why have a privileged monopoly like the Bank of England? Yet the banking school remained a determined enemy of free banking and devoted apologists for the bank. Thomas Tooke's most famous dictum was the striking: ‘Free trade in banking is synonymous with free trade in swindling.’ Fair enough. But, if we analyse this pronouncement logically and we find that banking is synonymous with swindling, then what is the rationale for placing the power of state privilege behind a monopoly 'swindler’? Even if banking is swindling, isn't ‘competitive swindling’ better than a state-privileged and dominant monopoly swindler? And yet Tooke fiercely fought to preserve the bank and its exclusive privileges in London and environs; his only proposed reform was to induce the bank to hold a higher reserve of specie to liabilities.

The one contribution of the banking school was to continue to emphasize -what Torrens knew but Loyd and Norman did not – that bank notes and bank demand deposits were equal and coordinate parts of the supply of money. Because of their grave error on this point (in Torrens's case to dismiss deposits as always in a fixed ratio to notes), the currency school, and its embodiment in Peel's Act, left deposits as the big hole in their attempt to make the money supply conform to movements in gold. As we have noted, the currency school counterparts in the United States did not make that error.

Free trade and laissez-faire thought was growing in dominance in Great Britain during this era, led by the intrepid merchants, manufacturers and publicists from Manchester. But where to stand on the vexed question of banking? Should banking be free or is fractional-reserve banking really 'swindling’ and therefore different from normal honest enterprise? Was Chancellor of the Exchequer Thomas Spring Rice correct when he stated in Parliament in 1839 ‘I deny the applicability of the general principle of freedom of trade to the question of making money?’

Of one thing the men of Manchester were certain: there was no quarter to be given the Bank of England. Thus, John Benjamin Smith, the powerful president of the Manchester Chamber of Commerce, reported to the chamber in 1840 that the crisis of 1839 was caused by the Bank of England's contraction, following inexorably from its own earlier ‘undue expansion of the currency’. Smith denounced the ‘undue privileges’ of the bank as the source of its control over the nation's economic life. Testifying before Parliament that year, Smith endorsed the currency school by criticizing the fluctuations of note issues by all the banks as well as the Bank of England, and went on to state: ‘it is desirable in any change in our existing system to approximate as nearly as possible to the operation of a metallic currency; it is desirable also to divest the plan of all mystery, and to make it so plain and simple that it may be easily understood by all.’ Not only did he thus endorse the currency principle; he went further to endorse Ricardo's scheme of creating a governmental national bank for the purpose of issuing bank notes.²³

A similar course was taken by Richard Cobden, the shining prince of the Manchester laissez-faire movement. Attacking the Bank of England, and any idea of discretionary control over the currency, Cobden fervently declared:

I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency... I should never contemplate any remedial measure, which left it to the discretion of individuals to regulate the amount of currency by any principle or standard whatever...

Rejecting both private and central bank management, Cobden was perceptive enough to see that the goal was not free banking per se, but to have a currency that mirrors genuine market forces of supply and demand: i.e. the fortunes of gold or silver money. He saw that the currency principle aimed to do just that, and hence his endorsement. And while his support for a government national bank of issue was too much like leaping out of the frying pan into the fire, it was understandable in the light of his refusal to trust the Bank of England to cleave to the currency path: ‘I should be sorry to trust the Bank of England again, having violated their principle [the Palmer rule]; for I never trust the same parties twice on an affair of such magnitude.’