Bankers and Credit/Chapter 1
On one of those pleasant after-dinner occasions when a Chancellor of the Exchequer is expected to unbend and to tell the nation and especially the City how well they are faring under his judicious treatment, Sir Robert Horne quoted Comte's belief that in a well-governed community all political power should be wielded by bankers. He added, however, that we can only arrive at this delectable situation when civilization attains the apex of its achievement, "and for this reason: I am sure we must all realize how hard it is to become a banker. I think I am right in saying that in all history, so far as we know, there is only one great statesman who has succeeded in becoming a banker, and I believe he presides over the London Joint City and Midland Bank." (Laughter and cheers).[1]
Whatever we may think of this doctrine that bankers are the best political rulers, there can be no doubt that political rulers have lately shown amazing capacity for creating chaos in the world of banking. Under the stress of war they seized and warped for their own purposes the banking and currency system of this country and of all other countries engaged in it and of many of those that were only affected indirectly, with the result that a system which had been brought to something very near to perfection is now
a melancholy mockery of its former beauty and efficiency. Makers of this chaos claim that it was a necessary part of the cost and consequences of war. If so, it is only one more joint in the harness of our so-called civilization, which had not even taught us how to conduct mutual slaughter on a world-wide scale, without very nearly wrecking the means by which we used to buy and sell. In some countries, indeed, the wrecking process may be said to have been complete. In August 1923 the German mark fell to about a two millionth of its pre-war value in sterling, being dealt in, or quoted, at 40 million to the pound.
In England the achievements of our rulers in the matter of currency chaos were much less devastating in their effects. With us the highest point, touched by the prices of commodities, which is the rough measure of the debasement of the buying power of our money, showed, as marked by the Economist Index Number, a multiplication in the course of nearly six years by a mere trifle of 3¼ as compared with the pre-war average, and in the course of the next two years this 3¼ was divided by two. Taking 100 as the figure for the general level of the prices of goods in July 1914, March 1920 recorded 325 and February 1922 showed that the average had come back to 166.
The effect of this rapid backward swing was in some ways much more disconcerting to industry than that of the previous rise, which had, while it lasted, greatly simplified the problems of production and commerce by ensuring a continuous advance in paper profits to all who held a stock of goods. But even the uncomfortable effects of this inconveniently rapid fall were preferable to the sapping of the foundations of the economic fabric that would have been involved by the continued progress of the process of debasement. Indeed, when we think of all that has happened to the English Money Market during and since the war, it seems to have good reason to be surprised, and proud of itself, when it finds itself still in existence and more or less doing its ordinary work. The marvel is, after the terrific shock that crashed upon monetary and all other business, that we have any financial institutions still standing on their legs. This is still more so when we remember that we of the common herd saw only a small part of all that happened. Much of the action took place behind the scenes. Banking statements and balance sheets were always designed rather to veil discreetly the modesty of our monetary institutions than to let the full light of day fall upon the beauties of their figures and proportions. Since the war this has been more than ever so. Much of the information that used to be made public has been withheld, and, owing to the enormous complications and cross currents behind the figures that have been published, it has been impossible to draw more than uncertain and halting inferences concerning their meaning.
We do know, however, that the English Money Market was made an instrument of war, and as such was very roughly handled. It was by no meang the same machine when it tried to take up its usual work when the war was over. Its basis and character had been radically altered. The politicians and officials who had charge of their country's fortunes during the contest found ready to their hand an almost too perfect financial weapon. This weapon they took and worked and overworked and twisted all out of shape. They did so chiefly because they found, in the Money Market's almost unlimited power to create credit, the easiest and most popular way of getting money that was wanted for the war. Money that they took by taxation meant a wrench. Money that they wheedled out of our pockets in subscriptions to loans meant much drum beating and effort. Money that they manufactured with the help of banks, thanks to the ever expanding elasticity of the Money Market, was much more easily come by and seemed at first to touch nobody's pocket.
