CHAPTER VIII.
The Principal Currency Drains.
The principal currency drains occur during the holiday season and at harvest time, more especially during the latter period, when large amounts of cash are sent into the country to satisfy the requirements of labour. Early in November a demand for gold arises in Scotland, owing to the fact that rents there fall due at Martinmas (11th November); and as the Scotch banks, by the Act of 1845, are compelled to hold gold against notes circulated in excess of their authorised issues, a rather heavy call is made upon the Bank of England, whose returns then show a noticeable decrease in the reserve and bullion. During years of active trade, and, consequently, of brisk demand for loanable capital, these autumnal drains of gold generally force up the rate of interest, thereby making the last quarter of the year the dearest for borrowers.
But we are discussing internal demands only, and as, so long as gold does not leave the country, it is merely a question of certain sums flowing from the London money market and drifting back to it again, this ebb and flow, which is shown by the various ups and downs occurring from time to time in the items of the Bank return, does not create any apprehension. Indeed, these movements occur so regularly at certain times of the year that large borrowers often anticipate them in order that they may tide over such periods with the minimum of inconvenience. It is, however, otherwise when gold is leaving the country in large quantities in order to settle the balance of our indebtedness to other nations, for that _may_ not come back. How it is again enticed to these shores I will endeavour to explain.
We now come to a foreign drain of gold; and this depletion of the currency, we know, flows from the store at the Bank of England into the hands of the foreign creditors of the nation. We export to, and import from, other nations on a gigantic scale, and as our imports are invariably in excess of our exports, it follows that the balance of indebtedness on this score is always very considerably against us; but there are other debts due to this country which from time to time turn the balance in favour of England, and the prices quoted for bills on the various Exchanges are the indexes which tell us whether gold is likely to be either received from, or sent to, the great commercial centres of the world.
Other debts due to this country have been mentioned--debts which either tend to reduce or turn in our favour the balance we owe to foreign countries. England has immense sums invested in foreign securities, and the interest received therefrom acts in this direction. So, too, does the huge sum earned by her ships in the shape of freights. Then, again, London, still earns a large amount in the shape of commissions, even if her position as the Clearing House of the world is now less powerful than formerly, owing to large accumulations of capital in other centres.
On the other hand a considerable amount of foreign capital is invested in English securities, which, when sold on the Stock Exchange, give the foreigner a claim on our stock of gold; and though we, by similar sales of foreign securities, can prevent this temporary drain of specie, the enormous dealings in stocks and shares on the various Exchanges are most keenly watched by the directors of the Bank of England, lest huge realisations of British securities by foreigners should drain the Bank of its gold, with which international indebtedness can alone be settled.
This brings us to the markets for bills of exchange, the prices of which, like those of every other security, are settled by supply and demand. If, at a given date, this country owes a foreign nation considerably more than it has to receive, then bills on England will be plentiful in that country; and, further, they will be cheap, because, as debtors to England have less to remit than the aggregate of bills on England offered for sale, the supply will be in excess of the demand, and English bills, consequently, can be bought at a discount. Conversely, the supply of bills in London on the foreign country will be smaller than the sum English debtors owe therein, and in order to save the expense of exporting gold, such bills will be eagerly sought after, and, as the supply is smaller than the demand, buyers soon drive them to a premium, when the rate of exchange is said to be "unfavourable" to England.
As the balance of our international indebtedness must be cancelled by gold, it follows that the fewer the bills offering the higher will be the prices paid for them; and when, just towards the end, it becomes evident that the supply is limited the bidding is often spirited; but the premium paid cannot exceed for any considerable length of time the expense incurred by exporting and insuring the precious metals between any two countries, as the debtor always has the choice of despatching gold to his foreign creditor, and, naturally, he chooses the cheaper expedient.
The extreme fluctuations are called "gold points," and they mark the limit to premiums procurable on bills of exchange. The table given below will show us those points at which gold will probably either leave or reach this country:
============================================================ Exchange. | Mint Par. | Gold | Gold | of Exchange. | Exports. | Imports. -----------------+------------------+-----------+----------- London on Paris | Francs 25·22½ | 25·12½ | 25·32½ Berlin | Marks 20·43 | 20·34 | 20·52 New York | Dollars 4·87 | 4·84 | 4·90 ============================================================
When the rates are near those given in the second column, the Bank, if its reserve be low, begins to consider the advisability of raising its rate of discount, for it is evident that foreign bills are at a stiff premium, and that a demand for gold may be made upon it at any moment. Of course the difference between the "gold points" gives scope for speculation, and some cambists gamble in bills for the rise or the fall just as speculators do in securities. Then, again, the arbitrageurs largely influence prices by buying and selling securities which are dealt in on the Stock Exchanges of more than one country. Wars, revolutions, panics, and social upheavals also cause abnormal fluctuations in the rates.
