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• Preface
• Studies In the Theory of International Trade
• Chapter I: English Theories of Foreign Trade, Before Adam Smith: I
• I. Introduction
• II. “ Mercantilism” and “bullionism”
• III. the Balance-of-trade Doctrine
• IV. Reasons For Wanting More Bullion
• V. Employment and the Balance of Trade
• Chapter II: English Theories of Foreign Trade, Before Adam Smith: Ii
• I. Legislative Proposals of Mercantilists
• II. the Collapse of Mercantilist Doctrine
• III. Some Modern Interpretations of English Mercantilism
• Chapter III: The Bullionist Controversies: I. The Inflation Phase
• I. the Participants In the Controversy
• II. the Factual Background
• III. Premium On Bullion As Evidence of Excess Issue: the Bullionist Position
• IV. Qualifications Conceded By the Bullionists
• V. Possible Objections to the Bullionist Position
• VI. the Anti-bullionist Position
• VII. the Balance of Payments Argument
• VIII. the Possibility of Excess Issue By Banks
• IX. Responsibility For the Excess Issue: Bank of England Vs. Country Banks
• X. Responsibility For Excess Issue: the Credit Policy of the Bank of England
• Chapter IV: The Bullionist Controversies: II. The Deflation Phase
• I. the Resumption of Cash Payments
• II. Responsibility of Resumption For the Fall In Prices
• III. the Economic Effect of Changing Price Levels
• IV. Ricardo's Position On the Gold Standard
• V. Reform Without Departure From the Metallic Standard
• VI. Paper Standard Currencies
• Chapter V: English Currency Controversies, 1825–1865
• I. Introduction
• II. the “currency School” -“banking School” Controversy
• III. the “palmer Rule ”
• IV. the Bank Act of 1844
• V. the Possibility of Overissue of Convertible Bank Notes
• VI. the Role of Deposits, Bills of Exchange, and “credit” In the Currency System
• VII. the Technique of Credit Control
• VIII. the Relation Between Bank of England Operations and Specie Movements
• IX. Currency Reform Proposals
• Chapter VI: The International Mechanism Under a Simple Specie Currency
• I. Introductory
• II. the Mechanism According to Hume
• III. an Omitted Factor? Relative Changes In Demand As an Equilibrating Force
• IV. Prices In the Mechanism: the Concept of “price Levels ”
• V. the “terms-of-trade” Concept
• VI. the Prices of “domestic” Commodities
• VII. the Mechanism of Transfer of Unilateral Payments In Some Recent Literature
• VIII. a Graphical Examination of Pigou's Analysis 1
• IX. Some Elaborations On the Basis of Pigou's Analysis
• X. an Alternative Solution
• XI. Types of Disturbance In International Equilibrium
• XII. Specie Movements and Velocity of Money
• XIII. Commodity Flows and Relative Price Levels
• XIV. Exchange Rates
• XV. A Criticism of the Purchasing-power Parity Theory 1
• Chapter VII: The International Mechanism In Relation to Modern Banking Processes
• I. Automatic Vs. Managed Currencies
• II. Primary and Secondary Expansion of Means of Payments
• III. Short-term Loans In the International Mechanism
• IV. Primary and Secondary Expansion In Canada , 1900–13
• V. the International Mechanism and Business Cycles
• Chapter VIII: Gains From Trade: the Doctrine of Comparative Costs
• I. the Nature and Origin of the Doctrine
• II. the Division of the Gain From Trade
• III. Trade In More Than Two Commodities
• IV. Trade Between More Than Two Countries
• V. Transportation Costs
• VI. Increasing and Decreasing Costs
• VII. Prices, Money Costs, and Real Costs
• VIII. Dependence of Comparative Cost Doctrine On a Real-cost Theory of Value
• IX. Differences In Wage Rates In Different Occupations
• X. Variable Proportions of the Factors and International Specialization
• XI. Variable Proportions of the Factor and Comparative Real Costs
• XII. “ Opportunity Cost” Analysis As a Substitute For Real Cost Analysis
• Chapter IX: Gains From Trade: the Maximization of Real Income
• I. “ Mass of Commodities” and “sum of Enjoyments”: Ricardo and Malthus
• II. Reciprocal Demand and the Terms of Trade
• III. Terms of Trade and the Amount of Gain From Trade
• IV. “ Net Benefit” In International Trade: Marshall
• V. Total Net Utility Derived From International Trade: Edgeworth
• VI. the Gain From Trade Measured In Money
• Appendix: a Note On the Scope and Method of the Theory of International Trade

