Book II, Chapter II, 4

By issuing too much paper money, whose excess continually came back to be exchanged for gold and silver, the Bank of England was compelled, year after year, to coin between eight hundred thousand pounds and a million annually—or about eight hundred and fifty thousand pounds on average. For this extensive coinage, the bank, because gold coins had become worn and debased a few years earlier, was frequently compelled to buy gold bullion at the high price of four pounds an ounce, then soon issue it as coin at £3:17:10 ½ an ounce. It thus lost between two and a half and three per cent. on the coinage of so large a sum. Although the bank paid no seignorage, and the government properly bore the cost of coinage, this generosity on the government's part did not spare the bank all expense.

The Scotch banks, faced with a similar excess, all had to keep agents in London constantly employed collecting money for them, at a cost seldom less than one and a half or two per cent. The money traveled north by wagon, insured by the carriers at the further expense of three quarters per cent., or fifteen shillings on the hundred pounds. These agents could not always refill their employers' coffers as fast as they emptied. In that case, the banks resorted to drawing bills of exchange on their London correspondents for the amount they needed. When those correspondents then drew on the banks for payment of that amount, with interest and commission, some banks, under the strain of their excessive circulation, sometimes had no way to honor the drafts except by drawing a second set of bills on the same correspondents or on others in London. The same sum—or, rather, bills for the same sum—could thus make more than two or three journeys, with the debtor bank always paying interest and commission on the entire accumulated amount. Even the Scotch banks that had never been conspicuously reckless sometimes had to resort to this ruinous expedient.

The gold coin paid out by the Bank of England or the Scotch banks for the portion of their paper beyond what the country's circulation could use was itself more than that circulation could use. Some of it went abroad as coin; some was melted and exported as bullion; and some was melted and sold to the Bank of England at the high price of four pounds an ounce. Only the newest, heaviest, finest pieces were carefully picked out of the coinage to be exported or melted. At home, while still coin, these heavy pieces were worth no more than light ones; abroad, or melted into bullion at home, they were worth more. To its astonishment, the Bank of England found that, despite its vast annual coinage, coins were as scarce each year as they had been the year before. Despite the great quantity of good new coin it issued annually, the condition of the coinage grew worse, not better, each year. It found itself obliged to coin nearly as much gold each year as in the preceding year; and as the price of gold bullion kept rising because coins were continually worn and clipped, the cost of this great annual coinage also kept rising. It should be observed that, in filling its own coffers with coin, the Bank of England must indirectly supply the entire kingdom, into which coin flows from those coffers by many routes. The bank therefore had to fill every gap in the kingdom's necessary coinage caused by the excessive circulation of Scotch and English paper money, and provide whatever coin was needed to support it. The Scotch banks all paid dearly, no doubt, for their own imprudence and neglect; but the Bank of England paid dearly not only for its own imprudence, but for the far greater imprudence of almost all the Scotch banks.

The original cause of this excessive circulation of paper money was the over-trading of certain daring projectors in both parts of the united kingdom.

What a bank can properly advance to a merchant or any other undertaker is neither his entire trading capital nor any substantial portion of it, but only the portion he would otherwise have to keep idle, in ready money, to meet occasional demands. If the paper money advanced by the bank never exceeds this amount, it can never exceed the value of the gold and silver that would have to circulate in the country without paper money; it can never exceed what the country's circulation can readily absorb and employ.

When a bank discounts for a merchant a genuine bill of exchange, drawn by a genuine creditor on a genuine debtor who actually pays it when due, the bank advances him only part of the value he would otherwise have to keep idle in ready money to meet occasional demands. Payment of the bill at maturity restores to the bank the value it advanced, with interest. So long as a bank deals only with such customers, its coffers resemble a pond: though one stream continually flows out, another, fully as large, continually flows in. Without further care or attention, the pond remains full, or very nearly so. Little or no expense can be required to replenish the coffers of such a bank.

