7.9 De facto victory for the banking school

It is a cliché that people are often appalled at the consequences of achieving their long-cherished goals. Because of the neglect of deposits, the enactment of the currency principle in Peel's Act in no way moderated bank credit expansion or the boom-bust cycle. Given the dashing of their dreams, the currency school, as in the case of all ideologues whose god has failed, could take several alternative courses of action. The most courageous would have been to admit that their principle was deeply flawed, to concede defeat, and to go back to the drawing board. Unfortunately, human beings are so constituted that they rarely opt for this noble course. Certainly none of the currency school distinguished themselves in this crisis. Instead, they took the route that all too many schools of thought, including the Marxists, have travelled: stoutly proclaiming that their theory is in excellent shape, while subtly but vitally redefining what the theory is all about.

For example, before 1844, the currency school, especially Colonel Torrens, adopted a monetary theory of the business cycle. Economic fluctuations were generated by bank credit expansion, led by the Bank of England, which led to inflation and booms, after which the inevitable contraction brought about bankruptcies and recessions. No sooner did the cycle of 1844—47 occur, however, when the currency men backtracked, virtually joining their old enemies of the banking school. The banking school had always proclaimed that banks and the money supply were merely passive respondents to boom-bust cycles generated by non-monetary forces in the ‘real’ economy. Usually the culprit was mysterious waves of 'speculation’, presumably driven by waves of over-optimism and over-pessimism. Now, the currency school, even Colonel Torrens, proclaimed that they had never, ever promised an end to the business cycle, which is, after all, governed by such non-monetary forces as speculation and over-optimism and pessimism. The most that regulation of the currency could do, the currency school now opined, is to eliminate whatever part of the business fluctuations were caused by movements of the money supply. And this, they staunchly affirmed, Peel's Act had indeed accomplished. The business cycle of 1844–47 might have been severe, but it would have been far worse if Peel's Act and the currency principle had not been in effect.

Thus Colonel Torrens, in numerous apologies for Peel's Act, put the blame for the boom of 1844–46 on ‘overtrading’ and railway speculation, as if this speculation had come out of the blue and was not the consequence of cheap, expanding bank credit. He also mentioned that one aspect of the inflationary boom was ‘rapid conversion of floating to fixed capital’, that is, a sinking of liquid capital into an excessive amount of fixed, long-range investment. Again, there was no hint that it was excessive bank credit that had generated this over-investment.

It is revealing to compare two critiques by Torrens of Mill's contention that the currency school claimed to be able to cure all business cycles and ‘commercial revulsions’. In 1844, in reply to Mill's essay in Westminster Review, Torrens pointed out that the currency school claimed to eliminate not all revulsions but only those originating ‘in a currency fluctuating alternately above and below the level to which a purely metallic currency would perform’. But in his point-by-point 1857 critique of the banking chapter in Mill's Principles, Torrens shifted the emphasis. Instead of paring down monetary-based fluctuations to gold currency, Torrens now claimed that most fluctuations began, not in over-issue by banks, but in disturbances not caused by money, which left the money supply out of harmony with the gold supply. Furthermore, Torrens was now easily able to cite Loyd and Norman in support. Loyd, too, now focused on the alleged non-monetary causes of fluctuations. Focusing, as the banking school had long done, on optimism and speculation, Loyd declared that 'so long as human nature remains what it is, and hope springs eternal in the human breast, speculations will occasionally occur, and bring their attendant train of alternate periods of excitement and depression’.

Thus, with the currency school coming to agree with the banking school on the primacy of non-monetary, and the passive dependence of monetary, causes of the cycle, the way was paved for a de facto consensus between the two schools. Since the currency school seemed content with the existing system so long as it enjoyed the label of the currency principle, the money supply was now deemed passive enough. At the same time, the Bank of England had enough real discretion and flexibility to satisfy the banking school and reconcile it rather easily to the status quo. Thus James Wilson, a leading banking school critic of Peel's Act, was readily able to vote for its continuance in the parliamentary committee of 1857–58. The banking school was content, in the British banking system of 1844–1914, to achieve the substance of their own creed while allowing the proud currency men to bask in the name. For their part, the currency men enjoyed the laurels of an empty victory: Norman, Torrens and Loyd (after 1850 made Baron Overstone), enjoyed great prestige while proclaiming the status quo a triumphant embodiment of their principles. The Bank of England's directors were happy to embrace the supposedly restrictive currency creed, and new currency epigones relayed what had become standard doctrine: misinterpreting the existing system as currencylike, and ignoring the entrenching of the boom-bust cycle in economic life.⁴⁰

With the currency school now committed to the banking school's non-monetary, ‘overtrading’ theory of the business cycle, and with such hard-money and free-banking writers as Robert Mushet and Henry Parnell gone from the scene, the currency analysis of the business cycle disappeared by default. Of the banking school analysts, the most important elaboration of the non-monetary cycle theory was that of James Wilson, in his Capital, Currency, and Banking (1847).⁴¹ Wilson developed what might be called a non-monetary over-investment theory, which foreshadowed the later Austrian cycle theory but lacked the crucial monetary causal element. He focused on railroad over-investment as the cause of the 1844–47 cycle, and persistently predicted a crisis based on his analysis from 1845 until the time of the crash.

