Saturday, February 20, 2021

Free vs Regulated Banking—Addendum to a History of the Bank of England: Do Modern Central Bankers Really Abide By Bagehot’s Dictum?

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8 MIN READ - From the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff

In the Economics Correspondent’s previous series on banking instability in England we learned that the first two centuries of the Bank of England's establishment and a slew of destructive banking regulations imposed by British Parliament led England to weather no fewer than seventeen financial crises. 

Ultimately a proposal for stability was penned by banker and The Economist editor Walter Bagehot (pronounced “badge-it”) in his famous 1873 book “Lombard Street.”

Bagehot blamed the Bank of England itself, its centralization of gold reserves, and the banknote monopoly bestowed upon it by Parliament for repeated systemic financial crises. Further he recommended throwing out the central bank and emulating the decentralized, deregulated, and nearly laissez-faire Scottish private banking system of 1716-1845 that had produced not a single crisis during its 129 years.

However Bagehot knew that it was politically impossible to dismantle the Bank of England since it had become so ingrained in the British psyche. Therefore his next best solution, assuming the central bank was to be upheld, was that it clean up its own mess, acting in a lender of last resort (LOLR) capacity: lending freely and early to solvent but illiquid banks at high interest rates during times of crisis.

Since then central bankers the world over have lauded Bagehot as a visionary, pioneer, and champion of central banking, and they’ve cited Bagehot’s Rule repeatedly as justification for their aggressive bailouts of troubled institutions.

In his book “The Courage to Act,” former Federal Reserve Chairman Ben Bernanke recounts the 2008 financial crisis and cites Bagehot more than any other nonliving economist (including Milton Friedman), justifying the Fed’s aggressive emergency lending programs by invoking Bagehot’s name over and over. 

Bernanke even goes so far as to suggest that if Bagehot were alive today he would wholeheartedly approve of such massive bailout programs. After detailing not only emergency lending and asset purchases for banks, but also TALF program lending on millions of auto loans, student loans, small business loans, and credit card loans he writes “Walter Bagehot would have been pleased.” (p. 469)

There’s no shortage of other central bankers asserting they were only following Bagehot’s antidotes and that Bagehot himself would have approved.

It may be no surprise to CO Nation that the Economics Correspondent disagrees.


We don’t have to look far to see what’s wrong with Bernanke’s characterization of archangelic Bagehot smiling down upon the 2008 Fed with patrimonial approval. We only need look closer for a moment at Bagehot’s Rule itself. 

The Federal Reserve’s website defines Bagehot’s Rule as:

“[T]o avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at 'high rates.”

This is an accurate summation, and even Bernanke himself states:

“To calm panic, Bagehot advised central bankers to lend freely at a high interest rate, against good collateral, a principle now known as Bagehot’s dictum.” (p. 45)

Why did Bagehot recommend that central bankers “lend freely (without limit),” to “solvent firms,” “against good collateral,” and “at high rates?”

-“Lending freely” is obvious. If many banks fail simultaneously due to illiquidity then panic and widespread depositor withdrawals could spread. Thus Bagehot argued the central bank should not skimp on short term lending assistance to bolster liquidity.

-As for “solvent firms” and “against good collateral,” that’s not too hard to understand either. 

Bagehot didn’t want the central bank pouring good money after bad into banks with negative equity. If banks were well managed but failing due to a simple liquidity run in times of panic, then the central bank would help savable institutions with its loans secured on good collateral. But for the minority of banks that were just badly managed and effectively bankrupt, they should be allowed to fail and not take central bank money down with them in the process.

-And “high rates” (sometimes referred to as “punitive rates”) were to ensure that illiquid banks regretted having managed their reserves so poorly. If they remembered paying so high a price for liquidity loans they were less likely to repeat their mistakes in the future (ie. moral hazard).

Also a punitive rate of interest ensured only truly needy banks would take central bank loans. If the interest rate was too low, healthy liquid banks would take advantage of the crisis to grab cheap funding and impose unnecessary leverage upon the central bank’s balance sheet.

