Front Page Titles (by Subject) PART THREE: MONEY AND BANKING - The Theory of Money and Credit
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PART THREE: MONEY AND BANKING - Ludwig von Mises, The Theory of Money and Credit 
The Theory of Money and Credit, trans. H.E. Batson (Indianapolis: Liberty Fund, 1981).
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MONEY AND BANKING
The Business of Banking
Types of Banking Activity
The business of banking falls into two distinct branches: the negotiation of credit through the loan of other people’s money and the granting of credit through the issue of fiduciary media, that is, notes and bank balances that are not covered by money. Both branches of business have always been closely connected. They have grown up on a common historical soil, and nowadays are still often carried on together by the same firm. This connection cannot be ascribed to merely external and accidental factors; it is founded on the peculiar nature of fiduciary media, and on the historical development of the business of banking. Nevertheless, the two kinds of activity must be kept strictly apart in economic theory; for only by considering each of them separately is it possible to understand their nature and functions. The unsatisfactory results of previous investigations into the theory of banking are primarily attributable to inadequate consideration of the fundamental difference between them.
Modern banks, beside their banking activities proper, carry on various other more or less closely related branches of business. There is, for example, the business of exchanging money, on the basis of which the beginnings of the banking system in the Middle Ages were developed, and to which the bill of exchange, one of the most important instruments of banking activity, owes its origin. Banks still carry on this business nowadays, but so do exchange bureaus, which perform no banking functions; and these also devote themselves to such business as the purchase and sale of securities.
The banks have also taken over a number of functions connected with the general management of the property of their customers. They accept and look after securities as “open” deposits, detach interest and dividend coupons as they fall due, and receive the sums concerned. They superintend the allotment of shares, attend to the renewal of coupon sheets, and see to other similar matters. They carry out stock exchange dealings for their customers and also the purchase and sale of securities that are not quoted on the exchange. They let out strong rooms which are used for the secure disposal of articles of value under the customer’s seal. All of these activities, whatever their bearing in individual cases upon the profitability of the whole undertaking, and however great their economic significance for the community as a whole, yet have no inherent connection with banking proper as we have defined it above.
The connection between banking proper and the business of speculation and flotation is similarly loose and superficial. This is the branch of their activities on which the general economic importance of the banks nowadays depends, and by means of which on the continent of Europe and in the United States they secured control of production, no less than of the provision of credit. It would not be easy to overestimate the influence on the organization of economic life that has been exerted by the change in the relation of the banks to industry and commerce; perhaps it would not be an exaggeration to describe it as the most important event in modern economic history. But in connection with the influence of banking on the exchange ratio between money and other economic goods, which alone concerns us here, it has no significance at all.
The Banks as Negotiators of Credit
The activity of the banks as negotiators of credit is characterized by the lending of other people’s, that is, of borrowed, money. Banks borrow money in order to lend it; the difference between the rate of interest that is paid to them and the rate that they pay, less their working expenses, constitutes their profit on this kind of transaction. Banking is negotiation between granters of credit and grantees of credit. Only those who lend the money of others are bankers; those who merely lend their own capital are capitalists, but not bankers.1 Our use of this definition of the Classical School should not furnish any ground for terminological controversy. The expression banking may be extended or contracted as one likes, although there seems little reason for departing from a terminology that has been usual since Smith and Ricardo. But one thing is essential: that activity of the banks that consists in lending other people’s money must be sharply distinguished from all other branches of their business and subjected to separate consideration.
For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, “The date on which the bank’s obligations fall due must not precede the date on which its corresponding claims can be realized.”2 Only thus can the danger of insolvency be avoided. It is true that a risk remains. Imprudent granting of credit is bound to prove just as ruinous to a bank as to any other merchant. That follows from the legal structure of their business; there is no legal connection between their credit transactions and their debit transactions, and their obligation to pay back the money they have borrowed is not affected by the fate of their investments; the obligation continues even if the investments prove dead losses. But it is just the existence of this risk which makes it worthwhile for the bank to play the part of an intermediary between the granter of credit and the grantee of it. It is from the acceptance of this risk that the bank derives its profits and incurs its losses.
That is all that needs to be said here about this branch of the business of banking. For as far as money and monetary theory are concerned, even the function of the banks as negotiators of credit is of significance only so far as it is able to influence the issue of fiduciary media, which alone will be discussed in the rest of the present work.
The Banks as Issuers of Fiduciary Media
To comprehend the significance of fiduciary media, it is necessary to examine the nature of credit transactions.
Acts of exchange, whether direct or indirect, can be performed either in such a way that both parties fulfill their parts of the contract at the same time, or in such a way that they fulfill them at different times. In the first case we speak of cash transactions; in the second, of credit transactions. A credit transaction is an exchange of present goods for future goods.
Credit transactions fall into two groups, the separation of which must form the starting point for every theory of credit and especially for every investigation into the connection between money and credit and into the influence of credit on the money prices of goods. On the one hand are those credit transactions which are characterized by the fact that they impose a sacrifice on that party who performs his part of the bargain before the other does—the forgoing of immediate power of disposal over the exchanged good, or, if this version is preferred, the forgoing of power of disposal over the surrendered good until the receipt of that for which it is exchanged. This sacrifice is balanced by a corresponding gain on the part of the other party to the contract—the advantage of obtaining earlier disposal over the good acquired in exchange, or, what is the same thing, of not having to fulfill his part of the bargain immediately. In their respective valuations both parties take account of the advantages and disadvantages that arise from the difference between the times at which they have to fulfill the bargain. The exchange ratio embodied in the contract contains an expression of the value of time in the opinions of the individuals concerned.
The second group of credit transactions is characterized by the fact that in them the gain of the party who receives before he pays is balanced by no sacrifice on the part of the other party. Thus the difference in time between fulfillment and counterfulfillment, which is just as much the essence of this kind of transaction as of the other, has an influence merely on the valuations of the one party, while the other is able to treat it as insignificant. This fact at first seems puzzling, even inexplicable; it constitutes a rock on which many economic theories have come to grief. Nevertheless, the explanation is not very difficult if we take into account the peculiarity of the goods involved in the transaction. In the first kind of credit transactions, what is surrendered consists of money or goods, disposal over which is a source of satisfaction and renunciation of which a source of dissatisfaction. In the credit transactions of the second group, the granter of the credit renounces for the time being the ownership of a sum of money, but this renunciation (given certain assumptions that in this case are justifiable) results for him in no reduction of satisfaction. If a creditor is able to confer a loan by issuing claims which are payable on demand, then the granting of the credit is bound up with no economic sacrifice for him. He could confer credit in this form free of charge, if we disregard the technical costs that may be involved in the issue of notes and the like. Whether he is paid immediately in money or only receives claims at first, which do not fall due until later, remains a matter of indifference to him.3
It seems desirable to choose special names for the two groups of credit transactions in order to avoid any possible confusion of the concepts. For the first group the name commodity credit (Sachkredit) is suggested, for the second the name circulation credit (Zirkulationskredit). It must be admitted that these expressions do not fully indicate the essence of the distinction that they are intended to characterize. This objection, however, which can in some degree be urged against all technical terms, is not of very great importance. A sufficient reply to it is contained in the fact that there are no better and more apt expressions in use to convey the distinction intended, which, generally speaking, has not received the consideration it merits. In any case the expression circulation credit gives occasion for fewer errors than the expression emission credit (Emissionskredit), which is sometimes used and has been chosen merely with regard to the issue of notes. Besides, what applies to all such differences of opinion is also true of this particular terminological controversy—the words used do not matter; what does matter is what the words are intended to mean.
Naturally, the peculiarities of circulation credit have not escaped the attention of economists. It is hardly possible to find a single theorist who has devoted serious consideration to the fundamental problems of the value of money and credit without having referred to the peculiar circumstances in which notes and checks are used. That this recognition of the individuality of certain kinds of credit transactions has not led to the distinction of commodity credit and circulation credit is probably to be ascribed to certain accidents in the history of our science. The criticism of isolated dogmatic and economico-political errors of the Currency principle that constituted the essence of most nineteenth-century investigation into the theory of banking and credit led to an emphasis being placed on all the factors that could be used to demonstrate the essential similarity of notes and other media of bank credit, and to the oversight of the important differences that exist between the two groups of credit characterized above, the discovery of which constitutes one of the permanent contributions of the Classical School and its successors, the Currency theorists.
The peculiar attitude of individuals toward transactions involving circulation credit is explained by the circumstance that the claims in which it is expressed can be used in every connection instead of money. He who requires money, in order to lend it, or to buy something, or to liquidate debts, or to pay taxes, is not first obliged to convert the claims to money (notes or bank balances) into money; he can also use the claims themselves directly as means of payment. For everybody they therefore are really money substitutes; they perform the monetary function in the same way as money; they are “ready money” to him, that is, present, not future, money. The practice of the merchant who includes under cash not merely the notes and token coinage which he possesses but also any bank balances which he has constantly at his immediate disposal by means of checks or otherwise is just as correct as that of the legislator who endows these fiduciary media with the legal power of settling all obligations contracted in terms of money—in doing which he only confirms a usage that has been established by commerce.
In all of this there is nothing special or peculiar to money. The objective exchange value of an indubitably secure and mature claim, which embodies a right to receive a definite individual thing or a definite quantity of fungible things, does not differ in the least from the objective exchange value of the thing or quantity of things to which the claim refers. What is significant for us lies in the fact that such claims to money, if there is no doubt whatever concerning either their security or their liquidity, are, simply on account of their equality in objective exchange value to the sums of money to which they refer, commercially competent to take the place of money entirely. Anyone who wishes to acquire bread can achieve his aim by obtaining in the first place a mature and secure claim to bread. If he only wishes to acquire the bread in order to give it up again in exchange for something else, he can give this claim up instead and is not obliged to liquidate it. But if he wishes to consume the bread, then he has no alternative but to procure it by liquidation of the claim. With the exception of money, all the economic goods that enter into the process of exchange necessarily reach an individual who wishes to consume them; all claims which embody a right to the receipt of such goods will therefore sooner or later have to be realized. A person who takes upon himself the obligation to deliver on demand a particular individual good, or a particular quantity of fungible goods (with the exception of money), must reckon with the fact that he will be held to its fulfillment, and probably in a very short time. Therefore he dare not promise more than he can be constantly ready to perform. A person who has a thousand loaves of bread at his immediate disposal will not dare to issue more than a thousand tickets each of which gives its holder the right to demand at any time the delivery of a loaf of bread. It is otherwise with money. Since nobody wants money except in order to get rid of it again, since it never finds a consumer except on ceasing to be a common medium of exchange, it is quite possible for claims to be employed in its stead, embodying a right to the receipt on demand of a certain sum of money and unimpugnable both as to their convertibility in general and as to whether they really would be converted on the demand of the holder; and it is quite possible for these claims to pass from hand to hand without any attempt being made to enforce the right that they embody. The obligee can expect that these claims will remain in circulation for so long as their holders do not lose confidence in their prompt convertibility or transfer them to persons who have not this confidence. He is therefore in a position to undertake greater obligations than he would ever be able to fulfill; it is enough if he takes sufficient precautions to ensure his ability to satisfy promptly that proportion of the claims that is actually enforced against him.
The fact that is peculiar to money alone is not that mature and secure claims to money are as highly valued in commerce as the sums of money to which they refer, but rather that such claims are complete substitutes for money, and, as such, are able to fulfill all the functions of money in those markets in which their essential characteristics of maturity and security are recognized. It is this circumstance that makes it possible to issue more of this sort of substitute than the issuer is always in a position to convert. And so the fiduciary medium comes into being in addition to the money certificate.
Fiduciary media increase the supply of money in the broader sense of the word; they are consequently able to influence the objective exchange value of money. To the investigation of this influence the following chapters are devoted.
Deposits as the Origin of Circulation Credit
Fiduciary media have grown up on the soil of the deposit system; deposits have been the basis upon which notes have been issued and accounts opened that could be drawn upon by checks. Independently of this, coins, at first the smaller and then the mediumsized, have developed into fiduciary media. It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction. If credit in the economic sense means the exchange of a present good or a present service against a future good or a future service, then it is hardly possible to include the transactions in question under the conception of credit. A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of the money in no way means that he has renounced immediate disposal over the utility that it commands.
