III. The “Palmer Rule”

In 1827 the Bank of England adopted a rule—later commonly known as the “Palmer rule” or the “rule of 1832” because it was first publicly explained, in 1832, by the then governor of the Bank, J. Horsley Palmer—which aimed at making the fluctuations in the English currency conform with those which would occur under a purely metallic currency by keeping its security holdings, including discounted paper, constant. At the same time, although apparently wholly independently, Pennington, a confidential adviser of the Treasury on currency matters, had recommended the same rule in a memorandum to Huskisson, then Chancellor of the Exchequer. The problem as Pennington saw it was to make the paper currency operate as would a “purely metallic currency”: “The great objection to a paper currency arises from the extreme difficulty of subjecting its expansion and contraction to the same law as that which regulates the expansion and contraction of a currency purely metallic.” He offered as a solution that the Bank of England should be given an exclusive monopoly of note issue (or direct control over the issues of the other banks) and should hold a fixed amount of securities. There could then be no variations in its outstanding note circulation without corresponding variations in its holdings of bullion:

Nothing more would be necessary than that the bank should constantly hold a fixed amount of the same unvarying species of securities. If its outstanding liabilities amounted, at any particular time, to £26,000,000, and if, against these, it held £18,000,000 of government securities and £8,000,000 of bullion, then, by confining itself to the £18,000,000 of securities, the action of the foreign exchange would necessarily turn upon the gold: at one time the bank might have six, at another time ten, and at another eight millions of treasure; and in all cases, its paper would contract and expand according to the increase or diminution of its bullion.

The Palmer rule was essentially the same. When the exchanges were at par and the currency “full,” the Bank should try to have a bullion reserve of one-third of its combined note and deposit liabilities, so that its current assets should be one-third bullion and two-thirds securities. Thereafter all that would be required would be to maintain the securities at a constant amount. An influx of gold from abroad would thus act to increase the note circulation by a corresponding amount; an efflux of gold or a demand for coin for internal circulation would result in a corresponding decrease in note circulation. The internal circulation, specie plus paper, would thus remain constant unless acted upon by external gold movements.

This rule had the fatal defect that it took no account of the necessity of also maintaining deposits constant if the maintenance of securities at a constant amount was to guarantee correspondence between the fluctuations in bullion and the fluctuations in note circulation. If the deposits were permitted to fluctuate, then as the bullion holdings fluctuated the note circulation might remain constant, or might fluctuate in the reverse direction. Under an inconvertible paper currency, a case could be made for the general policy of keeping the securities constant, if departure from this rule to offset variations in the velocity of circulation of notes and deposits were permitted, and if provision were made for adjustment of the amount of securities to the secular trend of production resulting from growth of population and capital. But under an international metallic standard, adherence to the rule of keeping the securities constant could lead to serious and lasting disequilibrium between the internal and the world price levels, and therefore to exhaustion or to indefinite accumulation of gold reserves.

It is not easy to understand Pennington's original position in this connection. The objective of control stated by him seems to involve an unqualified acceptance of the currency principle. But the method of control which he advocated, like the Palmer rule, would have made the fluctuations in notes plus deposits correspond with the fluctuations in specie reserves, whereas the currency principle called for correspondence between the fluctuations in notes alone and the fluctuations in specie reserves. It especially seems to call for explanation that Pennington, who was an important factor in drawing attention to the importance of deposits as a means of payment, should have advocated a rule which would permit of withdrawal through the deposits of all the specie reserves without calling for any positive corrective action on the part of the Bank. When Pennington later, in 1840, published his memorandum, his views had apparently undergone some modification. He now made it appear that by a “purely metallic currency” he had meant one which consisted only of specie, and that by “paper circulation” he had meant notes and deposits. This would bring his rule of control into conformity with his objective. Against the currency principle proper he protested that it would make the fluctuations in the currency (= notes and deposits) exceed the fluctuations which would occur under a simple specie currency, with the result that “the public will be exposed to very great alternations of comparative ease and difficulty in the operations of the money market.” What he now supported, apparently, was a provisional adherence to the Palmer rule, which would limit the fluctuations in notes and deposits to the fluctuations in specie reserves, with departure from it in the form of open-market sales of securities only when otherwise dangerous depletion of the specie reserves would occur.

As was to be expected, the affairs of the Bank went badly while the Palmer rule was in operation. From 1836 to 1839 in particular, while the rule was presumably being followed, the Bank was in serious difficulties much of the time. The Bank found at times that gold was being withdrawn for export through the deposits without any compensating reduction in the note circulation. It also found itself unable—or unwilling—to keep its securities constant, and it even increased its securities while a drain of gold was under way. Its difficulties were due in part to misguided violations of its own rule, but in part they were due also to the utter impracticability of the rule under a metallic reserve currency whenever greater contraction of the currency (notes and deposits) should be requisite than the rule of keeping the securities constant would permit.

Torrens and Overstone were critical of the Palmer rule, although they held that the departures from it had been such as to accentuate rather than moderate its shortcomings. They pointed out that if the currency principle were to be carried out, gold movements should not be permitted to operate on the deposits alone. When the Bank found that its gold reserves were being drawn out through its deposits, it should have reduced its note circulation by “forcible operation on its securities,” i.e., by deliberate contraction of its discounts or by sale of government securities in the open market. They held that maintenance of securities at a constant amount, instead of enforcing correspondence between the fluctuations in the amounts of bullion holdings and of note circulation, prevented the Bank from establishing such correspondence.

According to Torrens and to Overstone, the error in the Palmer rule was that it aimed at keeping the whole of the Bank securities constant, including those upon which “the Bank lent its deposits,” and that it permitted gold flows to act on the whole of the liabilities, including the deposits. The Bank, on the contrary, should keep constant only those securities upon which it put out its notes, i.e., should keep constant the amount of its uncovered note circulation. Only then would variations in the Bank's note circulation necessarily correspond with the variations in its bullion holdings. To enforce this procedure on the Bank, and to make certain that the securities held as backing for the notes should be segregated from those held as backing for the deposits, the banking and issue departments of the Bank should be formally separated, and the latter should be confined to the exchange of notes for bullion and of bullion for notes, pound for pound, except for a fixed maximum of notes to be covered by securities. The currency school undoubtedly wanted the note issue powers of the country banks to be withdrawn, or at least drastically restricted, but they did not enlarge upon this phase of the question, as a precaution, perhaps, against providing further stimulus to the already vigorous opposition of the country bankers to the currency school proposals.