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2: A General View of Lombard Street

The major players in the money market are the Bank of England (central bank), private banks, joint stock banks, and bill brokers. Before describing each separately, let's consider what they have in common and how they relate to one another.

The chief difference between a capitalist and a banker is that the capitalist loans or invests his won money, whereas bankers do so with the money of others - which is to say that bankers extend credit to some from money it owes to others, contributing no capital of its own to the economic system. Such a system has both merits and defects.

Central to the notion of banking is the concept of credit, which itself is based on promises to repay in future a debt incurred today. In a system of credit, soundness and reliability are concerns of the first order: we must have some assurance that promises will be kept, and if they are not, the credit system collapses.

That is, the banker must collect from its debtors in order to pay the demands of its own creditors - and so long as he retains adequate currency in reserve, he is fairly safe from risk of failure.

The lender extends and expects to repay in whatever legal tender is used, but is strongly influenced by the soundness of the monetary system: if the currency of a country is stable, he can collect in equal measure to what was loaned, with some increase for his own profit; but where the currency in which he deals loses its purchasing power, he must collect in greater measure to what was loaned due to its decreased value in future.

Legal tender, itself, is often a form of credit: the amount of currency issued by a government is based in part on its own reserves of precious metals (gold and silver, for which the notes may be redeemed) and in part upon credit - bills such as the American "greenback" which cannot be presently redeemed, but carry value in faith they can be exchanged or redeemed in future. The author examines the books of the Bank of England, and finds that the current currency is about 45% credit money, with 15m pounds of currency based on credit and 18m pounds backed by bullion.

In banking, a distinction must be made between the money that constitutes a "reserve" and that which is necessary to transact its daily business - that is, that some sum of money is wanted every day by its depositors that must be on hand to meet their regular demands, and a special reserve must be held by the bank to meet extraordinary demands, in both amount and timing. Another look into the books of the BE shows the bank maintains a cash reserve of about a third of its deposits, the other two-thirds being loaned out.

It's also noted that no other bank keeps such funds in reserve - a private bank maintains a small amount of cash on premises, and places its reserves in the vaults of the BE - which itself loans out two-thirds of their cash. This places on the central bank a high level of responsibility in taking care of its deposits, as the ability of every other bank to repay deposits depends on those banks' ability to withdraw the funds in their own reserves from the BE.

The business of bill brokers is much the same: those who underwrite bills are called upon to periodically redeem them, and must maintain only so much "real" money as is necessary to redeem the credit money they have issued, and maintain the remainder in a bank. The ban in turn retains some of the funds of the broker and deposits the remainder in the BE. The BE in turn retains some cash reserves and issues its own credit money. Ultimately, the stability of the entire monetary system comes back to the central bank.

But ultimately, the risk of the banking system falls on its depositors: where any bank fails, a depositor is in danger of losing his deposits at that bank. Should the central bank fail, all deposits at all banks are in jeopardy. And while the State assures us that this notion of danger is artificial or unreal, it must be remembered that the State itself is responsible for the situation: all money was once real (commodity) money until the state granted permission to the central bank to issue credit money, and while it regulates its ability to do so, regulation can be changed at a whim - and the required amount of reserves has, indeed, been decreased from half, to two-fifths, to one-third, by act of law.

London has also become a clearinghouse for foreign countries, as many of the central banks of continental Europe have effectively failed - while they have not collapsed, neither do they maintain cash reserves, but instead export their reserves to England for safe-keeping. It had been for quite some time that the banks of England and France were the keepers of the European reserve, but since the Bank of France has reneged on specie payments (it issues only currency and will not make payment in gold or silver), the entirety of the European economy is backed by reserves maintained on Lombard Street.

It has also become a clearinghouse of credit for foreign merchants - the number of mercantile bills drawn upon accounts in London "incalculably surpasses" the amount of such bills drawn upon the banks of any other nation. As such, not only the wealth but the regular course of commerce in all of Europe depends on the solvency and stability of the English banking system.

As such, the claim that England is the foundation of the world economy is not mere politics, but a statement of fact: the economic stability of the lesser nations of the world rely upon the nations of Europe, and the stability of European nations relies upon that of the English banks, to a historically unprecedented degree. Should there be a "run" on English banks, leading to their collapse, it would lead to a worldwide economic collapse.

The author reiterates that such a collapse would not merely wipe out the amassed wealth of nations, but paralyze the conduct of commerce, as the vast majority of transactions, both by individuals and merchants, is done by way of banks: consumers cannot purchase goods, nor merchants obtain inventory, except by their ability to offer currency whose value largely rests on the ability of the banking system, and ultimately the central bank, to redeem that currency as promised.