Small wonder that politicians gleefully seized a weapon which solved for them one of the worst of the war's problems, and used it with a freedom that was only checked by the need for preserving the financial decencies before the critical eyes of neutrals, from whom it might be necessary to borrow. With such effect did they use it that the Money Market, as it was before the war, is now a matter of ancient history. We are trying to struggle back to something like it, through a chorus of obstructive and objurgating critics who would rather try new systems. One of the objects of this book is to remind readers who are not versed in such matters of the benefits that our old system wrought for us, to show how it was twisted out of shape, and to put before them some of the proposals of the critics and reformers.
Before the war then our monetary system was based on gold, and the pieces of paper—notes and cheques—by which most of our large transactions were paid for, were claims to so much gold which the holder could turn into gold if he wanted to do so.
Our "legal tender" money—that is, money in which creditors were obliged to accept payment—consisted of golden sovereigns and half sovereigns and Bank of England notes, which were practically gold certificates. Silver and bronze coins were legal tender up to forty shillings and one shilling respectively.
Though practically a gold certificate, the Bank of England note issue was not wholly backed by gold in the Bank vaults; part of it was what is called "fiduciary," that is, "confidence money," being currency backed not by metal, but by British Government securities. The amount of the fiduciary notes, however, was fixed by the Bank Act of 1844, and for many years before the war had stood at £18,450,000. Above that point for every Bank note in existence there had to be so much gold coin or bullion in the Bank of England's vaults. It is true that under the terms of the Act, a certain amount of silver (one-fifth of the total bullion) was allowed as backing to the note issue. This right to base the Bank of England note on silver, however, had: not been used since 1861, and so, except to the extent of £18,450,000, the Bank of England note was actually a gold certificate. Its holder could always be certain of being able to turn it into gold on presenting it at the Bank of England. And this free and immediate convertibility of the Bank of England note was recognized as one of the chief props of the English monetary system. Anyone who had a Bank of England note, or any number of them, could rely upon being able to turn them into English sovereigns of the recognized weight and fineness without question and without delay, and to send the sovereigns to any country in which he wanted to put them.
The Bank of England note, however, was seldom seen in the course of ordinary payments. It used, I believe, to change hands in considerable quantities on race-courses, but as a general rule monetary business in this country was done, when it was a matter of comparatively small sums, by payments in gold, or in the subsidiary currencies of silver or bronze; or when larger amounts were being settled, by means of cheques drawn upon banks. These cheques also, though not legal tender, were always convertible, if the holder wished, into gold. Anyone who held an uncrossed cheque on an English bank and wanted gold for it could either go to it and demand its payment, in which case he would probably be offered the option of receiving payment in gold or Bank of England notes, and so could take gold at once. But if the bank preferred to exercise its legal right of meeting the cheque with Bank of England notes, which we have seen to be legal tender, then our gold seeker could take the notes to the Bank of England and demand sovereigns in exchange for them. Or, he could go to his own bank—and this he would have to do if the cheque which he held had been "crossed," pay the cheque into his account and draw against it. His own bank again would have the option of paying him in gold or in Bank of England notes, but in ordinary times would certainly be prepared to provide its own customer with gold. If for some special reason it stood on its right to pay in notes then the customer would have to go to the Bank of England for the gold that he wanted.
Thus before the war all our money was gold or claims to gold. Since cheques give their holders the right to take gold, the banks could not make themselves liable to meet cheques unless they had a proportion, such as experience had shown to be sufficient, of gold or of claims on the Bank of England's gold against the deposits of their customers. And so our money—in which terms I include coins, notes and cheques—could only be increased in quantity—except within the limits laid down by banking prudence—by bringing in more gold from abroad to be used either in circulation or in reserves against notes or deposits.
This foundation on which the English monetary system rested was taken from under it during and after the war. Its importance is not, at first sight, very evident. To the man in the street it might seem that all he need ask from the money that he takes in payment for his services, and pays out in payment for the goods that he needs, is efficiency in providing him with what he wants. As long as a piece of paper will buy things for him, he is not much cheered by the thought that he can, if he wants to, turn it into gold, which he would never want to do, except in order to turn the gold then, or on some "rainy day," into something else that he wanted. All this is quite true and was very sensibly recognized by most of us in the early days of the war when we were asked to help to win the war by paying all our gold into our banks and using the new Treasury notes instead, so that the gold might be sent abroad to buy things wanted for the fighting men.