V. The Possibility of Overissue of Convertible Bank Notes

The Bank Act of 1844, in setting a maximum limit for the note issues of the country banks and in providing for the eventual absorption of their circulation by the Bank of England, was carrying out the recommendations of the currency school. The bullionists, it will be remembered, had denied the possibility of a relative overissue of country bank notes if they were convertible upon demand into Bank of England notes or specie. But the boom of 1824–25 and the resultant crisis of 1826 opened the eyes of many to the expansion possibilities even under convertibility, and the currency school on this point did not adhere to the bullionist doctrine. They insisted that the country banks could expand their issues relatively to the Bank of England note circulation for a long enough period to create difficulties, without being adequately checked by the resultant adverse balance of payments with London. A fortiori, they held that the Bank of England and the country banks, acting together, could issue to excess even under convertibility.

Torrens on this question held views closer to those of the banking school than to those of his currency school associates. He claimed that when a relative overissue of country bank notes occurred, country notes would be presented to be exchanged for bills on London, which would in turn be exchanged for gold for export; the balance of payments both with London and with foreign countries would turn against the provinces, and the country banks would quickly find themselves compelled to contract their issues. Similarly, when the Bank of England directors “decreed a contraction of the currency, the provincial banks of issue, instead of resisting, obeyed and suffered.” 1

Norman replied that Torrens did not make sufficient allowance for “friction” when he claimed that the Bank of England had complete control over the country bank issues.2 Overstone argued that Torrens's conclusion rested on two assumptions, neither of which was valid: that the districts in which the two types of notes circulated were distinct and completely separated from each other,3 and that there was no delay before a contraction of Bank of England issues exercised its full effect on the reserves of the country banks. To Torrens's statement that when the Bank of England decrees contraction, the country banks of issue, instead of resisting, obey and suffer, he replied that “the country banks first resist, then suffer, and in the end submit.4

Torrens similarly claimed that nothing the Bank of England could do could increase the circulation by one pound beyond the amount decreed by the “necessary and natural law which governs the amount at which a convertible currency can be maintained.” If the Bank issued more notes it would displace an equal amount of bullion thereby driven abroad.5 Torrens and the remainder of the currency school thus meant different things by “excess” of note issue. Torrens by “excess” of note issue must have meant an amount of issue which was greater than was consistent with the retention of bullion in reserves or in circulation as coin at its existing and presumably appropriate volume and would therefore result in an immediate export of bullion. The currency school as a whole meant by excess of note issue an amount of issue such as to make the total circulation of notes and coin combined greater than could be permanently maintained consistently with maintenance of convertibility and of the gold standard. The latter explained the phenomena resulting from an excess note issue in terms of lags between the original excess issue and the consequent rise in prices, external drain of gold, and impairment of the Bank's bullion reserves. Torrens would here have no commerce with lags, and he gave no consideration to the possibility of a significant intervening period of excess aggregate circulation. It is not apparent, however, that Torrens ever realized the extent of the divergence of his views from those of the other prominent currency principle advocates, or the essential harmony between this phase of his analysis and that of the banking school writers whom he was vigorously attacking.

Against the possibility of overissue the banking school appealed to the alleged “law of reflux”, which amounted to nothing more than that the notes issued by a banking system on loan at interest to their customers would return to the banks in liquidation of these loans when they matured, and therefore any excess “would come back to the banks.”

New gold coin and new conventional notes are introduced into the market by being made the medium of payments. Bank-notes, on the contrary, are never issued but on loan, and an equal amount of notes must be returned into the bank whenever the loan becomes due. Bank-notes never, therefore, can clog the market by their redundance, nor afford a motive to anyone to pay them away at a reduced value in order to get rid of them. The banker has only to take care that they are lent at sufficient security, and the reflux and the issue will, in the long run, always balance each other.6

To Fullarton's “vaunted principle of reflux,” Torrens made an inadequate reply. If the Bank issued notes by discount of 60-day paper, there would be an interval of sixty days before an increase of notes would return to the Bank.7 But Fullarton had pointed out that there was no necessity “that the particular securities on which those notes were advanced should also furnish the channel for their return.” 8 As earlier loans matured during the 60-day interval, the Bank could contract its circulation by failing to replace them with new loans. What Fullarton certainly failed and Torrens apparently failed to see was that the “reflux” gave the Bank the power, but did not compel it, to contract its issues, and that by granting new loans as rapidly as old ones matured, the Bank could keep any quantity of notes out for any length of time, provided only that its bullion reserves were not exhausted, and that the Bank lent on terms attractive enough to find willing borrowers.9

