Lombard Street: A Description of the Money Market/Chapter 4

by Walter Bagehot

 

CHAPTER IV

 

the position of the chancellor of the exchequer in the money market

 

Nothing can be truer in theory 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. The Government is necessarily at times possessed of large sums in cash. It is by far the richest corporation in the country; its annual revenue payable in money far surpasses that of any other body or person. And if it begins to deposit this immense income as it accrues at any bank, at once it becomes interested in the welfare of that bank. It cannot pay the interest on its debt if that bank cannot produce the public deposits when that interest becomes due; it cannot pay its salaries, and defray its miscellaneous expenses, if that bank fail at any time. A modern Government is like a very rich man with very great debts which he cannot well pay; its credit is necessary to its prosperity, almost to its existence, and if its banker fail when one of its debts becomes due its difficulty is intense.

Another banker, it will be said, may take up the Government account. He may advance, as is so often done in other bank failures, what the Government needs for the moment in order to secure the Government account in future. But the imperfection of this remedy is that it fails in the very worst case. In a panic, and at a general collapse of credit, no such banker will probably be found. The old banker who possesses the Government deposit cannot repay it, and no banker not having that deposit will, at a bad crisis, be able to find the £5,000,000, or £6,000,000 which the quarter day of a Government such as ours requires. If a Finance Minister, having entrusted his money to a bank, begins to act strictly, and say he will in all cases let the Money Market take care of itself, the reply is that in one case the Money Market will take care of him too, and he will be insolvent.

In the infancy of Banking it is probably much better that a Government should as a rule keep its own money. If there are not banks in which it can place secure reliance, it should not seem to rely upon them. Still less should it give peculiar favour to any one, and by entrusting it with the Government account secure to it a mischievous supremacy above all other banks. The skill of a financier in such an age is to equalise the receipt of taxation, and the outgoing of expenditure; it should be a principal care with him to make sure that more should not be locked up at a particular moment in the Government coffers than is usually locked up there. If the amount of dead capital so buried in the Treasury does not at any time much exceed the common average, the evil so caused is inconsiderable: it is only the loss of interest on a certain sum of money, which would not be much of a burden on the whole nation; the additional taxation it would cause would be inconsiderable. Such an evil is nothing in comparison with that of losing the money necessary for inevitable expense by entrusting it to a bad bank, or that of recovering this money by identifying the national credit with the bad bank and so propping it up and perpetuating it. So long as the security of the Money Market is not entirely to be relied on, the Government of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank.

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.^[1] 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 any one 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 any one 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."^[2] 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 its 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 to 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 specie 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 licence. 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.

1. The functions of the old Metropolitan Board of Works are now vested in the London County Council, which has continued the arrangement with the bank (now the London County and Westminster Bank) for the deposit of security, and similar arrangements have been entered into by certain other banks who keep the accounts of other local authorities.
2. It may be noted that Parliament has for the time being endowed the Chancellor of the Exchequer with large powers of borrowing by Treasury bills. And as these are tendered for not only by home, but also by foreign capitalists, his field of borrowing is very extensive, and he gets the full advantage of the competition of lenders. Still the fact remains that, except with the special leave of Parliament, the Chancellor of the Exchequer cannot borrow except from the Bank of England on "deficiency bills." And as regards the fixing of rates by the Bank, while in the case of Ways and Means advances the rate of interest to be charged is a matter of negotiation between the Treasury and the Bank, the rate to be paid for Deficiency advances is under existing arrangements fixed at one-half of the Bank rate at the time.