Bankers who were Adam Smith’ contemporaries noted the political economist’s relative lack of curiosity about their business. They remembered the South Sea Bubble of 1720. They connected it with the experience of the Ayr Bank in 1772, as well as the other bank crises of 1745, 1763.
They knew, too, that the British banking system was changing rapidly in the years after Wealth of Nations appeared, producing one innovation after another. The use of personal checks grew rapidly in replacing bank notes. Many more country banks were established in cities outside of London. A new institution, the London Clearing House, was created to adjust payments between banks. Banking was becoming harder to understand, even for those engaged in the money markets.
But bankers mostly kept their heads down. They were businessmen, after all, struggling to compete, not theorists. They were concerned with financing Britain’s latest North American war – the colonial disturbances, as they were politely called.
Sir James Steuart might have founded an economics of money and banking and trade, but he was dead (and a mistrusted Catholic to boot). Alexander Hamilton, the architect of the financial system of the United States, was knowledgeable about the British system too, but since he was killed in a duel in 1804, at 49 (or 47), we are deprived of his mature reflections. In any event, he was more policy craftsman than theorist.
So it fell to a handful of practical men to instruct their fellow citizens in matters of money, banking, and credit. Three in particular stand out. The tendency has been to lionize economists as worldly philosophers and ignore philosophical bankers, but most of what was learned about managing money in the years between Adam Smith and the Great Depression owes to three practitioners: Henry Thornton, Walter Bagehot and Benjamin Strong.
Remember, the story we are telling here, week by week, is about what happened in 2008 – why it was misunderstood, and what has happened since. In this episode, I planned to recall various relevant developments from 1688 to 1926. Unfortunately, I only made it as far as 1848 before running out of time. The second half appears next week.
. Economics becomes a community
Political economists at the beginning of the nineteenth century were just coming into their own. Before The Wealth of Nations, writers on economic topics had built their systems from the bottom up. Often they were men of independent means, writing for the general public – men like James Steuart and Adam Smith. In other fields — botany, zoology, geochronicity, electricity – such highly knowledgeable individuals were generally known as savants. The word “scientist” wouldn’t be coined until 1833.
In retrospect, Smith’s acceptance as a Fellow of the Royal Society, in 1775, was a major step in the recognition by Britain’s scientific community of political economy as an established field. More important was possession of a paradigm, with its three concrete pictures employed analogically by Smith. The Wealth of Nations enabled a community of acolytes to form. Those who confessed to faith in it were economists; those who did not were not. But which puzzles to pursue? The agenda had yet to be worked out.
The 1790s began on an optimistic note, on both sides of the English Channel. The French Revolution, led by its commercial classes, seemed to promise liberalization and reform. Popular writers, including William Godwin and the Comte de Condorcet, citing Adam Smith, imagined a glorious future. But the Revolution turned into something else after 1791. War began with other European powers began; the monarchy was overthrown: the Terror of 1793-94 commenced. Britain reacted with alarm. Societies that had been formed to debate reform were shut down; the right of habeas corpus was suspended; authors were tried for their views. Meanwhile, textile manufacture and the slave trade boomed. Wages fell. Cheap coal turned crowded English cities black. Enclosures emptied the countryside as sheep replaced villagers and wool and imported cotton replaced linen in the mills. The grim implications of war with France overhung all.
Against this background appeared an Essay in the Principle of Population, which electrified intellectual circles in Britain. The anonymous author asserted flatly, “The power of population is indefinitely greater than the power in the Earth to produce subsistence for man.” He illustrated his reasoning with a simple table. Since passion between the sexes was a given, population could be expected to increase geometrically, while food would increase only arithmetically. A constant check on population at the level of subsistence would be the inevitable result – a conclusion only too plausible to those familiar with conditions of the poor in the slums of English cities. “I see no way by which man can escape from the weight of this law which pervades all animated nature.” When a signed second edition appeared in 1805, T.R. Malthus, curate of a little church twenty miles north of London, became the most famous economist in the world.
Meanwhile, a prosperous dealer in government securities named David Ricardo had read Adam Smith on holiday and, bothered by what he considered certain confusions, began contributing to financial newspapers.
Issues of money and banking and wartime finance brought Ricardo and Malthus together*, but it was to problems of scarcity to which the two men soon turned. By 1813, the long campaign against Napoleon was winding down; prices of grain were less than half what they had been two years before. An agricultural depression loomed. Landowners sought to protect their profits by establishing heavy duties on the importation of grain – the Corn Laws.
* Ricardo was taken on to the Bullion Commission, where he quickly overshadowed the leading banker of the day, Henry Thornton.