Therefore the claim obtained in exchange for the sum of money is equally valuable to him whether he converts it sooner or later, or even not at all; and because of this it is possible for him, without damaging his economic interests, to acquire such claims in return for the surrender of money without demanding compensation for any difference in value arising from the difference in time between payment and repayment, such, of course, as does not in fact exist. That this could be so repeatedly overlooked is to be ascribed to the long accepted and widely accepted view that the essence of credit consists in the confidence which the lender reposes in the borrower The fact that anybody hands money over to a bank in exchange for a claim to repayment on demand certainly shows that he has confidence in the bank’s constant readiness to pay. But this is not a credit transaction, because the essential element, the exchange of present goods for future goods, is absent. But another circumstance that has helped to bring about the mistaken opinion referred to is the fact that the business performed by banks in exchanging money for claims to money payable on demand which can be transferred in the place of money, is very closely and intimately connected with that particular branch of their credit business that has most influenced the volume of money and entirely transformed the whole monetary system of the present day, namely, the provision of circulation credit. It is with this sort of banking business alone, the issue of notes and the opening of accounts that are not covered by money, that we are concerned. For this sort of business alone is of significance in connection with the function and value of money; the volume of money is affected by no other credit transactions than these.
While all other credit transactions may occur singly and be per formed on both sides by persons who do not regularly occupy themselves with such transactions, the provision of credit through the issue of fiduciary media is only possible on the part of an undertaking which conducts credit transactions as a matter of regular business. Deposits must be accepted and loans granted on a fairly considerable scale before the necessary conditions for the issue of fiduciary media are fulfilled. Notes cannot circulate unless the person who issues them is known and trustworthy. Moreover, payment by transfer from one account to another presupposes either a large circle of customers of the same bank or such a union of several banking undertakings that the total number of participants in the system is large. Fiduciary media can therefore be created only by banks and bankers; but this is not the only business that can be carried on by banks and bankers.
One branch of banking business deserves particular mention because, although closely related to that circle of banking activities with which we have to deal, it is quite without influence on the volume of money. This is that deposit business which does not serve the bank as a basis for the issue of fiduciary media. The activity carried on here by the bank is merely that of an intermediary, concerning which the English definition of a banker as a man who lends other people’s money is perfectly apt. The sums of money handed over to the bank by its customers in this branch of business are not a part of their reserves, but investments of money which are not necessary for day-to-day transactions. As a rule the two groups of deposits are distinguished even by the form they have in banking technique. The current accounts can be withdrawn on demand, that is to say, without previous notice. Often no interest at all is paid upon them, but when interest is paid, it is lower than that on the investment deposits. On the other hand, the investment deposits always bear interest and are usually repayable only on notice being given in advance. In the course of time, the differences in banking technique between the two kinds of deposit have been largely obliterated. The development of the savings-deposit system has made it possible for the banks to undertake the obligation to pay out small amounts of savings deposits at any time without notice. The larger the sums which are brought to the banks in the investment-deposit business, the greater, according to the law of large numbers, is the probability that the sums paid in on any particular day will balance those whose repayment is demanded, and the smaller is the reserve which will guarantee the bank the possibility of not having to break any of its promises. Such a reserve is all the easier to maintain inasmuch as it is combined with the reserve of the current-account business. Small business people or not very well-to-do private individuals, whose monetary affairs are too insignificant to be transferred as a whole to a bank, now make use of this development by trusting part of their reserve to the banks in the form of savings deposits. On the other hand, the circumstance that competition among banks has gradually raised the rate of interest on current accounts causes sums of money that are not needed for current-account purposes, and therefore might be invested, to be left on current account as a temporary investment. Nevertheless, these practices do not alter the principle of the matter; it is not the formal technical aspect of a transaction but its economic character that determines its significance for us.
From the point of view of the banks there does exist a connection between the two kinds of deposit business inasmuch as the possibility of uniting the two reserves permits of their being maintained at a lower level than their sum would have to be if they were completely independent. This is extremely important from the point of view of banking technique, and explains to some degree the advantage of the deposit banks, which carry on both branches of business, over the savings banks, which only accept savings deposits (the savings banks being consequently driven to take up currentaccount business also). For the organization of the banking system this circumstance is of importance; for the theoretical investigation of its problems it is negligible.
The essential thing about that branch of banking business which alone needs to be taken into consideration in connection with the volume of money is this: the banks that undertake current-account business for their customers are, for the reasons referred to above, in a position to lend out part of the deposited sums of money. It is a matter of indifference how they do this, whether they actually lend out a portion of the deposited money or issue notes to those who want credit or open a current account for them. The only circumstance that is of importance here is that the loans are granted out of a fund that did not exist before the loans were granted. In all other circumstances, whenever loans are granted they are granted out of existing and available funds of wealth. A bank which neither possesses the right of note issue nor carries on current-account business for its customers can never lend out more money than the sum of its own resources and the resources that other persons have entrusted to it. It is otherwise with those banks that issue notes or open current accounts. They have a fund from which to grant loans, over and above their own resources and those resources of other people that are at their disposal.
The Granting of Circulation Credit
According to the prevailing opinion, a bank which grants a loan in its own notes plays the part of a credit negotiator between the borrowers and those in whose hands the notes happen to be at any time. Thus in the last resort bank credit is not granted by the banks but by the holders of the notes. The intervention of the banks is said to have the single object of permitting the substitution of its well-known and indubitable credit for that of an unknown and perhaps less trustworthy debtor and so of making it easier for a borrower to get a loan taken up by “the public.” It is asserted, for example, that if bills are discounted by the bank and the discounted equivalent paid out in notes, these notes only circulate in place of the bills, which would otherwise be passed directly from hand to hand in lieu of cash. It is thought that this can also be proved historically by reference to the fact that before the development of the bank-of-issue system, especially in England, bills circulated to a greater extent than afterward; that in Lancashire, for example, until the opening of a branch of the Bank of England in Manchester, ninetenths of the total payments were made in bills and only one-tenth in money or banknotes.4 Now this view by no means describes the essence of the matter A person who accepts and holds notes, grants no credit; he exchanges no present good for a future good. The immediately convertible note of a solvent bank is employable everywhere as a fiduciary medium instead of money in commercial transactions, and nobody draws a distinction between the money and the notes which he holds as cash. The note is a present good just as much as the money.
Notes might be issued by banks in either of two ways. One way is to exchange them for money. According to accounting principles, the bank here enters into a debit transaction and a credit transaction; but the transaction is actually a matter of indifference, since the new liability is balanced by an exactly corresponding asset. The bank cannot make a profit out of such a transaction. In fact such a transaction involves it in a loss, since it brings in nothing to balance the expense of manufacturing the notes and storing the stocks of money. The issue of fully backed notes can therefore only be carried on in conjunction with the issue of fiduciary media. This is the second possible way of issuing notes, to issue them as loans to persons in search of credit. According to the books, this, like the other, is a case of a credit and a debit transaction only.5 It is true that this is not shown by the bank’s balance sheet. On the credit side of the balance sheet are entered the loans granted and the state of the till, and on the debit side, the notes. We approach a better understanding of the true nature of the whole process if we go instead to the profit-and-loss account. In this account there is recorded a profit whose origin is suggestive—“profit on loans.” When the bank lends other people’s money as well as its own resources, part of this profit arises from the difference between the rates of interest that it pays its depositors and the rates that it charges its borrowers. The other part arises from the granting of circulation credit. It is the bank that makes this profit, not the holders of the notes. It is possible that the bank may retain the whole of it; but sometimes it shares it, either with the holders of the notes or, more probably, with the depositors. But in either case there is a profit.6
Let us imagine a country whose monetary circulation consists in 100 million ducats. In this country a bank-of-issue is established. For the sake of simplicity, let us assume that the bank’s own capital is invested as a reserve outside the banking business, and that it has to pay the annual interest on this capital to the state in return for the concession of the right of note issue—an assumption that does correspond closely with the actual situation of some banks-of-issue. Now let the bank have fifty million ducats paid into it and issue fifty million ducats’ worth of one-ducat notes against this sum. But we must suppose that the bank does not allow the whole sum of fifty million ducats to remain in its vaults; it lends out forty million on interest to foreign businessmen. The interest on these loans consitutes its gross profit which is reduced only by the cost of manufacture of the notes, by administrative expenses, and the like. Is it possible in this case to say that the holders of the notes have granted credit to the foreign debtors of the bank, or to the bank itself?
Let us alter our example in a nonessential point. Let the bank lend the forty million not to foreigners but to persons within the country. One of these, A, is indebted to B for a certain sum, say the cost of goods which he has bought from him. A has no money at his disposal, but is ready to cede to B a claim maturing in three months, which he himself holds against P. Can B agree to this? Obviously only if he himself does not need for the next three months the sum of money which he could demand immediately, or if he has a prospect of finding somebody who can do without a corresponding sum of money for three months and is therefore ready to take over the claim against P. Or the situation might arise in which B wished to buy goods immediately from C, who was willing to permit postponement of payment for three months. In such a case, if C was really in agreement with the postponement, this could only be for one of the three reasons that might also cause B to be content with payment after the lapse of three months instead of immediate payment. All these, in fact, are cases of genuine credit transactions, of the exchange of present goods for future goods. Now the number and extent of these transactions is dependent on the quantity of present goods available; the total of the possible loans is limited by the total quantity of money and other goods available for this purpose. Loans can be granted only by those who have disposal over money or other economic goods which they can do without for a period. Now when the bank enters the arena by offering forty million ducats on the loan market, the fund available for lending pur poses is increased by exactly this sum; what immediate influence this must have on the rate of interest, should not need further explanation. Is it then correct to say that when the bank discounts bills it does nothing but substitute a convenient note currency for an inconvenient bill currency?7 Is the banknote really nothing but a handier sort of bill of exchange? By no means. The note that embodies the promise of a solvent bank to pay a sum to the bearer on demand at any time, that is, immediately if desired, differs in an important point from the bill that contains the promise to pay a sum of money after the passage of a period of time. The sight bill, which as is well known) plays no part in the credit system, is comparable with the note; but not the time bill, which is the form regularly assumed by the bills that are usual in credit transactions. A person who pays the price of a purchased commodity in money, in notes, or by the transfer of any other claim payable on demand, has carried through a cash transaction; a person who pays the purchase price by the acceptance of a three-month bill has carried through a credit transaction.8
Let us introduce a further unessential variation into our example, which will perhaps help to make the matter clearer. Let us assume that the bank has first issued notes to the value of fifty million ducats and received for them fifty million ducats in money; and now let us suppose it to place a further forty million ducats in its own notes on the loan market. This case is in every way identical with the two considered above.
The activity of note issue cannot in any way be described as increasing the demand for credit in the same sense as, say, an increase in the number of bills current. Quite the contrary. The bank-of-issue does not demand credit; it grants it. When an additional quantity of bills comes on to the market, this increases the demand for credit, and therefore raises the rate of interest. The placing of an additional quantity of notes on the loan market at first has the opposite effect; it constitutes an increase in the supply of credit and has therefore an immediate tendency to diminish the rate of interest.9
It is one of the most remarkable phenomena in the history of political economy that this fundamental distinction between notes and bills could have passed unnoticed. It raises an important problem for investigators into the history of economic theory. And in solving this problem it will be their principal task to show how the beginnings of a recognition of the true state of affairs that are to be found even in the writings of the Classical School and were further developed by the Currency School, were destroyed instead of being continued by the work of those who came after.10
Fiduciary Media and the Nature of Indirect Exchange
It should be sufficiently clear from what has been said that the traditional way of looking at the matter is but little in harmony with the peculiarities of fiduciary media. To regard notes and current accounts, whether they are covered by money or not, as constituting the same phenomenon, is to bar the way to an adequate conception of the nature of these peculiarities. To regard noteholders or owners of current accounts as granters of credit is to fail to recognize the meaning of a credit transaction. To treat both notes and bills of exchange in general (that is, not merely sight bills) as “credit instruments” alike is to renounce all hope of getting to the heart of the matter.
