The Banking School/Currency School controversy is typically viewed as the second major British monetary controversy of the nineteenth century.
Perhaps a more just assessment of the controversy sees it as a long-running debate between the followers of the two great monetary theorists of the first two decades of the century: Henry Thornton and David Ricardo.
Although the controversy came to a head in 1844, when a parliamentary committee was formed to take evidence from a wide variety of British bankers and businessmen on the occasion of the renewal of the Bank of England’s charter, in reality, the controversy had cropped up repeatedly, from the time of the Bullion Committee hearings in 1810. The crisis of 1825 re-ignited the controversy. A variety of writers then began contesting the question of how the British banking system - and the Bank of England - should be organized and regulated in the wake of the banking crisis of 1825.The crisis of 1825 came on the heels of an economic boom in 1824. Agricultural and commodity prices rose sharply, and speculation in the stock market drove share prices sharply higher. Commercial banks, seeking higher earnings, loaned freely, as did the Bank of England, and commodity prices began to rise, while the pound sterling fell against foreign currencies. The fall in the exchange was accompanied by an outflow of capital, which generated fears that some banks would not be able to pay in specie on demand. In an attempt to prop up the British banking system, the Bank of England loaned freely, putting itself in some danger of having to suspend payments in gold. In the event, the bank managed to weather the storm without suspending payments in gold, but had the drain on the bank been only a little larger, or had it lasted only a little longer, suspension would have been required.
Although the Bank of England managed to survive the storm without resorting to a suspension of cash payments, the episode triggered a new round in the controversy over how the Bank of England should conduct its affairs.
Monetary pamphleteers began writing on the topic with renewed vigour. The memory of this episode guaranteed that the Government’s Bank Charter Committee would hold hearings on the renewal of the bank’s charter at its earliest opportunity, which came in 1832, before the bank’s current charter was to expire in 1833. These hearings were the most extensive ever held on the renewal of the bank’s charter up to that point. Although the committee determined that it was unable to state a “unified opinion” on the questions at hand (Fetter 1965 [1978]: 145), a number of principles were widely agreed upon. In particular, the committee was firm in its adherence to the gold standard, rejecting any return to a paper currency.During the hearings, the Bank Charter Committee called J. Horsley Palmer, the Governor of the Bank of England, who spent most of his life at the bank, beginning his first term as a director in 1825-26. He remained on the Court until 1857, except for the usual break every third year (Horsefield 1944 [1953]: 143). Palmer testified regarding the rules or guidelines utilized by the governor and directors in deciding how large the bank’s note issue should be. Governor Palmer, speaking for the bank’s directors, described the “Palmer rule” to the committee. According to the rule, when the circulation was “full”, that is, when the exchanges were just on the brink of turning against Great Britain, the bank should hold a gold reserve of “about one third” against the bank’s outstanding notes and deposits, except under unspecified “special conditions” (Fetter 1965 [1978]: 132-3). The absence of specific quantitative standards meant that
the bank’s directors were not constrained by rigid rules but had the discretion to manage the currency as they saw fit, at least within limits that were quite broad. Thus, the Palmer rule was far less restrictive than the proposition suggested several years earlier by James Pennington. In 1827, Pennington, who shortly thereafter was made a member of the Political Economy Club, laid out the first formal statement of the Currency Principle: the bank’s notes circulation should vary with the bank’s holdings of gold coin and bullion.
It is possible that Pennington was encouraged to write his manuscript by Thomas Tooke, whose views on monetary theory and policy later underwent a dramatic change. It is certain that Pennington’s idea became widely known and discussed by the members of the Political Economy Club, who disseminated it through their frequent interactions among themselves and with others interested in the monetary question.However, despite the bank’s adherence to a rule that purportedly ensured, to a significant degree, that the convertibility of the bank’s notes into gold on demand would be guaranteed, the Bank of England faced crises in 1835-36 and, much more violently, in 1839. So great was the 1839 crisis that the Bank of England had no recourse but to appeal to the Bank of France for help in order to maintain the convertibility of bank notes (Horsefield 1944 [1953]: 109). Not surprisingly the bank’s directors were subjected to withering criticism, and the public came to expect that the bank would exercise its “break clause” whenever monetary stringency emerged. Subsequently, a Secret Committee on Joint-Stock Banks, which held hearings from 1836 to 1838, and a Select Committee on Banks of Issue, which operated from 1840 to 1841, “produced only masses of evidence, from which the conscientious student of banking reforms could have deduced almost any remedy he cared, but which the Committees themselves found impossible to digest” (Horsefield 1944 [1953]: 109). However confused the Members of Parliament may have been, by the end of 1843, Prime Minister Robert Peel had a well-formulated plan in mind. Early in 1844, Peel met with William Cotton and J.B. Heath, the Governor and Deputy Governor of the Bank of England, to discuss the changes that he wished to see implemented when hearings were held later in the year. Peel was well prepared for the meeting: his memorandum contained “almost all the essential features of the 1844 Act”: the prohibition of any further banks of issue; the limitation of existing note-issues to their then size; the division of the structure of the Bank between an Issue Department and a Banking Department; and the limitation of the notes issued against securities to a fixed sum, any further issues to be backed by bullion. Peel added only one proposal that did not become part of the Act: that “extensions of the fiduciary issue should be permitted, if and when the need arose, on the sanction of three Ministers of the Crown” (Horsefield 1944 [1953]: 110-11). As Horsefield (ibid.: 113) has noted, this would not have come as a surprise to anyone familiar with Peel’s voting record as a Member of Parliament
Peel’s proposal set forth a pure currency-school approach to the regulation of the money supply. In accordance with the currency principle, bank notes were treated as money, but Bank deposits were not. This opened the door for the bank to expand credit excessively, even if its note issue were held within reasonable bounds.