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Gold Reserve

( Originally Published 1909 )

HAVING thus completed our inspection of the main wheels in the monetary machine, and arrived at a necessarily rough and elementary notion of the manner in which they work together and react upon one another, we are in a position to consider the problem that has for many years exercised the banking world, namely, the alleged inadequacy of the metallic basis on which the monetary machine manufactures credit, and the measures necessary for reinforcing it.

This inadequacy has been asserted over and over again by bank chairmen at half-yearly meetings, and by presidents of the Bankers' Institute in the course of inaugural addresses, and the few dissentients who deny its existence, generally complicate matters by maintaining that what is wrong is not the lack of gold but the over-extension of credit. 1 We need not pause to consider this delicate subtlety. Whether the foundation be too small for the building, or the building be too big for the foundation, the same practical conclusion arises, namely, that either the building must be reduced, or the foundation must be increased, or both processes must be carried out together. And when we find bankers themselves maintaining that the gold basis of their credit operations is inadequate, it must be admitted that their evidence is of the greatest possible weight, and that any outsider who gainsaid it would incur a heavy responsibility.

We have seen that banking in England, in its modern sense, works without any legal fetter or restriction, and we have seen reason for being thankful that it does so. And we have also seen that it has perfected a marvellously efficient system of credit, with a metallic basis economized with unparallelled skill and success. And the more closely one examines the basis of credit, the more clearly it becomes apparent that that basis itself consists to a considerable extent of credit.

For example, we saw that the half-dozen big banks whose balance-sheets we amalgamated on p. 59, had as the cash basis of their liabilities on current and deposit account, which amounted to 249 millions, 43 millions of cash in hand and at the Bank of England nearly 18 per cent., a high proportion according to present ideals. It would be interesting to know how much of this is gold. One of the banks included, the Union of London and Smith's, which we have referred to before as being conspicuously explicit in its balance-sheet, shows this same quality again by separating, alone among its peers, its cash in hand from its cash at the Bank of England. It had on June 30, 190$, 3,009,000 of cash in hand and 3,412,000 at the Bank of England. If these figures be a safe guide to the position of the Union's brethren, which we must admit that they may not be, we shall be within the mark if we assume that, out of the 43 millions held by the aggregated six, 20 millions are cash at the Bank of England, that is, are a liability of the Bank of England to these six banks. But the Bank of England's normal proportion of cash to liabilities in its Banking Department ranges from about 35 to 55 per cent.; and if we take it at 5o per cent., we are again doing full justice to the position ; so that of these 20 millions on which the six banks have based credits to are represented by cash held by the Bank of England. Moreover, the cash held by the Bank of England's Banking Department consists chiefly of its own notes, and its notes, though regarded for practical purposes as a bullion certificate, are actually backed by securities to the extent of nearly 18 1/2 millions almost exactly one-third of the outstanding amount of notes in the return given on p. 244. We thus arrive at the conclusion that, of the cash at the Bank of England which other banks use as the basis of credit, half may be taken as represented by securities and half by cash, and that this cash is itself represented as to one-third by securities and two-thirds by gold. The 20 millions of cash at the Bank of England are thus found to be based on 6,666,666 of actual gold.

And this is not all. For a considerable proportion of the cash in hand shown by the other banks will certainly consist of Bank of England notes, of which we have seen one-third to be represented by paper. Skill and success in the economy of metal could hardly be carried further. The reasons which make a gold basis necessary for credit were traced in earlier chapters, and may be roughly summarized as arising from the fact that gold is the only commodity that is everywhere and always in the economically civilized world accepted in payment of a debt, and that readiness to meet liabilities in gold, at once and without question, is an essential part of a banker's business as understood in this country.

The liabilities of bankers to the public we have seen to be created, for the most part, by securities that they buy and advances that they make in one form or another, the advances being the much bigger item, and bankers' liabilities form the credits with which the financial and commercial body carries on its business, and against which it draws the cheques, which are the most important part of our currency. The problem of banking is the creation of these credits for the service of commerce, with due consideration for a sufficient basis of gold to meet the demands which these liabilities render possible A banker who holds too high a proportion of gold curtails his own or his shareholders profits and the credit resources of the commercial community. The banker who holds too low a proportion runs a risk of being unable to meet his liabilities, to the detriment of his bank's credit, and with the possibility of raising a storm which might shake the whole banking community. Between these two evils the banker is asked to steer a middle course along the line of prudence and commonsense, and he is now convicted out of his own mouth of having erred a little on the side of making too much credit out of too little gold.

