The Origin of the Bank of England: A Credible Commitment to Sovereign Debt

Der-Yuan Yang, University of California-Santa Barbara

North [1991] identifies institutions and organizations as rules and players of a game, respectively. Throughout the development of history, many new organizations emerged and their functions evolved. Tracing the growth and change of some important institutions and organizations may give us valuable insights into contemporary economic issues.
Many economists have explored how the Bank of England has evolved since 1694 from a private business to the central bank, such as Bowen [1995]. We look at the Bank from a different perspective: as a credible commitment to build mutual trust between the king and Parliament. By credible commitment, we mean an institution which allows players of a game to make their actions transparent and to pledge valuable belongings, enabling players to cultivate mutual trust. To induce cooperation in a strategic situation, a credible commitment is functional; forcing players' actions to be transparent eliminates moral hazard, while pledging their valuable belongings changes players' incentives.
The sovereign debt scenario can be represented by a Prisoner's Dilemma (PD) game, in which both players' dominant strategy is to defect because there is no means to make both parties' commitment to cooperation trustworthy, even though they know that mutual cooperation will bring them altogether higher payoffs. If debtor countries cooperate but the creditors defect, then the creditors can continue to get debts serviced without contributing new loans, while debtor countries suffer from draining resources and economic austerity; the creditors are better off by choosing to defect when debtor countries cooperate. On the other hand, if the creditors cooperate but debtor countries defect, then the creditors offer new loans and lower interest charges, while debtor countries defer loan services and undertake no economic adjustments; debtor countries achieve a higher utility at the expense of the creditors. The worst scenario is when both parties defect; creditor banks may have to face bank runs, while debtor countries experience sluggish economic development. However, if they cooperate, creditors will get profits from providing financial services, sharing the fruits of debtor countries' economic prosperity. There is no means to make their commitment to cooperation credible in a PD game; hence, both will defect, ending up a worse outcome than if they cooperate. In ancient China, actual hostages were once used to induce cooperation among states [Qin 1996]. This episode indicates a possibility to solve the dilemma, even for players like sovereign states, which have no world government to regulate.
Cooperation is mutually beneficial to the sovereign debtors and the creditors. However, since each may be better off by defecting, as illustrated before, cooperation is not the best response for each party. Cooperation is particularly difficult with those debtors having delinquent records. Sovereign default occurred very often in the 19th and the early 20th centuries [Dawson 1990]. In the medieval period, kings of England likewise were notorious for their repudiation of loan contracts and persecution of defiant lenders [Hicks 1969]. However, as history has demonstrated, the English king managed to reach an efficient and cooperative solution with his creditors: after the Glorious Revolution, the crown's financing rate dropped dramatically and the credit line drastically increased [Weingast 1995]. The founding of the Bank of England played a critical role, a credible commitment making the king's promise to pay trustworthy and his actions manifest to the public. The importance of binding commitment cannot be overemphasized.

With Credible Commitment: The Nash Bargaining Solution
If signing a binding agreement is possible in a negotiation, then we may examine a cooperative scenario via the Nash bargaining solution. Yang [1997] analyzes a cooperative outcome of sovereign financing negotiation in a two-period model using the Nash bargaining solution. The result indicates that the initial debt and new loans are positively related, while the debt due in the second period and the interest rate are negatively related. This result assumes that both parties can commit to the agreement. The conclusion seems natural: if a debtor country faces a large initial debt, it will need resources to pay off the debt and to develop the economy. The creditor, thus, needs to provide more new loans to the debtor country. In addition, if the debt due in the second period grows, other things being equal, to help the debtor's economy sustain, the creditor had better cut the interest rate. This ideal cooperative resolution, nevertheless, seldom exists; how can a bank make more loans when there are already funds potentially facing high risk of default? If an agreement is not reached, both will attain the utility denoted by the threat point in the Nash bargaining solution, the same as if both defect in a PD game. That is, the debtor ends up breaching the contract because of insufficient liquidity, while the creditor confronts a large capital loss and potentially a bank run.
There needs to be a guarantee for the security of outstanding debts and new loans; particularly, when the debtors are sovereign states because no one can use the legal system to effectively enforce sovereign debts. However, the Nash bargaining solution does not discuss how commitment can be formed, which is a drawback of the model. To circumvent this shortcoming, Rubinstein [1982] develops a non-cooperative approach to inspect the sharing of a pie between two persons. Bulow and Rogoff [1989a and 1989b] adopt this approach to investigate the negotiation among sovereign debtors and creditor banks. Their results detail the negotiation processes, in addition to the gains and the costs to both parties. Though their non-cooperative approach provides an incentive compatible solution, the result is not efficient. Binmore [1993] indicates an approximation to the Nash bargaining solution via Rubinstein's [1982] non-cooperative framework. Instead of presenting more theoretical analyses, we explore a valuable lesson in history, looking for a credible commitment to solve the inefficiency. There indeed existed an institution to make one's commitment trustworthy, even for a sovereign.

