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Bank of England, Part 1: Hub of the Golden Age’s Global Fixed Exchange Rate System

By Frances Coppola

International businesses see central banks as economic controllers, managing monetary policy using a range of financial tools to meet defined targets for exchange rates, inflation rates, or unemployment rates. But that has not always been their purpose. The Bank of England (BoE) does such things today, but this second-oldest central bank in the world (after Switzerland's) was originally created to fund a war.

In 1694, the government of England was broke and the country rendered impoverished by a ruinous war with France. England needed to invest in its navy if it was to stand any chance of winning the war, but it could not raise the money from financiers – only £1.2 million at the time, or the equivalent of £214.5 million ($276.4 million) in 2016, according to the BoE's own inflation calculator.1 King William III seized on an idea presented three years before by a Scot named William Paterson, who proposed the creation of a bank to manage the country's finances. Perhaps, such a bank could provide the money he needed?


The public was invited to subscribe capital for the new bank. The necessary £1.2 million was raised within a few weeks and promptly lent to the government. The BoE was granted a Royal Charter on July 27, 1694,2 becoming the English government's banker and debt manager.3 It remains the U.K. government's banker to this day, although its responsibility for debt management was transferred to a new agency, the Debt Management Office, in 1998.4


Two Currencies, Two Central Banks and a Fixed Exchange Rate


The BoE's original remit did not include Scotland, because although the Crowns of England and Scotland had been unified since the death of Queen Elizabeth I in 1601 the Parliaments remained separate until 1707. So, in 1695 the Scottish Parliament chartered a bank of its own; the Bank of Scotland. This was Scotland's first bank.5


Like the BoE, the Bank of Scotland was a private institution: its initial capital was subscribed by Scottish entrepreneurs and businessmen. But unlike the BoE, the Bank of Scotland's remit was to support trade. It remains in private ownership to this day, though it is now owned by an English banking group after coming close to bankruptcy in the 2008 financial crisis.6


Both banks accepted private deposits and issued notes as a certificate of deposit. These notes were transferrable, and therefore soon circulated as a type of "bearer bond."7 Thus, right from the start, the central banks of England and Scotland issued their own banknotes.8 But unlike modern central banks, they did not issue the currency itself.


At that time the English pound, or "pound sterling," was defined as a weight of silver, and usually circulated as silver coinage created by the Royal Mint (although from 1663 onwards gold coins were also used). The "pound Scots" was similar, though of lower value: it was pegged to the pound sterling at an exchange rate of 12 to 1. Notes issued by the two banks could be exchanged on demand for the equivalent in gold or silver coinage. Bank notes were not "legal tender": creditors and merchants could demand settlement of obligations in coin instead of banknotes. Notes issued by the BoE became legal tender in England and Wales in 1833,9 but to this day, only coin is legal tender in Scotland.10


After the unification of the Parliaments in 1707, the pound sterling became the currency of the newly United Kingdom. However, the Bank of Scotland and other private banks continued to issue bank notes until 1844, when the BoE was granted a monopoly over banknote issuance in England and Wales.11 In Scotland and Northern Ireland, certain private banks still issue banknotes to this day, valid throughout Britain but rarely seen outside their respective regions.12


The Gold Standard: a Managed Exchange Rate System for an International Empire


In 1717 Sir Isaac Newton, then Master of the Royal Mint, fixed the exchange rate of the gold guinea to sterling. Henceforth, a gold guinea would be worth 21 shillings, while a silver pound would be 20. But this exchange rate turned out to be a considerable undervaluation of the international value of gold relative to silver. Over the next century, therefore, silver coinage gradually went out of use, replaced with the gold guinea, which represented better value at the prevailing exchange rate.13 Silver coins were melted down and turned into dinner services.14


The U.K. formally adopted gold as its currency standard in 1816, after a period during the Napoleonic wars when conversion of banknotes into gold and silver – at any exchange rate – was prohibited.15 Although the term "sterling" never fell out of favor, Britain remained on the gold standard until the outbreak of World War I in 1914.


Also during this period, the U.K. became the world's principal imperial power, building up an empire that at its height encompassed a quarter of the globe's land area.16 The British empire established colonies in Australia, New Zealand and Canada as well as large parts of Africa, the Caribbean and Latin America.17 The so-called "jewel in the crown" was India.18 It also had trading relationships with Eastern Asian countries such as China.


