Applied Philosophy

In this series of posts I will be discussing Lombard Street: A Description of the Money Market By Walter Bagehot (the text is available on the Internet). The book discusses the financial system of Britain circa 1870. I will be quoting whole paragraphs, with emphasis from me, and then commenting on them. The first part will handle the first two chapters (out of 13).

Part One

 

“If a merchant have 50,000 L. all his own, to gain 10 per cent on it he must make 5,000 L. a year, and must charge for his goods accordingly; but if another has only 10,000 L., and borrows 40,000 L. by discounts (no extreme instance in our modem trade), he has the same capital of 50,000 L. to use, and can sell much cheaper. If the rate at which he borrows be 5 per cent., he will have to pay 2,000 L. a year; and if, like the old trader, he make 5,000 L. a year, he will still, after paying his interest, obtain 3,000 L. a year, or 30 per cent, on his own 10,000 L. As most merchants are content with much less than 30 per cent, he will be able, if he wishes, to forego some of that profit, lower the price of the commodity, and drive the old-fashioned trader-the man who trades on his own capital-out of the market.”

-Lombard Street By Walter Bagehot, CHAPTER I [my emphasis]

The same process made GM-a company created by the investment banks to takeover the motor industry-rise in the thirties while Ford-a company created by a pioneer and functioned on its own capital-decline. The Ford family lost control of the company in the fifties and only recently did a Ford get back at the helm, but by now the ship is heading for the rocks and nothing will save it.

In the long run credit backed business will drive out independent business; when the business cycle declines the creditors get precedence over the shareholders, the end of that process is the complete domination of the financial sector over the whole economy.

 

“Great firms, with a reputation which they have received from the past, and which they wish to transmit to the future, cannot be guilty of small frauds. They live by a continuity of trade, which detected fraud would spoil. When we scrutinise the reason of the impaired reputation of English goods, we find it is the fault of new men with little money of their own, created by bank ‘discounts.’ These men want business at once, and they produce an inferior article to get it. They rely on cheapness, and rely successfully.”

-Lombard Street By Walter Bagehot, CHAPTER I [my emphasis]

Thus the constant degradation of quality, Microsoft is the best example of this, chosen and backed by Wall Street to take over the new sector of computer software in the eighties Microsoft never created a new product instead it attacks established sectors-by pioneers-and take them over by cheap products of lower quality (Word for WordPerfect, IE for Netscape, Xbox for PS, etc).

The difference with the time of Bagehot is that then the banks controlled a sector by controlling a number of producers-who nominally owned the business but in reality worked for the banks-while now the banks has a sort of a champion that they choose and promote as the sector’s kingpin.

The Champion will suddenly rise and dominate and seems to have a magic touch that turns previously unprofitable sectors into moneymaking machines, there are many examples of such companies: Nike is a good example, after pioneers in Europe developed the modern sport shoe, US financial powers transformed Nike, which was a distributor at that time, into a giant that swept all others off the field. The success of Nike followed the crazy money they poured into the sport’s sector, the old maxim holds true you need money to make money and you can only find money at the banks.

This degradation of quality extends to the culture: those who read Harry Potter and listen to the Beatles are actually consuming products that has been created, promoted and distributed by big money. The difference between these products and real music or literature is similar to the difference between plywood and mahogany.

 

“Some of those deposits too are of a peculiar and very distinct nature. Since the Franco-German war, we have become to a much larger extent than before the Bankers of Europe. A very large sum of foreign money is on various accounts and for various purposes held here. And in a time of panic it might be asked for. In 1866 we held only a much smaller sum of foreign money, but that smaller sum was demanded and we had to pay it at great cost and suffering, and it would be far worse if we had to pay the greater sums we now hold, without better resources than we had then.

It may be replied, that though our instant liabilities are great, our present means are large; that though we have much we may be asked to pay at any moment, we have very much always ready to pay it with. But, on the contrary, there is no country at present, and there never was any country before, in which the ratio of the cash reserve to the bank deposits was so small as it is now in England. So far from our being able to rely on the proportional magnitude of our cash in hand, the amount of that cash is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it.