Nevertheless, the patriotism of the public was promptly punished for the readiness with which it virtually renounced its right to demand gold and so gave the Government the power to print as much paper as it liked. Then the man in the street found out that money has not only to be freely convertible into goods, but must also, to do its work soundly, remain fairly steady in value and must, if possible, be convertible into the same quantity of goods to-day, and a week hence, and a year hence, and a hundred years hence. For the consequence of giving the Government a free hand with the printing press was that debauch of currency and credit creation which has already been referred to and will have to be more fully described later. It brought in its train a rise in prices that inflicted great injustice on all who were not able to increase their money incomes, and also upon those who had lent money at a fixed rate of interest or had made long contracts, such as are usual when houses are let, by which the user of an article paid a fixed sum each year for its enjoyment. All these unfortunates found that the money they received brought them in a continually diminishing amount of goods when they tried to buy with it—in other words that paper money did not long possess the same efficiency in providing its holders with what they wanted, as was formerly shown by gold. For the simple reason, that gold cannot be multiplied indefinitely, and paper can; and, Governments being what they are, there is always great danger that a people which adopts a paper currency and so gives its Government the power of printing money without limit, will find that the Government is printing too much and is thus lowering the value of all the money in existence, including gold, and causing a rise in prices with the evil consequences above set forth.
Such was the great advantage for purposes of use at home of a money based on a metal which the Government could not multiply at will. Perhaps even greater was its benefit in the field of foreign commerce. If stability of prices is a blessing when we buy and sell goods and services to one another, it is still more so when we buy and Sell abroad, if only because the transactions of foreign trade take a longer time to carry through and so involve longer credits. The merchant who is selling goods to China or Peru and may have to wait months before he gets his money, is not encouraged to do so if he finds that by the time he gets his money, it has so much less buying power than he expected when he shipped the goods, that he has made a loss on the bargain instead of reaping a pleasant profit.
When once the stability of prices is undermined by too much money being printed this may happen even to English merchants who have stipulated for payment in English money. But when payment is made in foreign money and foreign governments are working the printing press even more vigorously than ours, then the problem becomes complicated by violent movements in "exchange," that is in the value of other moneys as expressed in pounds. Instability and uncertainty play a duet with a crescendo movement that ends in a crash of hideous discord. As everyone knows these things have happened on a scale which has reduced foreign trade to a blind gamble and made more evident than ever the blessings that were secured to us by the gold standard, as used by us and the other economically civilized countries.
For they also had currencies which were more or less convertible into gold. It was always the boast of England that only in England did we enjoy ready convertibility, that only here could any holder of a monetary claim rely with certainty on being able to convert it into gold on demand. Nevertleless, though in other centres convertibility may not have been as free and certain and quick as it was here, it was at least the ostensible basis of the monetary System, and when the System was squeezed steadily enough it had to part with gold. When, during the crisis of 1907, the Bank of England put its official rate up to 7 per cent. and so exerted really severe pressure on all the countries of the world to send their gold, which they owed us or were prepared to lend to us, in order to help London to regulate and check the crisis which had been begun in America, the effect of this action was that gold poured into London from no less than seventeen other countries. Thus, though the gold basis of the currency systems of other countries was not as sure and solid as that of England, it was so to a sufficient point to secure that, at least in times of crisis and when sufficient pressure was applied, the principle of convertibility was allowed to work and the gold, when demanded, was surrendered to those who had claims for it and was allowed to leave the country and go to the place where it could be more usefully employed.
This gold backing to our monetary system and that of other countries in effect provided that all the great trading and financial countries were working with the same money. The nations coined the gold into coins of varying denominations and varying fineness, but the same metal was behind the monetary systems of all.
