Mercantilism and Inflation

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This article
is excerpted from An
Austrian Perspective on the History of Economic Thought, vol. 1,
Economic Thought Before Adam Smith
. An MP3 audio file of
this article, read by Jeff Riggenbach, is available
for download

The postmedieval
state acquired most of its eagerly sought revenues by taxation.
But the state has always been attracted by the idea of creating
its own money in addition to plundering directly the wealth of its
subjects. Before the invention of paper money, however, the state
was limited in money creation to occasional debasements of the coinage,
of which it had long managed to secure a compulsory monopoly. For
debasement was a one-shot process, and could not be used, as the
state would always like, to create money continually and feed it
into state coffers for use in building palaces, pyramids, and other
consumption goods for the state apparatus and its power elite.

The highly
inflationary instrument of government paper money was first discovered
in the Western world in French Quebec in 1685. Monsieur Meules,
the governing intendant of Quebec, pressed as usual for funds, decided
to augment them by dividing some playing cards into quarters, marking
them with various denominations of French currency, and then using
them to pay for wages and materials. This card money, later redeemed
in actual specie, soon became repeatedly issued paper tickets.

The first more
familiar form of government paper began five years later, in 1690,
in the British colony of Massachusetts. Massachusetts had sent soldiers
on one of their customary plunder expeditions against prosperous
French Quebec, but this time had been beaten back. The disgruntled
Massachusetts soldiery was even more irritated by the fact that
their pay had always come out of their individual shares of French
booty sold at auction, but that now there was no money for them
to collect.

The Massachusetts
government, beset by demands for payment of their salary by a mutinous
soldiery, was not able to borrow the money from Boston merchants,
who shrewdly considered its credit rating unworthy. Finally, Massachusetts
hit upon the expedient of issuing 7,000 pounds in paper notes, supposed
to be redeemable in specie in a few years. Inevitably, the few years
began to stretch out on the horizon, and the government, delighted
with this newfound way of acquiring seemingly costless revenue,
poured on the printing presses and quickly issued 40,000 more paper
pounds. Fatefully, paper money had been born.

It was to be
two decades before the French government, under the influence of
the fanatically inflationist Scottish theoretician John Law, turned
on the taps of paper-money inflation at home. The English government
turned instead to a more subtle device for accomplishing the same
objective: the creation of a new institution in history – a
central bank.

The key to
English history in the 17th and 18th centuries is the perpetual
wars in which the English state was continually engaged. Wars meant
gigantic financial requirements for the Crown. Before the advent
of the central bank and government paper, any government not willing
to tax the country for the full cost of war relied on an ever more
extensive public debt. But if the public debt continues to rise,
and taxes are not increased, something has to give, and the piper
must be paid.

Before the
17th century, loans were generally made by banks, and "banks"
were institutions in which capitalists lent out funds that they
had saved. There was no deposit banking; merchants who wanted a
safe place to keep their surplus gold deposited it in the King’s
Mint in the Tower of London – an institution accustomed to
storing gold. This habit, however, proved highly costly, for King
Charles I, needing money shortly before the outbreak of the civil
war in 1638, simply confiscated the huge sum of 200,000 pounds in
gold stored at the mint – announcing it to be a "loan"
from the depositors. Understandably shaken by their experience,
merchants began depositing their gold in the coffers of private
goldsmiths, who were also accustomed to the storing and safekeeping
of precious metals. Soon, goldsmiths’ notes began to function as
private bank notes, the product of deposit banking.

The Restoration
government soon needed to raise a great deal of money for wars with
the Dutch. Taxes were greatly increased, and the Crown borrowed
extensively from the goldsmiths. In late 1671, King Charles II asked
the bankers for further large loans to finance a new fleet. Upon
the goldsmiths’ refusal, the king proclaimed, on 5 January 1672,
a "stop of the Exchequer," that is, a willful refusal
to pay any interest or principal on much of the outstanding public
debt. Some of the "stopped" debt was owed by the government
to suppliers and pensioners, but the vast bulk was held by the victimized
goldsmiths. Indeed, of the total stopped debt of 1.21 million pounds,
1.17 million was owned by the goldsmiths.

Five years
later, in 1677, the Crown grudgingly began paying interest on the
stopped debt. But by the time of the eviction of James II in 1688,
only a little over 6 years of interest had been paid out of the
12 years’ debt. Furthermore, the interest was paid at the arbitrary
rate of 6 percent, even though the king had originally contracted
to pay interest at rates ranging from 8 to 10 percent.