By a series of steps familiar to almost every properly trained economists, Ricardo and Malthus thus reasoned out what they called the Law of Rent and the principle of diminishing returns. In 1817, Ricardo published a text, Principles of Political Economy and Taxation, modeled on The Wealth of Nations, but differing sharply from its conclusions. (For a short account of their collaboration, see this article by Robert Dorfman, of Harvard University.) Ricardo wrote to his friend, “Political economy you think is an inquiry into the nature and causes of wealth – I think it should rather be called an inquiry into the laws which determine the division of the produce of industry amongst the classes who concur in its formation.” And when all was reasoned through, he wrote, “Almost the whole produce of the country after paying the laborers [a subsistence wage], will be the property of the owners of land…” Investment would cease, industrial progress would come to a halt. Britain would enter a Stationary State.
This was what came to be known as Real Analysis, as opposed to Monetary Analysis, proceeding from the conviction that, as Joseph Schumpeter later described it, “all the essential phenomena of economic life are capable of being described in terms of goods and services, of decisions about them and relations between them.” Money enters only to facilitate transactions. As long as it works properly, it is merely a veil; the economy itself works as if all were barter. Monetary Analysis, on the other hand, insists on the centrality of banking and credit in the scheme of things. Schumpeter disparaged Ricardo’s passion for policy-oriented argument as the “Ricardian vice”: he would settle on a few aggregate variables and place the rest in cold storage as “given,” until his conclusions emerged as all but irrefutable. Such was the strength of the arithmetic models he introduced, Schumpeter wrote, not to mention the temper of the times, that the “victory of Real Analysis was so complete as to put Monetary Analysis well out of court for over a century.” though of course practical systems of money, credit and banking continued throughout that time, and the occasional theorist lingered outside the courtroom door.
There was great excitement about the new discoveries of “Economic Science.” Bank Reviews were established, the forerunners of scholarly journals. The Political Economy Club met in London in 1821 for the first time. Mathus feared that “general gluts,” long-lasting depressions, could occur. Ricardo , argued that the economy was inherently self-correcting, a machine, all right, but not so beautiful as Adam Smith had imagined. It was tilted decisively against the worker and the entrepreneur, in favor of owners of land. He won his argument hands down. The line of march had been decided. A leading man of letters, Thomas De Quincey, wrote in 1821 that, before Ricardo,
all other writers had been crushed and overlaid by the enormous weight of facts and documents; Mr. Ricardo alone had deduced, a priori, from the understanding itself, laws which first gave a ray of light into the unwieldy chaos of materials, and had constructed what had been but a collection of tentative discussions into a science of regular proportions now first standing on an eternal basis.
Henceforth economists would be those who studied the invisible hand of price system. In 1819, Ricardo added a chapter on machinery, but the logic of the pin factory was not pursued. His chapter on money was far back in the book, a straightforward embrace of the gold standard. Analysis of the system of money, banking and credit would remain a technology, blue-collar work performed by business historians. Ricardo died in 1823.
Ironically, the best work of the period on the nature of money had been published in 1802 by the banker with whom Ricardo had served on the Bullion Commission, whom he had shouldered aside.
. Inventing paper money
Henry Thornton was born in 1760, into a family that for several generations had traded with counterparts in Russia and the Baltic.* His grandfather, an uncle and his brother had been directors of the Bank of England. His brother served as governor in the tumultuous years of 1799-1801. Thus Thornton understood in his bones the history of British banking in the hundred years before he was born.
*Much of what we know about Thornton owes to the efforts of Friedrich von Hayek; Hayek’s interest becomes clear in the next episode.
Everyone could agree that 1688 was the starting point of modern British history. That was the year in which William, the Protestant Prince of Orange, at the urging of the English people, led by commercial interests, chased off James II, the newly-installed Catholic king of England (who was his uncle). William and his wife. Mary (daughter of James II), then became king and queen themselves – events celebrated ever after as “the Glorious Revolution. At the time, that change of rulers and the catch-phrase that described it seemed to mean nothing more than a genteel return to the status quo ante, and this interpretation was reinforced in the middle of the nineteenth century by the historian Thomas Babington Macaulay. Looking back from 150 years further on, Steve Pincus, of Harvard University, argues in 1688: The First Modern Revolution (Yale, 2009), that in fact, Britain had arrived at a great fork in the road. It was then, Pincus says, England’s economy booming, towns growing, trade expanding, that the English people rejected the French ideal that James had pursued and emulated the decentralized Dutch model instead. Thus Britain created the first modern nation state.