The fact that the banking world is in a position to air in public the existence of this error of its own is a comforting proof of its own confidence in itself, and indicates very clearly that the extent of the error is not considerable. It is the healthiest possible sign of the soundness of the banking position, and shows that the alarmists who point to the higher level of banking reserves held in other countries, and then draw terrifying inferences concerning the conditions prevalent here, are exciting themselves needlessly. As long as bankers are criticizing themselves and one another in public, we may be sure that the evil is not very deep-rooted. Nevertheless, the dangers involved by this evil, which have been pointed out above, are such that it should be removed at once. And so, though this book is only designed to make monetary matters a little clearer to those who do not understand them, it would not be complete without some account of the suggestions that have been made for the solution of the problem.

Among these suggestions many seem to indicate that the desired increase in the gold basis of credit is to be acquired by taking gold out of one pocket and putting it into the other. Whether it is to be done by the Treasury keeping a reserve against its banking liabilities to savings bank depositors, or by its repaying its debt to the Bank of England in gold, or by the establishment of a national gold reserve at the expense of the taxpayer, or by an issue of r notes against gold, or by the amassing of a special reserve by the banks to be deposited at the Bank of England under special safeguards, and only touched in times of need and all these proposals have been put forward as a solution of the problem it never seems, to be observed that the amount of gold in the country will not be directly increased by any of them. For whether the Treasury or the bankers produced the gold for the new reserve or to repay the bank, etc., it could only be got by either taking it from the Bank of England's vaults and putting it back again, or by taking it out of the tills of the other banks and putting it into the Bank of England's. And in either case the relation of the amount of credit to its gold base would be unaltered.

If, as is generally acknowledged in the City, the gold basis of our credit be inadequate, it must be increased since we do not dig out gold in this country, and have no big hoards that can be drawn on in our stockings and our pockets by imports, or rather by the retention of a larger proportion of the imports of gold which corne here regularly week by week from the mines of Johannesburg.

These mines are the chief source which feeds the London bullion market. Every Saturday the Union Castle steamer from the Cape lands a parcel of raw gold from the Rand ; every Monday it is dealt with in the bullion market, and after being refined goes to its purchaser. A certain proportion is always taken by " the trade," that is, the goldsmiths and others who use it in the arts and in commerce, and a certain proportion nearly always goes to India in the form of small and specially polished bars dear to native hoarders. The rest, if there be no competition, goes to the Bank of England, which pays for it, or gives credit for it, at the rate of 3 17S. 9d. per oz. When there is competition, foreign buyers take part of the parcel or all of it ; and sometimes the Bank of England secures a share by paying rather more than its statutory price, though it rarely bids higher than 77S. 10 1/2d. which is the rate at which gold is coined into sovereigns. But gold is best secured or retained, not by bidding for it in the bullion market, but by influencing the foreign exchanges through the discount rate current in the open market.

It has been shown in preceding chapters that the foreign demand for gold chiefly depends on the state of the exchanges. If the Paris cheque is at 25f. 13c. it is cheaper for any one who has a remittance to make to France to send gold rather than buy a draft. And the state of the foreign exchanges is influenced by the market rate of discount ; if the market rate is 1 1/4 per cent. here and 1 3/4 per cent. in Paris, French holders of English bills will not renew them as they fall due, but send them over to be collected and take the proceeds away ; and, as we have seen that it pays better at a certain exchange to take the proceeds in gold than by the purchase of a draft, gold goes from London to Paris.

Sometimes the foreign demand for gold arises from uneasiness, financial or political, at some foreign centre, which impels it to bid eagerly for gold, even though it may not be the more profitable form of remittance. But these operations are abnormal and exceptional, and it may be said that as a general rule, and with allowance for the innumerable exceptions that complicate the working of the most watertight economic law, gold is taken from London when the exchanges are against us, and the exchanges are influenced by the market rate of discount, which affects the import and export of securities, and so the trade balance in the widest sense of the term.

