6: Why Lombard Street Is Often Very Dull, and Sometimes Extremely Excited
In any market where banking is well-established, any sudden event that causes a spike in demand for actual cash may cause a panic. In such a market, there is an immense amount of credit money in circulation that is backed by a small cash reserve, such that banks do not have sufficient cash available to pay depositors who withdraw their funds. Given the recent history, such an incident seems to occur once very ten years or so.
Another curious phenomenon is that people in general are either well off or hard pressed all at the same time. While this would be expected in economies based on a single factor - such as agriculture, in which a dry season harms all farmers - it seems puzzling that it should remain so in a diversified economy in which there are numerous industries that depend on separate factors and conditions.
A few of the principles of diversified economy seem self-evident: primarily, that every producer is involved in the production of goods that others want, and not necessarily what he wants for his own consumption; and second, that since the goods are produced only to be exchanged, it is in the producer's interest to exchange them as quickly as possible.
There are also a few obvious mistakes that can be made in such an economy - for example, a person produces what they assume others want, only to find that thy do not want them. Or perhaps he produces what is wanted, but those who want it are unaware of where it exists. (EN: Interestingly, these are the chief concerns of marketing - determining what is wanted before production and calling attention to it afterward - though "marketing" was not considered as a profession at the time the author was writing.)
These principles are fairly obvious, but what is not obvious is the degree of their effects. Taken together, these factors are highly influential in the level of economic activity - whether the economy as a whole is brisk or stagnant. Where information flows freely, every merchant knows what goods customers want and in what quantity, every customer knows where to obtain that which he needs, every producer knows exactly how much to produce and when to produce it, every worker knows where and by whom his labor is in demand. This certainty allows for both efficiency (no mistakes are made) and alacrity.
Some level of certainty can be found in commerce within industries - when a chain of industries each produce goods for one another: when the clothier knows how many articles of clothing he must sell, the tailor knows how many he must make, the weaver knows how much cloth he will need, the spinner how much thread he must make, the farmer how much cotton he must plant. Where prediction is error, each of these partners in the value chain will have produced more than is needed, and will have borrowed more than they can repay by the sale of their goods.
(EN: It is not mentioned, but this is where the supply-side favors scarcity of goods: if they are conservative in their estimation of demand, they will produce less than what will likely be demanded and have greater certainty in their ability to clear their inventories and repay their debt.)
It also stands to note that the failure of any industry in the value chain impoverishes all the others - whether by an unexpected disaster or poor management, a firm that fails to produce in the needed quantity renders all others downstream of it to be able to produce in the quantities needed. This impoverishes not only the business owners, but the laborers in their employ, and the merchants who sell to those laborers, and the suppliers to those merchants.
In this way, the fate of all industries in a given economy are intertwined - which returns to the way in which prosperity or hardship seems to befall all at once: while the goods in a market are diverse, supply and demand lf goods are interconnected. And as demand of money relies upon the demand of the goods for which it is exchanged, the financial sector is subject to share in the depression of any industry.
The financial sector is also impacted by another factor: the disposition of one man to trust another. Ultimately, credit depends on the willingness of a creditor to trust in the debtor's ability to repay borrowed monies per their agreement. A disruption in an industry, such as previously described, is sooner remedied than a disruption in trust. That is, a spinner who lacks cotton is unable to make his thread and repay his loans - once cotton is available to him again, he can resume his trade immediately, but his creditor, mindful of the default, is less likely to trust him as immediately in future as a result.
After a great calamity, everyone is suspicious of everyone else, and the reluctance to extend credit does much to inhibit recovery from a period of difficulty - and thus begins a vicious cycle, in which the manufacturer cannot produce profit without credit, and the creditor is reluctant to provide loans to finance production without proof of profitability. As such the economy at large is likened to a steam engine: once slowed or stopped, it takes considerably more time for it to regain the speed it has lost.
In speculating about the money markets, it is often forgotten that the notion of interest on money is an unusual idea, present only in a few markets. In most nations, money remains in specie (coins of precious metals) and the practice of saving is no different than that of hoarding. It is thus in Asia, Africa, South America, and even much of Europe that those who have an excess of money hoard coin and the notion of giving it to someone else to lend to others, trusting it to be returned when needed, would be entirely unappealing. While the prudent Englishman seeks to put his savings into something that will earn five percent interest, most persons in most countries are "afraid to put their money into anything" other than a vault.
The same was historically true of England: any man who accumulated wealth had very little to do with it besides horde it in coin. A merchant could invest in his business, and a gentleman of some means could purchase land. In some instances, money could be invested in the stock of some business, such as the East India Company. But for the most part, there was simply no use for the money. During the reign of William the Third (1650-1702), it was generally speculated that "a very considerable mass of gold and silver was hidden in secret drawers and behind wainscots."
What came next was a "crowd of projectors" that devised a range of schemes that were "ingenious and absurd, honest and knavish" to provide a method for the disposal of all this pent-up capital It was around 16898 that the term "stockbroker" was first heard in London, as an individual who would amass small sums of capital for investment in a venture, the profits of which would be shared among the investors - and in the space of about four years, a great number of companies sprang into existence as a result, some of which patently absurd: companies that meant to manufacture lute strings, fish for pearls, import all manner of goods from the East, to salvage gold from shipwrecks, to seek out new copper mines, to launch fleets of fishing vessels, to improve the quality of English leather goods, for transmuting lead into silver, and so on. The fact that some such ventures turned out to be profitable only further encouraged investment in the most unlikely of schemes.
And behind many of these schemes were the bankers, who aggregated the small savings of many individuals and, rather than invest directly in such schemes, would lend money to those that seemed most plausible. While there may be little faith in the ability of a company to profit by seeking to salvage gold from wrecks, it was more certain that the company that was engaged to build ships for such a scheme would make a reasonable profit and be more certain in receiving payment for his effort.
