The Rationale of Central Banking and the Free Banking Alternative

Chapter VI

The Development of Central Banking in Germany
*40

The history of banking in Germany, like that of the United States, should properly be considered in terms of the separate States, but it is impossible to do that here and we shall concentrate our attention on the main events in Prussia, with an occasional reference to the policy of other States. The setting in Germany is dissimilar to that in the other countries we have so far considered, for the reason that Germany at no time adopted true
laisser-faire principles in her commercial policy, and therefore it is less surprising to find State intervention in banking in this country than in any other.

The longer retention of mediaeval restrictions on the free circulation of goods and services witnessed a corresponding lag in the development of banking.
*41 But a good deal of literature was written about banks in the early eighteenth century, and there was detectable in most of these writings a mercantilist idea that the setting up of banks would produce a sudden and conspicuous increase in wealth.
*42

The first steps were taken by princes and nobles who, motivated by fiscal needs, attempted to start banking before its time, before commercial conditions were ripe for it, and they consequently met with scant success at least so far as the note-issuing branch of the business was concerned. The first bank of issue to prove at all successful was the Royal Bank of Berlin, a State bank founded by Frederick the Great.
*43 It is doubtful whether even this one would have been so fortunate in these years had it not had assigned to it by law certain deposits,
*44 and been given also the management of the Exchequer funds. As it began, so it continued, throughout the whole of its existence, as a privileged institution under paternal protection and in close relations with the State. The first effects of this were witnessed in the Napoleonic Wars, when it suspended cash payments with Government sanction. The difficulties of the bank arose in the first place from the heavy loans it made to the Prussian Government, and they were later intensified by losses it suffered as a result of the Peace of Tilsit, which took away from Prussia certain Polish territories in which the bank had invested a large proportion of its deposits on mortgage. These assets were completely lost to the bank. It emerged from the war with an enormous deficit, and after the cessation of hostilities it was reorganised as a result of the war experiences and was made nominally independent of the Treasury and the Finance Minister, but its Chief remained, of course, a State official responsible to the King.

No specific prohibition existed at this time against the formation of private banks other than the obstacles that lay in the way of the establishment of joint stock organisations in all lines of business. In the ‘twenties two private banks set up in Prussia and broke the monopoly of the Royal Bank by undertaking both deposit business and note issue. These were the Berlin Kassenverein and the Pommersche Privatbank at Stettin.
*45

But this period of relative freedom came to an end in 1833, when there was a complete reversal of policy. A law of that year made the issue of all bearer notes dependent on the approval of the Government. This virtual prohibition was prompted not out of regard for the interests of the privileged Royal Bank, it must be noted, but to make way for the circulation of State paper money which had originated in the time of the Napoleonic Wars and was now to be extended. The Royal Bank itself was included in the prohibition; all three of the Prussian note-issuing banks had to give up the issue of notes. These increased restrictions on banking came almost at the very moment when changes in industrial technique were about to swell enormously the demand for credit.

About this time banks were being set up in several other States: the policy in each case was restrictive. In Bavaria the Mortgage and Exchange Bank set up in 1835
*46 was given a monopoly of the note issue, not in this case as the result of a desire to give priority to Government notes, of which there were none in Bavaria, but because of the fear that competition in the sphere of note issue would be dangerous, and in accordance with this dread of too many notes, we find a maximum limit to the note issue. A less understandable regulation was that which compelled the bank to invest at least three-fifths of its funds in land loans.

The Leipzig Bank of Saxony, founded in 1838, was not endowed with an exclusive privilege but was subjected to equally rigid restrictions. In this case the proportional reserve requirement (of two-thirds) was imposed in preference to the maximum limit on the note issue.

It was in the ‘forties that the struggle for free trade in banking became acute. In the preceding years capital had been relatively abundant and interest rates low, but about the middle of the decade a reversion set in as the result of increased capital needs for railway development, and interest rates rose. The public mind entertained exaggerated hopes as to the power of banking. It was a widespread belief that all that was necessary to relieve a scarcity of capital was an elastic note issue, and the issue of notes was still thought to possess something akin to a magic power of transforming poverty into wealth. The philosophy of the Saint Simonians, which conceived of a reformed society in which the banking system was given a central organising role in the assembly and distribution of capital, had also spread to Germany. These notions gave an impetus to two movements, the one demanding increased note issues and the other looking towards the creation of
crédit mobilier institutions.

Added to the demand for more capital, there was at this time a genuine currency difficulty. Very little gold was then in circulation, and in the absence of notes, payments had to be made in silver, which was very heavy to carry out. Notes were therefore found of very great convenience, and since they were relatively scarce, they were often sought even at a premium. There began an agitation against the repression of private initiative, and the Prussian Government was overwhelmed with schemes for the creation of private banks of issue to exist alongside the Royal Bank, all of which it strongly opposed. The demand for private initiative took two forms. One group merely wanted a private joint stock bank in place of the existing State bank; others wanted to go much further and demanded nothing less than a system of independent freely-organised competitive banks.

The Prussian Government was led out of passivity into action by the news that on one of its borders in the neighbouring state of Dessau the authorities had approved the project for a note-issuing bank which had plans for extending its activities over the border into Prussia. Although William IV commissioned Rother, the then Minister at the head of the Royal Bank, to work out a scheme for the establishment of private banks of issue, Rother dismissed the idea as being of not more than mere academic interest, and adopted the much less liberal alternative of reorganising the Royal Bank. This bank was still handicapped by lack of capital arising from the deficit left by the French Wars, and the scheme that was adopted was intended to replenish the assets of the bank and so strengthen its lending capacity. Rother certainly envisaged a State bank as the most desirable, but, probably owing to the lack of funds in the State Treasury, he fell back on the introduction of private share capital into the bank. So it was reconstituted in 1846 as the Prussian Bank, now partly controlled by private shareholders instead of wholly by the State. It was given back the right of note issue which it had formerly exercised, and its notes were gradually to replace the State paper then in circulation, but the law specified
both a maximum limit to the note issue
and a metal reserve proportion to the extent of one-third
*47 of the note circulation. The bank retained the privileges it had held as the Royal Bank, and its notes were made legal tender for public transactions. An important clause in the decree establishing the bank and characteristic of the banking notions of the period was that which stated specifically that it was its express task to prevent any great rise in the rate of interest, and it was, in fact, forbidden to raise the rate for lombard business above 6 percent.

But the extension of the note issue and the lending powers of the Prussian Bank did not suffice to quieten the agitation for greater freedom. The year 1847 was a year of very heavy demand for credit. This was especially true of the west, in the lower Rhineland and Westphalia, where industrial development was proceeding fast, and, although provision had been made in the constitution of the Prussian Bank for the establishment of branches, it had been particularly slow to develop them in these parts. Opinion in favour of private note-issuing banks became very strong, and its adherents began to hold organised discussions on the subject.
*48

The excitement of 1848 brought a sharp turn of events. The Government was persuaded to allow note-issuing powers to the Bank of Breslau and to the Chemnitzer Stadtbank; it also set up itself State loan banks in connection with the Prussian Bank; finally, it took the far more radical step of granting concessions for the creation of private note-issuing banks. But this was only a very grudging gift to the free-banking party; the concession was in each case given for a period of ten years only, and, moreover, the banks were over-regulated in the extreme. The celebrated
Normativ-Bedingungen, under which they were established, restricted the scope of their business to a minimum. Besides the stipulation that they must keep a metal reserve of one-third against their note issue, they were tied down to the smallest possible level of funds, and the lines of business in which they might engage were likewise restricted. Their paid-up capital must not exceed a certain very low figure. The maximum note issue for all the provinces together was fixed at a figure only one-third of the limit for the Prussian Bank and this total was divided equally among the provinces with no regard to their relative business needs. The banks were not allowed to have agents in other centres; they were not allowed to deal in Government securities that were not Prussian; neither could they discount bills whose acceptor lived outside the business place of the bank, and bills must be three-named; moreover, they were not allowed to pay interest on deposits, thus leaving such business entirely in the hands of the Prussian Bank. So urgent was the demand for notes, however, that the Berliner Kassenverein and the Stettin Bank
*49 immediately subjected themselves to these regulations in order to be able to exercise rights of issue.

Alongside the note issue campaign a second notion was beginning to exert an influence on the development of banking institutions in Germany. Almost as soon as the
crédit mobilier idea was first evolved in France it was taken up in Germany, and by the turn of the decade a number of joint stock banks were setting up in various parts of Germany in
crédit mobilier business. The Disconto-Gessellschaft in Berlin, the Schaffhausen’schen Bankverein in Cologne and the Darmstadter were among the most important. In Prussia it was still difficult to establish even these, since joint stock companies had to obtain special Government concession before they were allowed to go into business. So it was that the Bank für Handel und Industrie (later known as the Darmstadter) had to set up at Darmstadt because no concession could be obtained at the time either in Prussia or in Frankfurt am Main, and the Disconto-Gesellschaft was a partnership for six years before it could obtain a concession to become a joint stock concern.

