But the reserve in the Bank of England is subject to a still further strain occasioned by the necessities of foreign commerce. London is the center of English commerce, and in case the balance of trade* goes against England and in favor of any other country, that balance must be paid by London, and this is equivalent to saying that it must be paid by the Bank of England. When, during our civil war, the supply of cotton to England by the United States was cut off and exports to America greatly reduced, immense sums of money had to be sent to Australia and Egypt to pay for cotton to keep the looms of Manchester supplied. Of course no foreigner can take away the cash of England without giving a value therefor, but that value may be in produce or manufactures, represented by
bills of exchange which the foreigner discounts in Lombard Street, and then he may take away a part or all of the proceeds of his bills in bullion. No other city in the world cashes as many foreign drafts as London. No other city in the world receives as many remittances or pays as many drafts as London. No other city holds as much foreign money on deposit as London, for wherever the people have payments to make, at that place they must keep money on deposit. Formerly Paris was a European clearing house to a considerable extent, and divided the business and responsibility with London, but the changes in government in France have had the effect of greatly reducing the confidence of foreigners in the stability of the Bank of France, while the volume of mercantile business finding its natural settlement in London compelled banks all over the world to keep accounts there. As it is more convenient to keep one foreign account than several, and most convenient to keep this in the city with which transactions are largest and most numerous, there was thus placed upon merchants all over the world the effective pressure of more favorable exchange rates when bills could be drawn upon and payments made in London. Very large banks can keep accounts in all the European centers, but it would neither be profitable nor possible for small banks to keep such accounts, because of the amount of cash that would be locked up. Moreover the most favorable terms can be obtained upon large accounts only, and it is a custom, the world over, except in the United States, for banks to exact commissions on all services rendered. These considerations have tended to centralize the financial transactions in the Bank of England,* which has established a record for stability and uniformity of dealing through long generations.
*The phrase "Balance of Trade" is usually taken to mean the differences between imports and export3 of merchandise, but strictly the balance is caused quite as often through movements of capital in the form of loans or investments, as of merchandise. These movements not being "visible" through the records of the custom houses, are often very difficult to follow.
♦When the volume of exchanges on some other city, New York, for example, becomes so great relatively, that banks the world over find it cheaper to effect settlements there rather than in London, the prestige of London must surely begin to wane. There are other factors in the case, however, such as the amount of free capital available for discounting time bills of exchange, etc., but the foregoing is the chief one.
As the commerce of a nation increases the reserve on hand to settle the balance of that commerce must likewise increase. A single bad harvest in any important country with which England trades, may seriously affect the balance of trade with England, by reducing the demand for English manufactures. A sudden increase of imports or a cessation of exports causes a balance of trade to become due, which must be paid in bullion. Within a country, paper currency may be used in settlement of obligations, but in international trade the only cash is metal. The Bank of England must therefore keep a reserve which can be used for foreign payments either in bullion or legal tender notes which can be converted into bullion on demand by passing them over the counter of the issue department. The requirements of foreign commerce are often sudden and fluctuating, and must be met promptly. Therefore it is of the greatest importance that the reserve upon which this commerce depends should be both ample and ready, at all times, to satisfy the demands upon it.
Foreseeing the need for an increase in the reserve in anticipation of large foreign payments, soon to be made, the question at once arises, "How are the bank directors to secure the additional bullion?" They may reduce the volume of discounts, and this would in a measure help to accomplish the purpose, but would not afford a sufficient increase in the reserve to meet a large or continuous drain on the reserve. They may sell securities, but in a very large number of instances this would merely mean the transfer of a credit from one account to another on the bank's ledger, as the buyer of the securities would in all probability be an individual or bank having a deposit account with the Bank of England. What then is the means employed to increase the reserve? The answer is, raising the rate of discount. If the directors of the Bank of England vote to raise the rate of discount, it is proved by experience that money flows to Lombard Street and from the other banks it flows to the Bank of England. Money (i. e. capital) goes where it is wanted most and commands the highest rate of interest.
