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We are continuing our look at the Bank of England during the
"Classical gold standard" years, especially 1844-1913.
March
24, 2013: The Bank of England, 1720-1913
April
14, 2013: The Bank of England, 1844-1913
April
28, 2013: The Bank of England, 1844-1913 2: The Banking Department
Today, we will look at some of the BoE's daily operations, in
particular the evolution of its balance sheet on a weekly basis
during the years 1904 and 1905, a relatively placid time.
The Bank was divided into an Issue Department, which handled
banknotes, and a Banking Department, which handled deposits. Thus,
the two components of what we recognize today as "base money" were
split between the departments.
The Issue Department apparently had a rather simple system. It would
either take gold and deliver banknotes, or take banknotes and
deliver gold, at the parity price of £3 17s 10.5d per ounce of gold.
This is basically a currency-board type operation. However, the
Issue Department did not hold gold exclusively as assets. Government
debt and other securities (corporate and perhaps foreign sovereign
debt) were a significant part of its assets. There were no changes
in either during this two-year period. Over the longer term,
government debt holdings remained stable while other securities rose
from time to time. The Issue Department's management had some
discretion over the composition of its assets. As gold bullion
holdings grew due to the gradual increase over years of banknotes in
circulation, they would occasionally trade some non-interest-bearing
gold bullion for some interest-bearing bonds.
We see some definite seasonal patterns, with a decline in banknotes
outstanding toward the end of the year and a rise afterward.
The liabilities of the Banking Department were mostly deposits, both
public (government) and private (mostly other banks, i.e. "bank
reserves").
On the Asset side, the Banking Department had government bonds,
other securities (corporate and foreign sovereign bonds), and notes
(I believe these were loans). There was a little bit of gold
bullion, but not much.
We combine banknotes outstanding and bank reserves (deposits at the
BoE) to produce base money. About 50% of base money consisted of
banknotes and 50% was deposits. Base money was highly variable from
week to week. What produced these variations? Obviously, it was a
combination of both the activities of the Issue Department and the
Banking Department. The Issue Department mostly worked on an
automatic currency-board system as described. The Banking Department
had a much more discretionary operating pattern, although one that
nevertheless coincided with the overall operating framework of a
gold standard system.
To simplify:
A "private market participant" (i.e. member of the general public)
could go to the Issue Department and ask to trade bullion and
banknotes. The initiation of the transaction, or the discretionary
element, is wholly on the side of the PMP. That is what I mean by
"automatic": nobody in the Issue Department has to make any
decisions on a day-to-day basis. They just react to the private
market. (The Issue Department did make decisions about the
composition of assets, however, between bonds and bullion.)
A "private market participant" could go to the Banking Department
and ask to borrow money at the Discount Rate. The Banking Department
could choose whether to lend the money or not, the terms and so
forth. The initiation of the transaction, or the discretionary
element, was shared between the borrower and the lender.
However, no "private market participant" could go to the Banking
Department and demand that the Banking Department buy or sell
government or other bonds. The initiation of the transaction, or the
discretionary element, was solely on the side of the Banking
Department.
January
...
29, 2012: Gold Standard Technical Operating Discussions 3:
Automaticity Vs. Discretion
By "discretionary" I don't mean in the manner of floating fiat
currencies today, where policy boards just make stuff up as they go
along. The Banking Department still adhered to the operating
principles of the fixed-parity-value gold standard system. For
example, if the pound's value was a little high compared to other
gold-linked foreign currencies, or compared to gold bullion, the
Banking Department would purchase bonds, thus increasing the
monetary base and depressing the value of the pound. If the pound's
value was a little low compared to other gold-linked currencies or
gold bullion, the Banking Department would sell corporate or
government bonds, thus shrinking the monetary base. Despite the use
of the Discount Rate, they did not try to "manage interest rates" in
the manner of Keynesian floating fiat policy boards today. Their
policy target was the stable value of the pound vs. gold. However,
they had a little discretion as to how this would be accomplished.
If they goofed for some reason, and the pound's value deviated from
its official parity by a larger degree, people could still go to the
Issue Department and trade their pounds for gold, or vice versa. So,
there was a safety system in place in case the Banking Department
managers messed up. That is why John Stuart Mill always recommended
that convertibility (the ability to trade banknotes and bullion at
the Issue Department) was an essential part of a gold standard
system, for political reasons if not necessarily technical ones.
target="_blank" January
27, 2013: John Stuart Mill on an Inconvertible Paper Currency
The Banking Department could also adjust its deposits (and thus the
monetary base) via changes in its aggregate lending (i.e. "notes").