It therefore seems to follow that in order to attract gold, or to retain a larger share of the gold that comes here from the English-owned mines in Johannesburg, it is necessary to have a temporarily higher level of discount rates here. For, if we set about the business in the only other possible way, by paying a higher price for gold than anybody else in the bullion market, it is most probable that we shall only make matters worse, because as fast as the gold is accumulated, the faster will discount rates go down, and the more the exchanges will go against us, and the keener will foreign competition for gold become. For as monetary matters are at present arranged, any increase in the gold reserve stimulates expectations of cheaper credit and encourages the bankers and bill-brokers to buy bills at lower rates.

Having thus groped our way to a conclusion as to the method by which an increase in the gold basis of credit is to be secured, let us try to discover who should bear the expense, if any, of the operations that have to be carried out. More gold is wanted, because it is considered by the banking community that the amount of currency and credit is too big for the foundation of gold on which it is based. The creation of this currency and credit is profitable to those who make them and to those who use them, in other words, to the bankers, including the Bank of England, and to the commercial and financial community, including the Government, which makes both permanent and occasional use of the credit machine. And it seems obviously fair that those who benefit by the extension and elasticity of our currency and credit system should make any sacrifice that may be necessary for the establishment of a stronger foundation for it.

When bankers approach this question they are fond of pointing an accusing finger at the Post- Office Savings Bank, and the fact that the Treasury keeps not one farthing of metallic reserve against the millions of liability that this bank has in its books; and they maintain that the Treasury ought to lead the way by making amends in this matter and providing a reserve of gold against the Savings Bank deposits. With all deference to the eminent authorities who have enunciated this theory, I venture to think that they are shooting at the wrong mark. The manner in which the Treasury has handled this question of Savings-Bank finance is open to vigorous and voluminous criticism, but it is happily irrelevant to the present problem.

The Post-Office Savings Bank is not a bank in the ordinary sense of the word, and has nothing to do with this question of strengthening the basis of currency and credit, because it issues no currency and creates no credit. No one draws a cheque on the Post-Office Savings Bank, and no borrower goes to it with securities or bales of wool to ask it for an advance. It is a trust company rather than a bank, and the fact that it has the consolidated fund of the United Kingdom to draw on at need makes the provision of a gold reserve for it a needless and expensive luxury. The point at which the Government touches on the gold reserve question lies rather in the fact that it is to a certain extent responsible for one of the weaknesses in the basis of credit and currency, by permitting the Bank of England to issue notes against a promise to pay by the Treasury. We have seen above that one of the assets held in the Bank's Issue Department against its note issue is a loan to the Government standing at eleven millions odd. Since the Bank Charter Act was passed the cheque has to a great extent taken the place of the note for the purpose of currency, and the note has become a basis of currency, being held chiefly by bankers in their tills and cash reserves, and as part of the foundation on which they build their fabric of credit.

This being so, without any disrespect to the framers of the Act we can point out that a piece of paper which is used as a basis for currency and credit ought to be as little as possible based on other pieces of paper, in other words that the fiduciary part of the Bank's note issue might with advantage be reduced. And a very simple and obvious method of curtailing the proportion of paper that is behind the bank-note would be for the Government to repay gradually its book debt of eleven millions, perhaps at the rate of half a million or a million per annum, according to the prevalent conditions. There would be no need to ask the Treasury to make this repayment in gold and to expect it to go into the bullion market and bid for the necessary metal. I have tried to show that this is not the best way to increase the gold store, and in any case it is not an operation that the Treasury is well qualified to carry out.

All that is wanted is that the Government should out of the Sinking Fund give the Bank a cheque for perhaps half a million a year, in redemption of its book debt, which heads the assets in the Issue Department. A small part of the Sinking Fund would be devoted to this purpose and would be redeeming debt, which is its business.

Let us see what would follow. In the Issue Department account in the Bank return the notes issued and the Government debt would both be reduced by half a million. In the Banking Department account the Public Deposits would be reduced by half a million and likewise the notes held on the other side, forming part of the Bank's reserve.

