The Mystery of Banking

Step 2: Commercial Banks
Assets
Equity & Liabilities
Demand deposits to
the public
+ $100 billion
Reserves at 
the Fed
+ $100 billion
Federal Reserve
Assets
Equity & Liabilities
(new) U.S. Government
Demand deposits to
securities
+ $100 billion
banks
+ $100 billion
F
IGURE
11.11 — E
FFECT OF
F
ED
P
URCHASE ON
B
ANKS
Thus, we see that the chronic and accelerating inflation of our
time has been caused by a fundamental change in the monetary
system. From a money, centuries ago, based solidly on gold as the
currency, and where banks were required to redeem their notes
and deposits immediately in specie, we now have a world of fiat
paper moneys cut off from gold and issued by government-privi-
leged Central Banks. The Central Banks enjoy a monopoly on the
printing of paper money, and through this money they control
and encourage an inflationary fractional reserve banking system
which pyramids deposits on top of a total of reserves determined
by the Central Banks. Government fiat paper has replaced com-
modity money, and central banking has taken the place of free
banking. Hence our chronic, permanent inflation problem, a
problem which, if unchecked, is bound to accelerate eventually
into the fearful destruction of the currency known as 
runaway
inflation. 
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XII.
T
HE
O
RIGINS OF
C
ENTRAL
B
ANKING
1. T
HE
B
ANK OF
E
NGLAND
H
ow did this momentous and fateful institution of central
banking appear and take hold in the modern world? Fit-
tingly, the institution began in late seventeenth century
England, as a crooked deal between a near-bankrupt government
and a corrupt clique of financial promoters. 
Banking in England, in the 1690s, consisted of scriveners—
loan bankers who loaned out borrowed money, and goldsmiths,
who had accepted gold on deposit and were beginning to make
loans. The harrowing and expensive Civil Wars had finally con-
cluded, in 1688, with the deposition of James II and the installa-
tion of William and Mary on the throne of Great Britain. The
Tory party, which had been in favor, now lost its dominance, and
was replaced by the Whig party of noble landlords and merchant
companies enjoying monopoly privileges from the government.
Whig foreign policy was mercantilist and imperialist, with colonies
sought and grabbed for the greater glory of the Crown, trading
advantages, investments in raw material, and markets for shipping
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and exports. England’s great rival was the mighty French Empire,
and England set out in a successful half-century-long effort to
attack and eventually conquer that rival empire. 
A policy of war and militarism is expensive, and the British
government found, in the 1690s, that it was short of money and
its credit poor. It seemed impossible after a half-century of civil
wars and a poor record of repayment for the government to tap
sufficient savings by inducing people to buy its bonds. The British
government would have loved to levy higher taxes, but England
had just emerged from a half-century of civil wars, much of which
had been waged over the king’s attempt to extend his taxing
power. The taxing route was therefore politically unfeasible. 
A committee of the House of Commons was therefore formed
in early 1693 to figure out how to raise money for the war effort.
There came to the committee the ambitious Scottish promoter,
William Paterson, who, on behalf of his financial group, proposed
a remarkable new scheme to Parliament. In return for a set of
important special privileges from the State, Paterson and his
clique would form the Bank of England, which would issue new
notes, much of which would be used to finance the English
deficit. In short, since there were not enough private savers will-
ing to finance the deficit, Paterson and his group were graciously
willing to buy government bonds, provided they could do so with
newly-created out-of-thin-air bank notes carrying a raft of special
privileges with them. This was a splendid deal for Paterson and
company, and the government benefited from the flimflam of a
seemingly legitimate bank’s financing their debts. (Remember that
the device of open government paper money had only just been
invented in Massachusetts in 1690.) As soon as the Bank of Eng-
land was chartered by Parliament in 1694, King William himself
and various members of Parliament rushed to become sharehold-
ers of the new money factory they had just created. 
From the beginning, the Bank of England invested itself, aided
and abetted by the government, with an impressive aura of mys-
tery—to enhance its prestige and the public’s confidence in its
operations. As one historian perceptively writes: