Small Change and The Depression of 1837-1843 - Part Three
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Part three – Paper pennies and discounts
In the late 1740s, two of Scotland’s textile machinery experts presented the Lord Justice Clerk with their plan to create "a company on a much bigger scale than hitherto seen in Scotland." Ebenezer McCulloch and William Tod had their own engineering drawings for the improvement of the spinning and weaving of linen fiber. They also had a business plan for an enterprise to gain a near monopoly over the linen trade between Britain and its North American colonies. McCulloch and Tod had very good reasons to think that their idea for a venture would appeal to the second most senior judge in Scotland. Andrew Fletcher, Lord Milton, was not only a commissioner on the Board of Trustees for Fisheries, Manufactures and Improvements in Scotland but also the chairman of the Manufacturing Board’s Linen Committee.
Best of all, he was already an owner in the Edinburgh Linen Co-Partnery.
The events of 1745 and 1746 – i.e., the Jacobite rebellion of Bonnie Prince Charlie – had made things Scottish rather unpopular with King George II and his ministers. The three gentlemen decided that their chances for a royal charter would be greatly improved by seeking incorporation under the name of “The British Linen Company.” Whether by happy accident or Lord Milton’s clever design, the charter granted by the Crown was a hybrid. The incorporation not only gave Messrs. Fletcher, McCulloch and Tod limited personal liability but also granted the manufacturing company the right to establish a bank “unless prohibited.” By 1749 the British Linen Company was issuing promissory notes as payments to carters, fullers, weavers, and spinners. The next year the company printed and distributed non-interest-bearing demand notes in the size and style of those issued by Scotland’s two established banks – the Bank of Scotland and the Royal Bank of Scotland. The British Linen Company’s bank notes were denominated in pence and shillings as well as pounds; some were as low as a single penny.
By the middle of the decade, the company would divide itself into a textile business and a banking business; and the partners would get a business divorce, with McCulloch alone taking the textile business. The making and selling cloth to North America would prove to be an increasingly difficult enterprise; by 1760 the export part of the business would fail, and the manufacturing assets would be reorganized.
The British Linen Bank had no such troubles. As an independent retail bank of issue, it was an instant popular success and a profitable enterprise. When, in 1765, all the banks in the United Kingdom were prohibited from issuing notes of less than 10 pounds, the British Linen Bank would convert itself into being a merchant lender. It would continue in business as a merchant bank for another two centuries until merging into the Bank of Scotland in 1969.
Contrary to the standard Whig version of history, Parliament’s 1765 bank note “reform” was not an effort by parliament to save the British people from financial fraud by payday lenders. The working poor of Scotland had not been forced to use the paper pennies of the British Linen Bank as if they were scrip from the monopoly company store. People in Scotland without any connection to the textile trade willingly accepted and exchanged the small change notes without any concern about their ability to redeem them in metal. They did so for the simplest of reasons: With only occasional exceptions, the British Linen Company’s IOUs were the only currency alternative to barter.
Throughout the entire 18th century, almost no small change coinage was to be had in Great Britain. Transactions denominated in pence and shillings required a workaround – either paper bank notes, the intermittent copper coinage of farthings by the Royal Mint (four farthings to the penny) or private copper tokens. The last coinage of silver pennies had been in 1713 and those had been Maundy money – coins to be handed out as symbolic alms on the day before Good Friday. No general circulation pennies had been produced by the mint since the restoration of the monarchy in 1660.
The chronic shortage of small change in 18th century Britain was not caused by any shortage of copper, tin, silver or gold. Metal was available. Gold and silver came from trade, much of it for the tin and copper that Britain mined. By the end of the century, Britain had become the world’s largest producer of those base metals, and large copper neckpieces from the smelters of Cornwall had become the staple of the African slave trade. European slave merchants would trade shaped copper ingots with the leaders of the warrior tribes of the Gold and Ivory Coasts in exchange for the human contraband captured in their raids in the interior.
The inability of the royal mint to supply the country with money was entirely a technical problem of production. The mint’s manufacture of coins still used the techniques first developed in Renaissance Italy. Dies for each face of a coin were cut into steel, then placed in the arms of a press that were brought together against the metal blank. The entire process was powered by hand using the leverage of a mechanical screw to supply the necessary pressure. Dies could only last for the striking of a few hundred coins before their edges became so blunt that the coarsened images of struck coins were so blurred that no two coins duplicated one another. Whenever the royal mint attempted to save money by using worn dies, counterfeits became indistinguishable from genuine coinage. To produce coins that were distinguishable from fakes, the mint’s unit costs would be intolerably high. The work done by the mint’s assayers, melters, refiners, engravers and medallists raised the costs of making copper and even silver coins to amounts far greater than the exchange prices for their metal content alone.