The reduction in the Public Deposits would ultimately reduce the Other Deposits, because the use of Sinking Fund money for cancellation of this debt would reduce the amount that would otherwise be transferred to them through purchases of Consols or other stock. The proportion of metal behind the bank-note would thus be increased. If the process were sufficiently gradual it would cause no approach to monetary stringency ; but it would insensibly narrow the paper basis of credit, and this narrowing would have to be made good by the attraction of gold to take the place of the cancelled paper. At the same time it is chiefly a waste of time to discuss such a measure, because in the first place it would imply an alteration in the Bank's charter and much Parliamentary discussion and delay ; and in the second, since the profits of the Bank's fiduciary issue go to the Government, the loss following on its reduction would fall on the tax-payer, who would consequently look sourly on it. We must try some line of less resistance.

The attraction of gold to increase our store is best secured, as I have tried to show, by means of the market rate of discount. The market rate of discount is regulated in normal times chiefly by the action of the outer banks, and we thus arrive at their share in the operations which are necessary for the reinforcement of the basis of credit and currency.

Their share ought to be substantial. For they issue most of our modern currency in the form of cheque-books to be filled up by their customers, and manufacture most of the credit by making advances, discounting bills, and financing the discount houses. Any undue extension of credit that exists may fairly be laid at their door; for we have seen that the Bank of England, which is the greatest credit-maker of all, because the credits that it makes are regarded as cash by other credit-makers, exercises a self-denying restraint in the matter and habitually shows a very much higher proportion of cash to liabilities than the other banks.

Since, then, the other bankers are themselves responsible for the undue extension of credit, which they themselves have stated to be a problem requiring attention, it would seem that they themselves could very easily settle the matter, by quietly and gradually paring away the over-growth until the volume of credit was brought within a satisfactory relation to the cash on which it is based.

And it would also seem that this simple process would be the more expeditiously set about because its operation, as we shall see, would itself have the effect of helping to attract or retain gold, so that the strengthening process would go on at both ends at once the reduction of credit would increase the basis of credit, and the improvement in the proportion between the two would thus double its pace. Moreover, it would appear that a period of pronounced ease in the money market, due to slack trade and reaction after the American crisis, would be an ideal opportunity for the banks to set about curing the malady with which they find themselves to be afflicted.

This opportunity presented itself, and nothing was done. And for the very good reason that the banks are human. The need for reform has been put forward by big men in the banking world representing the big banks ; and the lesser lights representing the smaller banks do not like the notion of seeming to be led or instructed. Moreover, it is, as a rule, the smaller banks that are the worst offenders in the matter of overextension of credit, and they fear that a self-denying ordinance would affect their profits more than those of their bigger brethren. So they, or some of them, resent the whole discussion, urge that any restriction of credit would be bad for trade, refer the question to committees, ventilate proposals for the acquisition of gold by somebody else, and maintain that this is a national question which ought to be solved at the national expense, and so on. All this is very natural and reasonable and human, but does not quicken progress. And the advocates of reform are forced to the melancholy conclusion that agreement among the banks, which is the obvious and simple way of securing it, seems to be impossible.

This result is the more lamentable because the smaller banks are asked to do very little. Nobody suggests that a cast-iron rule ought to be laid down as to the proportion between cash and liabilities that a bank ought to keep. All that is needed is an extension of the publicity, which, partially and illogically applied, has already been coincident with a great increase in banking solidity and strength.

In other words, it is only suggested that the banks should show what proportion of cash to liabilities they habitually keep. This is already done by nearly all the biggest, strongest and most successful, and the adoption of the practice by the rest seems a most modest suggestion in the direction of reform.

We have seen in a former chapter that, under present arrangements, some banks publish a yearly balance-sheet, most of them a half-yearly, and a select few issue a monthly statement of cash and liabilities ; of these last, one shows its average daily cash holding throughout the month, the rest show the position on one day. In the case of some of them it is known that this statement gives a fair view of their normal position, but in that of others it is suspected that loans are occasionally called in or bills are allowed to run off, with a view to making a good display of cash, so that the statement is to some extent misleading ; and the habitual development towards stringency shown at the end of every month lends colour to this belief. The more acute development of stringency towards the end of each half-year, though to some extent due to other causes, also tends to show that the many banks which prepare balance-sheets only at those periods, restrict credits with the same object.

