A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The experience convinced most observers that monetary problems had been exacerbated by the defects of Palmer’s rule. The bank lost gold when deposits were withdrawn, and although currency remained unchanged, it had acted to increase security holdings so as to restore deposits despite the loss of gold. The currency school and the bankers drew very different conclusions, however. Anticipating a dispute that continued for the next century and beyond, Palmer and the group of writers known collectively as the banking school, generalizing from their experience with the rule and the events of the previous half century, concluded that no set of rules could guide the bank adequately. To the extent that they proposed solutions, they favored changes in the discount rate, to be made at the discretion of the bank, as required to protect the bullion stock and the exchange rate. The currency school, on the other hand, blamed the failures of the rule on the exercise of discretion by the bank and particularly the failure of the bank to keep a constant stock of gold and notes.

  The proponents of rules triumphed over the advocates of discretion. With the passage of Peel’s Act in 1844, the currency principle was established as the governing principle of the monetary system.

  29. The belief appears to rest on statements like the one by Palmer that a 5 percent rate was an offer to lend as much as the market wished to borrow at that rate. Under the usury law, the bank could limit borrowing only by imposing quantitative restrictions once bank rate was at 5 percent.

  NEW LESSONS FROM RENEWED CRISES

  The Bank Charter Act of 1844 (Peel’s Act) accepted a main point in Ricardo’s plan for a central bank: separation of monetary operations (the control of the note issue) from banking operations (control of deposits and lending). The bank was to have two departments, an Issue Department and a Banking Department. The Issue Department carried out the monetary operations under a formula that tied the note issue to the stock of gold, as the currency principle required. The bank’s maximum note issue was set at £14 million plus the stock of gold coin and bullion held by the Issue Department. The bank gained a monopoly of the note issue.30

  The Banking Department was expected to function in much the same way as any other private bank. Its reserves consisted of the notes of the Issue Department and a small stock of gold held to facilitate exchange of notes and deposits into gold. Whenever the Banking Department accumulated more notes than it wished to hold, the Issue Department redeemed them by paying out gold. The proponents of the act expected the bank to compete for discounts and to hold deposits for other London banks, and they saw no conflict of interest in these functions. The custom of country banks’ keeping deposits in London and of London banks’ keeping deposits at the Bank of England was well established. More important, the proponents of the act denied that deposits were money.

  The bank apparently welcomed its new freedom of action. Prices had fallen 20 percent in four years, and the gold stock had increased by £11 million to £12 million. It reduced bank rate from 4 percent to 2.5 percent within the month that the act passed, and the bank aggressively competed for discounts in London and at its branches. From the low level of £2.6 million in 1844, the discount portfolio jumped to £18.5 million in 1845, £34 million in 1846, and £38 million in 1847 while the bank’s income from discounts rose from £80,000 to £380,000 (Wood 1939, table 9, 137; Scammell 1968, 145).

  With the decline in British prices, gold had come to England at a steady rate during 1842 and 1843, increasing the bank’s gold holdings and expanding the monetary base. The 1844 act required the bank to follow the currency principle by issuing or withdrawing currency (notes) as gold held by the Issue Department rose and fell. The Banking Department could use all the gold it acquired to expand deposits. As a result the directors, for a time, took no action to control deposit expansion. Bank rate remained at the market rate of discount on bills of highest quality, whereas before it had served as a penalty rate. Prices started to rise in the second half of 1845. The gold flow reversed, so the bank raised the discount rate to 3.5 percent. The following year the rate was reduced to 3 percent, where it remained during the fall while gold flowed out.31 Between 1844 and 1847, prices rose by more than 20 percent, with much of the increase in 1847.

  30. Outstanding country notes were counted as currency for the first time. Further issues were banned, and outstanding issues had to be retired and replaced by Bank of England notes (Wood 1939, 111).