Let us assume that a drain is threatened from Paris. The gold in an English sovereign is, we can see, worth about 25·22½ francs, and if only 25·12½ is being offered on 'Change, it follows that bullion will soon be exported to France. This the Bank wants to prevent. The cost of transmission of bullion between the two countries is about one half per cent.; therefore, in order to induce French capitalists to invest in English bills of three months' date, the rate of interest in London must be more than two per cent. in excess of that in Paris before it will pay them to ship bullion to this country, if it be the intention of the purchasers to withdraw their capital when the bills mature, as the gain of two per cent. per annum for three months only just balances the loss of 10s. per cent. incurred on specie shipments, while no margin is left to defray possible loss through unfavourable exchanges at the time of withdrawal. Were a purchase of six months' bills contemplated, the difference in the two rates would only have to exceed one per cent. before bullion could be exported profitably.
When, therefore, the Bank of England wishes to influence the foreign exchanges, it raises its rate by one, instead of by one half as is usual when the drain is caused by the currency requirements of this country, or by an increased demand for loanable capital when trade is active and the foreign exchanges favourable. One constantly hears the question: Why has the Bank of England raised the rate by one instead of by one half as it did last time? A glance at the foreign exchange tables will generally supply the answer. If the expenses for transporting and insuring bullion between any two countries are appreciable, then were the Bank rate raised by one half (remembering that an addition of one half per cent. per annum gives a profit of only 2s. 6d. per cent. on a transaction in three months' bills) it is evident that the inducement is not sufficient to attract gold over here for that consideration alone.
By raising its rate, and, if necessary, borrowing in the market in order to bring the market rates in touch with its own, the Bank makes an investment in English bills a profitable transaction; and the greater its excess over foreign rates, the stronger is the inducement to send money to England. Of course, were this country really living on its capital, this influx of gold would only postpone the inevitable day of settlement, for a bankrupt does not increase his wealth by borrowing from one person in order to pay off another. But our receipts do not always coincide with our payments; and when, for instance, gold is sent to the United States in the autumn to help to pay for crops imported here, the Bank of England, by raising its rate of discount, and making that rate a representative one, attracts gold from the Continent, in order to tide over the interval between debts payable by us immediately and debts due to us at a future date.
English bills being a profitable investment, the price of paper on England at once begins to rise, and when the so-called gold point is reached the precious metals are shipped to these shores, because the premium on bills on England is in excess of the cost of despatching bullion. Every rise in the rate of discount here induces foreign holders of long-dated paper on England to retain their purchases. If they bought three months' bills on England when the Bank's discount rate was three, interest at the rate of three per cent. per annum was deducted from the face value of the bill to make it equivalent to a bill due at sight. Should the minimum rate be raised to four per cent., and were the holders then to remit the bills to this country to be discounted, they would have to submit to a deduction at the rate of four per cent. per annum. In other words, they would lose one per cent. per annum on the transaction. Long-dated bills would therefore be held until near maturity in order to avoid this loss.
An accretion to the Bank rate, then, not only attracts gold or capital here, but it also induces foreign holders of long-dated bills on England to keep them in their cases. On the other hand, a fall in the Bank's rate of discount from, say, three to two per cent. might not only slacken the demand for English bills, but it would also cause a considerable number of long-dated bills on England to be sent over here to be discounted, as the foreign holders would naturally be anxious to secure the profit between the three per cent. per annum paid to them, and the two per cent. per annum at which they would then be taken from them. The result might possibly be a temporary drain of gold from this side.
But it is when a home and a foreign efflux of gold occur at the same time that the situation becomes serious, and unless immediate action is taken by the directors of the Bank of England to check the outflow, there is always the danger--so small is our gold reserve when contrasted with our exports and imports--that a balance against us at an unlucky moment may create an awkward tension, which, unless speedily relieved, may possibly produce a crisis.
