The Theory of Money and Credit

Ludwig von Mises.
Mises, Ludwig von
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H. E. Batson, trans.
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Indianapolis, IN: Liberty Fund, Inc.
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Foreword by Murray Rothbard and Introduction by Lionel Robbins not available online
25 of 33


Money, Credit, and Interest

1 On the Nature of the Problem


It is the object of this chapter to investigate the connection between the amount of money in circulation and the level of the rate of interest. It has already been shown that variations in the proportion between the quantity of money and the demand for money influence the level of the exchange ratio between money and other economic goods. It now remains for us to investigate whether the variations thus evoked in the prices of commodities affect goods of the first order and goods of higher orders to the same extent. Until now we have considered variations in the exchange ratio between money and consumption goods only and left out of account the exchange ratio between money and production goods. This procedure would seem to be justifiable, for the determination of the value of consumption goods is the primary process and that of the value of production goods is derived from it. Capital goods or production goods derive their value from the value of their prospective products; nevertheless, their value never reaches the full value of these prospective products, but as a rule remains somewhat below it. The margin by which the value of capital goods falls short of that of their expected products constitutes interest; its origin lies in the natural difference of value between present goods and future goods.*56 If price variations due to monetary determinants happened to affect production goods and consumption goods in different degrees—and the possibility cannot be dismissed offhand—then they would lead to a change in the rate of interest. The problem suggested by this is identical with a second, although they are usually dealt with separately: Can the rate of interest be affected by the credit policy of the banks that issue fiduciary media? Are banks able to depress the rate of interest charged by them, for those loans that their power to issue fiduciary media enables them to make, until it reaches the limit set by the technical working costs of their lending business? The question that confronts us here is the much discussed question of the gratuitous nature of bank credit.


In lay circles this problem is regarded as long since solved. Money performs its function as a common medium of exchange in facilitating not only the sale of present goods but also the exchange of present goods for future goods and of future goods for present goods. An entrepreneur who wishes to acquire command over capital goods and labor in order to begin a process of production must first of all have money with which to purchase them. For a long time now it has not been usual to transfer capital goods by way of direct exchange. The capitalists advance money to the producers, who then use it for buying means of production and for paying wages. Those entrepreneurs who have not enough of their own capital at their disposal do not demand production goods, but money. The demand for capital takes on the form of a demand for money. But this must not deceive us as to the nature of the phenomenon. What is usually called plentifulness of money and scarcity of money is really plentifulness of capital and scarcity of capital. A real scarcity or plentifulness of money can never be directly perceptible in the community, that is, it can never make itself felt except through its influence on the objective exchange value of money and the consequences of the variations so induced. For since the utility of money depends exclusively upon its purchasing power, which must always be such that total demand and total supply coincide, the community is always in enjoyment of the maximum satisfaction that the use of money can yield.


This was not recognized for a long time and to a large extent it is not recognized even nowadays. The entrepreneur who would like to extend his business beyond the bounds set by the state of the market is prone to complain of the scarcity of money. Every increase in the rate of discount gives rise to fresh complaints about the illiberality of the banks' methods or about the unreasonableness of the legislators who make the rules that limit their powers of granting credit. The augmentation of fiduciary media is recommended as a universal remedy for all the ills of economic life. Much of the popularity of inflationary tendencies is based on similar ways of thinking. And it is not only laymen who subscribe to such views. Even if experts have been unanimous on this point since the famous arguments of David Hume and Adam Smith,*57 almost every year new writers come forward with attempts to show that the size and composition of the stock of capital has no influence on the level of interest, that the rate of interest is determined by the supply of and the demand for credit, and that, without having to raise the rate of interest, the banks would be able to satisfy even the greatest demands for credit that are made upon them, if their hands were not tied by legislative provisions.*58


The superficial observer whose insight is not very penetrating will discover many symptoms which seem to confirm the above views and others like them. When the banks-of-issue proceed to raise the rate of discount because their note circulation threatens to increase beyond the legally permissible quantity, then the most immediate cause of their procedure lies in the provisions that have been made by the legislators for the regulation of their right of issue. The general stiffening of the rate of interest in the so-called money market, the market for short-term capital investments, which occurs, or at least should occur, as a consequence of the rise of the discount rate, is therefore, and with a certain appearance of justification, laid to the charge of national banking policy. Still more striking is the procedure of the central banks when they think it beyond their power to bring about the desired general dearness in the money market by merely increasing the bank rate: they take steps which have the immediate object of forcing up the rate of interest demanded by the other national credit-issuing banks in their short-term-loan business. The Bank of England is in the habit in such circumstances of forcing consols on the open market,*59 the German Reichsbank of offering Treasury bonds for discount. If these methods are considered by themselves, without account being taken of their function in the market, then it seems reasonable to conclude that legislation and the self-seeking policy of the banks are responsible for the rise in the rate of interest. Inadequate Understanding of the complicated relationships of economic life makes all such legislative provisions appear to be measures in favor of capitalism and against the interest of the producing classes.*60


But the defenders of orthodox banking policy have been no happier in their arguments. They evidence no very considerable insight into the problems lying behind such slogans as "protection of the standard" and "control of excessive speculation." Their prolix discussions are generously garnished with statistical data that are incapable of proving anything, and they devote scrupulous attention to the avoidance of the big questions of theory that constitute the bulk of their subject. It is undeniable that there are some excellent works of a descriptive nature to be found among the huge piles of valueless publications on banking policy of recent years, but it is equally undeniable that with a few honorable exceptions their contribution to theory cannot compare with the literary memorials left by the great controversy of the Currency and Banking Schools.


The older English writers on the theory of the banking system made a determined attempt to apprehend the essence of the problem. The question around which their investigations centered is whether there is a limit to the granting of credit by the banks; it is identical with the question of the gratuitous nature of credit; it is most intimately connected with the problem of interest. During the first four decades of the nineteenth century the Bank of England was able to regulate only to a limited degree the amount of credit granted by varying the rate of discount. Because of the legislative restriction of the rate of interest which was not removed until 1837 it could not raise its rate of discount above five percent; and it never allowed it to fall below four percent.*61 At that time the best means it had of adjusting its portfolio to the state of the capital market was the expansion and contraction of its discounting activities. That explains why the old writers on banking theory mostly speak only of increases and diminutions of the note circulation, a mode of expression that was still retained long after the circumstances of the time would have justified reference to rises and falls in the rate of discount. But this does not affect the essence of the matter; in both problems, the only point at issue is whether the banks can grant credit beyond the available amount of capital or not.*62


Both parties were agreed in answering this question in the negative. This is not surprising. These English writers had an extraordinarily deep understanding of the nature of economic activities; they combined thorough knowledge of the theoretical literature of their time with an insight into economic life that was based upon their own observations. Their strictly logical training permitted them rapidly and easily to separate essentials from nonessentials and guarded them from mistaking the outer husk of truth for the kernel that it encloses. Their views on the nature of interest might diverge considerably—many of them, in fact, had but the vaguest ideas on this important problem, whose significance was not made explicit until a later stage in the development of the science—but they harbored no doubts that the level of the rate of interest as determined by general economic conditions could certainly not be influenced by an increase or diminution in the quantity of money or other media of payment in circulation, apart from considerations of the increase in the stock of goods available for productive purposes that might be brought about by the diminution of the demand for money.


But beyond this the paths of the two schools diverged. Tooke, Fullarton, and their disciples flatly denied that the banks had any power to increase the amount of their note issue beyond the requirements of business. In their view, the media of payment issued by the banks at any particular time adjust themselves to the requirements of business in such a way that with their assistance the payments that have to be made at that time at a given level of prices can all be settled by the use of the existing quantity of money. As soon as the circulation is saturated, no bank, whether it has the right to issue notes or not, can continue to grant credit except from its own capital or from that of its depositors.*63 These views were directly opposed to those of Lord Overstone, Torrens, and others, who started by assuming the possibility of the banks having the power of arbitrarily extending their note issue, and who attempted to determine the way in which the disturbed equilibrium of the market would reestablish itself after such a proceeding.*64 The Currency School propounded a theory, complete in itself, of the value of money and the influence of the granting of credit on the prices of commodities and on the rate of interest. Its doctrines were based upon an untenable fundamental view of the nature of economic value; its version of the quantity theory was a purely mechanical one. But the school should certainly not be blamed for this: its members had neither the desire nor the power to rise above the economic doctrine of their time. Within the Currency School's own sphere of investigation, it was extremely successful. This fact deserves grateful recognition from those who, coming after it, build upon the foundations it laid. This needs particular emphasis in the face of the belittlements of its influence which now appear to be part of the stock contents of all writings on banking theory. The shortcomings exhibited by the system of the Currency School have offered an easy target to the critical shafts of their opponents, and doubtless the adherents of the banking principle deserve much credit for making use of this opportunity. If this had been all that they did, if they had merely announced themselves as critics of the currency principle, no objection could be raised against them on that account. The disastrous thing about their influence lay in their claiming to have created a comprehensive theory of the monetary and banking systems and in their imagining that their obiter dicta on the subject constituted such a theory. For the classical theory whose shortcomings should not be extenuated but whose logical acuteness and deep insight into the complications of the problem are undeniable, they substituted a series of assertions that were not always formulated with precision and often contradicted one another. In so doing they paved the way for that method of dealing with monetary problems that was customary in our science before the labors of Menger began to bear their fruit.*65


The fatal error of Fullarton and his disciples was to have overlooked the fact that even convertible banknotes remain permanently in circulation and can then bring about a glut of fiduciary media the consequences of which resemble those of an increase in the quantity of money in circulation. Even if it is true, as Fullarton insists, that banknotes issued as loans automatically flow back to the bank after the term of the loan has passed, still this does not tell us anything about the question whether the bank is able to maintain them in circulation by repeated prolongation of the loan. The assertion that lies at the heart of the position taken up by the Banking School, namely that it is impossible to set and permanently maintain in circulation more notes than will meet the public demand, is untenable; for the demand for credit is not a fixed quantity; it expands as the rate of interest falls, and contracts as the rate of interest rises. But since the rate of interest that is charged for loans made in fiduciary media created expressly for that purpose can be reduced by the banks in the first instance down to the limit set by the marginal utility of the capital used in the banking business, that is, practically to zero, the whole edifice built up by Tooke's school collapses.


It is not our task to give a historical exposition of the controversy between the two famous English schools, however tempting an enterprise that may be. We must content ourselves with reiterating that the works of the much abused Currency School contain far more in the way of useful ideas and fruitful thoughts than is usually assumed, especially in Germany, where as a rule the school is known merely through the writings of its opponents, such as Tooke and Newmarch's History of Prices, J. S. Mill's Principles, and German versions of the banking principle which are deficient in comprehension of the nature of the problems they deal with.


Before proceeding to investigate the influence of the creation of fiduciary media on the determination of the objective exchange value of money and on the level of the rate of interest, we must devote a few pages to the problem of the relationship between variations in the quantity of money and variations in the rate of interest.

2 The Connection Between Variations in the Ratio Between the Stock of Money and the Demand for Money and Fluctuations in the Rate of Interest


Variations in the ratio between the stock of money and the demand for money must ultimately exert an influence on the rate of interest also; but this occurs in a different way from that popularly imagined. There is no direct connection between the rate of interest and the amount of money held by the individuals who participate in the transactions of the market; there is only an indirect connection operating in a roundabout way through the displacements in the social distribution of income and wealth which occur as a consequence of variations in the objective exchange value of money.


A change in the ratio between the stock of money and the demand for money, and the consequent variations in the exchange ratio between money and other economic goods, can exert a direct influence on the rate of interest only when metallic money is employed and variations arise in the quantity of metal available for industrial purposes. The augmentation or diminution of the quantity of metal available for nonmonetary uses signifies an augmentation or diminution of the national subsistence fund and thus it influences the level of the rate of interest. It is hardly necessary to state that the practical significance of this phenomenon is quite trifling. We may, for example, imagine how small in comparison with the daily accumulation of capital was the increase in the subsistence fund caused by the discoveries of gold in South Africa, or even the increase in the subsistence fund that would have occurred if the whole of the newly mined precious metal had been used exclusively for industrial purposes. But however that may be, all that is important for us is to show that this is a phenomenon that is only connected with nonmonetary avenues of employment of the metal.


Now as far as the monetary function is concerned, a long discussion is not necessary to show that everything here depends on whether or not the additional quantity of money is employed uniformly for procuring production goods and consumption goods. If an additional quantity of money were to increase the demand both for consumption goods and for the corresponding goods of higher order in exactly the same proportion or if the withdrawal from circulation of a quantity of money were to diminish these demands in exactly the same proportion, then there could be no question of such variations having a permanent effect on the level of the rate of interest.


We have seen that displacements in the distribution of income and property constitute an essential consequence of fluctuations in the objective exchange value of money. But every variation in the distribution of income and property entails variations in the rate of interest also. It is not a matter of indifference whether a total income of a million kronen is distributed among a thousand persons in such a way that a hundred persons get 2,800 kronen each and nine hundred persons 800 kronen each or in such a way that each of the thousand persons gets 1,000 kronen. Generally speaking, individuals with large incomes make better provision for the future than individuals with small incomes. The smaller an individual's income is, the greater is the premium which he sets on present goods in comparison with future goods. Conversely increased prosperity means increased provision for the future and higher valuation of future goods.*66


Variations in the ratio between the stock of money and the demand for money can permanently influence the rate of interest only through the displacements in the distribution of property and income that they evoke. If the distribution of income and property is modified in such a way as to increase capacity for saving, then eventually the ratio between the value of present goods and future goods must be modified in favor of the latter. In fact, one of the elements that help to determine the rate of interest, the level of the national subsistence fund, is necessarily altered by the increase of savings. The greater the fund of means of subsistence in a community, the lower the rate of interest.*67 It follows immediately from this that particular variations in the ratio between the stock of money and the demand for money cannot be always accredited with the same effects on the level of the rate of interest; for example, it cannot be asserted that an increase in the stock of money causes the rate of interest to fall and a diminution of the stock of money causes it to rise. Whether the one or the other consequence occurs always depends on whether the new distribution of property is more or less favorable to the accumulation of capital. But this circumstance may be different in each individual case, according to the relative quantitative weight of the particular factors composing it. Without knowledge of the actual data it is impossible to say anything definite about it.


