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Subtitle: A Description of The Money Market:
This printing does not name the publisher or date - it is in a easy to read
large format paperback. The pages are not numbered, there is no table of
contents - price was $5.00 from Amazon, a bargain.
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Reviewer's Comment:
The author was a practicing banker as well as influential author and editor in
financial affairs. His understanding of finance and banking is based on his
personal, practical experience as a banker, but it is timeless. His writing
skill, as a professional author, choice of vocabulary and adroit, sly humor
makes the reading of his prose enjoyable but necessarily exacting.
He offers his recommendations on what practical changes might be made to
improve the financial system of his time, but they should be the basis of
banking today. He is not well known enough nor are his many ideas understood
today. He is famous for one statement of advice on what a central bank should
do when there is a financial crisis. This is known as a central bank being the
'lender of last resort'. The panic takes place because in the normal daily
financial markets banks and bill brokers and others have created so much credit
on which market exchanges have been based that a mismatch between assets and
liabilities has expanded to the point that one or some institutions have
liabilities that cannot be reduced by exchange of the assets they maintain, and
trust in their solvency has been questioned. Since there is a financial network
in which individual's assets are other individual's liabilities and in the
reverse. The reduction (or elimination) of liabilities generates the reduction
of assets held by other individuals and institutions.
Mr. Bagehot's famous advice is that the central bank (that is the Bank of
England) should step in and provide or guarantee loans, in exchange for quality
securities, to support worthy (not insolvent) banks sufficient to maintain or
return the critical trust by the public that everyone will not loose their
assets due to others inability to pay off their liabilities - all of which is
denominated in the relatively tiny supply of gold coins held as bank reserve by
the BoE. Note that Bagehot's recommendation does not expand the already too
expanded credit market.
This book describes the situation, how it was created, who are the individuals
who conduct financial activities; what they actually do in contrast to what
they are theoretically presumed to do. What have been the results. He provides
cogent financial data on the reality of the 'money supply' - that is, credit
instruments and coinage in gold. The reader today likely will be surprised -
and hopefully enlightened when considering Bagehot's depiction of reality when
considering the financial world today. That is especially the world of today's
central banks.
I not only recommend, but urge, everyone interested in today's financial
system, especially the central banks to study this remarkable text. The $5.00
investment is almost nothing, but the hours you will spend to absorb the
content will be well worth your effort. The reality analyzed by Bagehot is
complex, the content of his analysis and commentary is complex, and both are
little known to individuals who should know it today. I can only offer a brief
summary of the varied content of this book plus a few of my comments on points
of interest. I add some references I consider useful below my comments.
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A summary:
Lombard Street: A Description of the Money Market (1873) is a book by
Walter Bagehot.
Bagehot was one of the first writers to describe and explain the world of
international and corporate finance, banking, and money in understandable
language. The book was initially printed in Great Britain by Henry S. King
& Co. in 1873.
Overview:
The book was in part a reaction to the financial collapse of Overend, Gurney
and Company, a wholesale discount bank located at 65 Lombard Street, London,
from which the book draws its title. When this bank suspended payments on 10
May 1866, panic spread across London, Liverpool, Manchester, Norwich, Derby and
Bristol.
Lender of last resort:
Lombard Street is known for its analysis of the Bank of England's response to
the Overend-Gurney crisis. Bagehot's advice (sometimes referred to as
"Bagehot's dictum") for the lender of last resort during a credit
crunch is summarized by Charles Goodhart as follows: Lend freely. At a high
rate of interest. On good banking securities.
(Nonetheless, Goodhart emphasizes that many of these ideas were spelled out
earlier by Henry Thornton's book The Paper Credit of Great Britain.) Bagehot's
dictum has been summarized by Paul Tucker as follows: "to avert panic,
central banks should lend early and freely (ie without limit), to solvent
firms, against good collateral, and at ‘high rates’".
In Bagehot's own words (Lombard Street, Chapter 7, paragraphs 57–58),
lending by the central bank in order to stop a banking panic should follow two
rules:
First. That these loans should only be made at a very high rate of interest.
This will operate as a heavy fine on unreasonable timidity, and will prevent
the greatest number of applications by persons who do not require it. The rate
should be raised early in the panic, so that the fine may be paid early; that
no one may borrow out of idle precaution without paying well for it; that the
Banking reserve may be protected as far as possible.
Secondly. That at this rate these advances should be made on all good banking
securities, and as largely as the public ask for them. The reason is plain. The
object is to stay alarm, and nothing therefore should be done to cause alarm.
But the way to cause alarm is to refuse some one who has good security to
offer... No advances indeed need be made by which the Bank will ultimately
lose. The amount of bad business in commercial countries is an infinitesimally
small fraction of the whole business... The great majority, the majority to be
protected, are the 'sound' people, the people who have good security to offer.