What Thornton knew from family lore is, roughly speaking, what can be gleaned today from reading The Origins of English Financial Markets: Investment and Speculation before the South Sea Bubble (Cambridge, 2009).by Anne L. Murphy, of the University of Hertfordshire.* Murphy describes the twenty years of exuberant speculation on London’s new stock market after 1688, the new derivatives instruments that developed, the financial press that emerged, and the Nine Years with France 1689-97. In its drive to become a global power, the government tried all kinds of ways to raise money, including its most ingenious and successful scheme, the incorporation in 1694 of the Bank of England.
* Like Thornton himself, Murphy is a practitioner-turned-theorist. She spent a dozen years trading currencies and derivatives in London’s City before re-tooling as a historian. A careful scholar can’t tell everything in a thesis book. Her next outing should be interesting, too.
Murphy’s book contains nothing about the Scottish banker John Law and his 1705 proposal for managed money in Money and Trade (those “splendid, but visionary ideas” that Adam Smith had briefly mentioned in his chapter on banking) and very little about the short-lived success Law had with his Mississippi Bank and France’s ventures in its colony in Louisiana, which inspired the British to create a South Sea Company of their own. But of course Thornton knew all that, too.
Despite its royal charter, the Bank of England was a profit-making bank, designed to serve as the government’s bank, marketing its debt and maintaining a secondary market for it; and lending newly-issued bank notes of its own. Investors included bankers from London’s City and others, from Amsterdam, Jews and Huguenots expelled from France. With the many private banks that soon formed, the Bank of England was swept up in the excitement surrounding the formation of the South Sea Company in 1711* – yet another scheme to fund the Royal Navy. All were caught in the Panic of 1720: the Bank of England survived, thanks to the Bubble Act; the others didn’t. And when its charter was renewed in 1742, the Bank of England was granted a monopoly on the issue of bank notes in England. By that time, the private banks of England and Scotland had thriving lending businesses of their own.
* The tale of the South Sea Company has been a source of fascination for three centuries, inspiring such books as Extraordinary Popular Delusions and the Madness of Crowds, by Charles MacKay, in 1841; Devil Take the Hindmost: A History of Financial Speculation, by Edward Chancellor, in 1996; and Famous First Bubbles: The Fundamentals of Early Manias, by Peter Garber, in 2000. The most enjoyable one I know is The South Sea Bubble, by John Carswell, in 1960.
. The £1 note defeats Napoleon
Young Henry Thornton began working for his father in the 1770s. He entered Parliament at 22, and, in 1784, joined the private banking house of Down and Free. The end of Britain’s war in North America brought a drain on gold in London. The Bank of England, beginning to find its way as the government’s bank, raised its interest rate, and many were ruined. It was said to have made a deep impression on young Thornton. His father, John, was celebrated by his contemporaries for his generosity and his impulsiveness as a trader; Henry, for his sobriety as a banker.*
* Ironically, Thornton is better known to history as among the leaders of the band of Anglican reformers, mocked as “the party of saints,” who lobbied strenuously for the abolition of slavery. Celebrating passage of the Act of Abolition in 1807, William Wilberforce playfully asked Thornton, “Well, Henry: What shall we abolish next?” His sterner friend replied gravely, “The lottery, I think.”
Banking in London expanded rapidly in the 1780s; Thornton’s father died in 1790 and he inherited a substantial sum; soon his firm was one of the largest in the City. Money poured into London after the French Revolution began; it fueled a craze for building canals. When the tide reversed, in the winter of 1793, the Treasury kept the system afloat by issuing exchequer bills, lending freely to troubled banks. The bailout was scarcely noted in the hub-bub of the looming war with France, It got Thornton thinking about the system of credit.
A far more grave crisis occurred in 1797 – an abortive French invasion triggered a run on the Bank of England; half its dwindling reserves were lost within days. Prime Minister Pitt ordered the suspension of payments in gold for bank notes presented for payment and put the authority of the government behind the Bank of England, which began lending to smaller banks being run upon The British government had begun an experiment with paper currency that would last until 1821.Short of coins, the Bank of England began issuing £5 notes, country banks £1 notes.
Still privately owned, the Bank of England was becoming a central bank, the regulator of the credit system and, in a crisis, the system’s lender of last resort. The phrase was coined after 1797 by banker Francis Baring, who borrowed it from the French, dernier ressort. As Britain’s foremost authority on banking, Thornton gave a clear account of the suspension to Parliament in secret hearings, and thereafter closely tracked the question of whether or not the value of the paper currency had become inflated. He resolved to write a book. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain appeared in 1802, clearly intended as a companion to The Wealth of Nations. Even its friends agree the book is stuffy, badly organized and overlong.