The conclusion that political economists drew from the mint’s production failures was that “value” was determined by labor content. For thinkers as subtle as Cantillon and Ricardo, the labor theory of value was not a theoretical conjecture; it was the logical conclusion to be drawn from the empirical evidence. Prices for the items people bought and sold were a function of how much work had gone into their manufacture and distribution. For land – a thing not made but found – the same yardstick could apply. Productive acreage was priced at the labor cost of the improvements required to make unproductive plots equally fertile.
The value of the denominations of the mint’s coinage was decided by what their metal cost and what was paid to the people who made them. The metallurgic discovery of crucible steel and Diedrich Uhlhorn’s invention of the knuckle-joint action coin press would solve the problem of the unit labor content of coinage. Mints throughout the world would develop amalgams of metal whose market prices would match the denominations of the coinage. (The U.S. penny would become a mix of copper and nickel.) The needed surcharge for the labor and equipment required to produce coins would fall to a fraction of 1% of the unit denomination for coins of all metals.
But the ability to produce enormous volumes of coinage at tiny unit labor costs did not answer the conundrum of how the denominations of bank notes could be so closely reconciled in price to the value of the metal and labor in coinage. How could the British Linen Bank’s currency paper exchange hands at the same values as the few actual copper farthings and silver pennies that were available? The subtleties that could be engraved into a die for printing a bank note were far greater than those that could be used in the stamping of a coin. A well-made bank note was more than an equal challenge to a counterfeiter as the faking of a coin, yet the cost to print each British Linen Company penny bank note was only a fraction of what it cost to coin four farthings.
Instead of seeing the innovation of small change bank notes as an improvement for the means of financial exchange, Adam Smith and others saw small-denomination currency as a threat to the wealth of the British nation. The poor and the near poor had to be prohibited from having any access to bank notes themselves. Small denomination notes would be abolished so that there was no possibility of the volume of paper pennies leading to drainage of specie reserves. The common people, with their limited understanding of finance, would not appreciate how vital it was for the country to have a hoard of gold and silver available on demand. That the central bank’s notes for pound sterling had to trade at par with their denominations in coinage was essential to maintain Britain’s system of imperial finance. As the successes of the Dutch had shown, even a small nation could leverage its advantages in maritime trade and warfare by establishing a national bank and exchange.
Foreigners had accepted the Bank of Amsterdam as a safe and neutral depository whose account balances and securities were assured stores of value. To assure the same steady inflows of specie that had made Holland wealthy enough to afford its bubble in the trading of tulips, Britain had to have a banking system anchored to a national bank whose notes and statements of accounts were always as good as the coinage they represented. The Bank of England must always have enough gold and silver coin in reserve so that specie could be sent abroad to the people who had not yet learned to accept the Crown’s sovereign paper.
There was an alternative. A country could simply view its money as the legal definition of the unit of measurement for all financial accounts. Just as a ton had the physical dimension of its mass, the pound sterling could be the unit price of a specific weight and measure of precious metal. Prices could be the equilibrium point, expressed in currency units, at which buyers and sellers found agreement. Precious metals were useful as measures because they had an enduring sameness; gold or silver remained unchanged over time. They were a reliable measure of a currency’s price because widely different cultures shared the belief that gold and silver were worth owning. Gold and silver clearly were stores of value, but it was not their status as official currency that made them precious. Legal tender – the law’s definition of money – could simply be the unit of measurement and nothing more.
The difficulty with such an arrangement was that it undermined sovereign authority. Throughout the 18th century, parliament and the Crown had taken advantage of the privileges and profits of seigniorage by having the Bank of England serve as the government’s sovereign intermediary. Just as the orders of the king were absolute orders of authority, the drafts and notes of the Bank of England were to be taken at face value as their own absolute monetary authority. Allowing the bank’s monetary orders to be priced by a discount against metal was to risk undermining the very authority of sovereignty itself. If the king’s credit was subject to negotiation, to the daily fluctuations of bid and ask, what logically prevented the orders of government itself from being open to negotiation?
