Friday, 21 October 2016

Danger to the Old Lady of Threadneedle Street?

Patrick O'Brien  is Professor Emeritus,
London School of Economics

NEW EHES Working paper 

The Bank Restriction Act of 1797 suspended the convertibility of the Bank of
England's notes into gold. The current historical consensus is that the suspension was a result of the state's need to finance the war, France’s remonetization, a loss of confidence in the English country banks, and a run on the Bank of England’s reserves following a landing of French troops in Wales.

In a recent EHES paper (O’Brien and Palma 2016) we argue that while these factors can help us understand the timing of the Restriction period, they cannot explain its success. We deploy new long-term data which leads us to a complementary explanation: the policy succeeded thanks to the reputation of the Bank of England, achieved through a century of prudential collaboration between the Bank and the Treasury. Furthermore, the Restriction Period led to a permanent shift in the role of banknotes in the economy, despite the inauguration of the classical gold standard in 1821.

Nuno Palma is Assistant Professor,
 University of Groningen

This episode has some parallel with the better-known 1914 suspension of the gold standard, but some important differences too. One such difference is the much more moderate effects that resulted. No major financial crisis followed, and inflation eventually increased but remained moderate. In the words of Schumpeter (1987/1954, p. 690-1): “In spite of the suspension … war finance did not produce any great effects upon prices and foreign exchange-rates until about 1800. To the modern student who is inured to stronger stuff, the most striking feature of the subsequent inflation is its mildness … at no time was the government driven to do anything more unorthodox than abnormally heavy borrowing from the Bank, and even this borrowing never surpassed the limits beyond which the term ‘borrowing’ becomes an euphemism for printing government fiat”.

The Bank of England – which was a private company, though it was already beginning to play a public role – had suffered a significant drain in its reserves from the mid-1790s. In 1797 it suspended convertibility of its notes into gold. It also started issuing small denomination notes. Banknotes became increasingly important as a means of payment. As we document in the paper, the economy-wide circulation of all means of exchange except coin (such as inland bills of exchange or banknotes) at the retail and wage-paying levels had remained limited until the 1790s. The data allows us to study the case of Bank of England notes in detail, by comparison with coin supply (Figure 1 below). As the figure suggests, the 1797 suspension marks a discontinuity for Bank of England notes, which increased a great deal in real terms after that date. At the same time, coin supply had been falling since shortly after the beginning of war. It is tempting to interpret this shift in terms of Gresham’s law, but we do not favor that interpretation because the selection of a “bad” means of payment implies asymmetry of information and no seller would have had any difficulty distinguishing Bank of England notes from coin. Instead, Bank of England notes eventually gained a discount (which reached a maximum of about 50%), but this only mattered after about 1808.

Not only did the value of Bank of England notes in circulation increase a great deal, but their denominational distribution changed. While up to the 1790s £10 notes were the lowest note denomination issued by the Bank of England (over £1,000 in 2015 prices), it was only in 1793, at the start of the war against Napoleonic France, that £5 notes were first issued. Denominations of £5 were in turn followed by £2 and £1 banknotes, issued in 1797, coinciding with the Restriction Period. Crucially, also allowing for a margin of contemporaneous inflation, £1 was then just enough to pay a laborer’s weekly wage. The fact that many new issues were of lower denominations implies that just looking at the value of the increase of Bank of England notes underestimates how much more frequent they became at this time. This had important long-term consequences, because it was at this point that for the first time ordinary people, and in particular the lower classes, became accustomed to banknotes as a means of payment.

Figure 1. Coin supply and Bank of England notes, at constant prices of 1700.
Sources: Bank of England (1967), Palma (2016); for the deflator, Broadberry et al (2015).

As the suspension took place, a large number of merchants all over the country signed declarations in which they promised to accept and keep using banknotes. The most prominent of these meetings was that of London; while the Bank of England had a role in arranging this meeting, the fact is that it could not force the merchants to take that decision, which was also publicly announced through publication in The Times. Hence both merchants and regular people accepted the Bank’s notes. Figure 2 shows a contemporary print where John Bull, who represents the English people, accepts the paper pound despite the warnings of French alarmists who warn him that it will be worthless once the French land.