The goldsmiths
were even more intensively thwarted by the new government of William
and Mary, ushered in by the Glorious Revolution of 1688. The new
regime simply refused to pay any interest or principal on the stopped
debt. The hapless creditors took the case to court, but while the
judges agreed in principle with the creditors’ case, their decision
was overruled by the Lord Keeper, who candidly argued that the government’s
financial problems must take precedence over justice and property

The upshot
of the "stop" was that the House of Commons settled the
affair in 1701, decreeing that half of the capital sum of the debt
be simply wiped out – and that interest on the other half begin
to be paid at the end of 1705, at the remarkable rate of 3 percent.
Even that low rate was later cut to 2.5 percent.

The consequences
of this declaration of bankruptcy by the king were as could be predicted:
public credit was severely impaired, and financial disaster struck
for the goldsmiths, whose notes were no longer acceptable to the
public, and for their depositors. Most of the leading goldsmith-creditors
went bankrupt by the 1680s, and many ended their lives in debtors’
prison. Private deposit banking had received a crippling blow, a
blow which would only be overcome by the creation of a central bank.

The stop of
the exchequer, then, coming only two decades after the confiscation
of the gold at the Mint, managed virtually to destroy at one blow
private-deposit banking and the government’s credit. But endless
wars with France were now looming, and where would government get
the money to finance them?[1]

came in the form of a group of promoters, headed by the Scot William
Paterson. Paterson approached a special committee of the House of
Commons formed in early 1693 to study the problem of raising funds,
and proposed a remarkable new scheme. In return for a set of important
special privileges from the state, Paterson and his group would
form the Bank of England, which would issue new notes, most of which
would be used to finance the government’s deficit. In short, since
there were not enough private savers willing to finance the deficit,
Paterson and company were graciously willing to buy interest-bearing
government bonds, to be paid for by newly created bank notes, carrying
a raft of special privileges with them. As soon as Parliament duly
chartered the Bank of England in 1694, King William himself and
various MPs rushed to become shareholders of this new money-creating

William Paterson
urged the English government to grant Bank of England notes legal-tender
power, but this was going too far, even for the British Crown. But
Parliament did give the bank the advantage of holding deposits of
all government funds.

The new institution
of government-privileged central banking soon demonstrated its inflationary
power. The Bank of England quickly issued the enormous sum of 760,000
pounds, most of which were used to buy government debt. This issue
had an immediate and substantial inflationary impact, and in two
short years, the Bank of England was insolvent after a bank run,
an insolvency gleefully abetted by its competitors, the private
goldsmiths, who were happy to return to it the swollen Bank of England
notes for redemption of specie.

At this point,
the English government made a fateful decision: in May 1696, it
simply allowed the bank to "suspend specie payment." In
short, it allowed the bank to refuse indefinitely to pay its contractual
obligations to redeem its notes in gold, while at the same time
continuing blithely in operation, issuing notes and enforcing payments
upon its own debtors. The bank resumed specie payments two years
later, but this act set a precedent for British and American banking
from that point on. Whenever the bank inflated itself into financial
trouble, the government stood ready to allow it to suspend specie
payments. During the last wars with France, in the late 18th and
early 19th century, the bank was allowed to suspend payments for
two decades.

The same year,
1696, the Bank of England had another scare: the specter of competition.
A Tory financial group tried to establish a national land bank,
to compete with the Whig-dominated central bank. The attempt failed,
but the Bank of England moved quickly to induce Parliament, in 1697,
to pass a law prohibiting any new corporate bank from being established
in England. Any new bank would have to be either proprietary or
owned by a partnership, thereby severely limiting the extent of
competition with the bank.

counterfeiting of Bank of England notes was now made punishable
by death. In 1708, Parliament followed up this set of privileges
by another crucial one: it now became unlawful for any corporate
bank other than the Bank of England, and for any bank partnership
over six persons, to issue notes. And, moreover, incorporated banks
and partnerships over six were also prohibited from making any short-term
loans. The Bank of England now only had to compete with tiny banks.

Thus, by the
end of the 17th century, the states of western Europe, particularly
England and France, had discovered a grand new route toward the
aggrandizement of state power: revenue through inflationary creation
of paper money, either by government or, more subtly, by a privileged,
monopolistic, central bank.

In England,
private banks of deposit were inspired to proliferate (especially
checking accounts) under this umbrella, and the government was at
last able to expand the public debt to fight its endless wars; during
the French war of 1702–13, for example it was able to finance
31 percent of its budget via public debt.


Of the 66 years from 1688 to 1756, fully 34, or more than half,
were spent in wars with France. Later wars, such as 1756–1763,
1777–1783, and 1794–1814, were even more spectacular,
so that of the 124 years from 1688 to 1814, no less than 67 were
spent by England in wars with the "French threat."

N. Rothbard
(1926–1995) was dean of the Austrian
School, founder of modern libertarianism, and academic
vice president of the Mises
. He was also editor — with Lew Rockwell —
of The
Rothbard-Rockwell Report
, and appointed Lew as his
literary executor.

Best of Murray Rothbard

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