As Bagehot himself wrote, a punitive rate of interest “will prevent the greatest number of applications by persons who do not require it… …that the [central] Banking reserve be protected as far as possible.” (p. 97)

-Finally it’s important to know Bagehot defined “solvent firms” as commercial banks only. (White, 2014)


So just how faithfully did Bernanke, the Fed, and the world’s central bankers adhere to Bagehot’s Rule in 2008?

1) “Lend freely (without limit).” 

There’s no question they adopted this policy and took it to new heights. Not only did the Fed lend trillions of dollars to troubled banks, it gladly allowed investment banks, insurance companies, and other nonbanking firms to change to commercial bank status overnight and secure bailout lending. General Electric comes to mind, having hurriedly bought a tiny Connecticut community bank in the depths of the crisis and then receiving a $16 billion Fed loan that dwarfed its newly acquired bank’s entire balance sheet.

Major insurers also changed their status such as The Hartford, Lincoln Financial, Genworth, and most famously AIG. And as Bernanke points out in his book, the lending extended to hundreds of billions of dollars for auto loans, student loans, small business loans, and credit card loans.

2) “Lend… …to solvent firms.”

Not only were the largest, most troubled institutions in 2008 illiquid, many were also insolvent. Loaded up to the hilt with nonperforming mortgages and bad securitized loans, firms like Citigroup, Merrill Lynch, countless regional and superregional banks, and nonbank institutions all received huge discount loans from the Fed despite their solvency coming into question or simply being bankrupt.

As evidence the Fed advanced credit to several commercial and investment banks that ultimately failed anyway or had to be saved through acquisition such as Washington Mutual (failed) and Wachovia (failed) or Bear Stearns, Merrill Lynch, and National City (all acquired).

But if the Fed loaned to many firms that were insolvent and never acquired, why are some of them still with us today? Because the Fed not only granted emergency liquidity loans, it also purchased their lousy mortgage securities in open market operations, the first time in its century-long history that the central bank bought mortgage paper instead of traditional, safer U.S. Treasuries.

Buying assets directly from banks, particularly lousy assets, was never on Bagehot’s list of remedies either.

Finally extending massive loans to non-commercial banking institutions, even solvent ones, violates another tenet of Bagehot’s Rule.

3) “Lend… on good collateral.” 

Obviously lending to banks that are offering failing subprime and Alt-A mortgages as collateral directly violates Bagehot’s Rule also.


4) “Lend… …at high rates [of interest].” 

As everyone already knows, the Fed loaned hundreds of billions of dollars through its discount window at nearly zero percent.

One can hardly call zero or even 0.5% interest a high or punitive rate, and in fact securing so much money so cheaply would have been impossible during the preceding boom years.

And with Fed lending rates so low, countless healthy and liquid banks lined up for cheap credit, something Bagehot specifically wished to avoid. Even banks that didn’t want rescue money were coerced into taking it, most famously Wells Fargo whose CEO was threatened with punitive government action if his bank didn’t accept a $25 billion TARP injection that the bank ultimately repaid with interest.

So if Bagehot were alive today, he’d perceive the world’s central bankers fulfilling only one of the four commandments of his doctrine while brazenly contravening the other three—all in his name.


Furthermore, if we look closer into Bagehot’s book we find he was a staunch hard-money gold standard advocate who hated any suggestion of unbacked or overissued paper money. Bagehot went out of his way to criticize central banker John Law’s 1719 Mississippi Company paper money scheme that inflated world history’s first stock market bubble in Paris which burst and threw France into a protracted depression.

He also sneered at the unbacked paper "greenbacks" circulating in America during and following the Civil War, although Congress began redeeming greenbacks for gold two years after Bagehot's death (1879).

And as we’ve already mentioned, Bagehot wanted to get rid of the Bank of England completely, but reluctantly accepted that doing so was politically impossible. His argument in “Lombard Street” is rather lengthy but here are key corroborating passages:

“I shall have failed in my purpose if I have not proved that the system of entrusting all our reserve to a single board, like that of the Bank [of England] directors, is very anomalous; that it is very dangerous; that its bad consequences, though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies.”