If it is known that the Bank of England is freely advancing on what in ordinary
times is reckoned a good security—on what is then commonly pledged and
easily convertible—the alarm of the solvent merchants and bankers will be
stayed. But if securities, really good and usually convertible, are refused by
the Bank, the alarm will not abate, the other loans made will fail in obtaining
their end, and the panic will become worse and worse.
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Chapter I, Introductory
- The author states his purpose: "I venture to call this Essay
"Lombard Street", and not the "Money Market" or any such
phrase, because I wish to deal and to show that I mean to deal, with concrete
realities." He dismisses the abstract theories propounded by many authors.
He mentions the Act of 1844, that has generated too much argumentation between
it supporters and attackers. They both consider that the Act has created the
major operations of the English Money Market. He comments: "The briefest
and truest way of describing Lombard Street is to say that it is by far the
greatest combination of economical power and economical delicacy that the world
has even seen. Of the greatness of the power there will be no doubt. Money is
economical power." He continues by noting that it has much more
"immediately disposable and ready cash than any other country." He
provides a statistic of the quantity of deposits in the banks of London, Paris,
New York and the German Empire with London containing more than twice the total
of the other three. And in addition there are more deposits that are not
revelled in many other banks. He agrees that there is much more money in those
other countries and the world than is officially accounted, but it is not
available for use in the money market. British monetary power is evidenced by
the huge volume of lending by British banks to all and sundry. In contrast to
earlier times, during which it was difficult for obtain capital to invest in
even the most potentially profitable new enterprise, now (mid 19th century)
such capital is so available that obtaining it is not a real concern. But such
loans are not the key function. He continues: "But though these occasional
loans to new enterprises and foreign States are the most conspicuous instances
of the power of Lombard Street, they are not by any means the most remarkable
or the most important use of that power. English trade is carried on upon
borrowed capital to an extent of which few foreigners have an idea, and none of
our ancestors could have conceived." He includes an example of the use and
power of capital put to use by credit."
This reality is something that Dr. McCloskey ignores in her three books that
focus on the beliefs of the bourgeois as the critical source of the Industrial
revolution. And Murray Rothbard and his libertarian acolytes simply cannot
understand this. But, while, as Bagehot points out, it was a small method in
Europe, it was a major one throughout American financial, and industrial
history.
His example is as follows: "If a merchant have 50,000 L. (that is pounds
sterling), all is own, to gain 10% on it he must make 5,000L., in a year, and
must charge for his goods accordingly, but if another has only 10,000L., and
borrows 40,000L., by discounts (no extreme instance in our modern trade), he
has the same capital of 50,000L., to use, and can sell much cheaper. If the
rate at which he borrows be 5 percent, he will have to pay 2,000L., a year; and
if, like the old trader, he make 5,000L., a year, he will still after paying
his interest, obtain 3,000L., a year, or 30 percent, on his own 10,000L."
It is critical today that everyone understand this power of capital consisting
of borrowed credit. Bagehot expands on the result by describing the 'democratic
structure of English commerce." The result has been the loss of social and
political power of the wealthy (including land owners) and the increase in
power of the merchant, business, middle class.
If virtually anyone with good standing and initiative can borrow capital to
equal the deployable capital of the great lords, the result is obvious. Bagehot
claims a defect that has been shown is the decline in public morality - 'the
constant leveling of our commercial houses is, too, unfavorable to commercial
morality." At the same time, a country dependent for economic innovation
and expansion by the activities of the ancient wealthy aristocracy, will lack
such progress. That is because such wealthy individuals prefer to sit on their
wealth, not invest it at risk. His summary is that Lombard Street in the 'great
go-between' the middle-man who matches investable savings by those who have it
and the needed investable capital of those entrepreneurs who produce expanding
quantities of goods and services - and the infrastructure that enables such
expansion. However, he warns, there never was a country in which the proportion
of ready cash (meaning real assets) to the volume of credit (imaginary capital)
supporting the economy, was so small. So TRUST is the watchword.
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Chapter II, A General View of Lombard Street
Mr. Bagehot describes the actual (material) structure of the banking system. It
consists of the Bank of England, Private Banks, Joint Stock Companies, and bill
brokers. He divides his account into two sections. The first part is a
description of the function of banks. He quotes David Ricardo on this: a
remarkable statement with study. According to Ricardo, the banker "begins
as soon as he uses the money of others', as long as he uses his own money he is
only a capitalist. Thus the Lombard Street denizens hold large volumes of other
people's money either on deposit or running account.
Here is the central point today. "In the continental language, Lombard
Street, is an organization of credit, and we are to see if it is good or bad
organization in its kind, or if, as is most likely, it turns out to be mixed,
what are its merits and what are its defects?"