An increase in the bank rate has an immediate effect on foreign exchange transactions, making it unprofitable, or tending to make it unprofitable, to withdraw gold for export, and at the some time tending to make it profitable to ship gold from other financial centers to London. The bankers there pay a higher rate of interest and charge borrowers a higher rate of discount. The effect of the operation of raising the rate of discount even slightly is to swell the reserve in the vaults of the Bank of England, and at the same time to diminish loans by discouraging borrowers. With money a little "tighter," imports are diminished and exports are increased, thus tending to change the balance of trade in England's favor and reduce the necessity for large foreign payments. The raising and lowering of the rate of discount by the directors of the Bank of England, then, acts as a lever of control to the financial and commercial systems of England. When the bank is "flooded" with money, and no prospects are visible of a drain upon the reserve, the rate of discount is lowered. Money now flows from Lombard Street into other channels both in England and on the Continent, where it can be more profitably employed; with a lower rate of discount, borrowers are more plentiful, and more goods are imported.
Many persons believe that the Bank of England has some peculiar power which enables it arbitrarily to fix the rate of interest, whereas the truth is the bank merely gives expression to the market value of money, as fixed by the laws of supply and demand. The value of money is settled, like that of all other commodities, by the inexorable law of demand and supply, and the bank merely takes the lead in fixing or establishing that value in the form of a discount rate. If the bank vaults are full, the bank lowers the rate to attract borrowers, the same as a merchant lowers the price of his goods in order to effect sales and reduce his stock, and the contrary policy is pursued to increase the cash in the bank vaults.
The government of the Bank of England is confided in a board of twenty-four directors, a governor and a deputy governor, who each serve one year. In theory a portion of the directors go out annually, remain out for a year and are then subject to re-election, but as a matter of fact they are nearly always re-elected at the end of the year, unless other members of the board oppose. All the directors in turn serve as deputy governor and governor, in rotation, and it is not until a director has been upon the board perhaps twenty years that he succeeds to the position of governor. When a vacancy occurs in the board by death or resignation, the directors usually select some promising young business man for the place. In order to reach the governorship within the period of a lifetime, it is necessary that new directors should be young men. The position of director of the Bank of England is considered a highly desirable one, as it gives a considerable status to both the individual and the house to which he belongs. By a long-established usage the directors cannot be connected with any other bank, in any official capacity. They must be merchants, brokers or capitalists of experience, and men presumed to possess information as to the present and future course of trade. The reason for the discrimination against bankers as members of the directory of the Bank of England no doubt arose out of the narrow-minded jealousy of former times, which regarded all other banks as rivals to be feared and opposed.
In theory the system of management of the Bank of England would seem to be very objectionable. A governor, the chief executive officer of the bank, allowed to hold the office but one year, a directory made up of merchants, a portion of them young men, and not a trained banker in the entire board,* would not ordinarily be regarded as a very competent or safe board. Indeed, were such a system of management proposed at the present time for the conduct of a new and important banking house in England or elsewhere, it would instantly be rejected as crude if not absurd. And yet the Bank of England, which holds the nation's reserve, is managed in this way. Banking is now regarded as a profession to which men should be trained by years of constant experience and familiarity with financial questions. And yet the Bank of England has been singularly well managed. Its directors have always seemed to appreciate the large responsibility resting upon them, as managers of the bank which sustains the credit system of England, and while at times they have erred in policy the great institution stands to-day as solid, in the estimation and confidence of the people, as the government itself.
♦There is no better school for the education of bankers in the larger lines of their profession, in a firm grip on guiding principles and a wide outlook over the whole commercial and financial world, than service on the board of the Bank of England. As nearly all of the board have been many years in office, they are as a lot, men of ripe experience, and as the new men are always in the minority and are constantly being educated by their environment and responsibilities, a tremendous force is thus developed in the line of conservative action. Technically they may not be bankers; practically they are very good ones.
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