by James Grant
Could Parliament not craft a kind of escape clause to render Peel’s Act more humane? A way to allow the Bank to issue currency beyond the limits prescribed by the act before a period of stringency turned into a run on the banks? And to take such action without having to waste the time involved in appealing to the chancellor? It was on this question that the differences in worldview between Norman and Bagehot were most marked. “Such power of relaxation appears fraught with evil,” Norman jotted on his paper. “The exception would infallibly become the rule—Nobody would regard the salutary provisions of the original law as final, and its objects would be gradually lost sight of, and finally disappear altogether.”
Better to let the law stand, then, said Norman, “at all hazards.” He granted that, in the recurrent episodes of financial disorder, some solvent businesses might be unable to borrow and that such deprivation could force some into bankruptcy. Well, if so, it was their own fault for sailing too close to the wind. In any case, crises soon passed. “The solvent would swim—the insolvent sink—and the public at large would learn a valuable lesson.”1
A YEAR AFTER NORMAN wrote his memo to himself, the Overend Gurney failure of 1866 pushed Bagehot to express his own views in his own paper. They were just as Norman had rendered them: The Bank of England owed a duty to the nation, not just to its stockholders, and must collect and husband the nation’s monetary gold. In a crisis, it must lend boldly at a high rate of interest. As for Norman’s silver-lining theory of financial calamities, Bagehot wanted no part of it. A more flexible monetary approach would perhaps foreclose the need of perpetually relearning—or, at least, reteaching—the hard lessons of 1825, 1839, 1847, 1857, and 1866. The Economist had heaped praise on the governor of the Bank of England, Lancelot Holland, for seeming to embrace these Bagehotian principles in the aftermath of the collapse of Gurney’s, but it was the praise of an editor who had reason to believe that his counsel had found its mark.
Was the matter then settled? It was not settled. In 1869, Robert Lowe, as Gladstone’s chancellor of the exchequer, took the position that the government was under no obligation to assist the Bank of England to smooth the seasonal bumps in the money market. If, said Lowe, the exigencies of his tax policy caused the Treasury to deposit less than usual at the Bank in some months and more than usual in other months, so be it.
It was no duty of the chancellor to deposit funds in the Bank of England, either to help the Old Lady’s shareholders or “to assist traders, or to set up storm signals announcing the coming of panics,” he continued. “There is no monarch set up by any other department of business to warn those engaged in it of dangers to come; they must look out for themselves, and I don’t see that Government should go out of its way merely to strengthen a great institution like the Bank of England.”2
The money market, then, could take care of itself.
The money market could not take care of itself, insisted Bagehot. The chancellor must give it a helping hand, if only because he might have to borrow in it. Besides, the government created the market by creating the Bank. It was not by chance that the Bank of England was the government’s sole depository or that, until the enactment of recent limited-liability legislation—another Robert Lowe creation—it was the only bank in England whose stockholders were not personally at risk for the solvency of the firm in which they owned a stake. The government had conferred those gifts and others on the Bank at its 1694 founding. With the passage of years had come reciprocal duties, whether or not the directors chose to acknowledge them. To hold the kingdom’s principal banking reserve was the first; to lend when others withdrew from lending was the second.
The chancellor could neither rewrite the founding law nor repeal the consequences of that law—as those consequences had unfolded over 175 years. He could not arbitrarily decide to become a borrower in November, rather than, as was customary in that month, a lender. The autumn was a time of seasonal stress in the money market. The government’s deposits, seasonally strong, strengthened the Bank when it most needed strengthening. The withdrawal of those funds would enfeeble the Bank and destabilize a vulnerable market. Said Bagehot: “When one ‘organization of credit,’ as the French call it, has grown up, the difficulty of changing it is very great. ‘Credit’ is the historical element in commerce; it rests on tradition and prestige; you cannot reshape it and reform it as you like.”3
Bagehot did not pause to explain what made the market vulnerable, nor why such prosperous London joint-stock banks as the London & Westminster did not themselves take steps to make it safer. Perhaps everyone knew why: a profit-seeking bank had stockholders to answer to.* It had no constituency for the cause of promoting a safer money market. A public-spirited policy of adding to one’s gold reserve, if such a thing could be imagined, would come at the cost of lower dividends, shiny ingots having displaced interest-bearing securities. The stockholders of the Bank of England were well aware of the tradeoff. The Old Lady owned plenty of gold and had, in comparison to the London & Westminster and its ilk, lower returns and smaller dividends to show for it. A private bank would assuredly add to its stock of non-yielding cash if by so doing it could enhance the value of its banking franchise; the trouble was that the Bank of England, in assuming the role of the steward of the nation’s gold—even if it did not speak the words to acknowledge it—had removed the incentive to private action. The fact, if not the policy, of the single gold reserve, and of the associated understanding that the Bank would lend in a season of crisis, was a kind of prototypical deposit insurance. If an archeological seeker of the origins of the socialization of risk in high finance wants to find clues, let him or her begin with an excavation of Lombard Street.
That the British gold reserve was centralized in the vaults of the Bank of England was a fact, as Bagehot had correctly observed. It fell to Thomson Hankey, Bagehot’s old adversary, to analyze the consequences of that fact. Hankey did so in the language of what is today called moral hazard.