“But it will be said ‘What would be better? What other system could there be?’ We are so accustomed to a system of banking, dependent for its cardinal function on a single bank [the Bank of England], that we can hardly conceive of any other. But the natural system that which would have sprung up if Government had let banking alone is that of many banks of equal or not altogether unequal size. In all other trades competition brings the traders to a rough approximate equality…”

“I shall be at once asked ‘Do you propose a revolution? Do you propose to abandon the one-reserve System and create anew a many-reserve system [private competitive Scottish system of 1716-1845]?’ My plain answer is that I do not propose it. I know it would be childish. Credit in business is like loyalty in Government. You must take what you can find of it, and work with it if possible…”

“…Just so, an immense system of credit, founded on the Bank of England as its pivot and its basis, now exists. The English people, and foreigners too, trust it implicitly... …Nothing would persuade the English people to abolish the Bank of England; and if some calamity swept it away, generations must elapse before at all the same trust would be placed in any other equivalent. A many-reserve system, if some miracle should put it down in Lombard Street, would seem monstrous there. Nobody would understand it, or confide in it…”

“…On this account, I do not suggest that we should return to a natural or many-reserve system of banking. I should only incur useless ridicule if I did suggest it.”

-Lombard Street, pp.32-34.

So in conclusion, whatever one thinks of the emergency measures employed in 2008, the claims by Bernanke and modern central bankers that they were only doing Bagehot’s bidding fall flat in light of even a cursory glance at the evidence.

They only followed one of the four conditions of Bagehot’s Rule while blatantly breaking the other three.

And while the gold standard or animus towards monopoly central banks is not addressed directly in Bagehot’s Rule, his unwavering support of the gold standard is present throughout his writings, and his calls for abolishment of the Bank of England in favor of a private, decentralized, competitive banking system appear within “Lombard Street” itself. 

Bagehot would have expressed outrage and indignation at the Fed and particularly the Bank of England issuing unbacked fiat paper monies and computerized reserves without gold backing, blowing up the very asset bubbles he had blamed the monopoly central bank for inflating in his own time.

So after scrutinizing Bernanke’s claims of devotion to Bagehot’s Rule a bit more closely, we can safely conclude that “No Mister Chairman, Walter Bagehot would not have been pleased. He would have been very, very displeased by the conduct of central banks not only in 2008, but for many decades prior.”

Saturday, February 13, 2021

Free vs Regulated Banking: British Parliament and the Bank of England (Part 3 of 3)

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5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff concludes with the third and final installment examining the history and failings of England’s crisis-prone banking system.


With each successive suspension of the 1844 Peel Act’s banknote restriction the Bank of England gradually adopted a policy of providing liquidity to strained private banks by lending its notes on a short-term basis. Each new ensuing crisis, while still serious and disruptive to the economy, ended progressively faster and with less economic damage than the great panics of 1825 and 1837.

By 1873 banker and The Economist editor Walter Bagehot (pronounced “badge-it”) could see clearly both the causes of and remedies to England's now-fifteen banking panics stretching back to 1694 and outlined two proposals for monetary reform in his seminal book “Lombard Street: A Description of the Money Market.”

In Bagehot’s opinion the Bank of England’s banknote monopoly was at the root of the problem. England, he said, should do away with the central bank completely and move towards a free, unrestricted, competitive and decentralized banking system like that which Scotland had enjoyed without a single crisis from 1716 to 1845.

But the Bank of England was now so engrained in English culture for nearly two centuries, Bagehot opined, that it had become as impossible an institution to remove as the Queen herself.

Thus his second best solution was for the Bank to use its considerable powers to clean up its own mess. 

When the central bank creates a crisis, he argued, it should stand ready to help solvent but temporarily illiquid private banks weather the storm by lending generously on good collateral at high rates of interest, a prescription famously referred to today as “Bagehot’s Dictum” or “Bagehot’s Rule.” After the crisis abates and returning depositors replenish the banks’ reserves, he said, they can then settle their emergency loans with the central bank.