These are the long-run effects on the rate of interest caused by variations in the ratio between the total demand for money and the total stock of it. They come about in consequence of displacements in the distribution of income and property evoked by fluctuations in the objective exchange value of money, and are as permanent as these fluctuations. But during the period of transition there occur other variations in the rate of interest that are only of a transitory nature. Reference has already been made to the fact that the general economic consequences of variations in the exchange value of money arise in part from the fact that the variations do not appear everywhere simultaneously and uniformly, but start from a particular point and only spread gradually throughout the market. So long as this process is going on, differential profits or differential losses occur, which are in fact the source from which the variations in the distribution of income and property arise. As a rule, it is the entrepreneurs who are first affected. If the objective exchange value of money falls, the entrepreneur gains; for he will still be able to meet part of his expenses of production at prices that do not correspond to the higher price level, while, on the other hand, he will be able to dispose of his product at a price that is in accordance with the variation that has meanwhile occurred. If the objective exchange value of money rises, the entrepreneur loses; for he will only be able to secure for his products a price in accordance with the fall in the price level, while his expenses of production must still be met at the higher prices. In the first case, the incomes of entrepreneurs will rise during the transition period; in the second case, they will fall. This cannot fail to have an influence on the rate of interest. An entrepreneur who is making bigger profits will be prepared if necessary to pay a higher rate of interest, and the competition of other would-be borrowers, who are attracted by the same prospect of increased profits, will make payment of the higher rate necessary. The entrepreneur with whom business is bad will only be able to pay a lower rate of interest and the pressure of competition will oblige lenders to be content with the lower rate. Thus a falling value of money goes hand in hand with a rising rate of interest, and a rising value of money with a falling rate of interest. This lasts as long as the movement of the objective exchange value of money continues. When this ceases, then the rate of interest is reestablished at the level dictated by the general economic situation.*68


Thus, variations in the rate of interest do not occur as immediate consequences of variations in the ratio between the demand for money and the stock of it; they are only produced by the displacements in the social distribution of property that accompany the fluctuations in the objective exchange value of money that the variations in the ratio between the stock of money and the demand for it evoke. Moreover, the oft-repeated question of the precise connection between variations in the objective exchange value of money and variations in the rate of interest betrays an unfortunate confusion of ideas. The variations in the relative valuations of present goods and future goods are not different phenomena from the variations in the objective exchange value of money. Both are part of a single transformation of existing economic conditions, determined in the last resort by the same factors. In now devoting to it the consideration it deserves, we atone for a negligence and fill a gap in the argument contained in our second part.

3 The Connection Between the Equilibrium Rate and the Money Rate of Interest


An increase in the stock of money in the broader sense caused by an issue of fiduciary media means a displacement of the social distribution of property in favor of the issuer. If the fiduciary media are issued by the banks, then this displacement is particularly favorable to the accumulation of capital, for in such a case the issuing body employs the additional wealth that it receives solely for productive purposes, whether directly by initiating and carrying through a process of production or indirectly by lending to producers. Thus, as a rule, the fall in the rate of interest in the loan market, which occurs as the most immediate consequence of the increase in the supply of present goods that is due to an issue of fiduciary media, must be in part permanent; that is, it will not be wiped out by the reaction that is afterward caused by the diminution of the property of other persons. There is a high degree of probability that extensive issues of fiduciary media by the banks represent a strong impulse toward the accumulation of capital and have consequently contributed to the fall in the rate of interest.


One thing must be clearly stated at this point: there is no direct arithmetical relationship between an increase or decrease in the issue of fiduciary media on the one hand and the reduction or increase in the rate of interest which this indirectly brings about through its effects on the social distribution of property on the other hand. This would follow merely from the circumstance that there is no direct relationship between the redistribution of property and the differences in the way in which the existing stock of goods in the community is employed. The redistribution of property causes individual economic agents to take different decisions from those they would otherwise have taken. They deal with the goods at their disposal in a different way; they allocate them differently between present (consumptive) employment and future (productive) employment. This may give rise to an alteration in the size of the national subsistence fund if the alterations in the uses to which the goods are put by the individual economic agents do not offset one another but leave a surplus in the one direction or the other This alteration in the size of the national subsistence fund is the most immediate cause of the variation which occurs in the rate of interest; and since, as has been shown, it is by no means unequivocally determined by the extent and direction of the fluctuation in the stock of money in the broader sense, but depends upon the whole social distributive structure, no direct relationship can be established between the variations in the stock of money in the broader sense and the variations in the rate of interest. In fact it is obvious that however great the increase in the stock of money in the broader sense might be, whether it occurred by way of an increase in fiduciary media or by way of an increase in the stock of money in the narrower sense, the rate of interest could never be reduced to zero. That could take place only if the displacements that occurred increased the national subsistence fund to such an extent that all possibilities of increasing production by engaging in more productive "roundabout" methods of production were exhausted. This would mean that in all branches of production the time that elapsed between the commencement of production and the enjoyment of the product was not taken into consideration, and production was carried so far that the prices of the products were only just sufficient to pay an equal return to the primary factors in each employment. In particular, as far as very durable goods are concerned, this would mean that their quantity and durability would be tremendously increased, until the prices of their services fell so low that they would only just provide for the amortization of the investments. It is impossible to conceive of the extent to which, for example, the supply of houses would have to be increased for their annual rental value to fall to a sum which would only just give a total return equal to their original cost by the time when their lengthened lives came to an end. Where the lifetime of a good can be almost indefinitely increased under conditions of decreasing cost, the result is that its services will become practically free goods. It seems hardly likely that a rigid proof could be given to show that the increase in the size of the national subsistence fund that may follow a redistribution of property could never go so far as this. But we have sufficient capacity for estimating the quantities involved without this unobtainable precise proof. As regards the displacements in the distribution of property that are evoked by an increase in the circulation of fiduciary media, it seems that we might go still further and safely assert that it can in no circumstances be very considerable. Although we cannot prove this in any way, whether deductively or inductively, it nevertheless appears a reasonable assertion to make. And we may content ourselves with that; for we do not intend to base any kind of further argument on such an undemonstrable proposition.


The question to which we now turn is the following: It is indisputable that the banks are able to reduce the rate of interest on the credit they grant down to any level above their working expenses (for example, the cost of manufacturing the notes, the salaries of their staffs, etc.). If they do this, the force of competition obliges other lenders to follow their example. Accordingly, it would be entirely within the power of the banks to reduce the rate of interest down to this limit, provided that in so doing they did not set other forces in motion which would automatically reestablish the rate of interest at the level determined by the circumstances of the capital market, that is, the market in which present goods and future goods are exchanged for one another The problem that is before us is usually referred to by the catch-phrase "gratuitous nature of credit." It is the chief problem in the theory of banking.


It is a problem whose great theoretical and practical importance has often been overlooked. The chief responsibility for this belongs to the not altogether fortunate manner in which it has been formulated. At the present time, the problem of the gratuitous nature of bank credit does not appear to be a very practical issue, and since the inclination toward questions of pure theory is hardly prominent among the economists of our day it is a problem that has been much neglected. Yet, if the way in which the problem is stated is modified only a little the unjustifiability of neglecting it becomes obvious, even from the point of view of those who are only concerned with the needs of everyday life. A new issue of fiduciary media, as we have seen, indirectly gives rise to a variation in the rate of interest by causing displacements in the social distribution of income and property. But the new fiduciary media coming on to the loan market have also a direct effect on the rate of interest. They are an additional supply of present goods and consequently they tend to cause the rate of interest to fall. The connection between these two effects on the rate of interest is not obvious. Is there a force that brings both into harmony or not? It is probable in the highest degree that the increase in the supply of fiduciary media in the market in which present goods are exchanged for future goods at first exerts a stronger influence than the displacement of the social distribution which occurs as a consequence of it. Does the matter remain at that stage? Is the immediate reduction of interest which indubitably follows the increase of fiduciary media definitive or not?


Until now, the treatment that this problem has met with at the hands of economists has fallen a long way short of its importance. Its real nature has for the most part been misunderstood; and where the problem was incorrectly stated to start with, it was natural that the subsequent attempts at its solution should not have been successful. But even the few theories in which the essence of the problem has been correctly apprehended have fallen into error in their efforts to solve it.


To one group of writers, the problem appeared to offer little difficulty. From the circumstance that it is possible for the banks to reduce the rate of interest in their bank-credit business down to the limit set by their working costs, these writers thought it permissible to deduce that credit can be granted gratuitously or, more correctly, almost gratuitously. In drawing this conclusion, their doctrine implicitly denies the existence of interest. It regards interest as com pensation for the temporary relinquishing of money in the broader sense—a view, indeed, of insurpassable naivety. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest hold an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy.*69


No less untenable is the attitude of orthodox scientific opinion toward the problem. Orthodox scientific opinion, following in this the example set by the adherents of the banking principle, is content to question the problem's existence. In fact, it cannot do otherwise. If the opinion is held that the quantity of fiduciary media in circulation can never exceed the demand—in the sense defined above—the conclusion necessarily follows that the banks have not the ability to grant credit gratuitously. Of course, they might not exact any reimbursement or compensation beyond the prime costs of the loans granted by them. But doing this would not fundamentally change the matter, except that the profits from the issue of fiduciary media that the banks would otherwise receive themselves would now go to the benefit of the borrowers. And since, according to this view, it does not lie in the power of the banks arbitrarily to increase the quantity of fiduciary media in circulation, the limitation of the issue of these would leave only small scope for the influence of their discount policy on the general rate of interest. It follows that only insignificant differences could arise between the rate of interest charged by credit-issuing banks and that determined by the general economic situation for other credit transactions.


We have already had an opportunity of finding out where the error in this argument lies. The quantity of fiduciary media flowing from the banks into circulation is admittedly limited by the number and extent of the requests for discounting that the banks receive. But the number and extent of these requests are not independent of the credit policy of the banks; by reducing the rate of interest charged on loans, it is possible for the banks indefinitely to increase the public demand for credit. And since the banks—as even the most orthodox disciples of Tooke and Fullarton cannot deny—can meet all these demands for credit, they can extend their issue of fiduciary media arbitrarily. For obvious reasons an individual bank is not in a position to do this so long as its competitors act otherwise; but there seems to be no reason why all the credit-issuing banks in an isolated community, or in the whole world, taken together could not do this by uniform procedure. If we imagine an isolated community in which there is only a single credit-issuing bank in business, and if we further assume (what indeed is obvious) that the fiduciary media issued by it enjoy general confidence and are freely employed in business as money substitutes, then the weakness of the assertions of the orthodox theory of banking is most clear In such a situation there are no other limits to the bank's issue of fiduciary media than those which it sets itself.


But even the Currency School has not treated the problem in a satisfactory manner It would appear—exhaustive historical investigation might perhaps lead to another conclusion—that the Currency School was merely concerned to examine the consequences of an inflation of fiduciary media in the case of the coexistence of several independent groups of banks in the world, starting from the assumption that these groups of banks did not all follow a uniform and parallel credit policy. The case of a general increase of fiduciary media, which for the first half of the nineteenth century had scarcely any immediate practical importance, was not included within the scope of its investigations. Thus it did not even have occasion to consider the most important aspect of the problem. What is necessary for clearing up this important problem still remains to be done; for even Wicksell's most noteworthy attempt cannot be said to have achieved its object. But at least it has the merit of having stated the problem clearly.


Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about.*70 Up to this point Wicksell commands assent; but his further argument provokes contradiction.


According to Wicksell, at every time and under all possible economic conditions there is a level of the average money rate of interest at which the general level of commodity prices no longer has any tendency to move either upward or downward. He calls it the normal rate of interest; its level is determined by the prevailing natural rate of interest, although, for certain reasons which do not concern our present problem, the two rates need not coincide exactly. When, he says, from any cause whatever, the average rate of interest is below this normal rate, by any amount, however small, and remains at this level, a progressive and eventually enormous rise of prices must occur "which would naturally cause the banks sooner or later to raise their rates of interest."*71 Now, so far as the rise of prices is concerned, this may be provisionally conceded. But it still remains inconceivable why a general rise in commodity prices should induce the banks to raise their rates of interest. It is clear that there may be a motive for this in the regulations, whether legislative or established by mercantile custom, that limit the circulation of fiduciary media; or necessary consideration of the procedure of other banks might have the same sort of effect. But if we start with the assumption, as Wicksell does, that only fiduciary media are in circulation and that the quantity of them is not legislatively restricted, so that the banks are entirely free to extend their issues of them, then it is impossible to see why rising prices and an increasing demand for loans should induce them to raise the rate of interest they charge for loans. Even Wicksell can think of no other reason for this than that since the requirements of business for gold coins and banknotes becomes greater as the price level rises, the banks do not receive back the whole of the sums they have lent, part of them remaining in the hands of the public; and that the bank reserves are consequently depleted while the total liabilities of the banks increase; and that this must naturally induce them to raise their rate of interest.*72 But in this argument Wicksell contradicts the assumption that he takes as the starting point of his investigation. Consideration of the level of its cash reserves and their relation to the liabilities arising from the issue of fiduciary media cannot concern the hypothetical bank that he describes. He seems suddenly to have forgotten his original assumption of a circulation consisting exclusively of fiduciary media, on which assumption, at first, he rightly laid great weight.


Wicksell incidentally makes cursory mention of a second limit to the circulation of fiduciary media. He thinks that the banks that charge a lower rate of interest than that which corresponds to the average level of the natural rate of interest encounter a limit which is set by the employment of the precious metals for industrial purposes. If the purchasing power of money is too low it discourages the production of gold but increases, ceteris paribus, the industrial consumption of gold, and the deficiency which would arise as soon as consumption began to exceed production has to be made up from the bank reserves.*73 This is perfectly true when metallic money is employed; an increase of fiduciary media must be stopped before the reduction of the objective exchange value of money that it brings about absorbs the value arising from the monetary employment of the metal. As soon as the objective exchange value of money had sunk below the value of the metal in industrial uses, every further loss in value (which, of course, would also affect the purchasing power of the money substitutes in the same degree), would send all those who needed the metal for industrial purposes to the counters of the banks as their cheapest source of supply. The banks would not be able to extend their issue any further since it would be possible for their customers to make a profit simply by the exchange of fiduciary media for money; all fiduciary media issued beyond the given limit would return immediately to the banks.*74


But demonstrating this does not bring us a step nearer to the solution of our problem. The mechanism, by which a further issue of fiduciary media is restricted as soon as the falling objective exchange value of the material from which the money is made has reached the level set by its industrial employment, is, of course, effective only in the case of commodity money; in the case of credit money, it is effective only when the embodied claim refers to commodity money. And it is never effective in the case of fiat money. Of greater importance is a second factor: this limit is a distant one, so that even when it is eventually effective it still leaves considerable scope for an increase in the issue of fiduciary media. But it by no means follows from this that it remains possible for the banks to reduce the rate of interest on loans as much as they like within these wide limits; as the following argument will attempt to prove.

4 The Influence of the Interest Policy of the Credit-issuing Banks on Production


Assuming uniformity of procedure, the credit-issuing banks are able to extend their issues indefinitely. It is within their power to stimulate the demand for capital by reducing the rate of interest on loans, and, except for the limits mentioned above, to go so far in this as the cost of granting the loans permits. In doing this they force their competitors in the loan market, that is all those who do not lend fiduciary media which they have created themselves, to make a corresponding reduction in the rate of interest also. Thus the rate of interest on loans may at first be reduced by the credit-issuing banks almost to zero. This, of course, is true only under the assumption that the fiduciary media enjoy the confidence of the public so that if any requests are made to the banks for liquidation of the promise of prompt cash redemption which constitutes the nature of fiduciary media, it is not because the holders have any doubts as to their soundness. Assuming this, the only possible reason for the withdrawal of deposits or the presentation of notes for redemption is the existence of a demand for money for making payments to persons who do not belong to the circle of customers of the individual banks. The banks need not necessarily meet such demands by paying out money; the fiduciary media of those banks among whose customers are those persons to whom the banks' own customers wish to make payments are equally serviceable in this case. Thus there ceases to be any necessity for the banks to hold a redemption fund consisting of money; its place may be taken by a reserve fund consisting of the fiduciary media of other banks. If we imagine the whole credit system of the world concentrated in a single bank, it will follow that there is no longer any presentation of notes or withdrawal of deposits; in fact, the whole demand for money in the narrower sense may disappear. These suppositions are not at all arbitrary. It has already been shown that the circulation of fiduciary media is possible only on the assumption that the issuing bodies enjoy the full confidence of the public, since even the dawning of mistrust would immediately lead to a collapse of the house of cards that comprises the credit circulation. We know, furthermore, that all credit-issuing banks endeavor to extend their circulation of fiduciary media as much as possible, and that the only obstacles in their way nowadays are legal prescriptions and business customs concerning the covering of notes and deposits, not any resistance on the part of the public. If there were no artificial restriction of the credit system at all, and if the individual credit-issuing banks could agree to parallel procedure, then the complete cessation of the use of money would only be a question of time. It is, therefore, entirely justifiable to base our discussion on the above assumption.