The rate of progress in the setting up of note-issuing banks was slow,
*50 and did not go far to meet the demands of the Free Banking Party. Under the leadership of Harkort in the Chamber of Deputies, this party secured the institution in 1851-2 of a parliamentary enquiry into banking and credit conditions in Prussia, and via these channels it gained more public attention. On the positive side the party demanded a relaxation of the
Normativ-Bedingungen, and on the negative side it declaimed against the Prussian Bank as a half-State institution standing in the way of private enterprise. Harkort tried hard but unsuccessfully to get legislation passed for the removal of the
Normativ-Bedingungen.

Some reforms did take place in the policy of the Prussian Bank; it began to adopt a more liberal lending policy
*51 and also extended its branches in the western provinces.

In the smaller States note-issuing banks were being founded in considerable numbers, and their notes soon began to circulate just over the boundary in Prussia and Saxony. These small States issued notes for lower denominations than the Prussian Bank, and the Prussian Government sought to exclude them from its territory by forbidding payments in non-Prussian notes for sums less than 10 Rthlr. Saxony, Bavaria and Württemberg followed the same course, but the laws had no effect because the banks against whom they were aimed merely replaced their 1 Rthlr. notes by 10 Rthlr. notes.

The Prussian Government saw that the only logical solution was to increase the note issue inside Prussia. Two alternative ways of doing this were conceivable. One was to change the law relating to the foundation of private banks and the other to centralise the banking system, and give unlimited rights of note issue to the Prussian Bank. Finally a compromise was adopted. The Government gave unlimited rights of note issue to the Prussian Bank and allowed it to issue notes of low denominations in return for a financial Operation which the Government regarded as very favourable to itself, namely, the commutation of half of its State paper money into interest-bearing State debt. Secondly, concessions were made in favour of private note-issuing banks. Four more received Government sanction to set up, and certain of the clauses of the
Normativ-Bedingungen were modified so as to allow the private banks to discount two-named bills, to set up agencies, to issue small notes, and to take interest-bearing deposits. The concession regarding interest-bearing deposits was subject to the condition that the amount taken must not exceed the amount of the original capital of the bank, and that the deposits should not be callable at less than two months’ notice.

Then the crisis of 1857 occurred, and this had a marked effect on the later trend of policy. It provoked a reaction against the bank creations of the ‘fifties
*52 and brought the beginnings of a change in attitude. The Prussian Bank was accused of having kept the discount rate too low before the crisis, and one good effect that came of it was the renunciation of the limitation of the rate of interest to 6 percent. In the crisis itself the bank assumed what had come to be considered the functions of a central bank by lending freely to reputable firms who found themselves in difficulties. The unlimited right of issue of the Prussian Bank was denounced, and there was a crop of literature in favour of a 100 percent specie backing for the note issue.
*53 The small
Zettelbanken of the border States were condemned, probably justifiably in many cases, since they had attempted the impossible thing of combining
crédit mobilier business with note issue. Steps were taken to exclude their notes both in Prussia and in Saxony. The Prussian Government forbade all payments in non-Prussian bank-notes. In Saxony the prohibition of foreign notes was to apply only if the note-issuing bank had no redemption centre in Saxony. The law was in either case ineffective in preventing the circulation of foreign notes; all that happened was that the notes went to a discount because of the risk of legal punishment.

The Prussian Chamber of Deputies was by now divided into many factions over the banking question, ranging from a leaning towards full freedom for all banks to issue notes at the one extreme to a preference for complete unity in the note issue at the other. The latter was as yet unpractical because of the impossibility of keeping out the notes of the border States, and Prussia’s negotiations to obtain uniformity of policy among the separate States met with little success. The systematic discussion of the whole banking question together with the formulation of a positive programme was taken up by a private association of free traders, the
Kongress deutscher Volkswirte, foremost among whom was Dr. Otto Michaelis. The free-banking
(Bankfreiheit) party had already somewhat changed its ground.
Bankfreiheit without any State intervention was no longer so prominent and was beginning to be relegated to a position of purely academic interest. The Congress opposed the too lax regulations of the ”
wilden Banken” of the border States, but condemned the over-supervision of the
Normativ-Bedingungen. They had by this time given up all hope of ever securing freedom for private banks in note issue, and henceforth concentrated their efforts on trying to secure freedom for deposit banking, on a joint stock basis, pointing out that it was unfortunate that people persisted in regarding note issue as the chief object of banking.

