Currency School

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The currency school emerged as an important body of monetary thinking following England’s resumption of specie payments after the Napoleonic Wars in 1821. England had suspended specie payments from 1797 to 1821 because of the financial stress of wars with France. The fundamental principle of the currency school lay in the concept of a money supply composed of coin and paper money acting just as if all money was entirely metallic.

Before the development of paper money, domestic supplies of metallic currency fluctuated with the ebb and flow of foreign trade. Buying goods from foreigners caused metallic currency to flow out, and selling goods to foreigners caused metallic currency to flow in. A net outflow of metallic currency depressed domestic prices, rendering domestic goods more competitive at home and abroad, and a net inflow of metallic currency lifted domestic prices, rendering domestic goods less competitive at home and abroad. Economic competition between countries ensured monetary stability.

The resumption of specie payments—that is, the return to convertibility of the pound in 1821—had not ended fits of monetary and financial disorder and adherents of the currency school saw variations in the money supply as the culprit. England had suffered major crises in 1836 and 1839, a mere three-year interval that many regarded as a wake-up call. According to the thinking of the currency school domestic money supplies were fluctuating, not with the ebb and flow of international trade, but with variations in bank notes issued by banks. Everyone agreed that banks could expand or contract the supply of bank notes within a wide range without endangering their ability to convert bank notes into specie.

The currency school argued that fluctuations in money supplies were the major cause of economic swings, an idea that is commonplace now, and that banks were causing these fluctuations. The solution to the problem lay in establishment of a state authority exercising a monopoly privilege on the issuance of bank notes, a practice that is universal in modern monetary institutions. Unlike current monetary arrangements, however, the currency school contended that the issuance of bank notes should be kept strictly proportional to domestic metallic currency and bullion. A loss of gold to other countries should cause domestic bank notes to decrease an equivalent amount, putting downward pressure on domestic prices. A gain in gold from other countries worked in reverse. At that time in England hundreds of banks issued bank notes without coordination, and the principle of convertibility had not assured that gold flows would drive domestic money supplies.

Opposed to the arguments of the currency school was the banking school. The banking school argued that bank notes expanding and contracting with the needs of trade were not a source of instability and that an elasticity of currency was needed to pave the way for economic expansion. The banking school preferred leaving the management of bank notes to bankers whose discretion was tempered by the requirement of convertibility.

The Bank Charter Act of 1844 was a great victory of the currency school over the banking school. The act included provisions that would ultimately give the Bank of England a monopoly on the issuance of bank notes. The act also separated the Bank of England’s note-issuing authority from its other banking business. In a departure from the principles laid down by the banking school, the act left the Bank of England with some discretion to regulate the issuance of bank notes independent of changes in gold reserves.

The currency school shares with the modern-day monetarist school the idea that the money supply should be managed by fixed rules rather than left to the discretion of bankers and policy makers. Modern-day monetarists would agree with the currency school that management of the money supply is the foundation of macroeconomic policy. Imbedded in the thinking of both the currency school and the monetarist school was skepticism about the wisdom of government policy makers, and a preference for policies founded on fixed principles rather than subjective judgments made in the midst of economic disturbances.