Book II, Chapter II, 5

More than five and twenty years have now passed since the paper money issued by Scotland's various banking companies fully equaled—or rather, somewhat exceeded—what the country's circulation could readily absorb and employ. Those companies had therefore long since given Scotland's traders and other undertakers all the assistance that banks and bankers could give consistently with their own interests. Indeed, they had done somewhat more. They had over-traded a little, bringing upon themselves the loss, or at least the reduction of profit, that invariably attends even the slightest over-trading in this business. Having received so much help from banks and bankers, the traders and undertakers wanted still more. They seem to have believed that the banks could expand their credit to any sum required at no greater cost than a few reams of paper. They complained that the directors' narrow outlook and timid spirit kept them from expanding credit in proportion to the growth of the country's trade. By that growth they no doubt meant the expansion of their own projects beyond what they could undertake with their own capital or with funds they could borrow privately in the ordinary way, on bond or mortgage. The banks, they seem to have thought, were bound in honor to make up the difference and furnish all the capital they wanted for trade. The banks disagreed. When they refused to extend credit, some traders turned to an expedient that for a time served their purpose, at far greater expense but just as effectively as the fullest extension of bank credit could have done. That expedient was the familiar device of drawing and redrawing bills, to which distressed traders sometimes resort on the verge of bankruptcy. Raising money this way had long been known in England, and during the late war, when high trading profits strongly tempted people to over-trade, it is said to have been practiced on a very large scale. From England it came to Scotland, where, relative to the country's very limited commerce and modest capital, it soon spread much farther than it ever had in England.

Drawing and redrawing is so familiar to businesspeople that an account of it might seem unnecessary. But this book may reach many who are not businesspeople, and even businesspeople may not generally understand its effects on banking. I shall therefore explain it as clearly as I can.

Merchant customs arose when Europe's barbarous laws did not enforce contracts; during the last two centuries, the laws of every European nation have adopted them. These customs have given bills of exchange such exceptional privileges that money is advanced on them more readily than on any other kind of obligation, especially when they fall due within two or three months of their date. If the acceptor fails to pay a bill on presentation when it falls due, he becomes a bankrupt from that moment. The bill is protested and returned to the drawer, who likewise becomes a bankrupt if he does not pay at once. Before reaching the person who presents it to the acceptor, it may have passed through several other hands, each person advancing its value to the next in money or goods. To acknowledge receiving that value, each in turn indorses it—that is, writes his name on its back. Each indorser in turn is liable to the bill's owner for its value, and becomes a bankrupt from the moment he fails to pay it. Even if the drawer, acceptor, and indorsers all have doubtful credit, the bill's short term still offers its owner some security. They may all be quite likely to go bankrupt, but it is unlikely that all will do so in such a short time. “The house is unsound,” a weary traveler tells himself, “and will not stand for long. But it is unlikely to fall tonight; I shall risk sleeping in it tonight.”

Suppose trader A in Edinburgh draws a bill on B in London, payable two months after its date. In fact B in London owes A in Edinburgh nothing. But he agrees to accept A's bill on condition that, before payment falls due, he may draw another bill on A in Edinburgh for the same amount plus interest and a commission, likewise payable two months after its date. Before the first two months expire, B accordingly redraws on A in Edinburgh. Before the second two months expire, A again draws a bill on B in London, also payable two months after its date; and before the third two months expire, B in London redraws another bill on A in Edinburgh, again payable two months after its date. This has sometimes continued not merely for months but for years, each bill returning to A in Edinburgh with all the earlier bills' accumulated interest and commission. Interest ran at five per cent. a year, and commission was never less than one half per cent. on each draft. Since the commission recurred more than six times a year, any money A raised this way necessarily cost him something more than eight per cent. a year, and sometimes much more when the commission rose or when he had to pay compound interest on earlier bills' interest and commission. This practice was known as raising money by circulation.

In a country where the usual profits of stock on most commercial projects are reckoned at between six and ten per cent., a venture would have to be extraordinarily fortunate for its returns both to repay the enormous cost of borrowing this way and to leave its projector a handsome surplus profit. Yet many vast and extensive projects were begun and pursued for several years with no other support than funds raised at this enormous expense. The projectors no doubt saw this great profit clearly in their golden dreams. But when they awoke, whether at their projects' end or when they could pursue them no longer, I believe they seldom had the good fortune to find it.