The maintenance of a significant cash reserve is a differentiating factor between the central bank and private banks: the central bank maintains a cash reserve of between 30 and 50 percent, whereas all private banks maintain merely as much money as they require to conduct their daily business. As such, the central bank and the commercial bank are not managed by the same principles.

It is a bit troubling that the reserve of the central bank is not set by any consistent or even documented set of principles: there never has been a distinct resolution passed by the directors of the BE that states how much reserve they mean to keep, or by what principles the daily maintenance of their levels of reserve will be guided. This is a cause of great public concern, which can be noticed in the newspapers' tendency to make recommendations to the banks on the subject of their reserves.

Considered as a business, banks are driven by two contradicting objectives. The first objective is to generate as much profit as possible by loaning out as much money as possible, funds lying idle in reserves producing for them no income. As such, the more money they have out on loan, the more interest they receive, and the greater interest they can offer their depositors. The second objective is to attract as many depositors as possible by generating in them the confidence that the funds they deposit are "safe" and can be accessed at any time, which itself requires the bank to keep a sufficient reserve. The business of banking, on a fundamental level, is driven by the resolution of these two conflicting goals.

The central bank has no such motive, or at the very least is motivated to a lesser degree to generate income from loaning money that is any private or commercial bank, and as such its greater value to depositors is not the potential to pay interest on deposits, but merely to be able to preserve their value and repay on demand - which naturally leads to the preference of a higher reserve.

As a consequence, there is a high degree of confidence in the solvency of the central bank: "no one has any fear." But in truth, the Bank has received assistance three times in the past quarter-century, without which it would have failed, and there have been a few historical incidents where the bank suspended payment of its own debts - and still, there is an ironclad faith in the soundness of the central bank.

While it is true that the bank has ultimately paid out what was owed, the notion of "ultimate payment" is abhorrent to any creditor: he places little value on the debtor who will repay him ultimately, eventually, and whenever he can, but values instead the debtor who will pay by the terms on which credit was extended - which in the case of a bank an its depositors, is immediately and on demand.

However, since the BE is largely creditor to merchants, it has some ability to suspend payment without immediate consequences: as for merchants, the majority of their capital is held in physical goods (facilities, equipment, inventory), only a small amount is tied up in cash for business operations. They have sufficient cash in their own reserves for their day-to-day operations, and need unusual amounts infrequently, for deals that can likely be postponed or they terms of payment negotiated with other merchants, whose own long-term interest in the stability of the banking system exceeds their short-term desire to be paid promptly.

Private banks, meanwhile, serve a larger number of smaller clientele, who are more impatient for their funds: the landlord and grocer are not likely to wait for payment with the patience with which a thread manufacturer can wait for payment by a cloth factory. Thus, the solvency of merchants and the discretion by which they manage the finances of their operation extend to the central bank some margin of safety, which can then be extended from the central bank to other banks whose reserves it maintains.

The position of Parliament on BE is that it is a bank, like any other bank, and has no duty to the public duties at all. The author suggests that "none out of ten" statesmen and public authorities, when asked, expressed that the affairs of BE are of no concern to Parliament at all. The result is that the custody of the entire banking system is placed in the hands of a board of directors who are "not particularly trained for the duty" and who have very little accountability should it be ruined by their mismanagement.

The security of any bank relies upon its management of funds to keep a reserve, beyond the amount needed for daily transactions, to accommodate unusual demand. The author identifies two potential sources of unusual demand: an outflow of cash needed to pay large and unusual foreign debts, and a sudden desire for domestic depositors to withdraw a large amount of funds, for rational or irrational reasons.

The BE is more exposed to risk of foreign demand than any bank in history due to its custodianship of an unprecedented amount of foreign deposits. However, ordinary foreign trade requires little movement of cash, as exports and imports tend to balance one another except in crisis situations, such as a significant increase in the import of foreign wheat in the wake of a bad domestic harvest. In those instances, the imbalance of trade requires an outlay of cash to pay for imported goods in excess of what is exported.

And to be specific, only metal is "cash" in foreign exchange - the paper monies of one nation have no exchange value in another - so ultimately, there is only one genuine currency, which is metal. Bank notes only hold value by virtue of being convertible into bullion at the issuing bank.

Retuning to trade imbalance, metal leaves a country as a result of a sudden event such as a ad harvest, or slowly and over a long period of time, such as the "cotton drain" that has long afflicted England, as metal has been exported slowly, over time, to India and China in exchange of cotton.

