The Bank of England Was Blamed by the “Bullionists” for the Restriction Crisis (1797-1821) But Defended by the “Anti-Bullionists”

Before 1800, decades of inconvertible paper money in England would have been considered unthinkable, and so previous monetary theorists had scarcely contemplated or analysed such an economy. But now writers were forced to come to grips with fiat paper, and to propose policies to cope with an unwelcome new era.

The political controversies during the restriction period centred on explaining the price inflation and depreciation and on assessing the role of the Bank of England. The ‘bullionists’ pointed out that the cause of the price inflation, the rise in the price of bullion over par, and the depreciation of the pound was the fiat money expansion. They further maintained that the central role in that inflation was played by the Bank of England, freed of its necessity to redeem in specie. Their opponents, the ‘anti-bullionists’, tried absurdly to absolve the government and its privileged bank of all blame, and to attribute all unwelcome consequences to specific problems in the particular markets involved. Depreciation in foreign exchange was charged to the outflow of bullion caused by excessive imports or by British war expenditures abroad (presumably unrelated to the increased amount of paper pounds or to the lowered purchasing power of the pound). The rise in the price of bullion was supposedly caused by an increased ‘real’ demand for gold or silver (again unrelated to the depreciated paper pound). The increases in domestic prices received less attention from the two sides of the debate, but they were attributed by the anti-bullionists to wartime disruptions and shortages in supply. Any ad hoc cause could be seized upon, so long as the great integrating cause, the expansion of bank credit and paper money, was carefully ignored and let off the hook. In short, the anti-bullionists reverted to mercantilist worry about ad hoc causes and the balance of trade on the market. The previous hard-won analysis of money and overall prices went by the board.

—Murray N. Rothbard, Classical Economics, vol. 2 of An Austrian Perspective on the History of Economic Thought (Auburn, AL: Ludwig von Mises Institute, 2006), 160-161.

The “Bullionist Controversy” Began in 1797 with a Massive Run on the Banks Followed by a Suspension of Specie Payment

The Bank of England had been the bulwark of the English (and, by serving as bankers’ bank, of the Scottish) banking system since its founding in 1694. The bank was the recipient of an enormous amount of monopoly privilege from the British government. Not only was it the receiver of all public funds, but no other corporate banks were allowed to exist, and no partnerships of more than six partners were allowed to issue bank notes. As a result, by the late eighteenth century, the Bank of England was serving as an inflationary engine of bank deposits and especially of paper money, on top of which a flood of small partnership banks (‘country banks’) were able to pyramid their own notes, using Bank of England notes as their reserve. As if this were not enough privilege, when the bank got into trouble by overinflating, it was permitted to suspend specie payment, that is, refuse to meet its obligation to redeem its notes and deposits in specie. This privilege was granted to the bank several times during the century after it opened its doors. However, each time the suspension, or ‘restriction’ of specie payment lasted only a few years.

In the 1790s, however, a startlingly new epoch began in the history of the British monetary system. In February 1793, a generation of fierce warfare broke out between revolutionary France and the crowned heads of Europe, led by Great Britain. While not exactly continuous, the war lasted, with slight interruptions, until Napoleon was finally defeated in 1815 and the monarchies of Europe reimposed the Bourbon dynasty upon the French nation. This massive war effort meant a rapid escalation of monetary inflation, government spending, and public debt by the British government.

During the 1780s, the inflationary process of bank credit expansion had managed to double the number of country banks in England, totalling nearly 400 by the outbreak of war. The shock of the war led to a massive financial crisis, including runs on the country banks, as well as numerous bankruptcies among banks and financial houses. One-third of the country banks suspended specie payment during 1793.

For a few years, the bank saved itself by pursuing a cautious and conservative policy. But soon, inflationary war finance, the drain of gold abroad in response to higher purchasing power elsewhere, the alarms of war, and the increased demand for gold upon the banks, all combined to precipitate a massive run on banks, including the Bank of England, in February 1797. The country banks suspended specie payments, and the government brought matters to a head by ‘forcing’ the bank to suspend specie payments, a ‘Restriction’ which the Bank of England of course was all too delighted to accept. For the bank could now continue operations, could expand credit, inflate its supply of notes and deposits, and insist that its debtors must repay their loans, while it could avoid the bother of redeeming its own obligations in specie. In effect, bank notes were unofficially legal tender, indeed virtually the only legal tender, and they were made official legal tender in 1812 until the resumption of specie payments in 1821.

—Murray N. Rothbard, Classical Economics, vol. 2 of An Austrian Perspective on the History of Economic Thought (Auburn, AL: Ludwig von Mises Institute, 2006), 159-160.

Richard Cantillon's Analysis of the Price-Specie-Flow Mechanism Is Superior to David Hume's Analysis

Hume's most important contribution is his elucidation of monetary theory, in particular his clear exposition of the price-specie-flow mechanism that equilibrates national balances of payments and international price levels. In monetary theory proper, Hume vivifies the Lockean quantity theory of money with a marvellous illustration, highlighting the fact that it doesn't matter what the quantity of money may be in any given country: any quantity, smaller or larger, will suffice to do money's work of facilitating exchange. Hume pointed up this important truth by postulating what would happen if every individual, overnight, should find the stock of money in his possession to have doubled miraculously:

For suppose that, by miracle, every man in Great Britain should have five pounds slipped into his pocket in one night; this would much more than double the whole money that is at present in the kingdom; yet there would not next day, nor for some time, be any more lenders, nor any variation in the interest.

Prices then, following Locke's quantity theory of money, will increase proportionately.

The price-specie-flow mechanism is the quantity theory extrapolated into the case of many countries. The rise in the supply of money in country A will cause its prices to rise; but then the goods of country A are no longer as competitive compared to other countries. Exports will therefore decline, and imports from other countries with cheaper goods will rise. The balance of trade in country A will therefore become unfavourable, and specie will flow out of A in order to pay for the deficit. But this outflow of specie will eventually cause a sharp contraction of the supply of money in country A, a proportional fall in prices, and an end to, indeed a reversal of, the unfavourable balance. As prices in A fall back to previous levels, specie will flow back in until the balance of trade is in balance, and until the price levels in terms of specie are equal in each country. Thus, on the free market, there is a rapidly self-correcting force at work that equilibrates balances of payments and price levels, and prevents an inflation from going very far in any given country.

While Hume's discussion is lucid and engaging, it is a considerable deterioration from that of Richard Cantillon. First, Cantillon did not believe in aggregate proportionality of money and price level changes, instead engaging in a sophisticated micro-process analysis of money going from one person to the next. As a result, money and prices will not rise proportionately even in the eventual new equilibrium state. Second, Cantillon included the ‘income effect’ of more money in a country, whereas Hume confined himself to the aggregate price effect. In short, if the money supply in country A increases, it will equilibrate not only by prices rising in A, but also by the fact that monetary assets and incomes are higher in A, and therefore more money will be spent on imports. This income or more precisely, the cash balance, effect will generally work faster than the price effect.

—Murray N. Rothbard, An Austrian Perspective on the History of Economic Thought, vol. 1, Economic Thought Before Adam Smith (Auburn, AL: Ludwig von Mises Institute, 2006), 426-427.