Wonderful, that is exactly what we must do today. The entire economy today is
created and based on CREDIT far more than it was in Bagehot's time, and he
believed it was huge then.
He continues, "The main point on which one system of credit differs from
another is 'soundness'. Credit means that a certain confidence is given, and a
certain trust reposed. Is that trust justified?" For banks the volume of
the credit is often very large and the time interval for repayment may be short
and unexpected.
Actually credit creates debt, and debt is a promise to produce something of
value equal to the value of the credit, plus an amount reflecting the value of
the TIME interval consumed. Can the borrower produce that something? An
additional and critical problem is that both the credit-debt and the existing
and future produce are 'valued' in 'money' and the 'value' of 'money' itself
varies over time.
Bagehot continues with discussion of the relationship of the bank's processes
to the home country's currency and the nation's laws about it currency system.
He points out, for instance, that in the United States (this is the 1880's) the
currency includes 'greenbacks' which are guaranteed by the government. But in
England the legal tenders are gold and silver coins plus Bank of England notes.
These latter are different from 'greenbacks' and they are limited with a legal
requirement that the bank retain a 'reserve 'of specified gold and silver. The
Bank of England "CANNOT INCREASE THE CURRENCY IN ANY MANNER."
BINGO!
He continues with specific amounts of assets and liabilities in the banking
system. The amazing answer is that private banks need not retain any reserve,
but only need sufficient currency to meet daily requirements for giving and
taking in the course of each day's activities. Meanwhile the Bank of England
must retain the nation's financial reserve and that reserve of real gold and
silver cash in its vault is only a third of the size of its liabilities. All
the other banks keep their reserves on deposit at the Bank of England. The
reality is that capital left in bank vaults is dead, it gains neither interest
nor profits from production. Therefor banks and other holders of capital will
seek to invest it in expected profitable enterprises. He continues further,
noting that London is also the clearing house for foreign countries which
generate liabilities as well.
"A large deposit of foreign money in London is now necessary for the
business of the world."
But that system is subject to the same conditions as TRUST is in the domestic
financial system. A 'run' on England would require substantial export of gold.
But the trust in the capability of the British financial system is so great
that no one, foreign or domestic, imagines otherwise. And this belief is based
on no legal authorities.
Now the world has 'petrodollars'. It was the profit that Great Britain made on
being the center of the world's financial system that greatly enhanced its
profits from export of manufactured goods. And the United States today has
replaced GB. And it was the foreign governments - mainly French - that drained
the US gold supply, forcing President Nixon to default by ending the connection
between the value of the dollar and the value of gold. Nevertheless,
Bagehot wants to state reality. "The result is that we have placed the
exclusive custody of our entire banking reserve in the hands of a single board
of directors not particularly trained for the duty - who might be called
'amateurs' who have no particular interest above other people's in keeping it
undiminished - who acknowledge no obligation to keep it undiminished who have
never been told by any great statesman or public authority that they are so to
keep it or that they have anything to do with it who are named by and are
agents for a proprietary which would have a greater income if it was
diminished..." Quite a potential for concern.
Bagehot moves to section II of the chapter. In this section he describes the
nature, sources, and potential results of the sudden financial demands that
might force the country, that is its bank, to take actions to prevent such
demands from damaging the British banking system. This comes down to raising
the interest rates to prevent the desire by others of an out flow and encourage
in inflow of bullion. He recounts the historical incidents in which the British
did not perform. He terms it "a more miserable history can hardly be found
than that of the attempts of the Bank....".
He turns to domestic drain on bank reserves. These, he notes, arise from
somewhat different causes and are more difficult to stem. He concludes,
"the best way for the bank or banks who have the custody of the bank
reserve to deal with a drain arising from internal discredit, is to lend
freely. The first instinct of everyone to the contrary." To be able to do
that the good banker will accumulate his reserve in good times so he can assure
the public that he has sufficient cash to satisfy all normal demand. He devotes
pages to this discussion. He writes that: "A panic, in a word, is a
species of neuralgia, and according to the rules of science you must not starve
it." He discusses the actions of banks and bill brokers with a hint that a
financial panic is coming. They stop giving discounts on any paper they still
accept but stop accepting paper as well. They cannot and do not create new
money. And any bank or bill broker who has deposited money (cash) in another
similar place calls for its return. Thus the crash of liquidity expands.
He provides the exact response of the Bank of England in the 3 events:
1847 loans on 'private securities' from 18,963,000L to 20,409,000L
1857 from 20,404,000L to 31,350,000L
1866 from 18,506000L to 33,447,000L
Note that these 'loans' were not issuing 'free credit' - they were exchanges of
bank credit or cash in gold for qualified, worthwhile securities. What they did
was exchange fixed capital assets take in for liquid capital assets with value
secured by the BoE.
