The Rationale of Central Banking and the Free Banking Alternative
By Vera C. Smith
The Rationale of Central Banking invites us to reassess our monetary institutions and give reform proposals due consideration. The decades since it first appeared in 1936 have restored its themes to relevance. Government-dominated monetary systems have continued to perform poorly. Other experience, as well as the work of James Buchanan and the Public Choice School, has heightened skepticism about government generally. People are now willing to discuss what Vera Smith set out to examine: “the relative merits of a centralized monopolistic banking system and a system of competitive banks all possessing equal rights to trade” (p. 3)…. [From the Preface, by Leland B. Yeager]
First Pub. Date
Indianapolis, IN: Liberty Fund, Inc. Liberty Press
The text of this edition is under copyright.
The Development of Central Banking in France
The unfortunate first experiences of note issues in France retarded banking development in that country for many years. The monopoly given to John Law in 1716 for his
Banque Générale resulted in a disastrous over-issue of paper, and the bank closed after five years. The Government thereafter raised the restrictions on the formation of note-issuing banks, but although firms set up to carry on other branches of banking business, chiefly discounting and exchange transactions, no bank of issue was founded before 1776. This was the
Caisse d’Escornpte, a partnership with limited liability, founded by Turgot, the French Minister of Finance. From the very beginning this bank came into very close relations with the State, and became, in fact, practically a branch of the financial department of the Government. The promise of an advance of 6,000,000 frs. to the Treasury in 1783 caused a “run” on the bank and it suspended payments. The exigencies of the State finances, already heavily in debt to the Caisse, resulted in the giving of forced currency to its notes in 1788, and after this followed the
assignat régime. The first assignats, issued in 1789, which were not themselves legal tender but short-dated interest-bearing Government bonds, backed by the
biens nationaux, were usually discounted with the Caisse. But in 1790 the assignats became legal tender currency. France was flooded with them and the Caisse collapsed, leaving behind it a distrust of paper money which was to be widespread and long-lived.
A decree of 1792 had forbidden the establishment of banks of issue, but the abrogation of this decree and the restoration of the ordinary currency in 1796-97 encouraged some of the Paris discount banks to undertake the issue of notes. Chief among these were the
Caisse des Comptes Courants and the
Caisse d’Escompte du Commerce. A new development took place in 1798 when a bank of issue was set up in the provinces, namely, at Rouen. This bank took the step of issuing notes as small as 100 frs. The Paris banks had not been in the habit of issuing notes for less than 250 frs. The freedom prevailing at this time in banking in France seems to have proved very satisfactory, and no disasters occurred, but the march of political events destined this state of affairs for a short existence.
Napoleon’s mania for centralisation and his difficulty in getting Government paper discounted, chiefly owing to the lack of confidence in that Government, turned his attention to the potentialities of a bank founded under Government auspices. So in 1800 he persuaded the stockholders in the
Caisse des Comptes Courants to dissolve the company and merge it into a new bank, called the Bank of France. The Bank was financed with an initial capital of 36,000,000 frs., obtained partly from the original capital of the
Caisse des Comptes Courants, partly by new subscription by the public and partly from Government funds, obtained from the sinking fund of the national debt. Soon after the foundation of the Bank the Government sold out a large part of its shares, but the independence of the Bank was not thereby much increased. Further negotiations, and manipulations, largely quite unscrupulous, were undertaken in 1802, as a final result of which the
Caisse d’Escompte du Commerce was unwillingly induced to fuse with the Bank of France.
The most severe blow to competition came a year later, however, when the Government, by the famous
loi du 24 Germinal an XI, granted to the Bank of France the exclusive privilege of issuing notes in Paris, ordered those Paris banks already issuing notes to withdraw them by a certain date, and forbade the Organisation of any bank of issue in the provinces except by the consent of the Government, which reserved the right not only to grant all privileges of issue but also to fix the maximum of such issue. The pretext for this piece of legislation was the slight financial crisis in 1802, but, in fact, nobody had brought any accusation against the competitive banks.
