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CHAP. III - Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain 
An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, edited and with an Introduction by F.A. Hayek (London: George Allen and Unwin, 1939).
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Of circulating Paper—of Bank Notes—of Bills considered as circulating Paper—different Degrees of Rapidity in the Circulation of different Sorts of circulating Medium, and of the same Sort of circulating Medium at different Times.—Error of Dr. A. Smith.—Difference in the Quantities wanted for effecting the Payments of a Country in Consequence of this Difference of Rapidity.—Proof of this taken from Events of 1793.—Fallacy involved in the Supposition that Paper Credit might be abolished.
We proceed next to speak of circulating paper, and first of Notes payable to Bearer on Demand, whether issued by a public bank or by a private banker.
When confidence rises to a certain height in a country, it occurs to some persons, that profit may be obtained by issuing notes, which purport to be exchangeable for money; and which, through the known facility of thus exchanging them, may circulate in its stead; a part only of the money, of which the notes supply the place, being kept in store as a provision for the current payments. On the remainder interest is gained, and this interest constitutes the profit of the issuer. Some powerful and well accredited company will probably be the first issuers of paper of this sort, the numerous proprietors of the company exerting their influence for the sake of the dividends which they expect, in giving currency to the new paper credit. The establishment of a great public bank has a tendency to promote the institution of private banks. The public bank, obliged to provide itself largely with money for its own payments, becomes a reservoir of gold to which private banks may resort with little difficulty, expence, or delay, for the supply of their several necessities.
Dr. A. Smith, in his chapter on Paper Credit, considers the national stock of money in the same light with those machines and instruments of trade which require a certain expence, first, to erect, and afterwards to support them. And he proceeds to observe, that the substitution of paper, in the room of gold and silver coin, serves to replace a very expensive instrument of commerce with one much less costly, and sometimes equally convenient. “Thus,” he says, “a banker, by issuing 100,000l. in notes, keeping “20,000l. in hand for his current payments, causes 20,000l. in gold and silver to perform all the functions which 100,000l. would otherwise have performed; in consequence of which, 80,000l. of gold and silver can be spared, which will not fail to be exchanged for foreign goods, and become a new fund for a new trade, producing profit to the country.”*
Dr. Smith, although he discusses at some length the subject of Paper Circulation, does not at all advert to the tendency of bills of exchange to spare the use of bank paper, or to their faculty of supplying its place in many cases.
In the former Chapter it was shewn that bills, though professedly drawn for the purpose of exchanging a debt due to one person for a debt due to another, are, in fact, created rather for the sake of serving as a discountable article, and of forming a provision against contingencies; and that, by being at any time convertible into cash (that is, into either money or bank notes) they render that supply of cash which is necessary to be kept in store much less considerable.
But they not only spare the use of ready money; they also occupy its place in many cases. Let us imagine a farmer in the country to discharge a debt of 10l. to his neighbouring grocer, by giving to him a bill for that sum, drawn on his cornfactor in London for grain sold in the metropolis; and the grocer to transmit the bill, he having previously indorsed it, to a neighbouring sugar-baker, in discharge of a like debt; and the sugar-baker to send it, when again indorsed, to a West India merchant in an outport, and the West India merchant to deliver it to his country banker, who also indorses it, and sends it into further circulation. The bill in this case will have effected five payments exactly as if it were a 10l. note payable to bearer on demand. It will, however, have circulated in consequence chiefly of the confidence placed by each receiver of it in the last indorser, his own correspondent in trade; whereas, the circulation of a bank note is owing rather to the circumstance of the name of the issuer being so well known as to give to it an universal credit. A multitude of bills pass between trader and trader in the country in the manner which has been described; and they evidently form, in the strictest sense, a part of the circulating medium of the kingdom.*
Bills, however, and especially those which are drawn for large sums, may be considered as in general circulating more slowly than either gold or bank notes, and for a reason which it is material to explain. Bank notes, though they yield an interest to the issuer, afford none to the man who detains them in his possession; they are to him as unproductive as guineas. The possessor of a bank note, therefore, makes haste to part with it. The possessor of a bill of exchange possesses, on the contrary, that which is always growing more valuable. The bill, when it is first drawn, is worth something less than a bank note, on account of its not being due until a distant day; and the first receiver of it may be supposed to obtain a compensation for the inferiority of its value in the price of the article with which the bill is purchased. When he parts with it, he may be considered as granting to the next receiver a like compensation, which is proportionate to the time which the bill has still to run. Each holder of a bill has, therefore, an interest in detaining it.
