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• Preface
• Studies In the Theory of International Trade
• Chapter I: English Theories of Foreign Trade, Before Adam Smith: I
• I. Introduction
• II. “ Mercantilism” and “bullionism”
• III. the Balance-of-trade Doctrine
• IV. Reasons For Wanting More Bullion
• V. Employment and the Balance of Trade
• Chapter II: English Theories of Foreign Trade, Before Adam Smith: Ii
• I. Legislative Proposals of Mercantilists
• II. the Collapse of Mercantilist Doctrine
• III. Some Modern Interpretations of English Mercantilism
• Chapter III: The Bullionist Controversies: I. The Inflation Phase
• I. the Participants In the Controversy
• II. the Factual Background
• III. Premium On Bullion As Evidence of Excess Issue: the Bullionist Position
• IV. Qualifications Conceded By the Bullionists
• V. Possible Objections to the Bullionist Position
• VI. the Anti-bullionist Position
• VII. the Balance of Payments Argument
• VIII. the Possibility of Excess Issue By Banks
• IX. Responsibility For the Excess Issue: Bank of England Vs. Country Banks
• X. Responsibility For Excess Issue: the Credit Policy of the Bank of England
• Chapter IV: The Bullionist Controversies: II. The Deflation Phase
• I. the Resumption of Cash Payments
• II. Responsibility of Resumption For the Fall In Prices
• III. the Economic Effect of Changing Price Levels
• IV. Ricardo's Position On the Gold Standard
• V. Reform Without Departure From the Metallic Standard
• VI. Paper Standard Currencies
• Chapter V: English Currency Controversies, 1825–1865
• I. Introduction
• II. the “currency School” -“banking School” Controversy
• III. the “palmer Rule ”
• IV. the Bank Act of 1844
• V. the Possibility of Overissue of Convertible Bank Notes
• VI. the Role of Deposits, Bills of Exchange, and “credit” In the Currency System
• VII. the Technique of Credit Control
• VIII. the Relation Between Bank of England Operations and Specie Movements
• IX. Currency Reform Proposals
• Chapter VI: The International Mechanism Under a Simple Specie Currency
• I. Introductory
• II. the Mechanism According to Hume
• III. an Omitted Factor? Relative Changes In Demand As an Equilibrating Force
• IV. Prices In the Mechanism: the Concept of “price Levels ”
• V. the “terms-of-trade” Concept
• VI. the Prices of “domestic” Commodities
• VII. the Mechanism of Transfer of Unilateral Payments In Some Recent Literature
• VIII. a Graphical Examination of Pigou's Analysis 1
• IX. Some Elaborations On the Basis of Pigou's Analysis
• X. an Alternative Solution
• XI. Types of Disturbance In International Equilibrium
• XII. Specie Movements and Velocity of Money
• XIII. Commodity Flows and Relative Price Levels
• XIV. Exchange Rates
• XV. A Criticism of the Purchasing-power Parity Theory 1
• Chapter VII: The International Mechanism In Relation to Modern Banking Processes
• I. Automatic Vs. Managed Currencies
• II. Primary and Secondary Expansion of Means of Payments
• III. Short-term Loans In the International Mechanism
• IV. Primary and Secondary Expansion In Canada , 1900–13
• V. the International Mechanism and Business Cycles
• Chapter VIII: Gains From Trade: the Doctrine of Comparative Costs
• I. the Nature and Origin of the Doctrine
• II. the Division of the Gain From Trade
• III. Trade In More Than Two Commodities
• IV. Trade Between More Than Two Countries
• V. Transportation Costs
• VI. Increasing and Decreasing Costs
• VII. Prices, Money Costs, and Real Costs
• VIII. Dependence of Comparative Cost Doctrine On a Real-cost Theory of Value
• IX. Differences In Wage Rates In Different Occupations
• X. Variable Proportions of the Factors and International Specialization
• XI. Variable Proportions of the Factor and Comparative Real Costs
• XII. “ Opportunity Cost” Analysis As a Substitute For Real Cost Analysis
• Chapter IX: Gains From Trade: the Maximization of Real Income
• I. “ Mass of Commodities” and “sum of Enjoyments”: Ricardo and Malthus
• II. Reciprocal Demand and the Terms of Trade
• III. Terms of Trade and the Amount of Gain From Trade
• IV. “ Net Benefit” In International Trade: Marshall
• V. Total Net Utility Derived From International Trade: Edgeworth
• VI. the Gain From Trade Measured In Money
• Appendix: a Note On the Scope and Method of the Theory of International Trade

III. The “Palmer Rule”

In 1827 the Bank of England adopted a rule—later commonly known as the “Palmer rule” or the “rule of 1832” because it was first publicly explained, in 1832, by the then governor of the Bank, J. Horsley Palmer—which aimed at making the fluctuations in the English currency conform with those which would occur under a purely metallic currency by keeping its security holdings, including discounted paper, constant. At the same time, although apparently wholly independently, Pennington, a confidential adviser of the Treasury on currency matters, had recommended the same rule in a memorandum to Huskisson, then Chancellor of the Exchequer. The problem as Pennington saw it was to make the paper currency operate as would a “purely metallic currency”: “The great objection to a paper currency arises from the extreme difficulty of subjecting its expansion and contraction to the same law as that which regulates the expansion and contraction of a currency purely metallic.” 1 He offered as a solution that the Bank of England should be given an exclusive monopoly of note issue (or direct control over the issues of the other banks) and should hold a fixed amount of securities. There could then be no variations in its outstanding note circulation without corresponding variations in its holdings of bullion:

