The Mode in Which the Value of Money is Settled in Lombard Street.
Many persons believe that the Bank of England has some peculiar
power of fixing the value of money. They see that the Bank of
England varies its minimum rate of discount from time to time, and
that, more or less, all other banks follow its lead, and charge much
as it charges; and they are puzzled why this should be. 'Money,' as
economists teach, 'is a commodity, and only a commodity;' why then,
it is asked, is its value fixed in so odd a way, and not the way in
which the value of all other commodities is fixed?
There is at bottom, however, no difficulty in the matter. The value
of money is settled, like that of all other commodities, by supply
and demand, and only the form is essentially different. In other
commodities all the large dealers fix their own price; they try to
underbid one another, and that keeps down the price; they try to get
as much as they can out of the buyer, and that keeps up the price.
Between the two what Adam Smith calls the higgling of the market
settles it. And this is the most simple and natural mode of doing
business, but it is not the only mode. If circumstances make it
convenient another may be adopted. A single large holder--especially
if he be by far the greatest holder--may fix his price, and other
dealers may say whether or not they will undersell him, or whether
or not they will ask more than he does. A very considerable holder
of an article may, for a time, vitally affect its value if he lay
down the minimum price which he will take, and obstinately adhere to
it. This is the way in which the value of money in Lombard Street is
settled. The Bank of England used to be a predominant, and is still
a most important, dealer in money. It lays down the least price at
which alone it will dispose of its stock, and this, for the most
part, enables other dealers to obtain that price, or something near
it.
The reason is obvious. At all ordinary moments there is not money
enough in Lombard Street to discount all the bills in Lombard Street
without taking some money from the Bank of England. As soon as the
Bank rate is fixed, a great many persons who have bills to discount
try how much cheaper than the Bank they can get these bills
discounted. But they seldom can get them discounted very much
cheaper, for if they did everyone would leave the Bank, and the
outer market would have more bills than it could bear.
In practice, when the Bank finds this process beginning, and sees
that its business is much diminishing, it lowers the rate, so as to
secure a reasonable portion of the business to itself, and to keep a
fair part of its deposits employed. At Dutch auctions an upset or
maximum price used to be fixed by the seller, and he came down in
his bidding till he found a buyer. The value of money is fixed in
Lombard Street in much the same way, only that the upset price is
not that of all sellers, but that of one very important seller, some
part of whose supply is essential.
The notion that the Bank of England has a control over the Money
Market, and can fix the rate of discount as it likes, has survived
from the old days before 1844, when the Bank could issue as many
notes as it liked. But even then the notion was a mistake. A bank
with a monopoly of note issue has great sudden power in the Money
Market, but no permanent power: it can affect the rate of discount
at any particular moment, but it cannot affect the average rate. And
the reason is, that any momentary fall in money, caused by the
caprice of such a bank, of itself tends to create an immediate and
equal rise, so that upon an average the value is not altered.
What happens is this. If a bank with a monopoly of note issue
suddenly lends (suppose) 2,000,000 L. more than usual, it causes a
proportionate increase of trade and increase of prices. The persons
to whom that 2,000,000 L. was lent, did not borrow it to lock it up;
they borrow it, in the language of the market, to 'operate with' that
is, they try to buy with it; and that new attempt to buy--that new
demand raises prices. And this rise of prices has three
consequences. First. It makes everybody else want to borrow money.
Money is not so efficient in buying as it was, and therefore
operators require more money for the same dealings. If railway stock
is 10 per cent dearer this year than last, a speculator who borrows
money to enable him to deal must borrow 10 per cent more this year
than last, and in consequence there is an augmented demand for
loans. Secondly. This is an effectual demand, for the increased
price of railway stock enables those who wish it to borrow more upon
it. The common practice is to lend a certain portion of the market
value of such securities, and if that value increases, the amount of
the usual loan to be obtained on them increases too. In this way,
therefore, any artificial reduction in the value of money causes a
new augmentation of the demand for money, and thus restores that
value to its natural level. In all business this is well known by
experience: a stimulated market soon becomes a tight market, for so
sanguine are enterprising men, that as soon as they get any unusual
ease they always fancy that the relaxation is greater than it is,
and speculate till they want more than they can obtain.
