Book II, Chapter II, 7

Under the 3rd George I. c.8, the bank delivered up two millions of exchequer bills for cancellation. It had therefore advanced the government £5,375,027:17 10d. by this time. Under the 8th George I. c.21, the bank purchased stock worth £4,000,000 from the South Sea Company; and in 1722, following the subscriptions it had taken to enable this purchase, its capital stock increased by £ 3,400,000. The bank had thus advanced the public £ 9,375,027 17s. 10½d. at this point, while its capital stock amounted to only £ 8,959,995:14:8d. It was then, for the first time, that the amount the bank had advanced the public and on which it received interest exceeded its capital stock, the amount on which it paid dividends to the owners of bank stock. In other words, the bank began to possess an undivided capital in addition to its divided capital. It has maintained an undivided capital of this kind ever since. By 1746, the bank had advanced the public £11,686,800 on various occasions, and successive calls and subscriptions had raised its divided capital to £ 10,780,000. Both sums have remained unchanged ever since. Under the 4th of George III. c.25, the bank agreed to pay the government £110,000 for the renewal of its charter, without interest or repayment. That payment therefore increased neither of the other two sums.

The bank's dividend has varied both with the rate of interest it received at different times on money advanced to the public and with other circumstances. This interest rate gradually fell from eight to three per cent. For some years now, the bank dividend has stood at five and a half per cent.

The Bank of England is as stable as the British government. Its creditors cannot suffer any loss unless everything it has advanced to the public is lost first. No other banking company in England may be established by act of parliament or have more than six members. It serves not merely as an ordinary bank but as a great instrument of state. It receives and pays most of the annuities due to public creditors; circulates exchequer bills; and advances the government the annual proceeds of the land and malt taxes, often not fully paid until years later. In carrying out these functions, its duty to the public may sometimes have compelled it, through no fault of its directors, to put too much paper money into circulation. It also discounts merchants' bills and has on several occasions upheld the credit of leading firms, not only in England but in Hamburgh and Holland. On one occasion, in 1763, it is said to have advanced some £1,600,000 for this purpose in one week, much of it in bullion. I do not, however, claim to vouch either for the size of the sum or for the brevity of the period. At other times this great company has been reduced to paying in sixpences.

The wisest banking operations increase a country's industry not by increasing its capital but by making more of its existing capital active and productive. The part of a dealer's capital that he must keep idle as ready money to meet occasional demands is dead stock: while it remains in that condition, it produces nothing for him or his country. Prudent banking enables him to turn that dead stock into active, productive stock: materials to work on, tools to work with, and provisions and sustenance to work for—stock that produces something for both himself and his country. Likewise, the gold and silver money that circulates in a country, distributing the annual produce of its land and labor to its proper consumers, is all dead stock, just like a dealer's ready money. It is a very valuable part of the country's capital, yet produces nothing for the country. By replacing much of this gold and silver with paper, prudent banking enables the country to turn much of its dead stock into active and productive stock, which does produce something for it. The gold and silver circulating in a country may fittingly be compared to a highway: it carries all the country's grass and corn to market, yet itself produces not one blade of either. By providing, if I may be permitted so bold a metaphor, a kind of wagon road through the air, prudent banking allows the country to turn much of its highways, as it were, into good pasture and cornfields, greatly increasing the annual produce of its land and labor. Yet we must acknowledge that commerce and industry, though they may grow somewhat, cannot be quite as secure when suspended, so to speak, on the Daedalian wings of paper money as when they travel over the solid ground of gold and silver. Beyond the accidents to which the managers' lack of skill exposes them, they are vulnerable to others against which no skill or prudence on the managers' part can protect them.

Consider an unsuccessful war in which an enemy seized the capital and with it the treasure supporting the credit of paper money. Such a war would throw a country whose entire circulation depended on paper into far greater confusion than one whose circulation consisted chiefly of gold and silver. Once the ordinary medium of commerce had lost its value, exchange could take place only through barter or credit. As taxes had ordinarily been paid in paper money, the sovereign would have nothing with which to pay his troops or provision his stores; the country's plight would be far harder to remedy than if most of its circulating money had been gold and silver. A sovereign who wishes always to keep his dominions in the condition in which they can most easily be defended should therefore guard not only against an excessive multiplication of paper money that ruins the very banks issuing it, but even against its multiplication to the point where it fills most of the country's circulation.

