Lombard Street

Bagehot could have called his book 'The Money Market'. He named it after a real street in the City of London instead, because he wanted to talk about concrete things: banks, deposits, bills, people who lend and people who borrow. If the subject sounds impalpable, he says, that is the writer's fault, not the subject's.

Then he puts the whole book into one line. Lombard Street is "by far the greatest combination of economical power and economical delicacy that the world has ever seen."

Most readers only hear the first half of that sentence. But power and delicacy are one fact, seen from two sides. Everything that makes the street strong is also what makes it fragile, and the chapter walks you from the first side to the second.

Start with the power. At the end of 1872, the banks that published their accounts held about 120 million pounds of deposits in London. Paris had 13 million, New York 40 million, the whole German Empire 8 million.

That does not mean England had more cash. Bagehot admits there was far more coin sitting outside banks in France and Germany. But French savings stayed in the custody of their owners, who trusted almost nothing. It took immense national misfortune and a vast loan in France's own securities to draw that hoard out.

English money was different. It was 'borrowable' money: deposited in a bank, it could be lent tomorrow to anyone with a sound use for it. A country's financial power, on this view, is not how much it owns but how much of it can be reached.

Why does putting money in a bank change what it is? Bagehot's answer is almost physical. "A million in the hands of a single banker is a great power." He can lend it at once, and borrowers know exactly where to go.

Scatter the same million in tens and fifties across a whole nation and it is no power at all. Nobody knows where it is, and nobody knows whom to ask for it.

So concentration, not sheer wealth, is the engine. Its effect shows up in a habit of mind his readers no longer noticed: they had lost the idea that a business likely to pay could die for want of money. A Londoner in Queen Elizabeth's time would have thought railways pointless, because no one could have collected the capital to build them.

According to Bagehot, why could so much more money be borrowed in London than in Paris?

• French law barred its banks from lending to foreign governments
• The Bank of England issued its notes more freely than the Bank of France
• English savings sat concentrated in banks, where lenders could reach them✓Correct answer
• England held more gold and coin in total than France did

Bagehot concedes that France had more cash outside banks than England. The difference was that English money was deposited and therefore 'borrowable', while hoarded French money, however large, was out of reach.

The power reaches down to the smallest trader. Take Bagehot's two merchants. The first has 50,000 pounds of his own. To earn 10 per cent he must make 5,000 a year, and he prices his goods to get it.

The second has only 10,000 of his own and borrows 40,000 by discounting bills at 5 per cent. He works the same 50,000 and pays 2,000 in interest. If he also makes 5,000, he keeps 3,000: thirty per cent on his own money.

Thirty per cent is far more than he needs. So he gives up part of it, lowers his prices, and drives the old merchant out of the market. Cheap, dependable credit creates what Bagehot calls a steady bounty on trading with borrowed capital, and the man who trades only on his own money is steadily discouraged.

In Bagehot's example, what lets the merchant with 10,000 of his own undersell the merchant with 50,000?

• Most of his capital need only earn interest, so a thinner margin still pays✓Correct answer
• He owes no interest on the borrowed money until his goods are sold
• His goods are poorer in quality, so they cost him far less to produce
• Banks charge small new traders lower rates than they charge old merchants

He needs only 5 per cent on the 40,000 he borrowed, not a full merchant's profit, so he can cut prices and still earn more on his own 10,000. Bagehot does grumble about shoddy goods from new men, but the arithmetic does not rest on that.