Figure 2. John Bull accepts paper money despite the warnings of French alarmists,
by James Gillray. Published at Hannah Humphrey’s print shop
on St. James Street, London, March 1st, 1797

The argument we make in this paper is that the emergency conditions of the 1790s combined with a long history of prudent behavior as well as close collaboration between the Bank and the Treasury to allow this to be possible. While Bordo and White (1991) focus on the credibility of the public finances of the British State, our focus here is on the credibility of the outstanding liabilities of one particular institution, the Bank of England. We argue that the credible commitment underpinning the success of British public finance consisted of two parts: the government's commitment to sound public finance, and the Bank's commitment to sustaining both public and private credit. In this paper we focus on the latter, and in particular on the matter of how by the late eighteenth century the Bank managed to implement a set of monetary policies that were highly unconventional by the standards of the time, with a good measure of success. 

The Bank of England shifted gears with the Restriction Period, but it would be wrong to assume that after 1821 there was a return to the previous status quo. Figure 3 presents the data of Figure 1 as a ratio, and extends its horizon to the mid-nineteenth century. The figure shows three important facts about this period. First, as we have previously seen, after a long period of stability, there was a spike in Bank of England notes at the time of the Restriction Period. Second, and importantly, when the supply of notes was later reduced, the reversal was only partial: the level did not return that of the 1790s. Third, and crucially, the previously stationary distribution then gained an upward trend – the growth which started in the 1790s continued into the nineteenth century. The regime change to the system caused by the Bank Restriction in the 1790s persisted well into the future, long after that act was repealed. Through a process of path-dependence, it caused a permanent shift to a fiat-based monetary system, which – despite the later imposition of the classical gold standard – allowed for continuous growth of fiat money relative to slower-growing quantities of precious metals well into the nineteenth century.

Figure 3 The ratio of bank of England notes to coin supply, 1696-1844

Which factors interacted with the Bank of England’s initial reputation to make the policy a success? Three reasons stand out. First, the Bank of England’s expansion of banknotes during the restriction was of a much smaller magnitude than had been the case in France a few years before. In 1797, the ratio of Bank of England notes over nominal GDP was just under 23%, and in the next few years issues were never such that the 20% percent mark was crossed again, a target made easier by the economic growth performance of the British economy during those years (Bank of England 1967, Broadberry et al 2015). This strongly contrasts with the case of France during the assignats debacle, where the expansion of fiat was eventually exponential (Sargent and Velde 1995). In contrast with France, the Bank of England’s policies were subject to a series of checks and balances, being closely monitored, as exemplified by the “Bullion report”, and related controversies and debates (see for instance Feavearyear 1931, pp. 190-2). Second, not only did Britain’s already have a comparatively high level of fiscal capacity, being able to credibly borrow, but the policies of the Bank were also at this time accompanied by a series of fiscal reforms. An example was the introduction of an income tax in 1798, which complemented the monetary reforms and allowed for the sustainability of the government’s budget constraint, while ruling out hyperinflation. Finally, the policy was promised (and believed) to be a temporary, wartime measure.

This blog post was written by:
Patrick O'Brien (Professor Emeritus of Global Economic History, Department of Economic History, London School of Economics)

Nuno Palma (Assistant Professor, Department of Economics, Econometrics, and Finance, University of Groningen)

The working paper can be downloaded here:


Bank of England (1967). Bank of England Liabilities and Assets: 1696 to 1966. Quarterly Bulletin, June edition. Available at, Accessed August 13, 2014

Bordo, M., and White, E. (1991). A tale of two currencies: British and French finance during the Napoleonic Wars. The Journal of Economic History 51(02): pp. 303-316

Broadberry, Stephen, Bruce Campbell, Alexander Klein, Mark Overton, and Bas van Leeuwen (2015). British Economic Growth, 1270-1870. Cambridge University Press

Feavearyear, A. (1931). Pound Sterling: A History of English Money. Oxford

Palma, Nuno (2016). Reconstruction of annual money supply over the long run: the case of England, 1279-1870. EHES Working Papers in Economic History No. 94

Sargent, T. and F. Velde (1995). Macroeconomic features of the French Revolution, Journal of Political Economy, 103

Schumpeter, J. A. (1987/1954). History of Economic Analysis. Routledge

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