Banking and interest rates
In Thornton’s view, a full understanding of the export and import of precious metals, and of their effect on domestic gold and silver markets and bank liquidity, must take into account all the factors that intervene in the functioning of the law of supply and demand in the currency market beyond the GPM.
On the one side, the trade balance varies with the money prices of goods and the exchange rate. On the other side, it also depends on events such as bad harvests or the suspension of trade routes as a consequence of wars. Above all, the exchange rate does not vary solely with the trade in goods but also with financial flows, such as the supply of sterling in the currency market from the British government in order to buy foreign currency and subsidize its allies in the war against France. Capital flows also arise from speculation on future exchange rates and from arbitrage between spot and anticipated exchange rates or between interest rates at home and abroad. All these factors operate simultaneously and the exchange rate may be within the gold import and export points, without any export or import of precious metals, although there may be a disequilibrium in the balance of trade. In this case, the balance of payments is said to be at equilibrium. On the other hand, if the exchange rate reaches a gold point (either import or export), whether there is a trade balance equilibrium or disequilibrium (either surplus or deficit), gold will move. In this case, the balance of payments is said to be in disequilibrium; the entry of gold means a surplus and the exit of gold means a deficit.In the event of a deficit in the balance of payments, the gold reserve of the Bank of England diminishes and the exchange rate stabilizes at the gold export point. However, if the Bank of England is authorized not to pay its notes and/or deposits in gold at a fixed price, the exchange rate will fall below the export point and the excess demand for gold resulting from international arbitrage will drive up the market price of gold.
Ricardo and his Currency School followers challenged Thornton’s approach to the balance of payments and exchange rates. Instead Robert Malthus (1811) and subsequent leading authors of the Banking School - Thomas Tooke in his History of Prices (1838-56) and Inquiry into the Currency Principle (1844), and John Fullarton in Regulation of Currencies (1844) - adopted it.One main feature of the balance of payments approach is that while the liquidity of the Bank of England is dependent on the balance of payments, this does not imply that the value of bank money is involved. This contradicts Hume’s approach. In 1802, the debate was centred on the liquidity of the money market in the context of a deficit in the balance of payments. Thornton’s balance of payments analysis complemented his theory of the Bank of England’s function as lender of last resort. Furthermore, the balance of payments approach opens the door to a rejection of the quantity theory. Thornton did not reject it, but the Banking School did. In fact, the Banking School referred to both Smith and Thornton. It took from Thornton the currency and money markets analysis. It accepted Smith’s real bills doctrine, his refusal of the quantity theory and his distinction between credit and money, that is, between “capital” and “currency”. “Capital” refers to the transactions between traders, whereas “currency” refers to the transactions between traders and consumers, that is, the expense of money income. In the former, credit is used as means of circulation, while in the latter money is used. If a change in the quantity of money income can modify the price level (see the thirteenth proposition in Tooke 1844), a change in the amount of bank deposits and/or bank notes does not. The quantity of credit is determined by demand; it depends on the price level.
The Banking School made two contributions to the balance of payments approach. First, it extended the distinction between “capital” and “currency” to the analysis of the trade balance.
Here, only “capital” is concerned, “currency” is not; in international trade, only credit is at work. Now, the flux and reflux of credit involved in financing exports and imports are not synchronized, so that the trade balance is often in disequilibrium, alternating periods of surplus and deficit. Tooke’s diagnosis is that, when facing a balance of payments deficit, the Bank of England must accept the decrease in its gold reserve without changing its issuing policy, the aim of which is the liquidity of the London money market. The second contribution concerns interest rate policy. According to the Banking School, in the event of a lasting balance of payments disequilibrium, the solution consists in attracting or repelling foreign capital by changing the level of the Bank of England discount rate. To sum up, the rule for the Bank of England is to let the gold reserve fluctuate freely between a minimum and a maximum (£5 million and £15 million, according to Tooke), and to raise (lower) the discount rate when the reserve reaches the lower (upper) limit. The role of the Bank of England in regulating the international capital flows through its discount policy was re-stated by George Joachim Goschen in The Theory of Foreign Exchanges (1861) and Walter Bagehot in Lombard Street (1873).