Lombard Street: A Description of the Money Market

by Walter Bagehot

It follows from what has been said that there are always possible and very heavy demands on the Bank of England which are not shown in the account of the Banking department at all: these demands may be greatest when the liabilities shown by that account are smallest, and lowest when those liabilities are largest. If, for example, the German Government brings bills or other good securities to this market, obtains money with them, and removes that money from the market in bullion, that money may, if the German Government choose, be taken wholly from the Bank of England. If the wants of the German Government be urgent, and if the amount of gold 'arrivals,' that is, the gold coming here from the mining countries, be but small, that gold will be taken from the Bank of England, for there is no other large store in the country. The German Government is only a conspicuous example of a foreign power which happens lately to have had an unusual command of good securities, and an unusually continuous wish to use them in England. Any foreign state hereafter which wants cash will be likely to come here for it; so long as the Bank of France should continue not to pay in specie, a foreign state which wants it must of necessity come to London for it.

And no indication of the likelihood or unlikelihood of that want can be found in the books of the Bank of England.

What is almost a revolution in the policy of the Bank of England necessarily follows: no certain or fixed proportion of its liabilities can in the present times be laid down as that which the Bank ought to keep in reserve. The old notion that one-third, or any other such fraction, is in all cases enough, must be abandoned. The probable demands upon the Bank are so various in amount, and so little disclosed by the figures of the account, that no simple and easy calculation is a sufficient guide. A definite proportion of the liabilities might often be too small for the reserve, and sometimes too great. The forces of the enemy being variable, those of the defence cannot always be the same.

I admit that this conclusion is very inconvenient. In past times it has been a great aid to the Bank and to the public to be able to decide on the proper policy of the Bank from a mere inspection of its account. In that way the Bank knew easily what to do and the public knew easily what to foresee. But, unhappily, the rule which is most simple is not always the rule which is most to be relied upon. The practical difficulties of life often cannot be met by very simple rules; those dangers being complex and many, the rules for encountering them cannot well be single or simple. A uniform remedy for many diseases often ends by killing the patient.

Another simple rule often laid down for the management of the Bank of England must now be abandoned also. It has been said that the Bank of England should look to the market rate, and make its own rate conform to that. This rule was, indeed, always erroneous. The first duty of the Bank of England was to protect the ultimate cash of the country, and to raise the rate of interest so as to protect it. But this rule was never so erroneous as now, because the number of sudden demands upon that reserve was never formerly so great. The market rate of Lombard Street is not influenced by those demands. That rate is determined by the amount of deposits in the hands of bill-brokers and bankers, and the amount of good bills and acceptable securities offered at the moment. The probable efflux of bullion from the Bank scarcely affects it at all; even the real efflux affects it but little; if the open market did not believe that the Bank rate would be altered in consequence of such effluxes the market rate would not rise. If the Bank choose to let its bullion go unheeded, and is seen to be going so to choose, the value of money in Lombard Street will remain unaltered. The more numerous the demands on the Bank for bullion, and the more variable their magnitude, the more dangerous is the rule that the Bank rate of discount should conform to the market rate. In former quiet times the influence, or the partial influence, of that rule has often produced grave disasters. In the present difficult times an adherence to it is a recipe for making a large number of panics.

A more distinct view of abstract principle must be taken before we can fix on the amount of the reserve which the Bank of England ought to keep. Why should a bank keep any reserve? Because it may be called on to pay certain liabilities at once and in a moment. Why does any bank publish an account? In order to satisfy the public that it possesses cash—or available securities—enough to meet its liabilities. The object of publishing the account of the banking department of the Bank of England is to let the nation see how the national reserve of cash stands, to assure the public that there is enough and more than enough to meet not only all probable calls, but all calls of which there can be a chance of reasonable apprehension. And there is no doubt that the publication of the Bank account gives more stability to the money market than any other kind of precaution would give. Some persons, indeed, feared that the opposite result would happen; they feared that the constant publication of the incessant changes in the reserve would terrify and harass the public mind. An old banker once told me: 'Sir, I was on Lord Althorp's committee which decided on the publication of the Bank account, and I voted against it. I thought it would frighten people. But I am bound to own that the committee was right and I was wrong, for that publication has given the money market a greater sense of security than anything else which has happened in my time.' The diffusion of confidence through Lombard Street and the world is the object of the publication of the Bank accounts and of the Bank reserve.

But that object is not attained if the amount of that reserve when so published is not enough to tranquillise people. A panic is sure to be caused if that reserve is, from whatever cause, exceedingly low. At every moment there is a certain minimum which I will call the apprehension minimum,' below which the reserve cannot fall without great risk of diffused fear; and by this I do not mean absolute panic, but only a vague fright and timorousness which spreads itself instantly, and as if by magic, over the public mind. Such seasons of incipient alarm are exceedingly dangerous, because they beget the calamities they dread. What is most feared at such moments of susceptibility is the destruction of credit; and if any grave failure or bad event happens at such moments, the public fancy seizes on it, there is a general run, and credit is suspended. The Bank reserve then never ought to be diminished below the 'apprehension point.' And this is as much as to say, that it never ought very closely to approach that point; since, if it gets very near, some accident may easily bring it down to that point and cause the evil that is feared.

There is no 'royal road' to the amount of the 'apprehension minimum': no abstract argument, and no mathematical computation will teach it to us. And we cannot expect that they should. Credit is an opinion generated by circumstances and varying with those circumstances. The state of credit at any particular time is a matter of fact only to be ascertained like other matters of fact; it can only be known by trial and inquiry. And in the same way, nothing but experience can tell us what amount of 'reserve' will create a diffused confidence; on such a subject there is no way of arriving at a just conclusion except by incessantly watching the public mind, and seeing at each juncture how it is affected.

Of course in such a matter the cardinal rule to be observed is, that errors of excess are innocuous but errors of defect are destructive. Too much reserve only means a small loss of profit, but too small a reserve may mean 'ruin.' Credit may be at once shaken, and if some terrifying accident happen to supervene, there may be a run on the Banking department that may be too much for it, as in 1857 and 1866, and may make it unable to pay its way without assistance—as it was in those years.

And the observance of this maxim is the more necessary because the 'apprehension minimum' is not always the same. On the contrary, in times when the public has recently seen the Bank of England exposed to remarkable demands, it is likely to expect that such demands may come again. Conspicuous and recent events educate it, so to speak; it expects that much will be demanded when much has of late often been demanded, and that little will be so, when in general but little has been so. A bank like the Bank of England must always, therefore, be on the watch for a rise, if I may so express it, in the apprehension minimum; it must provide an adequate fund not only to allay the misgivings of to-day, but also to allay what may be the still greater misgivings of to-morrow. And the only practical mode of obtaining this object is—to keep the actual reserve always in advance of the minimum 'apprehension' reserve.