Now, if this assumption holds good, and if we disregard the limit that has already been mentioned as applying to the case of metallic money, then there is no longer any limit, practically speaking, to the issue of fiduciary media; the rate of interest on loans and the level of the objective exchange value of money is then limited only by the banks' running costs—a minimum, incidentally which is extraordinarily low. By making easier the conditions on which they will grant credit, the banks can extend their issue of fiduciary media almost indefinitely. Their doing so must be accompanied by a fall in the objective exchange value of money. The course taken by the depreciation that is a consequence of the issue of fiduciary media by the banks may diverge in some degree from that which it takes in the case of an increase of the stock of money in the narrower sense, or from that which it takes when the fiduciary media are issued otherwise than by banks; but the essence of the process remains the same. For it is a matter of indifference whether the diminution in the objective exchange value of money begins with the mine owners, with the government which issues fiat money credit money, or token coins, or with the undertakings that have the newly issued fiduciary media placed at their disposal by way of loans.


Painful consideration of the question whether fiduciary media really could be indefinitely augmented without awakening the mistrust of the public would be not only supererogatory, but otiose. For the problems of theory that we are dealing with, it is a question that has scarcely any significance. We are not conducting our investigation in order to show that the objective exchange value of money and the rate of interest on loans could be reduced almost to zero; but in order to disclose the consequences that arise from the divergence (which we have shown to be possible) between the money rate and the natural rate of interest. For this reason, it is also a matter of indifference to us, as we have just shown, that under a system of commodity money the fiduciary media cannot continue to be augmented after the objective exchange value of the money is reduced to the level determined by the industrial employment of the metal.


If it is possible for the credit-issuing banks to reduce the rate of interest on loans below the rate determined at the time by the whole economic situation (Wicksell's natürliche Kapitalzins or natural rate of interest), then the question arises of the particular consequences of a situation of this kind. Does the matter rest there, or is some force automatically set in motion which eliminates this divergence between the two rates of interest? It is a striking thing that this problem, which even at a first glance cannot fail to appear extremely interesting, and which moreover under more detailed examination proves to be one of the greatest importance for comprehension of many of the processes of modern economic life, has until now hardly been dealt with seriously at all.


We shall not say anything further here of the effects of an increased issue of fiduciary media on the determination of the objective exchange value of money; they have already been dealt with exhaustively. Our task now is merely to discover the general economic consequences of any conceivable divergence between the natural and money rates of interest, given uniform procedure on the part of the credit-issuing banks. We obviously need only consider the case in which the banks reduce the rate of interest below the natural rate. The opposite case, in which the rate of interest charged by the banks is raised above the natural rate, need not be considered; if the banks acted in this way, they would simply withdraw from the competition of the loan market, without occasioning any other noteworthy consequences.


The level of the natural rate of interest is limited by the productivity of that lengthening of the period of production which is just justifiable economically and of that additional lengthening of the period of production which is just not justifiable; for the interest on the unit of capital upon whose aid the lengthening depends must always amount to less than the marginal return of the justifiable lengthening and to more than the marginal return of the unjustifiable lengthening. The period of production which is thus defined must be of such a length that exactly the whole available subsistence fund is necessary on the one hand and sufficient on the other for paying the wages of the laborers throughout the duration of the productive process. For if it were shorter, all the workers could no longer be provided for throughout its whole course, and the consequence would be an urgent offer of the unemployment economic factors which could not fail to bring about a transformation of the existing arrangement.*75 Now if the rate of interest on loans is artificially reduced below the natural rate as established by the free play of the forces operating in the market, then entrepreneurs are enabled and obliged to enter upon longer processes of production. It is true that longer roundabout processes of production may yield an absolutely greater return than shorter processes; but the return from them is relatively smaller, since although continual lengthening of the capitalistic process of production does lead to continually increasing returns, after a certain point is reached the increments themselves are of decreasing amount.*76 Thus it is possible to enter upon a longer roundabout process of production only if this smaller additional productivity will still pay the entrepreneur. So long as the rate of interest on loans coincides with the natural rate, it will not pay him; to enter upon a longer period of production would involve a loss. On the other hand, a reduction of the rate of interest on loans must necessarily lead to a lengthening of the average period of production. It is true that fresh capital can be employed in production only if new roundabout processes are started. But every new roundabout process of production that is started must be more roundabout than those already started; new roundabout processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout processes of production, because they yield the greatest returns. It is only when all the short roundabout processes of production have been appropriated that capital is employed in the longer ones.


A lengthening of the period of production is only practicable, however, either when the means of subsistence have increased sufficiently to support the laborers and entrepreneurs during the longer period or when the wants of producers have decreased sufficiently to enable them to make the same means of subsistence do for the longer period. Now it is true that an increase of fiduciary media brings about a redistribution of wealth in the course of its effects on the objective exchange value of money which may well lead to increased saving and a reduction of the standard of living. A depreciation of money, when metallic money is employed, may also lead directly to an increase in the stock of goods in that it entails a diversion of some metal from monetary to industrial uses. So far as these factors enter into consideration, an increase of fiduciary media does cause a diminution of even the natural rate of interest, as we could show if it were necessary. But the case that we have to investigate is a different one. We are not concerned with a reduction in the natural rate of interest brought about by an increase in the issue of fiduciary media, but with a reduction below this rate in the money rate charged by the banks, inaugurated by the credit-issuing banks and necessarily followed by the rest of the loan market. The power of the banks to do such a thing has already been demonstrated.


The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the laborers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall.


This is one of the ways in which the equilibrium of the loan market is reestablished after it has been disturbed by the intervention of the banks. The increased productive activity that sets in when the banks start the policy of granting loans at less than the natural rate of interest at first causes the prices of production goods to rise while the prices of consumption goods, although they rise also, do so only in a moderate degree, namely, only insofar as they are raised by the rise in wages. Thus the tendency toward a fall in the rate of interest on loans that originates in the policy of the banks is at first strengthened. But soon a countermovement sets in: the prices of consumption goods rise, those of production goods fall. That is, the rate of interest on loans rises again, it again approaches the natural rate.


This countermovement is now strengthened by the fact that the increase of the stock of money in the broader sense that is involved in the increase in the quantity of fiduciary media reduces the objective exchange value of money. Now, as has been shown, so long as this depreciation of money is going on, the rate of interest on loans must rise above the level that would be demanded and paid if the objective exchange value of money remained unaltered.*77


At first the banks may try to oppose these two tendencies that counteract their interest policy by continually reducing the rate of interest charged for loans and forcing fresh quantities of fiduciary media into circulation. But the more they thus increase the stock of money in the broader sense, the more quickly does the value of money fall, and the stronger is its countereffect on the rate of interest. However much the banks may endeavor to extend their credit circulation, they cannot stop the rise in the rate of interest. Even if they were prepared to go on increasing the quantity of fiduciary media until further increase was no longer possible (whether because the money in use was metallic money and the limit had been reached below which the purchasing power of the money-and-credit unit could not sink without the banks being forced to suspend cash redemption, or whether because the reduction of the interest charged on loans had reached the limit set by the running costs of the banks), they would still be unable to secure the intended result. For such an avalanche of fiduciary media, when its cessation cannot be foreseen, must lead to a fall in the objective exchange value of the money-and-credit unit to the paniclike course of which there can be no bounds.*78 Then the rate of interest on loans must also rise in a similar degree and fashion.


Thus the banks will ultimately be forced to cease their endeavors to underbid the natural rate of interest. That ratio between the prices of goods of the first order and of goods of higher orders which is determined by the state of the capital market and has been disturbed merely by the intervention of the banks will be approximately reestablished, and the only remaining trace of the disturbance will be a general increase in the objective exchange value of money due to factors emanating from the monetary side. A precise reestablishment of the old price ratios between production goods and consumption goods is not possible, on the one hand because the intervention of the banks has brought about a redistribution of property, and on the other hand because the automatic recovery of the loan market involves certain of the phenomena of a crisis, which are signs of the loss of some of the capital invested in the excessively lengthened roundabout processes of production. It is not practicable to transfer all the production goods from those uses that have proved unprofitable to other avenues of employment; a part of them cannot be withdrawn and must therefore either be left entirely unused or at least be used less economically. In either case there is a loss of value. Let us, for example, suppose that an artificial extension of bank credit is responsible for the establishment of an enterprise which only yields a net profit of four percent. So long as the rate of interest on loans was four and one-half percent, the establishment of such a business could not be thought of; we may suppose that it has been made possible by a fall to a rate of three and one-half percent which has followed an extension of the issue of fiduciary media. Now let us assume the reaction to begin, in the way described above. The rate of interest on loans rises to four and one-half percent again. It will no longer be profitable to conduct this enterprise. Whatever may now occur, whether the business is stopped entirely or whether it is carried on after the entrepreneur has decided to make do with the smaller profits, in either case—not merely from the individual point of view, but also from that of the community—there has been a loss of value. Economic goods which could have satisfied more important wants have been employed for the satisfaction of less important; only insofar as the mistake that has been made can be rectified by diversion into another channel can loss be prevented.

5 Credit and Economic Crises


Our theory of banking, like that of the currency principle, leads ultimately to a theory of business cycles. It is true that the Currency School did not inquire thoroughly into even this problem. It did not ask what consequences follow from the unrestricted extension of credit on the part of the credit-issuing banks; it did not even inquire whether it was possible for them permanently to depress the natural rate of interest. It set itself more modest aims and was content to ask what would happen if the banks in one country extended the issue of fiduciary media more than those of other countries. Thus it arrived at its doctrine of the "external drain" and at its explanation of the English crises that had occurred up to the middle of the nineteenth century.


If our doctrine of crises is to be applied to more recent history, then it must be observed that the banks have never gone as far as they might in extending credit and expanding the issue of fiduciary media. They have always left off long before reaching this limit, whether because of growing uneasiness on their own part and on the part of all those who had not forgotten the earlier crises, or whether because they had to defer to legislative regulations concerning the maximum circulation of fiduciary media. And so the crises broke out before they need have broken out. It is only in this sense that we can interpret the statement that it is apparently true after all to say that restriction of loans is the cause of economic crises, or at least their immediate impulse; that if the banks would only go on reducing the rate of interest on loans they could continue to postpone the collapse of the market. If the stress is laid upon the word postpone, then this line of argument can be assented to without more ado. Certainly, the banks would be able to postpone the collapse; but nevertheless, as has been shown, the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs, and its consequences are the worse and the reaction against the bull tendency of the market the stronger, the longer the period during which the rate of interest on loans has been below the natural rate of interest and the greater the extent to which roundabout processes of production that are not justified by the state of the capital market have been adopted.

Notes for this chapter

The fact that I have followed the terminology and method of attack of Böhm-Bawerk's theory of interest throughout this chapter does not imply that I am an adherent of that theory or am able to regard it as a satisfactory solution of the problem. But the present work does not afford scope for the exposition of my own views on the problem of interest; that must be reserved for a special study, which I hope will appear in the not too distant future. In such circumstances I have had no alternative but to develop my argument on the basis of Böhm-Bawerk's theory. Böhm-Bawerk's great achievement is the foundation of the work of all those who until now have dealt with the problem of interest since his time, and may well be the foundation of the work of those who will do so in the future. He was the first to clear the way that leads to understanding of the problem; he was the first to make it possible systematically to relate the problem of interest to that of the value of money.
See Hume, Essays, ed. Frowde (London), pp. 303 ff.; Smith, The Wealth of Nations, Cannan's ed. (London, 1930), vol. 2, pp. 243 ff.; see also J. S. Mill, Principles of Political Economy (London, 1867), pp. 296 f.
See, for example, Georg Schmidt, Kredit und Zins (Leipzig, 1910), pp. 38 ff.
The transaction is conducted by the bank selling part of its consols "for money" and buying them back immediately "on account." The on-account price is higher, because it contains a large part of the interest that is almost due; the margin between the two prices represents the compensation that the bank pays for the loan. The cost that this entails is made up for by the fact that the bank now gets a larger proportion of the lending business. See Jaffé, Das englische Bankwesen, 2d ed. (Leipzig, 1910), p. 250.
See, for example, Arendt, Geld—Bank—Börse (Berlin, 1907), p. 19.
See Gilbart, The History, Principles and Practice of Banking, rev. ed. (London, 1904), vol. 1, p. 98.
See Wicksell, Geldzins und Güterpreise (Jena, 1898), p. 74. Indeed, even the writers of that period do frequently deal with the problem of a change in the rate of interest; see, for example, Tooke, An Inquiry into the Currency Principle (London, 1844), p. 224.
See Tooke, An Inquiry into the Currency Principle (London, 1844), pp. 121 ff.; Fullarton, On the Regulation of Currencies, 2d ed. (London, 1845), pp. 82 ff.; Wilson, Capital, Currency and Banking (London, 1847), pp. 67 ff. Wagner follows the train of thought of these writers in his Die Geld- und Kredittheorie der Peelschen Bankakte, pp. 135 ff.
See Torrens, The Principles and Practical Operation of Sir Robert Peel's Act of 1844 Explained and Defended, 2d ed. (London, 1857), pp. 57 ff.; Overstone, Tracts and Other Publications on Metallic and Paper Currency (London, 1858), passim.
See Wicksell, op. cit., pp. 1 ff.
See Fisher, The Rate of Interest (New York, 1907), pp. 94 f.
See Böhm-Bawerk, Kapital und Kapitalzins, p. 622.
See Fisher and Brown, The Purchasing Power of Money (New York, 1911), pp. 58 ff.
See, for instance, the most recent literature on the German banking reform; for example, the above-cited work by Schmidt (see p. 379 n. 3). An historical study would have to examine the extent to which Law, Cieszkowski, Proudhon, Macleod, and others, are to be regarded as inventors and adherents of this doctrine.
See Wicksell, op. cit., pp. v ff.
See ibid., pp. v ff., III; also "The Influence of the Rate of Interest on Prices," Economic Journal 18 (1907): 213 ff.
See Wicksell, "The Influence of the Rate of Interest," p. 215.
See Wicksell, Geldzins und Güterpreise, pp. 104 f.
See Walras, Études d'économie politique appliquée (Lausanne, 1898), pp. 345 f.
See Böhm-Bawerk, op. cit., pp. 611 ff.
Ibid., pp. 151 ff.
The fact that the two movements occur in opposite directions, so that they cancel one another, had been emphasized by Mill (Principles, pp. 391 ff.) in order to show that the increase in the rate of interest caused by inflation would be counteracted by the circumstance that the additional quantity of notes, if issued by the banks (and the additional quantity of gold so far as it was used productively), have a reducing effect on the bank rate of interest.
See p. 259-60 above.