Bills, it is true, generally pass among traders in the country without there being any calculation or regular allowance of discount; the reason of which circumstance is, that there is a generally understood period of time for which those bills may have to run, which, according to the custom of traders, are accepted as current payment. If any bill given in payment has a longer time than usual to run, he who receives it is considered as so far favouring the person from whom he takes it; and the favoured person has to compensate for this advantage, not, perhaps, by a recompence of the same kind accurately calculated, but in the general adjustment of the pecuniary affairs of the two parties.
This quality in bills of exchange (and it might be added of interest notes, &c.) of occupying the place of bank paper, and of also throwing the interest accruing during their detention into the pocket of the holder, contributes greatly to the use of them. The whole trading world may be considered as having an interest in encouraging them. To possess some article which, so long as it is detained, shall produce a regular interest, which shall be subject to no fluctuations in price, which, by the custom of commerce, shall pass in certain cases as a payment, and shall likewise be convertible into ready money by the sacrifice of a small discount, is the true policy of the merchant. Goods will not serve this purpose, because they do not grow more valuable by detention; nor stocks, because, though they yield an interest, they fluctuate much in value; and, also, because the expence of brokerage is incurred in selling them, not to mention the inconveniences arising from the circumstance of their being transferable only in the books of the Bank of England. Stocks, however, by being at all times a saleable and ready money article, are, to a certain degree, held by persons in London on the same principle as bills, and serve, therefore, in some measure, like bills, if we consider these as a discountable article, to spare the use of bank notes. Exchequer bills will not fully answer the purpose, because there is a commission on the sale of these, as on the sale of stocks; and because, not to speak of some other inferior objections to them, they fluctuate, in some small degree, in price.
Bills, since they circulate chiefly among the trading world, come little under the observation of the public. The amount of bills in existence may yet, perhaps, be at all times greater than the amount of all the bank notes of every kind, and of all the circulating guineas* .
The amount of what is called the circulating medium of a country has been supposed by some to bear a regular proportion to the quantity of trade and of payments. It has, however, been shewn, that such part of the circulating medium as yields an interest to the holder will effect much fewer payments, in proportion to its amount, than the part which yields to the holder no interest. A number of country bank notes, amounting to 100l., may, for instance, effect on an average one payment in three days; while a bill of 100l. may, through the disposition of each holder to detain it, effect only one payment in nine days.
There is a passage in the work of Dr. Adam Smith which serves to inculcate the error of which I have been speaking; a passage on which it may be useful to comment with some particularity.
He says, “The whole paper money of every kind which can easily circulate in any country, never can exceed the value of the gold and silver of which it supplies the place, or which (the commerce being supposed the same) would circulate there, if there was no paper money.”
Does Dr. Smith mean to include, in his idea of “the whole paper money of every kind which can easily circulate,” all the bills of exchange of a country, or does he not? And does he also include interest notes, exchequer bills, and India bonds, and those other articles which very much resemble bills of exchange? In an earlier part of his chapter he has this observation—“There are different sorts of paper money; but the circulating notes of banks and bankers are the species which is best known, and which seems best adapted for this purpose.” We are led to judge by this passage, and also by the term “paper money of every kind” in the passage before quoted, that it was his purpose to include bills of exchange; on the other hand, if all the bills of exchange of a country are to be added to the bank notes which circulate, it becomes then so manifest, that the whole of the paper must be more than equal to the amount of the money which would circulate if there were no paper, that we feel surprised that the erroneousness of the position did not strike Dr. Smith himself. He introduces, indeed, the qualifying word “easily;” he speaks of “the whole paper money of every kind which can easily circulate.” But this term, as I apprehend, is meant only to refer to an easy, in contradistinction to a forced, paper circulation; for it is on the subject of a forced circulation that a great part of his observations turn. He seems, on the other hand, to have paid no regard to the distinction on which I have dwelt, of a more slow and a more rapid circulation; a thing which is quite different from an easy and a difficult circulation. He appears, in short, not at all to have reflected how false his maxim is rendered (if laid down in the terms which he has used) both by the different degrees of rapidity of circulation which generally belong to the two different classes of paper of which I have spoken, and also by the different degrees of rapidity which may likewise belong to the circulation of the same kinds of paper, and even of the same guineas, at different times.