We like to flatter ourselves that England is always safe; but so large is the amount of bills offering from day to day in the London money market that the very doubt of there not being sufficient capital in the possession of the banks to discount them creates uneasiness; and if it were thought that the Bank of England, which holds the few millions of reserve upon which hundreds of millions of credit rest, could not retain its gold, excitement would reach fever pitch in this country, for everybody's income would be in danger, and the Government, whose supineness allowed such a state of affairs to develop, would be in danger too. But we know that, in the rate of discount, the directors of the Bank possess an effective instrument to prevent such a catastrophe, and have the experience to use it to advantage.
Money begins to leave the Bank for internal circulation during the summer months in order to meet the demands created by the holidays and the harvest, and then in October there is always the probability of a large outflow of gold to the States to help pay for the crops imported therefrom; while the movement of specie to Scotland in November, occurring as it does just at a critical moment, is likely to cause some apprehension, should the Bank's reserve have been depleted earlier, unless the fact that it is merely a temporary transfer to enable the Scotch banks to comply with the Act of 1845 be thoroughly grasped.
The October drain of gold from the Bank when the New York exchange is unfavourable has in it an element of danger, especially if it happen at a time when the reserve at the Bank of England is unusually low; and if loanable capital be then abnormally scarce there is always the risk that the end of the year requirements may produce a tension, which, should credit be bad at the time, may develop into a panic.
If the Bank manage well, however, it fortunately often foresees that the autumnal demands may possibly impose a severe temporary strain upon its resources, and by raising its rate in anticipation of a short period of exceptional demand, it attracts gold to itself in order to be thoroughly prepared for possible large depletions of currency later on, for it is easier to accumulate gold before the event than to check an outflow when the movement is beginning to create uneasiness, and to attract attention to the lack of preparedness on the part of the Bank to meet large withdrawals of specie for export.
It is not my intention to write a treatise on the foreign exchanges, and I am quite well aware that I have only touched on the fringe of a great subject; but if these illustrations help, however slightly, to elucidate certain of those undercurrents which determine prices, then the sole aim of this chapter has been attained.
CHAPTER IX.
Banks and the Creation of Credit.
We have seen how the Bank of England came to occupy so commanding a position in the money market, and we now have to consider why its rate of discount is still a fairly reliable index to the value of loanable capital. Its advent was extremely distasteful to the private bankers, who then reigned supreme in London, and who were not slow to recognise in the new corporation a formidable competitor, for a company which financed the Government was obviously to be feared. Before 1826 the Bank of England was the only joint stock bank in the country. Its notes gradually drove those of the London bankers out of circulation, and until its joint stock rivals firmly established themselves in the Metropolis, the Bank was in every sense the most powerful institution of its kind in the land.
Being by far the largest lender of capital in the country, it was only natural that its rate should accurately interpret those forces which make loanable capital dear or cheap, as the case may be. But the Bank could not arbitrarily fix the value of money for a very considerable period, even when it was able to issue notes without let or hindrance, any more than it can now. Supply and demand must settle that ultimately; and whenever the Bank inflated prices by the over-issue of paper, we have seen that the reaction produced thereby invariably threatened its existence. This is easily explained.
Persons borrow money in order that they may trade with it; and sudden loans of large amounts of capital in the shape of notes immediately stimulate the markets, and the increased demand engendered thereby causes the prices of commodities to rise. Rising prices, whether of securities or goods, give a marked impetus to speculation--so hopeful are traders directly markets begin to improve; and increased speculation causes further rises in the prices of both commodities and loanable capital. Everybody wants to borrow, and to share, in the coming period of great prosperity.
With prices rising here, imports naturally increase, as foreigners are anxious to sell their goods in the best market. On the other hand, the English markets have become less profitable to buyers, and, consequently, exports fall off, the result being that the balance of our indebtedness to other nations is largely increased. The foreign exchanges soon begin to move against England, and the Bank of England (we will assume) which had created the speculation by large issues of notes, suddenly finds that it is threatened with a foreign drain of gold, and is compelled to raise its rate in order to protect its reserve.
Since 1844 this power has, of course, been taken out of the hands of the Bank; but it is evident that, even before that date, the Bank of England could not fix the rate of discount, for whenever it made the attempt it failed signally. The above illustration fully explains the reason why. Both before and after the Act the Bank of England would have suspended payment upon more than one occasion, when it neglected to keep an adequate reserve, but for Government intervention; and it will be in the same plight again if it trade with too large a proportion of its resources.