On the other hand, it is a complete mistake to assert that the nature of an act of exchange is altered by the employment of fiduciary media. Not only those exchanges that are carried through by the cession of notes or current-account balances covered by money, but also those exchanges that are carried through by the employment of fiduciary media, are indirect exchanges involving the use of money. Although from the juristic point of view it may be significant whether a liability incurred in an act of exchange is discharged by physical transference of pieces of money or by cession of a claim to the immediate delivery of pieces of money, that is, by cession of a money substitute, this has no bearing upon the economic nature of the act of exchange. It would be incorrect to assert, for instance, that when payment is made by check, commodities are really exchanged against commodities, only without any of the crude clumsiness of primitive barter.11 Here, just as in every other indirect exchange made possible by money, and in contrast to direct exchange, money plays the part of an intermediary between commodity and commodity. But money is an economic good with its own fluctuations in value. A person who acquires money or money substitutes will be affected by all the variations in their objective exchange value. This is just as true of payment by notes or checks as of the physical transference of pieces of money. But this is the only point that matters, and not the accidental circumstance whether money physically “enters into” the transaction as a whole. Anybody who sells commodities and is paid by means of a check and then immediately uses either the check itself or the balance that it puts at his disposal to pay for commodities that he has purchased in another transaction, has by no means exchanged commodities directly for commodities. He has undertaken two independent acts of exchange, which are connected no more intimately than any other two purchases.
It is possible that the terminology proposed is not the most suitable that could be found. This must be freely admitted. But it may at least be claimed for it that it opens the way to a better comprehension of the nature of the phenomena under discussion than those that have been previously employed. For if it is not quite true to say that inexact and superficial terminology has been chiefly responsible for the frequently unsatisfactory nature of the results of investigations into the theory of banking, still a good deal of the ill success of such investigations is to be laid to that account.
That economic theory puts questions of law and banking technique in the background and draws its boundaries differently from those drawn by jurisprudence or business administration is or should be self-evident. Reference to discrepancies between the above theory and the legal or technical nature of particular procedures is therefore no more relevant as an argument against the theory than economic considerations would be in the settlement of controversial juristic questions.
The Evolution of Fiduciary Media
The Two Ways of Issuing Fiduciary Media
Thus fiduciary media are claims to the payment of a given sum on demand, which are not covered by a fund of money and whose legal and technical characteristics make them suitable for tender and acceptance instead of money in fulfillment of obligations that are in terms of money. As has already been suggested, it is not the dead letter of the law so much as actual business practice that counts, so that some things function as fiduciary media, although they cannot be regarded as promises to pay money from the juristic point of view, because they nevertheless are in fact honored as such by somebody or other. We were able to show that, so far as they are not money certificates, even modern token coins and such kinds of money as the German thaler during the period from the establishment of the gold standard until its abolition, constitute fiduciary media and not money.
Fiduciary media may be issued in two ways: by banks, and otherwise. Bank fiduciary media are characterized by being dealt with as constituting a debt of the issuing body. They are entered as liabilities, and the issuing body does not regard the sum issued as an increase of its income or capital, but as an increase on the debit side of its account, which must be balanced by a corresponding increase on the credit side if the whole transaction is not to figure as a loss. This way of dealing with fiduciary media makes it necessary for the issuing body to regard them as part of its trading capital and never to spend them on consumption but always to invest them in business. These investments need not always be loans; the issuer may himself carry on a productive enterprise with the working capital that is put into his hands by the issue of fiduciary media. It is known that some deposit banks sometimes open deposit accounts without a money cover not only for the purpose of granting loans, but also for the purpose of directly procuring resources for production on their own behalf. More than one of the modern credit and commercial banks has invested a part of its capital in this manner, and the question of the right attitude in this case of the holders of the money substitutes, and of the state legislature that feels itself called upon to protect them, remains an open one. In earlier times there was a similar problem concerning banks issuing notes12 until banking practice or the law prescribed short-term loans as “cover.”
The issuer of fiduciary media may, however, regard the value of the fiduciary media put into circulation as an addition to his income or capital. If he does this, he will not take the trouble to cover the increase in his obligations due to the issue by setting aside a special credit fund out of his capital. He will pocket the profits of the issue, which in the case of token coinage is called seigniorage, as composedly as any other sort of income.
The only difference between the two ways of putting fiduciary media into circulation lies in the attitude of the issuer. Naturally, this cannot have any significance for the determination of the value of the fiduciary media. The difference between the methods of issue is a result of historical factors. Fiduciary media have sprung from two different roots: from the activities of the deposit and giro banks on the one hand, and from the state prerogative of minting on the other hand. The former is the source of notes and current accounts; the latter, that of convertible Treasury notes, token coins, and that current money of which the coinage is restricted, but which can be regarded neither as credit money nor as fiat money because it is actually convertible into money on demand to its full amount. Today the difference between the two methods of issuing is gradually disappearing, all the more as the state endeavors to act in the same way as the banks in issuing fiduciary media. Some states are already in the habit of devoting the profits of their coinage to special purposes and of refusing to treat them in any way as an increase of wealth.13
Of the two types of money substitutes issued by the banks, the current account is the older. The banknote, in fact, is only a development of it. It is true that the two are different in the eyes of the law and the banker, but they do not differ at all in the eyes of the economist. The only distinctions between them are in those legal or banking or commercial peculiarities of the banknote which give it a special capacity of circulation. It is easily transferable and very like money in the way in which it is transferred. Banknotes were therefore able to outstrip the older money substitute, the current account, and penetrate into commerce with extraordinary rapidity. For medium and small payments they offer such great advantages that the current account was hardly able to maintain its ground beside them. It was not until the second half of the nineteenth century that the current account once more became important along with the banknote. In large transactions, check and clearing payments are often superior to notes. But the chief reason why the current account was able in part to expel the banknote must by no means be sought in any inherent requirements of business. The current account is not, as it is sometimes the fashion to assert without any reason or proof, a “higher” form of money substitute than the banknote. The banknote has been supplanted by the current account in many countries because its development was artificially hindered and that of the current account artificially encouraged, the reason for this being that acceptance of the doctrines of the Currency principle led people to see danger for the stability of the exchange ratio between money and other economic goods only in the overissue of notes, and not in the excessive increase of bank deposits.
For the study of the credit system from the economic point of view, the contrast between notes and deposits is of minor importance. There are payments for which one or other form is the more suitable, and payments for which both forms are suitable. If their development had been allowed to take its own course, this fact would undoubtedly have been more evident than it is today when the attempt is sometimes made to bring about the employment of one or other kind of fiduciary medium by artificial means in circumstances where it appears the less appropriate technically.
Fiduciary Media and the Clearing System
That want of clarity concerning the nature of fiduciary media which constitutes the chief characteristic of the writings of the banking theorists and their epigoni, the modern writers on problems of banking theory, leads to a perpetual confusion between money substitutes and a series of institutions which reduce the demand for money in the narrower sense, and also to relative neglect of the differences that exist between money certificates and fiduciary media within the group of money substitutes proper.
The economic effect of an exchange that is carried out with the help of a certain quantity of a fungible good, can sometimes, if several persons have to transact business at the same time, be attained more indirectly in ways which, while they are formally of a more complicated legal structure, nevertheless fundamentally simplify the technical transaction and make it possible to dispense in particular instances with the physical presence of pieces of the medium of exchange. If A has to deliver a piece of cloth to B and receive a sheep from him for it, and if A at the same time has to give a sheep to C and receive from him a horse, these two exchanges can also be transacted if B gives a sheep to C on behalf and on account of A, so freeing himself from the obligation that he is under to give A a sheep in return for the cloth and A from the obligation that he is under to give C a sheep in return for the horse. Whereas the direct transaction of these two exchanges would have necessitated four transfers, this procedure necessitates only three.
The possibility of facilitating exchanges in this way is extraordinarily increased by extension of the custom of using certain goods as common media of exchange. For the number of cases in which anybody simultaneously owes and has a claim to a certain fungible good will increase with the number of cases in which one and the same fungible good—the common medium of exchange—is the object of exchange in individual transactions. Full development of the use of money leads at first to a splitting up into two acts of indirect exchange even of such transactions as could in any case have been carried through by direct exchange. The butcher and the baker, who could also exchange their products directly, often prefer to have their mutual relations take the form of an exchange carried through with the help of money which their other transactions assume also. The butcher sells meat to the baker for money and the baker sells bread to the butcher for money. This gives rise to reciprocal money claims and money obligations. But it is clear that a settlement can be arrived at here, not only by each party actually handing money over to the other, but also by means of offsetting, in which merely the balance remaining over is settled by payment of money. To complete the transaction in this way by full or partial cancellation of counterclaims offers important advantages in comparison with direct exchange: all the freedom connected with the use of money is combined with the technical simplicity that characterizes direct exchange transactions.
This method of carrying through indirect exchanges by cancellation of counterclaims is very greatly stimulated at the time when the cases where its employment is possible are increased by the fact that credit transactions, or the exchange of present goods for future goods, are becoming customary. When all exchanges have to be settled in ready cash, then the possibility of performing them by means of cancellation is limited to the case exemplified by the butcher and baker and only then on the assumption, which of course only occasionally holds good, that the demands of both parties are simultaneous. At the most, it is possible to imagine that several other persons might join in and so a small circle be built up within which drafts could be used for the settlement of transactions without the actual use of money. But even in this case simultaneity would still be necessary, and, several persons being involved, would be still seldomer achieved.
These difficulties could not be overcome until credit set business free from dependence on the simultaneous occurrence of demand and supply. This, in fact, is where the importance of credit for the monetary system lies. But this could not have its full effect so long as all exchange was still direct exchange, so long even as money had not established itself as a common medium of exchange. The instrumentality of credit permits transactions between two persons to be treated as simultaneous for purposes of settlement even if they actually take place at different times. If the baker sells bread to the cobbler daily throughout the year and buys from him a pair of shoes on one occasion only, say at the end of the year, then the payment on the part of the baker, and naturally on that of the cobbler also, would have to be made in cash, if credit did not provide a means first for delaying the one party’s liability and then for settling it by cancellation instead of by cash payment.
Exchanges made with the help of money can also be settled in part by offsetting if claims are transferred within a group until claims and counterclaims come into being between the same persons, these being then canceled against each other, or until the claims are acquired by the debtors themselves and so extinguished. In interlocal and international dealing in bills, which has been developed in recent years by the addition of the use of checks and in other ways which have not fundamentally changed its nature, the same sort of thing is carried out on an enormous scale. And here again credit increases in a quite extraordinary fashion the number of cases in which such offsetting is feasible.14 In all these cases we have an exchange made with the help of money which is nevertheless transacted without the actual use of money or money substitutes simply by means of a process of offsetting between the parties. Money in these cases is still a medium of exchange, but its employment in this capacity is independent of its physical existence. Use is made of money, but not physical use of actually existing money or money substitutes. Money which is not present performs an economic function; it has its effect solely by reason of the possibility of its being able to be present.
The reduction of the demand for money in the broader sense which is brought about by the use of offsetting processes for settling exchanges made with the help of money, without affecting the function performed by money as a medium of exchange, is based upon the reciprocal cancellation of claims to money. The use of money is avoided because claims to money are transferred instead of actual money. This process is continued until claim and debt come together, until creditor and debtor are united in the same person. Then the claim to money is extinguished, since nobody can be his own creditor or his own debtor.15 The same result may be reached at an earlier stage by reciprocal cancellation, that is by the liquidation of counterclaims by a process of offsetting.16 In either case the claim to money ceases to exist, and then, and not until then, is the act of exchange which gave birth to the claim finally completed.