The mechanism by which banks defend against shrinking reserves is elevation of the rate of interest charged on loans. One can delve deeply into the theory behind this but the general notion is lain enough: capital flows to the place where the most can be made of it - hence an increase in the interest rate of loans, and the interest paid on deposits, draws foreign deposits to English banks.

There is also the effect of the mercantile system, which proceeds at a slower pace: bit as the costs to manufacture goods falls, domestic prices fall, imports are diminished, and exports are increased, the net effect of which is to reverse the flow of capital that leaves the country when the balance of trade is unfavorable (more import than export).

The domestic drain of bank reserves is very different: it arises from a disturbance of credit within the country, which may be caused or enhanced by a foreign drain, but is largely a matter of the collective confidence of creditors in the ability of debtors to repay. When confidence in credit fails, there is less demand for borrowing to generate income for banks, and greater sums kept on deposit, which increases its own interest expense.

The notion of "discredit" is the belief that a person does not have any money, and does not have the ability to generate money for the repayment of loans. When the creditworthiness of a bank falls into question, its depositors seek to withdraw their funds - which depletes the bank's reserves and its ability to generate an income by lending money. In this way, a panic about the stability of a bank tends to feed itself and, in the process, causes the bank to become unstable.

While such a panic is assumed to be mainly a problem of the bank, it becomes a more significant problem for the merchants - who have bills to pay for their own expenses, and can only pay them either by withdrawing or borrowing money - and a merchant, unlike a bank or an individual depositor, is a common connection between many factors of the economy: its suppliers and customers, as well as its creditors, are all impacted when a business runs short of cash.

The author uses the term "alarm" to describe a situations where a creditor feels that a debtor will be unable to repay him by the terms under which credit was extended. The alarm subsides when money is paid, even if this is sooner than it was agreed upon, to alleviate the fear that it will not be repaid at all. If an alarm is not addressed, it aggravates into a panic, as the creditor himself is indebted to others, who then fear his ability to repay, and so on - until the entire chain of credit becomes fearful of the availability of money in the financial system.

Very often, panic extends as far as the bank that holds a reserve: a payment form one party to another is an exchange of funds between them, but what is withdrawn from one account is most often deposited in another. If they are both patrons of a same bank, that bank's reserves are undiminished. If they are patrons of separate banks, both of which maintain their reserves through a third bank, it still results in no change for the bank that maintains the reserve: the amount is moved from one account to another in the journals, while the metal remains in the vault.

Credit money arises when a bill is written against cash in reserve, and is passed from one hand to another is a series of commercial exchanges, and is not redeemed at the issuing bank. Great sums of cash exist in this form of paper money that do not impact the metal reserves of a bank and remain in circulation indefinitely, creating a false sense of security in the notion that such notes will never be redeemed.

Only on extraordinary occasions is the public at large so gripped by panic that they wish to redeem bank notes to take possession of precious metals. In such instances, banks that hold adequate reserves in proportion to bills issued can afford for a longer period of time to honor their paper monies, and bolster confidence by redeeming some portion of it to the point that the remainder is not redeemed, and the panic subsides before the complete metal reserves of the bank are exhausted.

This problem is unique to banks. In all other credit arrangements, the terms of repayment are established, and the creditor has no power to insist repayment other than by those terms. And as the bank plays both the role of creditor and borrower, it is in a position where it must wait on the repayment of sums borrowed, but its own depositors need not wait to have access to the funds deposited, even though they have been lent to others by the bank.

This places banks in a precarious position, and makes the task of managing the Money Market all the more difficult, as a panic causes depositors to withdraw funds for fear they will not be available if the panic persists and others to seek to borrow funds in the early stages of a panic for fear that credit will not be available if the panic persists.

In both respects, the English banking system is in an exceedingly delicate position: there is a great magnitude in the country's commerce as well as in the nation's wealth, and a significant proportion of the public, both individuals and businesses, carry significantly more debt than in previous times, or in other nations. As such, even a short-lived panic causes deposits to decrease and demand for credit to increase by considerable sums.

The solution of interest is itself not entirely reliable: the notion is that by raising the interest rate paid on deposits, the bank can attract new depositors or better retain the deposits it has, and by raising the interest rate demanded for loans, it can discourage additional borrowing, thus bolstering its reserves.

The reason this solution is not entirely reliable is that the supply and demand of money pay little heed to interest rates in the long term. While it can be effective in the short term, there is only so much money that is available outside the banking system to be deposited, and only so much credit that can be extended with the expectation of repayment. Value, for which money is given, is itself is made by industry, driven ultimately by the demand of goods, and production in excess of demand renders no profit to the producer.