[The method described in the text was neither the most common nor the most expensive way these adventurers sometimes raised money by circulation. Often A in Edinburgh would enable B in London to pay the first bill of exchange by drawing, a few days before it fell due, a second bill on the same B in London, payable after three months. A sold this bill, payable to his own order, in Edinburgh at par, and used its proceeds to buy bills on London payable at sight to B's order, sending them to him by post. Toward the end of the late war, the exchange between Edinburgh and London was frequently three per cent. against Edinburgh, and those bills at sight must often have cost A that premium. Repeated at least four times a year, therefore, and bearing a commission of at least one half per cent. each time, this transaction must then have cost A at least fourteen per cent. a year. At other times A would enable B to settle the first bill by drawing, a few days before it fell due, a second bill payable after two months, not on B but on a third person in London, C, for example. The new bill was payable to B's order; once C accepted it, B discounted it with a London banker. A then enabled C to settle it by drawing, a few days before its maturity, a third bill also payable after two months, sometimes on his original correspondent B and sometimes on a fourth or fifth person, D or E, for example. This third bill was payable to C's order, and once accepted C likewise discounted it with a London banker. Repeated at least six times a year, with a commission of at least one half per cent. each time in addition to the legal interest of five per cent., this way of raising money, like that described in the text, must have cost A something more than eight per cent. Since it avoided the exchange between Edinburgh and London, however, it cost less than the method described earlier in this note. But it required established credit with more than one London house, an advantage many of these adventurers could not always easily secure.]

A in Edinburgh regularly discounted the bills he drew on B in London, two months before they fell due, with a bank or banker in Edinburgh. B in London just as regularly discounted the bills he redrew on A in Edinburgh, either with the Bank of England or with some other London banker. Money advanced on these circulating bills was advanced in Edinburgh as paper issued by the Scotch banks, and in London, when discounted by the Bank of England, as that bank's paper. Although each bill on which paper had been advanced was paid when due, the value originally advanced on the first bill was never actually returned to the banks that advanced it. Before each bill fell due, another bill had already been drawn for a somewhat greater amount; discounting the new bill was essential to paying the one about to mature. The payment was thus entirely fictitious. The stream these circulating bills had set flowing from the banks' coffers was never replaced by any stream genuinely flowing back into them.

The paper issued against these circulating bills often amounted to the entire fund intended to support some vast project in agriculture, commerce, or manufactures, not merely the portion its projector would otherwise have had to keep idle in ready money to meet occasional demands if there had been no paper money. Most of this paper consequently exceeded the value of the gold and silver that would have circulated in the country without paper money. It exceeded what the country's circulation could readily absorb and employ, and so immediately returned to the banks for exchange into gold and silver, which the banks had to find however they could. The projectors had very cleverly contrived to draw this capital from the banks not merely without their knowledge or deliberate consent, but perhaps for a time without the slightest suspicion that they had advanced it at all.

If two people continually draw and redraw bills on each other and always discount them with the same banker, he must soon discover their practice and recognize that they are trading not with their own capital but with capital he supplies. It is much harder to discover when they discount bills sometimes with one banker and sometimes with another, and when the same two people do not constantly draw and redraw on each other but pass bills around a large circle of projectors. Such projectors have an interest in helping one another raise money this way, making it as hard as possible to distinguish a genuine bill from a fictitious one: a bill drawn by an actual creditor on an actual debtor from one whose only real creditor is the bank that discounts it and whose only real debtor is the projector using the money. A banker might make the discovery too late, after discounting so many of their bills that refusing to discount any more would necessarily bankrupt them all and, by ruining them, perhaps ruin himself. For his own safety and interests, he might be forced to continue for a time in this dangerous position, trying to withdraw gradually and raising ever greater obstacles to discounting bills each day. He would thereby compel the projectors, little by little, to seek other bankers or other ways of raising money, so that he himself could leave the circle as soon as possible. Accordingly, after some time, when they had already gone too far, the Bank of England, the leading London bankers, and even the more prudent Scotch banks began to make discounting difficult. This not only alarmed but infuriated the projectors. They called their own distress—immediately caused, no doubt, by this prudent and necessary restraint—the distress of the country. That national distress, they claimed, was entirely due to the banks' ignorance, timidity, and misconduct in failing to aid generously enough the bold enterprises of men striving to beautify, improve, and enrich the country. They apparently thought it the banks' duty to lend for as long, and as much, as they wished to borrow. But in denying further credit to people to whom they had already given far too much, the banks took the only course that could now save either their own credit or the country's public credit.