Any transfer of a claim which does not bring it nearer to being extinguished by cancellation or offsetting cannot decrease the demand for money. In fact, if the transfer of the claim is not instead of payment in money, then it is on the contrary the source of a fresh demand for money. Now cession of claims instead of payment in money has, apart from the use of money substitutes, never been of very great commercial importance. As far as claims that are already due are concerned, the holder will as a rule prefer to call in the outstanding sums of money, because he will invariably find it easier to buy (and carry through other transactions in the market) with money or money substitutes than with claims whose goodness has not been indisputably established. But if the holder does in exceptional cases transfer such a claim by way of payment, then the new holder will be in the same position. A further hindrance to the transfer of claims to money that are not yet due instead of payment in money is the fact that such claims can be accepted only by such persons as are able to agree to postponement of payment; to rest content with a claim that is not yet due, when immediate payment could be enforced, is to grant credit.
Commercial requirements had previously made use of the legal institution of the bill in a way that caused it to circulate in a manner fairly similar to that of fiduciary media. Toward the end of the eighteenth and at the beginning of the nineteenth century bills were current in the European commercial centers which were endorsed by the merchants in place of payment in money.17 Since it was the general custom to make payments in this way, anybody could accept a bill that still had some time to run even when he wanted cash immediately; for it was possible to reckon with a fair amount of certainty that those to whom payments had to be made would also accept a bill not yet mature in place of ready money. It is perhaps hardly necessary to add that in all such transactions the element of time was of course taken into consideration, and discount consequently allowed for. Now it is true that this might increase the technical difficulties in handling the circulatory apparatus, which was already not an easy matter to deal with for other reasons, such, for example, as the different amounts of the bills. But, on the other hand, it offered a profit to any holder who did not pass the bill on immediately but kept it for a while, even if only for a very short while, in his portfolio. Used in this way, the bill was able to make up to a certain extent for the lack of fiduciary media. Even though it might not be due for a long time ahead, the holder could regard it as liquid, because he could pass it on at any time.
Despite this, bills of this sort were not fiduciary media in the sense in which notes or deposits are. They lack the characteristic features and properties which enabled the fiduciary medium, the indefinitely augmentable product of the arbitrary issuing activity of the banks, to become a complete substitute for money for business purposes. It is true that the cooperation of issuers and acceptors can give the circulation of bills the capacity of unlimited augmentation and unlimited lease of life through the agency of bill jobbing and regular prolongation, even if technical difficulties alone are sufficient to prevent the bills from ever being used in business to the same extent as money substitutes. But every increase in the amount of bills in circulation makes negotiation of individual bills more difficult. It reduces the resources of the market. In fact, the holder of a bill, as distinct from the holder of a note or of a current account, is a creditor A person who accepts a bill must examine the standing of the previous endorser, and also that of the issuer and the others who are liable for the bill, but in particular the primary acceptor Whoever passes a bill on, in endorsing it undertakes responsibility for the payment of the amount of the bill. The endorsement of the bill is in fact not a final payment; it liberates the debtor to a limited degree only. If the bill is not paid then his liability is revived in a greater degree than before. But the peculiar rigor of the law relating to its enforcement and the responsibility of its signatories could not be eliminated, for it was these very characteristics alone that had made the bill a suitable instrument for the cession, in place of money payment, of unmatured claims for which the common-law provisions regarding indebtedness are little suited. To whatever extent the custom of issuing or endorsing bills in place of payment in money may have established itself, every single payment that was made in this way nevertheless retained the character of a credit transaction. It was necessary in each individual case for the parties to the transaction to begin by coming to a special agreement as to the present price to be paid for the claim that would not fall due until some future time; if the amount of bills in circulation increased greatly, or if doubts happened to arise concerning the solidity of the position of any of the signatories, then it became more difficult to place the bill even on fairly tolerable terms. Issuer and acceptor had then in addition to make arrangements for covering the bill before it fell due, even if only by negotiating a prolongation bill. There is none of this in the case of fiduciary media, which pass like money from hand to hand without any sort of friction.
The modern organization of the payment system makes use of institutions for systematically arranging the settlement of claims by offsetting processes. There were beginnings of this as early as the Middle Ages, but the enormous development of the clearinghouse belongs to the last century. In the clearinghouse, the claims continuously arising between members are subtracted from one another and only the balances remain for settlement by the transfer of money or fiduciary media. The clearing system is the most important institution for diminishing the demand for money in the broader sense.
In the literature of the banking system it is not as a rule customary to draw a sufficient distinction between the diminution of the demand for money in the broader sense which is due to the operations of the clearinghouses and the diminution of the demand for money in the narrower sense which is due to the extension of the use of fiduciary media. This is the cause of much obscurity.
Fiduciary Media in Domestic Trade
In the domestic trade of most civilized countries, the actual use of money for transacting exchanges made with the help of money has been very largely superseded by the use of money substitutes. And among the money substitutes, fiduciary media play a constantly increasing part. At the same time, the number of exchanges made with the help of money which are settled by the offsetting of counterclaims is growing also. There are countries in which nearly all the internal payments that are not settled by the clearing process are made without the use of money merely with the aid of banknotes and deposits that are not covered by money, of token coins in the proper sense of the word, and of other coins convertible on demand into money. In other countries, again, the fiduciary medium has not yet been developed to a like extent; but if we disregard those countries in which the insecurity of the law hinders the birth of that confidence in the soundness of the issuer which is the sine qua non for the circulation of money substitutes, then we shall find no part of the world in which a large proportion of the internal payments are not made by means of the use of fiduciary media alone, without the actual transference of money. It is only in medium-sized transactions that there is still room for the transference of actual money. In Germany and England before the war it was usual to make payments of twenty to one hundred marks and £1 and £5 by the transference of gold coins. Smaller and larger payments were made almost exclusively by the cession of token coins or notes or deposits which were only partly covered by money. It was the same in other countries.
The fact that money continued to be in actual circulation at all in a series of states, like Germany and England, and was not entirely superseded by fiduciary media and money certificates, was due solely to legislative intervention. For reasons which were connected with certain views on the nature of notes, it was thought that the circulation of notes of small denominations ought to be opposed.18 The battle against the one-pound note in England ended with the complete victory of the sovereign, and this victory had a significance outside England, too, for the disfavor in which small banknotes were held for decades on the continent of Europe was based upon English opinion. It is certain that in those states which have a sound administration of justice and a developed banking system, the employment of actual money in commerce could be replaced without difficulty by the issue of a corresponding quantity of small notes.
In some countries in which the actual transfer of money has been completely superseded by fiduciary media and money certificates, this end has been systematically sought and attained in a peculiar fashion and under very peculiar conditions. The silver-standard countries—India, primarily, but the situation was similar in other Asiatic states—after the great controversy about the standards had been decided in favor of monometallism, were forced to accept the world gold standard. But there were extraordinary difficulties in the way of the transition to a monetary system in imitation of English of German institutions. To introduce gold money in the circulation of these countries would have necessitated the conveyance of enormous quantities of gold to them, which would not have been practicable without serious convulsion of the European money market and would have meant great sacrifice. The governments of these countries, however, had to endeavor at all costs on the one hand not to raise the value of gold (so as not to disturb the European markets), and on the other hand not to reduce the value of silver any more than was necessary. The English government in India did not dare to undertake anything which might have had an unfavorable influence on the London money market; but, having regard to India’s Asiatic competitors, which presumably would remain on the silver standard, neither did it dare to take any steps which would expedite the fall in the price of silver and consequently weaken for a time, even if only in appearance, the ability of India to compete with China, Japan, the Straits Settlements, and the other silver countries. It therefore had the task of conducting India’s transition to the gold standard without buying gold in considerable quantities or selling silver.
The problem was not insoluble. Within limits, the circumstances were similar to those of the bimetallic countries which had discontinued the free coinage of silver at the end of the seventies. And besides, careful scientific consideration of the problem showed that it was possible to create a gold standard without a gold currency; that it was enough to discontinue the free coinage of silver and to announce its convertibility into gold at a specific rate, making this effective by establishing a suitable conversion fund, in order to give the country a gold standard which would differ from that of England only in the lower level of the stock of gold. It was only necessary to go back to the writings of Ricardo in order to find the plan for such a currency system already worked out in detail. Lindsay19 and Probyn20 followed this path and, building upon Ricardo, worked out plans for this kind of currency regulation. Both wanted to close the mints to silver and to make the rupee convertible into gold at a fixed ratio. For the future, only the rupee was to be legal tender. The two proposals differed on some minor points, of which the most important was that while Probyn held it necessary that the rupee should be convertible into gold in India itself, Lindsay was of the opinion that it would suffice if the conversion were to be in London from a gold reserve to be established there. Both proposals were rejected, by the Indian government and by the commissions appointed to inquire into the Indian monetary system. The opinion was expressed that a normal gold standard necessitates an actual gold currency, and that the lack of such a currency would awaken mistrust.21
The report of the commission of 1898 was signed by the most eminent experts of the day; its comments on the recommendations of Probyn and Lindsay were supported on the decisive point by the expert opinions of the biggest bankers in the British Empire. The course of events vindicated the theorists, however, not the statesmen and great financiers who had regarded them with amused commiseration. What was ultimately done in India corresponded roughly and on the whole to the recommendations of Probyn and Lindsay, even if there were variations in detail. And the monetary systems of other countries that had previously been on a silver standard were organized in a precisely similar manner The present currency system of India, of the Straits Settlements, of the Philippines, and of the other Asiatic countries which have followed their example, is superficially characterized by the fact that in domestic trade, payments in money, that is, in gold, do not occur at all or at least are far rarer than in the gold-standard countries of Europe and America, and even in these the actual circulation of gold is only quite small in proportion to the total of all the payments made with the help of money. Under the system in India, payments are made, along with notes, checks, and giro transfers, chiefly in silver coins, which are partly relics of the time of the silver standard, and partly minted by the government for the account of the state and to the benefit of the Treasury, which receives the considerable profits of the coinage. A conversion fund, which is set up and administered by the government, exchanges these silver coins at a fixed ratio for gold, gold securities, or other claims to money, payable on demand, while, on the other hand, it issues such silver coins in exchange for gold in unlimited quantities at the same rate, allowance being made for the expenses of storage, transportation, etc. The minor details of this arrangement differ in different countries; but the differences in its legal or banking technique are insignificant as far as its nature is concerned. It is, for example, of no further significance, whether or not the silver coins are converted on the basis of a legal obligation. All that matters is whether the conversion actually does take place on demand.22
There exists no fundamental difference at all between the currency system of these Asiatic and American countries and that that the European gold-standard countries once had. Under both systems, payments are made without the actual transference of money by the aid of the surrender of fiduciary media. The fact that in England and Germany the actual transference of money also played a certain part for medium-sized payments, whereas in India and in the Philippines the number of actual transfers of money is scarcely worth mentioning, or that in the former countries the proportion of the circulation that was not covered by money was smaller than in the latter, is quite inessential; it is a difference that is merely quantitative, not qualitative. Of no great relevance is the circumstance that the fiduciary media were in the one case predominantly banknotes and checks and are in the other case predominantly silver coins. The silver rupee is in truth nothing but a metallic note, for the conversion of which its issuer, the state, is responsible.23
Following up a train of thought of Ricardo’s, who was the first to develop the plan of this monetary system more than a hundred years ago,24 it is customary to speak of it as the gold-exchange standard. The aptness of this designation can only be conceded if it is intended to stress the peculiarities in banking and currency technique that characterize the system. But it is a name that must be rejected if it is intended to indicate the existence of a fundamental difference from what used to be the English and German type of gold standard. It is not correct to assert that in these countries gold functions merely as a measure of prices while the silver coins are used as a common medium of exchange. We know what little justification there is for speaking of a price-measuring function of money. In Ricardo’s sense, it was possible to speak of measurement and measures of value; from the point of view of the subjective theory of value these and similar concepts are untenable. In India and Austria-Hungary and in all other countries with similar currency and banking systems, gold is or was just as much a common medium of exchange as in prewar England or Germany; the difference between the two systems is only one of degree, not one of kind.