In Wilson's brilliant analysis, the boom begins with the excessive investment of savings in fixed capital. Savings are ‘floating’ or circulating capital, the wages fund that goes into the hiring of workers and buying of raw materials. But because of a sometime propensity to overtrade, businesses may invest in fixed capital beyond the annual supply of savings. Too many money savings are poured into the production of fixed capital, whereas too few are used to produce consumer goods. In short, the boom is characterized by an undue shift of resources from consumption goods to capital goods. The increased expenditure on fixed investment of capital – in the 1845 case heavy railroad investment – on the other hand, increases wages in the hands of consumers. But as the consumers come to spend their wages on a lower supply of consumer goods, the price of consumer goods will inevitably rise. In short, consumption and investment have become excessive in relation to the savings available. In response to the rising prices of consumer goods, consumer goods producers will attempt to expand output and thereby increase their demand for capital, i.e. their demand for loans. But the dearth of savings in relation to the demand for capital will bring about a rise in the rate of interest, and the sharp rise in interest rates will precipitate a recession. In short, the fixed investment-boom producers, in this case, the railways and suppliers of railway material, would be forced into a sharp scramble with the producers of consumer goods for suddenly scarce capital, and the resulting crisis and depression causes the abandonment or indefinite postponement of the excessive fixed investments. During the depression, excessive investment is abandoned, resulting eventually in recovery to a sound and normal condition.

Thus Wilson, in addition to seeing the unwise and excessive investment as well as the overconsumption and undersavings of the boom, demonstrated how the boom is the economic distortion that necessarily generates the unhappy but curative depression that finally restores a sound economy. He also saw how a rise in interest rates, as a signal of overconsumption and undersaving, brings about the restorative recession. In addition, he realized that a lack of savings was a key to the recession and concluded that greater savings would help speed the recovery.

While there is surely over-investment in the higher orders of capital goods during a boom, Wilson misfired when making his sharp distinction between floating and fixed capital. To Wilson, money savings going into fixed capital are somehow lost or 'sunk’, and thus disappear from the payment of wages. The problem is not in fixed vs floating capital, however, but consumption as against over-investment of all types in the higher orders of capital – whether in fixed plant or greater inventory of raw materials.

But the greatest problem in Wilson's discussion was his neglect of money. Money, he believed, was merely a device for facilitating exchanges, and therefore could never be a cause of economic fluctuations, but only an effect. And yet, if money was not involved, where do the railway firms get the new money to spend, even though savings have not risen? The only answer, which Wilson neglects, is an increase in money and bank credit loaned to those firms. And, if the money supply has not increased, why are the increases of wage payments by railway firms and other capital producers not offset by declines of wage payments in consumer industries? In short, why does the general level of prices increase from the beginning of the boom? Why don't consumer prices at least initially fall? The answer, once again, is the increase in the supply of money and credit that generates and fuels the boom. And finally, why can't the general run of businessmen, including the railway magnates, realize that their investments are outrunning savings, and why does the eventual critical rise in interest rates come as a shock? The answer, once more, is that the expansion of bank credit artificially lowers the interest rate, and lures business firms into the fatal over-investment.

Despite the fact that Wilson insisted that a quantity of money must not be confused with capital, he yet fell into the old Smithian trap of considering the supply of gold as ‘idle and unproductive’ capital, and so he believed that capital could be increased, and the depression greatly eased, by government issue of £20 million of small, £1 notes, which would replace the ‘idle and unproductive’ £20 million of gold in circulation. This huge issue, Wilson assured his readers, would not be inflationary because it would simply add to capital; and besides, he added smugly, no inflation could exist since the paper notes would continue to be convertible into gold. But what sort of gold convertibility, what sort of gold standard, exists when gold is supposed to disappear from circulation? The lesson is that, regardless how much devotion is professed to laissez-faire or the gold standard, at the heart of every banking school man, including those professing a free banking position, lies an unreconstructed inflationist.

