Unconventional Monetary Policy, circa 1793

From Henry Thornton’s An Inquiry Into The Nature And Effects Of The Paper Credit Of Great Britain:

The truth of this observation, as applied to Bank of England notes, as well as the importance of attending to it, may be made manifest by adverting to the events of the year 1793, when, through the failure of many country banks, much general distrust took place. The alarm, the first material one of the kind which had for a long time happened, was extremely great. It does not appear that the Bank of England notes, at that time in circulation, were fewer than usual. It is certain, however, that the existing number became, at the period of apprehension, insufficient for giving punctuality to the payments of the metropolis; and it is not to be doubted, that the insufficiency must have arisen, in some measure, from that slowness in the circulation of notes, naturally attending an alarm, which has been just described. Every one fearing lest he should not have his notes ready when the day of payment should come, would endeavour to provide himself with them somewhat beforehand. A few merchants, from a natural though hurtful timidity, would keep in their own hands some of those notes, which, in other times, they would have lodged with their bankers; and the effect would be, to cause the same quantity of bank paper to transact fewer payments, or, in other words, to lessen the rapidity of the circulation of notes on the whole, and thus to encrease the number of notes wanted. Probably, also, some Bank of England paper would be used as a substitute for country bank notes suppressed.

The success of the remedy which the parliament administered, denotes what was the nature of the evil. A loan of exchequer bills was directed to be made to as many mercantile persons, giving proper security, as should apply. It is a fact, worthy of serious attention, that the failures abated greatly, and mercantile credit began to be restored, not at the period when the exchequer bills were actually delivered, but at a time antecedent to that æra. It also deserves notice, that though the failures had originated in an extraordinary demand for guineas, it was not any supply of gold which effected the cure. That fear of not being able to obtain guineas, which arose in the country, led, in its consequences, to an extraordinary demand for bank notes in London; and the want of bank notes in London became, after a time, the chief evil. The very expectation of a supply of exchequer bills, that is, of a supply of an article which almost any trader might obtain, and which it was known that he might then sell, and thus turn into bank notes, and after turning into bank notes might also convert into guineas, created an idea of general solvency. This expectation cured, in the first instance, the distress of London, and it then lessened the demand for guineas in the country, through that punctuality in effecting the London payments which it produced, and the universal confidence which it thus inspired. The sum permitted by parliament to be advanced in exchequer bills was five millions, of which not one half was taken. Of the sum taken, no part was lost. On the contrary, the small compensation, or extra interest, which was paid to government for lending its credit (for it was mere credit, and not either money or bank notes that the government advanced), amounted to something more than was necessary to defray the charges, and a small balance of profit accrued to the public. For this seasonable interference, a measure at first not well understood and opposed at the time, chiefly on the ground of constitutional jealousy, the mercantile as well as the manufacturing interests of the country were certainly much indebted to the parliament, and to the government.

8 responses to “Unconventional Monetary Policy, circa 1793

  1. It seems Chuck Norris is older than I thought he was, if he was alive and kicking in 1793.
    I think you need a new title: “Chuck Norris turns 220″.

    Seriously, I wish more people today understood what Thornton understood then.

  2. From H.T. Easton, Banks and Banking, 1879:

    “In the panic of 1793 no less than 100 out of a total number of 400 country banks stopped payment, and the remainder were in a critical condition. The commercial crises were attributed to the monopoly of the Bank of England, combined with its restricted issue of notes at times when a stringency of the money market existed.”

    Apparently, the Bank came to the rescue of its own victims. Of course, 1793 marked the start of the Napoleanic wars, so Easton might have over-reached in blaming the Bank.

    But similar stories just as often end badly.
    1. A crisis leaves banks insolvent.
    2. The resulting bank run leads to a credit crunch and recession.
    3. Some bank with good credit could provide the needed cash,
    4. but quantity theorists object that issuing more cash will only cause a proportionate rise in prices. (Poor fools were never taught the backing theory.)
    5. So the needed cash is not issued, and recession continues

    • Mike,

      Thornton makes the same point regarding the country banks. The BoE didn’t actually come to the rescue. It was Parliament that approved exchequer bills.

      • Sorry, I should have said Parliament came to the rescue of the Bank’s victims.

        On the other hand, Thornton is not, and never has been, under-appreciated. Quite the opposite. For example:

        ” “Real notes,” it is sometimes said, “represent actual property. There are actual goods in existence, which are the counterpart to every real note. Notes which are not drawn, in consequence of a sale of goods, are a species of false wealth, by which a nation is deceived. These supply only an imaginary capital; the others indicate one that is real.”
        In answer to this statement it may be observed, first, that the notes given in consequence of a real sale of goods cannot be considered as, on that account, certainly representing any actual property. Suppose that A sells one hundred pounds worth of goods to B at six months credit, and takes a bill at six months for it; and that B, within a month after, sells the same goods, at a like credit, to C, taking a bill; and again, that C, after another month, sells them to D, taking a like bill, and so on. There may then, at the end of six months, be six bills of 100 pounds each existing at the same time; and every one of these may possibly have been discounted. Of all these bills, then, only one represents any actual property.” (Thornton, 1802, p. 86.)