Because of the U.K.'s global dominance, sterling became the premier currency for international trade. The gold sovereign circulated freely throughout the world, even in countries such as Portugal that were not part of the British Empire.19 Many countries, including the U.S., adopted a gold standard themselves, minting their own gold coins: these were exchangeable for gold sovereigns at an exchange rate determined by the weight and proportion of gold in the coins, known as "mint parity."20


At the heart of the international gold standard system was the BoE, which was required to maintain parity of bank note issuance with gold reserves: if it increased the notes in circulation, it had to obtain more gold to back them.21 It therefore intervened in the gold market, actively buying and selling gold.22 It also bought and sold its own banknotes, using discount rates to encourage market participants to buy its notes or sell them back. It acted therefore rather as the modern U.S. Federal Reserve does, supplying liquidity to the international financial system and acting as "lender of last resort" for distressed banks in the many financial "panics" of the 1800s.


This period in history is regarded by some as a "golden age" of free trade and global growth, enabled by a universal currency (gold) and a self-balancing international financial system in which temporary trade imbalances were automatically eliminated by flows of gold – a mechanism dubbed the "price-specie flow system" by the philosopher David Hume.23 The job of central banks was not to offset gold flows with monetary policy, but to encourage them: thus, a country suffering outflows of gold due to a trade deficit would raise, not lower, interest rates, thus discouraging imports and helping to return the external position to balance – and maintaining the fixed exchange rate versus gold. This was known as the "rules of the game."24 It was, unfortunately, often flouted, causing exchange rates to deviate and some central banks to stockpile gold.25 But this gold-based exchange rate system remained relatively stable until the outbreak of war in 1914.


After the end of World War I, Western countries attempted to re-create the pre-war gold standard and re-establish their lost currency exchange rate stability. Montagu Norman, then Governor of the BoE, was instrumental not only in bringing about the U.K.'s return to the gold standard in 1925,26 but in encouraging other countries such as Australia to do so as well. But the war had fundamentally reshaped the international political landscape, and the return to the gold standard proved short-lived and damaging.27



During the 1800s, the Bank of England gradually relinquished its commercial activities in favor of something much more akin to modern central banking – management of interest rates in order to maintain sterling's fixed exchange rate to gold, and supporting the international financial system. In the last hundred years of its 323-year history, however, it would abandon exchange rate management in favor of inflation targeting, and become independent of government – as will be seen in Part 2.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1. “Inflation Calculator,” Bank of England;
2. “The Bank of England Act 1998, the Charters of the Bank and related documents,” Bank of England;
3. “History of the Bank of England,” Bank of England;
4. “About the DMO,” UK Debt Management Office (DMO);
5. “Our Heritage: Timeline 1695-1800,” Lloyds Banking Group;
6. “Bank of Scotland,” Lloyds Banking Group;
7. “The Bank of England note: a short history,” Bank of England;
8. “Bank of Scotland 1696: paper money launched,” Lloyds Banking Group;
9. “The Heyday of the Gold Standard, 1820-1930,”;
10. “Legal Tender Guidelines,” The Royal Mint;
11. “The Bank of England Act 1998, the Charters of the Bank and related documents,” Bank of England;
12. “Bank of Scotland 1696: paper money launched,” Lloyds Banking Group;
13. “Isaac Newton: Financial Regulator,” Magic, Maths and Money;
14. “Liverpool Act of 1816,” Encyclopaedia of Money;
15. Ibid.
16. “How big was the empire?,” National Archives;
17. “British Empire,” Encyclopaedia Brittanica;
18. “Why was India so valuable to the British Empire?,” British Broadcasting Corporation;
19. “Great Britain and Her World, 1750-1914,” National Library of Australia;
20. “Mint Parity Theory of Equilibrium Rate of Exchange,” Your Article Library;
21. “History of the Bank of England,” Bank of England;
22. “The Bank of England as the World Gold Market Maker during the Classical Gold Standard Era 1889-1910,” Ugolini;
23. “David Hume,” The Concise Library of Economics;
24. “The international monetary system 1870-1773,” University of California, Berkeley;
25. “Gold Standard,” The Concise Library of Economics;
26. “The economy and the First World War,” Cabinet Papers;
27. “Currency wars and the fall of empires,” Frances Coppola, Pieria;

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