Even without over-trading, a merchant may often need ready money when he has no bills to discount. If, besides discounting his bills, a bank also advances him money on such occasions through a cash account, accepting repayment in installments as proceeds from occasional sales of his goods arrive, on the easy terms offered by the banking companies of Scotland, it frees him altogether from the need to keep any of his stock idle in ready money for occasional demands. When those demands arise, his cash account will suffice to meet them. In dealing with such customers, however, the bank must watch closely whether, over a short period—four, five, six, or eight months, for example—the repayments it normally receives from them fully equal the advances it normally makes. If certain customers' repayments generally equal their advances over such periods, it may safely continue to deal with them. Though the stream continually flowing out of its coffers may be very large, the stream flowing in must be at least as large. Without further care, therefore, its coffers will probably remain full or nearly full, and scarcely ever require extraordinary expense to replenish. If, on the contrary, other customers' repayments generally fall far short of the advances made to them, the bank cannot safely continue to deal with them, at least while their dealings remain of this kind. The stream flowing out is then necessarily much greater than the one flowing in; unless replenished through a great and constant expenditure, the coffers must soon be emptied altogether.

Accordingly, the banking companies of Scotland were for a long time careful to require frequent, regular repayments from every customer, and were reluctant to deal with anyone, whatever his fortune or credit, who failed to conduct what they called frequent and regular operations with them. By this vigilance they not only saved almost the entire extraordinary cost of replenishing their coffers but gained two other considerable advantages.

First, it enabled them to form a reasonable judgment of whether their debtors' circumstances were improving or declining, without seeking evidence beyond their own books. For the most part, people repay regularly or irregularly according as their circumstances prosper or decline. A private individual lending to perhaps half a dozen or a dozen debtors can personally, or through agents, observe and investigate each debtor's conduct and situation steadily and carefully. But a banking company lending to perhaps five hundred different people, its attention constantly taken up with very different matters, can have no regular information about most debtors' conduct and circumstances beyond what its books disclose. The Scotch banking companies probably had this advantage in mind when they required frequent and regular repayments from all their customers.

Second, this practice protected them against issuing more paper money than the country's circulation could readily absorb and employ. If, over moderate periods, a customer's repayments generally equaled the advances they had made him, they could be sure their advances of paper money had never exceeded the gold and silver he would otherwise have needed to keep on hand for occasional demands. Thus the paper circulated through him had never exceeded the gold and silver that would have circulated in the country without paper money. The frequency, regularity, and size of his repayments sufficiently showed that their advances had never exceeded the portion of his capital he would otherwise have had to keep idle in ready money for occasional demands—that is, to keep the rest of his capital constantly employed. Only this portion of a dealer's capital continually comes back to him, over moderate periods, as money, whether paper or coin, and continually goes out again in the same form. If the bank's advances had normally exceeded that portion, his ordinary repayments could not have equaled its ordinary advances over such periods. The stream entering the bank's coffers through his dealings could not have equaled the stream leaving them through the same dealings. If the bank advanced paper beyond the gold and silver he would otherwise have had to hold for occasional demands, its advances might soon exceed all the gold and silver that would have circulated in the country without paper money, assuming the same volume of commerce. They would consequently exceed what the country's circulation could readily absorb and employ, and the excess paper would immediately return to the bank for exchange into gold and silver. This second advantage, though just as real, was perhaps less clearly understood by the different Scotch banking companies than the first.

Once the convenience of discounted bills and cash accounts has freed the reputable traders of a country from having to keep any stock idle in ready money for occasional demands, they can reasonably expect no further assistance from banks and bankers. Having gone this far, banks cannot go farther consistently with their own interests and safety. A bank cannot, consistently with its interests, advance a trader all or even most of the circulating capital he uses in trade. Though that capital continually returns to him as money and goes out again as money, the returns of the whole are too far removed from its outgoings for his repayments to equal the bank's advances within the moderate periods convenient to a bank. Still less can a bank advance any substantial part of his fixed capital: the capital an iron-forge undertaker, for example, spends building his forge and smelting-houses, workshops and warehouses, and workers' dwellings, etc.; the capital a mine undertaker spends sinking shafts, building engines to draw out water, and making roads and wagonways, etc.; or the capital spent by a land improver clearing, draining, enclosing, manuring, and plowing waste and uncultivated fields, and building farmhouses with the necessary stables, granaries, etc. Returns on fixed capital are almost always much slower than returns on circulating capital. Even when such expenditures are undertaken with the greatest prudence and judgment, they very seldom return to the undertaker for many years—far too long a period to suit a bank. Traders and other undertakers may, certainly and quite properly, finance a substantial part of their projects with borrowed money. In fairness to their creditors, however, their own capital should be sufficient, so to speak, to insure their creditors' capital: it should make a loss to creditors extremely unlikely, even if the project falls far short of its promoters' expectations. Even with this safeguard, money intended to remain outstanding for several years should be borrowed not from a bank but on bond or mortgage from private people who intend to live on the interest of their money, rather than trouble to employ the capital themselves, and who are therefore willing to lend it to creditworthy people likely to retain it for several years. A bank that lends without the cost of stamped paper or attorneys' fees for drawing up bonds and mortgages, and accepts repayment on the easy terms of the Scotch banking companies, would certainly be a very convenient creditor for such traders and undertakers. But such traders and undertakers would assuredly be very inconvenient debtors for such a bank.

