A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  Ricardo had urged that paper money be kept in circulation. He recommended that bullion be held in ingots at the bank and the mint or held by private owners when demanded. The directors of the bank preferred bullion to paper for coins and notes of small denomination. English notes of less than five pounds, issued during the Restriction, were withdrawn from circulation after the Resumption. The effect was to raise the demand for gold in England and increase both the resource cost of maintaining the money stock and the rate of deflation required to restore convertibility at the previous fixed rate. By the winter of 1823–24, the bank’s gold stock reached a maximum and started to decline. The decline continued throughout 1824, accelerated in 1825, and reached a trough early in 1826. At the trough, the bank held only £2 million pounds after suffering a drain of £12 million in two years.

  23. The government’s budget surplus and deficits are from Wood 1939, table 6, 74–75. A brief discussion of the Dead Weight debt and open market operations is Wood 1939, 80–83.

  To stem the decline and protect the gold reserve, the bank refused to discount eligible paper, but it did not at first raise bank rate. Hawtrey (1962, 14–15) argues that raising the rate would not have been effective because short-term interest rates rose above 70 percent per annum. He overlooks the fact that before this occurred the crisis had intensified for several months and had become a panic after the bank restricted its loans. Bagehot, in a graphic passage, describes the money market in December 1825.

  In the panic of 1825, the Bank of England at first acted as unwisely as it was possible to act. By every means it tried to restrict its advances. The reserve being very small, it endeavored to protect the reserve by lending as little as possible. The result was a period of frantic and almost inconceivable violence; scarcely anyone knew whom to trust; credit was almost suspended; the country was, as Mr. Huskisson expressed it, within twenty-four hours of a state of barter. Applications for assistance were made to the Government, but . . . the Government refused to act. (1962, 98)24

  In previous crises, such as 1793 and 1811, the government had issued exchequer bills to the merchants. Sir Robert Peel believed that issuing bills would help only if the bank agreed to purchase them from the market. Since “intervention would be chiefly useful by the effect which it would have in increasing the circulating medium, we [Peel] advised the Bank to take the whole affair into their own hands at once, to issue their notes on the security of goods, instead of issuing them on Exchequer Bills, such bills being themselves issued on that security” (ibid., 99). With the government’s guarantee in hand, the bank raised the discount rate to 5 percent and resumed lending. Bagehot describes the turnaround:25

  “We lent it,” said Mr. Harman, on behalf of the Bank of England, “by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.” After a day or two of this treatment, the entire panic subsided, and the “City” was quite calm. (Ibid., 25)

  24. William Huskisson was a director of the bank and had been president of the Board of Trade. He was an active reformer who opposed mercantilism and favored the reforms advocated by Smith and Ricardo.

  25. Bagehot called this turnaround “classical” and liked the example so well he repeated much of the passage (1962, 99). Among the many bank failures of the period was Henry Thornton’s bank, Pole, Thornton, and Company, in which his son remained active after Thornton’s death in 1815. Bagehot’s analysis is, of course, similar to Thornton’s discussion of the panic of 1793. See note 11 above.

  The crisis, coming at the end of a period of alternating inflation, deflation, expansion, and depression that characterized the first quarter of the century, provided the impetus for an examination of monetary arrangements and produced some major changes in banking and central banking practices. Repeal of the usury law (1833) permitted the bank to raise the discount rate on short-term bills above the 5 percent limit, a very important step for the future development of central bank policy. Other changes made to improve the functioning of the banking system included the opening of branches of the Bank of England, the extension of the joint stock form of organization to commercial banks, and the granting of legal tender status to Bank of England notes. The latter changes show the tendency of governments (repeated on many subsequent occasions) to adopt new arrangements after a crisis even if there is little reason to believe that the previous arrangement was a major contributing cause of the crisis.

  As is often the case, changes in informal arrangements were far more important than the new laws. Of particular interest here are the changes in central banking practices, since they reveal the attitudes and understanding of the directors. But there were also important changes in the practices of bankers and bill brokers.

  The Bank of England was forced to accept, or at least to share, the responsibility for maintaining the payments mechanism and to function as lender of last resort to the economy. The bank did not publicly acknowledge the responsibility, and during the crisis the government had been forced to prod the bank and offer guarantees. A tradition was established thereby, and the bank was able to demand and get similar guarantees in later crises. The bank’s caution was partly a consequence of private ownership, as was alleged at the time, and perhaps partly of bureaucratic slowness resulting from its monopoly position, but it was partly lack of understanding of the responsibility of a central bank to serve as lender of last resort.