The circulation of every country may be divided into two branches: exchanges among dealers, and exchanges between dealers and consumers. The same pieces of money, whether paper or metal, may serve at times in one branch and at times in the other; but as both operate continuously and simultaneously, each needs a certain stock of money of one kind or another. The value of the goods passing among dealers can never exceed the value of those passing between dealers and consumers, since everything dealers buy is ultimately intended for sale to consumers. Trade among dealers, conducted wholesale, generally calls for a fairly large sum in each transaction. Trade between dealers and consumers, by contrast, is generally retail and often requires only very small sums: a shilling or even a halfpenny may suffice. Small sums, however, circulate much faster than large ones. A shilling changes hands more often than a guinea, and a halfpenny more often than a shilling. Thus, although all consumers' annual purchases are worth at least as much as all dealers' purchases, they can generally be transacted with much less money: by circulating more quickly, the same pieces serve many more purchases of the former kind than of the latter.

Paper money can be regulated to remain largely within exchanges among dealers, or to extend over much of the exchange between dealers and consumers as well. Where bank notes below £10 are not circulated, as in London, paper remains largely within trade among dealers. When a ten pound bank note reaches a consumer, he generally must change it at the first shop where he needs to buy five shillings' worth of goods. It often returns to a dealer before the consumer has spent a fortieth of its value. Where notes are issued for sums as small as 20s., as in Scotland, paper money extends into a substantial part of trade between dealers and consumers. Before the act of parliament stopping the circulation of ten and five shilling notes, it filled still more of that trade. In North American currencies, paper was commonly issued for as little as a shilling and filled almost the whole of that circulation. Some paper currencies in Yorkshire even issued notes for as little as a sixpence.

When issuing bank notes for such tiny sums is permitted and common, many people of scant means are both enabled and encouraged to become bankers. A person's promissory note for £5, or even 20s., might be refused by everyone, yet a note of his for only a sixpence will be accepted without hesitation. The frequent bankruptcies to which bankers so impoverished must be liable, however, may cause considerable hardship, and sometimes even great calamity, to the many poor people who have accepted their notes in payment.

It might be better if no bank notes worth less than £5 were issued anywhere in the kingdom. Paper money would then probably remain largely within trade among dealers throughout the kingdom, just as it does now in London, where no notes below £10 are issued. For in most parts of the kingdom, £5, though it may buy little more than half as many goods, is regarded as substantial a sum, and is as seldom spent all at once, as £10 amid the lavish spending of London.

It should be noted that wherever paper money remains largely confined to exchanges among dealers, as in London, gold and silver are always plentiful. Where it extends over a substantial portion of exchanges between dealers and consumers, as in Scotland and even more in North America, it drives gold and silver almost entirely out of the country: nearly all ordinary domestic transactions are then conducted in paper. The suppression of ten and five shilling bank notes somewhat eased Scotland's shortage of gold and silver; suppressing twenty shilling notes will probably ease it further. Those metals are said to have become more plentiful in America since some of its paper currencies were suppressed. They are also said to have been more plentiful before those currencies were introduced.

Even if paper money were largely confined to trade among dealers, banks and bankers could still assist the country's industry and commerce almost as much as they did when paper filled nearly all circulation. The ready money a dealer must keep at hand to meet occasional demands is intended entirely for his transactions with other dealers from whom he buys goods. He need keep none for transactions with his customers, the consumers, who bring ready money to him rather than take it from him. Therefore, even if paper could be issued only in denominations that largely restricted it to exchanges among dealers, banks and bankers could still, partly through discounting genuine bills of exchange and partly through lending on cash accounts, free most dealers from the need to keep a substantial portion of their stock idle as ready money for occasional demands. They could still give traders of every kind all the assistance it is proper for banks and bankers to give.

It may be said that to prevent private individuals from accepting a banker's promissory notes in payment, whatever the sum, when they are willing to do so—or to prevent a banker from issuing such notes when all his neighbors are willing to accept them—is an obvious violation of natural liberty, which the law should uphold, not infringe. Such regulations can certainly be regarded in some respects as violations of natural liberty. But exercises of a few individuals' natural liberty that might endanger the safety of society as a whole are, and ought to be, restrained by the laws of every government, the freest no less than the most despotic. The requirement to build party walls to keep fire from spreading violates natural liberty in precisely the same way as the proposed regulations of banking.