End of Notes

26 of 33


Problems of Credit Policy

(I) Prefatory Remark

1 The Conflict of Credit Policies


Since the time of the Currency School, the policy adopted by the governments of Europe and America with regard to the issue of fiduciary media has been guided, on the whole, by the idea that it is necessary to impose some sort of restriction upon the banks in order to prevent them from extending the issue of fiduciary media in such a way as to cause a rise of prices that eventually culminates in an economic crisis. But the course of this policy has been continually broken by contrary aims. Endeavors have been made by means of credit policy to keep the rate of interest low; "cheap money" (that is, low interest) and "reasonable" (that is, high) prices have been aimed at. Since the beginning of the twentieth century these endeavors have noticeably gained in strength; during the war and for some time after it they were the prevailing aims.


The strange vicissitudes of credit policy cannot be described except by passing in review the actual tasks that it has had to solve and will have to solve in the future. Although the problems themselves may always be the same, the form they assume changes. And, for the very reason that our task is to strip them of their disguises, we must first study them in their contemporary garb. In what follows, separate consideration will be given to such problems, first, as they exhibited themselves before the war, and then, as they have exhibited themselves in the period immediately after the war.*79

(II) Problems of Credit Policy Before the War*80

2 Peel's Act


Peel's Bank Act, and the ideas on which it was based, still sets the standard by which credit policy is ultimately governed nowadays; even those countries that do not follow the example of the English bank legislation, or do not follow it so faithfully as others, have yet not been able to withstand its influence altogether. Here we are confronted with a strange phenomenon. While the economic literature of all countries was directing the most violent and passionate attacks against the system of having a fixed quota of the note issue not backed by metal; while people were untiring in calling Peel's Act the unfortunate legislative product of a mistaken theory; while the currency principle continued to be represented as a system of erroneous hypotheses that had long been confuted; yet one legislature after another took steps to limit the issue of uncovered banknotes. And, remarkably enough, this procedure on the part of governments evoked but little censure, if any at all, from those whose views on banking theory should logically have led them most severely to condemn it. To start from the banking principle, which denies the possibility of an overissue of banknotes and regards "elasticity" as their essential characteristic, is necessarily to arrive at the conclusion that any limitation of the circulation of notes, whether they are backed by money or not, must prove injurious, since it prevents the exercise of the chief function of the note issue, the contrivance of an adjustment between the stock of money and the demand for money without changing the objective exchange value of money. It might easily have appeared desirable to Tooke's followers that provision should be made for backing that part of the note circulation that was not backed by metal; but logically they should have condemned the prescription that a certain proportion was to be maintained between the stock of metal and the note circulation. There is an irreconcilable contradiction, however, between the theoretical arguments of these writers and the practical conclusions that they draw from them. Scarcely any writer that need be taken seriously ventures to put forward proposals that might fundamentally disturb the various systems for restricting the unbacked note issue; not a single one definitely demands their complete abolition. Nothing could show the inherent uncertainty and lack of independence of modern banking theory better than this inconsistency. That the note issue must somehow be restricted in order to guard against serious evils is still accepted today as the essence of government wisdom in matters of banking policy, and the science which claims to have produced proof to the contrary always ends up by deferring to this dogma, which nobody is nowadays able to prove and everybody thinks himself able to refute. The conversatism of the English hinders them from meddling with a law which stands as a monument to an intellectual contest which went on for many years and in which the best men of the time participated; and the example of the world's chief bank influences all the other banks. The conclusions of two generations of economists have not been able to shake the opinions which are supposed to be the result of practical banking experience.


Many serious errors are involved in the currency principle. The most serious lies in its failure to recognize the essential similarity of banknotes and bank deposits.*81 Its opponents have skillfully discovered these weak spots in the system and directed their sharpest attacks accordingly.*82 But the doctrine of the Currency School does not stand or fall by its views on the nature of checks and deposits. It is enough to correct it on this one point—to take its propositions concerning the issue of notes and apply them also to the opening of deposit accounts—to silence the censures of those who adhere to the banking principle. That its mistake on this point is of small significance in comparison with that made by the banking principle can hardly need further discussion. And in any case, it does not seem an inexcusable mistake to have made if we take into account the relatively backward development of even the English deposit system at the time when the foundations of the classical theory of banking were being laid, and if we further consider the ease with which the legal differences between payment by note and payment by check might give rise to error.


As far as Peel's Act was concerned, however, this very shortcoming of the theory that had created it turned out to be an advantage; it caused the incorporation in it of the safety valve without which it would not have been able to cope with the subsequent increase in the requirements of business. The fundamental mistake of Peel's system, which it shares with all other systems which proceed by restricting the note circulation, lies in its failure to foresee the extension of the quota of notes not backed by metal that went with the increase in the demand for money in the broader sense. As far as the past was concerned, the act sanctioned the creation of a certain amount of fiduciary media and the influence that this had on the determination of the objective exchange value of money; it did not do anything to counteract the effects of this issue of fiduciary media. But at the same time, in order to guard the capital market from shocks, it removed all future possibility of partly or wholly satisfying the increasing demand for money by the issuing of fiduciary media and so of mitigating or entirely preventing a rise in the objective exchange value of money. This amounts to the same thing as suppressing the creation of fiduciary media altogether and so renouncing all the attendant advantages for the stabilization of the objective exchange value of money. It is an heroic remedy with a vengeance, in essence hardly differing at all from the proposals of the downright opponents of all fiduciary media.


Nevertheless, something was overlooked in the calculations of the currency theorists. They did not realize that unbacked deposits were substantially the same as unbacked notes, and so they omitted to legislate for them in the same way as for the notes. So far as the development of fiduciary media depended on the issue of notes, Peel's Act completely restricted it; so far as it depended on the open ing of deposit accounts, it was not interfered with at all. This forced the technique of the English banking system in a direction in which it had already been urged in some degree by the circumstance that the right of note issue in London and its environs was an exclusive privilege of the Bank of England. The deposit system developed at the expense of the note system. From the point of view of the community this was a matter of indifference because notes and deposits both fulfill the same functions. Thus Peel's Act did not achieve its aim, or at least not in the degree and manner that its authors had intended; fiduciary media, suppressed as banknotes, developed in the form of deposits.


It is true that German writers on banking held that it was possible to discover a fundamental difference between notes and deposits. But they did not succeed in demonstrating their contention; in fact they did not really attempt to do so. Nowhere is the inherent weakness of German banking theory more obvious than in connection with this particular question of the note versus the check, which for years has been the central issue of all discussion. Anybody who, like them, had learned from the English Banking School that there is no fundamental difference between notes and checks, and was in the constant habit of stressing this,*83 should at least be prepared to supply a detailed proof in support of an assertion that the banknote system represents "an earlier and lower stage of development of the credit economy" than the deposit bank and the check, with the connected system of the account current, book credit, and clearinghouse.*84 Certainly reference to England and the United States cannot be accepted as proof of the correctness of this assertion, least of all in the mouth of a decided opponent of Peel's Act and of the restriction of the note issue in general; for it is undeniable that the great importance of the deposit system and the decreasing relative importance of the banknote in Anglo-Saxon countries are the result of that act. The consequence is that the German literature on banking theory is full of almost unbelievable contradictions.*85


The repression of the banknote, as it has occurred in England and in the United States—in different ways and for different reasons, but as a result of the same fundamental ideas—and the corresponding growth in importance of the deposit, and the additional circumstance that the organization of the deposit banks has not attained that soundness that would have enabled it to retain the public confidence during dangerous crises, have led to serious disturbances. In England, as also in the United States, it has repeatedly happened in times of crisis that confidence has been destroyed in those banks that circulate fiduciary media in the form of deposits, while confidence in banknotes has been maintained. The measures by which the consequences which such a collapse of a part of the national business organization would infallibly have involved were avoided are well known. In England an attempt was made to fill the gap in the circulation which was due to the lack of large quantities of fiduciary media by the Bank of England being ready to increase the issue of its own notes. In the United States, where the law made this solution impossible, the clearinghouse certificates served the same purpose.*86 In both countries, attempts to give this device a legislative basis were made. But Lowe's bill was not passed, and even the Aldrich-Vreeland Act in the United States had only a partial success.*87


None of the many systems of limiting the note circulation has proved ultimately capable of interposing an insurmountable obstacle in the way of further creation of fiduciary media. This is equally true of Peel's Act, which completely forbids the new issue of fiduciary media in the shape of notes, and of such bank-of-issue legislation in other states as does leave a certain scope for the augmentation of notes not backed by money. Between the English act of 1844 and, say, the German act of 1875, there seems to be a fundamental difference: while the one rigidly fixes, for all time, the quota of the note circulation not backed by metal, the other, inasmuch as it only requires that a certain proportion of the note circulation shall be backed by metal and puts a tax upon the rest, does make provision within certain limits for its future extension. But everything depends upon the scope that is thus provided for extending the issue of fiduciary media. If it had been wide enough to give free play to the development of the unbacked note circulation, then the German law —and the same is true, not only of other laws based on the same principle (for example, the Austrian), but also of those that attempt to limit the circulation of notes in other ways, as for example, the French—would have had fundamentally different results from the English. Since in fact it proved to be too narrow for this, the difference between the two laws is merely one of degree, not one of kind. All these laws have limited the issue of fiduciary media in the form of notes, but have set no limits to their issue in the form of deposits. Making the issue of notes more difficult was bound to promote an increased employment of deposits; in place of the note, the deposit account came into prominence. For the development of the credit system, this change was not altogether a matter of indifference. The note is technically superior to the deposit in medium and small transactions; in many cases for which it might have been used as a money substitute, checks or clearing transfers could not be used, and in such cases restriction of the issue of fiduciary media in the form of notes was bound to have the effect of restriction of the issue of fiduciary media in general. Under the law of the United States of America, the issue of fiduciary media in the shape of deposits is also restricted; but since this only applies to some of the banks, namely, the national banks, it is not enough to make a big difference between the deposit business of the United States and that of the other countries in which no similar regulations have been established.


The real obstacle in the way of an unlimited extension of the issue of fiduciary media is not constituted by legislative restriction of the note issue, which, after all, only affects a certain kind of fiduciary medium, but the lack of a centralized world bank or of uniform procedure on the part of all credit-issuing banks. So long as the banks do not come to an agreement among themselves concerning the extension of credit, the circulation of fiduciary media can indeed be increased slowly, but it cannot be increased in a sweeping fashion. Each individual bank can only make a small step forward and must then wait until the others have followed its example. Every bank is obliged to regulate its interest policy in accordance with that of the others.

3 The Nature of Discount Policy


The most obscure and incorrect concepts are current concerning the nature of the discount policy of the central banks-of-issue. Often the principal task of the banks is said to be the protection of their cash reserves, as if it would pay them to make sacrifices for such an aim as that. No less widespread, however, is the view that the banks' obligation to follow a discount policy that takes account of the circumstances of other banks is imposed upon them merely by a perverse legislation and that the ideal of cheap money—in a double sense, namely, a low purchasing power of money and a low rate of interest—could be realized by the abandonment of certain out-of-date legal provisions.


It is unnecessary to devote very much time to the refutation of such views as these. After all that has been said on the nature of money and fiduciary media, there can hardly be very much doubt as to the aim of the discount policy of the banks. Every credit-issuing bank is obliged to fix the rate of interest it charges for loans in a certain conformity with that of the other credit-issuing banks. The rate cannot be allowed to sink below this level, for if it did, the sums of money needed by the bank's rapidly extending clientele for making payments to customers of other banks would increase in such a fashion that the bank's solvency would be imperiled. It is by raising the rate of discount that the bank safeguards its own capacity to pay. This end is certainly not attained by protecting the redemption fund, the small insignificance of which for maintaining the value of the fiduciary media has already been demonstrated, but by avoiding the artificial extension of the circulation of fiduciary media that would result from asking less interest than the other banks, and so also avoiding an increase in the demands for the redemption of the fiduciary media. The banks would still have to have a discount policy even if there were no legislative regulation of the note cover.


In Germany there has been a controversy as to whether certain measures of the Reichsbank are dictated by regard to the circumstances of the domestic money market or to those of the international. In the form in which it is usually put, the question is meaningless. The mobility of capital goods, which nowadays is but little restricted by legislative provisions such as customs duties, or by other obstacles, has led to the formation of a homogeneous world capital market. In the loan markets of the countries that take part in international trade, the net rate of interest is no longer determined according to national, but according to international, considerations. Its level is settled, not by the natural rate of interest in the country, but by the natural rate of interest anywhere. Just as the exchange ratio between money and other economic goods is the same in all places, so also the ratio between the prices of goods of the first order and those of goods of higher orders is the same everywhere. The whole system of modern international trade would be completely changed if the mobility of capital goods were to be restricted. In Germany there are many who demand such a prohibition or at least a considerable restriction of the investment of capital abroad. It is not our task to demonstrate what a small prospect of success a policy like this would have, or to show that the time is now past for a nation to decide whether or not it will take part in international trade. So long and insofar, however, as a nation participates in international trade, its market is only a part of the world market; prices are determined not nationally but internationally. The fact that the rate of interest in Germany may rise, not because any change has occurred in its determinants within the Reich but because there have been changes, say, in the United States, should not seem any more remarkable than, say, a rise in the price of corn that is due to the state of foreign harvests.


It has not been easy to reconcile policy with the extension and combination of national markets into a world market. Stronger than the resistance encountered centuries ago by the development of the town economy into the national economy is that which the nineteenth and twentieth centuries have opposed to the further stage of development into a world economy. Nowadays there is nothing like the feeling of homogeneity which previously overcame regional interests; the pronounced emphasis upon national antagonisms which sets the keynote of modern policy would perhaps stand in the way of attempts at economic unification even if there were no interests to which these attempts might prove injurious. From the point of view of the producer, low prices seem to be the greatest of all evils, and in every state those producers who are unable to meet competition strive with all the means at their disposal to keep the cheap commodities of the world market out of the national market. But whether they succeed in this in each individual case or not depends to a large extent on the strength of the political influence of the opposing interests. For in the case of every individual commodity, the producers' interest in high prices is opposed by the interest of consumers in the opening of the market to the cheapening effect of foreign competition. The matter is only decided by the conflict of the two groups. The distribution of forces is otherwise when the problem of freedom of capital transactions is under discussion. We have already seen that creditor interests always get the worst of it when they clash with debtor interests. The interests of the capitalists are scarcely ever represented in monetary policy. Nobody ever objects to the importation of capital from abroad on the ground that it leads to a depression of the rate of interest in the home market and a reduction of the income of the capitalists; quite the reverse. The universally prevailing view is that it is in the interest of the community that the rate of interest should be as low as possible. In those European states with large capital resources, which so far as international dealings in capital are concerned need be considered only as creditors and not as debtors, this policy is expressed in the endeavor to put obstacles in the way of foreign investment. Undoubtedly, this is not the only point of view from which modern states judge the export of capital. Other considerations enter into the matter as well, some in favor of exportation, some against it. There is, for instance, the fact that it is frequently impossible to export commodities except by allowing the payment for them to be postponed, so that future goods are acquired in exchange for the present goods surrendered; and that for this reason alone it is consequently necessary to promote the export of capital or at least not to hinder it.*88 Nevertheless, it must be insisted that the policy adopted by these states with regard to the export of capital is guided by the endeavor, among others, to keep the domestic rate of interest low. On the other hand, the same motive leads these states which because they are poor in capital have to play the part of international borrowers to encourage its importation.