  The basic cause of the crisis, however, was the bank’s inability or failure to slow the rate of monetary expansion in 1823–24. Many of the bank’s directors believed that the expansion had been partly the result of “speculation” and the panic a result of “overspeculation.” Influenced by the real bills doctrine, some directors attributed the start of speculation to the bank’s purchase of government securities, that is, the purchases of Dead Weight debt and other issues. But most of the directors recognized that the problem arose because of the expansion of the circulation or, as some of them put it, the reduction in interest rates.26

  The experience led many of the directors to conclude that the bank had been too ambitious when it agreed in 1822 to assist the government in a policy of reversing the price level decline. The bullion reserve had been at one of the highest points in the bank’s history when the policy started, but even so large a reserve had proved insufficient to satisfy the demand for bullion during the crisis. The experience seemed to support the extreme bullionist view that the combined circulation of gold and paper currency had to be kept equal to the amount of gold that would otherwise have circulated. Any excess would raise the price level in proportion to the excess issue, causing a fall in the exchange rate and a loss of bullion. This point was well known because Ricardo had stressed it in his writings and testimony, and it had become a main point of emphasis for the writers in what came to be known as the currency school. By accepting this point from Ricardo and the members of the currency school, the directors in effect rejected Thornton’s earlier stress on the effect of business conditions on confidence and of confidence on the demand for money. Neglect of Thornton’s promising start on an analysis that combined short- and long-run consequences of a change in gold or money closed off one of the few opportunities in a century to develop a general equilibrium analysis of money, bank credit, output, prices, and balance of payments.

  The wave of bank failures profoundly affected London bankers and bill brokers, just as a similar experience was to affect their American counterparts a century later. Innovation and changes in practices followed. The risks inherent in the previous practice of holding very low ratios of reserves to deposits and relying on the sale of bills, or in some instances ad
vances from the Bank of England, had proved larger than anticipated. The banks were partnerships at the time, so failure often meant the loss of a personal fortune. For a time the banks increased their reserve ratios by increasing their holding of bullion and deposits at the Bank of England relative to their deposits. They no longer relied on the purchase and sale of bills of exchange to adjust portfolios but held bills to maturity and adjusted portfolios by making or calling loans to bill brokers. As the banks withdrew from the bill market, some of the larger brokers accepted many of the functions the banks had performed. They bought and sold bills from their portfolios instead of acting as brokers (Scammell 1968, 133). Others continued a brokerage operation as before the panic.

  26. Very similar views about speculation are repeated in the Great Depression of the 1930s. Wood (1939, 83–84) presents a number of quotations from the parliamentary hearings of 1832 to show that the predominant view at this time was that it made very little difference whether the bank increased the circulation by a purchase of Treasury bills or by discounting commercial paper. This view contrasts with the views held by the bank’s directors earlier and criticized by Thornton and the views held by members of the Federal Reserve Board in the 1920s.

  Just as the United States banks in the 1930s virtually stopped all borrowing from the Federal Reserve, after 1825 English banks no longer relied on advances from the Bank of England. To increase cash, banks reduced call loans to the bill brokers. After 1830 the brokers were allowed to discount at the Bank of England, and they did so when the banks reduced call loans.

  Some may find in these developments the origin of a “tradition against borrowing.” Wood (1939, 90–104) points out that the facts do not support that hypothesis. Generally the bank’s discount rate was a penalty rate, above the rate on bills of highest quality, the only type eligible for discount. London banks did not borrow even in periods of crisis but relied on call loans to adjust their cash position. When the banks’ demand for cash assets increased, the country banks sent more bills to the bill brokers and surplus areas purchased fewer. London banks reduced call loans, and the bill brokers borrowed from the Bank of England. The so-called tradition against borrowing by banks should be seen, therefore, as a tradition of borrowing by the bill brokers and dealers who supplied reserves to the banks.

  Furthermore, there were other ways the bank’s rate policy affected the market. There were seasonal swings in the volume of exchequer bills. If the market refused to absorb the bills at existing rates, the bank was asked to lend to the Treasury or purchase bills in the open market. By raising bank rate, the bank induced the market to hold more bills. With the usury law repealed, the bank experimented with the use of bank rate as a means of controlling base money.

  FROM PALMER’S RULE TO PEEL’S ACT

  By the 1830s the main features of the monetary system were in place.27 A money market had developed, and the principal institutions had accepted distinctive roles. The Bank of England had a set of social objectives, some partial understanding of the steps required to achieve these objectives, and glimmerings of an understanding of the short-run consequences of its actions. Both the market and the bank realized that the bank’s responsibilities went beyond those of an ordinary bank to include the role of lender of last resort. Moreover, the bank accepted responsibility for maintaining specie payments at a fixed pound price of gold and had become familiar with the traditional central banking control techniques—discount rate changes, qualitative restrictions, and in a limited sense, open market operations.

  27. Bordo and Schwartz 1984 has a thorough discussion of the operation of the gold standard in Britain and other countries during the nineteenth century.

  In 1827 the bank added a rule of procedure to guide policy actions, known as Palmer’s rule after the governor who announced it at the parliamentary hearings of 1832. John Horsley Palmer saw the rule as a means of reducing the variability of the quantity of money in circulation and the exchange rate, and he apparently regarded such smoothing operations as part of the responsibility of a central bank.