Fiduciary Media in International Trade
The practice of making payments by the writing off or reciprocal balancing of claims is not restricted by the boundaries of states or countries. It was in fact in trade between different areas that the need for it was earliest and most strongly felt. The transportation of money always involves not inconsiderable cost, loss of interest, and risk. If the claims arising out of various transactions are liquidated not by the actual transference of money, but by balancing or offsetting, then all these expenses and dangers can be avoided. This provided an extraordinarily effective motive for developing those methods of making payments over long distances which saved the transference of sums of money. Quite early we find the use of bills established for interlocal payments; then in addition we later find checks, and ordinary and cable transfers, all forming the basis of an interlocal clearing system which worked through the ordinary free play of the market without the help of a special clearinghouse. When making payments within a given locality the advantages for the individual of the method of settling transactions by the clearing process and therefore without the use of cash are smaller than those when making payments between localities, and therefore it was a longer time before the system of reciprocal cancellation came into full operation with the establishment of clearinghouses.
If the clearing system has without difficulty transcursed political boundaries and created for itself a world-embracing organization in the international bill and check system, the validity of the fiduciary media, like that of all money substitutes, is nationally limited. There are no money substitutes, and so no fiduciary media, that are recognized internationally and consequently able to take the place of money in international trade for settling the balances that remain over after the clearing process. That is often overlooked in discussions of the present position of the international system of payments and the possibilities of its future development. Here again, in fact, the confusion creeps in, that has already been criticized adversely, between the system of reciprocal cancellation and the circulation of fiduciary media. This is most clear in the usual arguments about international giro transactions. In domestic giro transactions, payments are effected by the transfer of money substitutes, which are often fiduciary media, namely, the balances of the members at the giro bank. In international transactions, the money substitute is lacking, and even the international clearing system that is recommended in various quarters is not intended to introduce one. Rather it should be pointed out that this so-called international giro system—which incidentally was done away with again by the inflation during the war—while it may have changed the external form of the traditional manner of settling international monetary claims, has not changed in nature. When banks of various countries agree to give their clients the right to undertake direct transference from their balances to the balances of the clients of foreign banks, this may quite well constitute a new and additional method of international settlement of accounts. A Viennese desirous of paying a sum of money to somebody in Berlin was previously able either to use an international money order or to go to the exchange and buy a bill on Berlin and send it to his creditor As a rule he would have made use of the intermediate services of a bank, which for its part would perform the transaction through the purchase of a foreign bill or a check. Later, if he was a member of the check system of the Austrian Post Office Savings Bank and his creditor belonged to that of the German post office, he would have been able to make the transfer more simply by sending the appropriate order on the Vienna office of the Post Office Savings Bank. This might well be more convenient and better suited to the demands of business than the only method that was once usual; but, however excellent a method, it was not a new method of international monetary intercourse. For the balances of this international giro system, if they could not be paid by bills, had to be paid by the actual transference of money. It is not true that the international giro system has decreased the international transportation of money. Even before its introduction, the Viennese who wanted to pay money to somebody in Berlin did not buy twenty-mark pieces and send them to Berlin in a parcel.
The only thing calculated to create international money substitutes and subsequently international fiduciary media would be the establishment of an international giro bank or bank-of-issue. When it became possible to use the notes issued by the world bank and the accounts opened by it for the settlement of money claims of all kinds, there would no longer be any need to settle the national balances of payments by transportation of money. The actual transference of money could be superseded by the transference of the notes issued by the world bank or of checks giving disposal over the issuer’s account with the world bank, or even by simple entries in the books of the world bank. The balances of the international “clearinghouse,” which already exists today although it is not concentrated in any one locality and has not the rigid organization of the national clearinghouses, would then be paid off in the same way as those of the national clearinghouses are at present.
Proposals have been made again and again for the creation of international fiduciary media through the establishment of an interstate bank. It is true that this must not be taken to include every project for extending the international giro system in the sense in which this word is commonly used. Nevertheless, in certain writings which demand the foundation of a world bank, or at least of an interstate banking organization, there gleams the idea of an international fiduciary medium.25 The problems of organization raised by the establishment of such an international institution could be solved in various ways. The establishment of the world bank as a special form of organization and as an independent legal body would probably be the simplest form for the new creation. It would, however, also be possible, apart from this, to establish a special central authority for administering and investing the sums of money paid in to open the accounts, and for issuing the money substitutes. An attempt could be made to avoid the obstructions which the susceptibilities of national vanity would probably oppose to the local concentration of the business of the bank by leaving the reserves of the world giro authority and the world issuing authority in the keeping of the separate national banks. In the reserves of every central bank a distinction would then have to be made between two sums: one, which would have to serve as a basis for the world organization of the system of payments, and over which only the authorities of the latter would have power of disposal; and a second, which would continue to be at the service of the national monetary system. It would even be possible to go still further and leave the issue of international notes and other money substitutes to the individual banks, which would only be required in doing this to follow the instructions given by the authorities of the world organization. It is not our task to investigate which of the various possibilities is the most practical; it is its nature alone that interests us, not the actual form it might take.
Special reference must nevertheless be made to one point. If the balances in the books of the world bank are to be acquired only by cash payment of the full sum in money, or by transfer from some other account that has been acquired by cash payment of the full sum in money, and if the world bank is to issue notes only in exchange for money, then its establishment may certainly render unnecessary the transportation of quantities of money (which still plays a large part nowadays in the international payments system), but it would not have the effect of economizing money payments. It is true that it would be able to reduce the demand for money, because transferences would perhaps be completed more quickly and with less friction. But, as before, the payments that were made through the bank would involve the actual use of money. Of course, the money would remain in the vaults of the world bank and only the right to demand its surrender would be transferred. But the amount of the payments would be arithmetically limited by the amount of the money deposits in the bank. The possibility of trans ferring sums of money would be bound up with the existence of these sums of money in actual monetary shape. In order to free the international monetary system from these fetters the world bank would have to be granted the right of issuing notes as loans also and of opening accounts on credit; that is to say, the right of partly lending out its reserves of money. Then, and not until then, would the interstate system of payments be given a fiduciary medium such as is already possessed by the domestic system; it would become independent of the quantity of money in existence.
The realization of a world-bank project developed in this way is opposed by tremendous obstacles which it would hardly be possible to surmount in the near future. The least of these obstacles is constituted by the variety of the kinds of money that are in use in the individual states. Nevertheless, in spite of the inflation that was created by the world war and its consequences, we are every day approaching nearer and nearer to the situation of having a world monetary unit based on the metallic money gold. More important are the difficulties due to political considerations. The establishment of a world bank might come to grief owing to the uncertainty of its position in international law. No state would wish to incur the danger of the accounts of its citizens being impounded by the world bank in case of war. This involves questions of primary importance and therefore no provisions of international law, however surrounded with precautions they might be, could satisfy the individual states so far as to overcome their opposition to membership in such an organization.26
Nevertheless, the biggest difficulty in the way of issuing international credit instruments lies in the circumstance that it would scarcely be possible for the states that had joined the world-banking system to come to an agreement concerning the policy to be followed by the bank in issuing the credit instruments. Even the question of determining the quantity of them to be issued would disclose irreconcilable antagonisms. Under present conditions, therefore, proposals for the establishment of a world bank with power of issuing fiduciary media attract hardly any notice.27
Fiduciary Media and the Demand for Money
The Influence of Fiduciary Media on the Demand for Money in the Narrower Sense
The development of the clearing system, especially the extension of the clearinghouse proper, reduces the demand for money in the broader sense: part of the exchanges made with the help of money can be carried through without the actual physical circulation of money or money substitutes. Thus a tendency has arisen toward the reduction of the objective exchange value of money, which has counteracted the tendency for it to rise which was bound to result from the enormous increase in the demand for money in consequence of the progressive extension of the exchange economy. The development of fiduciary media has the same sort of effect; fiduciary media, which can, as money substitutes, take the place of money in commerce, reduce the demand for money in the narrower sense. This constitutes the great significance of fiduciary media, in this their effect on the exchange ratio between money and other economic goods is to be sought.
The development of fiduciary media, the most important institution for reducing the need for money in the narrower sense, equally with the establishment and development of clearinghouses, the most important institution for reducing the need for money in the broader sense, has not been merely left to the free play of economic forces. The demand for credit on the part of merchants and manufacturers and princes and states, and the endeavor to make a profit on the part of the bankers, were not the sole forces affecting its development. Intervention took place with the object of furthering and expediting the process. As the naive Midas-like trust in the usefulness of a large stock of precious metals disappeared and was replaced by sober consideration of the monetary problem, so the opinion gained strength that a reduction of the national demand for money in the narrower sense constituted an outstanding economic interest. Adam Smith suggested that the expulsion of gold and silver by paper, that is to say notes, would substitute for an expensive means of exchange a less expensive, which, however, would perform the same service. He compares gold and silver which is circulating in a country with a road over which all the corn has to be brought to market but on which nevertheless nothing grows. The issue of notes, he says, creates, as it were, a path through the air and makes it possible to turn a large part of the roads into fields and meadows and in this way considerably to increase the annual yield of land and labor.28 Similar views are entertained by Ricardo. He also sees the most fundamental advantage of the use of notes in the diminution of the cost to the community of the apparatus of circulation. His ideal monetary system is one which would ensure to the community with the minimum cost the use of a money of invariable value. Starting from this point of view, he formulates his recommendations, which aim at expelling money composed of the precious metal from actual domestic circulation.29
The views on the nature of methods of payment which diminish the demand for money, which were developed by the Classical economists, were already known in the eighteenth century. Their acceptance in the writings of the Classical economists and the brilliant way in which they were expounded, ensured general recognition for them in the nineteenth and twentieth centuries also. The opposition which they occasionally called forth, has now sunk into silence. In all countries the aim of banking policy is to secure the greatest possible extension of money-economizing means of payment.
If metallic money is employed, then the advantages of a diminution of the demand for money due to the extension of such other means of payment are obvious. In fact, the development of the clearing system and of fiduciary media has at least kept pace with the potential increase of the demand for money brought about by the extension of the money economy, so that the tremendous increase in the exchange value of money, which otherwise would have occurred as a consequence of the extension of the use of money, has been completely avoided, together with its undesirable consequences. If it had not been for this the increase in the exchange value of money, and so also of the monetary metal, would have given an increased impetus to the production of the metal. Capital and labor would have been diverted from other branches of production to the production of the monetary metal. This would undoubtedly have meant increased returns to certain individual undertakings; but the welfare of the community would have suffered. The increase in the stock of precious metals which serve monetary purposes would not have improved the position of the individual members of the community, would not have increased the satisfaction of their wants; for the monetary function could also have been fulfilled by a smaller stock. And, on the other hand, a smaller quantity of economic goods would have been available for the direct satisfaction of human wants if a part of the capital and labor power that otherwise would have been used for their production had been diverted to mining precious metals. Even apart from the diversion of production, a decrease of prosperity would result from the fact that as a consequence of the rise in value of the precious metals caused by the use for monetary purposes the stock available for industrial employment would decrease, since certain quantities would be transferred from the latter employment to the former This all becomes particularly clear if we think of an economic community which does not itself produce the precious metals, but imports them. Here the amount of their cost is expressed by the quantity of commodities that must be surrendered to foreign countries in order to obtain the supplementary quantity of monetary metal in exchange. In a country that itself produces the precious metals, the matter is the same in principle; all that is different is the way of reckoning the loss of welfare through the sacrifice of the other branches of production and the preference for mining the precious metals; it is perhaps less perceptible, but it is just as comprehensible in theory. The measure of the additional harm done by the diversion of metal to monetary uses is always given by the quantity of metal that is withdrawn from other uses in favor of the monetary use.
Where fiat or credit money is employed, these reasons in favor of the extension of clearing methods of payment and of the use of fiduciary media do not arise. The only thing in their favor is that they would avoid an increase in the value of money; although this consideration is decisive. Where they are employed, the principle of establishing the national monetary apparatus and maintaining it in working order with the minimum cost must be attained in another way. It must be an object of policy, for example, to manufacture the paper notes with the minimum cost of production. It is immediately obvious that nothing like the same quantitative significance can be attributed to this problem as to that of decreasing the monetary demand for precious metals. However great the care taken in producing the notes, their cost of production could never be anything near so great as that of the precious metals. If we take into further consideration the fact that the artistic production of the notes also constitutes a precautionary measure against counterfeiting, so that merely on this ground, economizing in this sphere is not worth considering, it follows that the problem of diminishing the cost of the circulatory apparatus when fiat or credit money is employed must be of an entirely different nature from what it is when commodity money is employed.