From this fact there came the great advantage that price levels were kept more or less in agreement in one country and another. If prices rose faster here than in other countries, we became a good country to sell to and a bad one to buy from, goods poured in and our exports were checked; if this process went far enough then some of our gold had to be sent abroad to pay for the goods and services which we had been buying abroad beyond the value of those which we were selling. The result of this export of gold was that the basis of our monetary system was narrowed, and we had to put up for the time being with a smaller volume of money, because the loss of gold made it necessary for the banks to contract the volume of deposits and cheque money, so as to keep up their proportion between cash and liabilities. We had less money to spend and prices would tend to fall because there would be so much less money in our pockets and at our banks ready to pay for goods. We thus became for the time being a bad country to sell to and a good country to buy from, and the process by which we had been buying too much was reversed. In this way big movements in prices could only take place in all the gold using countries together, and so the level of prices was kept much more steady than it would have been if each country could perform fancy variations on it without any reference to the tune being played by the rest of the orchestra. So the gold standard, by a beautiful system of checks and balances, maintained price levels in harmony among all the countries that used it and allowed it free play.
Another effect of the use by the chief countries of the same money was that it steadied rates of exchange, which are the prices of their currencies expressed in one another. When claims on England were so plentiful in New York that the price of sterling money in dollars fell below a certain point which was called "gold point," then these claims were in effect sent to London for collection in gold which was shipped to America. The cost of shipping and insuring the gold and the loss of interest involved by its journey were the influences which regulated the gold point. When claims on London were scarce and in demand, the same principle worked in the opposite direction, and so the rate of exchange between London and New York, or between any two countries with monetary systems effectively based on gold, could not, in theory, vary beyond certain limits. Owing to the varying effectiveness of the gold standards of the gold standard countries, fluctuations often exceeded the theoretical limits, but they were very definitely checked and restricted.
Such then were the chief blessings that the gold standard gave to us and to other countries that used it:—
1. Stability of prices at home.
2. Parallel movements in our prices and those of other gold using countries.
3. A limit on fluctuations in rates of exchange.
Stability of prices was by no means perfect; but the fluctuations that happened all through the century before the war were not much more than a ripple on the surface as compared with the tidal waves of the war and after-war period. It is only since we have lost these benefits owing to the surrender of a currency based on gold and the adoption of one based on the whims of politicians and the insolvency of Governments that we have fully recognized the beauties of the system that our rulers and those of other countries thought it necessary to wreck.
This system was provided for us partly by the Government, but chiefly by our banking machinery. The Government minted for us gold and subsidiary coins which we used in retail transactions and the Government had, by the Bank of England Charter Act of 1844, settled the terms under which the Bank of England was allowed to issue notes. Since these forms of currency or money were, as has been stated, legal tender, and so by the law of the land had to be accepted in payment by any creditor who had a claim for money, it was clear that they had to be subject to legal restriction. But the Bank of England's ordinary banking business, apart from its strictly regulated note issue, was left entirely to the discretion of its Governor and Directors; and we shall find that they, by the growth of a convenient monetary convention, were able to give quite unregulated elasticity to the otherwise too tight-laced system devised by Parliament. And still further elasticity was provided by the fact that the cheques, which had come to be the form of currency in which nearly all the big commercial transactions of the country were settled, were drawn on the banks by their customers according to mutual arrangements which were subject to no legal regulation, but depended solely on the prudence and sagacity of the bankers in granting credits against which cheques could be drawn.
Thus in the three generations before the war the bankers had taken the manufacture of money, in the widest sense of the word, out of the hands of the Government into their own, had broken the bands of the strait waistcoat in which business had been officially swaddled and had given it room to grow subject solely to regulation by banking prudence. Government had its revenge when the war came by making the bankers use the machine to suit its own purposes, expanding the elasticity with which they had endowed it into a Gargantuan balloon blown out to meet the exigencies of bad war finance.
The pre-war system can be most simply studied by looking at the balance sheet of one of our English banks, a summarized specimen of which is given below. Among the liabilities the large item of current and deposit accounts represents the extent to which the customers of the bank are able to call upon it to meet cheques drawn upon it. In the case of current accounts the money so held by the customer to his credit can be withdrawn at any moment. In the case of deposit accounts a certain amount of notice, usually a week, is required. But even in this case if the customer wanted money in a hurry he would certainly be able to arrange with his bank, though it might cost him something to do so, to be able to draw against his deposit account forthwith. London City and Midland Bank.
