Lombard Street: A Description of the Money Market
By Walter Bagehot
by Lauren Landsburg
When I was a graduate student in international monetary theory, my adviser and others occasionally suggested that I read Walter Bagehot some time. Because I was a graduate student, I doubted that any writer on “institutions” from the 1800s could be worth my time, so of course I didn’t even look the book up. My mistake!
When Walter Bagehot wrote Lombard Street: A Description of the Money Market, in 1873, he did the unthinkable: In language as fresh and clear today as it was over 100 years ago, he respectfully dissected the Bank of England’s foundations, economic incentives, goals, and functions. In the process, he illuminated in a mere few hundred brilliant pages what distinguishes a Central Bank from a commercial bank, both on a daily basis and during crises such as bank panics and recessions. The constitutions of most national Central Banks were reinvented and forever changed as a consequence. The U.S. Federal Reserve, founded in late 1913, and the Central Bank of Central Banks—the International Monetary Fund (IMF)—have ever since been influenced by the enduring independent thought and extraordinary clarity provided by Bagehot in this famous book.
Bagehot’s book was so readable and so remarkable that it was re-issued three times within a year, and was republished in many editions both during his lifetime and afterwards.
Our choice at Econlib, after studying several editions, is to provide the main text the way it was at the end of 1873 (in Bagehot’s third edition, printed within the first year of publication). In doing so, we hope we have caught any errors Bagehot himself may have noticed, while preserving the original language and authoritative care taken in the various quotations.
But: We are also adding some footnotes and a second Appendix provided later (that is, after Bagehot’s death in 1877): specifically, material from the 12th Edition (1906) and from the 14th Edition (1915). We believe that these later additions reflect the historical influence and popularity of this book during a period of time when the incipient Federal Reserve and other international Central Banks were founded and were, during their emergence, greatly influenced by it. The later footnotes are marked according to their editions. We have also included various prefaces, introductions, and Bagehot’s own “Advertisement,” to editions through the 14th, which explain who wrote which of the additions: E. Johnstone, A. W. Wright, and Hartley Withers all contributed.
We have preserved intact all of Bagehot’s original spellings, capitalization, and punctuation from the third edition, with the minor alteration that in a few cases we’ve indented long quotations from other sources for the sake of visual clarity. We’ve also preserved the punctuation and spelling of the additional material from later editions; thus, the observant reader will notice that punctuation differs in style in footnotes from later editions.
Editor, Library of Economics and Liberty
E. Johnstone; Hartley Withers, eds.
First Pub. Date
London: Henry S. King and Co.
Includes editorial notes and appendices from the 12th (1906) and the 14th (1915) editions.
The text of this edition is in the public domain. Picture of Walter Bagehot courtesy of The Warren J. Samuels Portrait Collection at Duke University.
- Introductions, by Hartley Withers
- Chapter II, A General View of Lombard Street
- Chapter III, How Lombard Street Came to Exist
- Chapter IV, The Position of the Chancellor of the Exchequer in the Money Market
- Chapter V, The Mode in Which the Value of Money is Settled in Lombard Street
- Chapter VI, Why Lombard Street Is Often Very Dull, and Sometimes Extremely Excited
- Chapter VII, A More Exact Account of the Mode in Which the Bank of England Has Discharged Its Duty of Retaining a Good Bank Reserve
- Chapter VIII, The Government of the Bank of England
- Chapter IX, The Joint Stock Banks
- Chapter X, The Private Banks
- Chapter XI, The Bill-Brokers
- Chapter XII, The Principles Which Should Regulate the Amount of Banking Reserve
- Chapter XIII, Conclusion
- Appendix I
- Appendix II
The Mode in Which the Value of Money is Settled in Lombard Street
Many persons believe that the Bank of England has some peculiar power of fixing the value of money. They see that the Bank of England varies its minimum rate of discount from time to time, and that, more or less, all other banks follow its lead, and charge much as it charges; and they are puzzled why this should be. ‘Money,’ as economists teach, ‘is a commodity, and only a commodity;’ why then, it is asked, is its value fixed in so odd a way, and not the way in which the value of all other commodities is fixed?
There is at bottom, however, no difficulty in the matter. The value of money is settled, like that of all other commodities, by supply and demand, and only the form is essentially different. In other commodities all the large dealers fix their own price; they try to underbid one another, and that keeps down the price; they try to get as much as they can out of the buyer, and that keeps up the price. Between the two what Adam Smith calls the higgling of the market settles it. And this is the most simple and natural mode of doing business, but it is not the only mode. If circumstances make it convenient another may be adopted. A single large holder—especially if he be by far the greatest holder—may fix his price, and other dealers may say whether or not they will undersell him, or whether or not they will ask more than he does. A very considerable holder of an article may, for a time, vitally affect its value if he lay down the minimum price which he will take, and obstinately adhere to it. This is the way in which the value of money in Lombard Street is settled. The Bank of England used to be a predominant, and is still a most important, dealer in money. It lays down the least price at which alone it will dispose of its stock,
*27 and this, for the most part, enables other dealers to obtain that price, or something near it.
The reason is obvious. At all ordinary moments there is not money enough in Lombard Street to discount all the bills in Lombard Street without taking some money from the Bank of England. As soon as the Bank rate is fixed, a great many persons who have bills to discount try how much cheaper than the Bank they can get these bills discounted. But they seldom can get them discounted very much cheaper, for if they did everyone would leave the Bank, and the outer market would have more bills than it could bear.
In practice, when the Bank finds this process beginning, and sees that its business is much diminishing, it lowers the rate, so as to secure a reasonable portion of the business to itself, and to keep a fair part of its deposits employed. At Dutch auctions an upset or
maximum price used to be fixed by the seller, and he came down in his bidding till he found a buyer. The value of money is fixed in Lombard Street in much the same way, only that the upset price is not that of all sellers, but that of one very important seller, some part of whose supply is essential.
The notion that the Bank of England has a control over the Money Market, and can fix the rate of discount as it likes, has survived from the old days before 1844, when the Bank could issue as many notes as it liked. But even then the notion was a mistake. A bank with a monopoly of note issue has great sudden power in the Money Market, but no permanent power: it can affect the rate of discount at any particular moment, but it cannot affect the average rate. And the reason is, that any momentary fall in money, caused by the caprice of such a bank, of itself tends to create an immediate and equal
rise, so that upon an average the value is not altered.
What happens is this. If a bank with a monopoly of note issue suddenly lends (suppose) 2,000,000
l. more than usual, it causes a proportionate increase of trade and increase of prices. The persons to whom that 2,000,000
l. was lent, did not borrow it to lock it up; they borrow it, in the language of the market, to ‘operate with’—that is, they try to buy with it; and that new attempt to buy—that new demand—raises prices. And this rise of prices has three consequences. First. It makes everybody else want to borrow money. Money is not so efficient in buying as it was, and therefore operators require more money for the same dealings. If railway stock is 10 per cent. dearer this year than last, a speculator who borrows money to enable him to deal must borrow 10 per cent. more this year than last, and in consequence there is an augmented demand for loans. Secondly. This is an
effectual demand, for the increased price of railway stock enables those who wish it to borrow more upon it. The common practice is to lend a certain portion of the market value of such securities, and if that value increases, the amount of the usual loan to be obtained on them increases too. In this way, therefore, any artificial reduction in the value of money causes a new augmentation of the demand for money, and thus restores that value to its natural level. In all business this is well known by experience: a stimulated market soon becomes a tight market, for so sanguine are enterprising men, that as soon as they get any unusual ease they always fancy that the relaxation is greater than it is, and speculate till they want more than they can obtain.
In these two ways sudden loans by an issuer of notes, though they may temporarily lower the value of money, do not lower it permanently, because they generate their own counteraction. And this they do whether the notes issued are convertible into coin or not. During the period of Bank restriction, from 1797 to 1819, the Bank of England could not absolutely control the Money Market, any more than it could after 1819, when it was compelled to pay its notes in coin. But in the case of convertible notes there is a
third effect, which works in the same direction, and works more quickly. A rise of prices, confined to one country, tends to increase imports, because other countries can obtain more for their goods if they send them there, and it discourages exports, because a merchant who would have gained a profit before the rise by buying here to sell again will not gain so much, if any, profit after that rise. By this augmentation of imports the indebtedness of this country is augmented, and by this diminution of exports the proportion of that indebtedness which is paid in the usual way is decreased also. In consequence, there is a larger balance to be paid in bullion; the store in the bank or banks keeping the reserve is diminished, and the rate of interest must be raised by them to stay the efflux. And the tightness so produced is often greater than, and always equal to, the preceding unnatural laxity.
There is, therefore, no ground for believing, as is so common, that the value of money is settled by different causes than those which affect the value of other commodities, or that the Bank of England has any despotism in that matter. It has the power of a large holder of money, and no more. Even formerly, when its monetary powers were greater and its rivals weaker, it had no absolute control. It was simply a large corporate dealer, making bids and much influencing—though in no sense compelling—other dealers thereby.
But though the value of money is not settled in an exceptional way, there is nevertheless a peculiarity about it, as there is about many articles. It is a commodity subject to great fluctuations of value, and those fluctuations are easily produced by a slight excess or a slight deficiency of quantity. Up to a certain point money is a necessity. If a merchant has acceptances to meet to-morrow, money he must and will find today at some price or other. And it is this urgent need of the whole body of merchants which runs up the value of money so wildly and to such a height in a great panic. On the other hand, money easily becomes a ‘drug,’ as the phrase is, and there is soon too much of it. The number of accepted securities is limited, and cannot be rapidly increased; if the amount of money seeking these accepted securities is more than can be lent on them the value of money soon goes down. You may often hear in the market that bills are not to be had,—meaning good bills of course,—and when you hear this you may be sure that the value of money is very low.
If money were all held by the owners of it, or by banks which did not pay an interest for it, the value of money might not fall so fast. Money would, in the market phrase, be ‘well held.’ The possessors would be under no necessity to employ it all; they might employ part at a high rate rather than all at a low rate. But in Lombard Street money is very largely held by those who
do pay an interest for it, and such persons must employ it all, or almost all, for they have much to pay out with one hand, and unless they receive much with the other they will be ruined. Such persons do not so much care what is the rate of interest at which they employ their money: they can reduce the interest they pay in proportion to that which they can make. The vital point to them is to employ it at
some rate. If you hold (as in Lombard Street some persons do) millions of other people’s money at interest, arithmetic teaches that you will soon be ruined if you make nothing of it even if the interest you pay is not high.
The fluctuations in the value of money are therefore greater than those on the value of most other commodities. At times there is an excessive pressure to borrow it, and at times an excessive pressure to lend it, and so the price is forced up and down.
These considerations enable us to estimate the responsibility which is thrown on the Bank of England by our system, and by every system on the bank or banks who by it keep the reserve of bullion or of legal tender exchangeable for bullion. These banks can in no degree control the permanent value of money, but they can completely control its momentary value. They cannot change the average value, but they can determine the deviations from the average. If the dominant banks manage ill, the rate of interest will at one time be excessively high, and at another time excessively low: there will be first a pernicious excitement, and next a fatal collapse. But if they manage well, the rate of interest will not deviate so much from the average rate; it will neither ascend so high nor descend so low. As far as anything can be steady the value of money will then be steady, and probably in consequence trade will be steady too—at least a principal cause of periodical disturbance will have been withdrawn from it.