Origins of Central Banking

[bit.do/wocb] In this post, we provide some details regarding the origins of the Bank of England, the mother of all Central Banks and discuss some implications of this early history for our modern world. For the full sequence of posts, see History of Central Banking. This post summarizes the 16m Video-Lecture:

For a more in-depth analysis of the significance of these historical events which led to the creation of the Bank of England, see “Monetization, Maturity Transformation, and MMT“

We start with an excerpt from Ellen Brown in the Web of Debt: The Shocking Truth About Our Money System and How We Can Break Free. Below, selected passages from Chapter 6: Pulling The Strings Of The King: The Moneylenders Take England: [passages in italics are my comments on the text, rest are quotes]

The first passage discusses how Queen Elizabeth asserted her sovereign right to issue money, and how the financiers worked to undermine this:

In 1600, Queen Elizabeth issued base metal coins as legal tender in Ireland. All other coins were annulled and had to be returned to the mints. When the action was challenged in the highest court of the land, the court ruled that it was the sovereign’s sole prerogative to create the money of the realm. What the sovereign declared to be money was money, and it was treason for anyone else to create it. Zarlenga states that this decision was so detested by the merchant classes, the goldsmiths, and later the British East India Company that they worked incessantly to destroy it.

Cromwell’s revolution was instigated and financed, on the condition that financiers were allowed back into England. In the process, the power to print money was given to the Parliament.

The moneylenders agreed to provide the funds to back Parliament, on condition that they be allowed back into England and that the loans be guaranteed. That meant the permanent removal of King Charles, who would have repudiated the loans had he gotten back into power. Charles’ recapture, trial, and execution were duly arranged and carried out to secure the loans to the Parliament.

Having wrested the power of creation of money away from the King, the moneylenders restored the aristocracy, but gained much greater powers in the process, by providing financial aid to the King. The process of “Enclosure” which was the privatization of the “commons” – land belonging to the public – enriched the wealthy elites enormously. It has been called a revolution of the rich against the poor by Polanyi. The financiers consolidated their grip on the power to print money:

After Cromwell’s death, Charles’ son Charles II was invited to return; but Parliament had no intention of granting him the sovereign power over the money supply enjoyed by his predecessors. When the king needed a standing army, Parliament refused to vote the funds, forcing him to borrow instead from the English goldsmiths at usurious interest rates. The final blow to the royal prerogative was the Free Coinage Act of 1666, which allowed anyone to bring gold or silver to the mint to have it stamped into coins. The power to issue money, which had for centuries been the sole right of the king, was transferred into private hands, giving bankers the power to cause inflations and depressions at will by issuing or withholding their gold coins.

None of the earlier English kings or queens would have agreed to charter a private central bank that had the power to create money and lend it to the government. Since they could issue money themselves, they had no need for loans. But King William III, who followed James II, was a Dutchman and a tool of the powerful Wisselbank of Amsterdam

Important additional historical detail, taken from Wikipedia:

England’s crushing defeat by France, the dominant naval power, in naval engagements culminating in the 1690 Battle of Beachy Head, became the catalyst for England rebuilding itself as a global power. England had no choice but to build a powerful navy. No public funds were available, and the credit of William III‘s government was so low in London that it was impossible for it to borrow the £1,200,000 (at 8% p.a.) that the government wanted.

Back to Ellen Brown

A Dutch-bred King Charters the Bank of England on Behalf of Foreign Moneylenders

The man who would become King William III began his career as a Dutch aristocrat. He was elevated to Captain General of the Dutch Forces and then to Prince William of Orange with the backing of Dutch moneylenders. His marriage was arranged to Princess Mary of York, eldest daughter of the English Duke of York, who reigned as James II of England from 1685 to 1688. James was then deposed, and William and Mary became joint rulers in 1689.

William was soon at war with Louis XIV of France. To finance his war, he borrowed 1.2 million pounds in gold from a group of moneylenders, whose names were to be kept secret. The money was raised by a novel device that is still used by governments today: the lenders would issue a permanent loan on which interest would be paid but the principal portion of the loan would not be repaid.⁶ The loan also came with other strings attached. They included:

1. The lenders were to be granted a charter to establish a Bank of England, which would issue banknotes that would circulate as the national paper currency.
2. The Bank would create banknotes out of nothing, with only a fraction of them backed by coin. Banknotes created and lent to the government would be backed mainly by government I.O.U.s, which would serve as the “reserves” for creating additional loans to private parties.
3. Interest of 8 percent would be paid by the government on its loans, marking the birth of the national debt.
4. The lenders would be allowed to secure payment on the national debt by direct taxation of the people. Taxes were immediately imposed on a whole range of goods to pay the interest owed to the Bank.⁷

The Bank of England has been called “the Mother of Central Banks.” It was chartered in 1694 to William Paterson, a Scotsman who had previously lived in Amsterdam.⁸ A circular distributed to attract subscribers to the Bank’s initial stock offering said, “The Bank hath benefit of interest on all moneys which it, the Bank, creates out of nothing.”⁹ The negotiation of additional loans caused England’s national debt to go from 1.2 million pounds in 1694 to 16 million pounds in 1698. By 1815, the debt was up to 885 million pounds, largely due to the compounding of interest. The lenders not only reaped huge profits, but the indebtedness gave them substantial political leverage.