  The panic of 1847 is in many respects similar to the panic of 1825.32 The bank raised the discount rate, first by steps of 0.5 percent and in April by 1 percent. When gold continued to flow out, the bank limited discounts and called advances. The brief panic that ensued ended when the gold flow reversed. During May and June the bank accumulated about £1 million of gold, and the reserves of the Banking Department increased by £3.5 million. In July the gold drain resumed. The bank met the new threat by raising bank rate to 5.5 percent and again placing restrictions on the type of discounts it would accept. A series of bank failures called forth new restrictions, and although the bank did not refuse to lend, it raised substantial doubt about its intentions by announcing that after October 15 bills could be discounted only at rates to be decided at the time of application. The currency drain intensified and produced a new wave of bank failures. The internal and external drain of £1 million pounds in the following week reduced the reserves of the Banking Department to £2 million and raised the fear that the bank would soon be unable to issue notes or accept deposits.33

  The bank looked to the government for assistance, just as it had in 1793, 1811, and 1825. This time assistance took the form of a letter indemnifying the bank for damages arising from violation of the 1844 act and empowering it to expand its discounts provided it raised the minimum discount rate to 8 percent. The bank quickly adopted the policy later known as “lend freely at a high rate.” Within a few days, the panic ended; bank rate was lowered to 7 percent within a month, and by late December it was back to 5 percent.

  The panic was mainly a monetary crisis, as that term is now understood, brought on by the tardy and hesitant actions of the Bank of England during the period of rising prices after 1844, followed by a very restrictive policy in 1846–47. The bank seems to have recognized that its policy had either caused or contributed to the crisis. During the next few years the securities portfolio fluctuated much less than in the past, and the bank was able to reduce the discount rate in a series of steps to 2.5 percent by 1849. At the time the bank had £17 million in gold, and the Banking Department had £12 million in reserves and only £25 million in securities.

  31. The price increase and gold flow were not entirely monetary in origin. The famous Irish potato blight required increased food imports, at higher prices, draining the gold stock.

  32. A thorough analysis of the 1847 panic is Dornbusch and Frenkel 1984.

  33. The act of 1844 required the bank to publish a weekly statement showing the principal assets and liabilities of the Issue and Banking Departments separately, so the bank’s situation was known within a few days.

  The panic helped to resolve some disputes about the role of a central bank. The currency school argued that before the act there was no effective limit on the note issue. The Bank of England was not required to maintain a fixed gold reserve ratio, and the regional banks could issue notes in response to demand. The currency school claimed that, as a consequence, money growth was procyclical in the early stages of an expansion. The increase in currency raised the price level, causing a loss of gold and a crisis.

  The so-called banking school differed about the importance of currency and did not rely on any of the monetary aggregates. Its proponents wanted the bank to discount only real bills, and they claimed that a real bills policy would prevent over- and underissue of money and credit. To the extent that they had a uniform view, they emphasized real events at home or abroad as the principal cause of crises. In their view, the role of the Bank of England was to serve as lender of last resort to the financial system. This distinguished the
bank from other banks. (See Laidler 1988, 100–102.)34

  The crisis showed that the system had not worked as the currency school predicted. The Banking Department had not been able to operate as an ordinary bank. At the beginning of the expansion, as in 1824–25, the bank held a stock of gold that was much larger than the stock usually held. Yet the gold stock and the reserve of the Banking Department had proved insufficient, and the bank had been forced to appeal to the government to suspend provisions of Peel’s Act. The currency school interpreted the crisis of 1825 as the consequence of the bank’s failure to keep note issue tied to gold. Prominent members of the banking school, who had opposed the act of 1844, interpreted the crisis of 1847 as evidence of the failure of the currency principle. These writers now urged the bank to adopt a more effective means of maintaining the exchange rate, protecting the gold reserve, and avoiding crises.