Sovereign Finances of England and France in the Past
In the medieval period, tax collection was a very difficult task; the king often relegated local agents and office holders to collect taxes for the sovereign, a practice called tax farming [Hicks 1969]. Generally, these agents or office holders had tax exemption privilege, narrowing the tax base and reducing tax revenue. However, tax farming supplied the king regular income: the agents and office holders committed fixed annual payment to the royal coffer regardless of the taxes they collected. In addition, they were good sources for the king to apply for loans. Though the king was often under the mercy of tax farmers and lost fiscal control, he gained facilitated credit and convenience [Brewer 1989, 88-134]. The kings, both in England and in France, were constantly in need of funds because of tremendous expenditures in wars. Wars forced the sovereign to finance his budget through borrowing, which resulted in heavy debt services of the royal coffer, aggravating the situation year after year (see [Hoffman 1994] and [Jones 1994]).
The fiscal deficit was more severe in France than in England; Bien [1987] has a holistic analysis of the scenario. The privileged group was ubiquitous in France, enjoying tax exemption and defying fiscal reforms. The king borrowed heavily from the privileged group, which in turn channeled money from the public; debt services absorbed about 68 percent of the tax revenue toward 1789. It is striking that the privileged group could borrow at low interest rates, 5 percent and below, in much the same way as the English king through Parliament and the Bank of England. However, this financing mechanism broke down when the king's fiscal demand grew incessantly due to expenditures on wars. Since the king had no means to make his commitment to debt services credible, as a result, when the privileged group rejected the king's request for further financing, he had to congregate the Estates General, which aroused not only a great debate but the French Revolution [Norberg 1994].
The case of England is distinct from that of France [Jones 1994]. Unlike the French sinuous financing, the English king had to negotiate directly with Parliament. After the Restoration, the king was permitted only limited funds, which started an annual deficit for the royal coffer. Though the king was not able to levy taxes illegally, he evaded Parliament's restriction by borrowing from bankers, secured on taxes approved by Parliament. The sovereign debt incurred high interest costs and caused conflicts between Parliament and the Financial Interests, resulting in sovereign default, Stop of Exchequer. Finally, Parliament realized that the threat to the properties constituted impingement on the nation, the Protestant religion, and its own existence. After the Glorious Revolution, Parliament dominated the political forum, and thus, the sovereign financial affairs. However, Parliament had no faith in the new king, William III, who badly needed resources to finance the wars against France. A mechanism had to be established to monitor the king's fiscal expenditures and to build the trust between the king and Parliament.

