John Fullarton’s law of reflux

The most effective attack on the proposed Bank Act and the Currency School system came not from Tooke but from John Fullarton. Unlike the Currency School adherents, such as Robert Torrens and Lord Overstone, Fullarton (and other Banking School theorists) were careful to differentiate between “money” and “credit.” Proponents of the Currency School routinely referred to ordinary banknotes as “money,” though such notes were in fact credit instruments: they represented both an asset to the holder and a liability to the issuer, whereas gold coins (and the bank’s fiduciary issue) were money, since no liability attached to them.

The debate over what was money and what was credit was not merely semantic. A pure paper currency represents no liability to the issuer. Thus, if the entire money supply of Great Britain had consisted of inconvertible bank notes, the Currency School would have been fully justified in arguing for a quantity-theoretic approach to the control of the money supply - or for a bank-managed proto-Keynesian policy (as Henry Thornton had described in the Paper Credit of Great Britain in 1802), for that matter. The problem, as the Banking School writers saw it, was that the Currency School wanted to impose a quantity-theoretic approach on an economy whose money supply was endogenous, by virtue of its commitment to tie the pound sterling to the international gold standard. While the Bank of England could and did sterilize specie flows to some extent, there were limits beyond which the Bank of England could not go in its attempt to force the currency to behave according to Currency Principle.

Fullarton understood that the British money supply was endogenous: “There is this broad and clear distinction between all currencies of value and currencies of credit, that the quantity of the former is in no degree regulated by the public demand, whereas the quantity of the latter is regulated by nothing else” (Fullarton 1844b [1845]: 63).

Fullarton insisted that the equilibrium price level was determined by the relative cost of gold production. However, that did not prevent him from recognizing that an increase or decrease of the amount of credit supplied could temporarily drive prices up or down. In Fullarton’s opinion, speculation in commodity markets, supported by an extension of bank credit, enabled the speculators to drive prices higher than they could have if working only with their own capital. On this issue, Fullarton’s views were not so different from those of Lord Overstone, although Fullarton did not focus so narrowly on the activities of country banks as did Overstone, who believed that a contraction of banknotes was typically offset by an increase in the circulation of country-banknotes, thereby prolonging the process of adjustment undertaken by the Bank of England.

Although Fullarton recognized the necessity of the Bank of England doing what it could to counteract speculative bubbles, he was not particularly optimistic that the Bank would have much success if speculation were excessive. In Fullarton’s view:

[T]he part which seems to me most befitting the Bank, and the most consistent with the duties of circumspection and forbearance prescribed by its position, is to hold itself aloof from all transactions of a speculative character, and refuse the aid of its credit in any shape to those who are avowedly or notoriously engaged in them. And, when it finds the balance of foreign pay­ments becoming unsettled, from the multitude and magnitude of such projects, the exchange depressed, and its treasure menaced with exhaustion, if it does not immediately exert itself, to the full extent of its power, to break up the speculation, and compel as many of the parties as it can control to bring their securities or their commodities (as the case may be) to market, it ought not to be from any particular tenderness to the individuals, but from a desire to spare, if possible, the number of innocent sufferers who would be involved in the catastrophe, and I may say, indeed, the public at large.

Fullarton feared that the Currency School’s adherence to the price-specie-flow theory would lead bank officials to take harmful measures to prevent large losses of bullion, when in fact all that was necessary to stem an outflow of bullion was to raise the bank rate, thereby putting upward pressure on market rates. If interest rates in Britain rose significantly above those in other economies, gold would begin flowing into the London market. Fullarton argued that large hoards of gold were held in many countries, hoards that migrated to the market offering the highest rate of return. If the Bank of England would commit to holding a large bullion reserve, on average, and to use a high Bank rate to attract foreign capital, the Bank could prevent major collapses in the British economy. Besides, Fullarton argued, gold drains are not interminable: drains caused by crop short­ages or war expenditures had clear limits. In addition, Fullarton argued that anything approaching a “perpetual drain would soon become as intolerable to the recipient as to the disbursing party” (Fullarton 1844: 151).

The outcome of the debate, of course, had been settled before the hearings of 1844 commenced. The Currency School held the political power, and the Bank Act of 1844 became law with little opposition in Parliament. The Bank of England was reorganized, with the Issue Department separated from the Banking Department. The bank was permitted to extend its issue of banknotes beyond the fiduciary limit of £14 million only as it obtained more bullion. That is, the Issuing Department faced a marginal reserve requirement of 100 per cent.