The extension of credit is also commonly believed to result in the rise of prices. In general, a retailer generates his profit by adding a markup on wholesale prices, and as such are of less significance. Wholesale transactions are commonly conducted with bills rather than cash. In times of good credit, these bills are used as instruments of trade: the holder of the bill can sell it, at a discount, to another party who will collect payment. In times of poor credit, there is less of a tendency to use bills in this manner, or to demand a significant discount, as collection is less certain.
Because these bills are discounted by the banks, who purchase them with the funds of their depositors, the discount rate on bills becomes the equivalent to a depreciation on precious metals - that is, the wholesaler who accepts a discount on a bill is in effect accepting less gold for his goods, and the knowledge that the bill will be discounted leads the wholesaler to demand more for his goods.
The author refers to an article in the Economist of December 1871, which further explores this notion, which considers the rise in the price of "most of the leading articles of trade: in the prior three years: wool, cotton, iron, wheat, copper, tin, and the like. The article considers the increase in prices to be the effect of "cheap money, cheap corn, and improved credit," rather than to the depreciation of precious metals.
The article notes two consequences of the 1866 commercial crisis. First, foreign debts were called in, to be paid in cash rather than in commodities, increasing the monetary base. Second, there arose the tendency of individuals to hold onto their money rather than spend it, but to still seek some advantageous use of it - primarily, by depositing it into banks to earn interest. There was also during this period a great influx of foreign deposits, especially the money of foreign governments. During the continental wars, England became the safe harbor of the treasuries of foreign nations, to a historically unprecedented degree. This, too, contributed to a vast pool of idle money in the vaults of British banks. In effect, this great amassment of money made it less valuable in trade.
During the same time period, the price of wheat in British markets fell dramatically, which had a significant effect on industry in general. Since the working classes were able to get cheap food, they had more money to spend on other things, and the net consequence was an increase in demand for almost all consumer goods. A demand for consumer goods results in a demand for economic goods, that is the materials, equipment, and labor required to manufacture the goods demanded. The demand for labor, particularly, places more money in the hands of people, who spend it on more things, and demand is further propagated.
When the stimulus of cheap corn is added to a plentitude of money, the conditions are set for a rise in prices, but this is further fueled by an improved availability of credit: money has been amassed, less of it is spent on necessities, and more of it flows to the banks, which need to put it to productive use in order to offer interest to depositors. As such, bankers seek to discount more bills of trade and become more eager to extend credit - and given that industry is meanwhile growing and improving, there is no shortage of borrowers who seek to borrow in order to produce, given their products are in heightened demand in the market.
The net result of these factors is a leap forward in national prosperity: labor is actively employed in producing goods, and the wages of are actively employed in the purchase of goods - but in times of prosperity, the market is still inclined to seek equilibrium. High demand of materials and labor creates scarcity of those same materials and labor, increasing their cost, and increasing the price of goods. That is, there is a correlation between prosperity and inflation - but it cannot be mistaken that inflation causes prosperity, but is its effect.
Prosperity is precarious, and subject to sudden reversal, such that a single incident in one industrial sector can deflate the sails of an entire fleet of industries. For example, a single bad harvest of wheat can cause a protracted rise in the price of food, draining from other sectors of the economy - decreasing the demand for goods, decreasing the need to produce them, decreasing the need for labor to produce them, decreasing the income of the laborers, decreasing the demand for goods, and so on, as the entirety of the economy finds itself moving rapidly in the opposite direction.
As such, there is great alacrity in an economic system: whether its motion is in the positive or negative direction, the system has considerable synergy and motion in either direction is greatly accelerated by the interaction of these various factors. The demand of money, hence the interest that can be demanded in exchange, is subject to wide variances.
It's noted, though, that even in times of economic adversity, there is demand of capital. The manufacturer or merchant who has borrowed considerably to finance his operations still has need to service his debt, and any business operations that set idle fail to generate the revenue to service the debt by which they were acquired. In such instances, the bankers and bill-brokers cannot sustain a high rate of interest, as those who demand are unable to pay it - and it is generally better for a money lender to accept less profit than to have borrowers default entirely on their loans.
Another factor is that the availability of credit is based largely on speculation: where economic conditions are predicted to be favorable, the rate of interest rises in anticipation of a greater ability to pay, and when they are predicted to be unfavorable, the rate of interest falls. This introduces a significant amount of variance and miscalculation to the economic system, as the cost of capital is influenced by expectations of the future rather than the present situation.
At most times of great commercial excitement, there arises a "kind of investing mania." When capital is easy to come by, it slows to speculative investment. This was true even in times prior to the rise of the banking industry, such as the South Sea mania on the early 1700s, which attracted and devoured so much capital that the British government outlawed the issuing of stock certificates, a law that was not repealed until 1825 Similar economic disasters have befallen the investment market in 1825 and 1866, each arising during a period of economic prosperity, and each resulting in a catastrophe that shocked the markets and the monetary system. Times of economic prosperity "almost always engender much fraud." In times of adversity, people are frugal and discerning, but their caution is abated in times of plenty, and this creates "a happy opportunity for ingenious mendacity"
All of this considered, we should be little surprised at the seeming cycles of the money market - boom leads to bust, in a cycle that has been repeated throughout history. If any relief is to be taken from this knowledge, it is that such things are to be expected, and that no great economic disaster will bring the system to ultimate destruction. And if any lesson is to be taken from it, it is that being conservative even in times of economic mania is a wise course of action: if we maintain significant reserves, its magnitude can sustain credit through the periodic economic crises.