Differentiating between two types of credit
Currency v. bank credit
A timeless debate
The true causes of a currency’s loss of purchasing power have been argued intellectually since the science of economics emerged as a separate discipline. And in mid-nineteenth century England, the debate led to two schools of thought. The currency school favoured a rules-based approach to the issuance of currency, while the banking school sought a more flexible approach. One of the currency school’s claims was that money creation should be a state monopoly, which cuts across the Austrian school’s free market philosophy. Indeed, Mises strongly criticised the German historical school and Georg Knapp (who wrote the State Theory of Money, published in 1905) for taking this line.
Otherwise, much of the currency school’s approach found favour with Mises. The debate between the currency and banking schools occurred at the time of the 1844 Bank Charter Act, which set the terms for the Bank of England’s modus operandi subsequently. Under that Act, the entire banking system was reformed, with the issue of banknotes by other banks in first restricted and then ceasing, giving the Bank of England the note-issuing monopoly. This was a win for the currency school. And in our quest to establish what leads to today’s currency debasement, this was an important if poorly understood development.
At the root of the currency school’s argument was the understanding that inflation was caused by the excessive issue of banknotes. This led to the terms of the BoE’s banknote issue tying it to gold by requiring the Bank to cover banknotes over £14m in circulation fully with gold, exchangeable into sovereign coin. While circumstances led to this provision being suspended on three occasions, it limited the expansion of banknotes in circulation.[i]
Therefore, between 1844 and 1900, the Bank’s note issue only increased from £37m to £42m[ii]. Meanwhile, the development of joint stock banking led to growing use of cheques drawn upon them substituting for Bank of England notes as payment media. Bank credit in money supply increased from £167m to £824m. The upper chart below shows this relationship up to the declaration of war in 1914, and the lower chart shows estimated consumer and producer price levels.
Clearly, the note issue hardly expanded, while bank credit did multiple times. The currency school’s contention that an expansion of currency undermines its purchasing power appears to apply to the note issue, but not to bank credit. And the long-term expansion of credit not undermining the currency’s purchasing power appears to support theories of the banking school.
But the banking school opposed restrictions on the note issue as well. Its supporters argued that both bank notes and deposits performed the same economic function. The school’s supporters contended that “The amount of paper notes in circulation was adequately controlled by the ordinary processes of competitive banking.” Subsequent evidence displayed in the first chart above shows the banking school was incorrect in their assertion.
At the same time, the currency school argued that demand deposits were not money (currency) and were therefore of no consequence for bank policy and the prevention of financial crises. The school has subsequently been criticised for omitting to understand that bank deposits act as currency.
Interestingly, the decades that followed the 1844 Act showed that the currency school was generally correct to ignore bank credit, if only for the wrong reasons. Bank credit is most certainly circulating currency, but its contribution to the currency’s changing purchasing power appears to be limited to a self-correcting cycle of bank credit leading to booms and busts along the way. But for the longer term, it is the steadiness of the bank note value tied to the gold sovereign and not the level of bank credit in the economy which was important.
The theoretical debate between the two schools was diverted by the 1847 crisis, which led the Bank to suspend gold convertibility at the request of the government. The government faced a crisis from the collapse of a speculative bubble, with many businesses failing. The situation was aggravated, or triggered, by a poor harvest and potato failure leading to increased food imports. Bank credit in 1846 stood at £192m, contracting to £167m in 1947, similar to the problem we might face today. In other words, it was the downturn of the credit cycle exposing malinvestments and excessive speculation which were the problem, not the gold coin standard.
Through the crisis, the Bank of England’s balance sheet was remarkably stable, allowing for an accounting quirk. In 1844, its balance sheet total was £82.9m and in 1847 it had fallen to £59.9m, most of which occurred in 1845. On the face of it, this is a severe contraction. But on its balance sheet the Bank recorded notes held in the bank as both an asset and a liability, which declined by £24.5m between those dates, approximating to the fall in total balance sheet assets. This is an accounting nonsense, because bank notes only have value when they are in public circulation: when they are in the issuer’s possession, they are no more than bits of paper. Therefore, the Bank’s balance sheet net of this anomaly was actually reasonably stable.
