Have been reading Fragile by Design: The Political Origins of Banking Crises and Scarce Credit by Charles Calomiris and Stephen Haber. It is an excellent, and highly readable, history of banking: slides from a presentation explaining the basic thesis of the book are here (pdf). The information in the book also explains a puzzle of economic history.
Technologically, the key inventions of that set off the Industrial Revolution occurred in the later C18th. Yet, as a mass economic phenomenon, the Industrial Revolution does not really start until the 1820s. The banking history set out in Fragile by Design–that English industry was starved of credit–explains why.
Plentiful public credit
The Bank of England (BoE) was set up in 1694, to be the Crown’s banker, remaining privately owned until 1946. Its role, in return for various privileges, was primarily to help the British state finance the “second hundred years war” (1689-1815) with France, which it did with brilliant success. Britain was able to spend its rival into the ground.
The BoE’s role was not to provide general private credit. In fact, the bargain struck with the BoE strangled private credit in England. No other joint-stock bank was allowed to operate within England and other banks were limited to partnerships of a maximum of six partners.
Thus, up until the 1820s, the entrepreneurs of the early Industrial Revolution in England and Wales had to essentially finance their expansion out of their own profits.
A sign of how limited private credit was in England and Wales was that, from 1694-1825, the Bank of England changed its bank rate, on average, once every 19 years. Not exactly the sign of a dynamic credit market. (The BoE website has a complete record [pdf] of the bank rate going back to its founding.)
Free banking Scots
Scotland was in a very different situation. Prior to the Act of Union (1707), Scotland had established the legislative framework for a competitive banking industry, under a system of free banking. The result was a dynamic, innovative (and stable) banking system. Scottish banks pioneered branch banking and Scottish business had good access to credit.
By 1825, the BoE’s privileges were increasingly looking like they were no longer worth the public policy costs. France was clearly beaten. The staggering British public debt–which peaked at 268% of GDP (pdf) in 1821–accumulated in the French wars had to be paid for. (The joke at the time was that half the debt had been accumulated pushing the Bourbons off the throne of France and the other half putting them back on.) The growing manufacturing interest wanted better access to credit. Scotland provided an object lesson in what was possible.
Changing the bargain
So, the Parliament began to chip away at the BoE’s privileges. The Country Bankers Act (1826) allowed the BoE to open branches in major cities, giving better access to its banknotes, and other joint-stock banks were allowed to operate in England–but not within 65 miles of the BoE’s Threadneedle St headquarters. This greatly improved access to credit for businesses in England and Wales. The Industrial Revolution began to take off seriously. During the period from 1826 to the passing of the Bank Charter Act (1844) (aka the Peel Act), the BoE changed its bank rate on average about once every 2 years. So, there was somewhat more vigour in the BoE’s wider credit activities.
But the English hybrid banking system (a large privileged bank, lots of small banks shut out of the main credit market) proved to be somewhat unstable. There were bank crises in 1825 and 1836-7. Hence the “Peel Act” of 1844. Alas, giving the BoE a monopoly of new banknotes in England and Wales while insisting on 100% gold coverage for its notes–in accordance with the views of the currency school–did not provide the stability hoped for, as there were further bank crises in 1847, 1857 and 1866. When the 100% cover ratio requirement (that the value of all notes issued had to equal its gold holdings) became too much of a constraint, the regulation was simply suspended (or ignored).
The banking school understood the operation of competitive banking and convertible (to specie) currency rather better than their, politically better connected, currency school rivals.
But the BoE did become a lot more active in broader credit markets–it changed its bank rate on average just under 5 times a year until the election of Abraham Lincoln as President led to the American Civil War and cotton blockade that made matters much more complicated. (From 1860-1866, the BoE changed its bank rate an average of 14 times a year–it had taken 145 years for the BoE to make its first 14 bank rate changes.) The BoE also began to grope towards a lender of last resort role, leading to the resolution of the BoE’s court of directors of March 11 1858:
That habitual advances by Discount or Loan to Bill Brokers, Discount Companies and Money Dealers being calculated to lead them to rely on the assistance of the Bank of England for their security in times of pressure; Advances to Bill Brokers, Discount Companies and Money Dealers shall be confined to Loans made at the period of the Quarterly advances, or to Loans made under special and urgent circumstances which shall be communicated by the Governors at the earliest opportunity to the Court for its approval.