Again, it may be said that we need not be alarmed at the magnitude of our credit system or at its refinement, for that we have learned by experience the way of controlling it, and always manage it with discretion. But we do not always manage it with discretion. There is the astounding instance of Overend, Gurney, and Co. to the contrary. Ten years ago that house stood next to the Bank of England in the City of London; it was better known abroad than any similar firm known, perhaps, better than any purely English firm. The partners had great estates, which had mostly been made in the business. They still derived an immense income from it. Yet in six years they lost all their own wealth, sold the business to the company, and then lost a large part of the company’s capital. And these losses were made in a manner so reckless and so foolish, that one would think a child who had lent money in the City of London would have lent it better. After this example, we must not confide too surely in long-established credit, or in firmly-rooted traditions of business. We must examine the system on which these great masses of money are manipulated, and assure ourselves that it is safe and right.”

-Lombard Street By Walter Bagehot, CHAPTER I [my emphasis]

Foreign money pouring in, high leverage and reckless speculation: London circa 1870 or New York circa 2007?

 

“All which a banker wants to pay his creditors is a sufficient supply of the legal tender of the country, no matter what that legal tender may be. Different countries differ in their laws of legal tender, but for the primary purposes of banking these systems are not material. A good system of currency will benefit the country, and a bad system will hurt it. Indirectly, bankers will be benefited or injured with the country in which they live; but practically, and for the purposes of their daily life, they have no need to think, and never do think, on theories of currency. They look at the matter simply. They say ‘I am under an obligation to pay such and such sums of legal currency; how much have I in my till, or have I at once under my command, of that currency?’ In America, for example, it is quite enough for a banker to hold ‘greenbacks,’ though the value of these changes as the Government chooses to enlarge or contract the issue. But a practical New York banker has no need to think of the goodness or badness of this system at all; he need only keep enough ‘greenbacks’ to pay all probable demands, and then he is fairly safe from the risk of failure. “

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

To give the “practical” banks the authority to regulate the currency is pure madness, they have no pain mechanism to stop them before they completely wreck the currency and destroy the whole system. Banks should be kept as far as possible from the currency for their own benefit. Since the Fed (US Federal Reserve) has been in charge of the dollar it lost more than ninety percent of its value, practical indeed.

 

“By the law of England the legal tenders are gold and silver coin (the last for small amounts only), and Bank of England notes. But the number of our attainable bank notes is not, like American ‘greenbacks,’ dependent on the will of the State; it is limited by the provisions of the Act of 1844. That Act separates the Bank of England into two halves. The Issue Department only issues notes, and can only issue 15,000,000 L. on Government securities; for all the rest it must have bullion deposited. Take, for example an account, which may be considered an average specimen of those of the last few years-that for the last week of 1869:

There are here 15,000,000 L. bank notes issued on securities, and 18,288,640 L. represented by bullion. The Bank of England has no power by law to increase the currency in any other manner. It holds the stipulated amount of securities, and for all the rest it must have bullion. This is the ‘cast iron’ system the ‘hard and fast’ line which the opponents of the Act say ruins us, and which the partizans of the Act say saves us. But I have nothing to do with its expediency here. All which is to my purpose is that our paper ‘legal tender,’ our bank notes, can only be obtained in this manner. If, therefore, an English banker retains a sum of Bank of England notes or coin in due proportion to his liabilities, he has a sufficient amount of the legal tender of this country, and he need not think of anything more.”

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

The Issue Department is 54.9% backed by gold, while the Banking Department is 2% backed by gold (Bank of England was a private bank and not a central bank). Bagehot is not exact when he states that “legal tenders are gold and silver coin (the last for small amounts only), and Bank of England notes” because silver was not allowed to trade freely on the market, the exchange rate was set by law, thus a silver coin was just a fraction of a gold coin in another colour, while the notes were partially backed by gold and partially by sovereign credit (limited to £15 million).

 

“The bill brokers lend most of their money, and deposit the remnant either with the Bank of England or some London banker. That London banker lends what he chooses of it, the rest he leaves at the Bank of England. You always come back to the Bank of England at last. But those who keep immense sums with a banker gain a convenience at the expense of a danger. They are liable to lose them if the bank fail. As all other bankers keep their banking reserve at the Bank of England, they are liable to fail if it fails. They are dependent on the management of the Bank of England in a day of difficulty and at a crisis for the spare money they keep to meet that difficulty and crisis. And in this there is certainly considerable risk. Three times ‘Peel’s Act’ has been suspended because the Banking Department was empty.“

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

What do you do when a bank is too big to fail? Break the law!

