War-Time Financial Problems

by Hartley Withers

XVIII

THE REGULATION OF THE CURRENCY

February, 1919

Macaulay on Depreciated Currency—Its Evils To-day—The Plight of the Rentier—Mr Goodenough's Suggestion—Sir Edward Holden's Criticisms of the Currency Committee—His Scheme of Reform—Two Departments or One in the Bank of England?—Not a Vital Question—The Ratio of Notes to Gold—Objections to a Hard-and-fast Ratio—The Limit on Note Issues—The Federal Reserve Act and American Optimism—Currency and Commercial Paper—A Central Gold Reserve with Central Control.

Everyone has read, and most of us have forgotten, the great passage in Macaulay's history which describes the evils of a disordered currency. "It may well be doubted," he says, "whether all the misery which had been inflicted on the English nation in a quarter of a century by bad Kings, bad Ministers, bad Parliaments and bad judges was equal to the misery caused in a single year by bad crowns and bad shillings…. While the honour and independence of the State were sold to a foreign Power, while chartered rights were invaded, while fundamental laws were violated, hundreds of thousands of quiet, honest and industrious families laboured and traded, ate their meals and lay down to rest in comfort and security. Whether Whigs or Tories, Protestants or Jesuits were uppermost, the grazier drove his beasts to market, the grocer weighed out his currants, the draper measured out his broadcloth, the hum of buyers and sellers was as loud as ever in the towns, the harvest-time was celebrated as joyously as ever in the hamlets, the cream overflowed the pails of Cheshire, the apple juice foamed in the presses of Herefordshire, the piles of crockery glowed in the furnaces of the Trent, and the barrows of coal rolled fast along the timber railways of the Tyne. But when the great instrument of exchange became thoroughly deranged, all trade, all industry, were smitten as with a palsy…. Nothing could be purchased without a dispute. Over every counter there was wrangling from morning to night. The workman and his employer had a quarrel as regularly as the Saturday came round. On a fair-day or a market-day the clamours, the reproaches, the taunts, the curses, were incessant; and it was well if no booth was overturned, and no head broken…. The price of the necessaries of life, of shoes, of ale, of oatmeal, rose fast. The labourer found that the bit of metal which, when he received it was called a shilling, would hardly, when he wanted to purchase a pot of beer or a loaf of rye bread, go as far as sixpence."

From some of the evils thus dazzlingly described we are happily free in these times. We are not cursed with a currency composed of coins which are good, bad and indifferent, with the result that the public gets the bad and indifferent while the nimble bullion dealers absorb and export the good. There is nothing to choose between one piece of paper and another, and all that is wrong with them is that there are too many of them. But the general result as it affects the labourer who wants to purchase a pot of beer or anyone else who wants to buy anything is very much the same. A bit of metal that is called a shilling has about the value of a pre-war sixpence and a bit of paper that is called a Bradbury fetches half as much as the pound of five years ago. Compared with what other peoples are suffering from the same disease arising from the same surfeit of money in one form or another, this nuisance that we are enduring is not too terribly severe. It has entailed great hardship on a class that is small in number, namely, those who have to live on fixed incomes. The salary-earner and the rentier have borne the brunt, while the wage-earner and the profit-maker have been able to expand their earnings, in paper, at least to a point at which the depreciation of currency have left them no worse off. Seeing that the wage-earners are those who do the dreariest and dirtiest jobs, and that the profit-makers are those who take the risks of industry and the enormous responsibility of organising enterprise, they are the classes whom it is clearly most desirable to encourage. The rentier in these days gets less than no sympathy, but we make a great mistake if we think that we can with impunity crush him between the upper and nether millstone of fixed income and rising prices. With his help we have equipped industry at home and abroad. We can, if we choose, by depreciating the currency still further, lessen still more the reward that we pay him for that benefit. He may kick, but he cannot abolish the equipment with which he has already provided industry. But if we make his life too hard he can strike like the rest of us, and by refusing to provide for any further expansion in industrial equipment, he can hold up production until we have devised some new method of laying up capital. Currency depreciation is good for the debtor and bad for the creditor; if it goes too far it kills the creditor and reduces business to chaos.

