Front Page Titles (by Subject) Sect. V.—: Paper Money. Principle on which its Value is Maintained. - Treatises and Essays on Subjects connected with Economic Policy with Biographical Sketches of Quesnay, Adam Smith & Ricardo
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Sect. V.—: Paper Money. Principle on which its Value is Maintained. - John Ramsay McCulloch, Treatises and Essays on Subjects connected with Economic Policy with Biographical Sketches of Quesnay, Adam Smith & Ricardo 
Treatises and Essays on Subjects connected with Economic Policy with Biographical Sketches of Quesnay, Adam Smith & Ricardo (Edinburgh: Adam and Charles Black, 1853).
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Paper Money. Principle on which its Value is Maintained.
In the earliest periods, subsequent to the invention of writing, the pecuniary engagements of individuals would be written on some sort of material. This secures alike the debtors and creditors; and obviates most part of the differences which are so very apt to arise when the terms of contracts are not distinctly specified. But a very short time only would elapse before individuals, having the written obligations of others in a portable form, would begin to transfer them to their debtors. And, after the advantages derivable from their employment in this way had been ascertained, it was an obvious source of emolument for persons, in whose wealth and discretion the public had confidence, to issue their obligations to pay certain sums, in such a form as might fit them for performing the functions of a circulating medium. None would refuse to accept as money the promissory notes or obligations of individuals of large fortune, and of whose solvency no doubt could be entertained. And as full value must be originally given for these notes, it is clear that, whilst their continuance in circulation is no loss to the public, it is a source of profit to the issuers.
Suppose, for example, that a merchant issues a promissory note for £1,000: Previously to putting it in circulation, he will have received an equivalent in money, or in some sort of produce; or, which is by far the most common case, he will have advanced it to an individual who has given him security for its repayment with interest. In point of fact, therefore, the issuer has exchanged his promise to pay £1,000 for the interest to be derived from a real capital of that amount; and so long as the promissory note, the intrinsic worth of which cannot well exceed a sixpence, remains in circulation, he will, supposing interest to be 5 per cent., receive from it a revenue of £50 a-year. The business of bankers who issue notes is conducted on this principle. They could make no profit were they obliged to keep dead stock or bullion in their coffers, equal to the amount of their notes in circulation. But if they be in good credit, a fourth or a fifth part of this sum will perhaps be sufficient; and their profits, after the expenses of their establishments, including the manufacture of their notes, are deducted, will be measured by the excess of the profit derived from their notes in circulation, over what they might derive from the employment of the stock kept in their coffers to meet the demands of the public. “A bank would never be established, if it obtained no other profits but those derived from the employment of its own capital: its real advantage commences only when it employs the capital of others.”1
No means having been devised to limit the supply of promissory notes issued by private individuals, their value, it is plain, could not be maintained if the issuers fell into discredit, or were relieved from their promise to pay them. But it is otherwise with promissory notes issued by the state, or by a company acting under its control. The quantity of such notes may be effectually limited. And we have seen that, when this is the case, intrinsic worth is not necessary to a currency, and that, by properly regulating the supply of paper declared to be legal tender, its value may be sustained on a par with gold or any other commodity.
A limitation of this sort sustained Bank of England paper at a variable value in the interval between the passing of the restriction act in 1797, and the resumption of bullion payments in 1820. And no rational explanation of this phenomenon, which is entirely at variance with the old theories of paper money, can be given on any other principle. The fact of their being more or less depreciated creates no indisposition on the part of the public to apply to banks whose notes are legal tender. Applicants for loans are indifferent whether the issuers of paper have, by issuing in excess, depressed its value relatively to gold, or whether they have restricted the supply so as to keep it on a level with that metal. These circumstances affect those whose incomes do not vary with variations in the value of money; but, inasmuch as prices rise and fall with its increase or diminution, they have little influence over merchants, who are the principal demanders of discounts. The presenter of a bill for £500 or £1,000 to a bank, has received it, if it have arisen out of a real commercial transaction, in lieu of goods which, at the then value of money, were worth £500 or £1,000; and it is this sum which, by presenting the bill to the bank, he wishes to obtain. If the value of money had been different, the price of the goods, and consequently the sum in the bill, would also have been different. It is to this market value of money at the time, that attention is exclusively paid in commercial transactions. When Bank of England paper was depressed through excess, in 1809-1814, from 10 to 25 per cent. below the value of bullion, the circumstance of its being enacted, that it should be paid in cash at the restoration of peace, had as little effect in raising its value, as its depreciation had in diminishing the applicants for discounts. The truth is, that individuals never resort to a bank for paper money, unless they have immediate occasion for it. As soon as it has been obtained, they throw it upon the market, for whatever it will bring. And as they purchased it on the same terms (for the value of money is hardly ever sensibly affected in the interval between the discount of a bill and the period when it becomes due), they generally get as much for it, and perhaps more, than it cost. We shall immediately explain what constitutes the natural limit to applications for discounts; but enough has been said to show, that it has nothing to do with the convertibility of notes into cash.