Balance Sheet—June 30, 1914.
| Paid-up Capital | £64,348,650 | Cash in hand and at Bank of England | £15,128,192 |
| Reserve Fund | 3,700,000 | Money at Call and Short Notice | 12,510,356 |
| Current, Deposit and other Accounts (including Undivided Profits) | 95,027,439 | Investments | 8,835,697 |
| Acceptances | 7,353,110 | Bills of Exchange | 10,230,300 |
| Advances, Loans and other Accounts | 54,081,382 | ||
| Liability of Customers for Acceptances | 7,353,110 | ||
| Premises | 2,290,162 | ||
| £110,429,199 | £110,429,199 |
Bankers had to decide in the light of their long experience of these matters, the proportion which prudence required them to maintain between this mass of deposits, which they might be asked to meet in cash, and their holding of cash, on the other side of the balance sheet. A rough and elastic proportion was thus established between their holdings of legal tender cash and credit at the Bank of England, and the extent to which the banks could create deposits by granting credits to the community. It will be seen, when we look again at the balance sheet, that, besides their cash, the banks held assets which, in varying degrees, could be turned into cash. They held loans at call and short notice, which are probably loans granted to bill-brokers and stockbrokers in the City of London, which, in ordinary times, a bank is easily able to call in. They also held a large portfolio of bills discounted, that is to say, bills of exchange or Treasury Bills which are, in most cases, a promise to pay issued by other banks or leading London finance houses, or merchants of established reputation, or the British Treasury, falling due at various dates, and quite certain in the ordinary course of business to be met at the date of maturity. They also hold investments in British Government and other securities, which, in most cases, could only be turned into cash by being sold on the Stock Exchange at the best prices they would fetch. In the case of most of them there is a practical certainty of being able to sell rapidly, and at a price near or above the price at which they stand in the books of the banks which held them.
The largest item on the asset side of the balance sheet consists of the loans and advances to customers, through which the banks of this country perform their function of directly assisting British trade and production, by supplying credit to customers in order to finance the enterprises in which they are engaged. These advances are clearly less liquid than the rest of the assets held by the bank. Nominally, they are usually repayable at an early date. But a bank which had made an advance to a customer would naturally hesitate much more about pressing him to repay it, if doing so would hamper him in the course of his business, than it would about calling in loans from bill-brokers and stockbrokers, or other professional dealers in credit, or by selling its own investments in the Stock Exchange.
But the most important thing to be noted about the banks' balance sheets is that by making these advances and making these investments the banks create new credit, which becomes expressed in deposits, either in their own books or in those of other banks. Whenever a bank makes a loan, it gives the borrower the right to draw upon it to the extent of the amount of the loan. The borrower, who gets this right, exercises it by drawing a cheque, which he pays out in the course of the transactions for which he had arranged the credit. Whether it is a case of a bill-broker, who borrows to finance a purchase of bills of exchange; or a stockbroker, who borrows to carry securities for his clients who hope to sell them at a profit; or a merchant, who borrows to buy commodities; or a manufacturer, who borrows to pay for raw material; or an ordinary individual, who borrows because he wants to buy an estate and has not yet provided, by the sale of securities or otherwise, the money that he needs for his purchase—whatever the reason for the purpose of the loan may be, the result will be the same. The borrower gets from his bank the right to draw the sum in question, say £20,000. He pays this £20,000 to the seller, to whom he owes money for bills of exchange or securities or raw material, or whatever it may be, and the seller pays the cheque into his own bank. The cheque goes through the clearing house and transfers £20,000 from the credit at the Bank of England of the paying bank to that of the receiving bank. The borrower's bank holds £20,000 less of cash at the Bank of England and £20,000 more in the shape of a loan to customers. The total of its balance sheet is unaltered and there has been a change, almost negligible in the vast total of its whole figures, in the nature of its assets. The seller's bank, on the other hand, has added £20,000 to its balance at the Bank of England and on the other side of its balance sheet the seller's account has been increased by this £20,000. This addition to deposits has been directly caused by the credit created by the borrower's bank.
