Why does it exist? The short answer is that, like most other central banks, it was created to provide government with funds to fight a war – in this instance in 1694, to wage war against France. Today, it uses more complex techniques but essentially it does the same thing, manipulating money in order to finance government policies. There is no magic money-printing alchemy that turns water into wine. Money-printing and coin-clipping are two sides of the same coin, and it is shameful that Keynesianism still has any disciples following the stagflation after the 1974 elections, with RPI prices doubling in 5 years and unemployment going up rather than down.
It was not ever thus. Originally the Bank of England was not government-owned; it took another 250 years or so to achieve that in full. But well before then it had created a virtual monopoly and as early as 1708 all English banks of any size were prohibited from issuing their own bank notes!
By the beginning of the nineteenth century free market banking in England was dead. But Scotland provided a model of sophisticated free market banking for some 100 years until Robert Peel’s banking acts of 1844-5 snuffed out all private bank notes in the UK, and imposed the notes of the Bank of England.
Today, few if any bankers have any idea of what banking actually is, or could be. Originally it was the safe storage of gold, for a fee. But bankers soon realised that many demand deposits lasted for long periods, which provided the opportunity not only to provide no-fee banking, but to provide interest as well. That necessarily involves “lending long” because interest comes exclusively out of the additional production from new capital provided by savers. Increasing the future supply of fish by building a new boat can’t be done overnight, so interest on demand deposits requires some resilience. The Scottish bankers held large fractional reserves of gold deposits and if any bank tried to steal a march on the rest it would be called to account immediately because inter-bank clearances were made daily, also in gold.
What about the need for a lender of last resort? Bagehot’s much trumpeted proposal in 1873 that the Bank of England should become such a Lender was predicated on the fact the Bank of England already had a legal monopoly of note issue that was not about to be broken up. At no time did he argue that this was a good thing or that free-market banking or the economy would suffer without such a lender.
The history of free-market banking in Scotland and more than 50 other countries is there for all to see – very successful and not contagious. Like all other market enterprises, free-market banks cooperate when that is beneficial. Yes, occasionally a bank will go bust, and should be left to do so; under such a scenario there would be no lack of private insurance against bank failures. Oh, and for those who are statistically minded, that century of free market banking saw Scotland’s income per head move from 50% of England’s to 100%. Coincidence?
Much monetary manipulation today concerns setting interest rates. Yet free-market interest rates are a sine qua non for the structure of the economy, representing as they do the time-preferences of consumers. Such preferences implicitly provide an equation in which 100 widgets today are worth the same as 100 plus x widgets say 5 years later; the value of x is the amount you gain from waiting, the extra coming from your savings which allow new capital equipment to be put in place and thus more widget production thereafter. If interest rates are out of whack we have guess what – a boom and bust.