The Bank’s charter gave the force of law to the “fractional reserve” banking scheme that put control of the country’s money in a privately owned company. The Bank of England had the legal right to create paper money out of nothing and lend it to the government at interest. It did this by trading its own paper notes for paper bonds representing the government’s promise to pay principal and interest back to the Bank — the same device used by the U.S. Federal Reserve and other central banks today.

End of Excerpt from Ellen Brown.

Some more detail of interest is that the creation of Bank of England was tremendously beneficial for England. The King, no longer constrained, was able to build up his navy to counter the French. The massive (deficit) spending required for this purpose led to substantial progress in industrialization. Quoting Wikipedia on this: “As a side effect, the huge industrial effort needed, including establishing ironworks to make more nails and advances in agriculture feeding the quadrupled strength of the navy, started to transform the economy. This helped the new Kingdom of Great Britain – England and Scotland were formally united in 1707 – to become powerful. The power of the navy made Britain the dominant world power in the late 18th and early 19th centuries”

The events described can be viewed from the perspective that accumulation of capital is a central driver of history:

Lessons from History

Contrary to what is commonly believed, history is not a sequence of facts, recorded observations of events. The central contribution of Ibn-e-Khaldun in his study of the rise and fall of civilizations was to discover the hidden logic, the short and long run causal chains, which were the drivers of history. In such a study, there is always room for error, because these causal chains can only be recovered on a speculative basis – they are not present on the surface. Yet, we must make the effort required for this deeper examination, because without it, we would be blind to the possibilities for our future. In attempting to understand the drivers of history, we come across the difficulty that there is always a multiplicity of causes, with complex interactions between them. In such situations, it is useful to isolate and simplify, and attempt to explain history on the basis of a small number of causal factors, while knowing that the reality is more complex. Another way of saying this is that every attempt to understand history is necessarily subjective; the best we can do is to present history from a multiplicity of perspectives. One of these perspectives is the view that money and finance have been the central drivers of history. As Giovanni Arrighi puts it, history is driven by cycles of accumulation of capital. While we understand this is a vast oversimplification, it is useful to take this perspective, just to see how far it can take us, without committing ourselves to believing in this perspective. It is in this spirit that we offer a “finance drives history” view of the creation of the first Central Bank. The history above can be encapsulated as follows:

1. Queen Elizabeth asserted and acquired the sovereign right to issue money.
2. The moneylenders (the mysterious 0.1% of that time) financed and funded a revolution against the king, acquiring many privileges in the process.
3. Then they financed and funded the restoration of the aristocracy, acquiring even more privileges in the process.
4. Finally, when the King was in desperate straits to raise money, they offered to lend him money at 8% interest, in return for creating the Bank of England, acquiring permanently the privilege of printing money on behalf of the king.

The process by which money was created by the Bank of England is extremely interesting. They acquired the debt of the King. This debt was used as collateral/backing for the money they created. The notes they issued were legal tender in England. Whenever necessary, they were prepared to exchange them for gold, at the prescribed rates. However, when the confidence of the public is high, the need for actual gold as backing is substantially reduced.

There is a small mystery here. The King’s debt was used as the backing for the money issued by the Bank of England. Why couldn’t the King issue debt directly, and have it used as money? This is the basic concept of sovereign money, and would have saved the King the 8% interest on the amount he had to borrow. The key here is to understand Minsky’s dictum: “Anybody can create money. The problem lies in having it be accepted.” The reason King William could not create money which would be widely acceptable by the public are the following

1. The authority to create money had been transferred to the Parliament.
2. The King could borrow, but did not have gold to pay back his debts.
3. When the King borrowed from the moneylenders, they did not give him gold. They gave him the authority to write checks on the Bank. The Bank could redeem these checks in notes which were backed by the King’s debt. Thus, the Bank “monetized” the debt of the King.
4. The Bank’s created money was far more acceptable than the King’s debt, because it had the appearance of being backed by gold (in addition to the King’s debt). The bankers, unlike the King, could convert bank-notes to gold as needed. This ability of the Bank to do so, created the confidence in the public, which allowed the bank to keep only a fraction of the entire amount of notes in circulation, in the form of gold.

This same system, fractional reserve banking, and the monetization of the debt of the Government, is still in operation. But very few have correct understanding of how the system works. It is worth pointing out that the reason the Bank of England was able to obtain a charter to print money was because it offered very generous terms to King William. It offered to provide him with all money that he needed, in return for his IOU’s — After all, having captured the Sovereign right to print money, it had the ability to print arbitrary amounts. Also, it did not ask for repayment of the principal, but only the interest on the debt. Finally, it also offered to collect this repayment, in form of taxes, on behalf of the King. This was a very sweet deal for the cash-strapped King. 

For more material, see:  The Battle for the Control of Money . 

The full 90m Video lecture is linked below; above material is covered in the first 16m.

This is Lecture 13 of Advanced Macro II, Spring 2019 by Dr. Asad Zaman at PIDE. Link to entire Lecture 13 on course website.