The attempt to depress the domestic rate of interest by influencing the international movement of capital is particularly pronounced in the so-called money market, that is, in the market for short-term capital investments. In the so-called capital market, that is, the market for long-term capital investments, there is less possibility of effecting anything by intervention; in any case, any steps that may be taken become effective much more quickly in the former than in the latter. Consequently there is a greater propensity toward exerting an influence on the rate of interest on loans in the money market than in the long-term capital market. But the most important cause of the persistence of demands for the exertion of influence upon the money market lies in the universally prevalent errors concerning the nature of fiduciary media and of bank credit. When a relatively small efflux of gold induces the powerful central bank-of-issue of a rich country to raise the discount rate there is a tendency to think that there must be some other way than this, by which the efflux of gold could be prevented without involving the community in what is regarded as the injurious effect of a rise in the rate of interest. It is not seen that what is happening is the automatic adjustment of the national to the world rate of interest owing to the way in which the country is involved in international trade. That the country cannot be cut off from participation in international capital dealings simply and solely by measures of banking and currency policy, is completely overlooked. This alone can explain how it can come about in large exporting countries that the very persons who demand measures for "cheapening" credit are those who benefit most from the export trade. If those manufacturers, for whom every increase in the rate of discount that can be traced to events abroad is an inducement to plead for a modification of the banking system in the direction of releasing the central bank-of-issue from its obligation to provide gold for export on demand, would realize that the increase in the rate of interest could be effectively stopped only by a suppression of the export of capital and complete exclusion of the country from international trade, then they would soon change their minds. And it seems that these implications have already won some degree of general recognition, even if the literary treatment of the problem may still leave something to be desired. In Germany and Austria it was only the groups that demanded the seclusion of the national market that also demanded the "isolation" of the currency.


Further explanation is unnecessary. Nevertheless, it may not be supererogatory to examine one by one the measures that are recommended by those who favor a low rate of interest and to show how incapable they would prove of leading to the expected result.

4 The Gold-Premium Policy*89


Let us first review the systems which are supposed to be able to maintain the level of the rate of discount in the national money market by making it more difficult or more expensive to procure gold at a rate below that determined by the circumstances of the international market. The most important and most well known of these is the gold-premium policy, as it was carried out by the Bank of France.


In view of the circumstances that nowadays the silver five-franc piece is still legally current coin, the Bank of France is authorized to redeem its notes at its own choice either in gold or in these pieces. It sometimes used to make use of this authority for the purpose of increasing the difficulty of procuring gold for export purposes. As a rule it made no difficulty about surrendering gold in exchange for notes. And it exchanged five-franc pieces in the same way for gold coins, although it was not obliged to do so, and by so doing it endowed the latter with the property of being money substitutes. Naturally, these facilities were not requisitioned to a great extent for purposes of domestic business. Notes and five-franc pieces enjoyed unlimited public confidence so that their employability as money substitutes was not in the least in question. But if the bank was asked to surrender gold for export, it did not necessarily do so. It is true that it used to hand over gold unhesitatingly for the requirements of what was called "legitimate" trade, that is, when it was needed to pay for imported commodities, especially corn and cotton. But if gold was demanded for the purpose of speculating on the difference between home and foreign interest rates, it was not handed over as a matter of course. For this purpose, the bank did not issue Napoleons, the French gold coins, at all; and it issued ingots and foreign gold coins only at an additional charge, varying from four to eight percent of the 3,437 francs at which it was legally bound to purchase a kilogram of fine gold. It is impossible to state the exact amount of this "gold premium," because the rate has never been published officially.*90


The purpose of the gold-premium policy was to postpone as long as ever possible the moment when the condition of the international money market would force the bank to raise the discount rate in order to prevent an efflux of gold. The lowness of the rate of discount is of extraordinary importance in French financial policy. In the interest of those classes of the community by which it is supported, the government of the Third Republic is obliged to avoid anything that might injure the high standing of the rentes which constitute the chief investment of those classes. Even a merely temporary high rate of discount is always dangerous to the rentes market, for it might induce some holders of rentes to dispose of their bonds in order to reinvest their capital more fruitfully, and the disturbance of the market that might result from this would have a disproportionately adverse effect on the quotation of the rentes. It is undeniable that the result aimed at was to a certain extent attained, even though the premium policy by no means possessed the significance that was erroneously ascribed to it.


It is above all mistaken to ascribe the lowness of the rate of discount in France to the procedure that has been described. If the rate of discount has been lower in France than in other countries, this is due to altogether different causes. France is of all the countries in the whole world that which is richest in capital; but its people are not greatly endowed with the spirit of initiative and enterprise.*91 Consequently its capital has to emigrate. Now in a country which exports capital, even disregarding the premium for risk-bearing that is contained in the gross rate of interest, the rate of interest on loans must be lower than in a country which imports capital. Capitalists, when comparing the yields of home and foreign investment, are led by a series of psychological factors to prefer the former to the latter when other circumstances are equal. This is enough to explain why long-term and short-term investments bear lower interest in France than in other countries, such as Germany. The cause is a general economic cause; it is a matter in which measures of banking or currency policy can have no influence. The ratio between the rate of interest in France and that abroad could not for long be forced away by the premium policy of the Bank of France from that determined by the general economic situation. The Bank of France was not above the laws that govern the course of economic affairs. In fixing the level of its discount rate, it was not exempt from the necessity for paying due attention to the level of the natural rate of interest. Like every other credit-issuing bank that has an influence on the domestic market, it had to endeavor to keep the rate of interest on domestic short-term investments at such a level that foreign investment did not appear so attractive to home capitalists as to endanger the bank's own solvency. Like the others, the Bank of France could effectively prevent an outflow of gold in one way only—by raising its discount rate.*92 Employing the premium policy could do no more than postpone for a short time a rise in the rate of discount that the state of the international money market had made necessary. The premium made it more expensive to export gold and so reduced the profitability of interest arbitrage transactions. When it was widely believed that the difference between the French and the foreign rates of interest was about to be altered in France's favor through a fall in the foreign rate, then arbitrage dealers would not export gold at all, since the small profit of the transaction would be too greatly reduced by the premium. In this way the Bank of France may sometimes have avoided raising the discount rate when it would otherwise have been necessary to do so for a short time. But whenever the difference between the rates of interest was significant enough to make short-term foreign investment still promise to be profitable in spite of the increased cost of procuring gold due to the premium, and whenever the result of arbitrage dealings was not jeopardized by the prospect of an imminent reduction of the foreign rate, then even the Bank of France could not avoid raising the rate of interest.


It has been asserted that it is possible for a central bank to use successive increases of the premium so as entirely to prevent the export of gold if it continually forces back the gold point or export limit as the fall in the rate of exchange requires.*93 This is undoubtedly correct. The procedure, as is well known, has been employed repeatedly; it is known as cessation of cash payments. The bank that adopts it deprives its fiduciary media of their character of money substitutes. If they continue to function as general media of exchange, it is in the role of credit money. Their value will have become subject to independent variation. In such a case, it is admittedly possible for the bank to follow a completely independent discount policy; it may now reduce to any desired extent the rate of interest it charges without running the risk of insolvency. But this brings to light the consequences that must follow a banking policy that endeavors by extending the issue of fiduciary media to depress the rate of interest on loans below the natural rate of interest. This point has already been discussed in detail; in the present connection there is a second point that is of importance. If the intervention of the bank leads to the artificial retention of the rate of interest on loans at a level below that of the rate given by international conditions, then the capitalists will be all the more anxious to invest their capital abroad as the gap between the domestic and foreign rates of interest increases. The demand for foreign common media of exchange will increase, because foreign capital goods will be desired more and home capital goods less. And there is no way in which the fall in the rate of exchange could automatically set forces in motion to reestablish between the bank money and gold, the world money, that exchange ratio which had previously existed when the notes and deposits of the bank were not credit money but still money substitutes. The mechanism of the monetary system tends to bring the exchange value of the two kinds of money to that "natural" level determined by the exchange ratio between each of them and the remaining goods. But in the present case it is the natural exchange ratio itself which has moved against the country that refuses to pay out gold. An "autonomous" interest policy must necessarily lead to progressive depredation.


There are many advocates of the gold-premium policy who make no attempt to deny that its employment in the way in which they intend must infallibly lead to a credit-money or fiat-money standard with a rapidly falling objective exchange value of the unit. In fact, they are inclined to regard this very fact as a special advantage; for they are, more or less, inflationists.*94


Nevertheless, this was by no means the way in which the Bank of France carried out its premium policy. It observed a fixed limit, above which it never allowed the premium to rise in any circumstances whatever. Eight per mill is probably the highest premium that it has ever demanded. And this was certainly not an error on the part of the bank; it was founded on the nature of the case. In the eyes of the French government and of the administration of the bank controlled by it, the amount of depreciation consequent upon a gold premium of eight percent was not intolerable; but, in view of the unpredictable reactions throughout the whole community it was thought better to avoid further depreciation. Thus the French gold-premium policy was not able to prevent the export of gold altogether, but could only postpone it for a short time. Now this fact alone, and not only when the difference between the rates of interest was so inconsiderable and transient that the rate of discount did not need to be raised at all, meant a cheapening of the rate of interest on loans. But this was offset by the increase in the rate of interest during those periods when the rate of interest abroad was relatively low. Whenever the loan rate abroad sank so low that it might have seemed advantageous to capitalists to transfer capital to France for investment, they nevertheless refrained from doing so if a long continuance of the situation could not be reckoned with or if the difference between the rates was not very great, because they had reason to fear that a subsequent repatriation of the capital when the situation was reversed would be possible only at an increased cost. Thus the gold-premium policy did not merely constitute a hindrance to the efflux of gold from France; it also hindered an influx. It reduced the rate of interest on loans at certain times, but raised it at other times. It is true that it did not altogether exclude the country from international dealings in capital; it only made participation in them harder; but it did this in both directions. Its effect, the intensity of which should not be overestimated, was principally expressed in the fact that the rate of interest for short-term investments has been more stable in France than in other countries. It has never sunk so low as in England, for example; but neither has it ever risen so high. This is shown quite dearly by a comparison of movements in the London and Paris loan rates.


It has become more and more clearly recognized that the gold-premium policy could not have these effects ascribed to it. Those who once regarded it as the remedy for all ills are gradually becoming silent.

5 Systems Similar to the Gold-Premium Policy


The legal provisions which have permitted the Bank of France to follow the gold-premium policy were absent in those countries which until recently were on a pure gold standard. Where the gold coins have not been supplemented by any money substitutes, fiat money, or credit money, with unlimited legal tender by any payer including the central credit-issuing bank, the fiduciary media have had to be redeemed at their full face value in money without a premium being charged in addition.*95 But in actual fact these banks also were tending to adopt a policy different in degree but certainly not in kind from the described procedure of the Bank of France.


In most countries, the central bank-of-issue was only obliged to redeem its notes in legal tender gold coins of its own country, after the pattern of English banking law. It is in accordance with the spirit of the modern monetary system and with the ultimate aims of monetary policy that this obligation has been understood also to refer to the surrender of gold ingots to exporters at the legal ratio or at least at a price that made it more profitable to procure bullion than coins. Thus until 1889 the Bank of England voluntarily extended its obligation to redeem its notes by paying out on demand in ingots the value of the notes in full-weight gold coins. It did this by fixing its selling price for gold bullion once for all at 77s. 10½d. per ounce of standard gold.*96 For a time the Continental banks-of-issue followed this example. But they soon determined upon a different procedure, and eventually the Bank of England too relinquished its old policy and adopted the practice of the Continental banks.


The Bank of England and the German Reichsbank, apart from the Bank of France the two most important credit-issuing banks in the world, were in the habit of issuing for export purposes worn gold coins only of inferior value. Sovereigns, as issued by the Bank of England for export, were usually from two to three percent worse than newly minted sovereigns. The weight of the twenty-mark pieces received by a person who withdrew gold coins from the German Reichsbank for purposes of exportation was, according to the calculations of experts, 7.943 grams on an average as against a standard average of 7.965 grams; that is, something over a quarter of one percent less than their mint value.*97 The Bank of England sometimes refused altogether to issue gold ingots, and sometimes would only issue them at a price in excess of the 77s. 10½d. which alone was usual until 1889. It sometimes raised the selling price of ingots to as much as 77s. 11d.*98


As regards the range and the effect of these measures, nothing need be added to what has already been said about the French gold-premium policy. The difference—as has been said—is only quantitative, not qualitative.*99


The other "little devices" which have also been employed for making the export of gold more difficult have their effect in precisely the same fashion. As, for example, when the German Reichsbank sometimes prohibited the issue of gold for export purposes except in Berlin by invoking the letter of section 18 of the Bank Act, which had the effect of making the export of gold more costly by burdening the gold exporters with the risk and cost of transporting the gold from Berlin to the place of export.

6 The Nonsatisfaction of the So-called Illegitimate Demand for Money


In the returns of the Bank of France it has been repeatedly asserted that the gold-premium policy was directed only against those who wished to withdraw gold from the bank for speculative purposes. The bank, it was said, never put difficulties in the way of procuring gold for satisfying the legitimate demands of French trade.*100 No explanation was given of the idea of "legitimate" demand and its contrary "illegitimate" demand.


The idea on which this distinction is obviously based is that trade in commodities and dealings in capital are two perfectly distinct and independent branches of economic activity and that it would be possible to restrict the one without affecting the other; that refusal to surrender gold for arbitrage dealing could not increase the expense of procuring commodities from abroad so long as no difficulty was made about placing at the disposal of the importer the sums needed by him to pay for his purchases.


On closer examination this argument can hardly be accepted as valid. Even if we completely ignore the fact that dealings in capital only constitute one form of the general process of exchange of goods and consider nothing beyond the technical problem of the withdrawal of gold, it is clear that the bank cannot achieve its aim by discriminatory treatment of different requests for gold. If exportation of gold did not seem profitable because of the difference between the rates of interest, imported raw materials would actually be paid for, partly or wholly, by the commodities exported. The importer would not try to obtain gold from the bank; he would go into the market and buy bills originating in the French export business. If gold were delivered to him by the bank without a premium while the rate of exchange rose roughly by the amount of and on account of the premium that was charged to arbitrage dealers, this might well mean a favoring of the import business, and might possibly in some circumstances benefit the consumer as well, although that depends entirely upon the state of competition among importers. But all the same, the rate of exchange would experience the variation that the bank wished to avoid. The upper gold point would be fixed too high by an amount equal to the amount of the premium.


