The Automatic Mechanism
(From chapter 12, Follow the Money)
<109>The logic of natural liberty was used to justify the shift to gold in the English economy in the 18th century. One of the gold standard’s leading proponents, William Shaw, put the matter bluntly. “The verdict of history on the great problem of the nineteenth century – bimetallism – is clear and crushing and final, and against the evidence of history no gainsaying of theory ought for a moment to stand.” (1)
Bimetallism was the 19th century’s version of state-controlled coinage, entailing a state-decreed exchange rate for gold versus silver. In celebrating the “crushing” defeat of bimetallism and the triumph of gold, Shaw saw only the victory of “natural” market forces over state control of currency. “The ceasing of the artificial arbitrary Mint rates made way for a naturally determined or commercial ratio, and the regulation of the international flow of the precious metals was left to the oscillation of trade balances, and to the action of interest rates and discount. The change is one from a mediaeval, State-bound, merely legislative system to the modern system, in which the flow of precious metals is determined by the perfectly natural and automatic action of international trade.” (2)
The currency systems of the nations of the world had switched over to the “perfectly natural and automatic” determinations of market forces. Shaw likens the operation of these market forces to machinery – a useful analogy when one wishes to attribute a technocratic disinterestedness to one’s policy preferences. This is how it worked:
<110>Between a circle of commercially interconnected countries, and over a certain cycle of time or operations, there is an equivalence of exchange of goods and services. Movements of currency in the most elementary form assist the process, as far as immediate settlements are concerned; bills of exchange assist it when there is need of deferred payments … and, finally, bank and discount rates assist the process by providing currency media at times and places which would otherwise be unable to attract a supply.… The machinery by which that equilibrium is accomplished is currency in the widest sense. The index or indicator and safety-valve of the whole is the rate of interest. On these bank rates are based the operations of the modern bullion dealers or arbitragists, which serve to equalise or economise the distribution of the precious metals all over the world. (3)
So there are “bills of exchange,” “bank and discount rates,” the “rate of interest” which acts as “indicator and safety-valve of the whole.” And are there actual persons behind all of this? Yes, there are: the “modern bullion dealers and arbitragists.” But what is the difference between these “modern” market makers and the ones prior to the advent of this mechanism? After all, Shaw does not cast their activities in a favorable light. “The monetary system of Europe,” he writes on page 72, “unconsciously bimetallic and with an appalling variety of ratio prevalent at the same moment in different places – lay open, helpless and defenceless, and inviting to the bullionist, financier, or arbitragist.” And on page 165 he writes, “In the seventeenth century there was no conception of theory at all, and the practical difficulty was how to frustrate the operations of the bullionist and arbitragist and politicians, and the depletion of national treasure due to their activity, and based on a difference of ratio prevailing in different countries.” But now the nations were to acquiesce in a system whereby these activities are put in the light of a disinterested machinery? Could it not have been that it was precisely the goal of the “bullionist, financier, or arbitragist” to implement a “machinery” putting himself in control of the currency, not of one nation, but of all the nations at once?
<111>Indeed, this constituted a triumph of prodigious proportions. Over time, this banking hegemony was achieved by laboriously overthrowing the state-managed system of coinage to establish a commodity-money system whereby the “most marketable commodity,” as it is termed – but can better be termed the “most market-cornerable commodity” (4) – was established as legal tender. This was achieved in England in surreptitious manner, through the systematic ensconcement of gold as the country’s currency, and the concurrent de facto abandonment of silver.
The vehicle by which the gold currency triumphed was the Bank of England, which received a monopoly on the issue of bank notes, and which was allowed to issue notes far in excess of “cash” reserves – cash, at this time, meaning gold, whether in coins or bullion. By this means, a state-sponsored monopoly reserve bank was put in charge of the nation’s money. And in true English fashion, there was never any legislation or declaration of such intent; one thing led to another, and before anyone knew it, the Bank of England was the custodian of the nation’s monetized wealth. (5)
In banking parlance, the Bank of England became the lender of last resort. Although the Bank was dragged into this role kicking and screaming, it was a role that developed in the nature of the case, given England’s “decision” to establish a gold standard for its currency. By making this scarce, costly commodity the sole final store of value and medium of exchange in its economy, England delivered itself over to the power of those banks – and the individuals behind them – who controlled that commodity. This ultimate power over the money base gave bankers a mechanism of control absolutely astounding in its scope and implications.