More than five and twenty years ago, the paper money issued by Scotland's various banking companies was already at least as much as the country could readily take up and use, and actually a little more. By then, these companies had given Scotland's traders and other business operators all the help that banks could give without endangering their own interests. They had even done a little more. They had over-traded slightly, bringing on the loss, or at least the reduction in profit, that even a little over-trading always causes in banking. The traders and operators wanted still more help. They apparently thought banks could extend credit as much as needed for no cost beyond a few reams of paper. They complained that bank directors were narrow-minded and timid. The directors, they said, failed to expand credit as the country's trade expanded. By this expansion of trade, they surely meant their own plans to do more than their capital, or the money they could normally borrow from private people by bond or mortgage, would allow. They apparently thought the banks had a duty to supply whatever was missing and give them all the capital they wanted for trade. The banks disagreed. When they refused to extend credit, some traders turned to a device that worked for a time. Though far more expensive, it served them as effectively as the greatest expansion of bank credit could have. This was the familiar device of drawing and redrawing bills of exchange, sometimes used by unfortunate traders on the edge of bankruptcy. Raising money this way had long been known in England. During the late war, when high trading profits strongly encouraged over-trading, it is said to have been used very widely there. It spread from England to Scotland, where, compared with the country's limited commerce and modest capital, it was soon used on a far greater scale than it ever had been in England.

Businesspeople know drawing and redrawing so well that an explanation may seem unnecessary. But many readers of this book may not be businesspeople, and even businesspeople may not fully understand its effects on banking. I will therefore explain it as clearly as I can.

Merchants established their own customs when Europe's harsh laws did not enforce their contracts. In the last two centuries, all European nations have made these customs part of their laws. These customs give bills of exchange special privileges, so lenders advance money against them more readily than against any other kind of obligation, especially if payment is due in just two or three months. If the person who accepted a bill does not pay when it is presented at maturity, he is bankrupt from that moment. The bill is formally protested and returned to the person who drew it, who is also bankrupt if he does not pay at once. The bill may have passed through several hands before reaching the person who presents it for payment. Each previous holder may have advanced its value to the next in money or goods and signed the back of the bill to show he had received that value. Each such signer, or indorser, is in turn liable to the current holder for its value, and becomes bankrupt from the moment he fails to pay. Even if the drawer, acceptor, and indorsers are all of doubtful credit, the short time before payment gives the holder some security. They may all be likely to go bankrupt, but it is unlikely that they will all do so in such a short time. A tired traveler says to himself, “The house is unsound and will not stand for long, but it probably will not fall tonight, so I will risk sleeping there tonight.”

Suppose trader A in Edinburgh draws a bill on B in London, payable two months after its date. B actually owes A nothing. But B agrees to accept the bill if, before it falls due, he can draw a bill on A in Edinburgh for the same sum plus interest and a commission, also payable two months after its date. Before the first two months end, B draws that bill on A. Before the second two months end, A draws a second bill on B in London, likewise payable two months after its date. Before the third two months end, B draws another bill on A in Edinburgh, also payable two months after its date. This has sometimes continued for several months or even several years. Each bill returns to A in Edinburgh with the interest and commission from all previous bills added. Interest was five per cent. a year, and commission was never less than one half per cent. on each bill drawn. Because this commission was paid more than six times a year, the money A raised this way necessarily cost him something more than eight per cent. a year. Sometimes it cost much more, when commissions rose or he had to pay compound interest on earlier interest and commissions. This was called raising money by circulation.

In a country where ordinary profits on stock in most commercial projects are thought to be between six and ten per cent., a project would have to be unusually fortunate to repay such enormous borrowing costs and still leave its promoter a good profit. Yet many vast projects were undertaken and carried on for several years with no funds except money raised at this enormous cost. In their golden dreams, their promoters no doubt pictured a great profit very clearly. But when they woke up, at the end of their projects or when they could no longer continue, I believe they very rarely found it.