The error of Dr. Smith, then, is this:—he represents the whole paper, which can easily circulate when there are no guineas, to be the same in quantity with the guineas which would circulate if there were no paper; whereas, it is the quantity not of “the thing which circulates,” that is, of the thing which is capable of circulation, but of the actual circulation which should rather be spoken of as the same in both cases. The quantity of circulating paper, that is, of paper capable of circulation, may be great, and yet the quantity of actual circulation may be small, or vice versa. The same note may either effect ten payments in one day, or one payment in ten days; and one note, therefore, will effect the same payments in the one case, which it would require a hundred notes to effect in the other.
I have spoken of the different degrees of rapidity in the circulation of different kinds of paper, and of the consequent difference of the quantity of each which is wanted in order to effect the same payments. I shall speak next of the different degrees of rapidity in the circulation of the same mediums at different times: and, first, of bank notes.
The causes which lead to a variation in the rapidity of the circulation of bank notes may be several. In general, it may be observed, that a high state of confidence serves to quicken their circulation; and this happens upon a principle which shall be fully explained. It must be premised, that by the phrase a more or less quick circulation of notes will be meant a more or less quick circulation of the whole of them on an average. Whatever encreases that reserve, for instance, of Bank of England notes which remains in the drawer of the London banker as his provision against contingencies, contributes to what will here be termed the less quick circulation of the whole. Now a high state of confidence contributes to make men provide less amply against contingencies. At such a time, they trust, that if the demand upon them for a payment, which is now doubtful and contingent, should actually be made, they shall be able to provide for it at the moment; and they are loth to be at the expence of selling an article, or of getting a bill discounted, in order to make the provision much before the period at which it shall be wanted. When, on the contrary, a season of distrust arises, prudence suggests, that the loss of interest arising from a detention of notes for a few additional days should not be regarded.
It is well known that guineas are hoarded, in times of alarm, on this principle. Notes, it is true, are not hoarded to the same extent; partly because notes are not supposed equally likely, in the event of any general confusion, to find their value, and partly because the class of persons who are the holders of notes is less subject to weak and extravagant alarms. In difficult times, however, the disposition to hoard, or rather to be largely provided with Bank of England notes, will, perhaps, prevail in no inconsiderable degree.
This remark has been applied to Bank of England notes, because these are always in high credit; and it ought, perhaps, to be chiefly confined to these. They constitute the coin in which the great mercantile payments in London, which are payments on account of the whole country, are effected. If, therefore, a difficulty in converting bills of exchange into notes is apprehended, the effect both on bankers, merchants, and tradesmen, is somewhat the same as the effect of an apprehension entertained by the lower class of a difficulty in converting Bank of England notes or bankers’ notes into guineas. The apprehension of the approaching difficulty makes men eager to do that to-day, which otherwise they would do to-morrow.
The truth of this observation, as applied to Bank of England notes, as well as the importance of attending to it, may be made manifest by adverting to the events of the year 1793, when, through the failure of many country banks, much general distrust took place. The alarm, the first material one of the kind which had for a long time happened, was extremely great. It does not appear that the Bank of England notes, at that time in circulation, were fewer than usual. It is certain, however, that the existing number became, at the period of apprehension, insufficient for giving punctuality to the payments of the metropolis; and it is not to be doubted, that the insufficiency must have arisen, in some measure, from that slowness in the circulation of notes, naturally attending an alarm, which has been just described. Every one fearing lest he should not have his notes ready when the day of payment should come, would endeavour to provide himself with them somewhat beforehand. A few merchants, from a natural though hurtful timidity, would keep in their own hands some of those notes, which, in other times, they would have lodged with their bankers; and the effect would be, to cause the same quantity of bank paper to transact fewer payments, or, in other words, to lessen the rapidity of the circulation of notes on the whole, and thus to encrease the number of notes wanted. Probably, also, some Bank of England paper would be used as a substitute for country bank notes suppressed.
