England has only once tasted the sweets and bitters of an inconvertible paper currency, but that short period is of exceptional interest, not only because of the national experience by which the country has so thoroughly profited, but also from the lessons which the student may learn as to the consequences of such an issue.

The years preceding the opening of the nineteenth century were one of the most critical periods in our history. England was at the head of the European confederation against revolutionary France, and she had to provide the greater part of the funds for carrying on the struggle. Pitt's constant remittances abroad to subsidise the lesser powers formed a standing menace to the financial well-being of the country. A demand for gold can take either of two forms. It may be a domestic demand, to fill up the gaps caused by a temporary failure of credit. In this case a great strain is thrown upon the Bank of England; when other paper is discredited the country has always been willing to accept the notes of the Bank of England, and has learnt to rely upon the Bank's assistance in cases of necessity. The latter has accepted the responsibility, and has found by experience that the best means of allaying the public fears is to lend freely and generously.

The other form of a demand for gold is a foreign demand, that is to say, a demand for export purposes. In this case the traditional policy of the Bank (a) is to restrict her issues of notes and her loans. The consequent scarcity of credit results in a rise in the rate of interest, which attracts foreign gold to this country and so stays the drain.

In 1797 a demand for gold occurred from both these quarters. Pitt had repealed the clause in the charter of the Bank of England forbidding them to lend to the Government beyond the amount of their capital, and was drawing freely on the Bank, which was compelled to honour his drafts, although it lent under protest. Then rumours of a French landing in the North of England led to a panic in Newcastle, which quickly spread to London. The Bank directors were at their wits end. On the one hand policy dictated the free lending of money in order to steady the public nerves and assuage the panic; but, on the other hand, Pitt's borrowings had so tied their hands, and reduced their stock of gold to such a low ebb, that this policy was impossible. On February 25th, 1797, therefore, as the only resource in these difficult circumstances, an Order in Council was issued directing the Bank to suspend payments in cash except under certain strict conditions, and an Act of Indemnity was quickly passed. This Act was only to be in force until June of the same year, and no better proof of the temporary nature of the Act can be found than the fact that Bank notes were not made legal tender, and no penalties were enacted for the refusal to receive them. As it turned out the Act was not finally repealed until the lapse of twenty-two years.

(a) The word "Bank," when spelt with a capital letter, is used here and in the following pages to denote the Bank of England.

The country took the suspension well. The Bank being freed from anxiety as to its gold reserve, was enabled to lend freely, and confidence was soon restored. A Committee of the House of Commons examined the books of the Bank and reported it perfectly solvent, and the Bank were authorised to issue £1 and £2 notes to take the place of guineas in small payments.

For a time the condition of the currency appeared quite normal, and no inconvenience seems to have been felt from the suspension. About 1801 however, two phenomena began to attract attention: first, a rise of the market price of gold bullion considerably above the Mint price; secondly, an unusual and continued adverse state of the foreign exchanges.

The market price of gold rose in 1801 to £4 5s. per ounce, the Mint price being as now,.£3 17s. 10 1/2d. This meant that people were willing to pay £4 5s. for an ounce of gold bullion which, when taken to the Mint, would only yield £3 17s. 10 1/2d. in coin.

The exchange with Hamburg, then the chief centre of exchange with England, fell to 14 per cent. below par.

We shall consider the foreign exchanges in a later chapter; suffice it to say now that this meant that if an Englishman owed a debt in Hamburg, it cost him 14 per cent. more to pay the debt than it would in the case of a debt of the same amount payable in London. But the cost of shipping gold to Hamburg, the most expensive way of settling the debt, was only 7 per cent.: how was the other 7 per cent. to be accounted for? An explanation was given in what is usually called Lord King's law, though Lord King was not the first to see the truth of it. This law is: If a metallic and a paper currency circulate together, and the market price of bullion rise appreciably above the Mint price, accompanied by a fall in the foreign exchanges below the "bullion point," that is, a fall which is greater than the cost of transmitting bullion, this difference between the Mint and the market prices of bullion represents the measure of the depreciation of the paper currency.

It was obviously absurd that people should be willing to buy gold bullion for coin at the rate of £4 5s. an ounce, when they could only get it coined at the rate of £3 17s. 10 1/2d. The fact, is the price of gold bullion was a paper price. A debt payable in Hamburg cost more to settle than one payable in London, because the former would have to be settled in coin or bullion, for the paper would not go abroad, while the latter would be settled in bank notes. The conclusion to be drawn was that these bank notes were depreciated, their purchasing power was less than gold of the same denomination.

This conclusion was at the time strenuously denied. It was pointed out that notes were not legal tender, and therefore, although they were temporarily inconvertible, no one was compelled to take them. The Act of 1797 said that payments in bank notes was to be deemed payment in gold only if offered and accepted as such. The notes circulated freely, without compulsion, and perfect confidence was expressed and felt in the Bank of England on all hands. How then could the notes be depreciated?