Lombard Street: A Description of the Money Market

When the trade of Banking began to be better understood, when the Banking system was thoroughly secure, the Government might begin to lend gradually; especially to lend the unusually large sums which even under the most equable system of finance will at times accumulate in the public exchequer.

Under a natural system of banking it would have every facility. Where there were many banks keeping their own reserve, and each most anxious to keep a sufficient reserve, because its own life and credit depended on it, the risk of the Government in keeping a banker would be reduced to a minimum. It would have the choice of many bankers, and would not be restricted to any one.

Its course would be very simple, and be analogous to that of other public bodies in the country. The Metropolitan Board of Works, which collects a great revenue in London, has an account at the London and Westminster Bank, for which that bank makes a deposit of Consols as a security. The Chancellor of the Exchequer would have no difficulty in getting such security either. If, as is likely, his account would be thought to be larger than any single bank ought to be entrusted with, the public deposits might be divided between several. Each would give security, and the whole public money would be safe. If at any time the floating money in the hands of Government were exceptionally large, he might require augmented security to be lodged, and he might obtain an interest. He would be a lender of such magnitude and so much influence, that he might command his own terms. He might get his account kept safe if anyone could.

If, on the other hand, the Chancellor of the Exchequer were a borrower, as at times he is, he would have every facility in obtaining what he wanted. The credit of the English Government is so good that he could borrow better than anyone else in the world. He would have greater facility, indeed, than now, for, except with the leave of Parliament, the Chancellor of the Exchequer cannot borrow by our present laws in the open market. He can only borrow from the Bank of England on what are called 'deficiency bills.' In a natural system, he would borrow of any one out of many competing banks, selecting the one that would lend cheapest; but under our present artificial system, he is confined to a single bank, which can fix its own charge.

If contrary to expectation a collapse occurred, the Government might withdraw, as the American Government actually has withdrawn, its balance from the bankers. It might give its aid, lend Exchequer bills, or otherwise pledge its credit for the moment, but when the exigency was passed it might let the offending banks suffer. There would be a penalty for their misconduct. New and better banks, who might take warning from that misconduct, would arise. As in all natural trades, what is old and, rotten would perish, what is new and good would replace it. And till the new banks had proved, by good conduct, their fitness for State confidence, the State need not give it. The Government could use its favour as a bounty on prudence, and the withdrawal of that favour as a punishment for culpable folly.

Under a good system of banking, a great collapse, except from rebellion or invasion, would probably not happen. A large number of banks, each feeling that their credit was at stake in keeping a good reserve, probably would keep one; if any one did not, it would be criticised constantly, and would soon lose its standing, and in the end disappear. And such banks would meet an incipient panic freely, and generously; they would advance out of their reserve boldly and largely, for each individual bank would fear suspicion, and know that at such periods it must 'show strength,' if at such times it wishes to be thought to have strength. Such a system reduces to a minimum the risk that is caused by the deposit. If the national money can safely be deposited in banks in any way, this is the way to make it safe.

But this system is nearly the opposite to that which the law and circumstances have created for us in England. The English Government, far from keeping cash from the money market till the position of that market was reasonably secure, at a very early moment, and while credit of all kinds was most insecure, for its own interests entered into the Money Market. In order to effect loans better, it gave the custody and profit of its own money (along with other privileges) to a single bank, and therefore practically and in fact it is identified with the Bank of this hour. It cannot let the money market take care of itself because it has deposited much money in that market, and it cannot pay its way if it loses that money.

Nor would any English statesman propose to 'wind up' the Bank of England. A theorist might put such a suggestion on paper, but no responsible government would think of it. At the worst crisis and in the worst misconduct of the Bank, no such plea has been thought of: in 1825 when its till was empty, in 1837 when it had to ask aid from the Bank of France, no such idea was suggested. By irresistible tradition the English Government was obliged to deposit its money in the money market and to deposit with this particular Bank.

And this system has plain and grave evils.

1st. Because being created by state aid, it is more likely than a natural system to require state help.

2ndly. Because, being a one-reserve system, it reduces the spare cash of the Money Market to a smaller amount than any other system, and so makes that market more delicate. There being a less hoard to meet liabilities, any error in the management of that reserve has a proportionately greater effect.

3rdly. Because, our one reserve is, by the necessity of its nature, given over to one board of directors, and we are therefore dependent on the wisdom of that one only, and cannot, as in most trades, strike an average of the wisdom and the folly, the discretion and the indiscretion, of many competitors.

Lastly. Because that board of directors is, like every other board, pressed on by its shareholders to make a high dividend, and therefore to keep a small reserve, whereas the public interest imperatively requires that they shall keep a large one.