Paper money consisting of bank notes issued by people of unquestionable credit, payable unconditionally on demand and in fact always promptly paid on presentation, is in every respect equal in value to gold and silver money: gold and silver can always be obtained for it. Whatever is bought or sold for such paper must necessarily be bought or sold as cheaply as it would have been for gold and silver.

Under 3rd George I. c.8, the bank handed over two millions of exchequer bills to be canceled. By then it had lent the government £5,375,027:17 10d. Under 8th George I. c.21, the bank bought £4,000,000 of stock from the South-sea company. In 1722, subscriptions raised to finance that purchase increased its capital stock by £ 3,400,000. By then the bank had lent the public £ 9,375,027 17s. 10½d., while its capital stock came to only £ 8,959,995:14:8d. This was the first time the amount the bank had lent the public, on which it earned interest, exceeded its capital stock, on which it paid dividends to the owners of bank stock. In other words, the bank now had capital beyond the capital distributed among its shareholders. It has had such additional capital ever since. By 1746, the bank had lent the public £11,686,800 in various transactions. Calls for funds and subscriptions had raised its dividend-paying capital to £ 10,780,000. Those two figures have stayed the same ever since. Under 4th of George III. c.25, the bank agreed to pay the government £110,000 for renewing its charter, with no interest or repayment. That payment therefore increased neither of the other two figures.

The bank's dividend has changed with the interest rate it received on its loans to the public and with other circumstances. That interest rate has gradually fallen from eight to three per cent. For some years now the bank's dividend has been five and a half per cent.

The bank of England is as stable as the British government. Its creditors cannot lose anything unless everything it has lent to the public is first lost. No other banking company in England may be established by act of parliament or have more than six members. The bank works not just as an ordinary bank but as a major instrument of the state. It receives and pays most of the annuities owed to the public's creditors. It puts exchequer bills into circulation and advances the government the annual proceeds of the land and malt taxes, often years before those taxes are fully paid. In doing these things, its public duties may sometimes have forced it to put too much paper money into circulation, through no fault of its directors. It also discounts merchants' bills and has several times upheld the credit of leading firms in England, Hamburgh, and Holland. In 1763, it is said to have advanced about £1,600,000 for this purpose in one week, much of it in bullion. But I cannot vouch for either the size of that sum or the shortness of that period. At other times this great company has had to make payments in sixpences.

Even the best banking practices do not increase a country's capital. They increase its industry by putting more of its existing capital to productive use. A dealer must keep some of his capital idle as ready money to meet occasional demands. As long as it sits there, that portion is dead stock: it produces nothing for him or his country. Good banking lets him turn this dead stock into productive stock: materials to work on, tools to work with, and provisions that support work. This stock produces something for him and for his country. Likewise, the gold and silver money circulating through a country distributes the yearly produce of its land and labor to its consumers. Like the dealer's ready money, it is all dead stock. It is a valuable part of national capital, but produces nothing for the country. By replacing much of this gold and silver with paper, good banking lets a country turn much of its dead stock into productive stock that yields something. The gold and silver in circulation are like a highway. The road carries all the country's grass and corn to market, but grows not a single pile of either itself. To stretch the comparison, good banking provides a kind of road for wagons through the air. It lets the country turn much of its highways into useful pasture and cornfields, greatly increasing the yearly output of its land and labor. Still, we must admit that trade and industry, even if they grow somewhat, are less secure when they are carried on paper money's wings, like those of Daedalus, than when they move on the solid ground of gold and silver. Besides the risks caused by poor management of paper money, they face other risks that even the most careful and skilled managers cannot prevent.

Suppose a country loses a war and the enemy captures its capital, along with the treasure backing its paper money. The resulting disruption would be much worse if all its transactions used paper than if most used gold and silver. The usual means of exchange would be worthless. People could trade only by barter or on credit. Since taxes had normally been paid in paper money, the ruler would have no means to pay the troops or stock their supply depots. The country's condition would be much harder to repair than if most transactions had used gold and silver. A ruler who wants his territory always to be as easy to defend as possible must therefore prevent not just an excessive issue of paper money that ruins the issuing banks. He must also prevent issues large enough to make paper the main currency of the country.