Finally, it must be pointed out that the distinction between a legitimate and an illegitimate demand for gold for export cannot be applied in practice. The demand for gold with which to pay for imported goods may be called legitimate, the demand for gold with which to buy foreign bills as a temporary investment with a view to exploiting a difference in interest rates may be called illegitimate. But there are many remaining intermediate cases, which cannot be placed in either one or the other category. Would it have been possible, say, for the Bank of France to put obstacles in the way of the withdrawal of deposits held by foreign states, municipalities, and companies, perhaps as the balances of loans? Or for the Austro-Hungarian Bank, which has repeatedly been accused of refusing to issue bills to persons who intend to carry out arbitrage dealings, to increase the difficulty of speculative repurchase of home securities from abroad?*101

7 Other Measures for Strengthening the Stock of Metal Held by the Central Banks-of-Issue


The endeavors of the central banks-of-issue to build up as large gold reserves as possible have led to the employment of devices which have just the opposite appearance to that of the premium policy and the systems similar to it. By raising the price they paid for gold imports the banks used to try to diminish the cost to the importer of importing gold and so to reduce the lower gold point.


Among these devices was the practice of granting interest-free or low-interest-bearing advances to importers of gold, a practice which was not unknown in England, France, and Germany.*102 There was also the practice of buying gold not only at the chief office, but also at branches situated near the national boundary.*103 Perhaps the most interesting of these devices was that of buying certain kinds of gold coin at a price in excess of their bullion value. If the bank issued to a gold exporter, instead of ingots or coins of the country, coins of the country to which he intended to send the gold, it could get a higher price for them than that corresponding to their gold content. For the exporter would save the expense of melting and recoinage and avoid the loss in which he would be involved by the fact that the domestic coins would be worn down to some extent. So the bank would be able to agree to pay a higher price than that corresponding to their metal content for the current gold coins of the states into which a future export of gold was probable.*104


All of these measures can best be described as weapons against the premium policies and related devices employed by foreign banks. If the central bank in a country A endeavored to raise the upper gold point for export from A to country B, then the bank in B took steps to lower it. If only used coins were issued for export purposes in A, this procedure was rendered nugatory when a price in excess of the gold content was paid in B for coins of country A. It is very probable that the devices and counterdevices were largely compensatory, so that the extension of the gap between the gold points, which otherwise would necessarily have resulted from the intervention of the banks, did not in fact occur.

8 The Promotion of Check and Clearing Transactions as a Means of Reducing the Rate of Discount


In Germany, where before the war relatively very much gold was in circulation, there was a constantly growing endeavor to withdraw it from circulation by an extension of check and clearing transactions and to divert it into the vaults of the Reichsbank. The aim of this propaganda is set forth in a circular of the elders of the Kaufmannschaft of Berlin, s.d. May 2, 1907, to the following effect: "The causes to which the high rate of interest in Germany are to be traced are rooted to a large extent in the circumstance that the German people make greater use than those in other countries of cash media of circulation (gold and silver) for payments arising in and out of the course of business, but have not yet sufficiently accustomed themselves to the procedure which might replace the use of gold and silver, and also of banknotes and Treasury notes, as media of circulation, namely, the use of checks and the clearing system. If a considerable proportion of payments could be settled by means of transfers from one account to another or by checks, then this would save large sums of currency, in gold and silver as well as in banknotes and this saved currency would then accumulate in the reserves of the banks-of-issue, especially of the central bank-of-issue, the Reichsbank. The more this happened, the smaller would be the demand for currency that had to be satisfied by the Reichsbank, and the stronger would be the cash reserve of the Reichsbank, which circumstances would contribute considerably toward a reduction of the rate of interest at the Reichsbank and in the whole country."*105


In this is a very clear demonstration of the weakness of the theoretical views that underlie modern banking policy. The level of the rate of interest is said to depend on the demand for currency. A strengthening of the cash reserve of the central bank-of-issue is credited with the effect of reducing the rate of interest in the whole country, and of reducing it appreciably. And this is not just the opinion of some private person or other, but that of the highly respected corporation of the Berlin Kaufmannschaft, and also, as everybody knows, that of the leaders of German economic policy in general. On this one point, all parties seem to be agreed, however much their views on the nature of economic phenomena may otherwise diverge. But even if this fundamental error is for a moment disregarded it is impossible to overlook the weakness of the doctrines expounded, and, above all, their contradictoriness. The proportion of cover for the Reichsbank notes provided for in the banking legislation of the seventies is treated as sacrosanct. The possibility of changing these provisions by substituting, say, a cover of one-quarter or one-fifth for that of one-third is never contemplated. The letter of the law has to be preserved while the assumptions on which it was based are being altered. When money substitutes in the form of deposits are augmented without provision being made for a monetary cover, the quantity of fiduciary media is increased. This is further demonstrative of the fact that even that part of the argument of the banking principle which was theoretically correct was unable to exert any influence on practical politics. Tooke and Fullarton repeatedly point out that there is no fundamental difference between notes and deposits (which they speak of as checks). Their modern successors do not dare to draw the logical conclusion from this incontrovertible fact; they stand for the differential treatment of fiduciary media according to whether they are notes or deposits.*106


If part of the gold in circulation in Germany and part of the banknotes had been replaced by fiduciary media in the shape of deposits, this might have led to a diminution of the rate of interest only insofar as the gold that had become superfluous was employed for obtaining capital goods from abroad. The replacement of notes without a metal backing by deposits without a metal backing is of no consequence in this connection. Only so far as notes covered by metal were replaced by deposits not covered by metal would there be any increase of the circulation of fiduciary media at the expense of that of money certificates, by which gold would be released for export to other countries. But the same result could have been attained by a diminution of the ratio between cover and banknotes; nevertheless this simpler device was generally held to be impracticable, in spite of the fact that it was precisely as safe or precisely as dangerous as the other. If the gold dispensed with in this way had been exported, then the stock of other economic goods at the disposal of the German nation would have increased correspondingly. This might have led to a fall, if only a trifling one, in the rate of interest, assuming that the quantity of gold expelled from Germany was absorbed abroad with a general fall in the objective exchange value of money. But the German champions of an extension of the checks and clearing system did not think of that when making proposals of this sort. They recommended the extension of the circulation of fiduciary media in the form of deposits because they believed that this would reduce the number and extent of those applications that made demands upon the credit that the Reichsbank granted in the form of notes; and they hoped that this would lead to a reduction in the rate of interest on loans. There is a serious error in all this. The level of the rate of interest on loans depends not on the amount of the national stock of money in the wider sense, nor, of course, on the amount of fiduciary media in circulation. It was not the legal regulations concerning cover that forced the Reichsbank to aim at a discount policy that would prevent any tension from arising between the natural rate of interest and the discount rate, but its inevitable concern for its own solvency.


In all those countries whose credit system is organized on the so-called single-reserve basis so that the stock of money needed for the redemption on demand of money substitutes is administered by a central bank on which in times of emergency all the credit-issuing banks must ultimately fall back, it is the directors of this bank who are the first to notice the outward flow of gold; and it is they who must be the first to take steps to stop it, since its first effects are directed against the institution for which they are responsible. Therefore, the raising of the discount rate by the central bank usually precedes the increased severity of lending terms in the open market and in the dealings between the private banks and their clients. And so superficial critics jump to the conclusion post hoc ergo propter hoc. Nothing could be more mistaken. Even quite apart from the proceedings of the central bank-of-issue, the private banks and others who issue money have to adjust their interest policy to the rate of interest ruling in the world market. Sums could be withdrawn from them for the purposes of interest arbitrage, just as from the central bank. In fact, so long as the mobility of capital is not restricted it remains impossible for the credit-issuing banks of any single country to follow an independent credit policy.

(III) Problems of Credit Policy in the
Period Immediately After the War

9 The Gold-Exchange Standard*107


Wherever inflation has thrown the monetary system into confusion, the primary aim of currency policy has been to bring the printing presses to a standstill. Once that is done, once it has at last been learned that even the policy of raising the objective exchange value of money has undesirable consequences, and once it is seen that the chief thing is to stabilize the value of money, then attempts are made to establish a gold-exchange standard as quickly as possible. This, for example, is what occurred in Austria at the end of 1922 and since then, at least for the time being, the dollar rate in that country has been fixed. But in existing circumstances, invariability of the dollar rate means invariability of the price of gold also. Thus Austria has a dollar-exchange standard and so, indirectly, a gold-exchange standard. That is the currency system that seems to be the immediate aim in Germany, Poland, Hungary, and many other European countries. Nowadays, European aspirations in the sphere of currency policy are limited to a return to the gold standard. This is quite understandable, for the gold standard previously functioned on the whole satisfactorily; it is true that it did not secure the unattainable ideal of a money with an invariable objective exchange value, but it did preserve the monetary system from the influence of governments and changing policies.


Yet the gold-standard system was already undermined before the war. The first step was the abolition of the physical use of gold in individual payments and the accumulation of the stocks of gold in the vaults of the great banks-of-issue. The next step was the adoption of the practice by a series of states of holding the gold reserves of the central banks-of-issue (or the redemption funds that took their place), not in actual gold, but in various sorts of foreign claims to gold. Thus it came about that the greater part of the stock of gold that was used for monetary purposes was gradually accumulated in a few large banks-of-issue; and so these banks became the central reserve banks of the world, as previously the central banks-of-issue had become central reserve banks for individual countries. The war did not create this development; it merely hastened it a little. Neither has the development yet reached the stage when all the newly produced gold that is not absorbed into industrial use flows to a single center. The Bank of England and the central banks-of-issue of some other states still control large stocks of gold; there are still several of them that take up part of the annual output of gold. Yet fluctuations in the price of gold are nowadays essentially dependent on the policy followed by the Federal Reserve Board. If the United States did not absorb gold to the extent to which it does, the price of gold would fall and the gold prices of commodities would rise. Since, so long as the dollar represents a fixed quantity of gold, the United States admits the surplus gold and surrenders commodities for gold to an unlimited extent, a rapid fall in the value of gold has hitherto been avoided. But this policy of the United States, which involves considerable sacrifices, might one day be changed. Variations in the price of gold would then occur and this would be bound to give rise in other gold countries to the question whether it would not be better in order to avoid further rises in prices to dissociate the currency standard from gold. Just as Sweden attempted for a time to raise the krone above its old gold parity by closing the mint time gold, so other countries that are now still on the gold standard or intend to return to it might act similarly. This would mean a further drop in the price of gold and a further reduction of the usefulness of gold for monetary purposes. If we disregard the Asiatic demand for money, we might even now without undue exaggeration say that gold has ceased to be a commodity the fluctuations in the price of which are independent of government influence. Fluctuations in the price of gold are nowadays substantially dependent on the behavior of one government, namely, that of the United States.*108


All that could not have been foreseen in this result of a long process of development is the circumstance that the fluctuations in the price of gold should have become dependent upon the policy of one government only. That the United States should have achieved such an economic predominance over other countries as it now has, and that it alone of all the countries of great economic importance should have retained the gold standard while the others (England, France, Germany, Russia, and the rest) have at least temporarily abandoned it—that is a consequence of what took place during the war. Yet the matter would not be essentially different if the price of gold was dependent not on the policy of the United States alone, but on those of four or five other governments as well. Those protagonists of the gold-exchange standard who have recommended it as a general monetary system and not merely as an expedient for poor countries, have overlooked this fact. They have not observed that the gold-exchange standard must at last mean depriving gold of that characteristic which is the most important from the point of view of monetary policy—its independence of government influence upon fluctuations in its value. The gold-exchange standard has not been recommended or adopted with the object of dethroning gold. All that Ricardo wanted was to reduce the cost of the monetary system. In many countries which from the last decade of the nineteenth century onward have wished to abandon the silver or credit-money standard, the gold-exchange standard rather than a gold standard with an actual gold currency has been adopted in order to prevent the growth of a new demand for gold from causing a rise in its price and a fall in the gold prices of commodities. But whatever the motives may have been by which the protagonists of the gold-exchange standard have been led, there can be no doubt concerning the results of its increasing popularity.


If the gold-exchange standard is retained, the question must sooner or later arise as to whether it would not be better to substitute for it a credit-money standard whose fluctuations were more susceptible to control than those of gold. For if fluctuations in the price of gold are substantially dependent on political intervention, it is inconceivable why government policy should still be restricted at all and not given a free hand altogether, since the amount of this restriction is not enough to confine arbitrariness in price policy within narrow limits. The cost of additional gold for monetary purposes that is borne by the whole world might well be saved, for it no longer secures the result of making the monetary system independent of government intervention.


If this complete government control is not desired, there remains one alternative only: an attempt must be made to get back from the gold-exchange standard to the actual use of gold again.

10 A Return to a Gold Currency


A return to the actual use of gold would be certain to have effects that would scarcely be welcomed. It would lead to a rise in the price of gold, or, what is the same thing, to a fall in the prices of commodities. The fact that this is not generally desired, and the reason why it is not, have already been dealt with. We may confidently suppose that such a fall in prices would cause just as much dissatisfaction as was caused by the process of expelling gold from circulation. And it hardly demands an excessive amount of insight to be able to predict that in such circumstances it would not be long before the gold standard was again accused of responsibility for the bad state of business. Once again the gold standard would be reproached with depressing prices and forcing up the rate of interest. And once again proposals would be made for some sort of "modification" of the gold standard. In spite of all these objections, the question of the advisability of a return to an actual gold standard demands serious consideration.


One thing alone would recommend the abandonment of the gold-exchange standard and the reintroduction of the actual use of gold; this is the necessity for making a recurrence of inflationary policies if not impossible at least substantially more difficult. From the end of the last century onward it was the aim of etatism in monetary policy to restrict the actual circulation of gold for three reasons: first, because it wished to inflate, without repealing the existing banking laws, by concentrating gold reserves in the central bank-of-issue; second, because it wished to accumulate a war chest; and third, because it wished to wean the people from the use of gold coins so as to pave the way for the inflationary policy of the coming Great War.


Admittedly it will not be possible to prevent either war or inflation by opposing such endeavors as these. Kant's proposal to prohibit the raising of loans for war purposes is extremely naive;*109 and it would be still more naive to bring within the scope of such a prohibition the issue of fiduciary media too. Only one thing can conquer war—that liberal attitude of mind which can see nothing in war but destruction and annihilation, and which can never wish to bring about a war, because it regards war as injurious even to the victors. Where liberalism prevails, there will never be war. But where there are other opinions concerning the profitability and injuriousness of war, no rules and regulations, however cunningly devised, can make war impossible. If war is regarded as advantageous, then laws regulating the monetary systems will not be allowed to stand in the way of going to war. On the first day of any war, all the laws opposing obstacles to it will be swept aside, just as in 1914 the monetary legislation of all the belligerent states was turned upside down without one word of protest being ventured. To try to oppose future war policies through currency legislation would be foolish. But it may nevertheless be conceded that the argument in favor of making war more difficult cannot be neglected when the question is being debated whether the actual domestic circulation of gold should be done away with in the future or not. If the people are accustomed to the actual use of gold in their daily affairs they will resist an inflationary policy more strongly than did the peoples of Europe in 1914. It will not be so easy for governments to disavow the reactions of war on the monetary system; they will be obliged to justify their policy. The maintenance of an actual gold currency would impose considerable costs on individual nations and would at first lead to a general fall of prices; there can hardly be any doubt about that. But all its disadvantages must be accepted as part of the bargain if other services are demanded of the monetary system than that of preparing for war, revolution, and destruction.


It is from this point of view that we should approach the question of the denominations of notes. If the issue of notes which do not make up a multiple of at least the smallest gold coins is prohibited, then in the business of everyday life gold coins will have to be used. This could best be brought about by an international currency agreement. It would be easy to force countries into such an agreement by means of penal customs duties.