Those who offer accommodation bills for discount, like those who offer real bills, consider only the present value of money. They immediately employ the proceeds in the purchase of commodities or services, or in the payment of debts; and whether one pound notes be worth 10s. or 20s. is of no consequence to them, inasmuch as the amount of the bill is regulated accordingly.
That country bank notes cease to circulate as soon as any suspicion is entertained of the solvency of their issuers, is nowise inconsistent with these statements. They bear to be exchangeable, at the pleasure of the holder, for Bank of England notes. But from the restriction in 1797 down to 1820, the latter not being exchangeable for anything else, took the place of coin, and became the standard of value. Hence, when a country bank lost credit, the circulation of its notes was stopped, from its being believed that it would be impossible to obtain Bank of England paper in their stead; or, in other words, that they would not exchange for that description of paper which constituted the real medium of exchange. But it is impossible that this paper should itself be affected by a want of credit. Every one knew that it had no intrinsic worth. And, as already shown, its value was regulated (and must, whenever it is not made exchangeable for a given quantity of some other commodity, continue to be regulated) by the amount in circulation.
It appears, therefore, that if there were perfect security, that the power of issuing paper money would not be abused; that is, if there were perfect security for its being issued in such quantities, as to preserve its value relatively to the mass of circulating commodities nearly equal, the precious metals might be dispensed with, not only as a circulating medium, or marchandise banale, but also as a standard to which to refer the value of paper.
Unfortunately, however, no such security can be given. This is a point respecting which there can be no difference of opinion. The history of this and all other countries, shows that the power of making unrestricted issues of paper money has never been entrusted to any man, or set of men, without being abused; that is, without its being issued in inordinate quantities. If a private banking company have power to supply the state with paper, to suppose that they should exert themselves to sustain its value on a par with gold, by carefully limiting their issues, would be equivalent to the not very reasonable supposition, that they should be attentive only to the public interests, and have little or no care of their own private advantage. The re-enactment of the restriction act, would have no influence over the value of paper, provided its quantity were not at the same time increased. But who can doubt that, in such circumstances, it would be increased? Such a measure would enable the Bank of England to exchange bits of engraved paper, not worth perhaps five shillings a-quire, for as many, or the value of as many, hundreds of thousands of pounds. And is it to be supposed, that the directors and proprietors should not avail themselves of such an opportunity to amass wealth and riches? If government enable a private gentleman to exchange a scrap of paper for an estate, will he be deterred from doing so by any considerations about its effect on the value of the currency? In Utopia we might, perhaps, meet with an individual influenced by such scruples, but if we expect to find him in England, we shall most likely be disappointed. It is quite essential that the issuers of paper money should be placed under some check or control. And the comparatively steady value of the precious metals, at once suggests that none can be so effectual as to lay them under the obligation of exchanging their notes, at the pleasure of the holders, for given and unvarying quantities of gold or silver.
It has, however, been contended, that there is a material difference between paper issued by government in payment of its debts, and that which is issued by private banking companies in discount of good bills. In regard to the former, it is admitted on all hands that it may be issued in excess; but in regard to the latter, it has been strenuously urged that “notes issued only in proportion to the demand, in exchange for good and convertible securities, payable at specific periods, cannot occasion any excess of the circulation, or any depreciation.” As all the statements advanced by those who argued that our paper currency was not depreciated between 1797 and 1819, involve this principle, it may be worth while to examine it a little minutely.
In the first place, it may be observed, that the demand for discounts does not depend on the nature of the security required for their repayment, but on the rate of interest for which they may be obtained, compared with the ordinary rate of profit made by their employment. If an individual can borrow £1,000, £10,000, or any greater sum, at 3, 4, or 5 per cent., and if he can realise 4, 5, or 6 per cent., or upwards, by its employment, it is evidently for his interest, and it would be for the interest of every other person similarly situated, to borrow to an unlimited extent. And banking companies, relieved from all obligation to pay their notes in cash, and not, of course, obliged to keep any unproductive stock or bullion in their coffers, would be able to issue their notes at the lowest possible rate of interest; and the demand for their paper would, therefore, be proportionally great.