[The method just described was neither the most common nor the most expensive way these speculators sometimes raised money by circulation. A in Edinburgh often enabled B in London to pay the first bill by drawing a second bill on the same B in London a few days before the first fell due. This second bill was payable in three months. It was made payable to A's own order, and A sold it in Edinburgh at its full face value. With the proceeds, A bought bills on London payable immediately to B's order, and mailed them to B. Toward the end of the late war, the exchange rate between Edinburgh and London was often three per cent. against Edinburgh. A must often have paid that premium for those immediately payable bills. This transaction, repeated at least four times a year and carrying a commission of at least one half per cent. each time, must then have cost A at least fourteen per cent. a year. At other times, a few days before the first bill fell due, A would enable B to pay it by drawing a second bill payable in two months, not on B but on a third person, C, for example, in London. The second bill was payable to B's order. Once C accepted it, B had a London banker discount it. A then enabled C to pay it by drawing a third bill, also payable in two months, a few days before the second fell due. This might be drawn on A's first contact B or on a fourth or fifth person, D or E, for example. It was payable to C's order, and once accepted C likewise had a London banker discount it. Such transactions, repeated at least six times a year, with a commission of at least one half per cent. each time and legal interest of five per cent., must have cost A something more than eight per cent., as in the method described above. By avoiding the unfavorable exchange rate between Edinburgh and London, however, this method cost less than the one described earlier in this note. But it required established credit with more than one London business house, something many of these speculators could not easily obtain.]

A regularly took the bills he drew on B to a bank or banker in Edinburgh to be discounted two months before they fell due. B likewise regularly took the bills he drew on A to the Bank of England or another banker in London to be discounted. Money advanced on these circulating bills was given in Edinburgh as Scotch bank paper. In London, when the Bank of England discounted the bills, it was given as that bank's paper. Every bill was paid when due, but the banks never actually got back the value advanced on the first bill. Before each bill came due, someone drew another bill for a somewhat greater amount, and discounting the new bill was necessary to pay the old one. So the apparent repayment was entirely fictitious. Money flowed out of the banks' vaults through these circulating bills, but no corresponding flow ever really came back in.

The paper issued against these circulating bills was often enough to fund an entire vast project in agriculture, commerce, or manufacturing. It was not limited to the part of the funding the promoter would otherwise have had to keep idle as cash for occasional demands. Most of this paper therefore exceeded the value of the gold and silver that would have circulated without paper money. It exceeded what the country's circulation could readily take up and use, and immediately returned to the banks for exchange into gold and silver. The banks had to find that gold and silver somehow. The promoters had cleverly drawn this capital from the banks without their knowledge or deliberate agreement, and perhaps for a while without the banks even remotely suspecting that they had lent it.

If two people continually draw bills on each other and always have the same banker discount them, he will immediately see what they are doing. He will see that they trade not with their own capital but with his. The trick is harder to detect if they sometimes use one banker and sometimes another. It is also harder if the same two people do not always exchange bills, but instead take turns within a large circle of promoters. They all benefit from helping each other raise money this way and make it as hard as possible to tell a genuine bill from a fictitious one: a bill drawn by a real creditor on a real debtor from a bill whose only real creditor is the bank that discounts it, and whose only real debtor is the promoter who uses the money. Even when a banker uncovered the scheme, it might be too late. He might already have discounted so many of their bills that refusing more would bankrupt them all and perhaps ruin him too. In this dangerous position, his own safety might require him to continue for a while. He would try to withdraw gradually by making it harder each day to discount their bills, pushing the promoters toward other bankers or other ways of raising money so he could leave the circle as soon as possible. In time, the Bank of England, the main London bankers, and even the more careful Scotch banks all began to make discounting difficult, after they had already gone too far. This not only alarmed the promoters but made them furious. They called their own distress, immediately caused by the banks' necessary and prudent restraint, the distress of the country. They blamed this supposed national distress entirely on the banks' ignorance, cowardice, and bad management. The banks, they said, were not generous enough in supporting the bold projects of people working to beautify, improve, and enrich the country. They apparently thought banks had a duty to lend for as long and as much as they wished to borrow. But by refusing more credit to people they had already lent far too much, the banks took the only remaining step that could save their own credit or the country's public credit.