In these two ways sudden loans by an issuer of notes, though they
may temporarily lower the value of money, do not lower it
permanently, because they generate their own counteraction. And this
they do whether the notes issued are convertible into coin or not.
During the period of Bank restriction, from 1797 to 1819, the Bank
of England could not absolutely control the Money Market, any more
than it could after 1819, when it was compelled to pay its notes in
coin. But in the case of convertible notes there is a third effect,
which works in the same direction, and works more quickly. A rise of
prices, confined to one country, tends to increase imports, because
other countries can obtain more for their goods if they send them
there, and it discourages exports, because a merchant who would have
gained a profit before the rise by buying here to sell again will
not gain so much, if any, profit after that rise. By this
augmentation of imports the indebtedness of this country is
augmented, and by this diminution of exports the proportion of that
indebtedness which is paid in the usual way is decreased also. In
consequence, there is a larger balance to be paid in bullion; the
store in the bank or banks keeping the reserve is diminished, and
the rate of interest must be raised by them to stay the efflux. And
the tightness so produced is often greater than, and always equal
to, the preceding unnatural laxity.
There is, therefore, no ground for believing, as is so common, that the
value of money is settled by different causes than those which affect
the value of other commodities, or that the Bank of England has any
despotism in that matter. It has the power of a large holder of money,
and no more. Even formerly, when its monetary powers were greater and
its rivals weaker, it had no absolute control. It was simply a large
corporate dealer, making bids and much influencing--though in no sense
compelling--other dealers thereby.
But though the value of money is not settled in an exceptional way,
there is nevertheless a peculiarity about it, as there is about many
articles. It is a commodity subject to great fluctuations of value,
and those fluctuations are easily produced by a slight excess or a
slight deficiency of quantity. Up to a certain point money is a
necessity. If a merchant has acceptances to meet to-morrow, money he
must and will find to-day at some price or other. And it is this
urgent need of the whole body of merchants which runs up the value
of money so wildly and to such a height in a great panic. On the
other hand, money easily becomes a 'drug,' as the phrase is, and
there is soon too much of it. The number of accepted securities is
limited, and cannot be rapidly increased; if the amount of money
seeking these accepted securities is more than can be lent on them
the value of money soon goes down. You may often hear in the market
that bills are not to be had, meaning good bills of course, and when
you hear this you may be sure that the value of money is very low.
If money were all held by the owners of it, or by banks which did
not pay an interest for it, the value of money might not fall so
fast. Money would, in the market phrase, be 'well held.' The
possessors would be under no necessity to employ it all; they might
employ part at a high rate rather than all at a low rate. But in
Lombard Street money is very largely held by those who do pay an
interest for it, and such persons must employ it all, or almost all,
for they have much to pay out with one hand, and unless they receive
much with the other they will be ruined. Such persons do not so much
care what is the rate of interest at which they employ their money:
they can reduce the interest they pay in proportion to that which
they can make. The vital points to them is to employ it at some
rate. If you hold (as in Lombard Street some persons do) millions of
other people's money at interest, arithmetic teaches that you will
soon be ruined if you make nothing of it even if the interest you
pay is not high.
The fluctuations in the value of money are therefore greater than
those on the value of most other commodities. At times there is an
excessive pressure to borrow it, and at times an excessive pressure
to lend it, and so the price is forced up and down.
These considerations enable us to estimate the responsibility which
is thrown on the Bank of England by our system, and by every system
on the bank or banks who by it keep the reserve of bullion or of
legal tender exchangeable for bullion. These banks can in no degree
control the permanent value of money, but they can completely
control its momentary value. They cannot change the average value,
but they can determine the deviations from the average. If the
dominant banks manage ill, the rate of interest will at one time be
excessively high, and at another time excessively low: there will be
first a pernicious excitement, and next a fatal collapse. But if
they manage well, the rate of interest will not deviate so much from
the average rate; it will neither ascend so high nor descend so low.
As far as anything can be steady the value of money will then be
steady, and probably in consequence trade will be steady too--at least
a principal cause of periodical disturbance will have been withdrawn
from it.