From the outset the Bank of France was under continuous pressure from Napoleon. As early as 1804 a dispute arose between them because the Bank was not discounting Government paper cheaply enough. Under this pressure the Bank discounted too much and issued more notes than it had the specie to maintain. This over-issue, together with the spread of a rumour to the effect that Napoleon had sent away the metallic reserves of the Bank to Germany for military needs, saw the Bank in serious difficulties in the following year. It had partially to suspend payment and its notes depreciated 10 percent to 15 percent. For this Napoleon laid the blame on the Bank and determined to bring its constitution more under the Government. So in 1806 he gave the State a larger share in the Bank’s administration by replacing the Committee elected by the stockholders by a Governor and two deputy-Governors appointed by the head of the State.
Further heavy loans to the Treasury in 1813 caused another partial suspension of cash payments in the next year. This gave impetus to a good deal of criticism and to a movement of opinion in favour of making the Bank independent of the Government, but nothing came of this proposal.
It soon became apparent that France was extremely backward, as compared with England and America, in the development of banking facilities; particularly slow was the pace at which they grew in the provinces where, so far, and apart from small firms specialising on exchange business, they were practically non-existent. Special authority had been given to the Bank of France in 1808 to set up branches, and in those towns where it established them it was to have exclusive rights of issue. It set up its first branch offices in Lyons, Rouen and Lille, but they were all closed down after a very brief existence, because they had proved unprofitable in the difficult years in which they had begun, and it was also argued in favour of their suppression that their demands might, in periods of tight credit, encroach on the reserve of the central bank in Paris.
Almost immediately on the abandonment by the Bank of France of the attempt to establish credit facilities outside Paris, there was a short period of increasing liberalism, during which three projects were sanctioned by the Government of the Restoration for the establishment of private departmental banks of issue. These were the Banks of Rouen, Nantes and Bordeaux, formed in 1817-18. But these banks were subjected to severe restrictions, which were of a nature to defeat any great expansion of their business. They had the right to issue notes only for their headquarters and one or two other towns mentioned in their statutes; they could only discount bills payable in their own district; and their sight liabilities might not exceed three times the amount of their metallic reserves. The restrictions of their operations to such narrow districts and their inability to set up branches or employ agents almost belied the title “Departmental.” Their sphere of operations was infinitely smaller than the
département, and they were, in fact, merely small local banks. Nevertheless, six additional departmental banks were founded between 1835 and 1838, and the Bank of France, now taking fright at the threat of a competing banking interest, began itself to organise branch offices, fifteen of which were started between 1841 and 1848. Each branch the Bank opened was of course given a monopoly of the note issue in its own town. Moreover,
Comptoirs of the Bank of France required for their authorisation only an
ordonnance royale, which would be granted on the recommendation of the
Conseil Générale de 1a Banque, whereas departmental banks after 1840 had to obtain a special Act of Parliament. Also the greater area over which the
Comptoir as a member of a branch system could conduct business gave it a great advantage over the departmental bank. There never even developed among the departmental banks any system of exchange of notes: nevertheless, the success of these banks and the services they rendered to the community were far from insignificant. They met with the disapproval of the Bank of France and after 1840 the Government refused to grant any more charters for their foundation. So the movement towards greater freedom in the note-issuing business was brought to an end. The representations of the departmental banks to the Chamber of Deputies, on the occasion of the discussions of the renewal of the charter of the Bank of France, asking for modifications of their statutes in the direction of removing some of the restrictions they contained, were also unsuccessful.
The trend of policy towards complete centralisation of the note issue reached its logical conclusion as a result of the 1848 political disturbances, but the opposition voiced by the Bank of France to the renewal of the charter of the Bank of Bordeaux in that year makes it practically certain that the departmental banks would in any case not have survived after the expiration of their charter rights.