While the Bank also acted as a normal bank, taking in deposits and making advances, these do not appear to have been excessive enough to detract from its note issuing function. That there was a run on the Bank’s gold reserves appears to have led to a dip in coin and bullion assets from £13.7m to a trough of about £9.9m in mid-April 1847[iii]. This arose due to an error made by the framers of the 1844 Act, who failed to understand that the run on its gold reserves arose not from one source, but two. They had anticipated that only bank notes could be redeemed for gold coin, not realising that cheques could be used for extracting bullion from the Bank as well. Therefore, the Act was mistakenly predicated on an expectation that a reduction of gold reserves would be matched by a reduction in notes in circulation.
Besides this error, the idea that the decline in gold reserves threatened the currency school concept with respect to the note issue overlooks the actuality. Bank notes in circulation held steady at about £20m, and that being the case, the public obviously regarded gold-backed BoE banknotes as safety during the crisis, which surely, was the legislators’ intention. For so long as the public have confidence in the gold coin exchange facility, it sees little need to hold gold coins.
The error committed by the Bank leading to the Act’s suspension was to not raise the discount rate earlier, and only then by too little. The crisis commenced in 1846, and the drain on the Bank’s gold reserves began. But the Bank did not raise the discount rate until 16 January the following year from 3% to 3 ½%. The run on its gold reserves continued, so a fortnight later the discount rate was raised to 4%. The run still continued until it lost another £3m in gold, when it then raised it to 5% on 10 April. If the Bank had raised its discount rate earlier and more aggressively, the run on its gold reserves would not have happened.
The 1847 crisis, so soon after the Bank Charter Act, has been taken by economists in the twentieth century as evidence that a gold standard is a straitjacket, preventing economic flexibility, seemingly supporting the Banking School’s approach. But we saw what we observe exhibited by central banks today: a government agency not taking a purely commercial approach to its own business.
As always, the situation is more complex than snap judgements on matters of principal. A deeper understanding of the role of credit is necessary.
Bank credit is central to our monetary system
As stated above, credit comes in two recognisable forms. There are bank notes, today issued by central banks but formally issued by commercial banks as well. These notes are a liability of the issuer and appear on a central bank’s balance sheet as such. And there is bank credit, the liability of commercial banks in the form of customer deposits, checking, or current accounts. Unofficially, credit also exists in shadow banking and further credit goes unrecorded between individuals.
Credit among individuals is an economic factor of the greatest importance, yet few economists appear to be aware of this fact. A father might tell his son or daughter that he will fund him or her through university. That is credit extended by a parent to a child. A local shop might offer an account for valued customers, allowing them to pay weekly or monthly, rather than as they spend. A builder or gardener will offer credit to customers by doing their work in anticipation of payment when the work is done. It is all credit.
Wholesalers offer retailers the facility to pay for goods a month after delivery, or even more — that is credit. When a trader buys securities for settlement the following day, that is credit until it is settled. The purchase of a futures contract on margin is a credit obligation for the full amount unless the obligation is sold before expiry. The examples in our daily life are numerous. These informal or non-banking arrangements are vital to the functioning of society, greasing the wheels of personal and business relationships. All this goes unrecorded in the monetary statistics.
Given the ubiquity of credit, would it be right to entirely ban banks as dealers in credit, who formalise credit arrangements benefiting trade, and whose credit is only a small part of the real total? But the whole economy revolves on credit. If there was no credit, the economy would cease to exist. And if there was no bank credit, we would simply return to feudalist conditions.
In accordance with Gresham’s law, people hoard gold coin instead spending bank notes and deposits. Everything is done on credit. Gold coin does not circulate, even under a gold standard, because people realise it is superior money to notes and deposit money. It is there as a backstop to bank notes and deposit accounts. And a population confident that it can always exchange bank notes for gold coin has little or no need to hold gold coin. Bank notes and bank deposits are far more convenient anyway. The stability of the BoE’s note issue during the 1847 crisis mentioned above refers.
So far, we can probably agree there is little contentious in these statements. When we take the subject further the disagreements arise. Gold should no longer be part of a modern monetary system, argue neo-Keynesians and most monetarists. Credit expansion is the source of inflation, argue others, particularly monetarists and the Austrians.
