On Lombard Street – Part I

‘But I maintain that the Money Market is as concrete and real as anything else; that it can be described in plain words; that it is the writer’s fault if what he says is not clear.’

‘The briefest and truest way of describing Lombard Street is to say that it is by far the greatest combination of economic power and economic delicacy that the world has ever seen. Of the greatness of the power there can be no doubt. Money is economical power.’

In the introduction to Lombard Street, Bagehot waxes on the economic virtues of a banking society, particularly in relation to his own, English, society and the heart of its banking, Lombard Street, in the City of London. From these opening pages, we can identify three economic advantages he claims accrue to those societies who have a tendency to hold their capital in bank deposits.

Firstly, money deposited in banks is available for investment. If it be deposited payable on demand or for a term, people are able to hold all or a portion of their liquid wealth in a way that makes that wealth available for investment. When that wealth is invested, it begins economic work either in enterprises producing goods and services, enterprises which, without the capital, would not have been undertaken or in capital investment, as in a home loan, where the cost of capital is happily borne out in return for the benefit.

Secondly, the pooling nature of banking lowers the transaction cost of collective investment. He writes, ‘A million in the hands of a single banker is a great power; he can at once lend it where he will and borrowers can come to him because they know he has it. But the same sum scattered in tens and fifties throughout the whole nation is no power at all: no one knows where to find it or who to ask for it.’ Banks serve as an apparatus for gathering wealth. Banks, because they are set up to do that, bear the associated costs relatively efficiently. If each entity which sought investment had to muster the pool of investors themselves, the costs would be much higher.

Thirdly, bankers provide value as investment managers. Bagehot comments on how bankers assess the risk and determine what kind of reward they would need to take that risk. He emphasizes how any plausible venture or good security will result in a loan at some price. Bankers make it their business to make good investments out of wise loans.

We can see the synergistic effect of these three benefits of banking when we regard what the situation would be without them. A businessman with a capital intensive venture would seek that capital from individuals, individuals who may not be interested in loaning their capital. He would have to go from person to person, trying to entice them with the opportunity to loan their savings to him. To merely undertake such a process would be daunting for someone who is, say, in the dam building business. Then, he would have to count on a preponderance of individuals to appropriately price the risk in loaning him money. When a cobbler regards his life’s savings, he would likely find it difficult to fully and appropriately appreciate the potential in the hydro-electric market. On demand and short term deposits, however, provide the individual with the liquidity that is their reason for keeping more than modest amounts of money. That money is efficiently pooled in the bank. Large, centralized institutions hold it rather than vast swathes of the population. And, because their business is in making good investments, bankers are in a position to appropriately price risk. All of this combines to allow economic cooperation otherwise unseen.

An organization is created between a bank’s depositors, the bankers, and the bank’s borrowers that allows capital to be deployed in new and innovative ways. Bagehot writes, ‘A citizen of London in Queen Elizabeth’s time could not have imagined our state of mind. He would have thought that it was

no use inventing railways (if he could have understood what a railway meant), for you would not have been able to collect the capital with which to make them…Taking the world as a whole-either now or in the past-it is certain that in poor states there is no spare money for new undertakings and that in most rich states the money is too scattered, and clings too close to the hands of the owners, to be often obtainable in large quantities for new purposes.’ Capital resources in a banking society, by contrast, are distributed amongst those who can make profit from them, facilitating innovation and productivity not otherwise possible.

In the next set of ruminations on Lombard Street, I’ll examine some of Bagehot’s introductory comments on the commercial effects of robust capital markets.

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