The 1848 political crisis foreshadowed in many people’s minds a repetition of the
assignat regime, and their first instinct was to hoard specie, with the inevitable consequence of a run on the banks. The Government was naturally interested in preserving the capacity of the Bank of France to give it financial support in dealing with the insurgents. It therefore gave to the Bank’s notes
cours forcé and allowed it to issue notes for 100 frs.,
*21 at the same time imposing what it regarded as a safeguard against excessive issues by putting a maximum limit of 350,000,000 frs. on its note issue. The departmental banks were, it is true, given what were nominally the same facilities, and their notes subjected to a maximum limit which amounted to 102,000,000 frs. for all nine banks together, but since their notes were made legal tender only within their own respective localities, while the notes of the Bank of France were legal tender all over France, the circulation of the Bank of France gained an overwhelming ascendancy over that of the departmental banks. The 1848 decree was consequently their ruin rather than their salvation, and in the same year they agreed to submit to a fusion with the Bank of France, practically the only course that remained open to them short of liquidation. Thus by two Government decrees they became
Comptoirs of the Bank of France, which acquired their authorised note issues as an addition to its legal maximum.
The events of the period immediately following 1848 throw light also on the subordination of the Bank to the will of the Treasury. Up to the decree to which we referred above, the Government had never imposed any limitation on the amount of the note issue. It had been content to rely, on the Bank’s obligation to pay specie on demand, and on a prohibition of small notes. Now that both these checks were gone, it did, as we have seen, impose a limit, but this the Government showed itself ever ready to raise if it should form any obstacle to the Bank’s readiness to lend to the Treasury. The difficulties of the Bank of France in meeting its obligations in cash, which had been the avowed reason for legalising its bankruptcy, had, so far as its private commercial obligations were concerned, been of very short duration, and it showed itself ready at an early date to revert to cash payments. But the scale at which Government borrowings at the Bank continued made its position unstable. In June, 1848, and again in November, 1849, the Government had arrived at agreements with the Bank by which the latter was to make regular advances of fixed sums during the succeeding two or three years. At the end of 1849 the Bank had received permission to increase its issue to 525,000,000 frs. By this time, however, it had a very strong metal reserve (about 400,000,000 frs.), and it had already begun suppressing the restrictive measures relating to the redemption of its notes, and it would probably have decided in favour of a complete resumption of cash payments much earlier if it had not been for the Government borrowing factor. If Treasury demands were going to continue at the same rate, the Bank believed its cash reserve would be inadequate. On the other hand, its note issue very soon approached the new maximum, and the Bank was faced with the choice either of applying for a further increase of its legalised circulation or of reverting to its old statutes under which it would be obliged to redeem its notes and
cours forcé would be abolished, but there would be no legal limitation on the total volume of notes it was allowed to issue. It was only after an agreement had been reached with the Treasury for the reduction of the Bank’s obligations to lend, that the Bank felt safe in reverting to its old statutes, and this it finally did in August, 1850.
We have seen how France emerged from the 1848 political crisis with a completely centralised, single, monopoly bank of issue. The progress of the industrial revolution in France round about 1850 brought into greater prominence the extreme paucity of credit facilities, most especially in the provinces, but even in Paris itself. Where facilities for the spread of a paper circulation had been withheld there was a corresponding absence of deposit banking, and the contrast was particularly strong with England where the country bankers with local connections and knowledge, even if they had rendered no other service, had at least accustomed the timid provincial mind to banking habits. Courcelle-Seneuil, especially, stressed the practical impossibility in the rural districts of France of either borrowing or lending, except through the local
notaire. Moreover, as he also pointed out,
*22 the fact that the farmers received the proceeds of the sales of their crops and stocks in lump sums at a particular time in the year and had to make their disbursements much more slowly over a much longer period meant that they were in possession of balances of spare cash for the greater part of the year. These balances could have been deposited in the banks and used to make short-term loans if there had been local banks to deal with the business. As it was, the balances simply went into hoards, and savings were not used.