The essential fallacy of the banking school doctrine had already been exposed during the bullionist controversy by Ricardo and others. It lay in its assumption that the “needs of business” for currency were a definite quantity independent of the state of business psychology and the activities of the banks. The banking school were right in insisting that the volume of bank credit was dependent on the willingness of businessmen to borrow, as well as on the willingness of banks to lend. But the willingness of businessmen to borrow depended on their anticipations of the trend of business, on the interest rate, and on their anticipations as to the willingness of the banks, in case of need, to renew loans upon their maturity. The banks, by lowering their interest rates, or consciously or unconsciously lowering their credit standards, could place more loans, and the increase of loans, by increasing prices and physical volume of sales, would in turn increase the willingness of businessmen to borrow. As Joplin had pointed out in 1826, bankers ordinarily do not see this, because they do not see that they themselves as a group had created the conditions which make an expansion of credit possible and appear to make it “necessary”:

Bankers, indeed, have the idea that their issues are always called forth by the natural wants of the country, and that it is high prices that cause a demand for their notes, and not their issues which create high prices and vice versa. The principle is absurd, but it is the natural inference to be deduced from their local experience. They find themselves contracted in their issues, by laws which they do not understand, and are consequently led to attribute the artificial movements of the currency to the hidden operations of nature, which they term the wants of the country.10

The banking school also argued, as against the possibility of overissue, that if any bank issued in excess of its usual amount it would find the balances running against it at the clearinghouse and would be forced to contract its issue. That the power to over-issue of a single bank, operating in competition with other banks, was closely limited, had long been known. It had been pointed out as far back as 1773 that if a single bank increases its note issue it at first causes a drain on the reserves of the other banks in its district, but that in time its balances to other banks become unfavorable and it is forced to contract its discounts in order to replenish its reserves.11 Lord King made the same point in 1804: “An excessive issue of notes by any particular banker is soon detected, if not by the public, at least by the interested vigilance of his rivals; an alarm is excited; and he is immediately called upon to exchange a very large portion of his notes in circulation for that currency in which they are payable.” 12

In the 1820's, in reply to the use of this argument to demonstrate the impossibility of overissue, a number of writers drew a distinction between what a single bank acting alone could do and what a large group of banks, or an entire banking system, could do, acting simultaneously.13 The Committee of 1826 on Joint-Stock Banks heard much evidence to the effect that the practice of the Scotch banks of making a periodic demand on each other for payment of their respective notes in cash, bills on London, or exchequer bills, was a complete safeguard against excess issue. The questions put to some of the witnesses indicate that the doctrine that banks acting together could issue to excess, though not accepted either by the questioners or the witnesses, was already current.14

In the same year, a number of writers denied the claims that were being made on behalf of the Scotch banks, that their regular procedure of presenting each other's notes for payment provided a guarantee against overissue, on the ground that if the banks all increased their issues simultaneously and in the same degree, they would not have adverse clearing balances against each other and therefore could overissue indefinitely.15 These writers overlooked or, in the case of Doubleday, denied, that, while simultaneous and equal expansion by the Scotch banks would not result in adverse clearing balances among themselves, it would result, at least after a time, in adverse balances with London. It is to their credit, however, that they perceived and expounded the important principle that there is less check to overexpansion by banks when they act in unison than when they act singly, and that it is an error to infer, from the limitations upon expansion to which a single bank acting alone is subject, that overexpansion for a time is impossible for an important group of banks, or a fortiori for a banking system as a whole, when acting in unison. After 1826, this principle was frequently stated,16 and it was adopted by the currency school as one of the elements in their reply to the banking school doctrine that overissue was impossible under convertibility. It became an important element in the then prevailing theory of business fluctuations that alternating waves of optimism and pessimism resulted in overtrading and speculation followed by collapse and contraction, and that the bankers, who as a group shared the optimistic or pessimistic views of their customers, fed the cycle by simultaneous expansion or contraction of their credits.17

