CHAPTER VIII

THE METAMORPHOSIS OF THE FUND

This is because of the character of legal tender currency, and a legal tender currency, however desirable and however great its merits, must necessarily have its shortcomings in a progressive state.

The loanable fund is restricted, or controlled, not by the growth of the country’s wealth, but by the production of gold. To control it by so artificial and arbitrary a circumstance as the output of gold may seem absurd, and from a strictly logical and economic standpoint it is absurd. The loanable fund ought to be governed entirely by the production of wealth, and not by something entirely independent of wealth and having no natural or economic connection with it.

I am now speaking of the loanable fund which collects in the joint stock banks. Of the other loanable fund, which collects in the Bank of England, I will speak later.

What the banks lend is liquid wealth, but the amount they can lend at any given moment is governed less by the amount of wealth that is brought to them than by the amount of gold they possess. This is the gold which, we say, constitutes their reserves.

Let us assume that it is the custom of the banks to keep a gold, or, rather, a legal tender reserve--it is chiefly composed of Bank of England notes--equal to fifteen per cent. of their combined pure and loan deposits. It follows that the growth of these deposits must be controlled by this fifteen per cent. reserve. This is so in practice. When the reserve begins to fall below this fifteen per cent., then the banks cease liquefying wealth and increasing the loan fund. When the reserve increases beyond the fifteen per cent., then the banks continue to liquefy the wealth.

It is then said that money--some say credit--is abundant, and the banks cannot find full employment for it. When the reserve falls it is said that money--or credit--is becoming scarce. We find, therefore, that the loan-fund actually contracts when trade is active, and expands when trade is depressed. In the economic interests of the nation the fund should grow simultaneously with and commensurately with the growth of trade and commerce.

In times of activity more wealth is created. It is like an abundant harvest resulting from a favourable season. In times of inactivity less wealth is created, to be likened to bad seasons and poor harvests. In times of activity there is necessarily and inevitably a greater demand for capital, that is to say, for more liquefied wealth. Bills of discount multiply, and they are taken to the banks as security for loans, in other words, to be converted into liquid form. Another phrase is, into floating capital. If they could not be so converted, the needs of the community in such times could not be met, for the bills of discount could not be used as currency, or capital, like cheques. They are discounted at the banks in order that they may be transformed into cheques, the representatives of floating or circulating capital. In this form they are able to reproduce wealth more rapidly than if they had to remain in their original form.

So it is with other forms of wealth, all are taken to the banks to be converted into quickly reproductive shape.

But the banks have to keep an eye on that gold reserve, watch it closely. Managers have to calculate when the limit of their conversion powers will be reached, and when it is reached their wealth-liquefying machinery has for the time being to cease working. It does not follow that when the machinery of one bank has to stop, the machinery of all the banks simultaneously stops. The limit may not yet have been reached in other banks. Borrowers, as they are called, then rush to them, and as the numbers grow and the pressure increases, so is the limit of the other banks more speedily reached, until at last the entire machinery comes to a stop. It often comes to a stop when in the interests of the economic welfare of the nation it should be working most actively.

But the machinery is controlled by another independent agency, and the economic interests of the nation must suffer the effects of this obtrusive force.

If this independent force be at times harmful and not beneficial to the economic welfare and progress of the nation, what is to be said of the cry that this force, in the most urgent times, should be made more interfering and harmful? What is to be said of the cry that at the moment when the need is greatest then the succour should be restricted?

What should we say of the doctor who by ligatures prevented the free flow of blood in the body of an active, energetic man, in order to paralyse his energies and enforce rest? We should say that he was not only an unscientific doctor, ignorant of the functions of the bodily organism, but that he was actually killing his patient. These gold reserves, therefore, act like ligatures, for they stop the free and health-giving flow of economic blood at the very moment when the flow should be stimulated.

In inactive times we see the metamorphosis of the fund take place. The loan deposits decrease, because the liquefied wealth becomes frozen again and the production of wealth decreases, while the pure deposits grow. The fact that the loan deposits decrease simultaneously with the contraction of wealth production is an additional proof that the loanable fund is wealth in liquid form. As the wealth in fixed form is withdrawn from the bank so the loan deposits drop.

Now the increased pure deposits may be regarded as a portion of the harvests gathered from the fructifying use of the liquid capital in times of activity. They are called the profits, or the savings of capital. They accumulate in times of depression. For lack of other employment they are placed on deposit with the banks. They are, in a way, loaned to the banks, and the banks are supposed to lend this money to the classes of borrowers already described. But the banks at these times benefit, or are presumed to benefit, not because the aggregate of the deposits grow enormously compared with other periods, but because these pure deposits bring them more gold. The loan deposits take gold, the pure deposits bring gold.

This is why, the aggregate being the same, or even less, the potential loanable fund is greater in inactive than in active times of trade. The gold reserves increase and the proportion of the reserves to the aggregate deposits rises. When this proportion rises, the banks say they can afford to let it fall, and therefore they can liquefy more wealth if there were more wealth to liquefy. But there is less wealth to liquefy, and therefore money is now said to be abundant and cheap. The banks are willing to take less interest, that is to say, a smaller share of the profits earned by liquefied capital.

