The Bank of England

Podcast Transcript

In the late 17th century, King William III of England was facing a problem.

He was in the middle of a prolonged war with France, was in desperate need of money, and he had exhausted most of the traditional sources for funding a war.

A proposal came forward for a new bank that could lend the crown money at favorable interest rates, and also solve several problems for merchants in the country.

Learn more about the Bank of England, one of the most important banks in history, on this episode of Everything Everywhere Daily.

Something that most leaders quickly realize is that wars are not really fought with weapons and men. They are ultimately fought with money.

In the early 1690s, King William III’s government was facing spiraling war costs in its conflict with Louis XIV of France during the Nine Years’ War.

Traditional methods of raising funds, such as short-term loans from goldsmith-bankers, taxes, and customs revenues, were insufficient and unreliable. England’s creditworthiness was weak, and lenders demanded high interest rates due to repeated defaults earlier in the century.

At the same time, London’s financial world was evolving.

Goldsmith-bankers had pioneered deposit-taking and lending, but there was no institution able to mobilize large amounts of capital on a long-term basis for the state, nor to issue a widely trusted, standard paper currency.

The solution to both of these problems was proposed by William Paterson, a Scottish merchant and financier with experience in Amsterdam’s sophisticated financial markets.

Paterson had a clear model in mind: the Amsterdam Wisselbank and the Swedish Riksbank, which demonstrated how a state-backed bank could finance government and simultaneously stabilize the currency.

In 1691, Paterson proposed a public corporation that would lend a substantial sum to the Crown at a fixed interest rate in return for the right to issue banknotes and conduct banking business. His original plan failed to gain traction, but wartime desperation revived the idea.

In 1694, the government was seeking £1.2 million, which was an enormous sum at the time, to fund the war effort. Parliament agreed to raise the money via a public subscription, in which investors would lend the sum to the government at 8 percent interest, plus an annual £4,000 management fee.

Subscribers would be incorporated as “The Governor and Company of the Bank of England”, with privileges including the right to issue banknotes backed by the government debt, to deal in bills of exchange, and to accept deposits. This arrangement effectively linked the new bank’s fortunes to those of the English state.

The Bank was created under the Tonnage Act of 1694, formally titled An Act for granting to Their Majesties several Rates and Duties upon Tonnage of Ships and Vessels, and upon Beer, Ale and other Liquors, for securing certain Recompenses and Advantages in the said Act mentioned, to such Persons as shall voluntarily advance the Sum of Fifteen hundred thousand Pounds towards carrying on the War against France.

It was a marriage of convenience: the government got the money it desperately needed, while the bank’s investors received 8% annual interest plus the exclusive right to issue banknotes in England.

The subscription for the £1.2 million loan opened in June 1694 and was fully taken up within 12 days, a sign of strong investor interest in the combination of high interest and royal backing. The Bank began operations in rented premises in the Mercers’ Hall, moving later to Grocers’ Hall, before eventually establishing its own headquarters in Threadneedle Street in 1734.

Initially, the Bank’s main assets were the government debt it had purchased, and its liabilities were the notes it issued against this debt. These notes began to circulate as a trusted paper currency, though at first mainly among merchants and financiers.

If you remember back to my episode on the gold standard, these paper notes were redeemable for gold upon demand.

The Bank faced early opposition from the Tory party, which saw it as an instrument of the Whig party, from goldsmith-bankers who lost influence, and from the Land Bank scheme, which was a rival project backed by landed interests.

It also had to weather a 1696 currency crisis caused by the Great Recoinage, which strained its reserves when holders of notes demanded silver in exchange.

Nevertheless, its survival and ability to roll over government loans cemented its position. Over the following decades, it became the indispensable fiscal arm of the British state, financing wars and underpinning public credit.

At its founding, the Bank was a regular commercial bank that happened to have a large, privileged client: the Crown. It took deposits, discounted bills of exchange, and issued banknotes, but its biggest role was holding and managing the government’s accounts. Its notes were backed partly by the £1.2 million loan to the Crown and partly by precious metal reserves.

However, this special relationship meant its fortunes rose and fell with government credit. The Nine Years’ War and War of the Spanish Succession in 1701 saw repeated calls for loans, and the Bank frequently rolled over and expanded its holdings of public debt. Its ability to raise funds for the state began to crowd out competitors.

A key turning point came in 1708, when Parliament renewed the Bank’s charter and granted it an exclusive privilege: no other bank with more than six partners could be formed in England. This effectively prevented the creation of competing large-scale joint-stock banks, leaving only small private banks alongside the Bank of England.

This period also saw the rise of long-term public debt instruments like consols, which are perpetual government bonds first issued in 1751, with the Bank acting as registrar and transfer agent. Its role as fiscal agent deepened, but it was still primarily a profit-seeking company owned by private shareholders.

By the mid-18th century, London’s money market increasingly revolved around the Bank. Its notes had wider circulation, and merchants held deposits there as a matter of convenience and prestige.

During the American Revolutionary War and the wars with Revolutionary France, government borrowing surged. The Bank’s advances to the Treasury became so large that its reserves of gold and silver were strained, foreshadowing the next major change in its operations.

In 1797, amid fears of French invasion and a drain on gold, the government suspended the Bank’s obligation to convert its notes into gold via the Bank Restriction Act. This “Restriction Period” lasted until 1821.