We are a very long way from the chaos to which many of our Continental neighbours have already reduced their monetary systems; but there is fortunately a very general feeling that we are a country with a reputation and a prestige on this point; and the business world is growing restive concerning the delay on the part of those responsible in putting an end to a state of things which may have been justified by the war's exigencies (though there is much to be said for the view that in fact it only added to the war's difficulties) but is now clearly as out of date as the censorship, which, like it, nevertheless, continues to flourish. This state of things arises from the arrangement tinder which an unlimited supply of legal tender currency can be manufactured by the Government, which encouraged to continue the system by the fact that each note issued is in effect a loan to itself without interest. At the meeting of Barclays Bank on January 27th, Mr. Goodenough demanded that the issue of currency notes by the Government should be stopped forthwith, and that if it were necessary to provide more currency it would be better for the banks to be allowed to issue notes themselves. This suggestion involves, of course, a complete reversal of the principles on which our monetary system has grown up, since it has long been based on a note-issuing monopoly in the hands of the Bank of England. But these are topsy-turvy days, in which greyheaded precedent is very justly at a heavy discount; and Mr Goodenough's suggestion very practically gets over a big difficulty that stands in the way of stopping the stream of Bradburys. This difficulty lies in the fact that if the banks were pulled at by their customers for currency and could not supply them with Bradbury notes, they would be forced to take notes from the Bank of England, with a bad effect on the appearance of its reserve. If the business of issuing notes were put into the hands of the clearing banks, their power to do so would be limited by the extent of their assets, or of such of their assets as were thought fit to rank as backing for their notes. In other words, the note-issuing business would once more have to be regulated on banking principles and controlled by the price asked, for advances, instead of expressing the helplessness and improvidence of an impecunious and invertebrate Government. In this manner the new departure might be a convenient halfway-house on the way from chaos back to sanity. But probably it is too revolutionary and goes too straight in the teeth of the Bank of England's privilege to receive much practical consideration; and there is the question whether the public would take the new paper readily and whether it could be made legal tender.

Sir Edward Holden, in one of those masterly surveys of world finance with which he now instructs the shareholders of the London Joint City and Midland Bank, assembled at their annual meeting, gave much of his attention to an attack on the report of Lord Cunliffe's Committee on Currency. This was only to be expected, since the Committee had made recommendations on lines which were largely conservative and did not embody any of the reforms or changes which had been previously advocated by Sir Edward. Being on this occasion chiefly critical, he did not make very clear in his latest speech the precise proposals that he favours. For them we have to go back to his speech of a year ago, as reported in the Economist of February 2, 1918, p. 171, where he stated that "if the Bank (of England) had been working on the same principles as other national banks of issue, there would have been little ground for anxiety," and that these principles are:—

1. One bank of issue and not divided into departments.

2. Notes are created and issued on the security of bills of exchange and on the cash balance, so that a relation is established between the notes issued and the discounts.

3. The notes issued are controlled by a fixed ratio of gold to notes or of the cash balance to notes.

4. This fixed ratio may be lowered by the payment of a tax.

5. The notes should not exceed three times the gold or the cash balance.

As will be remembered, the Cunliffe Committee recommended that the division of the Bank of England into an Issue Department and a Banking Department, should be retained; that the old principle by which above a certain fixed limit all notes should be backed by gold, should also be retained, but that if at any time a breach of this rule should be found necessary it should be possible, with the consent of the Treasury, and that Bank rate "should be raised to a rate sufficiently high to secure the earliest possible retirement of the excess issue." Since it was formerly only possible to exceed the limit on the fiduciary issue by a breach of the law, under the Chancellor of the Exchequer's promise to get an indemnity for it from Parliament, and since Treasury tradition insisted on a 10 per cent. Bank rate whenever such a breach was permitted or contemplated, it will be seen that the Cunliffe Committee proposed some considerable modifications in our system and hardly justified Sir Edward's assertion that it "proposed that the Bank should continue to work under the Act of 1844 as heretofore."