  Evidence of the change in policy and in the approach to policy is shown by the variability of the discount rate. Between 1793 and 1844 the bank changed the discount rate only eleven times, and except for a brief period in 1839, the rate was never less than 4 percent or more than 5 percent. Between 1844 and 1849 the rate changed sixteen times and varied between 2.5 percent and 8 percent, eight of the changes occurring in the crisis year 1847. During the quarter century beginning in 1850, bank rate changed more than 225 times, an average of once each five or six weeks. There are only three years from 1844 to 1914 in which the discount rate did not change. In two of them, 1895 and 1896, the rate remained constant at 2 percent, a rate that tradition had by that time established as a minimum.

  34. Hetzel (1987) finds references to the lender of last resort function as early as 1797.

  If the act of 1844 was a victory for the currency school, the victory was short-lived. We do not know the precise date on which the bank’s policy changed from reliance on the currency rule to reliance on discretion, but there can be no doubt that it pursued a less aggressive lending policy and a more variable bank rate policy after the panic. Bank rate remained above the market rate, and the bank’s stated policy was “to follow the market” (Wood 1939, 138). Attention shifted away from the theoretical issues raised by Thornton or Ricardo and toward the solution of so-called practical, or managerial, questions about how best to operate under the gold standard and how to avoid suspension and inconvertibility. The bank learned to use the discount rate to attract balances to London from country banks and from abroad or, when required, to send balances to the country or abroad. Gradually, the bank accepted responsibility for maintaining convertibility at the fixed mint price of gold and relied on changes in bank rate to attract and repel balances.35

  Thornton had described the relation between capital movements, exchange rates, and demand for gold and pounds. He recognized also that changes in the quantity of gold affected the monetary base, the volume of currency and deposits, expenditure, and prices. Most writers accepted the general framework, but many failed to emphasize the effects of gold movements on the prices of goods, on output, and on the price level that Thornton had stressed.

  By the 1850s most discussions of central bank policy that mentioned long-run (or general equilibrium) effects acknowledged that increases or decreases in money (however defined) changed prices in the same direction. However, many policy discussions ignored long-run effects and emphasized short-run changes in the money market and short-term capital flows. Effects of relative price changes on the balance of trade were said to operate slowly and as a consequence received much less attention than they had earlier. Critics of these orthodox views raised many of the objections that have been repeated ever since. Announcement effects and destabilizing speculation are common in the writing of the period. Some claimed that an increase in bank rate encouraged a withdrawal of gold from England because speculators anticipated a further increase; others claimed that monetary policy was counterproductive because exports had to be financed at a higher interest rate, whereas imports were not reduced until later, so gold was withdrawn (Wood 1939, 125–26; Viner 1965, 278–79).

  35. At about the same time, the Bank of France also began to change the discount rate more frequently.

  Hawtrey (1962) notes that bank rate policy was more variable from 1860 to 1880 than after 1880. He explains the greater variability during the earlier period as a consequence of the interaction between the bank and the market and argues that during this period a change in bank rate had a substantial effect on the balances country bankers held in London. A rise in bank rate restored the bank’s reserve by drawing balances from the country and permitted it to lower the rate. Once the bank lowered the rate, the balances went back to the country, forcing it to raise the rate again. The process continued until the bank’s reserve was restored. According to Hawtrey (xii), London banks acquired many of the country banks as branches after 1880 and centralized reserves at the head office, so a rise in bank rate drew fewer balances to London and a fall drew fewer balances out.

  The argument is of interest for two reasons. First, Hawtrey’s argument that institutional changes weaken the effectiveness of monetary policy returns many times. Second, his argument is opposite to the argument, frequently made in the United States, that a decentralized banking system is less responsive to interest rate changes. Most arguments of this kind confuse levels and changes. If banks holding negative excess reserves are penalized or incur a loss of utility greater than the cost of adjusting (by borrowing or by other means), on average each bank will hold positive excess reserves. Centralizing the banking system reduces the average level of reserves. Neither centralization nor decentralization, however, implies that the response to a change in the discount rate is larger before or after the change, only that variations take place around a new level. Moreover, the evidence for the period does not support Hawtrey. His argument requires the time series on bank rate to show advances followed by declines more frequently in the earlier years than in the later years. Most of the changes are unidirectional movements in both periods, contrary to Hawtrey’s hypothesis.