In letters to The Times in November 1872, Hankey, still a Bank director, denied that the Bank of England was encumbered by any such civic duty as Bagehot would saddle it with. In particular, the Bank was under no warrant to hold the reserves of gold that each bank should properly secure for itself. To maintain a comfortable cash reserve was simply sound banking practice, which the Bank did in its own interest, not the nation’s. Certainly, the Bank held no gold for the purpose of meeting a potential foreign drain. The gold dealers—for there were many such people in London, the world’s biggest gold market—would themselves contrive to find the bullion that might be required the next time foreigners lost confidence in British credit; Hankey estimated that there could be as much as £20 million worth of gold in the City available for export.4
Hankey’s prose was the sensible-shoe kind. Bagehot’s, in reply, fairly crackled—even, for once, in the headline: “The Dangerous Opinions Of A Bank Director.”
“Mr. Thomson Hankey,” the Economist responded, “—one of the most assiduous and influential of the Bank directors—has written a letter to the Times, of which the opinions seem to us to be so dangerous, that they call for careful comment. If we could believe that they represented the guiding policy of the Bank of England, we should expect a panic immediately.”
An experienced reader of the Economist would have guessed why. English credit (promises to pay money) was large and growing—in fact too large, and growing too fast, in relation to England’s gold. If the Bank, as Hankey rashly insisted, were to renounce responsibility for providing gold in times of monetary pressure, thoughtful people would take steps to protect themselves beforehand; they would sell securities and remove deposits from every bank but the Bank of England. Perhaps they would exchange credit instruments for gold. And since gold was scarce in relation to credit, the preemptive vanguard would prove the instigators of a run on the banks.
There was nothing like £20 million of idle, exportable bullion in London, the Economist went on to assert; there could not be,
because nobody was rich enough, or foolish enough, to forego the interest on £20 million by holding that magnificent sum in sterile metal. (Even at 3 percent, the lost income would come to £600,000 a year.) London was the world’s principal source of gold; since the French suspension of gold convertibility in 1870, it had become the world’s only dependable source, and to secure gold for export, you had to apply to the Bank of England. The Bank’s reserve
is the ultimate reserve; our means of meeting a foreign payment depend on the magnitude of that final fund. The country must not go without a reserve while the London bankers and the Bank of England are squabbling who shall keep it. The important question is not—does the Bank of England keep more cash in proportion than other bankers keep (which unquestionably it does), but does it keep enough to keep itself safe and all of us safe against the demands put upon us?5
If Bagehot wrote with special fluency on the question of the gold reserve, it was thanks to his years of practice with both sides of the argument. On the one hand, he would say, a system in which each bank keeps its own reserve was the best system. On the other, he would say that the system in which the Bank of England keeps a single reserve for all banks is the system in place and one too deeply engrained to change. He never attempted to show why change was out of the question, though he did, in one revealing passage, admit why, for bankers like him, change would be inexpedient:
the main source of the profitableness of established banking is the smallness of the requisite capital. Being only wanted as a “moral influence,” it need not be more than is necessary to secure that influence. Although, therefore, a banker deals only with the most sure securities, and with those which yield the least interest, he can nevertheless gain and divide a very large profit upon his own capital, because the money in his hands is so much larger than that capital.6
Which is to say that the Bank and its stockholders should bear the cost of the reserve because the private banks and their stockholders preferred not to.
Such contentions chased one another through the pages of the Economist. They likewise darted through the chapters of Bagehot’s monetary masterpiece, Lombard Street.
IT WAS A “LITTLE BOOK,” as Bagehot said, scarcely 73,000 words, and when it finally appeared, in the spring of 1873, the author apologized for it. He had been writing it at intervals since 1870—at Eliza’s and his new home in Wimbledon, not far from what is today that tennis mecca’s center court—but “pressing occupations” and “imperfect health” had interrupted him. He had needed a friend’s help to correct the proofs.
What reception awaited Lombard Street, the author could not say. The book dealt, in a critical way, with financial institutions and the people inside them: the Bank of England, private London banks, publicly owned (joint-stock) banks, bill brokers. It recommended monetary policy suitable for times of “apprehension” (the Bank should husband its reserves against the possibility of a run) and “panic” (lend freely at a high rate of interest against good banking collateral). It prescribed how much gold the Bank should hold (£15 million was best but no less than £10 million). It described the cycles of the credit market. It warned against the piling on of credit obligations on an inadequate reserve of gold. And it warned, too—recalling the failure of Overend Gurney—against complacency. “Money will not manage itself,” Bagehot famously cautioned, “and Lombard Street has a great deal of money to manage.”
The author did allow his book one redeeming quality. He had entitled it Lombard Street, the City’s fabled thoroughfare, and not “The Money Market” or any other such abstract name, “because I wish to deal, and to show that I mean to deal, with concrete realities.” On this promise, Bagehot richly delivered. Lombard Street is a grand tour of living finance under the classical gold standard.