So Bagehot writes that the BoE did its duty to quell a panic. But it did not
acknowledge that it was its duty and there was no law that would claim that it
had a duty. This leads him to a lengthy discussion of the potentially critical
situation. Then he proposes three remedies.
1. There should be a clear understanding between the Bank and public that it
will act by replenishing needed foreign accounts and/or lend in times of
internal panic.
2. The government of the Bank itself should be improved by reducing the
'amateur' clement and increase the professional element.
(But the results shown in the FED by professionals is negative.)
3. In addition to making the BoE stronger, make the entire banking system
stronger so it does not rely so completely on the BoE.
In the following chapters Bagehot elaborates on the causes and result of the
current banking system.
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Chapter III. How Lombard Street Came to
Exist, and Why It Assumed Its Present Form
This is a fascinating historical essay, a detailed description of modern
banking (Lombard Street is a popular name because the Bank of England and other
financial institutions have congregated on the street that became named
"Lombard because the medieval agents - representatives - of the Italian
(Lombard) banks were located there. "How" and why the banking system
current in England in 19th century developed as it did is the complex subject
Bagehot undertakes. His description of the history is not what most people
today recognize. Banks have three functions; to transfer financial accounts
(credit and liability) between institutions, especially foreign ones; to issue
bank notes (that is lending capital in the form of credit to those who ask for
it); and taking deposits of financial assets from the public. He includes
comments on many other topics as well.
His opening remark is itself priceless. "In the last century, a favourite
subject of literary ingenuity was 'conjectural history', as it was then called.
Upon grounds of probability a fictitious sketch was made of the possible origin
of things existing." He elaborates on the results of this kind of thinking
applied to banking and refuses to engage in it. "Conjectural history would
be inclined to say that all banking began thus but such history is rarely of
any value. The basis is false."
How wonderful can this idea be?? Shelves are loaded with 'professional'
accounts - theories about economic behavior, about the origin of money - even
about what money is are based on the same 'conjectures' resulting from
deductive thinking rather than inductive analysis. The mussing of famous
authors, who could not know the past as it was still opaque, continue to be
cited as authoritative proof by 'experts' today, of their elaborate
quantitative "econometric' algorithms - equations filled with variables -
frequent resort to the Latin 'save all' - "all things being the same'.
Then the controversies over theories are supported by 'ad homium', vitriolic
attacks.
Bagehot elaborates: "Hypothetical history, which explains the past by what
is simplest and commonest in the present, is in banking, as in most things
quite untrue. The real history is very different. New wants are mostly supplied
by adaptation, not by creating or foundation. Something having been created to
satisfy an extreme want, it is used to satisfy less pressing wants, or to
supply additional conveniences." ... "The first banks were not
founded for our system of deposit banking or for anything like it. They were
founded for much more pressing reasons, and having been founded, they, or
copies from them, were applied to our modern uses."
For his purposes he need not discuss ancient banking, about which little was
know in 1870 anyway.
"The earliest banks of Italy, where the name began, were finance
companies". They created foreign bills of trade (paper). From there he
described and excellent history of the development of more and more wide spread
banking systems that added more functions as well. He cites the problem
merchants and banks had with payments in a myriad of foreign coins having
different and often dubious values. "again, a most important function of
early banks is one which the present banks retain, though it is subsidiary to
their main use; viz, the function of remitting money." Money being coins.
The bank takes the coins, and sends its value in a bill of exchange with its
corresponding foreign bank. It was by supplying these other uses and proving
themselves trustable that banks then began to be seen by the public as a safe
place to deposit its cash. He includes specific quantities of the deposits in
French, German and UK banks. In his section II, he elaborates on the BoE and
its "note issue." He tells the sordid story of the time that King
Charles II simply refused to honor his deposits with the gold smiths, (the
actual protobanks of England at that time. This was called "shuting up the
Exchequer'. This "monstrous robbery" destroyed the credit of (trust
in) the Stuart monarchy. Which lead to the Glorious Revolution and the offer by
Parliament to the Dutch stadholder, William III. But that king was waging war
on France and had about zero credit in England, thus being nearly impossible to
obtain a loan.
The ingenious work around was developed. Wealthy or owners-so individual
merchants and aristocrats were induced to form a bank in which they deposited
1,200,000L at 8%; . They were the owners and were titled Governor and Company
of the Bank of England. This was 'loose' capital for which these gentlemen
apparently had no pressing alternative so the 8% interest was something. The
Bank then received special and unique privileges as the Bank of England.
Bagehot describes these. The bank could then lend to the sovereign at a higher
interest rate. That was the start. The 18th century witnessed much further
development during which time the debt of the government rose to unprecedented
heights to finance its many wars with France.
