The Mystery of Banking

180
The Mystery of Banking
2
Marvin Rosen, “The Dictatorship of the Bourgeoisie: England, 1688–
1721,” 
Science and Society 
XLV (Spring 1981): 44. This is an illuminating
article, though written from a Marxist perspective.
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sycophantic history of the Bank of England, put it, “Bank notes
were not yet King’s money, but they were getting near to it.”
3
In 1708, Parliament followed up this privilege with a further
one: It was now unlawful for any corporate body other than the
Bank of England to issue demand notes, and added a similar pro-
hibition for any partnership of more than six persons. Not only
could such bodies not issue notes redeemable on demand, but
they also could not make short-term loans under six months. In
this way, the Bank of England was enormously privileged by Par-
liament by being the only corporation or even moderately sized
institution allowed to issue bank notes; its only competitors could
now be very small banks with fewer than seven partners. 
Despite these provisions, the Bank soon suffered the compe-
tition of powerful Tory-connected rivals, launched during a brief
Tory ascendancy during the reign of Queen Anne. The South Sea
Company, created in 1711 and headed by Prime Minister Robert
Harley, was a formidable rival to the Bank, but it collapsed nine
years later after a bout of inflationary monetary expansion and
stock speculation. In the wake of the South Sea collapse, the Bank
of England was itself subject to a bank run and was again allowed
to suspend specie payments indefinitely. Still, the ignominious
end of the “South Sea Bubble” left the Bank of England striding
like a colossus, unchallenged, over the English banking system.
4
A similar run on the Bank of England was precipitated in
1745, by the rising of Bonnie Prince Charlie in Scotland, and once
more the Bank was permitted to suspend payments for a while. 
During the late eighteenth century, the Bank of England’s pol-
icy of monetary expansion formed the base of a pyramid for a
flood of small, private partnerships in note issue banks. These
The Origins of Central Banking
181
3
John Clapham,
The Bank of England
(Cambridge: Cambridge Univer-
sity Press, 1958), pp. 1, 50.
4
On the South Sea Bubble, see Carswell, 
The South Sea Bubble
. For
more on the early history of the Bank of England, in addition to Clapham,
see J. Milnes Holden, 
The History of Negotiable Instruments in English Law
(London: The Athlone Press, 1955), pp. 87–94, 191–98.
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182
The Mystery of Banking
“country banks” increasingly used Bank of England notes as
reserves and pyramided their own notes on top of them. By 1793,
there were nearly 400 fractional reserve banks of issue in Eng-
land. Inflationary financing of the lengthy, generations-long wars
with France, beginning in the 1790s, led to the suspension of
specie payment by one-third of English banks in 1793, followed
by the Bank of England’s suspension of specie payments in 1797.
That suspension was joined in by the other banks, who then had
to redeem their obligations in Bank of England notes. 
This time, the suspension of specie payments by the Bank
lasted 24 years, until 1821, after the end of the wars with France.
During that period, the Bank of England’s notes, in fact though
not in law, served as legal money for England, and after 1812
until the end of the period, was 
de jure
legal tender as well. As
might be expected, this period proved to be a bonanza for infla-
tionary bank credit and for creation of new, unsound banks. In
1797, there were 280 country banks in England and Wales. By
1813, the total number of banks was over 900. These banks pyra-
mided on top of a swiftly rising total of Bank of England notes.
Total bank notes outstanding in 1797 were £11 million. By 1816,
the total had more than doubled, to £24 million.
5
The fiat money period proved a bonanza for the Bank of Eng-
land as well. The Bank’s profits zoomed, and when specie payments
finally resumed, Bank stocks fell by a substantial 16 percent.
6
In 1826, banking was liberalized in England, since all corpo-
rations and partnerships were now permitted to issue demand
notes; however, the effect of the liberalization was minuscule,
since the new freedom was restricted to outside a 65-mile radius
from London. Furthermore, in contrast to the Bank of England,
the new bank corporations were subjected to unlimited liability.
Thus, the monopoly of the Bank was kept inside London and its
environs, limiting competition to 
country
banking. 
5
Estimated total of country bank notes, in 1810, was £22 million.
6
See Vera C. Smith, 
The Rationale of Central Banking
(London: E.S.
King & Son, 1936), p. 13.
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The Origins of Central Banking
183
7
Lawrence H. White, “Free Banking in Scotland Prior to 1845” (unpub-
lished essay, 1979), p. 1.
In 1833, banking was liberalized further, but only slightly:
deposit
but 
not
note issue corporate banking was allowed within
London. More significantly, however, the Bank of England now
received the permanent privilege of its notes functioning as 
legal
tender
. Furthermore, country banks, which previously were
required to redeem their notes in specie, now had the option of
redeeming them in Bank of England notes. These actions
strengthened the Bank’s position immeasurably and from that
point on, it functioned as a full central bank, since country banks
now took to keeping virtually all of their reserves at the Bank of
England, demanding cash, or gold, from the Bank as necessary. 
2. F
REE
B
ANKING IN
S
COTLAND
After the founding of the Bank of England, English banking,
during the eighteenth and first half of the nineteenth centuries,
was riven by inflation, periodic crises and panics, and numer-
ous—and in one case, lengthy—suspensions of specie payment. In
contrast, neighboring Scottish banking, not subject to Bank of
England control and, indeed, living in a regime of free banking,
enjoyed a far more peaceful and crisis-free existence. Yet the Scot-
tish experience has been curiously neglected by economists and
historians. As the leading student of the Scottish free banking sys-
tem concludes: 
Scotland, an industrialized nation with highly developed
monetary, credit, and banking institutions, enjoyed remark-
able macroeconomic stability through the eighteenth and
early nineteenth centuries. During this time, Scotland had
no monetary policy, no central bank, and virtually no polit-
ical regulation of the banking industry. Entry was com-
pletely free and the right of note-issue universal. If the con-
junction of these facts seems curious by today’s light, it is
because central banking has come to be taken for granted in
this century, while the theory of competitive banking and
note-issue has been neglected.
7 
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184
The Mystery of Banking
Scotland enjoyed a developing, freely competitive banking
system from 1727 to 1845. During that period, Scottish bank
notes were never legal tender, yet they circulated freely through-
out the country. Individual banks were kept from overissue by a
flourishing note exchange clearinghouse system. Since each bank
was forced to toe the mark by being called upon for redemption,
each bank would ordinarily accept each other’s notes.
8 
Whereas English country banks were kept weak and unreli-
able by their limitation to partnerships of six or fewer, free Scot-
tish banks were allowed to be corporate and grew large and
nationwide, and therefore enjoyed much more public confidence.
An important evidence of the relative soundness of Scottish banks
is that Scottish notes circulated widely in the northern counties of
England, while English bank notes never traveled northward
across the border. Thus, in 1826, the citizens of the northern Eng-
lish counties of Cumberland and Westmoreland petitioned Parlia-
ment against a proposed outlawing of their use of Scottish bank
notes. The petition noted that Scotland’s freedom from the six-