Bagehot’s book was well received by the public, the industry, and lawmakers and the Bank of England officially assumed the “lender of last resort” policy, the first adopted nationwide anywhere.

Although U.S Treasury Secretary Alexander Hamilton and English economist Henry Thornton were believed to have anticipated and proposed similar remedies in 1792 and 1802, Bagehot gets official credit having both articulated it so well in 1873 and providing impetus for the policy’s official adoption in Great Britain.

England suffered an incipient crisis in 1878 and one last brief but shallow crisis in 1890 (the Barings Crisis) which was only a blip on the radar compared to the Great Crises of 1825, 1837, and even 1857. Both emergencies were quickly stemmed by Bank of England liquidity loans. 

Further strengthening the industry were the continued expansions and mergers of small country banks into stronger, widely branched and highly diversified national banks—a trend that had begun with the Banking Copartnership Act of 1826. 

Hundreds of country banks operating only five branches on average in 1844 consolidated into fewer than 100 banks with 58 branches on average by 1899 (Turner, 2014). 

In 1900 25% of all U.K. deposits were controlled by the emergent “Big Five” banks including Barclays, Lloyds, Midland, and National Provincial. The Big Five’s market share grew to 40% by World War I (Turner).

Combined with an effective lender of last resort policy, England successfully avoided panics for 118 years following the Barings Crisis and its banking system even weathered the Great Depression without a crisis.

The contrast is striking. At least seventeen banking crises from 1694 to 1890, then zero from 1891 to 2007 with the scourge only returning in 2008.


So what lessons do we learn from the English banking experience of 1694-1890?

Far from unregulated laissez-faire, English banking was beset by a government-granted monopoly, perverse regulations, and legal restrictions on bank expansion for well over a century—regulations that were the root cause of the nation’s multiple financial crises.

At first private banks were kept small by Parliament’s Six Partner Rule, tying their hands, making them unable either to widely branch or diversify their loan portfolios and deposit bases, and excluding the most competent businessmen from entering banking.

But even as Six Partner Rule restrictions were relaxed, the central bank was granted an absolute banknote monopoly and assumed an indomitable role in the issuance of national credit. This artificially imposed pre-eminence led to a single institution’s credit policy expanding and contracting money and lending across the entire country, amplifying the boom-bust cycle.

All these dysfunctional, counterproductive regulations were imposed on the private sector for the first 126 years for the benefit of the British government itself—providing it with a reliable banker and compulsory credit line that would never be diminished by competing upstarts. 

The Bank of England and its directors would also continue to benefit from the monopoly and suppression of competition for another century-plus, profiting from its close relationship with government benefactors in a prime example of mercantilism—or what so many of us today refer to as “crony capitalism.”

The central bank was nationalized in 1946 and instead of enriching private shareholders its operating profits were transferred to the British government, just as the U.S. Federal Reserve diverts its earnings after member bank dividends to the U.S. Treasury today.

Later on the English experience teaches us that even the destabilizing effects of the monopoly central bank’s machinations can still be reasonably contained provided that:

-It’s constrained by an honest gold standard (such as the classical gold standard).

-Its directors are competent, apolitical, and act honestly.

-It acts quickly as lender of last resort to mitigate crises of its own creation.

-The private banking system is allowed to freely operate branch networks and conduct its own lending policies with minimal interference from government.

-The private banking system is allowed to reap the profits or losses of its policies, free from government privileges, guarantees, bailouts, and regulations that introduce moral hazard or otherwise distort market incentives.

Such an arrangement was Walter Bagehot’s next best blueprint for stability—second only to dissolving the central bank itself—and the formula promoted soundness in English banking for 118 years, even when Great Britain abandoned the gold standard in 1931.

Unfortunately in today’s era of fiat money, zero and subzero interest rates, “Greenspan puts,” “Too Big to Fail” doctrines, mortgage-hoarding and repackaging GSE’s, and Parliaments and Congresses commanding banks to lower lending standards for the benefit of special interest groups and uncreditworthy homebuyers, Bagehot’s rule can no longer stave off panic as the United Kingdom painfully learned during the 2008 global financial crisis.