11 The Problem of the Freedom of the Banks


The events of recent years reopen questions that have long been regarded as closed. The question of the freedom of the banks is one of these. It is no longer possible to consider it completely settled as it must have been considered for decades now. Unfortunate expe riences with banknotes that had become valueless because they were no longer actually redeemable led once to the restriction of the right of note issue to a few privileged institutions. Yet experience of state regulation of banks-of-issue has been incomparably more unfavorable than experience of uncontrolled private enterprise. What do all the failures of banks-of-issue and clearing banks known to history matter in comparison with the complete collapse of the banking system in Germany? Everything that has been said in favor of control of the banking system pales into insignificance beside the objections that can nowadays be advanced against state regulation of the issue of notes. The etatistic arguments, that were once brought forward against the freedom of the note issue, no longer carry conviction; in the sphere of banking, as everywhere else, etatism has been a failure.


The safeguards erected by the liberal legislation of the nineteenth century to protect the bank-of-issue system against abuse by the state have proved inadequate. Nothing has been easier than to treat with contempt all the legislative provisions for the protection of the monetary standard. All governments, even the weakest and most incapable, have managed it without difficulty. Their banking policies have enabled them to bring about the state of affairs that the gold standard was designed to prevent: subjection of the value of money to the influence of political forces. And, having arrogated this power to themselves, the governments have put it to the worst conceivable use. But, so long as the other political and ideological factors were what they were, we cannot conclude that the mere freedom of the banks would or could have made things different.


Let us suppose that freedom of banking had prevailed throughout Europe during the last two generations before the outbreak of the Great War; that banknotes had not become legal tender; that notes were always examined, not only with respect to their genuineness, but also with respect to their soundness, whenever they were tendered, and those issued by unknown banks rejected; but that the notes of large and well-known banking firms nevertheless were just as freely current as the notes of the great central banks-of-issue in the period when they were not legal tender. Let us further suppose that since there was no danger of a world banking cartel, the banks had been prevented, by the mere necessity for redeeming their notes in cash, from making immoderate endeavors to extend their issue by charging a low rate of interest; or at least, that the risk of this was no greater than under legislative regulation of the note system. Let us suppose, in short, that up to the outbreak of the war, the system had worked no better and no worse than that which actually existed. But the question at issue is whether it would have held its own any better after July 28, 1914. The answer to this question seems to be that it would not have done so. The governments of the belligerent—and neutral—states overthrew the whole system of bank legislation with a stroke of the pen, and they could have done just the same if the banks had been uncontrolled. There would have been no necessity at all for them to proceed to issue Treasury notes. They could simply have imposed on the banks the obligation to grant loans to the state and enabled them to fulfill this obligation by suspending their obligation to redeem their notes and making the notes legal tender The solution of a few minor technical problems would have been different, but the effect would have been the same. For what enabled the governments to destroy the banking system was not any technical, juristic, or economic shortcoming of the banking organization, but the power conferred on them by the general sentiment in favor of etatism and war. They were able to dominate the monetary system because public opinion gave them the moral right to do so. "Necessity knows no law" was the principle which served as an excuse for all the actions of all governments alike, and not only that of Germany, which was much blamed because of the candor with which it confessed its adherence to the maxim.


At the most, as has been explained, an effective if limited protection against future etatistic abuse of the banking system might be secured by prohibiting the issue of notes of small denominations. That is to say, not by uncontrolled private enterprise in banking, but on the contrary by interference with the freedom of the note issue. Apart from this single prohibition, it would be quite possible to leave the note issue without any legislative restrictions and, of course, without any legislative privileges either, such as the granting of legal tender to the notes. Nevertheless, it is clear that banking freedom per se cannot be said to make a return to gross inflationary policy impossible.


Apart from the question of financial preparation for war, the arguments urged in favor of the centralization, monopolization, and state control of banks-of-issue in general and of credit-issuing banks in particular are thoroughly unsound. During the past twenty or thirty years, the literature of banking has got so thoroughly lost among the details of commercial technique, has so entirely abandoned the economic point of view and so completely surrendered itself to the influence of the most undisguised kinds of etatistic argument, that in order to discover what the considerations are that are supposed to militate against the freedom of the banks it is necessary to go back to the ideas that dominated the banking literature and policy of two or three generations ago. The bank-of-issue system was then supposed to be regulated in the interests of the poor and ignorant man in the street, so that bank failures might not inflict loss upon those who were unskilled and unpracticed in business matters—the laborer, the salaried employee, the civil servant, the farmer. The argument was that such private persons should not be obliged to accept notes whose value they were unable to test, an argument which only needs to be stated for its utter invalidity to be apparent. No banking policy could have been more injurious to the small man than recent etatism has been.


The argument, however, that was then supposed to be the decisive one was provided by the currency principle. From the point of view of this doctrine, any note issue that is not covered by gold is dangerous, and so, in order to obviate the recurrence of economic crises, such issues must be restricted. On the question of the theoretical importance of the currency principle, and on the question of whether the means proposed by the Currency School were effective, or could have been effective, or might still be effective, there is nothing that need be added to what has been said already. We have already shown that the dangers envisaged by the currency principle exist only when there is uniform procedure on the part of all the credit-issuing banks, not merely within a given country but throughout the world. Now the monopolization of the banks-of-issue in each separate country does not merely fail to oppose any hindrance to this uniformity of procedure; it materially facilitates it.


What was supposed to be the decisive argument against freedom of banking in the last generation before the war is just the opposite to that which was held by the Currency School. Before the war, state control of banking was desired with the very object of artificially depressing the domestic rate of interest below the level that considerations of the possibility of redemption would have dictated if the banks had been completely free. The attempt was made to render as nugatory as possible the obligations of cash redemption, which constitutes the foundation stone of all credit-issuing bank systems. This was the intention of all the little expedients, individually unimportant but cumulatively of definite if temporary effect, which it was then customary to call banking policy. Their one intent may be summed up in the sentence: By hook or by crook to keep the rate of discount down. They have achieved the circumvention of all the natural and legal obstacles that hinder the reduction of the bank rate below the natural rate of interest. In fact, the object of all banking policy has been to escape the necessity for discount policy, an object, it is true, which it was unable to achieve until the outbreak of the war left the way free for inflation.


If the arguments for and against state regulation of the bank-of-issue system and of the whole system of fiduciary media are examined without the etatistic prejudice in favor of rules and prohibitions, they can lead to no other conclusion than that of one of the last of the defenders of banking freedom: "There is only one danger that is peculiar to the issue of notes; that of its being released from the common-law obligation under which everybody who enters into a commitment is strictly required to fulfill it at all times and in all places. This danger is infinitely greater and more threatening under a system of monopoly."*110

12 Fisher's Proposal for a Commodity Standard


The more the view regains ground that general business fluctuations are to be explained by reference to the credit policy of the banks, the more eagerly are ways sought for by which to eliminate the alternation of boom and depression in economic life. It was the aim of the Currency School to prevent the periodical recurrence of general economic crises by setting a maximum limit to the issue of uncovered banknotes. An obvious further step is to close the gap that was not reckoned with in their theory and consequently not provided for in their policy by limiting the issue of fiduciary media in whatever form, not merely that of banknotes. If this were done, it would no longer be possible for the credit-issuing banks to underbid the equilibrium rate of interest and introduce into circulation new quantities of fiduciary media with the immediate consequence of an artificial stimulus to business and the inevitable final consequence of the dreaded economic crisis.


Whether a decisive step such as this will actually be taken apparently depends upon the kind of credit policy that is followed in the immediate future by the banks in general and by the big central banks-of-issue in particular. It has already been shown that it is impossible for a single bank by itself, and even for all banks in a given country or for all the banks in several countries, to increase the issue of fiduciary media, if the other banks do not do the same. The fact that tacit agreement to this effect among all the credit issuing banks of the world has been achieved only with difficulty, and, even at that, has only effected what is after all but a small increase of credit, has constituted the most effective protection in recent times against excesses of credit policy. In this respect, we cannot yet*111 know how circumstances will shape. If it should prove easier now for the credit-issuing banks to extend their circulation, then failure to adopt measures for limiting the issue of fiduciary media will involve the greatest danger to the stability of economic life.


During the years immediately preceding the Great War, the objective exchange value of gold fell continuously. From 1896 onward, the commodity price level rose continuously. This movement, which is to be explained on the one hand by the increased production of gold and on the other hand by the extended employment of fiduciary media, became still more pronounced after the outbreak of the war. Gold disappeared from circulation in a series of populous countries and flowed into the diminishing region within which it continued to perform a monetary function as before. Of course, this resulted in a decrease in the purchasing power of gold. Prices rose, not only in the countries with an inflated currency, but also in the countries that had remained on the gold standard. If the countries that nowadays have a paper currency should return to gold, the objective exchange value of gold would rise; the gold prices of commodities and services would fall. This effect might be modified if the gold-exchange variety of standard were adopted instead of a gold currency; but if the area within which gold is employed as money is to be extended again, it is a consequence that can hardly be eliminated altogether It would only come to stop when all countries had again adopted the gold standard. Then perhaps the fall in the value of gold which lasted for nearly thirty years might set in again.


The prospect is not a particularly pleasant one. It is hardly surprising in the circumstances that the attention of theorists and politicians should have been directed with special interest to a proposal that aims at nothing less than the creation of a money with the most stable purchasing power possible.


The fundamental idea of Fisher's scheme for stabilizing the purchasing power of money is the replacement of the gold standard by a "commodity" standard. Previous proposals concerning the commodity standard have conceived it as supplementing the precious-metal standard. Their intention has been that monetary obligations which did not fall due until after a certain period of time should be dischargeable, by virtue either of general compulsory legislation or of special contractual agreements between the parties, not in the nominal sum of money to which they referred, but by payment of that sum of money whose purchasing power at the time when the liability was discharged was equal to the purchasing power of the borrowed sum of money at the time when the liability was incurred. Otherwise they have intended that the precious metal should still fulfill its monetary office; the tabular standard was to have effect only as a standard of deferred payments. But Fisher has more ambitious designs. His commodity standard is not intended merely to supplement the gold standard, but to replace it altogether. This end is to be attained by means of an ingenious combination of the fundamental concept of the gold-exchange standard with that of the tabular standard.


The money substitutes that are current under a gold-exchange standard are redeemable either in gold or in bills on countries that are on the gold standard. Fisher wishes to retain redemption in gold, but in such a way that the currency units are no longer to be converted into a fixed weight of gold, but into the quantity of gold that corresponds to the purchasing power of the monetary unit at the time of the inauguration of the scheme. The dollar—according to the model bill worked out by Fisher for the United States—ceases to be a fixed quantity of gold of variable purchasing power and becomes a variable quantity of gold of invariable purchasing power. Calculations based on price statistics are used month by month for the construction of an index number which indicates by how much the purchasing power of the dollar has risen or fallen in comparison with the preceding month. Then, in accordance with this change in the value of money, the quantity of gold that represents one dollar is increased or diminished. This is the quantity of gold for which the dollar is to be redeemed at the banks entrusted with this function, and this is the quantity of gold for which they have to pay out one dollar to anybody who demands it.


Fisher's plan is ambitious and yet simple. Perhaps it is unnecessary to state that it is in no way dependent upon Fisher's particular theory of money, whose inadequacy as regards certain crucial matter has already been indicated.*112


There is no need to criticize Fisher's scheme again with reference to the considerable dubiety attaching to the scientific correctness of index numbers and to the possibility of turning them to practical account in eliminating those unintended modifications of long-term contracts that arise from variations in the value of money.*113 In Fisher's scheme, the function of the index number is to serve as an indicator of variations in the purchasing power of the monetary unit from month to month. We may suppose that for determining changes in the value of money over very short periods—and in the present connection the month may certainly be regarded as a very short period—index numbers could be employed with at least sufficient exactitude for practical purposes. Yet even if we assume this, we shall still be forced to conclude that the execution of Fisher's scheme could not in any way ameliorate the social consequences of variations in the value of money.


But before we enter upon this discussion, it is pertinent to inquire what demands the proposal makes concerning business practice.


If it is believed that the effects of variations in the value of money on long-term credit transactions are compensated by variations in the rate of interest, then the adoption of a commodity standard based on the use of index numbers as a supplement to the gold standard must be regarded as superfluous. But, in any case, this is certainly not true of gradual variations in the value of money of which neither the extent nor even the direction can be foreseen; the depreciation of gold which has gone on since toward the end of the nineteenth century has hardly found any expression at all in variations in the rate of interest. Thus, if it were possible to find a satisfactory solution of the problem of measuring variations in the value of money, the adoption of a tabular for long-term credit transactions (the decision as to the employment of the index being left to the parties to each particular contract) could by no means be regarded as superfluous. But the technical difficulties in the way are so great as to be insurmountable. The scientific inadequacy of all methods of calculating index numbers means that there can be no "correct" one and therefore none that could command general recognition. The choice among the many possible methods which are all equally inadequate from the purely theoretical point of view is an arbitrary one. Now since each method will yield a different result, the opinions of debtors and creditors concerning them will differ also. The different solutions adopted, in the law or by the administrative authority responsible for calculating the index numbers, as the various problems arise will constitute a new source of uncertainty in long-term credit transactions—an uncertainty that might affect the foundations of credit transactions more than variations in the value of gold would.


All this would be true of Fisher's proposals also insofar as they concern long-term credit transactions. Insofar as they concern short-term credit transactions, it must be pointed out that even under the present organization of the monetary system future fluctuations of the value of money are not ignored. The difficulty about taking account of future variations in the value of money in long-term credit transactions lies in the impossibility of foreknowing the direction and extent of long-period variations even with only relative certainty. But for shorter periods, over weeks and even over periods of a few months, it is possible to a certain extent to foretell the movement of the commodity-price level; and this movement consequently is allowed for in all transactions involving short-term credit. The money-market rate of interest, as the rate of interest in the market for short-term investments is called, expresses among other things the opinion of the business world as to imminent variations in commodity prices. It rises with the expectation of a rise in prices and falls with the expectation of a fall in prices. In those commercial agreements in which interest is explicitly allowed for there would be no particular difficulty under Fisher's scheme in making the necessary adjustment of business technique; the only adjustment that would be necessary in the new circumstances would be to leave out of account all considerations of variations in the commodity-price level in future calculations of the rate of interest. But the matter is somewhat more complicated in those transactions in which an explicit rate of interest does not appear, but is allowed for implicitly in some other terms of the agreement.


An example of a case of purchase on credit will assist the discussion of this point. Let us assume that in such a case the index number over a period of five successive months rises each month in arithmetical progression by one percent of the index number proper to the first month, as shown in the following table:

Month Index No. Quantity of fine gold for which a
dollar may be redeemed,
in hundredths of a gram
1 100 160.0
2 101 161.6
3 102 163.2
4 103 164.8
5 104 166.4


A person who had bought commodities in February on three months' credit would have to pay back in May .048 of a gram of fine gold for every dollar over and above the gold content of the dollars in which he had made the bargain. Now according to present practice, the terms of the transaction entered into in February would make allowance for the expected general rise of prices; in the purchase then determined the views held by the buyer and the seller as to immediate probabilities concerning future prices would already be expressed. Now since under Fisher's plan the purchase price would still have to be settled by payment of the agreed number of dollars, this rise of prices would be allowed for a second time. Clearly this will not do. In other words, the present ordinary practice concerning purchases on credit and other credit transactions must be modified.