Several writers, however, went further, and insisted that even a single bank could overissue for a time, and that credit expansion initiated by a single bank might spread to other banks. McCulloch, in 1831, started from the hypothetical case of ten banks in London, each with a note issue of £1,000,000. If one of them should increase its issue to £2,000,000, there would result a fall in the exchanges and a demand for gold. But the demand on the overissuing bank would be only in the same proportion to its issue as on the other banks. If to check the drain of gold general contraction takes place, then, when the reserves had been replenished the bank which had expanded its issue would find itself with a circulation of £1,818,000, and the other banks would have a circulation of only £909,000 each. The other banks “would certainly be tempted to endeavor to repair the injury done them by acting in the same way.” Even a single bank can expand, therefore, and, more important, may arouse the other banks to a defensive expansion.18 McCulloch failed to point out that a single bank which expanded its note issue while other banks remained passive or contracted would suffer a drastic impairment of its reserves. He now also insisted, for reasons which are not clear but which arose probably more from considerations of Scotch patriotism than of Scotch logic, that, while expansion by a single London bank was possible, this did not hold for Scotch banks.

Scrope denied that McCulloch's reasoning was sound either for London or for Scotch banks. He did not explicitly raise the issue of the effect on the reserves of the expanding bank, but he claimed that a bank could expand its issue relatively to other banks only by discounting at a lower rate, or on inferior security, than its competitors, and that to maintain its increased circulation it must continue to discount on more favorable terms. “But if, as is presumable, the other banks are going as far in both these ways as a sound practice will permit, ... the bank in question cannot go beyond them without risks, such as no stable or solvent establishment would hazard.” 19

Sir William Clay, in the hearings before the 1838 Committee on Joint-Stock Banks, received an affirmative reply to the following question put by him to a witness:

Is there not this circumstance with regard to a competition in the issue of money, that although it may be true that one bank, of many (issuing in competition in Dublin, we will say), if it issued more in a larger proportion than its rival banks, would have its notes returned upon it; and is it not true that would not operate as a check, if all, in the spirit of competition in a period of excitement, were also disposed to issue largely?

Longfield, citing this question and answer, objected that they took insufficient account of the part which even a single bank could play in bringing about an expansion of the circulation. If a single bank in a particular region expanded its discounts and permitted its cash reserve ratio to fall, there would result a gold drain from the banks of the region as a whole either to hand-to-hand circulation or for export, which all the banks in that region would feel in proportion to their circulation. If the other banks kept their discounts constant, they would find their reserves falling in greater proportion than their circulation (because since their circulation was several times larger than their reserves, the loss of a given amount of cash through presentation of notes for payment would represent a greater relative reduction in their reserves than in their circulation). To maintain their former reserve ratio, they must drastically contract their discounts. The expanding bank, if it had sufficient capital to withstand the drain on its own reserves, could by this procedure drive the other banks out of business. If the other banks in self-defense expanded their discounts, and allowed their reserve ratios to fall, there would result a general expansion of credit and circulation in the district. “Thus a bank may be driven in self-defense to take up the system of overtrading adopted by its competitors, and where there are several joint-stock banks of issue, the country will suffer under alternations of high and low prices, of confidence and panic, of great excitement and general depression of trade.” Competitive issue of bank notes might therefore operate as a stimulus to, instead of as a protection against, the periodic recurrence of general overexpansion and overcontraction of the circulation.20

[1]A letter to ... Lord Melbourne, 2d ed., 1837, p. 48. He conceded a qualifying circumstance: if the adverse balance of payments of the provinces with London was met by shipments to London of Bank of England notes which had been in circulation in the country, the circulation and prices would rise in London as well as in the country, and the country banks would find themselves able to maintain for a time their increased circulation without losing all their reserves. To assure control of the circulation, therefore, it was necessary that the Bank of England should supply either all of the country circulation or none of it.

[2]Remarks upon some prevalent errors, 1838, p. 53.

[3]As we have seen, Torrens conceded that this assumption might not accord with the facts.

[4]Remarks on the management of the circulation [1840], Tracts, pp. 96 ff.

[5]The principles and practical operation of Sir Robert Peel's bill, 1848, p. 49.

[6]John Fullarton, On the regulation of currencies, 2d ed., 1845, p. 64 (italics in original). See also Tooke, History of prices, IV (1848), 185. Tooke denied only that banks could issue notes to excess and agreed that they could lend to excess in the form of deposits and bills of exchange. (An inquiry into the currency principle, 2d ed., 1844, p. 158, note.)

[7]The principles and practical operation of Sir Robert Peel's bill of 1844, 1848, pp. 106 ff.

[8]On the regulation of currencies, 2d ed., 1845, p. 96.

[9]Cf. T. P. Thompson, “On the instrument of exchange,” Westminster review, I (1824), 197: “... the confining either a private or public bank to discounting bills at dates however short, will be no limitation. For it amounts to a permission to issue in perpetuity as much paper as men can be persuaded to borrow, under the formality of from time to time renewing the contract.”