In upcoming chapters we’ll examine the parallel history of Scotland, England’s northern neighbor that allowed the closest to a laissez-faire, unregulated banking system the post-Renaissance world has ever seen. 

With no central bank and no restrictions on shareholders, branching, note issuance, liability, or geographic scale, Scotland experienced not a single banking crisis during its “free banking” era of 1716-1845 while its larger neighbor to the south was crippled again and again by repeated waves of financial turmoil.

Sunday, February 7, 2021

Free vs Regulated Banking: British Parliament and the Bank of England (Part 2 of 3)

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues with a brief history of repeated crises and failures in 19th century England’s regulated banking system—in stark contrast to the resilience and stability of Scotland’s unregulated one.

Repeated 19th century parliamentary debates on Bank of England reform
Parliament repeatedly debates Bank of England reform
during the 19th century


After Napoleon’s 1815 defeat at Waterloo Britain and France finally cemented a lasting peace after 127 years of on-again, off-again war. As the century-long era of Pax Britannica began, Parliament’s focus on the Bank of England’s mission shifted from that of longtime war financier to steward of economic development.

After another crushing banking panic and depression in 1825 (which Scotland again avoided), Parliament fiercely debated reforms to impose upon the Bank in exchange for its charter renewal.

Lord Liverpool, conservative Prime Minister and proponent of reform, argued the right of joint-stock banking should be extended to all private banks. 

According to Professor Andreades’ classic 1909 history, Liverpool “criticised severely… …the Act of 1709, which limited the number of partners in a bank of issue to six, so that any small provincial tradesman, a fruiterer, a grocer or a butcher, might open a bank whilst the right of issue was refused to genuine companies, well deserving of confidence.”

In the House of Commons conservative MP and future Prime Minister Sir Robert Peel urged his fellow ministers to learn from the deregulated free Scottish banking system which had suffered not a single crisis since its first private bank—the Bank of Scotland—received its charter in 1695. 

Here Andreades records that Peel “contrasted the monopoly which existed in England with the free Scotch system. He pointed out that in England 100 banks had failed in 1793, 157 between 1810 and 1817, and 76 during the recent crisis… …whilst in Scotland, on the contrary, there was only a single bank failure on record, and even in that case the creditors had ultimately been paid in full.” 

Furthermore Peel lamented that “the Bank of England’s monopoly lay like a dead hand on the organization of credit in this country, and demonstrated the superiority of the Scottish system.”

Parliament relaxed the Six Partner Rule in 1826, ending 118 years of crippling legal restrictions and finally permitting joint-stock banking across all of England except within the critical 65 mile radius around London. By 1833 joint-stock banking was finally permitted everywhere and the central bank’s longstanding monopoly on London banknotes was ended. 

But the Bank of England warned it would not do business with any bank that attempted to issue notes within London. As the small country banks would require several years to grow and eventually compete with the Bank of England head-on, the central bank’s threat alone kept the circulation of its own notes paramount for a while longer, particularly in the capital and financial center.

And in a foreshadowing of eventual abandonment of the liberalization trend, the 1833 charter renewal bestowed Bank of England notes legal tender status for redemption of private/country banknotes. Having long been treated as a de facto reserve asset by private banks, the central bank’s notes were now a de jure monetary reserve and became a form of high-powered money. 

Nevertheless progress slowly began. Freed from 125 years of Six Partner Rule constraints, well-managed small banks undertook expansion, several of them eventually into successful conglomerates. 

Taylors and Lloyds, a small Birmingham bank founded in 1765, eventually grew into Lloyds Bank, a modern household name. 

In 1736 a small non-issuance London bank took on a Quaker businessman named James Barclay as partner and renamed itself “Freame, Gould and Barclay.” Once permitted to add more than six capital partners the bank grew over time to become British multinational Barclays plc.