<112>Behind this mechanism were structural advantages beyond the legislation-decreed preeminence enjoyed by the Bank. One of these was the direct role it played in financing government budgets. In exchange for its loans, it received securities against which it could issue bank notes, which, because convertible into gold, enjoyed the status of gold. Secondly, it was intimately connected with the East India Company from the time of its origin, when the government of William III was strapped for cash. (6) It was therefore a primary recipient of the gold the East India Company brought in from the East, which it used to bolster its reserves. By these means and others, the Bank of England came to be the custodian of the lion’s share of the nation’s currency.
Other banks developed the practice of storing reserves with the Bank, which solidified its central-bank status. As Walter Bagehot explained, “the same reasons which make it desirable for a private person to keep a banker make it also desirable for every banker, as respects his reserve, to bank with another banker if he safely can. The custody of very large sums in solid cash entails much care, and some cost; everyone wishes to shift these upon others if he can do so without suffering. Accordingly, the other bankers of London, having perfect confidence in the Bank of England, get that bank to keep their reserve for them.” (7) And the country banks spread across the rest of England likewise kept accounts with the Bank, leading to the situation where the entire country’s banking reserves were lodged with one institution. That institution, in turn, took those reserves and lent above and beyond them. Actual bank reserves hereby came to be a fraction of nominal currency outstanding.
<113>With the publication of his groundbreaking book Lombard Street in 1873, Bagehot (“I am by no means an alarmist” (8)) sounded the alarm. “The main effect is to cause the reserve to be much smaller in proportion to the liabilities than it would otherwise be. The reserve of the London bankers being on deposit in the Bank of England, the Bank always lends a principal part of it.… We see then that the banking reserve of the Bank of England – some 10,000,000 l. on an average of years now, and formerly much less – is all which is held against the liabilities of Lombard Street; and if that were all, we might well be amazed at the immense development of our credit system.” But that is not all, for the country bankers do this too, as do Scotch and Irish bankers. “All their spare money is in London, and is invested as all other London money now is; and, therefore, the reserve in the Banking Department of the Bank of England is the banking reserve not only of the Bank of England, but of all London – and not only of all London, but of all England, Ireland, and Scotland too.” (9)
Although already an obviously precarious situation, it gets worse. For by this time, London had become the reserve bank not only for England, Ireland, and Scotland, but also for foreign countries such as Germany, likewise parking their gold reserves with the Bank of England.
Of late there has been a still further increase in our liabilities. Since the Franco-German war, we may be said to keep the European reserve also. Deposit Banking is indeed so small on the Continent, that no large reserve need be held on account of it. A reserve of the same sort which is needed in England and Scotland is not needed abroad. But all great communities have at times to pay large sums in cash, and of that cash a great store must be kept somewhere. Formerly there were two such stores in Europe, one was the Bank of France, and the other the Bank of England. But since the suspension of specie payments by the Bank of France, its use as a reservoir of specie is at an end. No one can draw a cheque on it and be sure of getting gold or silver for that cheque. Accordingly the <114>whole liability for such international payments in cash is thrown on the Bank of England. (10)
These foreign-owned reserves were crucial. The vicissitudes of the balance of payments could lead to their withdrawal at a moment’s notice, triggering the dreaded “run on the bank” for which reserves were entirely insufficient. “Now that London is the clearing-house to foreign countries, London has a new liability to foreign countries. At whatever place many people have to make payments, at that place those people must keep money. A large deposit of foreign money in London is now necessary for the business of the world.” (11)
This exposed not only the Bank of England but the entire domestic economy to foreign influence. The “automatic mechanism” of the international gold standard requires balances of payments between countries to be equalized by gold transfers. As international commerce increases, the reserves drawn upon to restore imbalances must also increase. And with a large amount of those reserves actually held by foreigners, the health of the banking system hangs in the foreign-sentiment balance. “The deposit at a clearing-house necessary to settle the balance of commerce must tend to increase as that commerce itself increases. And this foreign deposit is evidently of a delicate and peculiar nature. It depends on the good opinion of foreigners, and that opinion may diminish or may change into a bad opinion.… 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. And if that run should happen, the bullion to meet it must be taken from the Bank. There is no other large store in the country.” (12)
So here we have a better view of Shaw’s “perfectly natural and automatic” machinery. Indeed, Bagehot agrees with Shaw that the system functions in terms of market forces – “The value of money is settled, like that of all other commodities, by supply and demand, and only the form is essen<115>tially different.” (13) And Bagehot agrees with Shaw that interest rates are the means to raise and lower the value of money, the means by which that mechanism balancing international payments functions. “If the interest of money be raised, it is proved by experience that money does come to Lombard Street, and theory shows that it ought to come.… Continental bankers and others instantly send great sums here, as soon as the rate of interest shows that it can be done profitably.… And there is also a slower mercantile operation. The rise in the rate of discount acts immediately on the trade of this country.” Furthermore, “whatever persons – one bank or many banks – in any country hold the banking reserve of that country, ought at the very beginning of an unfavourable foreign exchange at once to raise the rate of interest, so as to prevent their reserve from being diminished farther, and so as to replenish it by imports of bullion.” (14)
This logic was used by John Stuart Mill to argue that gold supplies could be supplemented simply by adhering to the same rules as other commodities. Answering criticism of his position, he asked, “What hinders gold, or any other commodity whatever, from being ‘increased as fast as all other valuable things put together?’ If the produce of the world, in all commodities taken together, should come to be doubled, what is to prevent the annual produce of gold from being doubled likewise? … Unless it can be proved that the production of bullion cannot be increased by the application of increased labour and capital, it is evident that the stimulus of an increased value of the commodity will have the same effect in extending the mining operations, as it is admitted to have in all other branches of production.” (15) But such increases in bullion production are precisely what cannot be proved. This is the limiting factor that ensures an upward trend in the value of gold.