The same result appears if a bank buys bills of exchange from a bill broker—it parts with so much cash at the Bank of England which the broker transfers to his bank, so increasing both its cash and its deposits. Again, if a bank makes an investment by sending a broker into the Stock Exchange and buying, for example, £100,000 worth of Consols, it pays the seller £100,000 by a draft on its balance at the Bank of England. Its holding of cash is thus reduced by £100,000, its holding of investments is increased by the same amount, but the seller of the Consols pays into his own bank £100,000 of new credit, which has been created by the purchasing bank. The same thing happens when a bank, instead of buying securities on the Stock Exchange, invests by subscribing directly to a new issue made by the Government or any other borrower. The only difference is that in this case it hands over a draft on its balance at the Bank of England to the issuer of the loan instead of to someone who is selling through the market. As before, its cash is depleted, and its investments are increased by the amount of the transaction, but the issuer of the loan has got a cheque which he pays into some bank or other increasing its cash and its deposits. If the final receiver of the money borrowed or invested is a customer of the lending bank, then the lending bank will have increased its own deposits; its cash at the Bank of England will be unchanged, and its advances (or investments) and deposits will both be increased by the sum of the loan.
It is thus of the utmost importance to remember, as will be seen when we go further into our subject, that whenever a bank makes an investment or a loan or discounts a bill it is increasing the deposits, either of itself or of some other bank—of itself if the person to whom its borrowing customer finally pays the money lent is also one of its customers; as in the case of an investment if the seller of the security is one of its customers, or hands on the money received to one of its customers. By this process the banks create buying power or what may be called potential currency. They create the right to draw cheques, which are usually received without question in payment for commercial and financial transactions. But the extent to which they can engage in this currency making business is roughly limited by the extent of their holding of cash—legal tender money—and balance at the Bank of England; since they have to consider the proportion between their cash holding and their liability to their customers on current and deposit account. The amount of their cash holding depended, before the war, on the amount of gold that was in the country, since legal tender was then gold or a Bank of England note; and the amount of their balance at the Bank of England depended largely on the action of the Bank of England in creating credit by lending and investing, which it had been left free to do at its own discretion by the Bank Act of 1844, which had tied its hands so tight in the matter of note issue. And now we have to look at a pre-war specimen of the Weekly Return issued by the Bank of England:—
Bank of England.
Account for the Week Ended Wednesday, July 15th, 1914.
Issue Department.
| Notes Issued | £56,908,235 | Government Debt | £11,015,100 |
| Other Securities | 7,434,900 | ||
| Gold Coin and Bullion | 38,458,235 | ||
| £56,908 235 | £56,908,235 |
Banking Department.
| Proprietors' Capital | £14,553,000 | Government Securities | £11,005,126 |
| Rest | 3,431,484 | Other Securities | 33,623,288 |
| Public Deposits | 13,318,714 | Notes | 27,592,980 |
| Other Deposits | 42,485,605 | Gold and Silver Coin | 1,596,419 |
| Seven Day and other Bills | 29,010 | ||
| £73,817,813 | £73,817,813 |
It will be seen that the account is divided into two portions—the Issue Department and the Banking Department. As everyone knows, this eccentric and unique arrangement was imposed upon the Bank of England by Parliament, when it devised the Bank Charter Act of 1844. The Issue Department shows the total of the Bank of England notes issued with the assets held against them on the other side. These assets consist of gold coin and bullion to the extent of the whole amount of the note issue, except the £18,450,000, the fiduciary issue which is permitted, as already described, and was in February 1923 raised to £19,750,000. The Government debt is merely a book debt between the Government and the Bank of England—the very much expanded descendant of the £1,200,000 which was lent to the Government of William III, when the Bank of England was originally founded. There are also other securities in the Issue Department, which are, and in fact always have been, securities of the British Government. But it should be noted that nothing in the Bank Act restricted the Bank of England to securities of this kind for the backing of the fiduciary part of its note issue.