Unfortunately the 1833 reforms didn’t come in time to prevent another major panic just four years later, brought on by the statutory treatment of Bank of England notes as a reserve and such incompetent central bank negligence that Scottish economist Henry Dunning Macleod lamented “Of all the acts of mismanagement in the whole history of the Bank, this is probably the most astonishing.”

To address the causes of the Crisis of 1837 Parliament should have encouraged and waited for the small country banks to expand into a system of large, nationally branched note issuing institutions whose scale would diminish the Bank of England’s outsized influence. 

Instead the British government took a major step backwards and enacted the ill-advised Peel Act of 1844.


It was thought that the continued panics were caused by overissuance of notes by both the Bank of England and private country banks. But the applied remedy was to prohibit private banknote issuance altogether and grant a complete monopoly to the Bank of England. Furthermore, the central bank’s note issuances would be limited to the balance of its government debt holdings and no more than 100% of the Bank’s gold reserves.

Prime Minister Robert Peel had himself forgotten the experience of the Scottish system he had championed in 1826. For free and universal note issuance had been allowed in Scotland for 128 years and in all that time never once destabilized the money trade. 

Unlike in England, Scotland was ruled by unfettered market forces, free from government-backed monopolies and Six Partner Rules, and it was market competition that prevented Scottish banks from overissuing. The constant threat of redemption calls, often from competing banks, and an efficient private clearinghouse system kept them all in line.

Moreover Peel and Parliament were persuaded by the Bank of England governor and deputy governor that the tight regulatory straitjacket foisted upon both central and private banknote issuance would solve the problem. The directors favored a statutory reassertion of their bank’s dominance and according to economist Lawrence H. White “had been searching for a simple non-discretionary rule that would govern their circulation in such a way as to insulate the bank from public criticism of its monopoly.”

Hence the general trend of steady liberalization that had prevailed from 1826 to 1844 was reversed with a dose of heavy-handed government control over national finance.

With the Act’s passage Parliament adopted a de facto national credit policy dictated entirely by the Bank of England. Whereas before national credit had been incidentally influenced by the central bank, now it would be completely regulated by it.

With private banks no longer able to issue banknotes and forced to accept Bank of England paper as reserves, the entire banking system began to expand and contract credit in perfect concert with the central bank. As Bank of England note circulation increased so did private bank lending and interest rates fell. When Bank of England note circulation contracted, private credit dried up, interest rates rose, and panic and depression ensued.

This arrangement, a pyramiding where private banks amplify the credit movements of the monopoly central bank, is much like that of today’s relationship between U.S. commercial banks and the Federal Reserve System.

Most perversely of all, whenever depositors became nervous and increased their cash holdings, private banks were forced to crawl begging on knee to the Bank of England for more of its exclusive notes. But the Peel Act forbade the central bank from accommodating since it was prohibited from issuing beyond 100% of its gold reserves. 

Unable to obtain paper money to meet customer demands, and restricted from issuing their own, many perfectly solvent English banks failed needlessly due to short-term illiquidity.

Thus even with the Six Partner Rule repealed, Peel’s Act restrictions and a renewed consolidation of the Bank of England’s note monopoly continued to ferment crises in 1847, 1857, 1866, 1878, and 1890, bringing the number of crises since the Bank’s founding to at least seventeen (post-Peels’ Act plus crises in 1696, 1715, 1721, 1745, 1772, 1783, 1793, 1797, 1810, 1815, 1825, and 1837).

So bad a problem had the Peel Act created that on four occasions Parliament was forced to suspend its own lawthe 100% gold reserve note restrictionstarting with the Crisis of 1847 and lastly at the onset of World War I. 

With each suspension the Bank of England was briefly permitted to purchase assets or loan cash beyond the value of its gold holdings, and the Bank’s directors slowly adopted the institutional role of lender of last resort—albeit by happenstance—a subject we will cover in the last installment on England.

Tuesday, February 2, 2021

Free vs Regulated Banking: British Parliament and the Bank of England (Part 1 of 3)

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7 MIN READ - As part of his new series on the success and failure of free versus regulated banking systems the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff offers a brief history of the Bank of England. 