Yet, according to Jürg Niehans, a distinguished historian of thought, Paper Credit also contained “the outlines of the first model of financial intermediation in an open economy,” in which “labor, gold coins, bank notes, bills, trade credit, government securities and other claims are demanded and supplied, depending on market conditions.” Schumpeter, in his great History of Economic Analysis, reckoned that a single page contained a set of rules that “constitute a Magna Carta for credit management in an intact capitalist economy.” Not until 1935, when John Hicks took up the theory of money, wrote Niehans, would as much subtlety be seen again. Thornton understood, as Stuart had, that the banking system is vulnerable to panic because ratios of reserve requirements in the fractional banking system are subject to sudden changes when confidence is lost. The central bank exists, he considered, not to make a profit, but to stabilize the system, serving as lender of last resort in a crisis. And as for the strict bullionist position of Ricardo — paper money issued only in strict proportion to gold — he wrote:
If bills and banknotes were both extinguished, other substitutes for gold would be found. Mean save themselves the trouble of counting, weighing and transporting guineas in all the larger operations of commerce…. Credit would still exist, credit in books, credit depending on the testimony of witnesses, or on merely verbal promises.
Thornton’s book was ignored, except by bankers. He died in 1815. Ricardo took over as the leading expert of the day on currency matters, espousing a mechanical gold standard to which Britain would eventually return after its victory over the French. But bankers understood that it had been paper money that allowed England to keep its Navy at sea long enough to defeat the French at Trafalgar. And re-reading The Wealth of Nations while in exile at St. Helena, Napoleon would, at least by tradition, explain to an Italian journalist how it was that a nation of shopkeepers defeated a country many times its size with six times its population.
. “An Apparently Established Cycle”
The end of the war brought a boom in British exports to Europe and the United States and, in 1819, another panic, when it became clear that all that had been was being produced could not be sold. At least a dozen were killed and perhaps 600 injured when cavalry at St, Peter’s Field, near Manchester, charged into a crowd of 60,000 or so protesting suffrage limitations and economic conditions – the Peterloo Massacre. In Geneva, an Italian economist, Jean Charles Leonard Simond de Sismondi, theorized that the periodic tendency to crash might be due to consumers’ preferences shifting between work and leisure. More real analysis – but the first recognition of a business cycle. Another financial crisis and attendant panic occurred in 1825. And after the Panic of 1837, the banker S.J. Lloyd, better known later as Lord Overstone, put some flesh on the bones.
The history of what we are in the habit of calling “the state of trade” is instructive. We find it subject to various conditions which are periodically returning; it involves apparently an established cycle. First we find it in a state of quiescence, — next improvement, — growing confidence, — prosperity, — excitement, overtrading, — convulsion, — pressure, — stagnation, — distress, — ending again in quiescence.
In the convulsion of 1825, the Bank of England’s powers as a true central bank came into sharper focus. As Charles Kindleberger much later wrote, a standard operating procedure had been established: the private banks would finance the boom, the Bank of England would finance the crisis. What did it mean to finance a crisis? Jeremiah Harman, a Bank of England director for more than thirty years, explained the measures taken in 1825:
We lent it by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to any enormous amount, in short, by every means consistent with the safety of the Bank, and we were not, on some occasions, over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.
Some 73 of 770 banks in England failed. The country came within 48 hours “of putting stop to all dealings between man and man except by barter,” according to the financier William Huskisson. But the banking system was once again preserved. Among the casualties, however, was the venerable banking firm of Down, Thornton, and Free.
By the 1830s, the debate about money and banking had entered a new phase. The disagreements between Thornton and Ricardo about the proper relationship between bullion and paper money were recast as between the banking and currency schools. Advocates of the currency principle, forerunners of twentieth century monetarists, sought strict adherence to the gold standard, lest inflation occur. Expositors of the banking view, who had much in common with latter-day Keynesians, advocated leaving credit policy to practical bankers, consistent with the convertibility of notes to hard cash, in order to foster fullemployment and economic growth.
After a decade of intense debate, Parliament passed the Bank Act in 1844, separating the functions of the Bank of England into two offices: a Banking Department, to continue the original business of profitable lending, which was suffering somewhat from growing competition by private banks; and an Issue Department, to oversee the supply of paper money in strict accordance with currency principles. A century and a half later, Schumpeter wrote, “The Bank had few friends.” By 1950, he observed, “control” seemed to have become a popular concept. But in 1800,
To say openly that the bank was trying to control the banking system, let alone to manage the general business situation, would have evoked laughter, if not indignation: the thing to say was that the bank was modestly looking after its own business, that it simply followed the market and that it harbored no pretension of controlling anything or anybody.