The Austrian tradition is exemplified by the writings of Ludwig von Mises and Friedrich von Hayek. Mises observed the effects of inflation in Europe after the First World War, particularly in his native Austria. He understood why the crown collapsed and knew the remedy. Since then, he wrote extensively about the business, or trade cycle, undoubtedly caused by a cycle of bank credit expansion and subsequent contraction. But in all his writings, collectively running to over 7,000 pages, he mentions “bank credit” surprisingly little. In a word-search I counted only sixteen references to the phrase. It is not even listed in the glossary to the scholars’ edition of Human Action.
Mises’s lecture to the Vienna Congress of the International Chamber of Commerce on May 1933 is typical, when he stated that “The cause of the exchange rate’s depreciation is always to be found in inflation, and the only remedy for fighting it is a restriction of fiduciary media and bank credit”. That was one of the sixteen references to bank credit. But nowhere in his comments, so far as I can see, does he recommend a complete ban on bank credit — only its containment.
Hayek devised a triangle to illustrate to his students at the LSE the consequences of an artificial lowering of interest rates — the consequence of interest rate suppression and consequently credit expansion. It is tempting for the followers of these great men to conclude that credit must be banned if the purchasing power of currency is to be preserved. But we must acknowledge that a wholesale currency collapse through continual and accelerating debasement, such as that which afflicted Austria in 1922, is an entirely different matter from a cycle of bank credit.
But is banning bank credit practicable? The timing for raising the question is propitious, since we appear to be on the verge of another bank induced slump, this time of such potential severity that it could threaten the future of the entire banking structure from central banks downwards. But if bank credit expansion has an economic role that can be justified, then its replacement could end up being less beneficial, particularly if the state takes the initiative in establishing a different banking system. If it does, we can be sure it would be designed to serve the state more than the productive economy.
Some neo-Austrians put forward a simple proposition. That is, they recommend the ending of bank credit with banking being split into banks acting as custodians, the deposits remaining the property of the depositors, or as arrangers of finance to distribute savings to businesses in need of investment capital — never both. The world of circulating media supposedly becomes free of bank credit and from all the problems that it has created.
We should ask ourselves whether this is the nut we need to crack. Cycles of expansion and contraction of bank credit have existed for as long as we have statistical evidence. It dates back to Roman Law and the invention of double-entry bookkeeping. And yet we are still here and have a better standard of living than our forebears. It fuelled the industrial revolution. But with a time-lag, the price effect of changes in bank credit levels even under a gold coin standard did lead to significant fluctuations in the general price level, the consequence of the expansion and subsequent contraction of bank credit — credit-driven booms and busts. The length of time whereby bankers seem to forget the consequences of excessive credit expansion for their own operations is roughly eight to ten years, a periodicity which still held until the Lehman crisis.
In the nineteenth century, government economic policy was broadly to mind its own business and to let events in the economy take their course. Interestingly, fluctuations in the general level of prices in the United Kingdom diminished over the century, during which time the underlying trend of bank credit outstanding expanded significantly on the back of collective wealth, trade, and technological progress. Clearly, growing financial sophistication of credit markets was having a beneficial effect, particularly following the Bank Charter Act of 1844 which in its framing omitted to recognise the potential of bank credit to destabilise the gold-backed currency.
Therefore, a question is raised as to whether fluctuations in bank credit are the evil some neo-Austrians believe. Could it be that the greater evil is central banking intervention — attempts that turned into efforts to manage demand for bank credit though interest rate policies in the decades following the First World War? If so, a solution whereby no bank credit is created is not the remedy, but the abolition of central banking’s attempts to manipulate credit markets makes more sense.
[i] In 1847, England suffered a poor wheat harvest and the failure of the potato crop, leading to a surge in food imports and an outflow of gold. In 1857, following price rises of raw materials and freight charges caused by the Crimean War, the Indian mutiny and financial crisis in America led to bank failures of connected banks in London. And in 1866, Overend Gurney failed, a bank whose importance to the British financial system was probably as significant as that of JPMorgan Chase to that of the American financial system today.
[ii] Bank of England’s Quarterly Bulletin 1969: The Bank of England note: a short history. The Bank was empowered to issue notes to a ceiling of £14m, any excess had to be fully covered by gold.
[iii] See HD Macleod’s Elements of Banking (1876) pp 212