The Currency vs. Banking School Controversy
Liquidity scrambles, monetary substitutability and elasticity
In order to better understand the theories of banking, i.e. the ILF (I), FRC (II) and FMC (III) models outlined so far, it is beneficial to locate their individual reasoning in earlier debates within monetary economics. Joseph Schumpeter suggested that
“it is the common opinion that the foundations of the monetary science of today (or yesterday) were laid by the writers who discussed the issues of English monetary and banking policy from the Restriction Act (1797) to the gold inflation of the 1850’s.” [1]
Since neglecting the study of the history of monetary thought would only aggravate the seeming difficulty to make sense of the complex workings of the money creation process, this piece will focus on the so-called Currency vs. Banking School controversy developing in mid-19th century Britain.
Participants of the debate:
Prime proponents of the Currency School were Samuel Jones Loyd (later Lord Overstone), Robert Torrens, George Warde Norman and John Gellibrand Hubbard. On the other side as belonging to the Banking School were prominent figures such as Thomas Tooke, John Fullarton and John Stuart Mill.
Primary concern of the debate:
The central problem of the controversy related to safeguarding the external value of money, i.e. the rate of exchange, specifically the maintenance of the fixed external value of sterling with regards to preserve the gold standard amidst a series of liquidity crises recorded in British monetary history in 1825, 1836, 1847, 1857 and 1866. [2]
The British suspension of gold lasted throughout the Napoleonic wars 1803-1815 with a resumption to the gold standard effectively taking place after the Congress of Vienna in 1815. [3] The prevention of such “liquidity scrambles” or “runs for cash” and thus the prevention of bankruptcies was the primary focus of attention and aim alongside the external exchange rate. [4] This contrasts with another famous British debate, the Radcliffe debate, occurring in the mid-20th century whose primary concern was to find ways to control inflation. [5]
Position of the Currency School:
The Currency School based their argument on the Quantity Theory of Money,
“which postulates a more or less close link between the supply of money and the price level. An outflow of gold and external weakness of sterling was likely to be associated with rising internal prices and consequently with falling exports and rising imports. The problem was thus to halt or reverse the rise in internal prices, so that the balance of trade and payments would improve and the rate of exchange would strengthen. The solution was to reduce the internal money supply as gold flowed out and the exchanges weakened; the required downward pressure on prices would then be brought into play. […] [P]rices are responsive to the level of spending, spending is responsive to the supply of money, and money consists of coin and the Bank of England notes.” [6]
The difficulty of the Currency School consisted in the question of what counted as money. Defining money as ‘anything which is generally accepted in settlement of debts’, several asset classes may be involved. The Currency School considered only coin and Bank of England notes that both represent legal tender by Act of Parliament as generally acceptable means to service debts as opposed to commercial deposits that were excluded from their conceptualisation of money and did not count towards their definition of the money supply. [7]
Position of the Banking School:
For the Banking School this amounted to a somewhat arbitrary distinction carried out by the Currency School as commercial deposits function as much as ‘safe and convenient substitutes for coins and notes’ since their substitutability affords them with two main qualities money is commonly associated with: commercial deposits function as (1) a medium of exchange, i.e. as a means of payments; and (2) as a store of value. This grants this asset class a high degree of substitutability in the whole liquidity spectrum and it can function likewise as a highly liquid asset to be mobilised to settle debts. The Banking School questioned the Currency School’s attempt at making out an absolute difference in kind between metal specie, notes issued by a central authority and other monetary substitutes what Torrens termed ‘auxiliary media’ such as commercial deposits, bills of exchange or trade credit or book credits. What matters is what counts as a general reconciliation, as Richard Cantillon pointed out more than a century before. [8]
Major reference point:
The controversy reached its peak in the context of the Bank Act of 1844, also known as Peel’s Bank Act (named after the then British Prime Minister Robert Peel). It sought to restrict ‘the amounted currency in circulation to the quantity of gold in the country’. [9] The act's main advocates assembled in the Currency School whereas its main critics in the Banking School:
“Rather than fully backing each note with metal, Tooke argued that the Bank of England should simply be required to keep a large reserve of bullion for liquidity crises. According to Tooke, it was a mistake to think that controlling the amount of bullion could determine the amount of banknotes in circulation and that the number of notes in circulation in turn determined prices. Instead, the amount of money in circulation was ‘endogenous’ to the economic system rather than externally determined. The money supply could not be fixed from the outside but instead depended on the public's and industry's demand for money to which banks responded by creating credit; hence the name Banking School.” [10]
The Bank Act of 1844 nonetheless caused the separation of the Bank of England into two departments: (1) a note issuing department that was to respect the gold standard, i.e. limiting the supply of liquidity; and (2) a banking department exercising banking functions that was in turn as well constrained by liquid liabilities and that was not allowed to expand during moments of tension on the money market. [11] Both of these constraints imposed on the Bank of England eventually gave rise to fulfil its function to contain financial crises and to step in to act as a lender of last resort as early as in 1866. [12]
Legacy of the debate:
As the subject is related to the dispute of conceptualising money either as an exo- or endogeneous entity in the economic cycle, the legacy of the controversy reaches well into the 20th century when most attention was given to the problem of maintaining the internal value of money, i.e. controlling the rate of inflation:
“In the last decades of the twentieth century, this Currency School cause versus Banking School effect controversy evolved into a dispute between: (1) the Monetarists, who argued that the quantity of money supplied is (should be) exogenous and therefore a cause of inflation, and that by controlling money supply changes one controls the rate of inflation; and (2) the Post Keynesians, who, following Keynes (1973, pp. 222–3), believe that in a good monetary system, changes in the quantity of money supply should be endogenous, that is, central bankers should develop institutions that ensure that the money supply is responsive to changes in the demand for liquidity.” [13]
The differing viewpoints have consequentially differing emphases in their respective analytical frameworks: focus on money-supply related causal links means thus a rather inelastic view of the money supply function that gravitates around savers whereas emphasis on liquidity-oriented effects mean a more elastic view of it and centring around investors. [14] It is however not as clear-cut.