. The Less-Apparent Revolutions
The Panic of 1837, which originated in the cotton markets, produced a side benefit. The subsidiary bubble in indigo prices and eventual crash nearly ruined a London hat-maker named James Wilson. He paid his debts, quit the trade, and, in 1843, started The Economist: or The Political, Agricultural, Commercial, and Free-Trade Journal.
The Economist was something new under the sun: financial journalism with one eye on the economists, the other on the world itself. Wilson was conversant with standard books: asked for recommendations, he mentioned Smith and Ricardo . The only problem with economic principles, he wrote when the Whigs were voted out of office, was that they hadn’t been properly applied. At the same time, he possessed a strong business intuition, which kept him attentive to new developments. The year after it appeared, he added Banker’s Gazette to the name and, soon, a new section called Railway Monitor, effectively covering the two vantage points ignored by economists preoccupied with the price system.
An Industrial Revolution had started in the time of Adam Smith, though there is very little hint in The Wealth of Nations of what it would become. As late as 1819, the chapter about machinery that Ricardo added to his text formed no clear judgement. No one would dare speak of “revolution” in England, anyway, though the term had appeared in France as early as 1826. Not until 1832 did Charles Babbage publish On the Economy of Machinery and Manufactures, whose point was that the logic of Smith’s pin factory applied to much more than pins. Although he was one of Isaac Newton’s successors in the Lucasian chair of mathematics, at Cambridge University, Babbage’s carefully-observed book wasn’t enough to get him noticed by most economists: they were unaware of their blinders. Instead his fame rests on having conceived a mechanical computing machine. Karl Marx and John Stuart Mill read Babbage closely, though.
A second revolution was in its early stages then as well, though its significance wouldn’t become clear for another hundred years – and then only in the literature of another science. It was in 1929 that the American demographer Warren Thompson first described the demographic transition that had accompanied the Industrial Revolution, from high rates of birth and death to low ones. Economists, however, went right on teaching Malthus, gradually losing interest after 1850 in population.
The first growth theorist to make a dent on economics was Karl Marx. He was determined to follow the economics of the pin factory where they led. He arrived in London from Paris, in August 1849, a step ahead of the Prussian authorities. Already, with Friedrich Engels, he had written in The Communist Manifesto of 1844.
The bourgeoisie, during its rule of scarce one hundred years, has created more massive and more colossal productive forces than have all preceding generations together. Subjection of Nature’s forces to man, machinery, application of chemistry to industry and agriculture, steam-navigation, railways, electric telegraphs, clearing of whole continents for cultivation, canalisation of rivers, whole populations conjured out of the ground — what earlier century had even a presentiment that such productive forces slumbered in the lap of social labour?
Only recently had “industry” come to describe a new sector of economic life instead of an admirable characteristic attributed to individuals and groups. Marx was especially alert to the role that slavery had played in creating the intensive industrialized agriculture of sugar and cotton in the New World. He took Smith’s four stages and added a fifth and a sixth – industrialization and communism; that much was simple narrative and prophecy. But he had come later to British political economy. His goal, he told friends, was to turn Ricardo on his head. Instead of the landlords winding up with all the money, a new class, the dispossessed workers he called the proletariat, would take over the distribution of wealth through social control. But Marx’s skills as a strategist were even less adequate to the task of persuasion than as those he possessed as analyst. Instead of wading into the well-developed literature of the economists, he continued his journalism and set out to write a Bible for what amounted to a new faith.
It fell to John Stuart Mill to repair the damage. The son of James Mill, the economist who had introduced Ricardo to Malthus, John has been formidably educated by his father, had enjoyed long walks with Ricardo himself. He wrote an enormous philosophically-tinged history of science, A System of Logic, before turning his attention to a two-volume Principles of Political Economy, which appeared in 1848. His goal, Mill explained, was to bring The Wealth of Nations up to date.
In his “Preliminary Remarks,” Mill uncoupled growth theory from the price system completely and firmly set it aside. Political economy concerned itself with moral and psychological knowledge, not with physical knowledge; control of the powers of nature was a matter for the sciences themselves. His topic was the price system, labor, capital and land. He assigned a high place to Henry Thornton as a monetary theorist – the conduct of the Bank of England over fifty years had turned him into a prophet. He explained the new-found wealth associated with the Industrial Revolution by developing the concept of increasing returns. That kept competition at the center of the stage: “Happily,” he wrote, “there is nothing in the laws of Value which remains for the present or any future writer to clear up; the theory of the subject is complete.”
He persuaded most of Victorian England for the next forty years.
To be continued….