The Fluctuations in the Demand for Money
In order to be able to make an accurate estimate of the bearing of clearing methods of payment and of fiduciary media on the development of the demand for money, it is necessary to be clear about the nature of variations in the demand for money.
Fluctuations in the demand for money, insofar as the objective conditions of its development are concerned, are governed in all communities by the same law. An extension of the procedure of exchange mediated by money increases the demand for money; a decrease of indirect exchange, a return to exchange in natura, decreases it. But even apart from variations in the extent of indirect exchange which are insignificant nowadays, large variations in the demand for money occur which are determined by factors of general economic development. Increase of population, and progress in division of labor, together with the extension of exchange which goes hand in hand with it, increase the demand for money of individuals, and also therefore the demand for money of the community, which consists merely in the sum of the demands for money of individuals. Decrease of population and retrogression of the exchange economy, bring about a contraction in it. These are the determinants of the big changes in the demand for money. Within these large variations, it is possible to observe smaller periodical movements. Such are in the first place brought about by commercial and industrial fluctuations, by the alternation of boom and depression peculiar to modern economic life, by good and bad business.30 The crest and the trough of the wave always cover a period of several years. But also within single years, quarters, months, and weeks, even within single days, there are considerable fluctuations in the level of the demand for money. The transactions involving the use of money are concentrated together at particular points of time; and even where this is not the case, the demand for money is differentiated by the practice on the part of buyers of settling their share of transactions on particular dates. On the daily markets it may perhaps seldom happen that the demand for money during the hours of the market is greater than before or after The periodical rise and fall of the demand for money can be seen much more clearly where transactions are concentrated in weekly, monthly and annual markets. A similar effect results from the custom of not paying wages and salaries daily, but weekly, monthly, or quarterly. Rents, interest, and repayment installments, are as a rule paid on particular days. The accounts of the tailor, the shoemaker, the butcher, the baker, the bookseller, the doctor, and so forth, are often settled not daily but periodically. The tendency in all these arrangements is enormously strengthened by the mercantile practice of establishing certain days as days of settlement, or paydays. The middle and last days of the month have gained a special significance in this connection, and among the last days of the month, particularly the last day of the quarters. But, above all, the payments that have to be made in a community during the year are concentrated in the autumn, the decisive circumstance being that agriculture, for natural reasons, has its chief business period in the autumn. All of these facts have been repeatedly and exhaustively illustrated by statistics; nowadays they are the common property of all discussions on the nature of banks and money.31
The Elasticity of the System of Reciprocal Cancellation
It is usual to ascribe to the payment system elasticity that is said to be attained by means of the credit system and the continual improvements in banking organization and technique, the capacity of adjusting the available stock of money to the level of the demand for money at any time without exerting any influence on the exchange ratio between money and other economic goods. Between the volume of fiduciary media and the bank transactions or private arrangements that can take the place of a transfer of money, on the one hand, and the quantity of money, on the other hand, there is said to be no fixed relationship which could make the former rigidly dependent upon the latter. Instead of there being a fixed quantitative relationship between money and its substitutes, that is to say, between the stock of money and the various exchange and payment transactions, it is said that the organization of banking institutions and the credit system has made commerce in the highest degree independent of the quantity of money available. The present-day organization of the money, clearing, and credit system is said to have the tendency to balance out variations in the quantity of money and render them ineffective, and so to make prices as far as possible independent of the stock of money.32 By others, this adjusting capacity is ascribed only to fiduciary media, uncovered banknotes,33 or unbacked deposits.34
Before the soundness of these assertions can be tested, they must be brought out of the obscurity that is due to a confusion between the effects of the clearing system and those of the issue of fiduciary media. The two must be considered separately.
The reduction in the demand for money in the broader sense that results from the practice of settling counterclaims by balancing them against each other is limited in the first place by the number and amount of the claims and counterclaims falling due on the same date. No greater number or amount of claims can be reciprocally canceled between two parties than exist between them at the given moment. If, instead of payment in money, claims on third persons are transferred which are canceled by the transferee and the debtor by means of claims held by the latter against the former, the sphere of the offsetting process can be extended. The clearinghouses which nowadays exist in all important commercial centers are able to avoid the technical and legal difficulties in the way of such transfers, and have thus performed a quite extraordinary service in the extension of the system of reciprocal cancellation. Nevertheless, the clearing system is still capable of further improvement. Very many payments that could be settled by way of cancellation are still made by the actual transfer of money.
If we imagine the clearing system fully developed, so that all payments are first attempted to be settled by balancing, even those in everyday retail trade (which, for practical reasons, would not appear to be easy of accomplishment), then we are faced with a second limit to the extension of the clearing system, although this, unlike the first, is not surmountable. Even if the community were in a stable condition in which there were no variations in the relative incomes and wealth of individuals and in the sizes of their reserves, complete reciprocal cancellation of all the transfers of money that have to be made at a given moment would be possible, only if the money received by individuals was spent again immediately and nobody wanted to hold a sum of money in reserve against unforeseen and indefinite expenditure. But since these assumptions do not hold good, and in fact never could hold good, so long as money is in demand at all as a common medium of exchange, it follows that there is a rigid maximum limit to the transactions that can be settled through the clearing system. A community’s demand for money in the broader sense, even with the fullest possible development of the system of reciprocal cancellation, cannot be forced below a minimum which will be determined according to circumstances.
Now the degree in which a clearing system is actually developed within the limits which the circumstances of the time allow for it, is in no way dependent upon the ratio between the demand for money and the stock of money. A relative decline in the one or the other can of itself exercise neither a direct nor an indirect influence on the development of the clearing system. Such development is invariably due to special causes. It is no more justifiable to assume that progressive extension of settlement on the clearing principle reduces the demand for money precisely in the degree in which the increasing development of commerce augments it, than to suppose that the growth of the clearing system can never outstrip the increase in the demand for money. The truth is rather that the two lines of development are completely independent of one another. There is a connection between them only insofar as deliberate attempts to counteract an increase in the exchange value of money by reducing the demand of money through a better development of the clearing system may be made with greater vigor during a period of rising prices; assuming, of course, that the aim of currency policy is to prevent an increase in the purchasing power of money. But this is no longer a case of an automatic adjustment of the forces acting upon the objective exchange value of money, but one of political experiments in influencing it, and the extent to which these measures are accompanied by success remains a matter of doubt.
Thus it is easy to see what little justification there is for ascribing to the clearing system the property, without affecting the objective exchange value of money, of correcting the disparities that may arise between the stock of money and the demand for it, and which could otherwise be eliminated only by suitable automatic variations in the exchange ratio between money and other economic goods. The development of the clearing system is independent of the other factors that determine the ratio between the supply of money and the demand for it. The effect on the demand for money of an expansion or contraction of the system of reciprocal cancellation thus constitutes an independent phenomenon which is just as likely to strengthen as to weaken the tendencies which for other reasons have an influence in the market on the exchange ratio between money and commodities. It seems self-evident that an increase in the number and size of payments cannot be the sole determinant of the demand for money. Part of the new payments will be settled by the clearing system; for this, too, ceteris paribus, will be extended in such a way as thenceforward to be responsible for the settlement of the same proportion of all payments as before. The rest of the payments could only be settled by clearing processes if there was an extension of the clearing system beyond the customary degree; but such an extension can never be called forth automatically by an increase in the demand for money.
The Elasticity of a Credit Circulation Based on Bills, Especially on Commodity Bills
The doctrine of the elasticity of fiduciary media, or more correctly expressed, of their automatic adjustment at any given time to the demand for money in the broader sense, stands in the very center of modern discussions of banking theory. We have to show that this doctrine does not correspond to the facts, or at least not in the form in which it is generally expounded and understood; and the proof of this will at the same time refute one of the most important arguments of the opponents of the quantity theory.35
Tooke, Fullarton, Wilson, and their earlier English and German disciples, teach that it does not lie in the power of the banks-of-issue to increase or diminish their note circulation. They say that the quantity of notes in circulation is settled by the demand within the community for media of payment. It the number and amount of the payments are increasing, then, they say, the media of payment must also increase in number and amount; if the number and amount of the payments are diminishing, then, they say, the number and amount of the media of payment must also diminish. Expansion and contraction of the quantity of notes in circulation are said to be never the cause, always only the effect, of fluctuations in business life. It therefore follows that the behavior of the banks is merely passive; they do not influence the circumstances which determine the amount of the total circulation, but are influenced by them. Every attempt to extend the issue of notes beyond the limits set by the general conditions of production and prices is immediately frustrated by the reflux of the surplus notes, because they are not needed for making payments. Conversely, it is said, the only result of any attempt at an arbitrary reduction of the note circulation of a bank is the immediate filling of the gap by a competing bank; or, if this is not possible, as for instance because the issue of notes is legally restricted, then commerce will create for itself other media or circulation, such as bills, which will take the place of the notes.36
It is in harmony with the views expounded by the Banking theorists on the essential similarity of deposits and notes to apply what they say on this point about notes to deposits also. It is in this sense that the doctrine of the elasticity of fiduciary media is generally understood today;37 it is in this sense alone that it is possible to defend it even with only an appearance of justification. We may further suppose, as being generally admitted, that it is not because of lack of public confidence in the issuing bank that the fiduciary media are returned to it, whether in the form of notes presented for conversion into cash or as demands for the withdrawal of deposits. This assumption also agrees with the teachings of Tooke and his followers.
The fundamental error of the Banking School lies in its failure to understand the nature of the issue of fiduciary media. When the bank discounts a bill or grants a loan in some other way, it exchanges a present good for a future good. Since the issuer creates the present good that it surrenders in the exchange—the fiduciary media—practically out of nothing, it would only be possible to speak of a natural limitation of the quantity of fiduciary media if the quantity of future goods that are exchanged in the loan market against present goods was limited to a fixed amount. But this is by no means the case. The quantity of future goods is indeed limited by external circumstances, but not that of the future goods that are offered on the market in the form of money. The issuers of the fiduciary media are able to induce an extension of the demand for them by reducing the interest demanded to a rate below the natural rate of interest, that is below that rate of interest that would be established by supply and demand if the real capital were lent in natura without the mediation of money,38 whereas on the other hand the demand for fiduciary media would be bound to cease entirely as soon as the rate asked by the bank was raised above the natural rate. The demand for money and money substitutes that is expressed on the loan market is in the last resort a demand for capital goods or, when consumption credit is involved, for consumption goods. He who tries to borrow “money” needs it solely for procuring other economic goods. Even if he only wishes to supplement his reserve, he has no other object in this than to secure the possibility of acquiring other goods in exchange at the given moment. The same is true if he needs the money for making payments that have fallen due; in this case it is the person receiving the payment who intends to purchase other economic goods with the money received.
That demand for money and money substitutes which determines the exchange ratio between money and other economic goods achieves expression only in the behavior of individuals when buying and selling other economic goods. Only when, say, money is being exchanged for bread is the position of the economic goods, money and commodity, in the value scales of the individual parties to the transaction worked out and used as a basis of action; and from this the precise arithmetical exchange ratio is determined. But when what is demanded is a money loan that is to be paid back in money again, then such considerations do not enter into the matter. Then only the difference in value between present goods and future goods is taken into account, and this alone has an influence on the determination of the exchange ratio, that is, on the determination of the level of the rate of interest.
For this reason the Banking principle is unable to prove that no more fiduciary media can be put into circulation than an amount determined by fixed circumstances not dependent on the will of the issuer. It has therefore directed its chief attention to the proof of the assertion that any superfluous quantity of fiduciary media will be driven out of circulation back to the issuing body. Unlike money, fiduciary media do not come on to the market as payments, but as loans, Fullarton teaches; they must therefore automatically flow back to the bank when the loan is repaid.39 This is true. But Fullarton overlooks the possibility that the debtor may procure the necessary quantity of fiduciary media for the repayment by taking up a new loan.