It is therefore contended that, if all banks regularly showed their habitual position, the over-extension of credit would at once be cured, because the over-extension of credit is carried out by the banks which do not issue periodical statements, or prepare for them by calling in loans. Therefore, say the advocates of reform, if all the banks agreed to make monthly state- ments showing their average position, not the position on a certain day, this calling in of loans when publicity is applied, and over-extension of loans when it is withdrawn, would be made impossible. Another suggestion with high authority behind it and probably equally efficacious, proposes that every bank should make a weekly statement.

It is pleasant to build castles in the air, even in the monetary air, and in spite of the difficulties in the way of this simple reform, let us see how it would work, and what effect it would have on this question of the gold reserve.

Its immediate effect would be the blotting out of a certain amount of credit which ought not to be in existence, because its makers themselves consider it advisable to blot it out temporarily, whenever they have to show their position. This effect would be inconvenient to the users of this credit, and so great care would have to be exercised, and the matter would have to be dealt with cautiously, gradually, and after due notice.

" In consequence of this reduction of credit, loan rates would probably be temporarily higher and discount rates likewise., The trading community would find the process of financing itself rather more expensive, but need not be appreciably inconvenienced. The experience of the autumn of 1906 shows that trade can maintain great activity with a 6 per cent. Bank rate. It is highly important in the best interests of trade that banking credit should be soundly based, and the trader is obviously one of the parties who ought to be asked to contribute to any expense that may be involved by the improvement of its basis. The Government might, for a time, have to pay a higher rate on its Treasury bills, but the Government again, as a large and continuous user of credit, ought to contribute.

And though prophesying about economic processes is a dangerous amusement, there is every reason to expect that the higher level of rates established by the curtailment of credit would very quickly provide its own remedy by the attraction or retention of gold, and a consequent increase of the gold basis of credit resulting in its expansion to the old level. After that it would only be necessary to take care that the proper proportion is preserved, and this ought to be easily effected by means of the publicity which we are supposing ourselves to have secured, especially if at the same time a link, of the kind suggested in Chapter could be established between Bank rate and market rate. Bank shareholders as a whole need suffer no loss ; for a time there would be less bad credit made, but the price of good credit would be a shade higher, and this shade would probably suffice to maintain banking profits.

Shareholders in banks which have never traded in bad credit would probably benefit, and the banks which have relied too much on the over-extension of credit for making profits would suffer some temporary loss, but ultimately benefit by being induced to reform their methods.

We have thus arrived at the conclusion that in order to improve the basis of credit it would be desirable, if it were possible, to reduce the amount of the Bank of England's fiduciary note issue by the gradual reduction of the Government's book debt to the Bank, thus making the bank-note, which is itself used as cash and a basis of credit, more a bullion certificate and less a credit instrument. But we dismissed this as impracticable, at present, owing to Parliamentary and political reasons and suggested or repeated a suggestion that has high practical authority behind it---that much might be done if it were possible to curtail the supply of bad credit by inducing all the banks to show how much cash they habitually hold in proportion to their liabilities. And we showed some reason to believe that these measures would promptly increase the gold reserve, which is the metallic basis of credit, so enabling good and well-based credit to take the place of the bad and inflated credit that had been abolished.

As the gold came in attracted by the higher discount rate the balances of the other banks in the Bank of England would be increased ; or if they preferred to increase their own cash holdings, they could take out bank-notes to hold in their tills, leaving the gold on which they were based in the vaults of the Bank of England. For it seems desirable that the strengthened gold reserve should be patent to the world, and it would be so more effectively if aggregated in the Bank of England than if scattered about in the vaults and tills of the other banks.

If once the apparently insuperable obstacles in the way of putting these measures into effect could be overcome, the process would work quickly,cheaply and effectively. And it need not be carriedvery far. England has no need to heap up amountain of gold. Our banking system is happy in the possession of other reserves besides its metal and with them we shall deal in the next chapter.

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