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3. The Peelite Crackdown, 1844–1845

In 1844, Sir Robert Peel, a classical liberal who served as Prime Minister of Great Britain, put through

a fundamental reform of the English banking system (followed the next year by imposing the same reform upon

Scotland). The Peel’s Acts is a fascinating example of the ironies and pitfalls of even the most well-meaning

politicoeconomic reform. For Sir Robert Peel was profoundly influenced by the neo-Ricardian British

economists known as the Currency School, who put forth a caustic and trenchant analysis of fractional reserve

banking and central banking similar to that of the present book. The Currency School was the first group of

economists to show how expansion of bank credit and bank notes generated inflations and business cycle

booms, paving the way for the inevitable contraction and attendant collapse of business and banks.

Furthermore, the Currency School showed clearly how the Central Bank, in England’s case the Bank of

England, had generated and perpetrated these inflations and contractions, and how it had borne the primary

responsibility for unsound money and for booms and busts.

What, then, did the Currency School propose, and Sir Robert Peel adopt? In a praiseworthy attempt

to end fractional reserve banking and institute 100% money, the Peelites unfortunately [p. 188] decided to put

absolute monetary power in the hands of the very central bank whose pernicious influence they had done so

much to expose. In attempting to eliminate fractional reserve banking, the Peelites ironically and tragically put

the fox in charge of the proverbial chicken coop.

Specifically, Peel’s Act of 1844 provided (a) that all further issues of bank notes by the Bank of

England must be backed 100% by new acquisitions of gold or silver12; (b) that no new bank of issue (issuing

bank notes) could be established; (c) that the average note issue of each existing country bank could be no

greater than the existing amount of issue; and (d) that banks would lose their note issue rights if they were

merged into or bought by another bank, these rights being largely transferred to the Bank of England.

Provisions (b), (c), and (d) effectively eliminated the country banks as issuers of bank notes, for they could not

issue any more (even if backed by gold or silver) than had existed in 1844. Thereby the effective monopoly of

bank note issue was placed into the not very clean hands of the Bank of England. The quasi-monopoly of note

issue by the Bank had now been transformed into a total legally enforceable monopoly. (In 1844, the Bank of

England note circulation totalled £21 million; total country bank note circulation was £8.6 million, issued by

277 small country banks.)

By these provisions, the Peelites attempted to establish one bank in England—the Bank of

England—and then to keep it limited to essentially a 100% receiver of deposits. In that way, fractional reserve

banking, inflationary booms, and the business cycle were supposed to be eliminated. Unfortunately, Peel and

the Currency School overlooked two crucial points. First, they did not realize that a monopoly bank privileged

by the State could not, in practice, be held to a restrictive 100% rule. Monopoly power, once created and

sustained by the State, will be used and therefore abused. Second, the Peelites overlooked an important

contribution to monetary theory by such American Currency School economists as Daniel Raymond and [p.

189] William M. Gouge: that demand deposits are fully as much part of the money supply as bank notes. The

British Currency School stubbornly insisted that demand deposits were purely nonmonetary credit, and

therefore looked with complacency on its issue. Fractional reserve banking, according to these the orists, was

only pernicious for bank notes; issue of demand deposits was not inflationary and was not part of the supply

of money.

The result of this tragic error on bank deposits meant that fractional reserve banking did not end in

England after 1844, but simply changed to focusing on demand deposits instead of notes. In fact, the

pernicious modem system now came into full flower. Both the Bank of England and the country banks,

deprived of the right to issue notes at will, began to issue deposits to a fare-thee-well. And since only the Bank

of England could now issue notes, the country banks relied on the Central Bank to issue notes, which remained

as legal tender, while they themselves pyramided demand deposits on top of them.

As a result, inflationary booms of bank credit continued immediately after 1844, leading to the final

collapse of the Currency School. For as crises arose when domestic and foreign citizens called upon the banks

for redemption of their notes, the Bank of England was able to get Parliament to “suspend” Peels Act, allowing

the Bank to issue enough fractional reserve legal tender notes to get the entire banking system out of trouble.

Peels Act requiring 100% issue of new Bank of England notes was suspended periodically; in 1847, 1857,

1866, and finally, in 1914, when the old gold standard system went into the discard. How seriously the

government and the Bank of England kept to the spirit of noninflationary banking may be seen by the fact that

when the last vestiges of Peels Act were scrapped in 1928, the authorized maximum of the Bank of England

was permanently raised from the traditional, but now unfortunately obsolete, £14 million to the now realistic

£260 million, while any further issues could simply be authorized [p. 190] by the British government without an

act of Parliament Vera C. Smith justly writes that:

The 1847, 1857 and 1866 crises showed the Government always ready, on the only

occasions when it was necessary, to exempt the Bank from the provisions of the Bank

Act (Peel’s Act), and the opinion was necessarily expressed in some quarters that the

clause of the Act, limiting the fiduciary issue of the Bank, was a mere paper provision

having no practical application, since the Bank of England could always rely on the

Government to legalise a breach of it every time it got into a difficult position. The

relations between the Bank and the Government were, in fact, a tradition too long

established for either the Bank, or the public, or the Government, to envisage anything

other than full Government support to the Bank in time of stress. It had always been a

privileged and protected institution . . .13

If the political flaw of trusting a monopoly Bank of England combined with the economic flaw of

overlooking deposits to make the English banking system worse than before, the effect on Scotland was far

worse. For the Currency School theorists were totally ignorant of the beneficial workings of the Scottish free

banking system, and in their haste to impose a uniform monetary scheme on the entire United Kingdom, they

proceeded to destroy Scottish free banking as well.

Peel’s Act to Regulate the Issue of Bank Notes was imposed on Scotland in July 1845. No new

banks of issue were allowed in Scotland any longer; and the note issue of each existing bank could only

increase if backed 100% by specie in the bank’s vault. In effect, then, the Scottish banks were prevented from

further note issue (though not absolutely so as in the case of England), and they, too, shifted to deposits and

were brought under the Bank of England’s note issue suzerainty.

One interesting point is the lack of any protests by the Scottish banks at this abrogation of their

prerogatives. The reason is that Peels 1845 Act suppressed all new entrants into Scottish note banking,

thereby cartelizing the Scottish banking system, and winning the applause of the existing banks who would no

longer have to battle new competitors for market shares.14 [p. 191] [p. 192] [p. 193]