The equivalence between the Crown’s promises to pay and the coins that the royal mint occasionally produced had to be recognized for what it was; the confirmation of the government’s monopoly authority. If you were a conservative Tory, you saw the monetary rule as an extension of God’s anointment of the monarch; if you were a radical Whig, you saw the monetary rule as confirmation of the absolute power parliament had received through the consent of the governed. Either way, maintaining a perfect equality between the bank’s paper and the Crown’s coins was an unquestionable necessity.
Rather than increase the ease of exchange by allowing banks to issue and receive notes and discount them, parliament would protect the Bank of England’s status as an unimpeachable depository for international money by assuring that pound sterling notes always enjoyed a fundamental scarcity. The amount of paper that the Bank of England would produce as legal tender currency would be restricted to amounts tied directly to the bank’s reserves of precious metal coinage. The circulation of the credit paper of all the other banks in the United Kingdom would be subordinated to the restrictions imposed by the central bank; their notes issues would be tied to their reserves of coin and Bank of England notes. Britain would protect itself from any shortage of metal money by making official paper as scarce as coins had been under the mint’s old system of production. Placing a limit on the quantity of money would preserve its value and assure that coin and Bank of England notes were always priced by the market at par.
The effects of the Coalition Wars against France that began in the 1790s would be at least a temporary blemish on Parliament’s quantity theory. The exchange rates for Britain’s sovereign IOUs would not be determined solely by the number of notes that the Bank of England printed. As the news arrived in London of the British and Austrian armies’ losses to the French Revolutionary Army in the Flanders campaign, the rich in the City of London began to do what Adam Smith had warned that the working poor would have done – if the law still allowed them to hold paper money. The wealthy owners of the Bank of England’s 10 pound notes began pressing the Bank of England for the exchange of their paper in specie at par. By 1797, the pressures for redemption reached the point where the Pitt ministry had to give in. Parliament voted to order the Bank of England to suspend all exchange of its bank notes for coinage. The suspension of redemption would last for a quarter century.
In the years preceding the Panic, Britain had not seen any increase in the volume of money – either in the number of pieces of paper and coin in circulation or in the total amount of all forms of currency. The Bank of England had not increased its issue of bank notes; on the contrary, its issues outstanding had diminished because of increasing demands for redemption. The royal mint had not resumed production. Only after suspension would the Bank of England increase the number of notes in circulation by reducing the minimum denomination from 10 to five pounds. The deliveries of the cartwheel pennies from Thomas Boulton’s Soho manufactury would only begin to arrive at the mint after bank paper was no longer being swapped for coin.
Fears of a sudden and/or uncontrolled increase in the money supply had not caused merchants, private banks and other account holders to lose all faith in the pound sterling. Parliament and the Crown were still the Leviathan for the country’s political economy; they would continue to have the power to make whatever rules they chose about money. Loyal Britons were simply thinking that the exchequer would have more difficulty exchanging new debt for international money in 1797; therefore, gold sovereigns would buy more and Bank of England notes would buy less.
That citizens could have the right to sell short against their country’s own IOUs was, in parliament’s eyes, a financial heresy equal to treason. For Thomas Willing and George Washington, repricing the government’s credit in specie was hardly a betrayal of one’s country. Discounting was the necessary mechanism for finance. It was inherent in all monetary exchange. Even among the nations where the sovereign had absolute financial authority, their promises to pay would be subject to arbitrage between foreign exchange and domestic currency.
The questions for any financial system were how free people were to make exchanges and how much authority the government had to fix the price of its own obligations. In claiming valuation at par for the Bank of England’s monopoly legal tender bills of exchange, parliament and the Crown were requiring that everyone else grant them the privilege of a permanent zero discount.
If that system were adopted in the United States, if the federal government and its credit could stand apart from financial competition, Congress and compliant or extravagant presidents would be guaranteed to print money instead of coining, taxing or borrowing it. In doing so, they would distort or destroy the very equilibrium of financial exchange that had enabled people to extend commerce beyond barter and feudal entitlement. The purpose of the Constitutional gold standard was to establish a reference point against which the prices of credits and commodities were set by the open exchange of bank notes and other promises to pay money. Allowing Congress and the president to assert, claim or exercise a special right of issue was the very thing that the United States should not do, even if it had all the specie in the world.
Stefan Jovanovich manages the portfolio for The NJT Company, Inc., a family office based in Nevada.