Central Banking and Government Policy: Canada, 1871

Theory and Fact
Free banking means a private enterprise competitive market in banking services, including the provision of a medium of exchange (White, 1984, 1989; and Dowd, 1989). For the free banking proponent any govenment intervention in banking would have to be justified by proof of some failure in the market for banking services.

The Question
The Dominion note issue of 1871 was certainly a government intervention in banking. Was it justified by a market failure in the banking sector of the Canadian economy?

In Book II, Chapter 2 of the Wealth of Nations, Adam Smith approved of a legal prohibition of small denomination paper currency issues by private banks. He alleged a specfic market failure associated with the moral hazard of over issue and failure to redeem. The moral hazard, he suggested would arise from an invincible want of scruple with which the public would accept such notes from any source. The ease of fraudulent issues would lead to " ... the frequent bankruptcies to which such beggarly bankers must be liable."

Smith was reporting contemporary practice, with approval. About 1760, because of specific circumstances, the issue of small denomination bank notes was permitted in England and Scotland. The result was an excessive, inflationary issue that affected especially the working classes who were paid in small denominations. In response to this market failure, in 1765 in Scotland, and in 1775 in England, governments interfered in the market by prohibiting the issue of notes below one pound (Feavearyear, 162).

The question is, was the Canadian government's interference in the market, with its issue of Dominion notes in 1871, a consequence of some similar market failure in banking services in Canada? Was it an attempt to replace an unsound small denomination currency with a sound government issue?

The Answer in the Debates in the House of Commons
On May 14, 1869, John Rose, the Minister of Finance, made it very clear that the principal motive of the Government was to put the entire paper issue on a sound and reliable footing. There was to be one national currency, issued by the government through the banks, as in the United States, and for the same reason as in that country: to prevent
the extreme inconvience, not to say disaster, which resulted from [the] promiscous circulation of the notes of Banks, established in various localities all over the Union, each of which had a different degree of security to give its note-holders (Rose, 10).
The Minister was building up to the Uniform Currency Act of 1871, an Act that would provide a common currency for the federation newly formed in 1867.

The Minister was also changing the nature of banking in Canada. The proposed legislation would furnish the country with a currency backed by government bonds, as were the "greenbacks" of the United States, and it would put the Bank of Montreal in the position of a central bank. These other, and perhaps more important matters affected the progress of the bill through the House, but much of that story can be left out. All that needs to be remembered is that the Government's motives were mixed, to say the least, and that its stated purposes were not entirely candid.

The Minister's stated intention was reminiscent of the market failure agrument. For reasons related to other aspects of the bill, the minister was forced to resign (Masters, 1941; Shortt, 1920-34; Denison, 1966, vol. 2, 121-124). He was replaced by Francis Hincks, who reintroduced the bill with a very different intent with respect to all matters that went beyond simply providing a uniform national currency. In passing, as if to get the matter out of the way, the new Minister mentioned the need to provide security to note holders (Debates, 1870, pp. 193-194). According to Hincks, however, the previous minister had gone too far in trying to reduce the risk to note holders (Debates, 1870, pp. 196-197). In fact, the market failure argument was virtually retired by Hincks, who distinguished the principle intent of his own bill to be to let the public "profit from the circulation of the country". This, he said, the bill would do in two ways. It would require the banks to hold one half of their cash reserves in Dominion notes, for which they would have to pay the government in one way or another, and it would take into the government's hands the issue of denominations below four dollars (Debates, 1970, p. 198).

To this point in Hincks's remarks the Government's intent was not focused on the market failure consideration, but focus on anything was lost when he followed with a lenghty assurance of the security of Dominion notes, both large and small denomination, and by a statement that

with regard to the resolution on the currency, his object was simply to have one uniform currency for the whole Dominion. (Debates, 1970, p. 200)

Having been interrupted by Mackenzie, Cartwright, and Bolton of the Opposition, all of whom wanted "free banking", Hincks further clouded things by asserting that

The best paper currency for the country would be notes redeemable in gold ... for which the government would be responsible (Debates, 1870, p. 234).
This he said was England's system, supported for many years by the statements of Robert Peel, Lord Sydenham, Mr. Jones-Lloyd, and David Ricardo; but, he said, without explanation, that that system was impractical in Canada (Debates, 1870, p. 233).