  Palmer’s rule attempted to tie the liabilities of the Bank of England to the stock of bullion. When the exchange rate was at par, the sources of the monetary base were to consist of one-third bullion and two-thirds securities. Except for seasonal adjustments, discussed below, the security portfolio would be kept constant, and the bank would increase or decrease the note issue as gold flowed in or out.

  Every monetary rule is based on a theory of the monetary process, Palmer’s rule no less than those that came later. The theory behind the rule was the Hume-Thornton-Ricardo theory of the long-run consequences for prices, gold stock, and the exchange rate of changes in money. The rule accepts two propositions from that analysis. One, emphasized during the Restriction, is that depreciation of the exchange rate is evidence of an excessive issue of notes. The second is that the gold reserve is held against the bank’s notes and deposits, not just notes as the currency school proposed (Mints 1945, 83).28

  The main defects of Palmer’s rule as a guide to operating policy bring out some differences between the monetary theories of Thornton and Ricardo. First, Thornton accepted proposition one as a long-run proposition, but he argued at length that, in the short-run, changes in the demand for money (or monetary velocity) cannot be neglected. Such changes occur when new substitutes for money appear or their use expands. Thornton was clear that “paper credit,” which is to say bank deposits, differs from gold but that both are part of the “circulating medium” and both affect the price level. Second, Thornton urged the Bank of England to expand the monetary base with the long-run growth of trade. Third, he stressed the effects on money, output, and prices of temporary changes in the demand for currency. Under Palmer’s rule, expansion and contraction of money (currency and deposits) were tied to gold flows. However, the rule made no provision for changes in the amount of currency produced by country banks and no provision for changes in the distribution of the liabilities of the Bank of England between government deposits and base money.

  28. The modern version is known as the monetary theory of the balance of payments.

  The members of the currency school attacked Palmer’s rule on two grounds, both familiar. The rule allowed the bank discretion, not only because it had been adopted voluntarily but because in practice the rule was sufficiently complex that the bank could abandon it or make exceptions whenever it wished. A second, and more frequent, criticism concerned the definition of money. Palmer’s statement of the rule allowed the bank’s total liabilities—deposits and currency—to rise and fall with gold movements. Since the bank offset the effect of quarterly fluctuations in Treasury deposits on the base, it had to raise or lower the monetary base as gold flowed in and out. The currency school defined money as the sum of currency (notes) and bullion but excluded deposits. It argued that gold movements would have their expected effect on the price level and exchange rate only if changes in currency matched the changes in gold, and it urged the Bank of England to operate as if the source of the monetary base consisted entirely of bullion.

  Some of the issues raised by the currency school have had a long life. The issues resurface periodically when there are changes in the types of financial institutions or their activities. One part of the currency school position is that the price level depends on the type of liabilities or assets issued and repurchased by the central bank. These writers understood that money was neutral in the long run, but they emphasized a narrow definition of money. To maintain stable prices they believed the central bank should limit currency issues. The modern statement of the proposition usually assigns importance to a broader definition of money that includes checkable deposits and often time and saving deposits as well as some additional items.

  From 1827 to 1836 bank rate remained constant (at 4 percent), and the base fluctuated with market forces. The stock of bullion varied between £4 million and £12 million and the security portfolio between £20 million and £34 million, both
narrower ranges than in the previous decade. For this reason the rule might be regarded as a partial success. Some small portion of the fluctuations consisted of seasonal movements resulting from continuation of the bank’s practice of offsetting seasonal fluctuations in market interest rates caused by differences in the timing of Treasury payments and receipts. Apparently Palmer’s rule was never intended to apply to short-term portfolio changes of this kind, because neither Palmer nor most of the other directors believed at the time that short-term fluctuations in money (however defined) had a permanent effect on the exchange rate. The bank had not yet accepted the state of the money market as an indicator of bank policy, but it had started a move that would bring it to that position within a decade (Wood 1939, 45).

  Wood (1939, 102–3) argues that Palmer adopted the rule because he did not believe discount rate changes provided an effective means of controlling the bank’s portfolio, a point that Hawtrey repeats (1962, 14–15). These writers neglect that the rule was promulgated in 1827 and announced in 1832 when the bank still operated under the usury law.29 Whatever Palmer’s earlier views on the effectiveness of rate changes may have been, the bank under his leadership changed the discount rate seven times between the summer of 1836 and the winter of 1839–40 in response to a series of crises, first in the United States and later in Belgium. Equally important, the bank raised the discount rate above 5 percent, first to 5.5 and then to 6 percent, to stem the outflow of gold in 1839. By changing the rate and borrowing abroad to increase its bullion holdings, the bank was able to maintain specie payments throughout the period despite the loss of two-thirds of its bullion in 1839.