by Patrick O’Brien (LSE) and Nuno Palma (University of Manchester, ICS-UL, CEPR)
This blog post is based upon the authors’ article forthcoming inThe Economic History Review.
‘The stability of the Bank of England is equal to that of the British government …[The Bank of England] acts, not only as an ordinary bank, but as a great engine of state’.
Adam Smith 1776
In our article forthcoming in the Economic History Review, we study how from its foundation as a private corporation in 1694 the Bank of England extended large amounts of credit to support the British private economy and to support an increasingly centralized British state (O’Brien and Palma, forthcoming). The Bank helped the British state reach a position of geopolitical and economic hegemony in the international economic order. We show how the Bank of England contributed to form an effective and efficient fiscal-naval state and promoted the development of a system of financial intermediation for the economy. The evidence that we consider here shows that although the Bank was nominally a private institution and profits were paid to its shareholders, it was playing a public role well before Bagehot’s doctrine.
During the long eighteenth century (1688-1815), Britain’s engagements in successive bouts of warfare led to the formation of a powerful state, supporting—and supported by—a framework of ‘private’ institutions that eventually promoted its precocious transition through the First Industrial Revolution. Among the most important of these institutions was the Bank of England, founded in 1694 during King William’s War, 1689-97. The Bank supplied successive governments with flows of liquidity required to wage war. It supported the formation of the state and the building of fiscal capacity by providing the short-term liquidity necessary to deal with military crises. Without the Bank, these crises would have compromised Britain’s capacity to wage warfare, which in turn would have diminished long-term economic progress. By fostering the development of a more monetized economy, the Bank also made it easier for the state to collect taxes. Indirectly, it also encouraged overall financial intermediation for the private economy and contributed to the progressive emergence of an investment-friendly environment. But the Bank never became a systematic source of funds for the government in a way which would have vitiated the government’s commitment to price stability over the long run. The symbiotic relationship between the Bank of England and the British state was an advantage to the emergence of the Industrial Revolution.
In our article, we consider the role of the Bank of England’s support for the state and the economy. We elaborate upon the evolution of the institutional framework without which the money market could not have supported the British government’s systematic military successes over the eighteenth century. The culmination of these efforts was victory in the most protracted and costly conflict of all, namely the Revolutionary and Napoleonic wars, which witnessed a new and more radical form of monetary policy.
Figure 1. ‘The Hand-Writing upon the Wall’ by James Gillray
We argue that there were three key ways in which the Bank provided support to the state and the private economy. First, it played an important role as debt manager, helping the government to raise large amounts of credit from private investors. Second, it provided short-term finance to the government by directly buying unfunded debt, particularly in the form of Exchequer and Navy bills. It also lent to private investors, many of whom then invested in government securities. Thus, actions of the Bank leveraged the financial system. Third, it increased the money supply, which not only benefited the private economy—by extending the tax base—but also made a more monetized economy easier to tax.
Our conclusions differ in fundamental respects from the recent consensus with respect to the role of the state in crowding out economic growth during the eighteenth century. The main difference results from the realisation that crowding out is a short-term, static effect. It is true that by borrowing liberally to wage warfare, the state did dry up some amount of liquidity. But it does not follow that, in net terms, this slowed long-term aggregate economic growth. First, state borrowing itself encouraged, over a long period of time, the gradual development of an efficient system of financial intermediation, which eventually generated more liquidity. Second, in the context of a mercantilist international economic order, without the external warfare waged by the British state, the process of economic growth would have been slower. This is because military expenditure was not ‘pure waste’. Instead, it was a means to secure external security, internal order, and imperial expansion.
During the eighteenth century, the Bank of England provided critical support to the British state and economy. The relationship was symbiotic, since it benefited from lending and its privileged position, but it also supported the state by providing it with credit, especially during critical moments when the private market would have dried up. The ease with which the Bank could, in practice, deny funding to the state varied with respect to different contingencies, such as the state of reserves, whether a war was occurring or a charter renewal was approaching. But overall, and because the directors of the Bank perceived that the safety of the Bank would not be compromised, it acted with a large degree of autonomy, which turned out to be beneficial to the state in the long run. Fiscal capacity was positively affected, which meant that it was possible for the state to increasingly demand funds without credibility problems affecting the ability to repay at equilibrium interest rates. A positive loop ensued. The transformation of sovereign debt into money was in turn transmitted to the private economy, and this elastic supply of liquidity supported long-run economic growth and financial development.
It is sometimes argued that the British industrial revolution had little to do with the state or with political institutions, or that England industrialized despite the negative effects of the state and the banking system. The evidence we have presented here—taking the Bank of England as a case-study—suggests otherwise.
To contact the authors:
O’Brien, P. and Palma, N. ‘Not an ordinary bank but a great engine of state: the bank of England and the British economy, 1694-1844’, Economic History Review (forthcoming).
Smith, A. The wealth of nations (1776/2003).