The Origin of the Bank of England: A Credible Commitment
The French king's financing was a roundabout approach: the king borrowed from the privileged group, which in turn acquired funds from the public. The privileged group offered the public two protections, binding forces among members and their capital, but the king had none to render the privileged group. For this reason, the privileged group could borrow at low interest rates, but not the king.
The English sovereign financing followed a more direct path. The king could not raise taxes without Parliament's consent; even if he evaded by borrowing from bankers, the king used legitimate taxes as a guarantee. Consequently, the king had to negotiate directly with Parliament, where the financial resources actually came from.
Compared to the English case, in France, after the privileged group rejected the funds the royal coffer desperately needed, the king had to resort to his subjects, resulting in the convocation of the Estates General. As for England, when Parliament declined the king's request for financial support, the sovereign had no other alternatives; the crown was forced to make his commitment to loan contracts credible.
Andreades [1966, 43-59] describes concisely the origin of the Bank of England. Confronted with insufficient tax revenue, the king realized that the creation of a bank might strengthen his financial position. Though William III introduced many new taxes, the revenue did not reach the level expected due to corruption; additionally, recognizing his unpopularity, the king had to undertake fiscal reforms with great caution. With limited confidence in the new king, Parliament approved taxes only for the services for the current year, the best guarantee that Parliament would meet regularly. Due to his predecessors' notorious records of debt repudiation and the lack of trust in the stability of the government, the king was forced to plead for a loan of 100,000 from the City of London, the raising cost was about 30 percent of the loan. Though several other innovative measures were implemented to raise funds, these sums were not enough to meet the expenses of wars. Furthermore, the costs for these expedient maneuvers were too high to bear. At last, the plan to establish the Bank of England was adopted in 1694. In addition to managing the national debt, the Bank succeeded in combining the national interests with private ones.
Financing through the Bank made the disbursement of funds transparent, thus, the king would not be able to evade the legislature's supervision, eliminating moral hazard problem. The episode in which funds allocated to wage wars against Holland were instead used to form alliance with the supposed enemy would not happen again [Jones 1994]. Moreover, the king had no choice but keep his promise to pay; if sovereign default occurred, the national debts, the Bank's major assets, would become worthless and the Bank would go bankrupt, a result fatal to the State [Hicks 1969]. The Bank acted as a credible commitment in the hands of Parliament. Parliament prevailed in the political forum, but the legislature had no incentives to renege the financing contract, which might have resulted in the collapse of the nation, and consequently, Parliament's demise. The Bank created a commonwealth for all the English people, making cooperation incentive compatible for the king and Parliament. Without the Bank, the king would have no means to sustain the fiscal crisis since taxes were not enough to pay off loans and military expenditures; he could not but default. As for Parliament, due to the lack of trust in the crown and notorious records of sovereign default, lending was not the legislature's best response. After all, the founding of the Bank resolved both parties' dilemma, cultivating mutual trust between the king and Parliament. The Bank engineered enormous financial resources to the army and the navy, helping England dominate in the world. Above all, the Bank secured the public trust, an indispensable factor in economic development and power struggle against France. If not for the Bank, England might not have defeated France in the economic and power competition in the 18th century.

Conclusion
This paper has explored the emergence of the Bank of England as well as investigated sovereign financing and a credible commitment toward a cooperative solution in a sovereign debt negotiation. The sovereign financing negotiation can be represented by a PD game, in which both parties' dominant strategy is to defect, though they realize that cooperation can make them better off. Since no means exists to make their commitment to loan contracts credible, cooperation is not an incentive compatible strategy.
In the financial evolution of the 17th and the 18th centuries, the Bank played a critical role, acting as the king's credible commitment to Parliament. If the king defaulted, the national debts, the Bank's major assets, would become valueless and the Bank would go bankrupt, which would cause the kingdom to collapse. Therefore, the crown would not repudiate the loans. Even though Parliament prevailed in the political forum, members of Parliament had no incentive to abuse the Bank, either. Once they breached the financing contracts, the consequence would be no different from sovereign default: the breakdown of public trust would occasion Parliament's annihilation.
The analysis has demonstrated how the Bank, acting as a credible commitment, made the financing contracts between the king and Parliament binding. Even in a PD game, we have found a means to make cooperation an optimal strategy, which has tremendous implication in the reforms of international financial organizations. To facilitate future sovereign financing and economic development in less developed areas, we may need an institution, a new rule of sovereign financing, which is able to disclose openly the relevant economic operations of sovereign states and to manage impartially the finances thereof. The proposal of debt swap for environment could be a feasible option for the Third World debt crisis in the 1980s. Further research in this field may shed light on the reforms of how the international community should manage its financial affairs.

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