The history you are about to read here is noncontroversial. Any monetary economic historian worth his or her salt is fully aware of these events as evidenced by the Bank of England’s own website attached below.

England’s perversely regulated banking system, which bore roughly seventeen banking crises over two centuries, stands in stark contrast to deregulated Scotland which experienced none during its own 129 year “free banking” era.


The Bank of England was established in 1694, the conception of a king and parliament desperately in need of funds to wage war against France.

The Glorious Revolution (1688) had deposed King James II and nearly a century of House of Stuart Catholics from the English throne. The crown was transferred to James’ protestant daughter Mary and her husband the Dutch King William III, aka. William and Mary.

Unfortunately, the deposed James was also first cousin to French monarch and fellow catholic Louis XIV and his ousting undid England’s alliance with France. War broke out, but the Royal Navy was inferior to the French at that time and was soundly beaten at the Battle of Beachy Head (1690).

With Anglo-French conflicts erupting in North America and alliances being forged with continental European nations, a new era of longer, more protracted, more global, and more expensive wars was beginning. Nations were learning that money was as important in war as battlefield strategy.

As one contemporary English financier and Treasury advisor wrote:

"If we in England can put our affairs into such a posture, as to be able to hold out in our expense longer than France, we shall be in a condition to give the peace; but if otherwise, we must be contented to receive it.”

“For war is quite changed from what it was in the time of our forefathers when in a hasty expedition, and a pitched field, the matter was decided by courage. But now the whole art of war is in a manner reduced to money and now-a-days, that prince, who can bell find money to feed, clothe, and pay his army, not he that has the most valiant troops, is surest of success and conquest."

-Charles Davenant, "An Essay Upon Ways and Means for Supplying the War" (1695)

Unfortunately the English public of 1694 was already overtaxed and tax evasion was rife. The government’s credit among its own citizenry was poor. As a revenue workaround there were attempts to implement a poll tax, a lottery, and a failed land bank, all of which fell far short of raising the estimated £1,200,000 believed needed to effect the war.

Hence the Bank of England scheme was proposed by a brilliant and patriotic financier named William Paterson and championed by King William's Chancellor of the Exchequer Charles Montagu.

The Bank’s founders would launch today’s equivalent of an IPO, with the added incentive of patriotic exhortations, and those funds raised would be loaned to the government. Queen Mary herself subscribed to £10,000 as part of a marketing drive that enticed not only the Bank’s directors and wealthy merchants but also everyday citizens to invest.

The share offering was a success. The Bank quickly raised the £1,200,000 it sought, mostly in silver coinage (ie. specie), and loaned its new paid-in capital to the government primarily as written banknotes which served as claims on specie. In exchange the Bank received government bonds which it used as security against additional private commercial loans it issued while holding a smaller gold and silver reserve.

The Bank’s first several years were tumultuous and it suffered several crises and suspensions, although some of these can be blamed on interventions by both the English and overseas governments. 

An ill-conceived silver recoinage in 1696 led to a brief shortage of coins and a run on Bank of England specie, forcing it into an embarrassing suspension of its banknotes’ convertibility into precious metal. 

Jealous goldsmiths hoarded Bank of England notes and then demanded simultaneous redemption to ruin the Bank, leading to another suspension as the directors scrambled to call in loans and secure more silver. 

Multiple attempted invasions by the deposed Catholic king’s son James Edward Francis Stuart (James III or “The Old Pretender”) fermented panic and rumors of his army landing in Scotland caused a run on the Bank.

And the Bank’s own worst enemy was King William himself who demanded more and more loans, each larger than the previous, stretching the Bank’s finances so thin that it was left with an increasingly inadequate and vulnerable silver reserve. In one particularly brazen act William demanded another large advance of banknotes, then resubmitted them to the Bank for redemption nearly bankrupting it of its silver coinage.