 

“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 whole liability for such international payments in cash is thrown on the Bank of England. No doubt foreigners cannot take from us our own money; they must send here ‘value in some shape or other for all they take away. But they need not send ‘cash;’ they may send good bills and discount them in Lombard Street and take away any part of the produce, or all the produce, in bullion. It is only putting the same point in other words to say that all exchange operations are centering more and more in London. Formerly for many purposes Paris was a European settling-house, but now it has ceased to be so. The note of the Bank of France has not indeed been depreciated enough to disorder ordinary transactions. But any depreciation, however small-even the liability to depreciation without its reality-is enough to disorder exchange transactions. They are calculated to such an extremity of fineness that the change of a decimal may be fatal, and may turn a profit into a loss. Accordingly London has become the sole great settling-house of exchange transactions in Europe, instead of being formerly one of two. And this pre-eminence London will probably maintain, for it is a natural pre-eminence. The number of mercantile bills drawn upon London incalculably surpasses those drawn on any other European city; London is the place which receives more than any other place, and pays more than any other place, and therefore it is the natural ‘clearing house.’ The pre-eminence of Paris partly arose from a distribution of political power, which is already disturbed; but that of London depends on the regular course of commerce, which is singularly stable and hard to change.”

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

The “natural pre-eminence” of London didn’t stop New York from growing to a contender’s size and after the great war to a leading position and after the second war to a dominant centre, at which time many said that it will “maintain” it because of its “natural” position due to the vast industrial base of the US. Since then the industry has been destroyed and yet the finance trade thrived, clearly the pre-eminence of a financial centre is achieved by any number of factors (in this case colonial plunder, namely the transfer of wealth from India to England) but then it sustains itself by its own steam, until the fire dies out or the engine blows up (see The Magical Engine). Bagehot clearly shows a bias in his analysis; he neither admits the true source of English wealth nor the true reason for continued domination.

 

“In most banks there would be a wholesome dread restraining the desire of the shareholders to reduce the reserve; they would fear to impair the credit of the bank. But fortunately or unfortunately, no one has any fear about the Bank of England. The English world at least believes that it will not, almost that it cannot, fail. Three times since 1844 the Banking Department has received assistance, and would have failed without it. In 1825, the entire concern almost suspended payment; in 1797, it actually did so. But still there is a faith in the Bank, contrary to experience, and despising evidence. No doubt in every one of these years the condition of the Bank, divided or undivided, was in a certain sense most sound; it could ultimately have paid all its creditors all it owed, and returned to its shareholders all their own capital. But ultimate payment is not what the creditors of a bank want; they want present, not postponed, payment; they want to be repaid according to agreement; the contract was that they should be paid on demand, and if they are not paid on demand they may be ruined. And that instant payment, in the years I speak of, the Bank of England certainly could not have made. But no one in London ever dreams of questioning the credit of the Bank, and the Bank never dreams that its own credit is in danger. Somehow everybody feels the Bank is sure to come right. In 1797, when it had scarcely any money left, the Government said not only that it need not pay away what remained, but that it must not. The ‘effect of letters of licence’ to break Peel’s Act has confirmed the popular conviction that the Government is close behind the Bank, and will help it when wanted. Neither the Bank nor the Banking Department have ever had an idea of being put ‘into liquidation;’ most men would think as soon of ‘winding up’ the English nation.“

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

An implicit government backing that becomes explicit in times of stress: The Bank of England bailed by the British government or the GSE’s bailed by the US government? Change the m in million to b and the story is the same.

 

“No country has ever been so exposed as England to a foreign demand on its banking reserve, not only because at present England is a large borrower from foreign nations, but also (and much more) because no nation has ever had a foreign trade of such magnitude, in such varied objects, or so ramified through the world. The ordinary foreign trade of a country requires no cash; the exports on one side balance the imports on the other. But a sudden trade of import like the import of foreign corn after a bad harvestor (what is much less common, though there are cases of it) the cessation of any great export, causes a balance to become due, which must be paid in cash.