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Chapter IV, The Position of the Chancellor of
the Exchequer in the Money Market:
Remember that the BoE was created as a private bank with shareholders, yet
performs the public service of holding the government's money and the reserve
of money that should defend the money market. One result is that the public
expects the Government to assist the bank in any case of financial emergency.
He concludes that: "this is the sort of anticipation which tends to
justify itself, and to casue what it expects."
"Nothing can be truer than the economical principle that banking is a
trade and only a trade, and nothing can be more surely established by a larger
experience than that a Government which interferes with any trade injures that
trade. The best thing undeniably that a Government can do with the Money Market
is to let it take care of itself."
"But a Government can only carry out this principle universally if it
observe one condition: it must keep its own money."
That was the central financial idea of one US President, Andrew Jackson.
The Exchequer is the British treasury that used to pay and receive taxes and
other income. The Chancellor is a member of Parliament, a government cabinet
minister somewhat like a US Secretary of the Treasury. The office has had many
changes since the early 12th century.
Bagehot describes some of the major changes in the B0E and its relation to the
government Exchequer. He writes that the system has 'grave evils'.
1. By being created by state aid it is more likely than a natural system to
require state help.
2. Because being a one reserve system it reduces spare cash in the Money
Market, which makes the market more delecate.
3 Because a one reserve system supervised by one board of governors makes the
market dependent on their wisdom.
4. Because that board of governors will be pressed by the shareholders to
generate high dividends, and keep a small reserve when the public insterest
requires a large reserve.
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Chapter V, The Mode in Which the Value of
Money is Settled in Lombard Street:
Bagehot is using the term 'money' in the official definition meaning that it IS
coined currency. This confuses then and today this concept with the idea that
'money' is a general metric that quantifies the 'value' of all things traded in
markets.
Yes, 'money' in his sense has value and its value changes and must be
established (settled by specific institutions) continually. By 'money' he
(everyone then) thinks only of gold currency. And gold is a commodity. The
problem since silver and gold were adopted as currency is that they are both
commodities which have value in raw form and a different value when minted into
a coin that has a different face value.
Bagehot writes that the public considers that the BoE has a special power to
fix the value of money. But, he writes, the value of money like that of all
other commidiies, is set by supply and demand. He means mney as currency. But
the value of money on Lombard street is influenced by the Bank of Egland as the
most important dealer in money,which can set a minimum value it will accept. he
explains the cause being there is not enough money on Lombard Street to
discount all the bills, which forces the dealers to go to the BoE, which can
fix its own rate. But its ability is limited. He describes the complex
interactions in the markets as, for instance, where to the bank issue a sizable
amount of bank notes (credit) the individuals who obtained it would use it to
buy, generating a rise of prices that would then generate more individuals into
raising prices.
The value of money does change. His conclusion: "The fluctuations in the
value of money are therefore greater than those on the value of most other
comodities. 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.".
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Chapter VI, Why Lombard Street is often Very
Dull, and Some times Extremely Excited -
By 'dull' he means normal financial conditions and by 'excited' he means an
expected or already occuring panic. Or he means good times with expanding
standard of living and bad times in a depression. He devotes the chapter to
analyzing these conditions. His critical point is based on two principles:
1. 'That as goods are produced to be exchanged, it is good that they should be
exchanged as quickly as possible. "
2 "That as every producr is mainly occupied in producing what others want,
and not what he wants himself, it is desireable that he should always be able
to find, without effort, without delay, and without uncertainty, others who
want what he can produce.".
His key concept is time. Time is an asset that has value.
He describes how all segments of the economy including industry are
interrelated. Over either a very short time or eventually changes (such as a
depression) in one industry will be influenced by changes in the others. He
especially notes changes in agriculture, because in the 19th century
agriculture was still a dominant industrry. Various industries also have
different inputs of labor or raw materials.
He mentions the history of many panics, such as the famous South Sea fiasco,
but also many more that are rarely mentioned in historical literature today.
Each involved gulible individuals who 'invested' (actually speculated) by
exchanging their capital for promises. He includes the most famous of all that
is currently being cited: "For an Undertaking which shall in due time be
revealed". He does not mention that Isaac Newton, also lost a forltune in
such a 'bubble'. Bagehot describes the panic of 1867 in great detail, including
dta on the price of wheat, the quantity of iron exported, and the role of the
money supply.
Here are several of his comments:
"But though plentify money is necessary to high prices, and though it has
a natural tendency to produced these prices, yet it is not of itself sufficient
to produce them." To lower prices it is necessary to have a 'satisfactory'
way to employ the money. He writes that: "augmented money" comes from
the savings of the people, "And will be invested in the manner which the
holders for the time being consider suitable to such savings."