At first sight there seems to be a good deal of difference between Sir Edward's ideal and Lord Cunliffe's, but is not the difference to a great extent superficial? Whether the Bank be divided into two departments, each presenting a separate account, or its whole business be regarded as one and stated in one account, seems to be rather a trifling question. And the arguments put forward for their several views by the two champions are not strikingly convincing. Sir Edward wants only one account, because he thinks the consequence would be a stronger reserve and fewer changes in bank rate. But a mere change of bookkeeping such as the amalgamation of the two accounts would not make a half-pennyworth of difference to the extent of the Bank's responsibilities and its ability to meet them, and it is on variations in these factors that movements in bank rate are in most cases decided. On the other hand, Lord Cunliffe and his colleagues argue that the main effect of putting the two departments into one would be to place deposits with the Bank of England in the same position as regards convertibility into gold as is now held by the note. On this point Sir Edward's answer is telling: "In reply to this statement, I say that the depositors at the present time can always get gold by drawing out notes from the reserve and taking gold from the Issue Department. There seems to be little difference between the depositors attacking gold direct and attacking the gold through the notes in the reserve. If the Bank cannot pay the notes when demanded the whole machinery stops." Quite so. The notion that the holder of a Bank of England note has now a stronger hold over the Bank's gold than the depositor seems to be baseless. He can exercise his hold more quickly perhaps, though even this is doubtful. Since banknotes are not legal tender at the Bank of England, it is not quite clear that the depositor would even have to take the trouble to go first to the Banking Department for notes and then to the Issue Department for gold. He might be able to insist on gold in immediate payment of his deposit. Still less convincing is the Committee's argument that "the amalgamation of the two departments would inevitably lead in the end to State control of the creation of banking credit generally." Their report might have explained why this should be so, for to the ordinary mind the chain of consequence is not apparent. On the whole it is hard to see much good or harm to be achieved by changing the form of the Bank return. It might make the Bank's position look stronger, but it could not make it really stronger. Nor would it really impair the strength of the note-holder's position as against the depositor, because even now there is no essential difference. It would substitute a more businesslike and simple statement for a form of accounts which is cumbrous and stupid and Early Victorian—a relic of an age which produced the crinoline, the Crystal Palace and the Albert Memorial. On the other hand, to alter a statistical record merely for the sake of simplicity and symmetry is questionable. Unless we are getting more and truer information, it is a pity to make comparisons between one year and another difficult by changing the form in which figures are given.

A more essential difference between the two policies lies in Sir Edward's advocacy of a ratio—three to one—between notes and gold, and the Committee's support of the old fixed line system. By the latter, if gold comes in, notes to the same extent can be created, and if gold goes out notes to the amount of the export have to be cancelled. Under Sir Edward's policy the influx and efflux of gold would have an effect on the note issue which would be three times the amount of the gold that came in or went out. This at least is the logical effect of his statement that "the notes should not exceed three times the gold or the cash balance." This law does not seem to be quite consistent with his view that the fixed ratio of gold to notes may be lowered by the payment of a tax; but presumably the tax would come into operation before the three to one part was reached, and at three to one there would be a firm line drawn. On this assumption the Committee's argument is a very strong one. "If," says its report (Cd. 9182, p. 8), "the actual note issue is really controlled by the proportion, the arrangement is liable to bring about very violent disturbances. Suppose, for example, that the proportion of gold to notes is actually fixed at one-third and is operative. Then, if the withdrawal of gold for export reduces the proportion below the prescribed limit, it is necessary to withdraw notes in the ratio of three to one. Any approach to the conditions under which the restriction would become actually operative would then be likely to cause even greater apprehension than the limitation of the Act of 1844." Certainly if, during a foreign drain, for every million of gold that went out, another two millions of credit, over and above, had to be cancelled, it is easy to imagine a very jumpy state of mind in Lombard Street and on the Stock Exchange. Sir Edward and the Committee seem to be agreed as to a limit on the note issue, but of the two limiting systems the old one advocated by the Committee, though apparently more severe, would seem to have much less alarming possibilities behind it.

A point on which the commercial world does not seem to have made up its mind, however, is whether there should be a limit at all. Under the old Act there was a limit which could only be passed by a breach of the law. Under the Cunliffe proposal the limit could be passed with the consent of the Treasury. Sir Edward has not told us of what machinery he proposes for the passing of the limit which he lays down; but in view of the great apprehension that an approach to the limit point would, as shown by the Committee, produce, it is clear that there would have to be a way round. In Germany there is no limit; you pay a tax on the excess issue and go on merrily. In America it would seem that the German system has been taken for a model. In his speech on January 29th Sir Edward quoted Senator Robert Owen, who was the principal pioneer of the Federal Reserve Bill through the Senate, as follows:—"The central idea of the system is elastic currency issued against commercial paper and gold, expanding and contracting according to the needs of commerce…. It is of great importance that the volume of these notes should contract when the commerce of the country does not require the notes to be circulation, and the reserve board can require them to be returned by imposing a tax upon the issue…. Under the reserve system a financial panic is impossible. People will not hoard currency nor hoard gold when they know that they can get currency or get gold when required…. America no longer believes a financial panic possible, and therefore the business men, being perfectly assured as to the stability of credits, do not hesitate to enter manufacturing and commercial enterprises from which they would be deterred under old conditions of unstable credit." Well, let us hope the Senator is right and that America is right in believing that a financial panic is no longer possible there. But one cannot help feeling that such a belief may be rather dangerous in the minds of people so ready to take rose-coloured views as our American cousins. The Federal Reserve system has worked beautifully in a period in which American finance has had nothing to do but rake in the enormous profits of American production at the expense of warring Europe and lend part of them, to be spent in America, to the Allied belligerents. It may work equally well if and when the problem to be faced is different, but it will be interesting to see—for those of us who live to see—what sort of a tax will be needed to "require" America, in one of its holiday moods, to return currency that it thinks it needs and the Federal Reserve Board regards as redundant.