Money circulates in every country in two ways: between dealers themselves, and between dealers and consumers. The same coins or notes can be used in either kind of transaction. But both kinds happen at the same time, so each needs its own supply of money, whether paper or metal. The value of goods exchanged between dealers can never exceed the value of goods exchanged between dealers and consumers. Everything dealers buy is ultimately meant for consumers. Wholesale deals between dealers generally need a fairly large sum for each transaction. Retail purchases by consumers, on the other hand, often need only a small sum: a shilling or even a halfpenny may do. Small sums, however, change hands faster than large ones. A shilling changes owners more often than a guinea, and a halfpenny more often than a shilling. So although consumers' total yearly purchases are worth at least as much as dealers' purchases, a much smaller amount of money can generally handle them. By passing quickly from hand to hand, the same pieces of money pay for many more retail than wholesale purchases.

Paper money can be regulated so that it circulates mainly among dealers, or so that it also circulates widely between dealers and consumers. In London, where there are no bank notes below £10, paper money mainly passes between dealers. If a consumer receives a ten pound bank note, he usually has to change it at the first shop where he wants to buy five shillings' worth of goods. It thus often goes back to a dealer before the consumer spends even a fortieth of its value. In Scotland, where notes as small as 20s. are issued, paper money is used considerably in exchanges between dealers and consumers. Before an act of parliament stopped the circulation of ten and five shilling notes, it filled an even larger part of those exchanges. In North America, paper currency was commonly issued in sums as small as a shilling and covered nearly all such exchanges. Some Yorkshire paper currencies were issued in sums as small as a sixpence.

When issuing notes for such tiny sums is allowed and common, many people with very little means can become bankers. Nobody would accept a person's promissory note for £5, or even for 20s., but they will accept one for a sixpence without hesitation. Such impoverished bankers are likely to fail frequently. Their failures may cause considerable hardship, and sometimes disaster, for many poor people who accepted their notes as payment.

Perhaps no bank notes should be issued anywhere in the kingdom for less than £5. Paper money would then probably be limited mainly to transactions between dealers everywhere, as it now is in London, where no notes below £10 are issued. In most of the kingdom, £5 may buy little more than half what £10 buys in London, but people treat it as a substantial sum and are just as unlikely to spend it all at once as Londoners, with their lavish spending, are to spend £10 at once.

When paper money is largely limited to dealings between dealers, as in London, gold and silver are always plentiful. Where paper is widely used between dealers and consumers, as in Scotland and even more in North America, it drives gold and silver almost entirely out of the country. Nearly all ordinary domestic trade then uses paper. Banning ten and five shilling notes somewhat eased the shortage of gold and silver in Scotland; banning twenty shilling notes will probably ease it further. Those metals are said to have become more plentiful in America since some of its paper currencies were abolished. They are also said to have been more plentiful before those currencies began.

Even if paper money were largely limited to exchanges between dealers, banks could still do nearly as much for a country's industry and trade as when paper was used for almost all exchanges. Dealers keep ready money to meet occasional demands from other dealers whose goods they buy. They do not need to keep it for dealings with their customers: consumers bring money to the dealers rather than taking it from them. So even if notes could be issued only in sums large enough to keep them mainly in dealers' hands, banks could still discount genuine bills of exchange and make cash-account loans. They could thus spare most dealers from having to leave a substantial amount of stock idle as ready money to meet occasional demands. Banks could still give traders of every kind all the help they properly can.

One might say it plainly violates natural liberty to forbid people to accept a banker's promissory notes as payment, whatever the sum, when they want to accept them. It would likewise violate that liberty to forbid bankers to issue notes that all their neighbors willingly take. The law's proper job is to protect natural liberty, not interfere with it. Such regulations can indeed be seen as restricting liberty in some respect. But every government, free or despotic, does and should restrict the liberty of a few people when exercising it could put the whole community in danger. The requirement to build walls between adjoining properties to keep fire from spreading restricts liberty in exactly the same way as these proposed banking rules.

Bank notes issued by people whose credit is beyond doubt are worth as much as gold and silver money in every respect, provided they are payable on demand without conditions and are in fact always promptly paid when presented. Anyone holding them can get gold and silver money at any time. Goods bought or sold with such paper must therefore be bought or sold at the same price as they would be with gold and silver.