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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 effiux. And
the tightness so produced is often greater than, and always equal
to, the preceding unnatural laxity.

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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 buythat 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 0 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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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 pmdence,
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.

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