In his Principles of Political Economy (1848), John Stuart Mill set forth a cycle theory that blended Wilson's analysis with a Tookean emphasis on commodity speculation, and unfortunately brought in the Ricardian gloom about the alleged inevitable tendency toward a falling rate of profit as agriculture yields ever lower returns. Mill, in short, fused the standard Tooke-banking school emphasis on speculation, over-optimism, and overtrading with Wilson's analysis of the conversion of circulating into fixed capital. Once again, the doctrine was non-monetary, with money playing a passive, non-essential, and at best secondary role. Thus Mill adopted Wilson's railroad investment theory of the cause of the recent 1845–47 cycle. The Ricardian motif led Mill to anticipate Schumpeter and hail the inflationary boom as necessary and vital to the achievement of economic growth, by enabling a periodic escape from the falling rate of profit. As a result, Mill was among the first to develop the idea that business fluctuations tend to repeat as recurring cycles, a process which he considered beneficial. He was not worried about recessions, since the contraction and Say's law ensured a rapid return to full employment and prosperity.

There was another important reason for the effective fusion of the currency and banking schools after the enactment of Peel's Act. Both these groups, after all, were dedicated to retention of the gold standard as their top monetary priority, even though the banking school version tended to be highly attenuated. But as soon as the great crisis of 1847 occurred and brought monetary and banking controversy back to Britain, the ultra-inflationist opponents of the gold standard came on the attack, calling either for fiat money inflation or, at best, a bimetallic gold/silver standard. In the face of this onslaught, the currency and banking schools closed ranks, which largely accounts, for example, for James Wilson's voting to retain Peel's Act in 1858.

In fact, it took no more than the crisis of 1847 to encourage the men of Birmingham to resume their assault on gold. Matthias Attwood's old fiat money pamphlet was promptly reprinted, a Birmingham delegation headed by George Frederick Muntz called upon the prime minister, and the Birmingham Currency Reform Association sent a memorial to the queen. The Times felt called upon to denounce the Birmingham men in an editorial and T Perronet Thompson warned a friend of an increasing flow of ‘half-mad pamphlets from Birmingham’. And other sectors in the north of Britain joined in the cry. The Liverpool Currency Reform Association was active enough to be denounced in two issues of The Economist, and Scotland revealed its inflationist bent by an anti-gold article in the Tory Blackwood's Edinburgh Magazine. Furthermore, an organizing convention of the National Anti-Gold Law League was held in Glasgow and was attended by 3 000 people.

The threat of silver bimetallism also surfaced during the crisis of 1847. Particularly important was the powerful banker, Alexander Baring, now Lord Ashburton, always ready to ride his hobby horse of bimetallism, and a petition of a number of influential ‘Merchants, Bankers, and Traders of London against the Bank Act’. Wilson denounced the bimetallist doctrine of Ashburton and the London petitioners as ‘extraordinary’, and ‘most inexplicable and unreasonable’. So serious was the bimetallic threat considered that the two stalwarts of the currency school, Loyd and Torrens, collaborated in writing an anonymous pamphlet in a point-by-point rebuttal of the London petition.⁴² The telling thrust in the Torrens-Loyd polemic was to show that the logic of the bimetallist position pointed straight to the far more consistent, though far more dangerous, policy of Birmingham fiat money:

The Birmingham philosophers are consistent reasoners, and have the sagacity to perceive that an arbitrary extension of the paper circulation is incompatible with the maintenance of a metallic standard. The inferior logicians who have signed the London petition, while demanding the establishment of a double metallic standard, are unable to perceive that an extension of paper money through the exercise... of the relaxing power for which they pray would render impracticable the maintenance of any metallic standard.⁴³

The high-water mark of the assault on gold came in votes in Parliament in 1848. In the Commons committee, the veteran radical leader Joseph Hume's motion denouncing Peel's Act for aggravating the crisis of 1847 was defeated by a vote of 13 to 11. The 11 supporters included a coalition of free banking remnants like Hume, inflationists and protectionists like the Birmingham Tory Richard Spooner, and bimetallists like Thomas Baring and Lord Bentinck. Furthermore, the report of the House of Lords committee criticized Peel's Act and recommended watering down the restrictive provisions on bank notes. While the committees were deliberating, the veteran anti-bullionist John Charles Herries moved to repeal the limitations on bank notes of the Act of 1844 and all the Acts of 1845. Here was a rallying-point for all soft currency men of whatever stripe – Birmingham men, bimetallists, or soft gold men. Herries's motion lost rather narrowly, by a vote of 163 to 142. The major speeches for the motion came not from the moderates, but from Birmingham men like Richard Spooner. In answer to Spooner, the great Robert Peel rose and pointed out that although Birmingham doctrine was in ‘a small minority’ within the House of Commons, outside the House ‘of those who talk about the currency, and write about the currency, the vast majority’, indeed ‘nine tenths’, agree with Spooner, that is, want ‘issues of paper without the check of convertibility’.