Now, the only source from which large sums of cash can be withdrawn in countries where banking is at all developed, is a ‘bank reserve.’ In England especially, except a few sums of no very considerable amount held by bullion dealers in the course of their business, there are no sums worth mentioning in cash out of the banks; an ordinary person could hardly pay a serious sum without going to some bank, even if he spent a month in trying. All persons who wish to pay a large sum in cash trench of necessity on the banking reserve. But then what is ‘cash?’ Within a country the action of a Government can settle the quantity, and therefore the value, of its currency; but outside its own country, no Government can do so. Bullion is the cash’ of international trade; paper currencies are of no use there, and coins pass only as they contain more or less bullion.”

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

Here the US has an advantage on old little England, since 1972 the US has been settling international trade only with “paper” currency. The US hegemony has meant that it can settle all international trade with paper (see Monetary Weapons).

 

“A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them. The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. ‘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.

The problem of managing a panic must not be thought of as mainly a ‘banking’ problem. It is primarily a mercantile one. All merchants are under liabilities; they have bills to meet soon, and they can only pay those bills by discounting bills on other merchants. In other words, all merchants are dependent on borrowing money, and large merchants are dependent on borrowing much money. At the slightest symptom of panic many merchants want to borrow more than usual; they think they will supply themselves with the means of meeting their bills while those means are still forthcoming. If the bankers gratify the merchants, they must lend largely just when they like it least; if they do not gratify them, there is a panic.”

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

The same has been happening in our time as in 1825. The Fed has tried every means and mode to give money to the banks and has been taking securities off their balance sheet and giving them treasuries. Corporations has been tapping their credit lines and putting the cash in the money market funds for less than the inflation rate, so they can have it if they need it.

 

“No doubt all precautions may, in the end, be unavailing. ‘On extraordinary occasions,’ says Ricardo, ‘a general panic may seize the country, when every one becomes desirous of possessing himself of the precious metals as the most convenient mode of realising or concealing his property, against such panic banks have no security or any system.’ The bank or banks which hold the reserve may last a little longer than the others; but if apprehension pass a certain bound, they must perish too. The use of credit is, that it enables debtors to use a certain part of the money their creditors have lent them. If all those creditors demand all that money at once, they cannot have it, for that which their debtors have used, is for the time employed, and not to be obtained. With the advantages of credit we must take the disadvantages too; but to lessen them as much as we can, we must keep a great store of ready money always available, and advance out of it very freely in periods of panic, and in times of incipient alarm.”

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

In the long term all credit systems are doomed to “perish”, gold or no gold.

 

“And great as is the delicacy of such a problem in all countries, it is far greater in England now than it was or is elsewhere. The strain thrown by a panic on the final bank reserve is proportional to the magnitude of a country’s commerce, and to the number and size of the dependent banks-banks, that is, holding no cash reserve that are grouped around the central bank or banks. And in both respects our system causes a stupendous strain. The magnitude of our commerce, and the number and magnitude of the banks which depend on the Bank of England, are undeniable. There are very many more persons under great liabilities than there are, or ever were, anywhere else. At the commencement of every panic, all persons under such liabilities try to supply themselves with the means of meeting those liabilities while they can. This causes a great demand for new loans. And so far from being able to meet it, the bankers who do not keep an extra reserve at that time borrow largely, or do not renew large loans very likely do both.”

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

The Credit Crunch, this paragraph is followed by a description of a credit crunch: liquid assets become illiquid; the lender of last resort has to provide liquidity and take these illiquid assets.

 

“The mode in which the Bank of England meets this great responsibility is very curious. It unquestionably does make enormous advances in every panic”

-Lombard Street By Walter Bagehot, CHAPTER II [my emphasis]

With every new panic the scale of the bailout gets bigger.

 

“I shall have failed in my purpose if I have not proved that the system of entrusting all our reserve to a single board, like that of the Bank directors, is very anomalous; that it is very dangerous; that its bad consequences, though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies.”

-Lombard Street By Walter Bagehot, CHAPTER II

Words of wisdom. Central banking is anomalous, dangerous and the subject is obscured and hidden from public debate, things haven’t improved since (I recommend reading Henry C. K. Liu’s Critique of Central Banking for a general overview).