Nothing more would be necessary than that the bank should constantly hold a fixed amount of the same unvarying species of securities. If its outstanding liabilities amounted, at any particular time, to £26,000,000, and if, against these, it held £18,000,000 of government securities and £8,000,000 of bullion, then, by confining itself to the £18,000,000 of securities, the action of the foreign exchange would necessarily turn upon the gold: at one time the bank might have six, at another time ten, and at another eight millions of treasure; and in all cases, its paper would contract and expand according to the increase or diminution of its bullion.2

The Palmer rule was essentially the same. When the exchanges were at par and the currency “full,” the Bank should try to have a bullion reserve of one-third of its combined note and deposit liabilities, so that its current assets should be one-third bullion and two-thirds securities. Thereafter all that would be required would be to maintain the securities at a constant amount. An influx of gold from abroad would thus act to increase the note circulation by a corresponding amount; an efflux of gold or a demand for coin for internal circulation would result in a corresponding decrease in note circulation. The internal circulation, specie plus paper, would thus remain constant unless acted upon by external gold movements.3

This rule had the fatal defect that it took no account of the necessity of also maintaining deposits constant if the maintenance of securities at a constant amount was to guarantee correspondence between the fluctuations in bullion and the fluctuations in note circulation. If the deposits were permitted to fluctuate, then as the bullion holdings fluctuated the note circulation might remain constant, or might fluctuate in the reverse direction. Under an inconvertible paper currency, a case could be made for the general policy of keeping the securities constant, if departure from this rule to offset variations in the velocity of circulation of notes and deposits were permitted, and if provision were made for adjustment of the amount of securities to the secular trend of production resulting from growth of population and capital. But under an international metallic standard, adherence to the rule of keeping the securities constant could lead to serious and lasting disequilibrium between the internal and the world price levels, and therefore to exhaustion or to indefinite accumulation of gold reserves.4

It is not easy to understand Pennington's original position in this connection. The objective of control stated by him seems to involve an unqualified acceptance of the currency principle. But the method of control which he advocated, like the Palmer rule, would have made the fluctuations in notes plus deposits correspond with the fluctuations in specie reserves, whereas the currency principle called for correspondence between the fluctuations in notes alone and the fluctuations in specie reserves. It especially seems to call for explanation that Pennington, who was an important factor in drawing attention to the importance of deposits as a means of payment, should have advocated a rule which would permit of withdrawal through the deposits of all the specie reserves without calling for any positive corrective action on the part of the Bank. When Pennington later, in 1840, published his memorandum, his views had apparently undergone some modification. He now made it appear that by a “purely metallic currency” he had meant one which consisted only of specie, and that by “paper circulation” he had meant notes and deposits.5 This would bring his rule of control into conformity with his objective. Against the currency principle proper he protested that it would make the fluctuations in the currency (= notes and deposits) exceed the fluctuations which would occur under a simple specie currency, with the result that “the public will be exposed to very great alternations of comparative ease and difficulty in the operations of the money market.” 6 What he now supported, apparently, was a provisional adherence to the Palmer rule, which would limit the fluctuations in notes and deposits to the fluctuations in specie reserves, with departure from it in the form of open-market sales of securities only when otherwise dangerous depletion of the specie reserves would occur.7

As was to be expected, the affairs of the Bank went badly while the Palmer rule was in operation. From 1836 to 1839 in particular, while the rule was presumably being followed, the Bank was in serious difficulties much of the time. The Bank found at times that gold was being withdrawn for export through the deposits without any compensating reduction in the note circulation. It also found itself unable—or unwilling—to keep its securities constant, and it even increased its securities while a drain of gold was under way. Its difficulties were due in part to misguided violations of its own rule,8 but in part they were due also to the utter impracticability of the rule under a metallic reserve currency whenever greater contraction of the currency (notes and deposits) should be requisite than the rule of keeping the securities constant would permit.