In other words, the BoE would be less helpful during lending booms and more discriminating in crises. In the last great British banking crisis until the GFC, the Overend & Gurney crisis of 1866, the BoE lent to those financial operations it viewed as solvent but illiquid but not those–such as Overend, Gurney & company–it viewed as insolvent under, what became known as Bagehot’s dictum or Bagehot’s rule. From then on, the British financial system was remarkably stable, weathering problems such as the Barings crisis of 1890, until the Global Financial Crisis of 2007-2008.
Social bargaining state
What we see in the earlier history is a rather nice example of social bargaining. The BoE is established in a rather narrow social bargain between it and the Crown. However, the Crown was able to borrow because it was a credible debtor–the constraints from the power of Parliament after the Glorious Revolution (1688) enabling it to be so. The BoE bank bargain thus feeds into a wider social bargain between the Crown and those represented in Parliament.
The development of a market for public debt (culminating in the consol from 1751) had two effects. First, it more reliably and extensively freed the English-cum-British state from the constraints of current revenue (since it could spend against future revenue now). Second, it provided an extensive elite interest in the success of the state, since they held its debt. A state they substantially directed, through Parliament.
Come the successful conclusion of the Napoleonic Wars, then the trade-offs begin to shift, as previously noted. The debt burden expanded the state’s interest in developing the economic capacity of the society it derived its revenue from. So, the BoE bank bargain was re-negotiated via the mechanism of Parliament to broaden access to credit. As the Industrial Revolution took off, the British economy expanded dramatically, as did revenues, making sustained repayment of the debt increasingly easy. So the debt-to-GDP ratio shrank dramatically even as the state-revenue-to-GDP also shrank (though nowhere near as dramatically).
The economic success of the Parliamentary-bargaining British state in developing British society to sustain it was striking. In 1820, using Angus Maddison’s data, the British economy was less than a sixth of the Chinese economy, by 1870 it was half the size of the Chinese economy and by 1913 it was about the same size of the Chinese economy. (By 1950, it was considerably bigger than the Chinese economy.)
The greater capacity to effectively socially bargain was the British state’s great advantage over its French rival. Indeed, the inadequacy of the French monarchy’s social bargaining mechanisms to manage its debt burdens is what eventually brought down the Bourbon monarchy of France.
Calomiris & Haber point out that is an advantage to be able to entrench social bargains in law, so they don’t have to be continually re-negotiated. Not an option available in Islam, greatly reducing the chances of Islam developing any sort of indigenous Parliamentarism.
A fundamental dynamic in the long run history of the state is states trying to develop the level and contours of social activity within their society that permits them to survive. They do this by establishing sufficient coercive dominance and providing public goods (notably external protection and domestic peace) and infrastructure (such as irrigation, roads, bridges, canals, dams, land clearance and reclamation) that encourages a high enough level of social and economic activity to provide them with revenue and labour.
Generally, any social bargaining involved was fairly passive. What developed in Europe (particularly North-western Europe) and Japan were rather more active levels of social bargaining. In the social bargaining with, and about, the Bank of England, we can see a state developing the capacities of its supporting society, being able to do so with dramatic success due to active social bargaining being embedded in its institutional structures. Including, making social bargains that expanded the ambit of social bargaining. It was not the archetypal autocratic state “sitting on top” of its supporting society–the ultimate expression of which was mandarin-ruled China–but a state which deeply penetrated its society and was penetrated in turn by said society.
We can also see how the pressures on public policy can shift, leading to a change in the operative social bargains. Including why the Industrial Revolution began in the 1760s but did not take off until the 1820s.