When we look at the Banking Department's figures we find it much more similar to the balance sheet of an ordinary bank. Capital of course explains itself. "Rest" is the somewhat eccentric title under which the Bank of England describes its reserve fund, which is also eccentric in the fact that it fluctuates with a frequency and to an extent which is unusual with other reserve funds. In fact this item appears to include both the reserve fund and the profit and loss account.
In the next two items we find the real significance of the Bank of England's position. The Public Deposits are the deposits of Government Departments, and it need not be said that the Bank of England's position, as bank of the British Government, has been in the past the main cause of its great prestige and of its paramount position in the London Money Market. Nowadays, perhaps, the next item is even more important. The Other Deposits include the balances of the chief English banks, all of which keep an account at the Bank of England, through which they settle the balances of the huge transactions between one another that are carried through every day by the clearing house, and this balance at the Bank of England is included by the other banks, with their holding of legal tender currency, as "cash" in their balance sheets and statements. It must be noted, however, that the Other Deposits include many accounts besides those of the banks included in the clearing house system, commonly called the clearing banks. They include the balance of the Indian Government, Colonial and Foreign Governments, home and foreign Municipalities, and the many private customers of the Bank of England; and since, as we have seen on looking at the balance sheet of one of the clearing banks, these institutions do not separate their cash at the Bank of England from their holding of legal tender cash, one of the chief clues to the real position of the Money Market, namely the amount of cash at the Bank of England held by other banks, is always veiled from the gaze of the curious.
On the other side of the account we are faced by similar obscurities. Government securities include only promises to pay of the British Government, but they may be in the form of undated or long-dated loans, such as Consols or War Loans, or they may be Treasury Bills, or they may be temporary advances, which the Government secures from the Bank of England in the form of Deficiency Advances for meeting interest due on Government debt; or Ways and Means advances necessitated at a time when the revenue of the country is coming in too slowly to meet the daily payments that the Government has to make. The "Other securities" include every investment or promise to pay that the Bank of England may hold, other than those issued by the British Government. And advances that it may make to banks, though banks very rarely borrow from it, or to bill-brokers, stockbrokers, or its ordinary customers, are here jumbled together in a comprehensive medley, with the result again that inferences drawn from the movement upward or downward of this item are extraordinarily likely to mislead the too curious inquirer.
We saw that any investment or loan made by an ordinary bank increased the deposits in the hands of itself or of some other bank. When the Bank of England makes investments or advances, it increases the deposits that it holds, either "Public" or "Other," either on account of the British Government or of some other customer. Since the Public deposits, the balances held by the public departments, are in normal times a more or less constant quantity, the usual effect of any advances that may be made by the Bank of England, either to the Government or to anybody else, is to increase the total of the "Other" deposits; since what the Government borrows it pays out to individuals or companies to whom it owes money and they pay it into their own banks.
It may happen occasionally that those who are given an advance by the Bank of England may use it in order to withdraw cash, just as a borrower, who borrows from an ordinary bank in order to pay wages to his workmen, may take out coin for that purpose. In either case, however, it is most likely that the coin or notes so taken out will come back in the ordinary course of trade to be deposited with one bank or other in the case of ordinary banks; or with the Bank of England itself in the case of advances made by the Bank of England; but in the latter case there is the exception that demands made upon it for cash may—or might in pre-war days—take the form ultimately of demands upon the Issue Department for gold for purposes of export. When this happened, instead of an addition to its deposits being shown, a decrease in the cash holding of its banking department would follow and the proportion between its reserve and its liabilities declined. Its reserve consists of the last two items on the assets side, by far the larger one being composed of notes—its own notes issued by the Issue Department. Anybody who, by borrowing from the Bank of England, secures credit in its Banking Department can exercise that credit by taking out some of the notes held in that Department's assets. Before the war, he could then go to the Issue Department and take out gold in exchange for his notes, which were forthwith cancelled, because their gold backing had gone. The consequent reduction of the Bank of England's reserve, and of its proportion to liabilities would immediately be noted by the market as likely to cause the Bank, if the process went further than it thought prudent, to raise, by an advance in Bank Rate, the price at which it would grant credit. Bank Rate is the official minimum rate at which the bank will discount bills; and the rate at which it will make advances is usually ½ per cent. above.