In 1873, Hankey brought out a second printing of his Principles of Banking, featuring a new preface aimed directly at “the able editor of the Economist.”7 Worthy and perhaps, in some ways, more farsighted than Lombard Street, Hankey’s second edition was no more scintillating than the first.
Lombard Street scintillates. Not surprisingly, it begins with a paradox. “The briefest and truest way of describing Lombard Street,” says Bagehot, “is to say that it is by far the greatest combination of economical power and economic delicacy that the world has ever seen.” Money is power, and Britain had more money than any other country: the London banks held £120 million of deposits, three times more than the New York banks and nine times more than the Parisian ones. The collection of this vast floating pool in the City of London marked an epoch in financial history. For the first time no worthwhile enterprise, and no “civilized” government, need fail for a want of capital.8 At the right rate of interest and against the correct collateral, or even on the strength of a sufficiently compelling story about future profits, a borrower would likely find accommodation.
It did not escape this critic of the 1867 Reform Act that the new structure of English commerce was democratic. Gone were the great merchant princes, “pushed out, so to say, by the dirty crowd of little men.” Gone, too, were the good old standards of commercial probity. The “new men” flashed more credit than money in their hurry to get rich. Cutting corners, they produced shoddy wares. “They rely on cheapness, and rely successfully.”†
On the other side of the ledger of that ostensible drawback was an undoubted advantage: no country was ever so keen as England to seize an opportunity. “The rough and vulgar structure of English commerce is the secret of its life,” wrote Bagehot, still under Darwin’s influence, “for it contains ‘the propensity to variation,’ which, in the social as in the animal kingdom, is the principle of progress.”9
Part and parcel of up-tempo English trade was heavy English borrowing. Like Norman, Hankey, and Overstone, Bagehot worried that too little cash undergirded too much debt:
There never was so much borrowed money collected in the world as is now collected in London. Of the many millions in Lombard street, infinitely the greater proportion is held by bankers or others on short notice or on demand; that is to say, the owners could ask for it all any day they please: in a panic some of them do ask for some of it. If any large fraction of that money really was demanded, our banking system and our industrial system too would be in great danger.10
But the collapse of the house of Overend Gurney—“one would think a child who had lent money in the City of London would have lent it better”11—was a blow against lazy confidence. The time had come to see English high finance for the precarious structure it was.
Stuckey’s was not unusual in showing next to no gold on its balance sheet.‡ No bank but one, Bagehot asserted, held more than trace amounts of legal tender (gold and notes of the Bank of England being the two forms of legally sanctioned final payment)—and that single exception was the Old Lady herself. On the year-end 1869 statement date, the Bank showed £11.3 million of such reserves against £27.2 million of liabilities.12
So all were leveraged to the Bank: it held not only its own reserve, but also the cash deposits of the rest of the London banking community. Nor was the Bank itself overendowed with real money. In each of the crisis years 1847, 1857, and 1866, as Bagehot pointed out, the Bank of England’s cash reserve had dwindled to £3 million or less. On each occasion, Peel’s Act had been suspended to allow for the emergency issuance of Bank notes, and only then did the danger pass.
Not that these near misses were the products of a single bad law; they were, rather, the consequence of the “immense development of our credit system—in plain English, [of] the immense amount of our debts payable on demand and on the smallness of the sum of actual money which we keep to pay them if demanded.” Cash was the Old Maid of English finance: no eager, profit-seeking banker or broker wished to be stuck with it.13
Not a few of the liabilities about which Bagehot worried were foreign; the Franco-Prussian War had put a scare into monied people. Searching for safe harbor, they had fixed on London, but they could just as easily pa
ck up for another place. Foreign deposits were fickle.
After the panic of 1866, especially after the suspension of Peel’s Act (which many foreigners confound with a suspension of cash payments), a large amount of foreign money was withdrawn from London. And we may reasonably presume that in proportion as we augment the deposits of cash by foreigners in London, we augment both the chances and the disasters of a “run” upon England.14
A run on England meant a run on England’s gold, and to Bagehot, if not to Hankey, that meant the Bank’s gold. Most of these debts were contracted by private parties, yet the gold with which to settle them was locked in quasi-sovereign vaults. “[A]ll our credit system depends on the Bank of England for its security,” Bagehot warned. “On the wisdom of the directors of that one Joint Stock Company, it depends whether England shall be solvent or insolvent.”
It was therefore more than gratifying that the quality of the management of the Bank of England was on the upswing; the directors’ intervention in the Panic of 1866 was their best response to any crisis since 1825.15 Yet actions were not enough—“though the practice is mended the theory is not.” The directors never made public how much gold they intended to keep or named the principle by which they arrived at their decision. “The result,” said Bagehot, summing up the case against a system he insisted was unchangeable,§
is that we have placed the exclusive custody of our entire banking reserve in the hands of a single board of directors not particularly trained for the duty—who might be called “amateurs”—who have no particular interest above other people in keeping it undiminished—who acknowledge no obligation to keep it undiminished—who have never been told by any great statesman or public authority that they are so to keep it or that they have anything to do with it—who are named by and are agents for a proprietary which would have a greater income if it was diminished—who do not fear, and who need not fear, ruin, even if it were all gone and wasted.16