This reduction in lending could take place on a loan-by-loan basis
-- loans would simply be refused or not rolled over -- or it could
take place accompanied by an adjustment in the Discount Rate, which
was the Banking Department's official lending rate. If the Discount
Rate was higher than other competing commercial banks, then people
would tend not to borrow from the Bank of England, and existing
lending would naturally mature and be paid back (most of this
lending was likely short-term in nature). If the Discount Rate was
lower than competing commercial banks, people would tend to borrow
from the Bank of England and lending would expand.
As we can see, most of the short-term variation in base money came
from the Banking Department's open-market operations.
As might be expected, changes in lending are somewhat smooth and
slow-moving. The loan book either expands or contracts bit-by-bit,
as individual loans are either made or mature. However, it was easy
to change the monetary base more quickly with open market operations
in government and other types of bonds. This is one reason why the
BoE, by this time, had transitioned mostly to open-market operations
as a way of managing the monetary base. It was quicker and more
direct, especially for the short term. Also, the Bank of England
probably didn't want to jigger its Discount Rate too often. During
this time period, the Discount Rate looked like this:
When the Banking Department sold a bond, or when one of its loans
matured, the buyer would of course have to make a payment to the
Bank of England. The Bank of England would accept only two means of
payment: either banknotes, or deposits at the BoE. The deposits
would likely be held by some other British commercial bank. Thus, if
you were a private buyer of a bond the BoE was selling, you would
ask your commercial bank to pay the BoE. The commercial bank would
have a deposit at the BoE (essentially the commercial bank's bank
account), which would be debited by the amount of the payment. Thus,
that commercial bank's deposits would be reduced, and aggregate
deposits would also be reduced. You can see how the discretionary
open-market operations of the Banking Department, in other words
purchases and sales of government and other bonds (corporate etc.),
would lead directly to changes in deposits at the BoE and thus base
money.
In the case of payment by banknotes, of course the banknotes in
circulation would decline. The Banking Department could either hold
these banknotes in its vault, or go to the Issue Department and
trade them for gold bullion.
In the case of a normal bond sale, between two private parties,
Buyer A buys a bond from Seller B. Buyer A's bank, Bank A, pays for
the bond using its deposits at the Bank of England. Bank A's deposit
decreases by the amount of the bond sale, and Bank B's deposits at
the BoE increase by the amount of the bond sale. Bank B then credits
Seller B's account at Bank B for the proceeds of the sale. You can
see that the aggregate deposits at the BoE don't change in this
case. Only open market operations, or sales and purchases of bonds,
by the Banking Department leads to changes in the monetary base.
(Essentially the same process applies to direct lending.)
If we aggregate both the assets of the Issue Department and Banking
Department, typical of central banks today which do not have two
departments, it looks like this.
At any time, a commercial bank with a deposit at the Bank of England
could ask for a withdrawal in the form of banknotes. In this case,
if the Bank of England did not have the banknotes on hand, it would
have to get them from the Issue Department. The Bank of England
would sell one of its assets (for example a government bond) and use
the proceeds of the sale to buy gold bullion on the open market. It
would then take the gold bullion to the Issue Department and trade
it for banknotes. Then it would deliver the banknotes to the
commercial bank. Let's say the withdrawal was for £1m. Deposits
would decline by £1m. BoE assets (a bond) would decline by £1m.
Issue Department assets would increase by £1m in gold bullion, and
banknotes in circulation would increase by £1m. Thus, deposits would
decline by £1m and banknotes in circulation would increase by £1m.
Total base money (banknotes plus deposits) would be unchanged, but
the composition would change.
You could go the other way. Let's say a commercial bank brings £1m
of banknotes to the Banking Department and wants to deposit them.
Deposits increase by £1m, and Banking Department Assets increase by
£1m in banknotes. The Banking Department may decide to hold the
banknotes, against probable future demands. However, if it does not
wish to do so, it could either use the banknotes to buy an
interest-bearing bond, or send them to the Issue Department to get
gold bullion. If nobody wanted the extra banknotes, it would
eventually end up at the Issue Department, where banknotes in
circulation would decrease by £1m and gold bullion would decrease by
£1m. In this way, the composition of base money would see deposits
increase by £1m and banknotes in circulation decline by £1m, with no
change in overall aggregate base money.
Thus, although the Issue Department and the Banking Department were
in a sense two different systems working in parallel, in practice
they were tied together. Today, central banks do much the same
thing, but without the separation of departments.
If you have a good understanding of how the Bank of England worked,
including both the Issue and Banking Departments, compare now to how
the Federal Reserve worked in the 1920s. You will find it was much
the same. This is no surprise: the Bank of England's example was
widely imitated throughout the world.
target="_blank" December
23, 2012: The Federal Reserve in the 1920s 4: The Historical
Record
target="_blank" December
16, 2012: The Federal Reserve in the 1920s 3: Balance Sheet and
Base Money
target="_blank" November
...
25, 2012: The Federal Reserve in the 1920s 2: Interest Rates
target="_blank"November
...
18, 2012: The Federal Reserve in the 1920s
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