Anticipating this objection, Mill goes on: “But, secondly, even if the currency could not be increased at all, and if every addition to the aggregate <116>produce of the country must necessarily be accompanied by a proportional diminution of general prices; it is incomprehensible how any person who has attended to the subject can fail to see that a fall of price, thus produced, is no loss to producers: they receive less money; but the smaller amount goes exactly as far, in all expenditure, whether productive or personal, as the larger quantity did before. The only difference would be in the increased burthen of fixed money payments; and of that (coming, as it would, very gradually) a very small portion would fall on the productive classes, who have rarely any debts of old standing, and who would suffer almost solely in the increased onerousness of their contribution to the taxes which pay the interest of the National Debt.” Such explaining-away of the effects of deflation is sheer wishful thinking, and reality repeatedly proved this statement wrong. (16) But the sentiment lived on at the Bank of England: “the traditional rule of the bank stated that a 10 percent bank rate would draw gold out of the ground itself.” (17)
What are the implications of such a position? Interest rates are raised and lowered simply because other countries have more or less demand for gold. In other words, the entire domestic economy rises and falls, is stimulated or depressed, by the vagaries of the international gold market, and hence of economic and financial conditions in any foreign country or countries which may or may not, for whatever reason, desire gold or dump it. Thus, during the downturn of the 1870s, “while the German Government was collecting gold for one reason, the French for a second, the American was collecting it for a third. There was little left to come to England. It was impossible to cure the slump – not because there was not the productive capacity to produce more goods, but because there was not sufficient gold at the apex of the inverted pyramid of credit to finance the increased productivity.… What a system – a system that punished with atrophy the whole productive life of England because of other policies that were no <117>more connected with that life than were the activities of the man in the moon!” (18)
One commodity market, and a “thin” one at that, held the fate of national economies in its hands. “Periods of internal panic and external demand for bullion commonly occur together.… We must look first to the foreign drain, and raise the rate of interest as high as may be necessary. Unless you can stop the foreign export, you cannot allay the domestic alarm.” (19)
It was Samuel Loyd, Lord Overstone – “perhaps, the greatest financier of modern times” (20) – who was the architect of this mechanism. Loyd was behind the Bank Act of 1844, by which the currency of England was rigidly restricted to a gold-specie money base – who, in Adams’ words, by this means “succeeded in laying his grasp upon the currency of the kingdom.” (21)
Loyd comprehended this bullion-based system’s permanent potential of enriching the creditor at the expense of the debtor, benefitting the possessors of wealth at the expense of those who produce it. “Certainly he understood as few men, even of later generations, have understood, the mighty engine of the single standard. He comprehended that, with expanding trade, an inelastic currency must rise in value; he saw that, with sufficient resources at command, his class might be able to establish such a rise, almost at pleasure; certainly that they could manipulate it when it came, by taking advantage of foreign exchanges.” The mechanism of foreign exchange thus could be leveraged to the advantage of the creditor: “a contraction of the currency might be forced to an extreme, and that when money rose beyond price, as in 1825, debtors would have to surrender their property on such terms as creditors might dictate,” which property might then be resold at a profit when gold resumed its influx and prices again began <118>rising. (22) Hence, a mechanism for expropriating wealth from the middle class and depositing it in the hands of wealthy capitalists. Given such a system, it is no wonder that anti-capitalism took hold.