Torrens and Overstone were critical of the Palmer rule, although they held that the departures from it had been such as to accentuate rather than moderate its shortcomings. They pointed out that if the currency principle were to be carried out, gold movements should not be permitted to operate on the deposits alone. When the Bank found that its gold reserves were being drawn out through its deposits, it should have reduced its note circulation by “forcible operation on its securities,” i.e., by deliberate contraction of its discounts or by sale of government securities in the open market. They held that maintenance of securities at a constant amount, instead of enforcing correspondence between the fluctuations in the amounts of bullion holdings and of note circulation, prevented the Bank from establishing such correspondence.9

According to Torrens and to Overstone, the error in the Palmer rule was that it aimed at keeping the whole of the Bank securities constant, including those upon which “the Bank lent its deposits,” and that it permitted gold flows to act on the whole of the liabilities, including the deposits. The Bank, on the contrary, should keep constant only those securities upon which it put out its notes, i.e., should keep constant the amount of its uncovered note circulation. Only then would variations in the Bank's note circulation necessarily correspond with the variations in its bullion holdings.10 To enforce this procedure on the Bank, and to make certain that the securities held as backing for the notes should be segregated from those held as backing for the deposits, the banking and issue departments of the Bank should be formally separated, and the latter should be confined to the exchange of notes for bullion and of bullion for notes, pound for pound, except for a fixed maximum of notes to be covered by securities.11 The currency school undoubtedly wanted the note issue powers of the country banks to be withdrawn, or at least drastically restricted, but they did not enlarge upon this phase of the question,12 as a precaution, perhaps, against providing further stimulus to the already vigorous opposition of the country bankers to the currency school proposals.

[1]James Pennington, Memorandum (privately printed), 1827, p. 8. The memorandum is reprinted in Pennington, A letter ... on the importation of foreign corn, 1840, pp. 82 ff.

[2]Memorandum, p. 14.

[3]Cf. the testimony of Mr. Palmer, Report from the [Commons] Committee of Secrecy on the Bank of England charter, 1832, p. 11.

[4]G. W. Norman later claimed that the Bank authorities were aware, when they adopted the Palmer rule, that it would allow an external drain of gold to be met by a diminution of deposits instead of by a contraction of note circulation, but thought it nevertheless the best principle available and practicable. (Remarks upon some prevalent errors, with respect to currency and banking. 1838, pp. 79 ff.)

[5]Letter ... on the importation of foreign corn, 1840, pp. 89–90.

[6]Ibid., p. 100.

[7]Cf. ibid., pp. 98–99.

Pennington later claimed that there was no danger that the reserves of the Bank of England could be seriously depleted through withdrawal of deposits, while the amount of note circulation remained undiminished: This ... could only happen to a very small extent, for a large portion of those deposits consists of the reserves of the private banks, which they are obliged to keep in hand, and which, in times of pressure and alarm, they find it expedient to increase rather than diminish. If, instead of leaving these reserves in the hands of the Bank, they withdrew them in the shape of bank notes, in order to keep them in their own tills, the operation would obviously be altogether a nugatory one. It would be holding their reserves in one shape, instead of in another. (“Letter from Mr. Pennington on the London banking system,” in John Cazenove, Supplement to thoughts on a few subjects of political economy, 1861, p. 53, note.)

[8]Palmer later defended the violations of the rule by the claim that they were all due to deliberate adjustment to exceptional circumstances. (J. Horsley Palmer, The causes and consequences of the pressure upon the money-market, 1837; ibid., Reply to the reflections, ... of Mr. Samuel Jones Loyd, 1837; also, his testimony before the Committee on banks of issue, 1840, Report, pp. 103 ff.) But circumstances which the Bank regarded as exceptional appeared to recur with surprising frequency. It is not clear what the motives of the Bank were in its departures from its own rule. Longfield pointed out that in case of an external drain: “The securities [under the Palmer rule] were to be kept even [i.e. not increased] for the convenience of the public, not the safety of the bank. The bank would be still more secure if it were active, and reduced its securities whenever an adverse state of the exchanges, or any other circumstance, leads to a demand for gold.” (“Banking and currency, IV,” Dublin University magazine, XVI (1840), 619.) On the same principle, expansion of its security holdings would under these circumstances serve the “convenience” of the public even better. But the income of the Bank would also profit from maintenance or expansion of its security holdings. As Samson Ricardo queried, “May not a slight consideration for the Bank Stock proprietors sometimes interfere with a strict adherence to the principle laid down?” (Observations on the recent pamphlet of J. Horsley Palmer, 1837, p. 27.) In justice to the Bank directors, however, it should be noted that it was a rule of the Bank that no director should hold more than £2000 of the Bank's stock, the minimum qualifying amount.

[9]Cf. Torrens, A letter to ... Lord Melbourne, on the causes of the recent derangement in the money market, 2d ed., 1837, p. 29; Overstone, Reflections suggested by ... Mr. J. Horsley Palmer's pamphlet [1837], reprinted in Overstone, Tracts and other publications on metallic and paper currency, J. R. McCulloch ed., 1857, p. 29.

[10]Torrens, Supplement to a letter ... on the derangement in the money market, 1837, p. 6, and appendix, pp. 4, 5; Overstone, Reflections, 1837, in Tracts, pp. 7–9.

[11]Torrens, A letter to Thomas Tooks, Esq., in reply to his objections, 1840, pp. 5 ff.; Overstone, Reflections [1837], in Overstone, Tracts, pp. 38–39.

[12]Cf. G. W. Norman, Letter to Charles Wood, Esq., M. P. on money, 1841, p. 95: “I advisedly pass over the question, should the treasure in the Bank of England increase and decrease in equal proportion with its own notes or in equal proportion with the whole paper-money of the country?”