The success of the remedy which the parliament administered, denotes what was the nature of the evil. A loan of exchequer bills was directed to be made to as many mercantile persons, giving proper security, as should apply. It is a fact, worthy of serious attention, that the failures abated greatly, and mercantile credit began to be restored, not at the period when the exchequer bills were actually delivered, but at a time antecedent to that æra. It also deserves notice, that though the failures had originated in an extraordinary demand for guineas, it was not any supply of gold which effected the cure. That fear of not being able to obtain guineas, which arose in the country, led, in its consequences, to an extraordinary demand for bank notes in London; and the want of bank notes in London became, after a time, the chief evil. The very expectation of a supply of exchequer bills, that is, of a supply of an article which almost any trader might obtain, and which it was known that he might then sell, and thus turn into bank notes, and after turning into bank notes might also convert into guineas, created an idea of general solvency. This expectation cured, in the first instance, the distress of London, and it then lessened the demand for guineas in the country, through that punctuality in effecting the London payments which it produced, and the universal confidence which it thus inspired. The sum permitted by parliament to be advanced in exchequer bills was five millions, of which not one half was taken. Of the sum taken, no part was lost. On the contrary, the small compensation, or extra interest, which was paid to government for lending its credit (for it was mere credit, and not either money or bank notes that the government advanced), amounted to something more than was necessary to defray the charges, and a small balance of profit accrued to the public. For this seasonable interference, a measure at first not well understood and opposed at the time, chiefly on the ground of constitutional jealousy, the mercantile as well as the manufacturing interests of the country were certainly much indebted to the parliament, and to the government* .
That a state of distrust causes a slowness in the circulation of guineas, and that at such a time a greater quantity of money will be wanted in order to effect only the same money payments, is a position which scarcely needs to be proved. Some observations, however, on this subject may not be useless. When a season of extraordinary alarm arises, and the money of the country in some measure disappears, the guineas, it is commonly said, are hoarded. In a certain degree this assertion may be literally true. But the scarcity of gold probably results chiefly from the circumstance of a considerable variety of persons, country bankers, shopkeepers, and others, augmenting, some in a smaller and some in a more ample measure, that supply which it had been customary to keep by them. The stock thus enlarged is not a fund which its possessor purposes, in no case, to diminish, but a fund which, if he has occasion to lessen it, he endeavours, as he has opportunity, to replace. It is thus that a more slow circulation of guineas is occasioned; and the slower the circulation, the greater the quantity wanted, in order to effect the same number of money payments.
Thus, then, it appears, that the sentiment which Dr. Smith leads his readers to entertain, namely, that there is in every country a certain fixed quantity of paper, supplying the place of gold, which is all that “can easily circulate” (or circulate without being forced into circulation), and which is all (for such, likewise, seems to be the intended inference) that should ever be allowed to be sent into circulation, is, in a variety of respects, incorrect. The existence of various hoards of gold in the coffers of bankers, and of the Bank of England, while there are no corresponding hoards of paper, would of itself forbid any thing like accurate comparison between them. Many additional, though smaller, circumstances might be mentioned as contributing to prevent the quantity of notes which will circulate from being the same as the quantity of gold which would circulate if there were no notes; such as their superior convenience in a variety of respects, the facility of sending them by post, the faculty which they have of being either used as guineas, or of supplying the place of bills of exchange, and furnishing a remittance to distant places.