“The interest of money,” says Mr Ricardo, “is not regulated by the rate at which the Bank of England will lend, whether it be 5, 4, or 3 per cent., but by the rate of profit which can be made by the employment of capital, and which is totally independent of the quantity or of the value of money. Whether the bank lent one million, ten millions, or a hundred millions, they would not permanently alter the market rate of interest; they would alter only the value of the money which they thus issued. In one case, ten or twenty times more money might be required to carry on the same business than what might be required in the other. The applications to the bank for money, then, depend on the comparison between the rate of profit that may be made by the employment of it, and the rate at which they are willing to lend it. If they charge less than the market rate of interest, there is no amount of money which they might not lend; if they charge more than that rate, none but prodigals and spendthrifts would be found to borrow of them. We accordingly find, that when the market rate of interest exceeds the rate of 5 per cent., at which the bank uniformly lends, the discount office is besieged with applicants for money; and, on the contrary, when the market rate is even temporarily under 5 per cent., the clerks of that office have no employment.”1
From 1809 to 1815 inclusive, the period in which the value of paper relatively to gold was lowest, the market rate of interest considerably exceeded the rate of 5 per cent., which was then charged by the Bank of England and most country banks. Although, therefore, the amount of paper currency had, in that interval, been very much increased, the applicants for fresh discounts continued as numerous as ever. And had the Bank directors not been apprehensive that, ultimately, they might have to pay their notes in specie, there can be little doubt that the numbers of them in circulation would have been materially greater. Such, at least, would have been the case, had the directors acted to the full extent of their avowed opinion, that it was impossible to reduce the value of paper, by engrossing into the circulation such quantities as were issued in discount of good bills. The wants of commerce are altogether insatiable. Inconvertible paper money, provided the rate of interest at which bills are discounted be less than the market rate, can never be too abundant. As long as this is the case, million after million may be thrown upon the market. The value of the currency may be so reduced as to require a one pound note to purchase a quartern loaf; but the circumstance of its value being diminished in proportion to the increase of its quantity, would render the demand for additional supplies as great as ever.
Were the Bank of England in possession of a process whereby she could produce sovereigns with the same facility as notes, there could be no question that she might depreciate the value of gold, by making large issues of what was produced at so very little cost. Now, in what respect would this fictitious case differ from the real situation of the Bank, were the restriction act renewed and made perpetual? She would then be able, without let or hindrance, to exchange paper for landed property, manufactured goods, government securities, etc. But we have seen that the value of this paper, like the value of gold in the hypothetical case, depends entirely on the proportion which the supply bears to the demand. And as the demand is not affected by an increase of quantity—for that increase, by diminishing its value, renders the larger quantity of as little efficacy as the smaller—it is abundantly clear, provided the Bank lent at a sufficiently low rate of interest, that there could be no limit to her issues.
On the whole, therefore, whether the power to issue paper be vested in a private company or in government, it is plain, it should be placed under some efficient control, such as the obligation to pay in gold or silver. It is easy to discover the manner in which a check of this kind limits the issue of paper and sustains its value. Whenever the Bank has issued so much paper as to sink its value relatively to bullion, its notes begin to return upon it, to be exchanged for a higher value; and the Bank is obliged, to prevent the exhaustion of its coffers, to contract its issues, and raise its paper to a level with gold. An extremely small profit, or an extremely small depreciation of paper, as compared with gold or silver, is sufficient to make the holders of bank paper send it to be exchanged for these metals; and hence the value of bank notes, convertible at pleasure into an unvarying quantity of gold or silver, can never differ considerably from its value. The issues of the Bank of England were, for more than a century previously to 1797, limited in the manner now explained; and, during that whole period, they were hardly ever depreciated ¼ per cent., and never more than 2 per cent., and that but for a few days only.
But though it be thus necessary to avert injurious fluctuations in the value of paper, that it should be made exchangeable at the pleasure of the holder for gold or silver, it is not essential to this end that it should be made exchangeable for gold or silver coins. Previously to the resumption of specie payments by the Bank of England in 1821, she was obliged to give bars of assayed bullion in exchange for notes, according to a plan suggested by Mr Ricardo. And there can be no doubt that this obligation would have sustained the value of paper quite as effectually as it is sustained by the obligation to pay in coin of the legal weight and purity, at the same time that it would have saved the greater part of the heavy expense occasioned by the use of metallic money. But, how important soever, these were not the only considerations that had to be attended to. The discovery of means for the prevention, or at least diminution, of the forgery to which the substitution of notes for guineas had given rise, was indispensable to the maintenance of Mr Ricardo’s plan; and, notwithstanding all the efforts that have been made, this desideratum has not yet been supplied. Forgery in the larger description of notes, or in those for £5 and upwards, may, with due precaution, be prevented from becoming injuriously prevalent. But low notes, or those of the value of £1 or £2, having to circulate amongst the labouring classes, and in immense numbers, present facilities for the issue of spurious paper, which it has been found impossible materially to diminish. Hence, in 1821, the plan of paying in bars of bullion was abandoned, and the Bank of England recommenced paying in specie.
[1 ] Ricardo, “Proposals for an Economical and Secure Currency,” p. 87.
[1 ] Principles of Political Economy, p. 511.