The Bank of England as lender of last resort
Thornton linked the suspension of payments with the need to preserve the lender-of- last-resort function of the Bank of England. He considered the situation in 1797 with respect to the 1793 financial crisis.
At that time, the banking system experienced liquidity difficulties which ended in a systemic crisis after the Bank’s refusal to discount bills and issue banknotes because its reserve was at a very low level; a refusal in accordance with Smith’s theory. According to Thornton, the banking system had suffered a flight to quality resulting from the public distrust of business, and, in such circumstances, the solution lies in the capacity of the Bank of England to restore confidence by increasing the supply of money, which means issuing its debt. The crisis was resolved by issuing 5 million sterling Exchequer bills which were lent to the merchants by the Treasury, and which the bank had to circulate (since 1707). Although the Bank of England was not the lender in 1793, it supported the Treasury’s lending by issuing its notes. It is important to note that the Treasury took the credit risk, and the Bank took the liquidity risk. By assuming a higher liquidity risk in this way, the Bank of England helped the banks to manage their own liquidity, and resolved the crisis. Although its notes were not legal tender, the bank guaranteed the liquidity in the money market. However, if the bank succeeded in restoring confidence, in the circumstances of 1793, without having to suspend the payment of its notes, in the circumstances of 1797 - the fear of a French invasion - the suspension of payments was unavoidable. According to Thornton:The law authorizing the suspension of cash payments of the bank seems, therefore, to have only given effect to what must have been the general wish of the nation in the new and extraordinary circumstances in which it found itself.
If every bill and engagement is a contract to pay money, the two parties to the contract may be understood as agreeing, for the sake of a common and almost universal interest, to relax as to the literal interpretation of it, and as consenting that “money should mean money’s worth,” and not the very pieces of metal: and the parliament may be considered as interposing in order to execute this common wish of the public. (Thornton 1802 [1939]: 139)Explaining the lender-of-last-resort function of the Bank of England led Thornton to criticize Smith’s credit and monetary theory. Contrary to the real bills theory, he considered that the credit risk is linked to the solvency of the debtor rather than the reality of the merchandises traded, and that credit granting and money issuing have effects on prices that depend on the price anticipations of debtors. Against Smith’s issuing rule - that issues should be reduced when the reserve falls - Thornton introduced the concept of circulating medium (which includes different kinds of credit instruments, the notes of different banks, the notes of the Bank of England and the legal tender coins) and pointed out the solvency hierarchy existing between the different issuers of debt, with the Bank of England at the top. He demonstrated that the various components of the circulating medium have different velocities of circulation according to particular interest rates and degrees of confidence. Thornton considered that the instruments forming the circulation medium vary with the general level of confidence. In the case of distrust, the velocity of circulation of paper credit at the bottom of the hierarchical solvency structure increases, although it decreases at the top; there is an increasing demand for guineas and Bank of England notes, then an increasing supply of paper credit to be discounted on the money market, and then rising interest rates. By lending its notes irrespective of its reserve, the bank stops this process. This function must be performed whether there is convertibility of England banknotes or not, as was the case during the war. Ricardo never commented on this part of Thornton’s contribution to monetary theory.