For many years, the Bank of England issued too much paper money. The excess kept coming back to be exchanged for gold and silver. As a result, the bank had to mint between eight hundred thousand pounds and a million a-year in gold coins, or about eight hundred and fifty thousand pounds on average. Because gold coins had become worn and reduced in weight a few years earlier, the bank often had to buy gold bullion at the high price of four pounds an ounce. It then issued that gold as coins at £3:17:10 ½ an ounce, losing between two and a half and three per cent. on this very large amount of coinage. The bank paid no seignorage, or minting charge, because the government paid for the minting itself. Even so, this government generosity did not spare the bank all the expense.

The Scotch banks had also issued too much paper. They all had to keep agents in London to collect money for them, at a cost that was rarely less than one and a half or two per cent. The money was sent by wagon, and the carriers insured it for an additional three quarters per cent., or fifteen shillings on the hundred pounds. Sometimes the agents could not replenish the banks' cash as quickly as it was spent. The banks then drew bills of exchange on their contacts in London for the money they needed. Later, those contacts drew bills on the banks to recover the money, interest, and commission. Some banks were in such trouble from their excessive issue of paper that they could pay only by drawing a second set of bills, on the same London contacts or others. The same sum—or rather, bills for that sum—might make more than two or three journeys this way. The bank that owed the money kept paying interest and commission on the entire accumulated amount. Even Scotch banks that had never been extremely reckless sometimes had to use this ruinous method.

The Bank of England and the Scotch banks paid out gold coins in exchange for the paper that exceeded what the country could use in circulation. That gold also exceeded what the country could use as coins. Some was sent abroad as coins, some was melted and sent abroad as bullion, and some was melted and sold to the Bank of England at the high price of four pounds an ounce. Only the newest, heaviest, best coins were carefully selected for export or melting. At home, while they remained coins, these heavy pieces were worth no more than light ones. Abroad, or melted into bullion at home, they were worth more. Despite minting so many coins each year, the Bank of England was surprised to find the same shortage of coins year after year. Despite all the good new coins the bank issued each year, the condition of the coinage got worse instead of better. Each year the bank had to mint nearly as much gold as it had the year before. As coins continued to wear down or be clipped, the price of gold bullion kept rising, making this large annual minting more expensive every year. When the Bank of England fills its own vaults with coins, it must indirectly supply the whole kingdom, because coins constantly flow out of its vaults in many ways. The bank therefore had to fill every gap in the kingdom's necessary supply of coins caused by the excessive circulation of English and Scotch paper money. The Scotch banks certainly paid dearly for their own carelessness and lack of attention. But the Bank of England paid dearly not just for its own mistakes, but for the much greater mistakes of almost all the Scotch banks.

The original cause of this excessive circulation of paper money was the over-trading of some daring speculators in both parts of the united kingdom.

A bank should not advance to a merchant or other business operator all his trading capital, or even a substantial part of it. It should advance only the part he would otherwise have to keep idle as cash to meet occasional demands. If the paper money advanced by the bank never exceeds that amount, it can never exceed the gold and silver that would have to circulate in the country without paper money. It can never exceed what the country's circulation can readily take up and use.

Suppose a bank discounts a genuine bill of exchange drawn by a genuine creditor on a genuine debtor, who actually pays it when it falls due. The bank advances only part of the cash the merchant would otherwise have to keep idle to meet occasional demands. When the debtor pays the bill, the bank gets back what it advanced, with interest. So long as the bank deals only with customers like these, its vaults resemble a pond with one stream flowing out and another equally large stream flowing in. The pond stays full, or nearly full, without extra effort. Such a bank needs little or no expense to refill its vaults.