Thus we see that the Bank of England, like the other banks, creates credit by any advances that it makes; and its action in so doing is of especial importance because the credit that it creates is regarded as cash by the other banks. If it lends money to Government to pay interest on Government debt, the Government draws upon the credit so created, and pays out cheques to the debt holders, which they pay into their banks, and so there is finally an increase in the balances of the Joint Stock banks at the Bank of England and in the amount of the Bank of England's "Other" deposits. On the other side of the account there will be an increase in the Bank of England's holdings of Government securities. The same thing happens if the Bank of England lends money to the Government to pay for a battleship, or to meet the salaries of its officials, or if it lends money to any other borrower for any other purpose. The borrower draws a cheque, which is paid into one bank or another and increases the credits held by the banking community at the Bank of England. And, as has been shown above, other banks include their credits with the Bank of England with their legal tender cash. Thus, whenever the Bank of England lends, it places at the disposal of the other banks, a sum which entitles them to issue for the purposes of the general public, a much larger amount of credit. On the other hand when the Bank of England reduces its securities, either by selling stock or by inducing its borrowers to liquidate their loans by charging them a higher price for them, which it does by raising its official rate of discount, the effect is to contract the basis of credit and to cause a still greater contraction in credit, so that the proportion between cash and credits may be maintained more or less on the usual level.
Thus the system worked in the old days with an efficiency, which roused the envy of the rest of the world, though it was plentifully criticized by those whose withers were galled by its restrictions, which as we now see, had so beneficial an effect in steadying prices. Owing to the terms of the Bank Charter Act it was not possible to increase the volume of legal tender currency in the country, except by attracting gold from abroad in payment either for goods exported, or of debts called in, or of loans raised. Theorists could easily show that a currency system based on gold does not secure perfect stability of prices, because the quantity of gold produced often varies in relation to the quantity of goods coming to market; and the Quantity. Theory of money shows us that steadiness of prices is secured, or assisted, by steadiness in the relation between the volume of money and that of goods. Practical business men, who often want more credit than is good for them, used also to rail at the restriction upon the credit facilities of the country involved by the gold standard. They argued that industry can only expand if any adventurous person who thinks that he can make a profit by starting and organizing "enterprises of great pith and moment" can always be certain by applying to his bank to get as much credit as he wants, and that the limitation on the power of banks to create credit, imposed by the gold standard, made industry most absurdly depend on the amount of gold that was being dug up out of the bowels of the earth and shipped to this country.
Certainly it is easy to make merry over a system based on a metal which was chosen by mankind as a medium of exchange, because of its universal appeal to male and female vanity, and is even now, owing to the hoarding habits of primitive peoples into whose control it comes, often dug up in one quarter of the globe only to be buried in another. But imperfect stability of prices secured by the gold standard has been seen to be much better than the perfect instability produced by the printing-press in the hands of impecunious Governments. And the monetary system of England had in effect very cunningly weakened the restrictions of the Bank Charter Act by establishing, as part of the foundation of our credit system, the principle that a balance at the Bank of England can be ranked as cash with gold or gold certificates. Balances at the Bank of England could be, and were, expanded at moments of exceptional demand to any extent that the Bank of England thought prudent. When demands arose for expansion of credit, and the ordinary banks found that their proportion of cash to liabilities was becoming too low, all that they had to do was to call in part of their loans, which they habitually advanced to the London bill-brokers as their second line of reserve. The bill-brokers, in order to repay these loans, went to the Bank of England to borrow, and it lent them money with which they paid off their loans to the other banks. So the balances at the Bank of England of the other banks were increased, and the cash basis of our credit system expanded with extraordinary ease by a few entries in the Bank of England's books. This easy elasticity, which made our monetary system an almost perfect machine when worked by bankers for financing our production and trade, lent itself only too well to abuse by politicians, when a great war called for sacrifice, but the politicians found it simpler to invite us to make money out of our country's need.