There is a further objection to the same remark of Dr. Smith. It would lead an uninformed person to conceive, that the trade of a country, and of this country in particular, circumstanced as it now is, might be carried on altogether by guineas, if bank notes of all kinds were by any means annihilated. It may already have occurred, that if bank paper were abolished, a substitute for it would be likely to be found, to a certain degree, in bills of exchange; and that these, on account of their slower circulation, must, in that case, be much larger in amount than the notes of which they would take the place. But further; if bills and bank notes were extinguished, other substitutes than gold would unquestionably be found. Recourse would be had to devices of various kinds by which men would save themselves the trouble of counting, weighing, and transporting guineas, in all the larger operations of commerce, so that the amount of guineas brought into use would not at all correspond with the amount of the bills and notes suppressed. Banks would be instituted, not of the description which now exist, but of that kind and number which should serve best to spare both the trouble of gold, and the expence incurred by the loss of interest upon the quantity of it in possession. Merely by the transfer of the debts of one merchant to another, in the books of the banker, a large portion of what are termed cash payments is effected at this time without the use of any bank paper* , and a much larger sum would be thus transferred, if guineas were the only circulating medium of the country. Credit would still exist; credit in books, credit depending on the testimony of witnesses, or on the mere verbal promise of parties. It might not be paper credit; but still it might be such credit as would spare, more or less, the use of guineas. It might be credit of a worse kind, less accurately dealt out in proportion to the desert of different persons, and therefore, in some instances, at least, still more extended; it might be credit less contributing to punctuality of payments, and to the due fulfilment of engagements; less conducive to the interests of trade, and to the cheapening of articles; and it would, perhaps, also be credit quite as liable to interruption on the occasion of any sudden alarm or material change in the commercial prospects and circumstances of the country.
[* ]Dr. Smith, in confirmation of this, remarks how greatly Scotland had been enriched in the twenty-five or thirty years preceding the time at which he wrote, by the erection of new banks in almost every considerable town, and even in some country villages, the effects having been, as he affirms, precisely those which he had described. The trade of Glasgow he states to have been doubled in about fifteen years after the erection of its first bank, and the trade of Scotland to be thought to have been more than quadrupled since the first erection of its two first public banking companies. This effect, indeed, he conceives to be too good to be accounted for by that cause alone; though he deems it indisputable, that the banks have essentially contributed to the augmentation of the trade and industry of Scotland. The gold and silver of Scotland, circulating before the union, is estimated by him at full a million; the quantity since the union at less than half a million; and the paper circulating in Scotland since the union at about one million and a half.
[* ]Mr. Boyd, in his publication addressed to Mr. Pitt on the Subject of the Bank of England Issues, propagates the same error into which many others have fallen, of considering bills as no part of the circulating medium of the country. He says, “by the words “means of circulation,” “circulating medium,” and “currency,” (which are used as synonymous terms in this Letter) I understand always ready money, whether consisting of bank notes or specie, in contradiction to bills of exchange, navy bills, exchequer bills, or any negotiable paper which form no part of the circulating medium, as I have always understood that term. The latter is the circulator; the former are merely objects of circulation.” . . . See note to the first page of Mr. Boyd’s Letter to Mr. Pitt.
[* ]Liverpool and Manchester effect the whole of their larger mercantile payments not by country bank notes, of which none are issued by the banks of those places, but by bills at one or two months date, drawn on London. The bills annually drawn by the banks of each of those towns amount to many millions. The banks obtain a small commission on these bills.
[* ]The commissioners named in the act state in their report, “that the knowledge that loans might have been obtained, sufficed, in several instances, to render them unnecessary; that the whole number of applications was three hundred and thirty-two, for sums amounting to £ 3,855,624; of which two hundred and thirty-eight were granted, amounting to £ 2,202,000; forty-five for sums to the amount of £.1,215,100 were withdrawn, and forty-nine were rejected for various reasons. That the whole sum advanced on loans was paid, a considerable part before it was due, and the remainder regularly at the stated periods, without apparent difficulty or distress.”
[* ]The following custom, now prevailing among the bankers within the city of London, may serve to illustrate this observation, and also to shew the strength of the disposition which exists in those who are not the issuers of bank notes to spare the use both of paper and guineas. It is the practice of each of these bankers to send a clerk, at an agreed hour in the afternoon, to a room provided for their use Each clerk there exchanges the drafts on other bankers received at his own house, for the drafts on his own house received at the houses of other bankers. The balances of the several bankers are transferred in the same room from one to another, in a manner which it is unnecessary to explain in detail, and the several balances are finally wound up by each clerk into one balance. The difference between the whole sum which each banker has to pay to all other city bankers, and the whole sum which he has to receive of all other city bankers, is, therefore, all that is discharged in bank notes or money, a difference much less in its amount than the several differences would be equal to. This device, which serves to spare the use of bank notes, may suggest the practicability of a great variety of contrivances for sparing the use of gold, to which men having confidence in each other would naturally resort, if we could suppose bank paper to be abolished.