The Franco-German war, which broke out in 1870 did not at first exercise any very great effect on the English money market, for though the Bank raised its rate to six per cent. on the 4th August that year, it was at two and a half before the end of September. Indeed, after the panic of 1866 down to the middle of 1870, scarcely a ripple disturbed the unusual calm of the money market, but the three crises since 1844 were largely accountable for that. They taught both Lombard Street and the Bank of England that caution is essential to the successful working of our banking system, and that fair reserves, however great the loss of interest incurred thereupon, are indispensable to a banker. The result of these bitter lessons may be read in the comparatively peaceful history of English banking since 1866.
In 1870 specie payments were temporarily suspended by the Bank of France, and the European demand for the precious metals had to be met by the Bank of England. A much larger amount of foreign capital, consequently, was deposited in London, which then became the Clearing House of Europe, and the accumulation of so much foreign money unquestionably made the money market more sensitive, and increased the responsibilities of the Bank, whose store in the Issue Department was then peculiarly exposed to the danger of a drain outwards.
The Franco-German war ended disastrously for France in 1871, and the vanquished had to pay a huge indemnity to the victor. France paid considerable sums to Germany by bills on England, and although Germany employed a certain proportion of the capital so obtained in the London money market, it withdrew large sums in gold, which were required for purposes of currency reform. During the latter part of 1872 the Bank rates were decidedly high, and in November, 1873, nine per cent. was recorded for about two weeks, but by December it was down to four and a half again. The Bank, no doubt, had its anxious moments during this period, for the larger the drain outwards the more dependent would be the bill brokers upon it, and the directors could not refuse to increase their advances to the brokers, because, had they done so, there would have been a panic at once.
We can now see distinctly how our system works. First, we get the bill brokers or middlemen, who, from the nature of their business, cannot afford to keep reserves, because their margin of profit is so small; and secondly there are the bankers, who keep their reserves with the Bank of England, which is thereby placed, so to speak, in the centre of the money market.
The Bank, after it was stripped of its monopoly of joint stock banking, failed for a time to understand its new environment, and it would have closed its doors three times since 1844 but for Government intervention, viz., in 1847, 1857, and 1866. However, when we remember that its directors were merchants, not trained bankers, and that the Bank had to adapt itself to entirely changed surroundings, this result is not remarkable. So little acquainted were the directors with the laws of banking that they actually believed the Act of 1844 would prove a panacea for all kinds of financial troubles; but their eyes were opened very widely indeed in 1847, and they gradually came to the common-sense conclusion that "the higher the ratio of reserve in the Banking Department the smaller is the danger of disaster to the Bank and to the country."
During 1866 the Bank was fairly well prepared, and, for the first time in its history, it met a panic in a scientific or common-sense manner, and advanced without hesitation to all would-be borrowers whose securities were good. The greatest danger the Bank has to face is the suspension or stoppage of the credit machine of which it is the heart, for if the progress of that machine be arrested, then the trade of the country must also stop, and England will be bankrupt.
So long as the machine can be kept in motion a catastrophe is impossible, and experience has taught the Bank that, during a period of pronounced distrust, this can only be done by advancing liberally against certain securities, and by a skilful use of the "Bank rate." The whole credit machine must work smoothly, and it would be madness, at such a moment, for the Bank to attempt to leave any part of the machine (the bill brokers for instance) to its fate. This is now fully recognised, and consequently a better feeling exists between the various divisions of the money market.
The credit machine is kept in motion by the workshops; therefore, during a panic money has to be advanced to discount good trade bills in order to support the workshops, for if a rumour got about that the banks were refusing the acceptances of strong firms, the pressure to borrow would immediately increase, thereby adding a fresh danger to the situation, and causing nervous depositors to rush in a body to the banks for their money.
It follows, therefore, that in order to arrest a panic, and to prevent a dangerous run upon their resources, the banks must lend freely to strong clients. In a time of financial stress the weak go to the wall, for finance is no exception to the rule that only the strong can live when a storm bursts and causes a struggle for existence. There is no room for sentiment at such a moment. The fight is bitter and to the finish. Sentiment comes in afterwards. This state of affairs is one of the curious products of modern civilisation, and, if you want to alter it, you must first alter human nature, which changes strangely little as the centuries roll on.
At first sight these sudden advances seem highly imprudent, because the banks are parting with their resources, but unless the workshops are assisted the banks must break: whereas, by advancing liberally on the best securities at high rates of interest, the dangerous element is speedily weeded out, and, provided the reserves of the banks are fairly large in proportion to their liabilities, a healthy reaction is practically certain to assert itself long before the end of their lending power is reached. The Bank, when it advances, of course creates credit in its books, and so adds to the resources of Lombard Street. The relief thus obtained is artificial, and, were it intended as a permanent cure of a disease, it must in the end only aggravate the malady. But it is temporary assistance during a trying time that the workshops require, and it is just this which our modern credit system, when skilfully administered, can give admirably. In fact it possesses the very machinery for the purpose. This sudden demand for additional credit (not specie) during a period of pronounced distrust is fortunately of short duration, and the Bank is, therefore, only called upon to make large loans for a short time, as, though the depression following a panic may prove lasting, the acute stage which the Bank has to face is soon over.