5: The Mode in Which the Value of Money is Settled in Lombard Street
There is a widely-held belief that the Bank of England has "some peculiar power" in terms of setting the value of money. It's plainly evident that other banks seem to follow BE whenever the discount rate of bills is changed, which seems to be contrary to the way in which the value of all other commodities is fixed.
However, there are no mysterious forces at work, and BE wields no special power: the value of money is settled by supply and demand, like any other good: buyers want to pay as little as possible, sellers to get as much as possible, and the price reflects the agreement of the two. However, even in consumer goods, a single large holder has considerable ability to influence the others in the market: he may obstinately adhere to his price, and his insistence sways the expectations of other bidders - instead of striving to outbid him, there is a pause as they consider whether the amounts they had in mind to pay are reasonable.
Also, banks function as money brokerages - they do not consume what they purchase as is the case with a buyer of most commodity goods - but seek to obtain money only to loan it out again: a bank that bids higher for discounting bills must also loan the proceeds at a higher rate to maintain their profit margin, and can thus only do so if there us demand to borrow at a higher rate. Given that BE's share of the market is immense, any money will ultimately be taken or repaid to its reserves, and any difference between the rates of any other bank an that of BE constitutes a loss to the other bank.
The notion that the BE has control over the money market stems from the time, prior to 1844, when the bank could issue as many notes as it pleased. But even under those circumstances, the notion is a mistake: even a bank with complete authority over the money supply, as the value of money is set by those who employ it in trade. While it can set a discount rate in the short-term, over the longer term those involved in commerce will make their own assessment in the value of money - that is, prices will rise to reflect the decreased value of money and, if money decreases in value sufficiently, people will no longer regard its issue as having any value at all and identify a different medium of exchange.
During the period when the currency remains accepted in commerce, but has lost a portion of its value, the net effect is an increase in prices. If the bank issues 10% more money that it can be expected to substantiate in bullion, the value of that money decreases by a corresponding degree, and prices rise to reflect this. This, in turn, increases borrowing: if a weaver must pay 10% more for thread, he must borrow 10% more to buy it, then charge 10% more of his customers to recover the expense and repay the loan. His customers in turn must demand 10% more for their products (even if their product is labor), and so on, until equilibrium is restored. In the short term, some loss is taken by parties who do not realize the loss in value, and who correspondingly hesitate to raise their own prices, but given time, the decrease in the value of money ripples through the system.
From the banker's perspective, however, the cheapening of currency creates a disparity of value in future - he must eventually produce the bullion to redeem his notes - which leads to an increase in the interest rate he must charge to loan money, which is the only means he has to acquire the metal to redeem his own notes. And while banks can print money at a whim, they do not have the power to generate a demand for credit - and raising the interest rate in fact decreases demand for credit, which works against their long-term interests.
However, the process is not necessarily as gradual nor as exact in practice: the value placed upon any commodity by the market is subject to great fluctuations that can be produced by a slight excess or slight deficiency in quantity due to panic and fear in the marketplace. In the case of money, which is a medium of universal exchange, the level of emotion is greatly exaggerated: if buyers and sellers believe the value of money will fall even slightly, buyers will be eager to be rid of it and merchants reluctant to accept it, to a degree that exceeds a common-sense prediction of the decrease in its value.
(EN: This is an entirely speculative and psychological argument, but it nonetheless borne out in practice even to the present day, when a quarter-point change in the interest rate has a dramatic impact on the economic activity of the US, and even on a global scale.)
If money were held as commodity by the owners of it, its value would be less subject to such wild fluctuation - one can be as assured of the value of a silver coin in one's purse as of any other physical good: a bolt of cloth today will have the same value tomorrow to a person in need of clothing, and will give as much value for it in trade. But given that money has value only as a token of trade, and given that the vast majority of money is in the hands of a banking system that can arbitrarily change its value, there is great uncertainty and concern that feeds sentiments of panic
Understanding these conditions enables us to consider the responsibility that is shouldered by the BE by virtue of the central banking system, and the limitations of its power. A central bank has no control over the permanent value of money, but can influence its momentary value in ways that shift it from a position of equilibrium. However, great damage can be done to the economy and wealth of a nation in the short amount of time, and the bank is subject to the effects of its own decisions as any other citizen. As such it remains in the interest in banks to preserve stability in a monetary system.