When the Bank’s charter came up for renewal in 1707 the directors argued they had accommodated the government up to the point of near ruin on multiple occasions and demanded some sort of concession in return for their loyalty to the Crown.

So in a series of quid-pro-quo arrangements between business and government which were so common in those days of mercantilism, Parliament granted the Bank a monopoly on joint-stock banking. Written into the Bank of England Act of 1708 was the so-called “Six Partner Rule” decreeing:

“It shall not be lawful for any body politic, or corporate whatsoever… … exceeding the number of six persons, in that part of Great Britain called England, to borrow or take up any sum or sums of money on their bills or notes payable at demand, or at any less time than six months from the borrowing thereof."

This monopoly, the original and only definition of monopoly that reigned for over three hundred years before Standard Oil—the sole right to operate in a market at the exclusion of any would-be competitor, enforced by the power of the State—would set the stage for a series of financial crises and bank failures that would plague England for well over a century.

The Bank was also given a total monopoly on note issuance within a 65-mile radius of London making it the only source of paper money in the business and financial center.

The Act’s desired and very successful objective was to prevent any competing bank from gaining enough scale and influence to challenge the Bank of England, thus preventing funds from moving elsewhere and depriving Parliament of its handpicked source of reliable and ample wartime credit. While other private banks could not raise capital from any more partners (ie. shareholders) than six, the Bank of England’s shareholder base was unlimited.

Thus outside of London the English countryside was scattered with dozens, and eventually hundreds of tiny banks that, even where well-managed, were legally restricted from growing to any meaningful size or servicing any large geographic area.

The preponderance of small country banks gave rise to at least four destabilizing factors:

1. Small banks with limited geographic scale were unable to diversify their loan portfolios. Dependent on only the local industry or crop, a downturn in a single economic sector could ruin a bank since it had no loans from any other industry or region.

2. Small banks were also unable to diversify their depositors. Dependent on only the local community, a single wealthy depositor could bring down a bank with one large withdrawal, something even more likely to occur during times of trouble.

3. The restriction precluded the most capable businessmen from entering banking. Successful entrepreneurs in the textiles, agricultural, machinery, or overseas trades were excluded from finance as their lucrative enterprises were already joint-stock companies, thus leaving banking to less competent upstarts. As William Dodgson Bowman’s Bank history (1937) tells us…

“In the provinces, people of many different occupations took up the trade—grocers, bakers, drapers, graziers, chemists and tailors,” but only a few banks “were founded by prudent business men, who understood the business and were alive to the importance of maintaining an adequate cash reserve against their paper issues.”


“A number of the banks were run by people with inadequate capital, with little knowledge of banking principles and methods. These mushroom concerns were responsible for large issues of notes, which were found to be merely wastepaper as soon as there was a sudden demand for cash.”

4. The legal restrictions placed on the size of country banks made each bank’s notes issuance small and localized. Thus Bank of England notes so dominated English circulation that they came to be treated as a reserve themselves, much as Federal Reserve Notes were legal reserves during the Fed gold standard era of 1914-1933 and remain fiat paper legal reserves today. This added an additional macroeconomic destabilizer as the entire country’s credit policy tended to expand and contract with that of the Bank of England, leading to larger and more widespread boom-bust cycles.

In the span of 125 years from the enactment of the Six Partner Rule to its final repeal in 1833, England suffered from no less than ten banking panics including major ones in 1721, 1772, 1797, 1815, and 1825.

Meanwhile north of the border in Scotland, where neither the Six Partner Rule nor any central bank existed, a nearly 100% unregulated system of private, competitive, nationally branched and highly diversified banks experienced no financial crises during the same 125 year period (sole exception: the Napoleonic Wars suspension which will be explained in a chapter on Scotland).

Nonetheless, Parliament did nothing to reform the Six Partner Rule as its overriding concern was guaranteeing itself a reliable source of credit to finance England’s century-plus series of on-again, off-again conflicts with France. Economic and financial stability consistently came second to war.

Stay tuned for next week’s second chapter on lessons learned from the experience of Parliament and the Bank of England.

Bank of England’s history at