But today the 'augmented money' is not coming from the savings of people but is
given free of exchange by government. And much of it is not being invested but
used to fund consumption of previously produced assets created by others.
He also notes: "The rise has also been aided by the revival of credit.
This, as need not be at length explained is a great aid to buying, and
consequently a great aid to the rise of Prices."
But apparently it does need to be explained to economists at the FED.
Another cogent comment:"And in so far as the apparent prosperity is caused
by an unusual plentifulness of loanable capital and a consequent rise in
prices, that prosperity is not only liable to reaction, but certain to be
exposed to reaction. The same causes which generate this prosperity will after
they have been acting a little longer, generate an equivalent adversity."
Further: "In consequence, a long-continued low rate of interest is almost
always followed by a rapid rise in that rate". He provides a lenthy
explaination of how and why this takes place.
Another truism: "The good times too of high prices almost always engender
much fraud."
Finally he again stresses that the entire banking structure is based on trust.
It needs to maintain a sizable reserve of real 'money' (meaning, again at that
time, currency denominated in the value of gold) - not fiat money.
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Chapter VII, A More Exact Account of the Mode
in Which the Bank of England has Discharged Its Duty of Retaining a Good Bank
Reserve, and of Administering It Effectively
In this chapter Bagehot publishes details on the 'mode in which the BoE
operates. This includes the stateemts and actions of its Board of Governors
during times of panic. He cites his own articles in the 'Economist' and
comments that many of those directors did not like them. They revealed too
much. His advice stated then: "I consider it to be the undoubted duty of
the Bank of England to hold its banking deposits (reserving generfally about
one-third in cash) in the most avalable securities; and in the event of a
sudden pressure in the money mrket, by whatever circumstace it may be caused,
to bear its full shre of a drain on its resources."
The governors denied they had such duty and didn't like his idea about their
reserve.
He includes the statements and specific comments by BoE officials. He also
includes resolutions and actions of Parliament. He recounts incidents in the
historical record, such as 1825. "Under such circumstances, the Bank
directors inevitably made mistakes of the greatest magnitude."
He focuses on the Banking Department of the Bank. I shouldexplain the
interwesting way theBoE was organized into two separate department, one for
'banking', meaniing investing and loaning; and the other for currency, meaning
operating a daily source of cash for the immediate needs of its depositors, and
for which it only held a cash reserve adequate to insure a daily reserve to
keep incoming deposits equal to outgoing withdrawals of deposits. That daily
action had no effect on the size of the national money supply.
In the US that significant distinction used to be the law that seperated
investment banks from depositary banks but it was abolished during the Clinton
adminstration.
The British structure became critical during the panics of 1847 and of 1857
when Parliament had to issue a 'licence' authorizing the BoE to 'borrow'
currency from its currency reserve to save its banking reserve which had
declined in fall of 1857 from 4,024,000L on October 10th to 957,000L on
November 13. Fortunately, Bagehot observes, that while the BoE denies the duty
it has begun to act. In the case of a run on its gold overseas it has raised
its interest rate to reduce export of capital and encourge import of same. For
example, he cites the condition in 1866 when a drain of gold was begining due
to the collapse of the Overend and Gurney private financial firm and the BoE
had retained a substantian banking reserve that assuted the public. But, he
notes. in 1870 the Bank of France suspended specie payments generating demands
on the market for bullion.
Just like in 1971 when the French government demanded gold from the US, forcing
Pres. Nixon to abrogate the link between the dollar and gold.
Bagehot questions whether the directors of the BoE realize the danger they are
in, stating 3 specific defects. The critical action of the BoE with its gold
reserve is to preserve the functioning credit market.
The same problem that faced the FED and Treasury in 2008.
Bagehot discusses the, then, existing controversy among officials and
politicians was about what the BoE can do or should do. It fundamentally was
about - should the Bank remain a private one with independence. The arguments,
themselves, involve understanding or lack thereof, of the nature of financial
panics, the role of any bank, and the nature of currrency and credit. His
explaination is too lengthy and complex for summarizing here.
But one of the specifics he discusses is the manner in which the BoE can and
has raised ready cash in a panic is by exchanging some of its cash reserve for
secure, valuable, securities (stock in companies or debentures).
This also is what in which the FED did suddenly resort. But it has continued to
due emergency measures far after the financial emergency ended and for an
entirely different purpose - to provide credit for givernment fiscal policy -
both for the welfare state and to create a 'green' economy. Bagehot believes:
'As we have seen, principle requires that such advances, if made at all for the
purpose of curing panic, should be made in the manner most likely to cure that
panic.... unfortunately, the Bank of England do not take this course".
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Chapter VIII, The Government of the Bank of
England
In this chapter Bagehot describes the internal functioning of the BoE and its
senior officers. The lasting concept is that everything must be based on the
quality of the the individuals.