Following up trains of thought that are already to be found in Fullarton and the other writers of his circle, and in support of certain institutions of the English and Continental banking system, which, it must be said, have quite a different significance in practice than that which is erroneously ascribed to them, the more recent literature of banking theory has laid stress upon the significance of the short-term commodity bill for the establishment of an elastic credit system. The system by which payments are made could, it is said, be made capable of the most perfect adjustment to the changing demands upon it, if it were brought into immediate causal connection with the demand for media of payment. According to Schumacher, that can only be done through banknotes, and has been done in Germany by basing the banknotes on the commodity bills, the quantity of which increases and decreases with the intensity of economic life. Through the channel of the discounting business, in place of interest-bearing commodity bills (which have only a limited capacity of circulation because their amounts are always different, their validity of restricted duration, and their soundness dependent on the credit of numerous private persons), banknotes are issued (which are put into circulation in large quantifies by a well-known semipublic institution and always refer to the same sums without limitation as to time, and therefore possess a much wider capacity of circulation, comparable to that of metallic money). Then on the redemption of the discounted bill an exchange in the contrary direction is said to take place: the banknotes, or instead of them metallic money, flow back to the bank, diminishing the quantity of media of payment in circulation. It is argued that if money is correctly defined as a draft on a consideration for services rendered, then a banknote based on an accepted commodity bill corresponds to this idea to the fullest extent, since it closely unites the service and the consideration for it and regularly disappears again out of circulation after it has negotiated the latter. It is claimed that through such an organic connection between the issue of banknotes and economic life, created by means of the commodity bill, the quantity of the means of payment in circulation is automatically adjusted to variations in the need for means for payment. And that the more completely this is attained, the more out of the question is it that the money itself will experience the variations in value affecting prices, and the more will the determination of prices be subject to the supply and demand on the commodity market.40
In the face of this, we must first of all ask how it is possible to justify the drawing of a fundamental distinction between banknotes and other money substitutes, between banknotes not covered by money and other fiduciary media. Deposits which can be drawn upon at any time by check, apart from certain minor technical and juristic details which make them unusable in retail trade and for certain other payments, are just as good a money substitute as the banknote. It is a matter of indifference from the economic point of view whether the bank discounts a bill by paying out currency in notes or by a credit on a giro account. From the point of view of banking technique there may be certain differences of importance to the bank official; but whether the bank issues credit in the business of discounting only or whether it also grants other short-term loans cannot be a very fundamental issue. A bill is only a form of promissory note with a special legal and commercial qualification. No economic difference can be found between a claim in the form of a bill and any other claim of equal goodness and identical time of maturity. And the commodity bill, again, differs only juristically from an open book debt that has come into being through a credit-purchase transaction. Thus it comes to the same thing in the end whether we talk of the elasticity of the note circulation based on commodity bills or of the elasticity of a circulation of fiduciary media resulting from the cession of short-term claims arising out of credit sales.
Now the number and extent of purchases and sales on credit are by no means independent of the credit policy followed by the banks, the issuers of fiduciary media. If the conditions under which credit is granted are made more difficult, their number must decrease; if the conditions are made easier, their number must increase. When there is a delay in the payment of the purchase price, only those can sell who do not need money immediately; but in this case bank credit would not be requisitioned at all. Those, however, who want money immediately can only make sales on credit if they have a prospect of immediately being able to turn into money the claims which the transaction yields them. Other granters of credit can only place just so many present goods at the disposal of the loan market as they possess; but it is otherwise with the banks, which are able to procure additional present goods by the issue of fiduciary media. They are in a position to satisfy all the requests for credit that are made to them. But the extent of these requests depends merely upon the price that they demand for granting the credit. If they demand less than the natural rate of interest—and they must do this if they wish to do any business at all with the new issue of fiduciary media; it must not be forgotten that they are offering an additional supply of credit to the market—then these requests will increase.
When the loans granted by the bank through the issue of fiduciary media fall due for repayment, then it is true that a corresponding sum of fiduciary media returns to the bank, and the quantity in circulation is diminished. But fresh loans are issued by the bank at the same time and new fiduciary media flow into circulation. Of course, those who hold the commodity-bill theory will object that a further issue of fiduciary media can take place only if new commodity bills come into existence and are presented for discounting. This is quite true. But whether new commodity bills come into existence depends upon the credit policy of the banks.
Let us just picture to ourselves the life history of a commodity bill, or, more correctly, of a chain of commodity bills. A cotton dealer has sold raw cotton to a spinner. He draws on the spinner and has the three-month bill discounted that the latter has accepted. After three months have passed, the bill will be presented by the bank to the spinner and redeemed by him. The spinner provides himself with the necessary sum of cash, having meanwhile spun the cotton and sold the yarn to a weaver, by negotiating a bill drawn on the weaver and accepted by him. Whether these two sale-and-purchase transactions come to pass depends now chiefly upon the level of the bank discount rate. The seller, in the one case the cotton dealer, in the second case the spinner, needs the money immediately; he can only make the sale with a delay in the payment of the purchase price if the sum due in three months less discount at least equals the sum under which he is not inclined to sell his commodity. It is unnecessary to give any further explanation of the significance attaching to the level of the bank discount rate in this calculation. Our example proves our point just as well even if we assume that the commodity that is sold reaches the consumers in the course of the three months during which the bill circulates and is paid for by them without direct requisitioning of credit. For the sums which the consumers use for this purpose have come to them as wages or profits out of transactions that were only made possible through the granting of credit on the part of the banks.
When we see that the quantity of the commodity bills presented for discount increases at certain times and decreases again at other times, we must not conclude that these fluctuations are to be explained by variations in the demands for money of individuals. The only admissible conclusion is that under the conditions made by the banks at the time there is no greater number of people seeking credit. If the banks-of-issue bring the rate of interest they charge in their creditor transactions near to the natural rate of interest, then the demands upon them decrease; if they reduce their rate of interest so that it falls lower than the natural rate of interest, then these demands increase. The cause of fluctuations in the demand for the credit of the banks-of-issue is to be sought nowhere else than in the credit policy they follow.
By virtue of the power at their disposal of granting bank credit through the issue of fiduciary media the banks are able to increase indefinitely the total quantity of money and money substitutes in circulation. By issuing fiduciary media, they can increase the stock of money in the broader sense in such a way that an increase in the demand for money which otherwise would lead to an increase in the objective value of money would have its effects on the determination of the value of money nullified. They can, by limiting the granting of loans, so reduce the quantity of money in the broader sense in circulation as to avoid a diminution of the objective exchange value of money which would otherwise occur for some reason or other In certain circumstances, as has been said, this may occur. But in all the mechanism of the granting of bank credit and in the whole manner in which fiduciary media are created and return again to the place whence they were issued, there is nothing which must necessarily lead to such a result. It may quite as well happen, for instance, that the banks increase the issue of fiduciary media at the very moment when a reduction in the demand for money in the broader sense or an increase in the stock of money in the narrower sense is leading to a reduction of the objective exchange value of money; and their intervention will strengthen the existing tendency to a variation in the value of money. The circulation of fiduciary media is in fact not elastic in the sense that it automatically accommodates the demand for money to the stock of money without influencing the objective exchange value of money, as is erroneously asserted. It is only elastic in the sense that it allows of any sort of extension of the circulation, even completely unlimited extension, just as it allows of any sort of restriction. The quantity of fiduciary media in circulation has no natural limits. If for any reason it is desired that it should be limited, then it must be limited by some sort of deliberate human intervention—that is by banking policy.
Of course, all of this is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then—apart from an extension of its clientele—it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause. And just because it has employed a false principle for explaining the phenomenon that it has observed, it has also completely closed the way to understanding of a second tendency of the market, that emanates from the circulation of fiduciary media. It was possible for it to overlook the tact that so far as the banks proceed uniformly, there must be a continual augmentation of the circulation of fiduciary media, and consequently a fall of the objective exchange value of money.
The Significance of the Exclusive Employment of Bills as Cover for Fiduciary Media
The German Bank Act of March 14, 1875, required that the notes issued in excess of the gold cover should be covered by bills of exchange; but in practice this provision has been understood to refer only to commodity bills. The significance of this prescription differs from that popularly attributed to it. It does not make the note issue elastic; it does not even bring it, as is erroneously believed, into an organic connection with the conditions of demand for money; these are all illusions, which should long ago have been destroyed. Nei ther has it the significance for maintaining the possibility of conversion of the notes that is ascribed to it; this will have to be referred to in greater detail later.
The limitation of the note issue not covered by metal, that is of fiduciary media in the form of banknotes, is the fundamental principle of the German act, which is based upon Peel’s Act. And among the numerous and multiform obstacles that have been set up with this aim, the strict provision concerning the investment of the assets backing the note issue takes a not altogether unimportant place. That these must consist not merely in claims, but in claims in the form of bills; that the bills must have at the most three months to run; that they should bear the names, preferably of three, but at least of two, parties known to be solvent—all these conditions limit the note issue. At the very beginning, a considerable part of the national credit is kept away from the banks. A similar effect results from the further limitation of the note cover merely to commodity bills, as was undoubtedly intended by the legislature even though express provision for it was omitted from the Bank Act, probably because of the impossibility of giving a legal definition of the concept of a commodity bill. That this limitation did in fact amount to a restriction of the issue of fiduciary media is best shown by the fact that when the Bank Act was passed the number of commodity bills was already limited, and that since then, in spite of a considerable increase in the demand for credit, their number has decreased to such an extent that the Reichsbank meets with difficulties when it attempts to select such bills only for purposes of investing without decreasing the amount of credit granted.41
The Periodical Rise and Fall in the Extent to Which Bank Credit Is Requisitioned
The requests made to the banks are requests, not for the transfer of money, but for the transfer of other economic goods. Would-be borrowers are in search of capital, not money. They are in search of capital in the form of money, because nothing other than power of disposal over money can offer them the possibility of being able to acquire in the market the real capital which is what they really want. Now the peculiar thing, which has been the source of one of the most difficult puzzles in economics for more than a hundred years, is that the would-be borrower’s demand for capital is satisfied by the banks through the issue of money substitutes. It is clear that this can only provide a provisional satisfaction of the demands for capital. The banks cannot evoke capital out of nothing. If the fiduciary media satisfy the desire for capital, that is if they really procure disposition over capital goods for the borrowers, then we must first seek the source from which this supply of capital comes. It will not be particularly difficult to discover it. If the fiduciary media are perfect substitutes for money and do all that money could do, if they add to the social stock of money in the broader sense, then their issue must be accompanied by appropriate effects on the exchange ratio between money and other economic goods. The cost of creating capital for borrowers of loans granted in fiduciary media is borne by those who are injured by the consequent variation in the objective exchange value of money; but the profit of the whole transaction goes not only to the borrowers, but also to those who issue the fiduciary media, although these admittedly have sometimes to share their gains with other economic agents, as when they hold interest-bearing deposits, or the state shares in their profits.
The entrepreneurs who approach banks for loans are suffering from shortage of capital; it is never shortage of money in the proper sense of the word that drives them to present their bills for discounting. In some circumstances this shortage of capital may be only temporary; in other circumstances it may be permanent. In the case of the many undertakings which constantly draw upon short-term bank credit, year in, year out, the shortage of capital is a permanent one.
For the problem with which we are concerned, the circumstances causing the shortage of capital on the part of entrepreneurs do not matter. We may even provisionally disregard, as of minor importance, the question whether the shortage is one of investment capital or working capital. Sometimes the view is propounded that it is unjustified to procure investment capital partly by way of bank credit although this is less undesirable as a way of procuring work ing capital. Such arguments as these have played an important part in recent discussions of banking policy. The banks have been adversely criticized on the ground of their having used a considerable part of the credit issued by them for granting loans to industrial enterprises in search not of fixed but of working capital and of having thus endangered their liquidity. Legislation has been demanded to limit to liquid investments only the assets backing the liabilities arising from the issue of fiduciary media. Provisions of this sort are designed to deal with fiduciary media in the form of deposits in the same way as the note issue has been dealt with under the influence of the doctrines of the Currency School. We have already commented on their significance and have shown, as further discussion will remind us, that the only practical value of these, as of all similar restrictions, lies in the obstacles they oppose to unlimited expansion of credit.