        Thornton’s mistake was in failing to realize that no matter how we look at it, 600 pounds of debt will not be created unless security worth 600 pounds is offered in exchange. The scenario Thornton described is illustrated in Figure 1. Suppose A sells wheat worth 100 pounds to B, and receives B’s IOU in exchange. B then sells the wheat to C, in exchange for C’s IOU, and the process repeats six times. If B is respected in the community, then his IOU might serve as money, and the exchange would have increased the money supply by 100 pounds. Alternatively, as Thornton states, B’s IOU might be discounted by a banker, and the banker’s IOU would then serve as money. In either case, each exchange potentially increases the supply of money, and it is possible, as Thornton states, that six successive sales of the same wheat could increase the money supply by 600 pounds.
        Thornton’s error becomes apparent once we realize that A would only accept B’s IOU if it were backed by something worth 100 pounds. For example, B might own property that A could take from him in court. It is as if B’s IOU were actually backed by a lien on B’s property, C’s IOU by a lien on C’s property, etc. Every additional sale of the wheat would create new IOU’s backed by new goods, and no matter how far the process went, the self interest of the parties involved would assure that every new IOU would be backed by goods of commensurate value.

  3. Mike,

    That Thornton quote is taken out of context. If you read the surrounding point, he is arguing that the distinction that some make between real bills and so-called “fictitious” bills is meaningless. His point in that example is that it is impossible (and pointless) to distinguish between bills that are backed by goods and bills that are backed by collateral.

  4. Mike,

    Here is the full context of Thornton’s argument:

    ” “Real notes,” it is sometimes said, “represent actual property. There are actual goods in existence, which are the counterpart to every real note. Notes which are not drawn, in consequence of a sale of goods, are a species of false wealth, by which a nation is deceived. These supply only an imaginary capital; the others indicate one that is real.”

    In answer to this statement it may be observed, first, that the notes given in consequence of a real sale of goods cannot be considered as, on that account, certainly representing any actual property, Suppose that A sells one hundred pounds worth of goods to B at six months credit, and takes a bill at six months for it; and that B, within a month after, sells the same goods, at a like credit, to C, taking a like bill; and again, that C, after another month, sells them to D, taking a like bill, and so on. There may then, at the end of six months, be six bills of 100l. each existing at the same time; and every one of these may possibly have been discounted. Of all these bills, then, one only represents any actual property.

    In the next place it is obvious, that the number of those bills which are given in consequence of sales of goods, and which, nevertheless, do not represent property, is liable to be encreased through the extension of the length of credit given on the sale of goods. If, for instance, we had supposed the credit given to be a credit of twelve months instead of six, 1,200l. instead of 600l. would have been the amount of the bills drawn on the occasion of the sale of goods; and 1,100l. would have been the amount of that part of these which would represent no property.

    In order to justify the supposition that a real bill (as it is called) represents actual property, there ought to be some power in the bill-holder to prevent the property which the bill represents, from being turned to other purposes than that of paying the bill in question. No such power exists; neither the man who holds the real bill, nor the man who discounts it, has any property in the specific goods for which it was given: he as much trusts to the general ability to pay of the giver of the bill, as the holder of any fictitious bill does. The fictitious bill may, in many cases, be a bill given by a person having a large and known capital, a part of which the fictitious bill may be said, in that case, to represent. The supposition that real bills represent property, and that fictitious bills do not, seems, therefore, to be one by which more than justice is done to one of these species of bills, and something less than justice to the other.”

    http://oll.libertyfund.org/index.php?option=com_staticxt&staticfile=show.php%3Ftitle=2041&layout=html#chapter_145573

    Thornton clearly recognizes that so-called fictitious bills are backed by something — in his example the person’s capital. This seems consistent with what you have said.

    • Josh:
      Here’s what I consider to be Thornton’s key passage:

      “the notes given in consequence of a real sale of goods cannot be considered as, on that account, certainly representing any actual property,…Of all these bills, then, one only represents any actual property.”

      Thornton was right in the sense that a farmer’s $100 IOU does not represent a warehouse receipt against $100 of corn. He was wrong to claim that the IOU did not represent any actual property. The IOU was a claim against the farmer’s property in general. If the farmer’s property is worth $100, then he can write, at most, $100 worth of IOU’s against that property. The holder of the IOU places a $100 lien against the farmer’s property and the farmer cannot borrow again against the same property. Thus, if $600 worth of IOU’s have been issued, the receivers of those IOU’s would have liens against $600 worth of actual property.

      This is true of both real bills and fictitious bills, so Thornton was right to dismiss the distinction between the two. But he then made the mistake of supposing that the rule of only issuing new money against real (or even fictitious) bills would NOT prevent over-issue of money and would therefore not prevent inflation. This was wrong. The real bills rule would assure that every time a bank issued a new dollar, that bank got a dollar’s worth of new assets in exchange. Thus backing moves in step with the quantity of money, and the issuance of new money would not cause inflation.

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