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Chapter IX, The Joint Stock Banks
This is the term meaning private banks that are owned by shareholder investors.
The BoE is a special, large joint stock bank with unique privileges. He
identifies three categories:
1 Those in which the capital is used not to work the business but to guarantee
the business. Thus a banker's business - his proper business - does not begin
while he is using his own money: it commences when he begins to use the capital
of others." In these the banker's own capital is sufficient to convince
the public that their deposits in or loans to the bank are safe.
2. These banks have some sort of exclusive privilelge which is based on good
judgment.
3rd. Banks that have a business both large and simple, they employ more money
than most individuals or small banks have. All the banks can be very profitable
because they a small amount of their own capital versus much larger amount of
other people's capital and they pay interest on that other people's capital
that is less than the interest they charge on the investments and loans they
create out of other people's capital. Bagehot includes data showing the profits
banks have, and their dividends. Their own capital in the bank grows with the
earnings they retain.
He presents the total for the jointstock banks in London. They have 30,000,000L
in deposits; their capital is not more than 3,000,000L; they have invested
31,000,000L and this leaves only 2,000,000L as their reserve against
liabilities. He judges that in general these banks are governed by astute,
experienced men. Of interes is that he points out that rural banks have more
need of study because the laws governing real property are complex. But banks
in large cities should practically run themselves with good managers. His
conclusion: As the size of the banks and finance industry has increased the
ratio of its ready reserve capital to its liabilities (especially short term)
has decreased , the reserve is very small.
Here is the 'kicker': Now, no cause is more capable of producing a panic,
perhaps none is so capable, as the failure of a first-rate joint stock bank in
London." Therefore the banking system is of 'primary importance to us
all."
Lehman, anybody??
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Chapter X, The Private Banks
A 'private bank' is indeed private. It has been created by an individual owner,
a man of substance and known quality and integrity. He becomes entrusted with
the money of his friends and neighbors. He is well known to everyone. The
original London bankers were such: "He represented a certain union of
pecuniary sagacity and educated refinement which was scarcely to be found in
any oher part of society." Frequently ownership and of course control was
hereditary. Bagehot believes that: "Banking is a watchful, but not a
laborious trade." The banker can devote much of his time and thinking to
other issues. He considers it a 'happy life."
That was then.
BUT not now. 'I fear, we must doubt of it"; meaning the continuance of
that old class. "In 1810 there were 40 private banks in Lombard Street but
now there are 3". And no new ones. Modern conditions prevent the creation
of new 'private banks'. In addition, it is typical of hereditary systems (such
as monarchies) that include banks that the following generations lack either
the skill or character - or both - of the founding generations. He examines
again the joint stock banks and indicates that the comparison favors their
continued replacement of the private banks.
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Chapter XI, The Bill Brokers:
Mr. Bagehot explains their role in the finance industry. They are
"specially qualified dealers who can lend from their own capital or can
borrow cash from banks. They exchange good paper, bonds or stock securities for
negotiable credit (which functions as money) that the bill brokers deposit at
the bank in exchange for the cash from the bank. He continues: "They act
thus as intermediaries between the borrowing public and the less qualified
capitalist, knowing better than the ordinary capitalist which loans are better
and which are worse." The desired purpose of this is to move capital that
is inactive (in the hands of the capitalist that has no direct investment use
for it) to the entrepreneur, for instance manufacturer, who needs the capital
to expand production. He provides an example: "Many stock brokers transact
such business upon a grand scale. they lend large sums on foreign bonds or
railway shares or other such securities, and borrow those sums from bankers,
depositing the securities with the bankers, and generally, through not always
giving their guarantee." and, "By far the greatest of these
intermediate dealers are the bill brokers." Note that the credit in the
form of a loan of cash has not been giver for nothing, It has been an exchange
of a valuable security for cash. And the bill broker has also made an exchange,
the security received for the loan is exchanged in turn for a loan from a bank.
It is the bank that is the source of the currency (money). But the bank is
making its loan (credit) to the bill brokers in much greater quantity that the
amount of actual (real) currency (gold coin) in its vault. So the process is
creating liquidity in the market on the basis of imaginary money.
The whole system rests on (survives) the trust by all involved in the quality
of the individuals - their trustworthiness. And it depends on the future
capability of the receiver of the credit-cash - the entrepreneur, to make the
profits from production that are expected. All these transactions are
'discounted' meaning the difference between the value of the exchanged capital
and the actual quantity exchanged - that amounts to interest.