The Second and Third Readings of the bill clouded things even more. During the Third reading, Etienne Cartier, who had been silent during the First and Second readings, offered a summary of the Government's position that included a statement that the Government would take over the issue of smaller notes for the security of farmers who held them. The business community, he said, generally held larger denomination notes, and was able to take care of itself. In short, Cartier recalled the Smithian, market failure argument from its retirement.

Debate in the House of Commons on the bill of 1871 seems not to have uncovered the Government's "real" intentions. So, to get some further insight into the possible motives of the Government, motives that were not stated, but were impliict consquences of policies adopted in previous years, we must search the previous years. It may be, for example, that on Smithian grounds the Imperial Government had adopted a policy of prohibiting private colonial banks from issuing small denomination bills, and that the reasons given in 1870 were just convenient, contemporary rationalizations of a practice stablished by Smithian Imperial decree in the earliest period of Canadian banking.

The Answer Drawn from the Situation Prior to 1870
The first instruction from the Imperial Government concerning issues of small denomination notes in Canada arrived in the early 1830s, when, ostensibly, the Imperial authorities were attempting to facilitate trade by introducing a common, sterling currency into all of the colonies. At the time, Commissary General Routh wrote concerning the problem of dollar currency bank notes in Canada.
It is expedient to restrict the bank notes on renewal of [the banks's] several charters to sums of five pounds sterling and to prevent their issue under that amount.
There had been an earlier attempt on the part of the Imperial authorities to regulate the issue of small denomination notes. Their stated motivation then was to meet the need for a regular, secure currency, along the lines suggest by Adam Smith in his rationalization of the issues of the Amsterdam bank (Smith, 446-455), and along the lines of those who initially proposed the chartering of banks in Canada (Neufeld, p. 38). Adam Shortt points out, however, that as a result of historical accident the Imperial Government was profiting from the issue of over-valued sterling silver, and wanted to increase its profit by extending the issue throughout the Empire (Shortt, 1986, pp. 220-221). Quite possibly, then, neither the alleged nor the "real" reasons for Imperial regulation of small denomination paper currency involved the market failure argument of Smith's Book II, Chapter 2.

Routh's suggestion was not taken in Canada, but a "hurried Act" of the Legislative Assembly

... excluded from circulation in Lower Canada any bank notes, or other notes, under five dollars, except those of the incorporated banks of the province (Shortt, 1986, pp. 237, 239).
The motivation for giving the Lower Canada banks a monopoly of the issue of small denomination notes was not mentioned in the Act.

There were some colonial interests opposed to small denomination issues by the banks, but here again, the market-failure argument was not clearly involved. Having had the paper issues of the pre-Conquest period repudiated by both France and Britain, the French population was loath to get caught again. Their concern looks like the market failure argument. At the same time, however, the balance of payments was such that good currency tended to be bought up by the banks, particularly the Bank of Montreal, for profitable resale in the New York exchange market. So, in the early 1830s, there were complaints from Lower Candian merchants that small denomination paper currency was driving specie out of the country (Shortt, 1986, 26-268).

It seems, then that there were a number of reasons for a number of interests to want to regulate the issue of small denomination currency. When the Upper Canada Assembly considered applications for bank charters in 1834, for example, the established Upper Canada banks petitioned to have the bills of foreign [Lower Canada and United States] banks declared legal tender only for values of 20 shillings and higher. Their hope was to establish a monopoly over that part of the paper issue usually not returned for redemption (Shortt, 1986, 304).

Adam Shortt's Answer to the Question of Motivation
In 1839, following the financial and political crisis of 1837, even before the new Governor, Lord Sydenham, lectured the Assembly on the virtues of the Currency School position, the Upper Canada Assembly considered the possibility of a provincial government currency. The discussion at that time was a repeat of a similar discussion that had taken place in 1821. Adam Shortt cited the relevant 1821 Resolution at length.
Resolved, that it is the opinion of this House, that the establishment of a provincial bank under proper restrictions would be beneficial to the country, by remedying the great want of specie, by securing to ourselves whatever advantages are to be derived from the issue of a paper currency, and by establishing a circulating medium of known security, instead of the paper of private banks, uncontrolled by charter or legislative provisions, and which from it being rejected by the public receivers, does not answer effectually all the purposes of trade (Shortt, 1986, 100).