Another point on which Sir Edward lays great stress, in his attack on the Bank Act of 1844 and the Committee which supports its main principles, is the beauty of the bill of exchange as backing for a note issue, as opposed to Government securities. "There is," he says, "no automatic system for the redemption of currency notes as would be the case if they were issued against bills of exchange, which in due course would have to be paid off." Again, "it seems to me that notes should not be issued against Government securities which may or may not be paid off, but against bills of exchange which must be met at due date." This advantage about a bill of exchange is a very real one to the individual holder who can always put himself in funds by letting the contents of his portfolio "run off"; but is there much in it as a safeguard against excessive issue of currency in times of exuberance? In such times bills that fall due are pretty sure to be replaced by new ones drawn against fresh production—since over-production is a common symptom of commercial exuberance—or against a resale of the goods on which the original bills were based. As long as anyone who can show produce can be certain to get credit and currency, the notion that the maturing of bills of exchange can be relied to restrict currency expansion within safe limits is surely a dangerous assumption. The principle of a fixed limit, to be broken in case of real need, but only after some ceremony has been gone through giving notice of the fact that a crisis has been reached, seems rather to be required by the psychology of speculative mankind. But even if Sir Edward's preference for bills of exchange as backing for notes has all the merits that he claims that is no reason for urging the repeal of the Bank Act to secure their use. Because the Bank Act does not forbid it: it merely says, "there shall be transferred, appropriated and set apart by the said governor and company to the Issue Department of the Bank of England securities to the value of," etc. It is the practice of the Bank to put Government securities into the Issue Department, but the terms of the Act do not compel them to do so, and if an excess issue were needed they would seem to be empowered to put any bills that they discounted into the assets held against the note issue. On the whole the terms of the Act leaving them freedom in the matter, except with regard to the "Government debt" of £11 millions, which is specially mentioned as to be transferred to the Issue Department, seem to be preferable to a special stipulation in favour of bills of exchange.

But the most important difference between Sir Edward Holden and the Cunliffe Committee seems to be in their attitude towards the gold reserve and the relation between the Bank of England and the rest of the items that compose the London money market. The Committee, working to restore the conditions which made our market the centre of the world's finance, endeavoured to give back the control of the central gold reserve to the Bank of England by suggesting, among other things, that the other banks should hand over their gold to it. They omitted to discuss the serious question of the greater difficulty that the Bank is likely to find in future in controlling the price of money in the market, owing to the huge size that the chief clearing banks have now reached. But a central gold reserve under central control was evidently the object at which they aimed. Sir Edward will have none of this. He says that if this were done the position of the Joint Stock banks would be weakened, though he does not explain why, since they would obviously hold notes in place of their gold and so would be able to meet their customers' demands, now that the latter are accustomed to the use of notes for pocket money. He points out that "the gold which was held by the Joint Stock banks before the war proved most useful…. At the beginning of the war the banks paid out gold, satisfied the demands of their customers for small currency, and thus eased the situation until currency notes became available." He seems to have forgotten that the banks, or most of them, refused to part with their gold, paid their customers in Bank of England notes which, being for £5 at the smallest, were of little use for pocket money, and so drove them to the Bank to get gold; and we had to have a prolonged bank holiday and a moratorium. Sir Edward is in favour of three gold reserves, one to be held by the Government, one by the clearing banks, and one by the Bank of England. If there were differences between the three controllers of the reserve at a time of crisis the consequence might be disastrous.

In view of the admiration expressed by Sir Edward for the new American system which is so clearly based on central control it is rather illogical that he should be so strongly in favour of independence on this side of the water. His opinion is that "the policy of the Joint Stock banks ought to be to make themselves independent of the Bank of England by maintaining large reserves in their vaults." Independence and individualism are a great source of strength in most fields of financial activity, but in view of the great problems that our money market has to face there seems to be much to be said for co-operation and central control, at least until we have got back to a normal state of affairs with regard to the foreign exchanges.