Of course the system depends on the fact that the borrower needs the capital
for some purpose and it should be a worthy one. Everyone relies especially in
not only the trustworthiness of the bill brokers but also their knowledge and
skill at choosing to lend only to profitable enterprise. When something goes
wrong and people become concerned (even panic) their demands on the enterprises
(or individuals) (either the bill brokers or the banks or both) who have issued
a greater value of promises than the value of the real reserves they have on
hand. Mr. Bagehot discusses this process in the context of a discussion about
whether the reserve (in real currency) should be centered in one institution
(central bank - such as the Bank of England) or can be held by multiple
institutions such as many private banks.
Mr. Bagehot describes all this in complex but clear detail.
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Chapter XII, The Principles Which Should
Regulate the Amount of the Banking Reserve to Be Kept by the Bank of England:
The previous discussion leads to this topic. The question - how large in
currency (that meant gold) should the Bank of England hold to assure the safety
of the British economy in cases of panic or other need. Bagehot explains with
data in previous chapters that the bank holds in gold a very tiny fraction of
the total credit money that is used as the liquidity that finances the markets.
And, morever, that 'market' is now world-wide as British capital (credit) is
exchanged everywhere and the BoE stands ready to support it. This is a
contentious issue with many strongly opposed opinions held by many commentators
and authorities.
Bagehot poses to himself the question he faces - OK what is your actual opinion
about the required quantity of reserves the BoE should retain.? At risk of
injuring his own reputation he replies. "I should say that at the present
time the mind of the monetary world would become feverish and fearful if the
reserve in the Banking department of the Bank of England went below
10,000,000L." He admits that present day thought considers that sum to be
too large. But he notes that he also advises that the governing body of the BoE
should be strengthened. So to prevent the reserve from falling to 10,000,000L
the daily sum should be 11,000,000L or 11,500,000 L. And this means that the
Bank should begin to 'take precautions' if the sum reaches 14- 15,000,000L. If
the pressure is coming from foreigh sources, the Bank should begin to raise
interest rates.
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Chapter XIII, Conclusion
Bagehot admits that he has identified a 'deep malady' and 'only suggested a
superficial remedy." He rejoins that he has prefered that the banking
system as a whole be changed from its present situation in which the entire
reserve is held in one place, the BoE. He wants the banks each to have and
manage their own reserves and be liable for its adequacy. But he recognizes
that his prefered change is impossible. The change would disrupt the entire
money market system. He again states facts. "the total of deposits in the
banking system is 60,000,000L supported by good securities. (in other words is
is NOT liquid) But they have virtually no cash in reserve to comply with
depositors demands in a panic. They could not sell the securities to raise cash
as there would be no buyers. Thus the response would fall to the BoE. But, as
he noted previously, the system cannot be changed. He can only hope for
'palliatives'. But eventually the BoE was nationalized.
Nor can the FED system in the US be changed. Although there are at least as
many futile critics today as there were in England in 1870.
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Wikipedia entry on Lombard Street
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James Grant, Bagehot: The Life and
Times of the Greatest Victorian - The definitive biography of Walter Bagehot in
the context of British financial industry and its functions during his time.
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Perry Mehrling, The New Lombard Street:
How the Fed Became the Dealer of Last Resort
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Anatole Kaletsky, Capitalism 4.0: The
Birth of a New Economy in the Aftermath of Crisis
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Charles Goodhart
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Anatole Kaletsky,
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Nomi Prins, Collu$ion, How Central
Bankers Rigged the World
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Peter Zeihan, The End of the World is Just
the Beginning: Mapping the Collapse of Globalization
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Peter Zeihan, The Absent Superpower
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Peter Zeithan,Disunited Nations
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Peter Zeithan, The Accidental
Superpower
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Peter Zeihan and Lauren Goodrich, A
Crucible of Nations: The Geopolitics of the Caucasus,
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Lawrence White, The Theory of Monetary
Institutions
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Anat Admati & Martin Hellwig, The
Banker's New Clothes: What's Wrong with Banking and What to Do about It
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Charles W. Calomiris & Stephen H. Haber,
Fragile by Design: The Political Origins of Banking Crises & Scarce
Credit
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Danielle DioMartino Booth,FED UP, An
Insider's Take on Why the Federal Reserve is bad for America
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Peter Conti-Brown, The Power and
Independence of the Federal Reserve
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Martin Katusa, The Colder War: How the
Global Energy Trade Slipped from America's Grasp
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Martin Katusa, The Rise of America:
Remaking the World Order,
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Gregory R. Copley, The Art of Victory:
Strategies for Personal Success and Global Survival in a Changing World
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Gregory R. Copley, The New Total War of
the 21st Century, and the Trigger of the Fear Pandemic
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Ziad K. Abdelnour, Economic Warfare:
Secrets of Wealth Creation in the Age of Welfare Politics
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Robert D. Blackwell & Jennifer M.
Harris, War by Other Means: Geoeconomics and Statescraft
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William Bonner & Lila Rajiva,
Mobs, Messiahs, and Markets:
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