Introduction:

It was central to British nineteenth century monetary orthodoxy that the money supply would grow endogenously in line with the nation’s need for currency. Virtually all had accepted David Hume’s demonstration in 1752 that the balance of payments was self-correcting, and that any country which adopted a gold or silver standard would gradually obtain whatever specie it required for its monetary circulation through an excess of exports over imports.

Hume’s argument had preceded the near-universal use of paper money. This added a significant complication, and Adam Smith and David Ricardo established principles which became the starting point for the theory of how the potential benefits from paper money should be exploited, and its impact upon Hume’s argument.

Smith showed how the “judicious operations of banking”, by allowing near-costless paper money to perform the same functions as gold and silver enabled some of the real resources tied up in such coins to be traded for additional productive capital in agriculture, industry and commerce. He created the powerful metaphor that paper money provides “a sort of wagon-way through the air” which, if such roads existed, would enable “a country to convert, as it were, a great part of its highways into good pasture and corn fields” in the manner that costless paper money serves the same purpose as expensive gold and silver coins.

Ricardo added the insight (1816 and 1824) that since prices expressed in gold can be expected to fluctuate less than those expressed in any other medium, a paper currency would need to be freely convertible into gold to obtain the same degree of price stability. It would ideally be managed by commissioners, independent of government and appointed for long periods, with the sole responsibility of managing the paper currency. With paper thus acting as if it were gold, the money supply, which would consist partly of gold and partly of paper, would grow endogenously in line with the needs of the economy in precisely the manner of Hume’s argument.

The benefit which Ricardo’s argument called for, the gold convertibility of sterling, which Sir Isaac Newton originally established in 1717 as Master of the Mint, was lost in 1797, when Britain abandoned its gold standard early in the Revolutionary and Napoleonic war with France. After much debate in which Ricardo was closely involved, in 1821 Britain returned to the gold standard at the same value of sterling, £3 17s 10½ d to an ounce of gold, as Newton originally established. Responsibility for the maintenance of this exchange rate rested with the Bank of England, a private banking company with a less than distinguished management. Six of its nine governors between 1828 and 1847 suffered the indignity of personal bankruptcy, in one case while in office (his son and partner had speculated imprudently) and the remaining five after the completion of their generally two year terms.2 Governors were drawn from those of the Bank’s directors who were willing to be considered for the chair on a ‘Buggins turn’ basis.