But depositors also have to take a smaller share of these profits. The banks divide their smaller share of the profits with the pure depositors, and, therefore, can give only a smaller rate of interest on the deposits. Dissatisfied with this small rate of interest, depositors seek for other channels of use, other forms of investment, and when they find these other channels, they withdraw their deposits and reconvert them into fixed or frozen capital. They may speculate with them in mining or rubber shares, or invest them in Consols or War Loans. When this is done, gold is automatically withdrawn from the banks and the proportion may drop. Should the proportion drop, banks can lend less, and the potential resources for liquefying capital becoming less, they can begin to charge more for these services.

When the pure deposits increase the reserve of gold automatically increases. Therefore, though the risks of the banks increase, because the liabilities on demand increase, so the power to meet those risks automatically increases. This being so, the necessity for increasing gold reserves is less apparent; for they increase automatically. When the pure deposits decrease and the loan deposits increase the proportion falls, but it falls at a time when the risks are lessened if set against the pure deposits as distinct from the loans owing to the bank.

It will be seen, therefore, owing to the constantly fluctuating character of a bank’s liabilities, or risks, it is impossible to maintain a fixed, undeviating reserve, whether it be a high reserve or a low reserve. And we know that this impossibility is demonstrated every day in Lombard Street.

It is demonstrated at the end of each month, when the banks cease lending, and when they compel their loan depositors to pay in their loans. This is proof that a proportion of the deposits are loans to the bank. As these loan deposits thereby contract, banks cannot compel the pure depositors to withdraw their deposits, therefore the proportion of the gold reserve to the _whole_ rises, and the wish of those who clamour for high reserves is fulfilled.

This policy is resorted to because an idea exists amongst bankers that, instead of going to theatres and other places of amusement, the public, as a body, spends its leisure time during the closing days of each month working out the proportion of the reserves to the total deposits. This is a fantastic dream. The public does nothing of the kind. It is fallacious to imagine the public working out the proportions minutely and then deciding in strictly mathematical fashion whether a bank is safe or not, and whether there is likely to be an immediate run upon it or not. If bankers and theoretical financiers were only gifted with the power to understand human psychology there would be less contention amongst them on questions of pure theory. They would not magnify the unimportant at the expense of the important functions of banking, and magnify the superficial at the expense of the deep traits of British character.

We see the same policy adopted at the end of each half-year, or year, when the banks make up their half-yearly or yearly balance sheets. Such a great deal has been made of this high reserve need--as though it were possible for any mortal being to draw up an absolute line of safety--that at these periods trade is penalized because bankers imagine that the millions of this nation are auditing their accounts. They see them poring over these accounts in the great castles of the realm, and in the cottages of the poor. It is a pure delusion, and if the millions engaged themselves voluntarily in these uncongenial tasks, the result would only be national confusion, and not national agreement. There can be national agreement on one thing connected with the banking system, and one thing only, alike in the mansion and in the cottage, and that is agreement upon the honesty and soundness of that system. And honesty and soundness are not to be tested solely by the bulk of the legal tender reserves.

The only members of the community who, perhaps, might be more concerned than others about these reserves are the very members who share the responsibility equally with the banks. They are those who borrow from the banks, who get their liquid capital there. All they have to do is to cease borrowing, cease converting their wealth into currency, and the thing is done. The remedy is in their hands.

Do they do this? No. Do they show this feverish concern? No. What do they do? These men, who have more at stake than the other millions, actually growl when the banks refuse to liquefy their wealth. They make it a grievance, and a sore grievance. To imagine, therefore, that these growlers are watching minutely the movements in the reserve is a delusion verging near to absurdity.

When some bank managers tell borrowers they must repay their loans, then they rush round to other bank managers, caring not a fig about reserves so long as they can get the accommodation they want, for their needs are above all other considerations. And when they find that no bank manager will serve them, and when all bank managers tell them they are sold out, then they have to go to the Bank of England. They do not like to go to the Bank of England, because they have to pay more for the services that Bank renders. That is to say, they have to share with the Bank of England a larger portion of the profits they make than the portion they would divide with the joint stock banks.

By this analysis we see that the deposits of a bank, the so-called loanable fund, consists of pure deposits, which we may call cash deposits, and loan-deposits, which those who believe in credit creation call credit deposits. These latter deposits represent the wealth placed with the bank, and so long as this wealth is in liquid form in these deposits it cannot be employed in its fixed form. These deposits are loans owing by the bank and owing to the bank. Others call them credit deposits created by the banks themselves.

These loans are made in relation to the proportion each bank is in the habit of maintaining between its cash, or legal tender reserves, and the deposits as a whole. The loan deposits increase or decrease according as this proportion rises or falls.

It is left to the discretion of each bank to decide what the proportion shall be. There is no legal compulsion. Therefore it is their practice to retain the minimum ratio which they consider sufficient for their safety. When this safety limit is passed, then they stop lending and proceed to call in their loans. The totality of the deposits automatically diminishes, and though not a sovereign has been added to the reserve, the proportion rises.

This, then, is the important point. Not so much the amount of the reserve, as the proportion. One bank may have fifty millions in its reserve, and another bank only fifteen. But the smaller bank may have a higher proportion to its liabilities and the larger bank a smaller proportion. The test, therefore, if there must be a test, is the proportion of the reserve to the total liabilities, and with this I shall deal more fully later on.