Arguably, discounting bills can also create additional money, but bill brokers are in the same position as banks insofar as the bills they discount must eventually be redeemed, and they must be able to pay them at their date of redemption. They have some advantage over in their ability to predict when they will be required to return capital, but must still be governed by the balance of payments between those to whom they have extended credit and those who have effectively issued them credit to create bills.

The issue is further compounded when one considers that the cash reserves of bill brokers are warehoused in the banking system, which is ultimately supported by the BE.

A few further points are considered, both of which rest on the same basic assumption: BE, as issuer of currency and the custodian of the "State account" is a public institution whose actions are geared to safeguard the monetary system and preserve the public welfare. This is simply not the truth, as the BE is just a bank, like any other, in its business operations, and has no special concern nor any formal duty at all to preserve the general welfare of the nation.

The BE is generally concerned with its own security and prosperity, which generally coincides with the security and prosperity of the nation. This is entirely coincidental, and decisions made by the bank in times of crisis demonstrate that there is no direct connection between the two: the bank does not respond to a crisis until its own security is threatened, and then does not consistently act in the most prudent manner.

Considering the actions of the BE during the crises of 184, 1957, and 1866, the bank directors either did not consider, or chose not to take, the option of taking action early in the crisis to stave off panic - this would have served the general welfare and restored confidence in the financial system, diminishing the panic in its early stages. Instead, the BE itself became a participant in the panic, seeking to preserve its own reserve by tightening credit, issuing no new bills, and even delaying the redemption of bills that were due. None of this was in the public interest, but its own.

The author underscores his thesis: that a system that entrusts all of its reserves to a central bank, run by an independent board of directors, is

"very dangerous" and that while the negative consequences have been felt at times, they have not yet been seen to the full measure, and are often obscured by theoretical argument and hidden in the complexity of the financial system.

And there remains the question, "what would be better?" We are so accustomed to the notion of central banking that we can hardly conceive of any other. But it is unheard of, in any industry, for one single firm to have such a great predominance over all others in its market: should the largest wheat farmer fail, it has no impact on any other farmer to produce wheat (and instead, is a boon to them, as there will be increased demand for their product). Outside of England, banking operates in the same manner as any other business: each bank remains free-standing and independent, as in "not dependent" on other banks. Should one fail, the others will remain unaffected.

(EN: The counter-argument is efficiency. A central bank performs for other banks the same service as any commercial bank performs for its own customers, in enabling them to earn interest on cash reserves that are not presently needed, but will be needed in future, by lending funds out until such time they are required. This does not contradict the point, that consolidating capital consolidates the risk to the owners of capital, but explains why a central bank is desired by commercial banks in spite of the inherent risk.)

The author plainly states that he does not propose a revolution or an abolishment if central banking, and does not thing such an extreme argument merits much consideration: "You must take what you can find and work with it if possible." Just as the subjects of a tyrant loyally obey the tyrant without hesitation or doubt, so must participants in the money market maintain their loyalty to the central banking system - but at the same time, to seek a method of mitigating their risk. If the tyrant were displaced, it would be a matter of time before another would rise in his place.

The drawback of free banking is that it creates a decentralized system of control, which would serve the purpose of mitigating risk, but would create a system in which many small banks act independently, which would be too complex to be monitored or controlled, and undermine public confidence in the value of the money they issue. Having a central bank creates a currency that is relied upon simply because it stems from a single source that can be identified and monitored. Moreover, a multiple-reserve system of banking is what originally existed before the establishment of central banks - there are a multitude of reasons that this makes good sense, and any argument to the contrary would be met by ridicule.

The author looks to the example of the Bank of France, which was in effect a public institution, controlled by the sovereign and regents of the bank to use it as a mechanism to promote the general welfare. Functionally, it remains a bank, but in terms of its management, it is handled as a public resource. While this system "works fairly well" in France, the author's sense is it would not be palatable to the English, who have a distrust of the motives of government and are uncomfortable with the idea of handing it control over the financial infrastructure.

As such, both free-banking and government-controlled banking are clearly out of the question. In light of that, the author proposes three remedies:

  1. There should be a clear understanding that the bank holds the financial reserve of the nation, and must also accept the obligation to use this reserve to promote the general welfare: to maintain its reserves, and lend it freely in times of panic to stabilize the financial system.
  2. The management of the bank should be adjusted to diminish the "amateur element" and augment the "trained banking element" to ensure greater constancy in administration.
  3. To diminish the strain on the central bank by requiring greater fiscal responsibility of commercial banks.

To more fully understand these proposals, it's necessary to consider the component parts of the money market, and the "curious set of causes" that have led it to its present structure.