Posted by: Dirk | April 2, 2014

Bagehot on ‘legal tender’

Walter Bagehot described the lender of last resort function of the Bank of England in his classic ‘Lombard Street: a description of the money market’, which is available online for free at Econlib. In a very important section in chapter 7 he writes:

I do not imagine that it would touch the Issue Department. I think that the public would be quite satisfied if they obtained bank-notes. Generally nothing is gained by holding the notes of a bank instead of depositing them at a bank. But in the Bank of England there is a great difference: their notes are legal tender. Whoever holds them can always pay his debts, and, except for foreign payments, he could want no more. The rush would be for bank-notes; those that could be obtained would be carried north, south, east, and west, and, as there would not be enough for all the country, the Banking Department would soon pay away all it had.

Nothing, therefore, can be more certain than that the Bank of England has in this respect no peculiar privilege; that it is simply in the position of a Bank keeping the Banking reserve of the country; that it must in time of panic do what all other similar banks must do; that in time of panic it must advance freely and vigorously to the public out of the reserve.

And with the Bank of England, as with other Banks in the same case, these advances, if they are to be made at all, should be made so as if possible to obtain the object for which they are made. The end is to stay the panic; and the advances should, if possible, stay the panic. And for this purpose there are two rules:—First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer. The news of this will spread in an instant through all the money market at a moment of terror; no one can say exactly who carries it, but in half an hour it will be carried on all sides, and will intensify the terror everywhere. No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the ‘unsound’ people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected. The great majority, the majority to be protected, are the ‘sound’ people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.

These two rules for the lender of last resort are very famous, but let me focus on the legal tender issue:

Generally nothing is gained by holding the notes of a bank instead of depositing them at a bank. But in the Bank of England there is a great difference: their notes are legal tender. Whoever holds them can always pay his debts, and, except for foreign payments, he could want no more.

This is interesting because Bagehot talks here about the demand for what we now call reserves. Reserves are deposits at the central bank held by other banks. These reserves can be changed into notes and coins, and in this forms households and firms can hold them. Bagehot then continues to say that these notes can always pay ‘debts […] except for foreign payments’. I assume he means debts both public and private. Public debts are mostly taxes, but could also mean tariffs (Bagehot wrote in the 19th century). Private debts are probably bank loans and debt instruments like securities. Normally, we discharge both public and private debts through deposits, not through bank notes. (Have you ever repaid a bank loan in cash?) So, deposits are promises to deliver reserves at par, and when that promise looks rather shaky a bank run can occur.

What is interesting is that in Bagehot the demand for money (and implicitly, the demand for deposits) comes not from the fact that money and credit can be used to buy stuff, but that deposits and bank notes can be used to pay one’s debts. Whereas private debts can be at least theoretically fully repaid, the state can through the imposition of taxes generate perpetual debt. It seems that it is the government then which is the ‘creditor of last resort’, forcing households and businesses to accept money to pay their taxes. It might be argued that this is why the private sector also uses legal tender as the unit of accounts of its own debt contracts. Hopefully we will never have a real world experiment which either confirms or rejects this theory.


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