The swing towards increasing freedom in the note issue was slowing up. It received practically its last acknowledgment in 1863 when certain of the restrictions on private note-issuing banks were slightly modified; they were allowed to take additional interest-bearing deposits, the limit now being twice instead of once the amount of their paid-up capital, and the period of their concession was extended from ten to fifteen years. In the Chamber of Deputies there was still a good deal of criticism of the Prussian Bank, and most especially of its unlimited right of note issue, and Michaelis was recommending the passing of a Peel’s Act for Germany.

In the south of Germany the restrictions were still very stringent. Where there was not monopoly there was complete prohibition of note issue, as was the case in Baden and Württemberg. In both these States the Governments had persistently opposed the establishment of a note-issuing bank, and it was only in the Franco-Prussian War that one was conceded for the first time.

Most forces were now operating in the direction of securing further centralisation. The 1866 crisis impressed many observers with the advantages of a strong bank which can give liberal accommodation in a crisis. The continual consolidation of political authorities helped to widen the area over which a common policy could be pursued. Prussia acquired new territories after the war of 1866 to which the business of the Prussian Bank was extended, and the
Norddeutscher Bund in 1870 gained control over banking legislation in all the member States. A reform of the law relating to joint stock companies freed them from the obligation to obtain authoritative concession, and this at last opened the way to the establishment of non-note-issuing banks, which was all that the free-banking party now demanded. The final impulse to the adoption of central banking was given to Germany’s experiences in the first years of her operation of the gold standard.

At the formation of the Reich in 1871 the laws of the
Norddeutscher Bund were extended to the whole of German territory and a uniform currency was established for the first time; it was based on the gold standard, and the payment of the French indemnity provided an easy opportunity for accumulating the necessary reserves.

As early as 1873 a crisis occurred, however. The note issues of those banks which had had no maximum limit or which had never previously reached their limit had risen very rapidly after 1871, and this was especially true of the Prussian Bank. When the French indemnity stopped, the exchanges went against Germany, and gold started to flow out. Germany had had very little experience of external specie flows, because when silver had been the standard it had been very expensive to collect specie and export it, and the specie points had therefore been very wide. Neither were the Germans familiar with the effect of a gold flow in rectifying the exchanges, and the immediate consequences of the first gold exports was a scare that all the gold was going out and that Germany would be off the gold standard. The undue alarm that thus arose had an important influence on bank policy. It brought in the first place a sudden realisation of the uses of discount policy. German opinion had been very much influenced by English events, and especially by Peel’s Act, and following on English doctrine, it was believed that in order to manipulate a discount policy it was necessary to have a specially constituted central bank, which would be responsible for controlling specie flows.

These ideas were embodied in the German Bank of 1875.
*54 The Act was closely modelled on the English Act of 1844, but far more statutory requirements were imposed. The position of the private note banks was as follows: Thirty-three note-issuing banks were recognised for the whole of the Reich and no new ones might be established. The fiduciary issues of all the banks, including the Reichsbank, were given a legal maximum, and a reserve proportion of one-third against their total note issue was also imposed. If any bank relinquished its issue, the Reichsbank was to acquire an addition to the same amount to its legal fiduciary issue. Submission to the terms of the Act involved disabilities, however, in the form of a restriction on certain types of business. Thus, if banks wanted to continue to issue notes they must not engage in acceptance business; they might trade only in certain classes of bonds, must not engage in mortgage business, and could not discount bills having more than three months to run.

The Reichsbank was constituted out of the old Prussian Bank, which was turned into a wholly privately owned concern, but retained the official administration with still very little control left in the hands of the shareholders; it was consequently considerably less independent of Government control than the Bank of England. The business of the Reichsbank was restricted to certain lines: discount and lombard business was subject to the same limitations as in the case of the private banks, and the taking of interest-bearing deposits was permissible only up to a fixed sum. The notes of the Reichsbank were not made legal tender, but they were given much wider circulation than the notes of private banks, in that, whereas a private bank might not pay out notes of any other private bank except to the issuing bank or for payment to the place wherein the issuing bank was situated, notes of the Reichsbank might be paid out by the receiving bank without restriction.

A private note-issuing bank was allowed to stay out from the provisions of the Act, but if it did this it was to have its operations restricted to the territory of the State which gave it its right of note issue.

The provisions of this Act secured to the Reichsbank the position of a modern central bank.