All that a person will have to do after the introduction of the commodity standard, who would have bought a commodity in January on three months' credit at $105 under a simple gold standard, is to take account of the expected fluctuations in the value of gold in a different way in order not to buy dearer than he would have bought in gold dollars. If he correctly foresees these fluctuations as amounting to three dollars, then he would have to agree to pay a purchase price of only (160 × 105)/164.8 dollars = 101.94 dollars. Fisher's project makes a different technique necessary in business; it cannot be claimed that this technique would be any simpler than that used under the pure gold standard. Both with and without Fisher's plan it is necessary for buyers and sellers to allow for variations in the general level of prices as well as for the particular variations in the prices of the commodities in which they deal; the only difference is in the method by which they evaluate the result of their speculative opinion.


We can thus see what value Fisher's scheme has as far as the consequences of variations in the value of money arising in connection with credit transactions are concerned. For long-term credit transactions, in which Fisher's scheme is no advance on the old and oft-discussed tabular standard which has never been put into execution because of its disadvantages, the use of the commodity standard as a supplement to the gold standard is impracticable because of the fundamental inadequacy of all methods of calculating index numbers. For short-term credit transactions, in which variations in the value of money are already taken account of in a different way, it is superfluous.


But variations in the objective exchange value of money have another kind of social consequence, arising from the fact that they are not expressed simultaneously and uniformly with regard to all commodities and services. Fisher's scheme promises no relief at all from consequences of this sort; Fisher, indeed, never refers to this kind of consequence of variations in the value of money and seems to be aware only of such effects as arise from their reactions on debt relationships contracted in terms of money.


However it may be calculated, an index number expresses nothing but an average of price variations. There will be prices that change more and prices that change less than the calculated average amount; and there will even be prices that change in the opposite direction. All who deal in those commodities whose prices change differently from the average will be affected by variations in the objective exchange-value of gold in the way already referred to (part 2, chap. 12, secs. 3 and 4), and the adjustment of the value of the dollar to the average movement of commodity prices as expressed in the chosen index number will be quite unable to affect this. When the value of gold falls, there will be persons who are favored by the fact that the rise in prices begins earlier for the commodities that they sell than for the commodities that they have to buy; and on the other hand there will be persons whose interests suffer because of the fact that they must continue to sell the commodities in which they deal at the lower prices corresponding to earlier circumstances although they already have to buy at the higher prices. Even the execution of Fisher's proposal could not cause the variations in the value of money to occur simultaneously and uniformly in relation to all other economic goods.


Thus, the social consequences of variations in the value of money could not be done away with even with the help of Fisher's commodity standard.

13 The Basic Questions of Future Currency Policy


Irving Fisher's scheme is symptomatic of a tendency in contemporary currency policy which is antipathetic to gold. There is an inclination in the United States and in Anglo-Saxon countries generally to overestimate in a quite extraordinary manner the signifi cance of index methods. In these countries, it is entirely overlooked that the scientific exactness of these methods leaves much to be desired, that they can never yield anything more than a rough result at best, and that the question whether one or other method of calculation is preferable can never be solved by scientific means. The question of which method is preferred is always a matter for political judgment. It is a serious error to fall into to imagine that the methods suggested by monetary theorists and currency statisticians can yield unequivocal results that will render the determination of the value of money independent of the political decisions of the governing parties. A monetary system in which variations in the value of money and commodity prices are controlled by the figure calculated from price statistics is not in the slightest degree less dependent upon government influences than any other sort of monetary system in which the government is able to exert an influence on values.


There can be no doubt that the present state of the market for gold makes a decision between two possibilities imperative: a return to the actual use of gold after the fashion of the English gold standard of the nineteenth century, or a transition to a fiat-money standard with purchasing power regulated according to index numbers. The gold-exchange standard might be considered as a possible basis for future currency systems only if an international agreement could impose upon each state the obligation to maintain a stock of gold of a size corresponding to its capacity. A gold-exchange standard with a redemption fund chiefly invested in foreign bills in gold currencies is in the long run not a practicable general solution of the problem.


The first German edition of this work, published in 1912, concluded with an attempt at a glimpse into the future history of money and credit. The important parts of its argument ran as follows:


"It has gradually become recognized as a fundamental principle of monetary policy that intervention must be avoided as far as possible. Fiduciary media are scarcely different in nature from money; a supply of them affects the market in the same way as a supply of money proper; variations in their quantity influence the objective exchange value of money in just the same way as do variations in the quantity of money proper. Hence, they should logically be subjected to the same principles that have been established with regard to money proper; the same attempts should be made in their case as well to eliminate as far as possible human influence on the exchange ratio between money and other economic goods. The possibility of causing temporary fluctuations in the exchange ratios between goods of higher and of lower orders by the issue of fiduciary media, and the pernicious consequences connected with a divergence between the natural and money rates of interest, are circumstances leading to the same conclusion. Now it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. The basic conception of Peel's Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition.


"At first it might appear as if the execution of such radical measures would be bound to lead to a rise in the objective exchange-value of money. But this is not necessarily the case. It is not improbable that the production of gold and the increase in the issue of bank credit are at present increasing considerably faster than the demand for money and are consequently leading to a steady diminution of the objective exchange value of money. And there can be no doubt that a similar result follows from the apparently one-sided fixing of prices by sellers, the effect of which in diminishing the value of money has already been examined in detail. The complaints about the general increase in the cost of living, which will continue for a long time yet, may serve as a confirmation of the correctness of this assumption, which can be neither confirmed nor refuted statistically. Thus, a restriction of the growth of the stock of money in the broader sense need not unconditionally lead to a rise in the purchasing power of the monetary unit; it is possible that it might have the effect of completely or partly counteracting the fall in the value of money which might otherwise have occurred.


"It is not entirely out of the question that the monetary and credit policy of the future will attempt to check any further fall in the objective exchange value of money. Large classes of the population—wage and salary earners—feel that the continuous fall in the value of money is unjust. It is most certain that any proposals that promise them any relief in this direction will receive their warmest support. What these proposals will be like, and how far they will go, are matters that it is difficult to foresee. In any case, economists are not called upon to act as prophets."


Elsewhere in the course of the argument it was claimed that it would be useless to try and improve the monetary system at all in the way envisaged by the tabular standard. "We must abandon all attempts to render the organization of the market even more perfect than it is and content ourselves with what has been attained already; or rather, we must strive to retain what has been attained already; and that is not such an easy matter as it seems to appear to those who have been more concerned to improve the apparatus of exchange than to note the dangers that implied its maintenance at its present level of perfection.


"It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of the fiduciary medium must necessarily lead to its breakdown. Once common principles for their circulation-credit policy are agreed to by the different credit-issuing banks, or once the multiplicity of credit-issuing banks is replaced by a single world bank, there will no longer be any limit to the issue of fiduciary media. At first, it will be possible to increase the issue of fiduciary media only until the objective exchange value of money is depressed to the level determined by the other possible uses of the monetary metal. But in the case of fiat money and credit money there is no such limit, and even in the case of commodity money it cannot prove impassable. For once the employment of money substitutes has superseded the employment of money for actual employment in exchange transactions mediated by money, and we are by no means very far from this state of affairs, the moment the limit was passed the obligation to redeem the money substitutes would be removed and so the transition to bank-credit money would easily be completed. Then the only limit to the issue would be constituted by the technical costs of the banking business. In any case, long before these limits are reached, the consequences of the increase in the issue of fiduciary media will make themselves felt acutely."


Since then we have experienced the collapse, sudden enough, of the monetary systems in a whole series of European states. The inflation of the war and postwar periods, exceeding everything that could have been foreseen, has created an unexampled chaos. Now we are on the way to mastering this chaos and to returning to a new organization of the monetary system which will be all the better the less it differs from the system in force before the war.


The organization of exchange that will thus be achieved again will exhibit all the shortcomings that have continually been referred to with emphasis throughout the present book. It will be a task for the future to erect safeguards against the inflationary misuse of the monetary system by the government and against the extension of the circulation of fiduciary media by the banks.


Yet such safeguards alone will not suffice to avert the dangers that menace the peaceful development of the function of money and fiduciary media in facilitating exchange. Money is part of the mechanism of the free market in a social order based on private property in the means of production. Only where political forces are not antagonistic to private property in the means of production is it possible to work out a policy aiming at the greatest possible stability of the objective exchange value of money.

Notes for this chapter

[Some of the problems that have arisen since are referred to on pp. 23-31. H.E.B.]
[See editor's Introduction, pp. 21-22, above. H.E.B.]
See Torrens, The Principles and Practical Operation of Sir Robert Peel's Act of 1844 Explained and Defended, 2d ed. (London, 1857), pp. 8 ff.
See Tooke, An Inquiry into the Currency Principle (London, 1844), pp. 23 ff.
See Wagner, "Banknote," in Rentzsch, Handwörterbuch der Volkswirtschaftslehre (Leipzig, 1866), p. 91.
See Wagner, "Kredit," ibid., p. 201.
See Schumacher's criticism of this contradiction, Weltwirtschaftliche Studien (Leipzig, 1911), pp. 62 ff.
See Cannon, Clearinghouses: Their History, Methods and Administration (New York, 1900), pp. 79 ff.
The Federal Reserve Act has since provided the United States with a basis for issuing notes in order to allay a panic.
See Sartorious von Waltershausen, Das volkswirtschaftliche System der Kapitalanlage im Auslande (Berlin, 1907), pp. 126 ff.
[See pp. 21-22 above. H.E.B.]
See Rosendorff, "Die Goldprämienpolitik der Banque de France und ihre deutschen Lobredner," Jahrbücher für Nationalökonomie und Statistik 21 (1901): 632 ff.; Dunbar, Chapters on the Theory and History of Banking, 2d ed. (New York, 1907), pp. 147 ff.
See Kaufmann, Das französische Bankwesen (Tübingen, 1911), pp. 35 ff.
On this, see Rosendorff, op. cit., pp. 640 ff., and passages cited in the essay "Die neue Richtung in der Goldpolitik der Bank von Frankreich," Bank-Archiv. 7 (1907): (72) ff., taken from the statements of account of the Bank of France, in which the raising of the discount rate is spoken of as the "seul moyen connu de défendre l'encaisse."
See Landesberger, Währungssystem und Relation (Vienna, 1891), p. 104.
Ibid., p. 105, and Über die Goldprämienpolitik der Zettelbanken (Vienna, 1892), p. 28.
Even at the time when the thaler was still unlimited legal tender and so occupied position analogous to that of the French five-franc piece, the German Reichsbank never followed a gold-premium policy on the French pattern, although it was often advised to do so. This is probably to be ascribed not so much to the circumstance that the number of thalers was relatively small as to the influence of Bamberger's ideas throughout the Reich. An open break with the principles of the banking and currency reform of the period after 1870-71 was, in view of the prevailing opinion, out of the question.
See Koch, Der Londoner Goldverkehr (Stuttgart, 1905), p. 708.
Ibid., pp. 81 f.
See Clare, A Money Market Primer and Key to the Exchanges, 2d ed. (London, 1893), p. 22.
Rosendorff ("Die Goldprämienpolitik der Banque de France," p. 636) would appear to be mistaken in thinking it possible to detect a difference of principle between the procedure of the Bank of England and the Reichsbank in paying out gold and the gold-premium policy of the Bank of France. He bases his view on the argument that, whereas the latter refuses altogether to pay out French gold coins and is thus theoretically able to raise the amount of the premium indefinitely, the Bank of England and the Reichsbank, which in contrast to the Bank of France always redeem their notes at their full value in current gold coin and have never attempted to refuse to pay out gold, are able to raise the selling price of bullion only by the amount of the cost of minting and an allowance for wear and tear. Rosendorff, in arguing from the statement that the Bank of France is "theoretically" able to raise the amount of the gold-premium indefinitely, flatly contradicts what he says in the rest of his book. In fact it does not do it, quite apart from the consideration that the law forbids it also. But if it did it, then it would completely alter the character of the French monetary system. It could not be expected that the French government and the Chambers would sanction the transaction to a credit-money standard which would be involved in such a procedure.
Thus, in the Compte rendu for 1898 (pp. 12 f.): "Si nous nous efforçons de conserver de grandes disponibilités métalliques et de les ménager le mieux possible, nous ne devons pas non plus perdre de vue les intérêts du commerce et lui refuser les moyens de payement qu'il réclame pour les besoins les plus légitimes, c'est-à-dire pour l'approvisionnement du marché français."
See my article Das Problem gesetzlicher Aufnahme der Barzahlungen in Osterreich-Ungarn, p. 1017. If the Austro-Hungarian Bank were to follow the example of the Bank of France in this or some other way it would achieve an exactly opposite result to that achieved by the French institution. Like that of the Bank of France, its action would restrict not merely the efflux but also the influx of gold. In France, the creditor nation, this means something very different from what it means in Austria, the debtor nation. In France, restriction of the importation of capital (which would only exceptionally occur) is unobjectionable; in Austria, the country that is dependent on constant importation of capital from abroad, it would have quite a different effect. The fact that there was a possibility of difficulties in subsequently repatriating the capital would mean that a greater gap than otherwise would have to occur between the Viennese and the foreign rates of interest before capital would be sent to Austria, and this would mean that the rate of interest in Austria would always be higher. The fact, on the other hand, that the export of Austrian short-term capital would also not be profitable except when there was a greater gap than otherwise between the home and foreign rates would not counteract the above disadvantage, because the question of capital exportation from Austria-Hungary to western countries very seldom arises.
See Koch, op. cit., p. 79; Die Reichsbank 1876-1900 (Berlin, 190l), p. 146.
See Obst, Banken und Bankpolitik (Leipzig, 1909), pp. 90 f.; Hertz, "Die Diskont und Devisenpolitik der österreichisch-ungarischen Bank," Zeitschrift für Volkswirtschaft, Sozialpolitik und Verwaltung 12 (1903): 496.
See Koch, op. cit., pp. 79 ff.; Hertz, op. cit., p. 521; Spitzmüller, "Valutareform und Währungsgesetzgebung," in Oesterreichischen Staatswörterbuch, 2d ed., vol. 2, p. 300.
See also Proebst, Die Grundlagen unseres Depositen- und Scheckwesens (Jena, 1908), pp. 1 ff.
It is only in very recent years that views on this point in dominant circles have begun slowly to change.
[The reader will remember that this was written in 1924. H.E.B.]
See Keynes, A Tract on Monetary Reform (London, 1923), pp. 163 ff.
See Kant, Werke, vol. 5, Zum ewigen Frieden (Insel-Ausgabe), pp. 661 f.
See Horn, Bankfreiheit (Stuttgart, 1867), pp. 376 f.
[It should be remembered that this was written in 1924. H.E.B.]
See pp. 166 f. above. Fisher particularly refers to this independence (Stabilizing the Dollar [New York, 1920], p. 90) and Anderson similarly affirms it, although in his book The Value of Money he has most severely criticized Fisher's version of the quantity theory of money. See Anderson, The Fallacy of "The Stabilized Dollar" (New York, 1920), pp. 6 f.
See pp. 215 ff. and 232 ff. above.

End of Notes

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