The Mystery of Banking

186
The Mystery of Banking
“While England, during the past year, has suffered in almost every
branch of her national industry, Scotland has passed compara-
tively uninjured through the late monetary crisis.”
11
3. T
HE
P
EELITE
C
RACKDOWN
, 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). Peel’s Act is a fascinat-
ing example of the ironies and pitfalls of even the most well-
meaning politico-economic reform. For Sir Robert Peel was pro-
foundly 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 bank-
ing 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 atten-
dant 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 infla-
tions and contractions, and how it had borne the primary respon-
sibility 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 percent money, the Peelites unfortu-
nately 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. 
11
Robert Bell, 
Letter to James W. Gilbart . . .
(Edinburgh: Bell & Brad-
fute, 1838), p. 8; White, “Free Banking,” p. 38.
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12
In fact, the maximum limit of Bank of England notes not backed by
gold was set at £14 million; circulation of bank notes in 1844 was £21 mil-
lion, making the restriction on the Bank even more rigorous.
The Origins of Central Banking
187
Specifically, Peel’s Act of 1844 provided (a) that all further
issues of bank notes by the Bank of England must be backed 100
percent by new acquisitions of gold or silver
12
; (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 elim-
inated 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 Eng-
land. 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 totaled £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 lim-
ited to essentially a 100 percent 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 percent rule. Monop-
oly power, once created and sustained by the State, will be used
and therefore abused. Second, the Peelites overlooked an impor-
tant contribution to monetary theory by such American Currency
School economists as Daniel Raymond and William M. Gouge:
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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 theorists, 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 modern 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 Cur-
rency School. For as crises arose when domestic and foreign citi-
zens called upon the banks for redemption of their notes, the
Bank of England was able to get Parliament to “suspend” Peel’s
Act, allowing the Bank to issue enough fractional reserve legal
tender notes to get the entire banking system out of trouble. Peel’s
Act requiring 100 percent 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 Peel’s 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 by the British government without an
act of Parliament. Vera C. Smith justly writes that: