VIII. The Relation Between Bank of England Operations and Specie Movements

The Bank of England did not itself engage directly in import or export transactions in bullion or specie. It was obligated, however, to give specie upon demand in exchange for its own notes, and as a part of its regular routine it also upon demand gave notes in exchange for specie, cashed its depositors' checks in specie, and bought gold bullion of standard fineness at the fixed price of £3.17.9 per ounce. In addition, the Bank operated its bullion department on ordinary commercial principles, buying and selling silver bullion and gold bullion of other than the standard fineness at the prevailing market prices. Periods of business expansion were also as a rule periods of expansion of Bank note circulation, of increased indebtedness to the Bank of private bankers and other clients, and of decline in the Bank's specie reserves. As long as the Bank of England would freely discount, a credit expansion could go on indefinitely, without a rise in the rate of interest or depletion of the cash reserves of private banks. A credit expansion, if peculiar to England, or relatively more marked there than abroad, would operate to stimulate imports and, through increased domestic absorption of supplies, to check exports, and would thus tend to create an unfavorable balance of payments. Even a credit expansion in which England was lagging behind the rest of the world might deplete specie reserves in England if it resulted in a substantial internal drain of gold to satisfy the demand for increased hand-to-hand specie circulation. The role of the Bank of England under such circumstances, whether she acted to protect her own specie reserves or to control the credit situation, was to check such credit expansion before it had reached a dangerous level. We are here concerned with the contemporary views as to the mechanism whereby the Bank of England could influence the flow of specie into and out of the country and thus into and out of her own coffers.

It was common doctrine that the market rate of interest influenced the flow of specie, a high rate operating to attract specie and a low rate to force it out, and that the Bank of England could regulate the flow of specie through its power over the market rate of interest. It was taken for granted that normally there were no idle funds outside the Bank of England, and that any reduction by the Bank of England of the volume of credit it had outstanding, whether accomplished through raising its discount rate, rationing, sales of securities in the open market, or borrowing from the market, would, other things being equal, force a rise in the market rate of interest. It was pointed out, however, that at times the market was sufficiently independent of the Bank to make the Bank's discount rate ineffective as a controlling factor unless supported by open-market sales and, in extreme cases, by borrowing from the market. On the other hand, there was recognition of the possibility that increases in the Bank rate might act as a deflationary factor not only directly through their influence on the volume of advances to the Bank's own customers, but also indirectly through their psychological influence on the market judgment as to business prospects and therefore on the willingness of private bankers to lend and of businessmen to borrow and on the velocity of circulation.

Most of the discussions of the role of the interest rate referred only to short-run disturbances, including periodic business fluctuations, or “cycles,” and the changes in interest rates were related to specie movements mainly in terms of their influence on the international movement of short-term funds, and their influence on relative prices was commonly held to be too slow-working to be an important factor in restoring international equilibrium. Most emphasis was put on the international mobility of funds devoted to investment in securities, in response to relative changes in the market rates of interest in London and abroad, but many other ways in which a relative rise of the English interest rate could attract short-term funds from abroad or check their flow to abroad were noted.

Most of the writers of the period conceded the efficacy of the Bank discount rate, if employed skillfully and forcibly enough, as a regulator of specie movements through its influence on the international movement of short-term funds and, to a less extent, on the commodity trade balance. A skeptical note, however, was struck occasionally in the literature. It was pointed out that in so far as the movement of short-term funds was concerned what mattered was only the relative height of market rates of interest in London and abroad, and that rates were likely to rise and fall simultaneously in the important money markets. It was later claimed, moreover, that the foreign central banks, and especially the Banque de France, for a time during this period systematically followed the practice of meeting increases in the English discount rate by increases in their own rates in order to protect their reserves. A rise in the discount rate, moreover, might be interpreted as a signal of impending financial stress and thus instead of attracting funds to England might frighten them away. One writer, otherwise favorable to its use, regarded it as a defect of the discount rate as a regulator of specie flows that it operated to check exports, presumably by making it more costly or more difficult to finance them. Finally, the opponents of a metallic standard or of central bank control thereof tended either to deny in general terms the efficacy of the discount rate as a regulator of specie movements, or to deny any need of such control given the existence of a self-regulating mechanism, or to claim that the regulation, whether effective or not in protecting specie reserves, was costly to internal prosperity when it involved increase in the discount rate and contraction of credit, or to find still other objections to it.