In practice, Loyd’s engine functioned just as he smugly envisioned it. As he testified to a Parliamentary committee in 1847, “Monetary distress tends to produce fall of prices; that fall of prices encourages exports and diminishes imports; consequently it tends to promote an influx of bullion;” therefore, falling prices are a natural phenomenon and a necessary prerequisite for a return to growth. “As followed out by his successors, Loyd’s policy has not only forced down prices throughout the West, but has changed the aspect of civilization. In England the catastrophe began with the passage of the Bank Act,” of 1845, the work of Prime Minister Robert Peel, Loyd’s “lieutenant.” (23)
The upshot of this situation was a system centered on the Bank of England but extending across the Western world, whereby international bankers controlled national economies. “The merchant bankers of London had already at hand in 1810-1850 the Stock Exchange, the Bank of England, and the London money market.… In time they brought into their financial network the provincial banking centers, organized as commercial banks and savings banks, as well as insurance companies, to form all of these into a single financial system on an international scale which manipulated the quantity and flow of money so that they were able to influence, if not control, governments on one side and industries on the other.” (24)
This control rested on the acceptance, by governments and industry, of two basic “axioms,” as Quigley terms them, both of which “were based on the assumption that politicians were too weak and too subject to temporary popular pressures to be trusted with control of the money system.” According to these axioms, “the sanctity of all values and the soundness of money must be protected in two ways: by basing the value of money on gold and by allowing bankers to control the supply of money. To do this it <119>was necessary to conceal, or even to mislead, both governments and people about the nature of money and its methods of operation.” (25)
The shibboleth of “stabilization” was just such an example of bankers’ deception, claiming as it did that it was necessary for them to manage the currency, established on gold, to attain the stabilization of prices and foreign exchange. But as Quigley notes, this “really achieved only stabilization of exchanges, while its influence on prices were quite independent and incidental, and might be unstabilizing (from its usual tendency to force prices downward by limiting the supply of money).” Such a program of stabilization actually destabilized prices domestically. (26)
In fact, the 19th century witnessed repeated bouts of whipsaw boom-and-bust generated precisely by this so-called “automatic mechanism” of “stabilization.” Prime Minister Robert Peel “spoke of having put the country back upon an ‘automatic metallic currency’ and of a return to ‘the ancient right standard of England.'” (27) But there was nothing of ancient right about it, and the automatic machinery actually ceased functioning whenever put under sufficient strain. It was the principle of the money multiplier, a function of fractional-reserve banking, that guaranteed its own failure, as practice sufficiently demonstrated. (28) By this “automatic” mechanism, then, every time one pound of gold should leave the country, 10 pounds in paper money or other currency would have to be withdrawn from circulation. Hence, the smallest shifts in foreign exchange had a multiplier effect on domestic prices. Furthermore, in the case of a supplementation to the gold stock, the inflationary effect might materialize or it might not, depending on <120>the course of lending; but in the case of a diminution, the deflationary effect must materialize of necessity. “If an ounce of gold was added to the point of the pyramid in a system where law and custom allowed 10 percent reserves on each level, it could permit an increase of deposits equivalent to $2067 on the uppermost level. If such an ounce of gold were withdrawn from a fully expanded pyramid of money, this would compel a reduction of deposits by at least this amount, probably by a refusal to renew loans.” (29)
Quigley’s ruminations on the power of these bankers are telling. “On the whole,” he writes in his seminal work Tragedy and Hope, “in the period up to 1931, bankers, especially the Money Power controlled by the international investment bankers, were able to dominate both business and government. They could dominate business, especially in activities and in areas where industry could not finance its own needs for capital, because investment bankers had the ability to supply or refuse to supply such capital.” (30) And as far as governments were concerned, the need for credit was one obvious such tool, but “bankers could steer governments in ways they wished them to go by other pressures” as well. “Since most government officials felt ignorant of finance, they sought advice from bankers whom they considered to be experts in the field.” Which led them to do things they otherwise wouldn’t, given the consequences. “The history of the last century shows … that the advice given to governments by bankers, like the advice they gave to industrialists, was consistently good for bankers, but was often disastrous for governments, businessmen, and the people generally.” Governments might not immediately accede to such good advice; in that case, it “could be enforced if necessary by manipulation of exchanges, gold flows, discount rates, and even levels of business activity. Thus Morgan dominated Cleveland’s second administration by gold withdrawals, and in 1936-1938 French foreign exchange manipulators paralyzed the Popular Front governments.” (31)
McNair Wilson draws a similar picture. “By acquiring the power to export gold … its owners acquired the right to change the level of price of <121>goods both in the country from which the gold was taken and in the country into which they chose to send it.… The Money power has acquired the right of creating demand and also of abolishing it at its pleasure, and so, in effect, has set itself in the place of humanity as well as in the place of Kings. When it wills that production shall take place it expands credit; when it wills that production shall cease, credit is restricted. Thus boom and slump may be made to follow each other in endless succession.” (32)
Hollis’s conclusion is succinct: “[The gold standard’s] virtue was not that it gave the country a stable monetary system but, on the contrary, that it put it within the power of a few determined men to plunge the country into chaos whenever they wanted to.” (33)
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1. William A. Shaw, The History of Currency 1252 to 1894 (London: Wilsons & Milne, 1896), pp. vii-viii. The verdict against bimetallism is anything but crushing. See Irving Fisher, “The Mechanics of Bimetallism,” in The Economic Journal, Vol. 4, No. 15 (Sep., 1894), pp. 527-537; Milton Friedman, “Bimetallism Revisited,” in The Journal of Economic Perspectives, Vol. 4, No. 4 (Autumn, 1990), pp. 85-104; and above all, Marc Flandreau, The Glitter of Gold: France, Bimetallism, and the Emergence of the International Gold Standard, 1848-1873, trans. Owen Leeming (Oxford, England: Oxford University Press, 2004).