In 1821, as in 1871, there were two main motivations alleged for a government issued currency: a secure currency, which the private banks were not providing, and fiscal benefits. Shortt thought the second of these, the needs of the Provincial Treasury, to have been the most motivating of the two in the subsequent fifty year progress towards the 1871 small denomination government issue.

At every stage in the development the pressing need of the government for something like a forced loan from the people was the occasion of each new extension of the system (Shortt, 1986, 608).

In explanation of the 1871 emphasis on monopoly of the small denomination issues, Shortt referred to Hincks himself.

... [with respect to] the issue of all small notes below four dollars ... He referred to the fact, so obvious at the time, that since the American Civil War the smaller note issue of the banks had been supplanted by American silver. The Government was already taking measures to rid the country of this silver in order to make room for the circulation of the small Dominion notes. Thus by the proposed changes the banks would suffer very little restriction while the Government would considerably benefit (Shortt, 1986, 608). Because, of course, the notes would not be returned for redemption, and the banks would have to purchase government bonds to receive them.

From reading Shortt, it would seem that the extension of the issue of small denomination Dominion notes in 1871 was an attempt to force a loan from the people by issuing that portion of the currency that would least likely be returned for redemption, and would least arouse the banks to political opposition. It was not an Act that contradicted Adam Smith, so the market failure argument could be used to support it in debate even though the main motivation was fiscal benefit for the government.

Still, if allowance is made for the possibilty that Shortt's account of the earlier period was as biased as his account of the Act of 1871, the question of the Government's motivation in 1871 is thereby only dubiously resolved. It has to be remembered that Shortt wrote his account in the first two decades of the twentieth century, when he was busy trying to convince the Senate Banking Committee that departure from the gold standard would be disastrous. To correct for Shortt's possible bias some reference to regulations relating to small denomination paper issues in nineteenth century Britain would seem to be in order.

The Answer in Britain
In the late 1790s, during the war with France, Acts were passed allowing both the Bank of England and the country banks to issue small denomination notes.
The public accepted the notes because there was nothing else and because they served the purposes of trade for the time being as well as gold (Feavearyear, 171).

These acts remained in force until the time of the Bullion Committee Report of 1810, at which time it seemed evident that

... the note issue of the Bank of England had risen since 1797, particularly notes of less than five pounds (Feavearyear, 183)
The conclusion was
... that the rise in the price of bullion and the adverse exchanges was caused solely by an over-issue of Bank of England notes (Feavearyear, 184).
It would seem, then, that the problem with small denomination issues by private banks was as much that of inflation as of insecurity for individual note holders. The small denominations were not prohibited at the time of reestablished convertibility in 1821, and Feavearyear reports the general opinion at the time of the 1825 crisis that
It was the hundreds of small independent note issues, all capable of easy expansion and all liable to rapid discredit, which were to blame (Feavearyear, 223).

In 1826 an Act prohibited the issue of notes less than five pounds in England and Wales. The Act was not extended to Scotland because there was not the multipicity of small banks, with the result that there had never been a failure to redeem, according to Feavearyear (Feavearyear, 226), but that seems to reintroduce the market failure consideration.

Motivation in England and the View of Francis Hincks
The great issues of the middle and late years of the nineteenth century in England were embodied in the Bank Charter Act of 1844. Although the institutional structure of the banking system was a subject of the Act, its principal focus was on macroeconomic control over prices and the general level of economic activity, not on microeconomic efficiency as affected by market failure. So, (1) because the Currency School doctrines on which that Act was based were imported into Canada in the person of Lord Sydenham, (2) because Hincks repeatedly stated that Sydenham's Currency School opinions, though impractical, embodied what was best for Canada, and (3) because Hincks was the author of the Act of 1871, it would seem either (1) that the focus of the Act of 1871 was macroeconomic control, and not microeconomic efficiency, or (2) the aspect of Sydenham's scheme that was, in Hinck's view, impractical in Canada was its focus on macroeconomic control. So, in this view of things, the question boils down to what was the aspect of Sydenham's Currency School proposal that Hincks found impractical in Canada?