These four evils were inseparable from the system, but there is besides an additional and accidental evil. The English Government not only created this singular system, but it proceeded to impair it, and demoralise all the public opinion respecting it. For more than a century after its creation (notwithstanding occasional errors) the Bank of England, in the main, acted with judgment and with caution. Its business was but small as we should now reckon, but for the most part it conducted that business with prudence and discretion. In 1696, it had been involved in the most serious difficulties, and had been obliged to refuse to pay some of its notes. For a long period it was in wholesome dread of public opinion, and the necessity of retaining public confidence made it cautious. But the English Government removed that necessity. In 1797, Mr. Pitt feared that he might not be able to obtain sufficient species for foreign payments, in consequence of the low state of the Bank reserve, and he therefore required the Bank not to pay in cash. He removed the preservative apprehension which is the best security of all Banks.

For this reason the period under which the Bank of England did not pay gold for its notes—the period from 1797 to 1819—is always called the period of the Bank restriction. As the Bank during that period did not perform, and was not compelled by law to perform, its contract of paying its notes in cash, it might apparently have been well called the period of Bank license. But the word 'restriction' was quite right, and was the only proper word as a description of, the policy of 1797. Mr. Pitt did not say that the Bank of England need not pay its notes in specie; he 'restricted' them from doing so; he said that they must not.

In consequence, from 1797 to 1844 (when a new era begins), there never was a proper caution on the part of the Bank directors. At heart they considered that the Bank of England had a kind of charmed life, and that it was above the ordinary banking anxiety to pay its way. And this feeling was very natural. A bank of issue, which need not pay its notes in cash, has a charmed life; it can lend what it wishes, and issue what it likes, with no fear of harm to itself, and with no substantial check but its own inclination. For nearly a quarter of a century, the Bank of England was such a bank, for all that time it could not be in any danger. And naturally the public mind was demoralised also. Since 1797, the public have always expected the Government to help the Bank if necessary. I cannot fully discuss the suspensions of the Act of 1844 in 1847, 1857, and 1866; but indisputably one of their effects is to make people think that Government will always help the Bank if the Bank is in extremity. And this is the sort of anticipation which tends to justify itself, and to cause what it expects.

On the whole, therefore, the position of the Chancellor of the Exchequer in our Money Market is that of one who deposits largely in it, who created it, and who demoralised it. He cannot, therefore, banish it from his thoughts, or decline responsibility for it. He must arrange his finances so as not to intensify panics, but to mitigate them. He must aid the Bank of England in the discharge of its duties; he must not impede or prevent it.

His aid may be most efficient. He is, on finance, the natural exponent of the public opinion of England. And it is by that opinion that we wish the Bank of England to be guided. Under a natural system of banking we should have relied on self-interest, but the State prevented that; we now rely on opinion instead; the public approval is a reward, its disapproval a severe penalty, on the Bank directors; and of these it is most important that the finance minister should be a sound and felicitous exponent.

CHAPTER V

The Mode in Which the Value of Money is Settled in Lombard Street.

Many persons believe that the Bank of England has some peculiar power of fixing the value of money. They see that the Bank of England varies its minimum rate of discount from time to time, and that, more or less, all other banks follow its lead, and charge much as it charges; and they are puzzled why this should be. 'Money,' as economists teach, 'is a commodity, and only a commodity;' why then, it is asked, is its value fixed in so odd a way, and not the way in which the value of all other commodities is fixed?

There is at bottom, however, no difficulty in the matter. The value of money is settled, like that of all other commodities, by supply and demand, and only the form is essentially different. In other commodities all the large dealers fix their own price; they try to underbid one another, and that keeps down the price; they try to get as much as they can out of the buyer, and that keeps up the price. Between the two what Adam Smith calls the higgling of the market settles it. And this is the most simple and natural mode of doing business, but it is not the only mode. If circumstances make it convenient another may be adopted. A single large holder—especially if he be by far the greatest holder—may fix his price, and other dealers may say whether or not they will undersell him, or whether or not they will ask more than he does. A very considerable holder of an article may, for a time, vitally affect its value if he lay down the minimum price which he will take, and obstinately adhere to it. This is the way in which the value of money in Lombard Street is settled. The Bank of England used to be a predominant, and is still a most important, dealer in money. It lays down the least price at which alone it will dispose of its stock, and this, for the most part, enables other dealers to obtain that price, or something near it.

The reason is obvious. At all ordinary moments there is not money enough in Lombard Street to discount all the bills in Lombard Street without taking some money from the Bank of England. As soon as the Bank rate is fixed, a great many persons who have bills to discount try how much cheaper than the Bank they can get these bills discounted. But they seldom can get them discounted very much cheaper, for if they did everyone would leave the Bank, and the outer market would have more bills than it could bear.