2. Shaw, The History of Currency, pp. 160-161.
3. Shaw, The History of Currency, pp. 165-166.
4. One 19th-century pamphlet emphasized just this aspect: F.W. Bain, The Corner in Gold (London: James Parker and Co., 1893).
5. “With so many advantages over all competitors, it is quite natural that the Bank of England should have far outstripped them all. Inevitably it became the bank in London; all the other bankers grouped themselves round it, and lodged their reserve with it. Thus our one-reserve system of banking was not deliberately founded upon definite reasons; it was the gradual consequence of many singular events, and of an accumulation of legal privileges on a single bank which has now been altered, and which no one would now defend.” Walter Bagehot, Lombard Street: A Description of the Money Market (New York: Charles Scribner’s Sons, 1897 [1873]), pp. 99-100.
6. “Twice William Paterson submitted a proposal which was to provide the King with the necessary funds, whilst those who advanced the money were to be considered as founders of a National Bank. Each time his efforts were in vain. In 1694 Michael Godfrey and some others who experienced financial difliculties in connection with the East India Company, invoked Paterson’s aid. A third project was devised on the same lines as the two former ones. In consideration of an annual payment of £100,000 the promoters undertook to find a capital of £1,200,000 on behalf of the Government. Thanks to their influence, this scheme was successful.” W. R. Bisschop, The Rise of the London Money Market 1640-1826 (London: P.S. King and Son, 1910), pp. 68-69.
7. Bagehot, Lombard Street, p. 27.
8. Bagehot, Lombard Street, p. 20.
9. Bagehot, Lombard Street, pp. 29-31.
15. John Stuart Mill, Principles of Political Economy with some of their Applications to Social Philosophy, William J. Ashley, ed. (London; Longmans, Green and Co., 1909), III.13.12, n. 43.
16. Mill, Principles of Political Economy, III.13.12, n. 43. Perhaps this is why this section, first included in the second edition of 1849, was removed in the 5th edition of 1862. See the Library of Economics and Liberty [Online] version, available at http://www.econlib.org/library/Mill/mlP42.html.
17. Quigley, Tragedy and Hope, p. 347.
18. Hollis, The Two Nations, p. 173.
20. “Cautious and sagacious, though resolute and bold, gifted with an amazing penetration into the complex causes which control the competition of modern life, he swayed successive administrations, and crushed down the fiercest opposition.” Adams, The Law of Civilization and Decay, p. 335.
21. Adams, Law of Civilization and Decay, p. 336.
22. Adams, Law of Civilization and Decay, p. 337-338.
23. Adams, Law of Civilization and Decay, pp. 336, 338, 339.
24. Quigley, Tragedy and Hope, p. 51.
25. Quigley, Tragedy and Hope, p. 53.
26. Quigley, Tragedy and Hope, p. 53.
27. Christopher Hollis, The Two Nations: A Financial Study of English History (London: G. Routledge and Sons, 1935), p. 97.
28. “It is not necessary to follow through the monotonous and dreary story of the breakdown of Peel’s system every single time that it was subjected to any strain from 1821 to 1931.… The amount of money in circulation, under Peel’s system, obviously depends upon the amount of gold in the country. If the banks as a rule lend ten Promises to Pay for every pound of gold that they possess – the proportion which they soon adopted – then if £1 of gold leaves the country, £10 of Promises to Pay have to be withdrawn from circulation by the banks refusing to make new loans when old loans have been repaid.” Hollis, The Two Nations, p. 98.
29. Quigley, Tragedy and Hope, p. 57.
30. Quigley, Tragedy and Hope, p. 60.
31. Quigley, Tragedy and Hope, p. 62.