[10]Views on the subject of corn and currency, 1826, pp. 45–46. Joplin is arguing that there are limitations on the power of issue of individual banks, and that the bankers perceive this, but that they do not perceive that these limitations do not apply to the banking system as a whole.

[11]Adam Dickson, An essay on the causes of the present high price of provisions, 1773, pp. 46–47.

[12]Thoughts on the effects of the Bank restrictions, 2d ed., 1804, p. 100

[13]According to C. A. Phillips, writing as late as 1920 (Bank Credit, 1920, p. 32): “the accepted statements of banking theory, with scarcely an exception, have made no such distinction [i.e., between the power of issue of a single bank and of a banking system acting in harmony], with the result that confusion, obscurity, and error prevail with reference to the most fundamental principles of the subject.”

[14]Cf. Report on Joint-Stock Banks, 1826, p. 269: “Q. Do you think that this is a sufficient check against the possibility of an overissue by any particular bank? A. I think no particular bank can overissue. Q. Do you think that, if all the banks were to combine, they could, by any means, force more notes permanently into circulation than the transactions of the country required? A. I think it quite impossible; the notes which are not required for the use of the country would instantly be returned to the banks.” Cf. also, ibid., pp. 59, 213.

[15]Cf. J. R. McCulloch, “Fluctuations in the supply and value of money,” Edinburgh review, XLIII (1826), 283:

... the mutual exchanges that are made, twice a week, by the Scotch bankers, of each other's notes in their possession ... though in many respects an useful and convenient regulation, is quite ineffectual, either to prevent the excessive issue of the notes of any one banking company, in which the public has confidence, or to prevent a general over-issue. If the different banks were to increase their issues in the same, or nearly the same proportion, the whole currency of the country might be doubled, were that otherwise practicable, in the course of twelve months, without the notes of any one company becoming excessive in relation to the others; for, as the increased amount of notes that might be payable by a particular company would, under such circumstances, be met by the equally increased amount that would be receivable by it, the balance to be paid in cash or bills on London, would not really be greater than it had been before the augmentation. Cf. also Henry Burgess, A letter to ... George Canning, 1826, pp. 45–46; Thomas Joplin, Views on the subject of corn and currency, 1826, pp. 44–45; Thomas Doubleday, Remarks on some points of the currency question, 1826, pp. 30–31.

[16]Cf. e.g., Sir Henry Parnell, Observations on paper money, banking, and overtrading, 2d ed., 1829, pp. 88–89; A merchant, Observations on the crisis, 1836–37, 1837, p. 19

[17]Cf. Sir Henry Parnell, Observations on paper money, 2d ed., 1829, p. 90; Overstone, Reflections, suggested by ... Mr....Palmer's pamphlet [1837], in Tracts, p. 32; Sir William Clay, Remarks on the expediency of restricting the issue of promissory notes. 1844, pp. 34 ff. Cf. also, “The Bank of England and the country banks,” Edinburgh review, XLV (1837), 76: The radical defect, in fact, in the constitution of the Bank, consists in its participation too much in the feelings and views of the mercantile class. It is managed by merchants, and we need not wonder that it should sympathize with them. It may, however, be inferred, with almost unerring certainty, that the Bank is acting on erroneous principles, when its conduct is warmly approved by the merchants, and conversely. Whenever the city articles of the metropolitan papers teem with eulogies on the conduct of the Bank, we may be quite certain that mischief is abroad.

[18]J. R. McCulloch, Historical sketch of the Bank of England, 1831, pp. 48–50. Cf. also Henry Burgess, A letter to ... George Canning, 1826, pp. 45–46.

[19]G. Poulett Scrope, A plain statement of the causes of and remedies for, the prevailing distress, 1832, pp. 13 ff. These risks, presumably, were of losses through bad debts, not of impairment of cash reserves.

[20]M. Longfield, “Banking and currency, II,” Dublin University magazine, XV (1840), 218–19. Cf. Overstone, Remarks on the management of the circulation [1840], Tracts, pp. 98–99: “The desire to extend his own issue is the motive of each issuer; this motive will lead each party to meet an expansion of issue on the part of others by a corresponding expansion on his own part; but it will also lead him to look upon contraction in any quarter as a favorable opportunity, not for contracting, but for expanding his own issues, with the view and in the hope of possessing himself of the ground from which his rival has receded.”