Freed from convertibility, the bank could issue more notes than its gold reserves would otherwise allow, effectively creating money to finance war. This marked the first time its note-issue powers were used as a deliberate macroeconomic tool, even if contemporary understanding of “monetary policy” was rudimentary.

It was the first time, but it would not be the last.

The Bank Restriction Period also sparked intense debates about banking theory. Two schools of thought emerged: the “Banking School,” which believed banks should have flexibility in note issuance, and the “Currency School,” which wanted strict controls. This intellectual battle would shape central banking theory for generations.

Also, if you remember back to a previous episode, it was at the start of the 19th century when the United States established the First Bank of the United States, which was explicitly modeled on the Bank of England.

After returning to gold convertibility in 1821, the Bank faced criticism for its role in credit cycles and financial crises, such as the panic of 1825. Economists like David Ricardo argued that note issuance should be strictly tied to gold reserves to prevent inflation.

The 1830s and 1840s brought increasing calls for a legal framework to control the Bank’s powers, partly due to the influence of the “Currency School” of economists, who wanted a rules-based system linking note issuance to gold holdings.

The Currency School won a decisive victory with the Bank Charter Act of 1844, one of the most important pieces of financial legislation in history. This act essentially created the template for modern central banking by separating the Bank’s functions into two departments.

The Issue Department of the bank could only issue banknotes backed by gold, with a small exception for government debt, while the Banking Department conducted normal commercial operations.

This act also gave the Bank of England a monopoly on note issuance in England and Wales, gradually phasing out other banks’ ability to print money. Scotland and Northern Ireland retained some note-issuing banks, which continue today as historical remnants.

It was with this 1844 act that the Bank of England began to look and behave more like a modern central bank.

The mid-to-late Victorian era saw the Bank of England mature into its role as the world’s premier central bank. The gold standard provided a stable monetary anchor, and London became the undisputed center of global finance.

Walter Bagehot, editor of The Economist, wrote the influential book “Lombard Street” in 1873, which articulated principles that still guide central banking today. Bagehot argued that during financial crises, central banks should “lend freely, at a high rate, against good collateral.”

The outbreak of World War I in 1914 marked the end of the classical gold standard and the beginning of more active government intervention in monetary policy. The Bank helped finance the war effort and managed complex exchange rate arrangements.

The interwar period was turbulent, featuring deflation, the return to gold in 1925 at an overvalued rate that hurt British exports, and then the abandonment of gold once again in 1931 during the Great Depression.

World War II brought even greater government control over finance. The Bank became essentially an arm of the Treasury, managing war finance, exchange controls, and rationing of credit. By war’s end, the stage was set for a fundamental change in the Bank’s status.

The Bank of England Act 1946 formally nationalised the institution, transferring its stock into public ownership and placing it firmly under ministerial control, even as it retained operational expertise over monetary and financial operations.

The post-war period coincided with the Bretton Woods System, which saw the US Dollar take over from the British Pound as the world’s reserve currency.

When President Nixon ended dollar-gold convertibility in 1971, the world entered the era of floating exchange rates that continues today. The Bank had to learn new skills in managing a floating currency while dealing with the inflation pressures of the 1970s.

The biggest post-war event for the Bank of England took place on September 16, 1992. A day known as Black Wednesday.

The European Exchange Rate Mechanism or ERM was created in 1979 as part of the European Monetary System, intended to keep participating European currencies stable within narrow margins ahead of an eventual monetary union, which became the Euro.

Britain joined the ERM relatively late, in October 1990. The Pound Sterling entered at a central rate of 2.95 Deutsche Marks, with a permitted fluctuation band of ±6 percent.

By the early 1990s, the UK was in recession. Unemployment was rising, housing prices had collapsed, and interest rates were above 10 percent to defend the ERM parity and fight inflation.

Meanwhile, the Bundesbank in Germany had raised interest rates to combat inflation pressures from the reunification boom. Because ERM members had to keep their exchange rates in line with the Deutsche Mark, the UK was forced to maintain high rates despite its weak economy.

Currency traders, most famously George Soros’s Quantum Fund, concluded the pound’s ERM rate was unsustainable. The logic was simple:

If the UK kept high interest rates to defend the pound, it would deepen its recession.
If it cut rates to support the economy, the pound would fall below its ERM band.

Speculators began selling pounds for Deutsche Marks in huge volumes, betting the UK would devalue or drop out of the ERM. The Bank of England spent billions of pounds from its reserves buying sterling in the foreign exchange market to prop up the rate.

On Black Wednesday, the Bank of England began the day intervening heavily in the market.

The government announced an emergency hike in interest rates from 10% to 12%, and later said they would go to 15% the next day, measures meant to attract capital back into sterling. Despite these moves, selling pressure continued unabated, overwhelming the Bank’s interventions.

By the evening, Chancellor Norman Lamont announced the UK was suspending its membership in the ERM and returning to a floating exchange rate. The pound fell sharply on currency markets, from around 2.78 Marks to about 2.60 Marks in a single day.

The UK Treasury reportedly lost between £3.3 billion to £5 billion in the failed defence of the pound.

The Quantum Fund reportedly made over £1 billion in profit from shorting pound, cementing Soros’s public reputation as “the man who broke the Bank of England.”

Over three centuries, the Bank of England has changed dramatically from a joint stock company designed to help the king fight a war with France, to becoming the bank behind the world’s most preeminent currency during the gold standard, to being the United Kingdom’s central bank in the modern world of floating exchange rates.

Perhaps most importantly, it served as a template for almost every central bank in the world.