The Origins of Both Endogenous Money and the Industrial Revolution

by Philip Pilkington

Fixng the Economists Article of the Week

The latest issue of the Review of Keynesian Economics (ROKE) is out and it looks like this publication is taking off fast. It includes, among other things, an introduction by the president of the Argentinian central bank (which is available free online) and a book review by me (which is not). But here I want to focus on one paper in particular. It is by William E. McColloch and is entitled A Shackled Revolution? The Bubble Act and Financial Regulation in Eighteenth Century England (it is available free in working form here).

The paper in question is arguing against the story told by some economists that the Bubble Act of 1720 was passed in response to the infamous South Sea Bubble getting out of hand and that this then constrained the ability of private firms to borrow and incorporate until its repeal in 1825. McColloch argues that this was not the case. On careful examination it appears that the Bubble Act was passed in order to keep the South Sea Bubble afloat as it ensured that competitors could not soak up the liquidity that the South Sea Company required to avoid falling into the abyss.

In this post, however, I want to focus on the latter aspect as it ties into debates regarding the endogeneity of money and the role of governments and central banks in the economy. First, however, I should probably give some quick historical background as many may be unfamiliar with the relationship between the South Sea Bubble and contemporary forms of credit creation.

The South Sea Company came into existence in 1711. The main reason for its birth was because government borrowing was becoming increasingly costly. Even though the Bank of England had been established in 1694 its powers were not yet fully realised. Add to this the loss of confidence among the public in government debt due to the funding of the War of Spanish Succession (1701-1714) and you can explain the spiking interest rates at the time.

The following graph gives a good idea of this by calculating the total debt service cost of public debt in the 18th century in England (apologies about the quality, I had to take a photo on my phone).

The South Sea Company then was basically set up to soak up this debt and then issue stock instead. Effectively then, the South Sea Company was a shell company being used to transform distrusted public debt into trusted South Sea stock. And as we can see, with regards getting interest rates down it worked rather well. Even after the collapse of the company in 1720 the problems with public debt largely evaporated.

This is precisely when the Bank of England came into its own. As McColloch writes:

First… the Bank did not maintain anything like a fixed ratio between its bullion reserves and its note issue. Particularly in the latter half of the eighteenth century, the Bank appears to have significantly expanded its discount activities during periods of crisis, acting, in the view of some scholarship, as a lender of last resort. Second, while the private banks of London were formally prohibited from discounting directly with the Bank, a number of partners of some of the major London houses maintained drawing accounts with the Bank which likely came with informal access to the Bank’s discount facilities on occasion. Further, Clapham records that while the volume of discounts remains relatively stable between 1720 and 1750, there was, by the early 1760s, a ‘gigantic increase’ in volumes. This increase plainly coincides with the rise of the country banks, and the emerging process industrialization generally. (p310)

In other words, at the same time as the government debt situation normalised money appears to have become largely endogenous. The South Sea debacle can then be read as a minor blip on the way to the modern central banking system where the central bank provides discounting on demand and credit is extended in line with economic development.

This can be clearly seen in the fact that, as Matias Vernengo has pointed out, interest rates in 18th century England fell substantially across the board. In addition to this, McColloch notes, throughout the 18th century government involvement in the English economy grew immensely, averaging 12% of GDP in the 100 year period.

The industrial revolution (usually dated 1760-1820/1840) had its origins in the same period as that when the pillars of the state/central bank aspect of our modern mixed economies were put in place. Never did there really exist any pure “free market” that was then perverted by government and central bank usurpation. Rather the process of industrialisation and industrial revolution was buttressed by bigger government and more extensive central bank involvement in the economy.