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.
CHAPTER V.
The Mode in Which the Value of Money is Settled in Lombard Street.
Many persons believe that the Bank of England has some peculiar power of fixing the value of money. They see that the Bank of England varies its minimum rate of discount from time to time, and that, more or less, all other banks follow its lead, and charge much as it charges; and they are puzzled why this should be. 'Money,' as economists teach, 'is a commodity, and only a commodity;' why then, it is asked, is its value fixed in so odd a way, and not the way in which the value of all other commodities is fixed?
There is at bottom, however, no difficulty in the matter. The value of money is settled, like that of all other commodities, by supply and demand, and only the form is essentially different. In other commodities all the large dealers fix their own price; they try to underbid one another, and that keeps down the price; they try to get as much as they can out of the buyer, and that keeps up the price. Between the two what Adam Smith calls the higgling of the market settles it. And this is the most simple and natural mode of doing business, but it is not the only mode. If circumstances make it convenient another may be adopted. A single large holder—especially if he be by far the greatest holder—may fix his price, and other dealers may say whether or not they will undersell him, or whether or not they will ask more than he does. A very considerable holder of an article may, for a time, vitally affect its value if he lay down the minimum price which he will take, and obstinately adhere to it. This is the way in which the value of money in Lombard Street is settled. The Bank of England used to be a predominant, and is still a most important, dealer in money. It lays down the least price at which alone it will dispose of its stock, and this, for the most part, enables other dealers to obtain that price, or something near it.
The reason is obvious. At all ordinary moments there is not money enough in Lombard Street to discount all the bills in Lombard Street without taking some money from the Bank of England. As soon as the Bank rate is fixed, a great many persons who have bills to discount try how much cheaper than the Bank they can get these bills discounted. But they seldom can get them discounted very much cheaper, for if they did everyone would leave the Bank, and the outer market would have more bills than it could bear.
In practice, when the Bank finds this process beginning, and sees that its business is much diminishing, it lowers the rate, so as to secure a reasonable portion of the business to itself, and to keep a fair part of its deposits employed. At Dutch auctions an upset or maximum price used to be fixed by the seller, and he came down in his bidding till he found a buyer. The value of money is fixed in Lombard Street in much the same way, only that the upset price is not that of all sellers, but that of one very important seller, some part of whose supply is essential.
The notion that the Bank of England has a control over the Money Market, and can fix the rate of discount as it likes, has survived from the old days before 1844, when the Bank could issue as many notes as it liked. But even then the notion was a mistake. A bank with a monopoly of note issue has great sudden power in the Money Market, but no permanent power: it can affect the rate of discount at any particular moment, but it cannot affect the average rate. And the reason is, that any momentary fall in money, caused by the caprice of such a bank, of itself tends to create an immediate and equal rise, so that upon an average the value is not altered.
What happens is this. If a bank with a monopoly of note issue suddenly lends (suppose) 2,000,000 L. more than usual, it causes a proportionate increase of trade and increase of prices. The persons to whom that 2,000,000 L. was lent, did not borrow it to lock it up; they borrow it, in the language of the market, to 'operate with' that is, they try to buy with it; and that new attempt to buy—that new demand raises prices. And this rise of prices has three consequences. First. It makes everybody else want to borrow money. Money is not so efficient in buying as it was, and therefore operators require more money for the same dealings. If railway stock is 10 per cent dearer this year than last, a speculator who borrows money to enable him to deal must borrow 10 per cent more this year than last, and in consequence there is an augmented demand for loans. Secondly. This is an effectual demand, for the increased price of railway stock enables those who wish it to borrow more upon it. The common practice is to lend a certain portion of the market value of such securities, and if that value increases, the amount of the usual loan to be obtained on them increases too. In this way, therefore, any artificial reduction in the value of money causes a new augmentation of the demand for money, and thus restores that value to its natural level. In all business this is well known by experience: a stimulated market soon becomes a tight market, for so sanguine are enterprising men, that as soon as they get any unusual ease they always fancy that the relaxation is greater than it is, and speculate till they want more than they can obtain.
In these two ways sudden loans by an issuer of notes, though they may temporarily lower the value of money, do not lower it permanently, because they generate their own counteraction. And this they do whether the notes issued are convertible into coin or not. During the period of Bank restriction, from 1797 to 1819, the Bank of England could not absolutely control the Money Market, any more than it could after 1819, when it was compelled to pay its notes in coin. But in the case of convertible notes there is a third effect, which works in the same direction, and works more quickly. A rise of prices, confined to one country, tends to increase imports, because other countries can obtain more for their goods if they send them there, and it discourages exports, because a merchant who would have gained a profit before the rise by buying here to sell again will not gain so much, if any, profit after that rise. By this augmentation of imports the indebtedness of this country is augmented, and by this diminution of exports the proportion of that indebtedness which is paid in the usual way is decreased also. In consequence, there is a larger balance to be paid in bullion; the store in the bank or banks keeping the reserve is diminished, and the rate of interest must be raised by them to stay the efflux. And the tightness so produced is often greater than, and always equal to, the preceding unnatural laxity.