The Bank was then by far the largest dealer in credit, and from time to time it stated the minimum rate at which it would lend or discount. But the private bankers were at liberty to underbid it; and although it could, by making sudden advances, cause money to fall in value, its power was not of a lasting character, and the rise which followed was quite beyond its control. Its rivals are now much more powerful, and the Bank is only one large dealer among many--therefore it has to either raise or lower its rate according to the demands made upon its resources; but from its position in the centre of the money market it still possesses a latent power for possible evil, which appears to have escaped the attention it deserves.
This brings us to the vexed question of the creation of credit by a bank, and though it is stoutly maintained that an ordinary banking company cannot create credit, I venture to think that, given certain conditions, it does. But perhaps, before proceeding further, it will be better to briefly discuss the Clearing House system.
Cheques and bills, we all know, pour up to London in a constant stream to the numerous banks, and are presented by them either to the firms upon whom they are drawn or to their agents at the Lombard Street Clearing House. As every bank which is a member of the Clearing House keeps an account with the Bank of England, the debit and credit balances (the result of this exchange) are adjusted in the books of the Bank at the end of each day, and so, though the balances standing to the credit of the various banks are diminished or increased, the total sum to the credit of all the clearing bankers remains unaltered. In other words, the balances, which are the outcome of the exchange of credit documents at the Clearing House, are finally arranged by transfer entries in the books of the Bank of England.
Every cheque presented in the House is debited to one bank and credited by another, therefore the totals of the debit and credit entries must agree; and if the totals are the same, then the debit and credit balances must agree also. In the smaller towns the banks exchange the local cheques between themselves, and settle the balances in cash or by payments through London. But Birmingham, Bristol, Leeds, Leicester, Liverpool, Manchester, and Newcastle-on-Tyne have Clearing Houses of their own at which local cheques and bills are presented.
We can now approach the question of the creation of credit by a bank. Suppose a bank suddenly increases its advances to its customers by £1,000,000, and that the customers pay away the whole sum by cheques. The said cheques are, say, paid by the recipients to the credit of their accounts with other banks, which present them at the London Clearing House. The balance of the bank which made the advance is thereby reduced £1,000,000 at the Bank, and the accounts of other banks are credited to the same extent; so the deposits at the Bank of England are not reduced one penny by the transfer. But £1,000,000 has been added to the working resources of the other banks; and as the liabilities of the bank that made the advance have not been reduced, surely this is a creation of credit? Of course, the bank which made the loan has lost £1,000,000 in "cash" at the Bank of England, and that asset would then be merged in "advances," which are up £1,000,000; and though the bank has not created credit in its own books, it has in those of its rivals. Surely, then, every bank which makes a new advance to a customer, who employs the sum placed to his credit to cancel certain debts of his own, creates credit in the books of other institutions. But the Bank of England can also create credit in its own.
On the other hand, say, Bank A calls in £1,000,000 from the bill brokers, who obtain credit to the extent of £1,000,000 from, say, Bank C, and draw cheques thereupon, and hand them to Bank A, which takes them to the Clearing House. C's balance at the Bank is reduced by £1,000,000, and A's is increased by a like sum; but in neither case is the "liabilities" side of the balance sheet affected. It is a mere transfer of credit from one account on the "assets" side to another on the same side, while the bankers' balances at the Bank of England remain the same. However, should Bank A advance £1,000,000 to a customer, who draws cheques against it, then the creation of credit in the books of other banks begins, as illustrated by our first example.
Again, take the case of a bank which sells securities, say Consols, to the amount of £1,000,000. It receives cheques upon other banks for a like sum; and these it takes to the Clearing House, where it presents them to those banks upon which they are drawn. The result is that the selling bank's balance at the Bank is up £1,000,000, and that the accounts of the other banks are down £1,000,000; but their liabilities also are down £1,000,000, whereas the liabilities of the selling bank are precisely the same. It has simply transferred £1,000,000 from Consols to "cash" at the Bank of England on the "assets" side of its balance sheet. Such a sale has reduced the floating capital of the banks by £1,000,000. Further, could not a little "window dressing" be done in this manner were a bank to find itself short of "cash" at the end of the half-year? By lending the sum so obtained the selling bank could create an amount of credit in the books of its rivals similar to that which it had previously destroyed. By buying stock back, too, it would produce exactly the same effect as if it made a loan.