In practice, when the Bank finds this process beginning, and sees that its business is much diminishing, it lowers the rate, so as to secure a reasonable portion of the business to itself, and to keep a fair part of its deposits employed. At Dutch auctions an upset or maximum price used to be fixed by the seller, and he came down in his bidding till he found a buyer. The value of money is fixed in Lombard Street in much the same way, only that the upset price is not that of all sellers, but that of one very important seller, some part of whose supply is essential.

The notion that the Bank of England has a control over the Money Market, and can fix the rate of discount as it likes, has survived from the old days before 1844, when the Bank could issue as many notes as it liked. But even then the notion was a mistake. A bank with a monopoly of note issue has great sudden power in the Money Market, but no permanent power: it can affect the rate of discount at any particular moment, but it cannot affect the average rate. And the reason is, that any momentary fall in money, caused by the caprice of such a bank, of itself tends to create an immediate and equal rise, so that upon an average the value is not altered.

What happens is this. If a bank with a monopoly of note issue suddenly lends (suppose) 2,000,000 L. more than usual, it causes a proportionate increase of trade and increase of prices. The persons to whom that 2,000,000 L. was lent, did not borrow it to lock it up; they borrow it, in the language of the market, to 'operate with' that is, they try to buy with it; and that new attempt to buy—that new demand raises prices. And this rise of prices has three consequences. First. It makes everybody else want to borrow money. Money is not so efficient in buying as it was, and therefore operators require more money for the same dealings. If railway stock is 10 per cent dearer this year than last, a speculator who borrows money to enable him to deal must borrow 10 per cent more this year than last, and in consequence there is an augmented demand for loans. Secondly. This is an effectual demand, for the increased price of railway stock enables those who wish it to borrow more upon it. The common practice is to lend a certain portion of the market value of such securities, and if that value increases, the amount of the usual loan to be obtained on them increases too. In this way, therefore, any artificial reduction in the value of money causes a new augmentation of the demand for money, and thus restores that value to its natural level. In all business this is well known by experience: a stimulated market soon becomes a tight market, for so sanguine are enterprising men, that as soon as they get any unusual ease they always fancy that the relaxation is greater than it is, and speculate till they want more than they can obtain.

In these two ways sudden loans by an issuer of notes, though they may temporarily lower the value of money, do not lower it permanently, because they generate their own counteraction. And this they do whether the notes issued are convertible into coin or not. During the period of Bank restriction, from 1797 to 1819, the Bank of England could not absolutely control the Money Market, any more than it could after 1819, when it was compelled to pay its notes in coin. But in the case of convertible notes there is a third effect, which works in the same direction, and works more quickly. A rise of prices, confined to one country, tends to increase imports, because other countries can obtain more for their goods if they send them there, and it discourages exports, because a merchant who would have gained a profit before the rise by buying here to sell again will not gain so much, if any, profit after that rise. By this augmentation of imports the indebtedness of this country is augmented, and by this diminution of exports the proportion of that indebtedness which is paid in the usual way is decreased also. In consequence, there is a larger balance to be paid in bullion; the store in the bank or banks keeping the reserve is diminished, and the rate of interest must be raised by them to stay the efflux. And the tightness so produced is often greater than, and always equal to, the preceding unnatural laxity.

There is, therefore, no ground for believing, as is so common, that the value of money is settled by different causes than those which affect the value of other commodities, or that the Bank of England has any despotism in that matter. It has the power of a large holder of money, and no more. Even formerly, when its monetary powers were greater and its rivals weaker, it had no absolute control. It was simply a large corporate dealer, making bids and much influencing—though in no sense compelling—other dealers thereby.

But though the value of money is not settled in an exceptional way, there is nevertheless a peculiarity about it, as there is about many articles. It is a commodity subject to great fluctuations of value, and those fluctuations are easily produced by a slight excess or a slight deficiency of quantity. Up to a certain point money is a necessity. If a merchant has acceptances to meet to-morrow, money he must and will find to-day at some price or other. And it is this urgent need of the whole body of merchants which runs up the value of money so wildly and to such a height in a great panic. On the other hand, money easily becomes a 'drug,' as the phrase is, and there is soon too much of it. The number of accepted securities is limited, and cannot be rapidly increased; if the amount of money seeking these accepted securities is more than can be lent on them the value of money soon goes down. You may often hear in the market that bills are not to be had, meaning good bills of course, and when you hear this you may be sure that the value of money is very low.