“Credit is the pavement along which production travels, and bankers if they know their duty, would provide the transport facilities to just the extent that is required in order that the productive powers of the community can be employed to their full capacity.” [15]
Keynes insisted further in his General Theory that an ‘essential property’ of money (and all other liquid assets) is a zero (or almost negligible) elasticity of production. [16] Stimulation of economic activity and achievement of full capacity roots in the recognition that money ‘comes into existence along with debts, which are contracts of deferred payment and […] offer contracts for sale or purchase’. [17] With this insight that the ‘supply of money, and debt and production-offer contracts are intimately and inevitably related’, one can argue then for the existence of a hybrid system of money creation, consisting of two distinct processes involving contracts, one associated with exogeneous money — the portfolio change process, and the other with endogeneous money — the income-generating finance process. [18]
In the end, with having established that the money creation process is a hybrid system, Michel Aglietta grasps the interdependency of monetary orders to political disputes and configurations of political economies over time:
“Money is not an immutable object. It is an institutional system that develops across history. This point is of primary importance to any monetary conception of the economy, because the transformation of money influences the way it acts on the economy. If money is a mode – or series of modes – of economic coordination, these modes themselves have historical characteristics. It follows from this that any empirical investigation into the monetary modes of economic coordination must be based on data that span the course of history. The metamorphoses of money interact with the transformations of political systems, and this very interaction enables us to verify our hypotheses on money as a mode of economic coordination.” [19]
Sources:
[1] Schumpeter, J. A. (1963) [1954] 'Chapter 7: Money, Credit, and Cycles', in History of Economic Analysis, New York, NY: Oxford University Press, p. 688.
[2] Cramp, A. B. (1962) ‘Two Views on Money’, in Lloyds Bank Review, No. 65, pp. 1-15 (p. 7).
[3] Eich, S. (2022) The Currency of Politics, Princeton, NJ: Princeton University Press, p. 15.
[4] Cramp, A. B. (1962) ‘Two Views on Money’, in Lloyds Bank Review, No. 65, pp. 1-15 (p. 7).
[5] Ibid.
[6] Ibid., pp. 7-9.
[7] Ibid., p. 2.
[8] Braudel, F. (1986) [1979], Civilization and Capitalism, Vol. I: The Structures of Everyday Life, New York, NY: Harper & Row, p. 476.
[9] Eich, S. (2022) The Currency of Politics, Princeton, NJ: Princeton University Press, p. 116.
[10] Ibid., p. 117.
[11] Aglietta, M. (2018) [2016] Money: 5,000 Years of Debt and Power, London: Verso, pp. 210f.
[12] Ibid.
[13] Davidson, P. (2006) ‘Exogeneous versus endogeneous money: the conceptual foundations’, in Setterfield, M., ed., Complexity, Endogeneous Money and Macroeconomic Theory, Cheltenham, UK: Edward Elgar, pp. 141-149 (p. 142).
[14] Ibid., p. 143.
[15] Keynes, J. M. (2011) [1930] Treatise on Money, Mansfield Centre, CT: Martino, p. 219f.
[16] Keynes, J. M. (2018) [1936] ‘Chapter 17: The Essential Properties of Interest and Money’, in The General Theory of Employment, Interest and Money, Cham, CH: Palgrave Macmillan, pp. 195-213, (p. 202f.).
[17] Keynes, J. M. (2011) [1930] Treatise on Money, Mansfield Centre, CT: Martino, p. 3.
[18] Davidson, P. (2006) ‘Exogeneous versus endogeneous money: the conceptual foundations’, in Setterfield, M., ed., Complexity, Endogeneous Money and Macroeconomic Theory, Cheltenham, UK: Edward Elgar, pp. 141-149 (p. 146).
[19] Aglietta, M. (2018) [2016] Money: 5,000 Years of Debt and Power, London: Verso, p. 6.