Bank of England

The Bank of England is the central bank of the United Kingdom. Its development and that of the English banking system has become the model for many other countries.

History
Banking in the modern sense originated in about the middle of the seventeenth century, when merchants took to depositing their balances of coin and bullion with the goldsmiths. The goldsmiths began to offer interest on deposits, since they could re-lend them at higher rates, and the receipts they gave in acknowledgment of the deposits began to circulate as money. And so arose a number of small private firms, all having equal rights, and carrying on the issue of notes unrestricted and free from Government control.

Early history
Charles II relied to a very large extent for his financial needs on loans from the London bankers. He ran heavily into debt and in 1672 suspended Exchequer payments and so the repayment of bankers' advances. The King's credit was ruined by this for several decades. To substitute for these sources of income, William III and his government founded with a Scottish financier William Patterson the 'Governor and Company of the Bank of England', as a minor declaration in the many clauses of the Tunnage Act of 1694 (thus, the Bank in its early years was called the "Tunnage Bank." ) The Bank was founded with a capital of £1,200,000, immediately lent to the Government. In return the Bank could issue notes to the same amount.

The Bank of England went bankrupt after two years of operation, in 1696, and survived because of government granted suspension of payments. The English Crown remained its main customer and granted additional privileges, such as legal protection against the competition of other banks.

The extensions of its charter often "coincided with the grant of additional loans to the State", and the initial limits on the activities of the Bank and the sums it could borrow to the crown were over time repealed. The accumulating privileges gave the Bank of England a position of prestige and influence in the financial world, and smaller banks had difficulties to compete in the same lines of business. In London was the majority of private note issues abandoned by about 1780. The smaller banks began to keep balances with the Bank of England, which was already beginning to acquire the characteristics of a Central Bank.

The modern form of central banking was established by the Peel Act of 1844. The Bank of England was granted an absolute monopoly on the issue of all bank notes in England. These notes, in turn, were redeemable in gold. Private commercial banks were only allowed to issue demand deposits. This meant that, in order to acquire cash demanded by the public, the banks had to keep checking accounts at the Bank of England. In effect, bank demand deposits were redeemable in Bank of England notes, which in turn were redeemable in gold. There was a double-inverted pyramid in the banking system. At the bottom pyramid, the Bank of England, engaging in fractional-reserve banking, multiplied fake warehouse receipts to gold—its notes and deposits—on top of its gold reserves. In their turn, in a second inverted pyramid on top of the Bank of England, the private commercial banks pyramided their demand deposits on top of their reserves, or their deposit accounts, at the Bank of England.

Going off the gold standard
At the start of the Great Depression in 1931, after bank runs on Austria and Germany, it was clear that England would be the next to suffer a worldwide lack of confidence in its currency, including runs on gold. Sure enough, in mid-July, sterling redemption in gold became severe, and the Bank of England lost $125 million in gold in nine days in late July.

The remedy to such a situation under the classical gold standard was very clear: a sharp rise in bank rate to tighten English money and to attract gold and foreign capital to stay or flow back into England. In classical gold standard crises, the bank had raised its bank rate to 9 or 10 percent until the crises passed. And yet, England was so to cheap money, that it entered the crisis in mid-July at the absurdly low bank rate of 2.5 percent, and grudgingly raised the rate only to 4.5 percent by the end of July, keeping the rate at this low level until it finally threw in the towel and, on the black Sunday of September 20, went off the very gold-exchange standard that it recently had foisted upon the rest of the world. Indeed, instead of tightening money, the Bank of England made the pound shakier still by inflating credit further. Thus, in the last two weeks of July, the Bank of England purchased nearly $115 million in government securities.

England disgracefully threw in the towel even as foreign central banks tried to prop the Bank of England up and save the gold-exchange standard. Answering Norman’s pleas, the Bank of France and the New York Fed each loaned the Bank of England $125 million on August 1, and then, later in August, another $400 million provided by a consortium of French and American bankers.

England betrayed not only the countries that aided the pound, but also the countries it had cajoled into adopting the gold-exchange standard in the 1920s. It also specifically betrayed those banks it had persuaded to keep huge sterling balances in London: specifically, the Netherlands Bank and the Bank of France. Indeed, on Friday, September 18, Dr. G. Vissering, head of the Netherlands Bank, phoned Monty Norman and asked him about the crisis of sterling. Vissering, who was poised to withdraw massive sterling balances from London, was assured without qualification by his old friend Norman that, England would, at all costs, remain on the gold standard. Two days later, England betrayed its word. The Netherlands Bank suffered severe losses. The Netherlands Bank was strongly criticized by the Dutch government for keeping its balances in sterling until it was too late.

The Bank of France also suffered severely from the British betrayal, losing about $95 million. Despite its misgivings, it had loyally supported the English gold-standard system by allowing sterling balances to pile up. The Bank of France sold no sterling until after England went off gold; by September 1931, it had amassed a sterling portfolio of $300 million, one-fifth of France’s monetary reserves. In fact, during the period of 1928–31, the sterling portfolio of the Bank of France was at times equal to two-thirds of the entire gold reserve of the Bank of England.

Despite Montagu Norman, who began to blame the French government for his own egregious failure, it was not the French authorities who put pressure on sterling in 1931. On the contrary, it was the shrewd private French investors and commercial banks, who, correctly sensing the weakness of sterling and the British refusal to employ orthodox measures in its support, decided to make a run on the pound in exchange for gold. The run was aggravated by the glaring fact that Britain had a chronic import deficit, and also was scarcely in a position to save the gold standard through tight money when the British government, at the end of July, projected a massive fiscal 1932–33 deficit of £120 million, the largest since 1920. Attempts in September to cut the budget were overridden by union strikes, and even by a short-lived sit-down strike by British naval personnel, which convinced foreigners that Britain would not take sufficient measures to defend the pound.

As soon as England went off the gold standard, the pound fell by 30 percent. It is ironic that, after all the travail Britain had put the world through, the pound fell to a level, $3.40, that might have been viable if she had originally returned to gold at that rate. Twenty-five countries followed Britain off gold and onto floating, and devaluating, exchange rates. The era of the gold exchange standard was over.

The Scottish Exception
The Bank of England does not have a monopoly on the issue of banknotes in Scotland (or Northern Ireland). The reason was the union of Scotland and England after the foundation of the bank, and so could the Scottish banks develop separately. The Bank of Scotland was a privately held bank, with a monopoly held from 1695 to 1716, its charter was not renewed. Another charter was granted in 1727 to the Royal Bank of Scotland.

The private banks, however, could operate freely as long as the shareholders accepted unlimited liability for the debts of their banks. Banking was soon dominated by a number of companies of considerable size and financial strength. The system was distinguished by keen competition between the banks and a strict practice of regularly clearing each other's notes (exchanges were made twice a week and balances immediately settled). They quickly adopted branch organisation, and there was, as compared with other countries, a much more rapid growth of deposit banking and development of loan technique. The highly developed Scottish banking, free from legislative interference, has inspired many proponents of free banking.

Links

 * Bank of England, home page and the founding document (pdf)
 * British History Online, Statutes of the Realm, Volume 6.
 * John H. Clapham, The Bank of England: A History, 1694–1914, (archived)
 * Financial Crisis and Economic Recession, The Fatal Error of Peel's Bank Act by Professor Huerta de Soto
 * The Bank of England by Walter Thornbury, 1878 (from Old and New London: Volume 1)