Whether Peel was over-reacting to what he considered expressions of evil, or whether his raising the spectre of Birmingham was a ploy to rally the troops, that tactic was successful, and Herries's motion to consider the reports of the Lords and Commons committees, was defeated without even coming to a formal vote. From then on, for a decade, the spectre of Birmingham was enough to win the moderate gold men and the banking school to an all-out defence of the Peel Act status quo. During the mid-1850s, Wilson's Economist followed this path, and the veteran currency man James Pennington wrote a worried letter to a friend that ‘There is just now a widespread clamour calling for repeal of that Act [the Bank Act of 1844] which clamour, if it prevails, will I think, be followed by a clamour, equally loud, for doing away altogether with the obligation of specie payments’.⁴⁴

We may fittingly close our discussion of the aftermath of Peel's Act by focusing on two important contributions, after the passage of the Act, by the wisest of the currency school, Colonel Robert Torrens. In the course of his critique in 1857 of the banking school chapter of Mill's Principles, Torrens added another vital point in criticizing the view that banks, being passive, can have no power to increase their liabilities, and hence have no power to raise prices. Torrens trenchantly pointed out that Mill

excludes from his consideration the important fact, that banks possess in themselves the power of increasing and diminishing the demand for banking accommodation when they raise the rate of discount, the demand for accommodation contracts, and when they lower the rate it expands... and unless he is prepared to disprove the fact that banks can lower the rate of discount, he cannot consistently maintain that their power of increasing the issue is limited...

Amidst all the assaults on the Peel's Act system, by Birmingham fiat money men, bimetallists, remnants of free bankers, and banking school adherents, it is remarkable that apparently not a single writer, parliamentarian, or man of affairs called for a tougher policy of plugging up the enormous hole in the currency system by extending the 100 per cent reserve principle to deposits as well as notes. Not a single currency man admitted any flaw in his previous position, nor advocated, like Jacksonians in the United States, pressing on to a full 100 per cent reserve position on all bank demand liabilities, including deposits. The closest that anyone came to this view was Colonel Torrens. In a poignant moment in the history of economic thought, in his last published work at the age of 77, Torrens wrote a review in the January 1858 issue of Edinburgh Review, of the collected Tracts and Other Publications on Metallic and Paper Currency by his old friend and ally Samuel Loyd, Lord Overstone, edited by John R. McCulloch. After eulogizing the contributions of Lord Overstone, and once again defending Peel's Act, Torrens went on to try to explain the business cycle culminating in the recent crisis of 1857. In sharp contrast to his surrender a decade earlier to the banking school in blaming ‘overtrading’ for the crisis of 1847, Torrens now strongly affirmed that ‘Were there no overbanking, there could not be (except for brief periods) overtrading and excessive speculation’. And the overbanking, since Peel's Act, clearly meant deposits. For Torrens could scarcely ignore the fluctuations that were occurring in the amount of bank deposits. Discussing deposit banking, Torrens emphasized that by creating new demand deposits through loans, the banks exerted ‘the same influence upon the markets as an increase in the numerical amount of the circulation [of notes]’. Torrens had always been the only currency man to understand the true monetary importance of deposits; now he pressed on to a vigorous condemnation of the commercial bankers and their expansion of deposits in the recent boom as well as their contraction and bankruptcy during the crisis. Thus, Torrens bitterly inquired:

Are the scales of justice held even, when a petty thief, or the forger of a five-pound note, is treated as a felon, and when the speculating banker... obtains from the Court of Bankruptcy a full liquidation of his debts, and receives from sympathising friends and half-ruined creditors the means of recommencing his disreputable and mischievous career?

Torrens went on to show how additional loans ‘from deposits produce effects upon prices, upon commercial credit and upon the exchanges, results analogous to those produced by additional issues of bank notes’. Virtually conceding that Peel's Act suffered from not being applied to deposits, Robert Torrens now conceded that ‘even under a currency exclusively metallic [i.e. coins without notes] overbanking and the insolvency of discount-houses may occasion disasters as formidable as those which can result from an unrestricted use of bank notes and a suspension of cash payments’.

In his conclusion, Torrens expressed strong doubt whether ‘the advantages of discount [deposit] banking, even when conducted under a metallic currency, balance the evils it inflicts’. It seems that Torrens was on the brink of advocating the extension of the currency system to deposits, and perhaps if he had lived to write more on money and banking, he would have done so.