We have now described the features which set the stage for the opening of the free-banking controversy in France. In addition, less commendable but nevertheless very powerful grounds were provided by the gradual emergence during the next two decades of the beginnings of a discount policy, the occasional stringency of which evoked a torrent of criticism against the Bank of France. This particular aspect of the discussion is explained by a conception of the nature and object of banking which had its origins in the very earliest days of French banking. Right from the beginning the Government had imposed limitations on the flexibility of discount rate. In the case of the
Caisse d’Escompte it was forbidden to charge more than 4 percent. The rate of discount of the Bank of France was fixed provisionally by the Government at 6 percent, and for the first six years it was held invariable at that figure, until in 1806 it was reduced to 5 percent. Discount policy in these years was primarily conditioned by the claims of Napoleon. It was his idea that the aim of the Bank of France must be to discount for all commercial firms of reasonable standing at 4 percent, and he criticised the Bank for not being liberal enough, and it was at his instance that the rate was reduced to 4 percent in 1807. It was not changed again until 1814, when it was raised to 5 percent. It seems to have been the policy of the Bank to maintain as far as possible a
stable rate, for it was sticky in both directions, and when the Bank found it necessary to extend or to contract credit, it would adopt almost any conceivable means of doing so other than that of adjusting
*23 the price it charged for its loans. In 1819 it adopted for some months the policy of charging a lower rate (4 percent) on bills of short date (having less than thirty days to run) before it finally decided to reduce all rates to 4 percent. In times of strain it kept the rate of interest constant and resorted to rationing, or to the purchase of specie at a premium, in order to strengthen its reserve. It was for the first time in 1847 that it discovered the effectiveness of a rise in the rate in stemming a drain of cash. It had already relowered its rate when the 1848 crisis brought another shock, and it was still too much afraid of using the weapon of discount rate to combat it. It continued throughout the year to discount at 4 percent, while the departmental banks, which were less able to bear the strain, were charging 6 percent. The reduction of the rate in 1852 to 3 percent brought to an end a period of just over thirty years, during which, with the sole exception of 1847, its rate of discount had remained unchanged at 4 percent. This is in striking contrast to the practice of the Bank of England, whose rate was changed no less than fifty times between September, 1844, and December, 1856.
From the ‘fifties onwards the French rate began, however, to fluctuate more frequently. The greater willingness to change the rate was probably strengthened by the greater need to do so, arising with the increased mobility of specie due to improved transport facilities and communications, which made arbitrage operations much easier. Also, perhaps, some allowance should be made for the beginnings of the activities of the
Crédit Mobilier in the direction of capital export. Anyhow, a strong tendency to an outflow of specie set in between 1855 and 1857, culminating with the crisis of that year. The Bank was at first hesitant about raising bank rate, and in the autumn of 1856 the Governor asked the Emperor to sanction a suspension of cash payments. This the Emperor refused and the Bank next reverted to the practice of imposing a limit (two months) on the
échéance of bills it was prepared to discount. Finally in 1857 it gave definite recognition to the principle of raising bank rate when there is a drain on the specie reserve, and in that year the Usury Laws prohibiting a rate above 6 percent were abrogated so far as the Bank of France was concerned. But even so, the Bank still relied partly on the method of charging higher rates on the longer-dated bills. In 1861 the rate was held for some weeks at 7 percent, and from that time onwards it fluctuated much more violently than heretofore, and began to oscillate more or less in harmony with the Bank of England rate.
In England the doctrine of bank rate was now fairly generally accepted, largely owing to the writings of MacLeod. But in France it provoked the first big attack on the Bank, and a corresponding demand in some quarters for permission to establish other banks of issue. Many of the adherents of this view pointed out that the charter by which the Bank of France was granted its privilege did not prevent the establishment in France of other banks of issue, that it was a monopoly not by law but in fact only and that the Government was free to give rights to other institutions in places not occupied by the Bank.
Increased practical significance was given to the discussion by incidents arising out of the annexation of Savoy in 1864, and it was around the Bank of Savoy controversy that the more general question came to be focussed. Not the least disinterested and perhaps the most prominent among the participants in the discussion were the Pereire brothers, founders of the new type of credit institution known as the
Crédit Mobilier. This was a bank which carried out underwriting, the marketing of bonds and equities, and even direct subscription to the newly issued capital of industrial companies, as well as to State loans. The founders had projects for setting up similar institutions in other countries. This they failed to do directly, although the French
Crédit Mobilier was imitated independently in Germany. The Pereire brothers had from the outset always hoped to add to their other financial business the business of note issue; this was incidentally a combination that had exceedingly little chance of success, as was proved by German experiences. Investments which consist for the most part of industrial securities and which are difficult to sell in certain states of the market except at heavy loss prove very dangerous assets to hold against liabilities of the very shortest term, viz., notes payable on demand. The Pereires, however, saw no possibility of obtaining note-issuing rights until the rights of the Bank of Savoy came up for discussion and reopened the whole question of free trade in banking
versus the monopoly of the Bank of France.