Adam Shortt on What Was Impractical
What was proposed as Currency School doctrine in Canada in the early 1840s was not a carbon copy of the English Currency School prooposal, but a government owned bank with a monopoly of the issue of currency. This proposal had been made in the Canadas in 1821. It was thoroughly discussed in both Upper and Lower Canadian Assemblies in 1820 and 1821. It was, in fact, embodied in an Act of the Upper Canadian Assembly but failed to be proclaimed only by seeming accident. The Currency School proposal in Canada played the role in 1840 that the Social Credit proposal of Major Douglas in Canada in 1920 (Neill). Neither had effects beyond changing the semantics of ongoing debate. Further, it is significant that the failed 1821 Upper Canada Act could not have established an inconvertible currency even if enacted, because an inconvertible currency would have violated the British statute 4 Geo. III chap. 34. Further yet, as Shortt was quick to point out, it would have been open to abuse by the government (Shortt 1986, 79-80, 99-101), just as the issues of the New England colonies and of Virginia, against which 4 GEo. III, chap. 34 was directed, were open to abuse and in fact were abused.

Sydenham's Currency School paradigm was rejected in Canada, according to Adam Shortt, because conditions in a frontier country with a few primary product exports were quite other than those of a fully developed and balanced economy, such as that of England. What the frontier wanted was not stability and a safe place to put excess capital, that is, in general, macroeconomic stability. What the frontier wanted was expansion and more capital to put in places of expected high return, that is, in general, growth and development. The need was for capital, so the currency was organized, foolishly according to Shortt, to generate capital (Shortt, 1986, 406-409). But here we have Shortt again making the two basic points of all of his writings: first, that the Canadian banks were typically North American, and well within the traditions of early United States banking (Shortt, 1896, 1-17); and that the primary thrust of Canadian banking legislation up to and including the Act of 1871, was to generate capital for public works yet to be undertaken, or undertaken and not yet paid for.

The American Way in Canada
Shortt was surely right in his assessment of American Banking. It had been the "habit" of the original English colonies to issue paper in lieu of taxes, and the Continental Congress also issued paper. During the Civil War the U.S. Federal government issued the so-called Greenbacks. In the latter instance no denomination less than $5.00 was to be isssued, but specie disappeared from circulation and fractional paper currency was then issued. When a new system of national banks was put in place in 1863, $300,000,000.00 was issued on the Security of United States bonds, one sixth of which was in denominations of less that $5.00. None of it was convertible, and there was strong agitation for the permanent acceptance of an inconvertible national curency (Hepburn, 1903, 185, 191, 307-08). In the United States, as in Canada, the problem of small denomination paper, that is, the moral hazard of inconvertability and over issue, was recongnized, but circumstances were such that it was given a low priority in policy.

Nice questions could be raised concerning the issue of currency to pay for services directly, and the issue of currency on security of government bonds, the first of which may be said to be an issue for revenue, and the second an issue for capital. And there are questions to be answered about the extent to which currencies issued by the colonies were to cover war debts as opposed to debts associated with economic development. Indeed, questions could be raised about the extent to which American practices were different from European practicies in these matters; but there is a limit to what should be attempted in the fine tuning of arguments - a limit that has already been passed here. Banking was not the same thing in America and Europe, not only because America was a frontier economy being built in a rush from the top down (Innis, 28, 201), but at the top in Europe there was innovation that found a ready testing ground in America. In the early years in America paper money was disassociated from specie and precious metals, and "Bank ... in colonial language meant an issue of paper money" (Schumpeter, 293-299, Weeder, 314-330, 318).

Shortt's answer concerning the "why" of the 1871 issue was well founded, though his judgement on the policy correctness of the "why" may not have been. The small denomination issue of 1871 was not intended to remedy the microeconomic market failure pointed out by Adam Smith. it was not intended to remedy macroeconomic instability. Rather, it was intended to produce capital to finance public works.

Proponents of free banking have nothing to explain away with respect to the market failure motivation of the Dominion Government at the time of the small denomination issue of 1871. Market failure in banking was not the problem motivating the legislation. Still, insofar as they were represented by the Opposition in Parliament, they were very disapproving of the actual motivation. The chief motivation of the Government was consistent with the propensity-to-abuse assertions of free banking proponents. If Rose's original bill had passed, Canada would have had a central bank intended to facilitate the revenne grab that Vera Smith, an historian of the free banking pursuasion, has suggested was typical of the establishment of all central banks (Smith, 1936).

Rose's bill was not passed, and Canada did not get a central bank until 1935. All it got was an issue of Dominion notes; and, of course, the motivation of the Canadian Government in establishing the Bank of Canada in 1935 cannot be deduced from what was intended in 1871.

References and Bibliograpy

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