  A more plausible partial explanation of the higher variability in the ten to fifteen years before 1880 than after 1880 is that trade expanded and in the 1870s several countries accumulated gold to prepare for a resumption of specie payments. Gold production was considerably smaller and more variable than it had been in the decade following the discoveries of gold in California and Australia. The growth in world demand for gold meant that the Bank of England had to either pursue a more deflationary policy than in earlier years or let its reserve ratio of gold to monetary liabilities decline. The bank chose the latter course. The monetary base, deposits and notes at the Bank of England, rose relative to gold during the sixties and seventies. As a result, a given change in gold both permitted a larger expansion and required a larger contraction in the monetary base and the stock of money.

  The variability of the bank’s policy meant that the economy had to adjust frequently to large swings in monetary policy. Table 2.1 gives the data on the size and frequency of changes in bank rate. When reading these data, it is important to keep in mind that the changes were always made in a series of steps; most often the rate increased in steps of one percentage point and decreased in steps of one-half point. The data understate, to a considerable extent, the frequency with which the economy had to adjust to changes in bank rate.

  A key difference between the earlier and later policies appears in the data at the end of table 2.1. After 1873 bank rate remained within a narrower range than before. More often than not, the rate was between 2 and 6 percent, and until 1907 it did not exceed 6 percent again, and then only for a short time. There is little doubt that the Bank of England’s discount policy became less variable. The reason is that between 1876 and 1886 the price level fell at a compound rate of nearly 4 percent a year. Since the bank did not set bank rate below 2 percent, the economy had to undergo enough deflation to equilibrate the balance of payments and maintain the bank’s reserve position. When economic expansion to
ok place and gold was withdrawn, the bank raised the rate by steps of 1 percent just as it had done during the period of inflation. The bank did not recognize that a 5 or 6 percent bank rate was a much more restrictive policy with 4 percent average deflation than during years with positive average inflation. A short period with bank rate above 5 percent brought contraction, renewed deflation, and an inflow of gold. During the last quarter of the nineteenth century as a whole, bank rate remained above 5 percent a combined total of only twenty-six weeks.

  The bank failed to recognize the effect of inflation on interest rates or to distinguish between market rates and real rates of interest. Thornton’s recognition of this distinction was lost. For the next century, during wars, depressions, inflations, and deflations, central bankers used the absolute value of market rates to judge whether rates were high or low and monetary policy tight or easy. Many of their most serious mistakes resulted from this error.36

  We can only speculate on other reasons for reduced variability, but one plausible reason is that the variable policy was followed by a series of disturbances and some crises. In 1857, 1866, 1873, 1878, and 1890 the Bank of England was forced to respond to an internal, external, or combined internal and external demand for gold. These disturbances to financial stability were by no means wholly a result of the bank’s policy. In 1857 the expansion of the economy was brought to an end by an external drain to the United States to satisfy the demand for gold during the United States panic of 1857. The disturbance was made worse by the failure of a large discount house, Sanderson and Company. In 1866 a crisis occurred, intensified by the failure of several banks and discount houses—including the largest discount house, Overend, Gurney and Company—a failure often attributed to poor management but no doubt intensified by the balance of payments deficit of 1865. In 1873 there were drains of gold to Germany, Austria, and the United States owing to crises in those countries, and in 1878 the failure of a large Scottish bank—the City of Glasgow Bank—induced an internal demand for gold and Bank of England notes as well as a series of bank failures. The problem in 1890 involved one of the largest and most prestigious merchant banks, Baring Brothers (see Schwartz 1987b, 272–74).