If money were all held by the owners of it, or by banks which did not pay an interest for it, the value of money might not fall so fast. Money would, in the market phrase, be 'well held.' The possessors would be under no necessity to employ it all; they might employ part at a high rate rather than all at a low rate. But in Lombard Street money is very largely held by those who do pay an interest for it, and such persons must employ it all, or almost all, for they have much to pay out with one hand, and unless they receive much with the other they will be ruined. Such persons do not so much care what is the rate of interest at which they employ their money: they can reduce the interest they pay in proportion to that which they can make. The vital points to them is to employ it at some rate. If you hold (as in Lombard Street some persons do) millions of other people's money at interest, arithmetic teaches that you will soon be ruined if you make nothing of it even if the interest you pay is not high.

The fluctuations in the value of money are therefore greater than those on the value of most other commodities. At times there is an excessive pressure to borrow it, and at times an excessive pressure to lend it, and so the price is forced up and down.

These considerations enable us to estimate the responsibility which is thrown on the Bank of England by our system, and by every system on the bank or banks who by it keep the reserve of bullion or of legal tender exchangeable for bullion. These banks can in no degree control the permanent value of money, but they can completely control its momentary value. They cannot change the average value, but they can determine the deviations from the average. If the dominant banks manage ill, the rate of interest will at one time be excessively high, and at another time excessively low: there will be first a pernicious excitement, and next a fatal collapse. But if they manage well, the rate of interest will not deviate so much from the average rate; it will neither ascend so high nor descend so low. As far as anything can be steady the value of money will then be steady, and probably in consequence trade will be steady too—at least a principal cause of periodical disturbance will have been withdrawn from it.

CHAPTER VI

Why Lombard Street is Often Very Dull, and Sometimes Extremely Excited.

Any sudden event which creates a great demand for actual cash may cause, and will tend to cause, a panic in a country where cash is much economised, and where debts payable on demand are large. In such a country an immense credit rests on a small cash reserve, and an unexpected and large diminution of that reserve may easily break up and shatter very much, if not the whole, of that credit. Such accidental events are of the most various nature: a bad harvest, an apprehension of foreign invasion, the sudden failure of a great firm which everybody trusted, and many other similar events, have all caused a sudden demand for cash. And some writers have endeavoured to classify panics according to the nature of the particular accidents producing them. But little, however, is, I believe, to be gained by such classifications. There is little difference in the effect of one accident and another upon our credit system. We must be prepared for all of them, and we must prepare for all of them in the same way—by keeping a large cash reserve.

But it is of great importance to point out that our industrial organisation is liable not only to irregular external accidents, but likewise to regular internal changes; that these changes make our credit system much more delicate at some times than at others; and that it is the recurrence of these periodical seasons of delicacy which has given rise to the notion that panics come according to a fixed rule, that every ten years or so we must have one of them.

Most persons who begin to think of the subject are puzzled on the threshold. They hear much of 'good times' and 'bad times,' meaning by 'good' times in which nearly everyone is very well off, and by 'bad' times in which nearly everyone is comparatively ill off. And at first it is natural to ask why should everybody, or almost everybody, be well off together? Why should there be any great tides of industry, with large diffused profit by way of flow, and large diffused want of profit, or loss, by way of ebb? The main answer is hardly given distinctly in our common books of political economy. These books do not tell you what is the fund out of which large general profits are paid in good times, nor do they ex plain why that fund is not available for the same purpose in bad times. Our current political economy does not sufficiently take account of time as an element in trade operations; but as soon as the division of labour has once established itself in a community, two principles at once begin to be important, of which time is the very essence. These are:

First. That as goods are produced to be exchanged, it is good that they should be exchanged as quickly as possible.

Secondly. That as every producer is mainly occupied in producing what others want, and not what he wants himself, it is desirable that he should always be able to find, without effort, without delay, and without uncertainty, others who want what he can produce.

In themselves these principles are self-evident. Everyone will admit it to be expedient that all goods wanting to be sold should be sold as soon as they are ready; that every man who wants to work should find employment as soon as he is ready for it. Obviously also, as soon as the 'division of labour' is really established, there is a difficulty about both of these principles. A produces what he thinks B wants, but it may be a mistake, and B may not want it. A may be able and willing to produce what B wants, but he may not be able to find B—he may not know of his existence.

The general truth of these principles is obvious, but what is not obvious is the extreme greatness of their effects. Taken together, they make the whole difference between times of brisk trade and great prosperity, and times of stagnant trade and great adversity, so far as that prosperity and that adversity are real and not illusory. If they are satisfied, everyone knows whom to work for, and what to make, and he can get immediately in exchange what he wants himself. There is no idle labour and no sluggish capital in the whole community, and, in consequence, all which can be produced is produced, the effectiveness of human industry is augmented, and both kinds of producers—both capitalists and labourers—are much richer than usual, because the amount to be divided between them is also much greater than usual.