Now we come to the creation of credit by the Bank of England in its own books. Were the Bank to suddenly lend £3,000,000, the "Other Deposits" would be up to that extent, and "Other Securities" would also be up to a like amount, because the Bank would credit its customers and debit the loans. Both sides of its return are increased, but, so far, credit has not been created by these mere book entries, though the way for its creation has been prepared. The customers or persons to whom the advances have been made begin to draw upon their accounts by cheques, and as these cheques are returned by the other bankers to the credit of their accounts (bankers' balances) it follows that "Other Deposits" are not reduced at the Bank. The Bank, then, has created £3,000,000 of credit in its books, and though it can no longer make sudden loans by a huge issue of notes as was possible prior to 1844, yet, because it holds the bankers' balances, we can see that it is able to produce precisely the same effect by means of another instrument.
If the Bank lends £3,000,000 to the Government, "Public Deposits" and "Government Securities" advance proportionately. When the Government begins to pay out, then a large part of this sum returns to "Bankers' Balances," and credit is created at the Bank of England to the extent of the sum so returned. But the banks (Lombard Street) have more to lend; therefore money is made artificially cheap.
On the other hand, the Government sometimes borrows in the open market on Treasury bills. Credit is then transferred at the Bank through the medium of the Clearing House from "Bankers' Balances" to "Public Deposits." The resources of Lombard Street are reduced, and until Government disbursements are made, and credit thereby transferred to Lombard Street, money becomes tight, and borrowers are often driven to the Bank.
We have seen that in the end an over-issue of notes is certain to reduce the Bank's reserve to a dangerously low level, and that, therefore, directors who know their business would hesitate to make so risky an experiment. The same argument is equally applicable to the creation of credit by sudden large loans on the part of the Bank in its own books. Such loans, we have seen, increase both sides of the return; but the Bank's reserve of notes and coin in the Banking Department remains at the same figures, consequently, its ratio per cent. to liabilities shows an ominous decline, which is, of itself, a warning that something is wrong.
Let us assume that the Bank suddenly lends £5,000,000. Money is thereby made artificially cheap, and the market rate for bills must fall in consequence. But the bankers' balances have been increased in the books of the Bank of England, and Lombard Street is not going to quietly look on while Threadneedle Street does all the business. Consequently, the bankers lend a portion of their balances at lower rates still, in order to attract business to themselves, and the market rate falls again. Here we have a situation analogous to that described in the earlier part of this chapter.
Now suppose this movement took place in October, and that a drain of gold occurred outwards. The Bank, in order to arrest the said drain, would have to raise its rate, and to bring the market rate in touch with its own it would be compelled to sell Consols, thereby reducing the bankers' balances in its books, and, of course, lessening the power of the banks to lend. But such a process is an expensive one, for the Bank is in reality borrowing back at panic prices the capital it created during a time of temporary ease.
Although the Bank undoubtedly possesses this power, the directors are not likely to abuse it, because the risk incurred is out of all proportion to the possible gain if the deal is carried through successfully; so we may say that their power to create credit in their books is limited or regulated by the ratio per cent. of the Bank's reserve to its liabilities.
Of course, it may be asked: Is it safe to entrust such power to a board of directors who have to earn dividends for a body of stockholders?
That is a difficult question to answer, and one, moreover, to which there is no occasion to reply in this work. It may safely be said that no director who understands his business would take the risk upon any consideration; but there is the remote chance that an incompetent Governor might be placed at the helm, and in that event, however improbable, should he lose sight of everything but the dividends, he might create a terrible panic throughout the land. On the other hand, all who see the Bank return from week to week may read the signs, and should the ratio fall abnormally low the critics would flagellate the Governor unmercifully, and the business man, who is unaccustomed to the pleasantries of criticism, unless he be a most hardened member of his species, squirms under such a lash, fearful that his friends may read just what the Press thinks of him; so he takes heed.
Though the Bank's rate is not always the same as the market rate, it is seldom very much out of touch therewith. When the directors find that their rate of discount is too high to attract custom, then, if the reserve be also high, they lower their minimum in order to get a fair share of the business that is doing. Their other alternative, of course, is to borrow on stock, and in that manner to compel the bill brokers to pay them a reluctant visit.