Even without over-trading, a merchant may often need cash when he has no bills to discount. If the bank discounts his bills and also lends him money through a cash account at such times, accepting repayments in installments as sales of his goods bring in money, it gives him the easy terms offered by the banking companies of Scotland. He no longer needs to keep any of his stock idle as cash to meet occasional demands. When those demands arise, he can meet them from his cash account. But a bank dealing with such customers must watch whether their repayments over a short period—four, five, six, or eight months, for example—usually equal the advances it makes to them. If they usually do, the bank can safely keep dealing with them. Even if a large stream of money flows out of its vaults, at least as much flows in. Its vaults are likely to stay full or nearly full without extra effort and will hardly ever need costly replenishment. But if some customers usually repay far less than they receive, the bank cannot safely go on dealing with them, at least while they continue this way. Much more money flows out than flows in, and the vaults will soon be empty unless they are replenished through a large, continuous expense.

For a long time, therefore, the banking companies of Scotland carefully required all customers to repay frequently and regularly. They did not want to deal with anyone, however wealthy or creditworthy, who failed to conduct what they called frequent and regular operations with them. This practice saved almost all the unusual expense of refilling their vaults. It also gave them two other important advantages.

First, it let the banks judge reasonably well whether their borrowers were prospering or declining, using only their own records. People generally repay regularly when their affairs prosper and irregularly when they decline. A private lender with perhaps half a dozen or a dozen borrowers can observe each person's behavior and situation carefully and regularly, in person or through agents. But a banking company lending to perhaps five hundred different people is busy with many other matters. For most borrowers, its own records are its only regular source of information on their behavior and circumstances. The Scotch banks probably had this advantage in mind when they required frequent, regular repayments from all customers.

Second, it protected the banks against issuing more paper money than the country could readily take up and use. If a customer's repayments usually equaled his advances over moderate periods, the banks could be sure that the paper they advanced to him never exceeded the gold and silver he would otherwise have kept on hand for occasional demands. The paper they put into circulation through him therefore never exceeded the gold and silver that would have circulated without paper money. How often he repaid, how regularly he did so, and how much he paid showed that the advances never exceeded the part of his capital he would otherwise have kept idle as cash for occasional demands, so that the rest of his capital could remain in use. Only this part of a dealer's capital regularly returns to him as money, whether paper or coin, and leaves him as money again within moderate periods. If the bank had usually advanced him more than this, his normal repayments could not have equaled its normal advances over such periods. The stream his business sent into the bank's vaults could not have matched the stream it drew out. Advances of bank paper beyond the gold and silver he would have kept for occasional demands could soon exceed even all the gold and silver that would have circulated in the country, assuming the same commerce but no paper money. The paper would then exceed what the country's circulation could readily use. The excess would immediately return to the bank to be exchanged for gold and silver. This second advantage was just as real as the first, though perhaps not all the Scotch banking companies understood it as well.

When discounting bills and offering cash accounts free reputable traders from the need to keep any stock idle as cash for occasional demands, they cannot reasonably expect any further help from banks. Banks cannot safely or profitably go further. A bank cannot profitably advance a trader all, or even most, of his circulating capital. Although that capital keeps returning to him as money and leaving him as money, the time between its total outlays and total returns is too long. His repayments could not equal the bank's advances within periods short enough to suit a bank. A bank is even less able to advance a substantial part of his fixed capital. An iron-forge operator, for example, uses fixed capital to build his forge, smelting-houses, workshops, warehouses, and workers' homes, etc. A mine operator uses it to sink shafts, build engines to draw out water, and make roads and wagonways, etc. Someone improving land uses it to clear, drain, enclose, fertilize, and plow unused, uncultivated fields, and to build farmhouses with their stables, granaries, etc. Fixed capital almost always returns much more slowly than circulating capital. Even the wisest spending of this kind seldom pays the operator back for many years, far too long for a bank. Traders and other business operators may properly fund a substantial part of their projects with borrowed money. But to be fair to their creditors, their own capital must be large enough to protect the creditors' capital, so that a loss to them is extremely unlikely even if the project falls far short of expectations. Even then, money not intended to be repaid for several years should not be borrowed from a bank. It should be borrowed on bond or mortgage from private people who want to live on interest rather than manage capital themselves, and are therefore willing to lend to creditworthy people who will keep it for several years. A bank that lends without the cost of stamped paper or lawyers' fees for bonds and mortgages, and accepts repayment on the easy terms of the Scotch banking companies, would certainly be a very convenient lender for these traders and operators. But they would be very inconvenient borrowers for such a bank.