The treaties accompanying the annexation of Savoy established that individuals and institutions belonging to Savoy should be allowed to exercise the same rights in France as they had held under the law of Savoy, and the Bank of Savoy concluded from this that it had the right to establish branches over the whole of France and to issue notes payable on demand. It was here that the
Crédit Mobilier saw its chance. It concluded an agreement with the Bank of Savoy by which the Pereires were, by their own subscription, to raise a capital of the bank to ten times its present amount and gain a controlling influence in the concern. The Bank of France was much alarmed at the prospect of having the Bank of Savoy as a competitor, especially as certain features of the Bank of Savoy’s business were likely to make it a keen rival. The Bank of Savoy paid interest to depositors, issued notes for as low a denomination as 20 frs., and could discount two-named paper, whereas the Bank of France paid no interest on deposits and had not as yet issued notes for less than 100 frs.,
*24 and could only discount three-named bills. The Bank of France made a protest on the plea of the Government’s contractual obligation to maintain its privilege, and obtained from the Minister of Finance a letter signifying the Government’s opposition to the Pereire agreement with the Bank of Savoy, and then entered itself into negotiations with that Bank, as a consequence of which the latter agreed to renounce its claims to issue notes in return for an indemnity.
This incident, together with the raising of the discount rate to 8 percent in 1864, directed the attention of many people to the hitherto rather neglected subject of the theory of the money market. Its immediate effect was to produce a demand for the appointment of a Commission to enquire into the policy of the Bank of France. Isaac Pereire wrote a pamphlet demanding such an enquiry, and the Emperor received a petition from 300 Paris merchants also demanding an investigation, on the grounds that the raising of the discount rate by the Bank of France had led to the periodic return of crises. Finally the Bank itself suggested that these demands should be satisfied, so that its position, in face of the attacks that were being made against it, might be elucidated.
The direction of the enquiry was undertaken by the
Conseil Supérieur du Commerce de l’Agriculture et de l’Industrie. The discussions opened in February, 1865, and did not finish until June, 1866, by which time much of the earlier enthusiasm had died down. The problems raised for discussion were primarily two: firstly, whether the Bank’s new policy of raising its discount rate in times of strain was preferable to its old policy of maintaining its rate invariable, and, secondly, whether a single bank of issue was superior to a plural system of competing banks. Evidence was taken from practically all those having any competence to speak on the subject. The results showed a verdict of the majority on both issues in favour of the Bank of France.
This may be taken to mark the close of the discussion so far as the practical issue was concerned, but among the more academic writers it continued for several years longer, until it was superseded at the beginning of the ‘seventies by the bimetallic question. It was a strange coincidence that the
Crédit Mobilier, the chief engineer of the accusation against the Bank of France, should almost at the very moment of the Bank’s acquittal find itself in serious difficulties, which were to lead to its going into liquidation only a year later.
At the same time as France was consolidating her centralised system, the trend in neighbouring countries was in the same direction. In Holland the debates in 1863 on the proposal to replace the monopoly of the Netherlands Bank by free trade in the issue of notes had resulted in a decision in favour of the retention of the monopoly. In Italy increased centralisation of the note issue was proceeding
pari passu with political unification.
(a) to be allowed to discount paper payable not only in their own town, but also in any town having a bank;
(b) to be able to discount bills having two signatures only, the present requirement being three;
(c) to be authorised to issue notes for 100 frs.
Comptoirs in the provinces it could, like the departmental banks, issue them for as low as 250 frs. In 1847 the same minimum denomination was made to apply to Paris, where provincial notes for that amount had in any case been circulating previously.