The cash reserve which is maintained by every business enterprise also is a part of its working capital. If an enterprise feels for any reason obliged to increase its reserve this must be regarded as an increase of its capital. If it requisitions credit for this purpose, its action cannot be regarded as any different from a demand for credit that arises from any other cause—say, on account of an extension of plant or the like.
But attention must now be drawn to a phenomenon which, even if it adds nothing new to what has been said already, may serve to set some important processes of the money-and-capital market in a clearer light. It has been repeatedly mentioned already that commercial practice concentrates all kinds of settlements on particular days of the year so that there is bound to be a bigger demand for money on these days than on others. The concentration of days of settlement at the end of the week, the fortnight, the month, and the quarter, is a factor which considerably increases the demand for money, and so of course the demand for capital, on the part of undertakings. Even though an entrepreneur could reckon safely on sufficient receipts on a given day to meet the obligations falling due on that or the following day, still it would only be in the rarest cases that he could use the former directly for paying the latter. The technique of payment is not so far developed that it would always be possible to fulfill obligations punctually without having secured some days beforehand free disposal over the necessary means. A person who has to redeem a bill that falls due at his bank on September 30 will usually have to take steps, before that date, for covering it; sums which do not reach him until the very day of maturity of the bill will mostly prove useless for this purpose. In any case it is completely impracticable to use the receipts on any given day for making payments that fall due on the same day at distant places. On the days of settlement there must therefore necessarily be an increased demand for money on the part of the individual undertaking, and this will disappear again just as quickly as it arose. Of course, this demand for money too is a demand for capital. Hypercritical theorists, following Mercantile usage, are accustomed to draw a subtle distinction between the demand for money and the demand for capital; they contrast the demand for short-term credit, as a demand for money, with the demand for long-term credit, as a demand for capital. There is little reason for retaining this terminology, which has been responsible for much confusion. What is here called the demand for money is nothing but a real demand for capital; this must never be forgotten. If the undertaking takes up a short-term loan to supplement its cash reserve, then the case is one of a genuine credit transaction, of an exchange of future goods for present goods.
The increased demand of the entrepreneur for money and consequently for capital which occurs on these days of settlement, expresses itself in an increase of the requests for loans that are made to credit-issuing banks. In those countries where notes and not deposits are the chief kind of fiduciary media, this is perceptible in an increase in the quantity of bills handed in at the banks-of-issue for discounting and, if these bills are actually discounted, in the quantity of notes in circulation.42 Now this regular rise and fall of the level of the note circulation round about the days of settlement can in no way be explained by an increase in the total quantity of bills in existence in the community. No new bills, particularly no new short-term bills, are drawn and handed in to the banks to be discounted. It is bills that have the normal period to run, that are negotiated shortly before maturity. Until then they are retained in the portfolios either of nonbankers or of banks whose issue of fiduciary media is limited, whether because they have a small clientele or because of legal obstacles. It is not until the demand for money increases that the bills reach the large banks-of-issue. It is clear how little justification there is for the assertion that the amount of the note issue of central European banks-of-issue is organically connected with the quantity of bills drawn in the community. Only some of the bills are discounted at the banks by the issue of fiduciary media; the others complete their term without calling bank credit into use. But the proportion between the two amounts depends entirely on the credit policy that the credit-issuing banks follow.
Bank legislation has taken particular account of the extraordinary increase in the demand for money round about quarter-day. Article two of the German Bank (Amendment) Act of June 1, 1909, extends the usual tax-free quota of notes of 550 million marks to 750 million marks for the tax accounts based on information concerning the last days of March, June, September, and December in each year, thus sanctioning a procedure that the banks had been in the habit of following for decades. On every day of settlement, the entrepreneur’s demand for credit increases, and therefore the natural rate of interest also. But the credit-issuing banks have endeavored to counteract the increase in interest on loans either by not raising the rate of discount at all, or by not raising it to an extent corresponding to the increase in the natural rate of interest. Of course, the consequence of this has necessarily been to swell their circulation of fiduciary media. State banking policy has in general put no obstacles in the way of this practice of the banks, which undoubtedly helps to stabilize the objective exchange value of money. The German Bank Act of 1909 was the first which took steps to give it direct support.
The Influence of Fiduciary Media on Fluctuations in the Objective Exchange Value of Money
Thus there is no such thing as an automatic adjustment of the quantity of fiduciary media in circulation to fluctuations in the de mand for money without an effect on the objective exchange value of money. Consequently all those arguments are ill founded which seek to deny practical significance to the quantity theory by reference to the alleged elasticity of the circulation of money. The increase and decrease of the stock of fiduciary media in a free banking system have no greater natural connection, direct or indirect, with the rise and fall of the demand for money in the broader sense, than the increase and decrease of the stock of money have with the rise and fall of the demand for money in the narrower sense. Such a connection exists only insofar as the credit banks deliberately try to bring it about. Apart from this, the only connection that can be established between the two sets of variations, which are in themselves independent of each other, is like that of the policy which, say, in a period of increasing demand for money in the broader sense aims at an increase of fiduciary media in order to counteract the rise in the objective exchange value of money which might otherwise be expected. Since it is impossible to measure fluctuations in the objective exchange value of money, even only approximately, we are not able to judge whether the increase of fiduciary media that has occurred during the last century in nearly all the countries of the world has together with the increase in the quantity of money kept pace with the increase in the demand for money in the broader sense, or fallen behind it, or outstripped it. All that we can be sure of is that at least a part of the increase in the demand for money in the broader sense has been robbed of its influence on the purchasing power of money by the increase in the quantity of money and fiduciary media in circulation.
The Redemption of Fiduciary Media
The Necessity for Complete Equivalence Between Money and Money Substitutes
There is nothing remarkable in the fact that money substitutes, as completely liquid claims to money against persons whose capacity to pay is beyond all doubt, have a value as great as the sums of money to which they refer Admittedly, the question does arise: Are there any persons whose capacity to pay is so completely certain as to be quite beyond all doubt? And it may be pointed out that more than one bank, whose solvency nobody had dared to call in question even the day before, has collapsed ignominiously; and that so long as the remembrance of events of this sort has not entirely vanished from human memory, it must evoke at least a small difference between the valuation of money and that of claims to money payable at any time, even if, as far as human foresight goes, these latter are to be regarded as completely sound.
It is undeniable that such questions reveal a possible source of a certain lack of confidence in notes and checks, which would necessarily result in money substitutes having a lower value than money. But, on the other hand, there are reasons which might cause individuals to value money substitutes more highly than money, even if demands for the conversion of money into money substitutes were not always satisfied immediately. We shall have to speak of this later. Furthermore, quite apart from all these circumstances, it should be clearly pointed out that doubts as to the quality of fiduciary media are hardly tenable nowadays. In the case of money substitutes of medium and small denominations, among which token coins occupy the most important place, doubts of this nature do not come into consideration at all. But in the case also of the money substitutes that are used to meet the requirements of large-scale business, the possibility of loss is as good as nonexistent under present conditions; at least the possibility of loss is no greater in connection with the money substitutes issued by the large central banks than is the danger of demonetization that threatens the holders of any particular kind of money.
Now the complete equivalence of sums of money and secure claims to immediate payment of the same sums gives rise to a consequence that has extremely important bearings on the whole monetary system; namely, the possibility of tendering or accepting claims of this sort wherever money might be tendered or accepted. Exchanges are made through the medium of money; this fact remains unaltered. Buyers buy with money, and sellers sell for it. But exchanges are not always made by the transfer of a sum of money. They may also be made by the transfer or assignment of a claim to money. Now claims to money which fulfill the conditions mentioned above pass from hand to hand without those who acquire them feeling any need for actually enforcing them. They completely perform all the functions of money. Why then should the bidders burden themselves with the trouble of redeeming them? The claim which has been set in circulation remains in circulation, and becomes a money substitute. So long as confidence in the soundness of the bank is unshaken, and so long as the bank does not issue more money substitutes than its customers require for their dealings with one another (and everybody is to be regarded as a customer of the bank who accepts its money substitutes in place of money), then the situation in which the right behind the money substitute is enforced by presentation of notes for redemption or by withdrawal of deposits simply does not arise. The bank-of-issue may therefore assume that its money substitutes will remain in circulation until the necessity of dealing with persons outside the circle of customers forces holders to redeem them. This, in fact, is the very thing which enables the bank to issue fiduciary media at all, that is, to put money substitutes in circulation without maintaining in readiness the sum that would be necessary to keep the promise of immediate conversion that they represent.
The body which issues the fiduciary media and is responsible for maintaining their equivalence with the sums of money to which they refer must nevertheless be able to redeem promptly those fiduciary media which their holders present for conversion into money when they have to make payments to persons who do not recognize these fiduciary media as money substitutes. This is the only way in which a difference between the value of money on the one hand and of the notes and deposits on the other hand can be prevented from coming into existence.
The Return of Fiduciary Media to the Issuer on Account of Lack of Confidence on the Part of the Holders
The view has sometimes been expressed that if an issuing body wishes to secure equivalence between its fiduciary media and the money to which they refer, it should take precautions so as to be able to redeem those fiduciary media that are returned to it through lack of confidence on the part of the holders. It is impossible to subscribe to this view; for it completely fails to recognize the significance and object of a conversion fund. It cannot be the function of a conversion fund to enable the issuing body to redeem its fiduciary media when its counters are besieged by holders who have lost confidence in them. Confidence in the capacity of circulation of fiduciary media is not an individual phenomenon; either it is shared by everybody or it does not exist at all. Fiduciary media can fulfill their function only on the condition that they are fully equivalent to the sums of money to which they refer. They cease to be equivalent to these sums of money as soon as confidence in the issuer is shaken even if only among a part of the community. The yokel who presents his note for redemption in order to convince himself of the bank’s capacity to pay, which nobody else doubts, is only a comic figure that the bank has no need to fear It need not make any special arrangements or take any special precautions on his account. But any bank that issues fiduciary media is forced to suspend payments if everybody begins to present notes for redemption or to withdraw deposits. Any such bank is powerless against a panic; no system and no policy can help it then. This follows necessarily from the very nature of fiduciary media, which imposes upon those who issue them the obligation to pay a sum of money which they cannot command.43
The history of the last two centuries contains more than one example of such catastrophes. Those banks that have succumbed to the onslaughts of noteholders and depositors have been reproached with bringing about the collapse by granting credit imprudently, by tying up their capital, or by advancing loans to the state; extremely serious charges have been brought against their directors. Where the state itself has been the issuer of the fiduciary media, the impossibility of maintaining their redeemability has usually been ascribed to their having been issued in defiance of precepts based on banking experience. It is obvious that this attitude is due to a misunderstanding. Even if the banks had put all their assets in short investments, that is, in investments that could have been realized in a relatively short time, they would not have been able to meet the demands of their creditors. This follows merely from the fact that the banks’ claims fall due only after notice has been given, while those of their creditors are payable on demand. Thus there lies an irresolvable contradiction in the nature of fiduciary media. Their equivalence to money depends on the promise that they will at any time be converted into money at the demand of the person entitled to them and on the fact that proper precautions are taken to make this promise effective. But—and this is likewise involved in the nature of fiduciary media—what is promised is an impossibility insofar as the bank is never able to keep its loans perfectly liquid. Whether the fiduciary media are issued in the course of banking operations or not, immediate redemption is always impracticable if the confidence of the holders has been lost.
The Case Against the Issue of Fiduciary Media
Recognition of the fact, which had been pointed out before the time of Ricardo, that there is no way in which an issuer of fiduciary media can protect itself against the consequences of a panic or avoid succumbing to any serious run, may lead, if one likes, to a demand that the creation of fiduciary media should be prohibited. Many writers have adopted this attitude. Some have demanded the prohibition of the issue of such notes as have no metal backing; others, the prohibition of all clearing transactions except with full metallic cover; others again, and this is the only logical position, have combined both demands.44
Such demands as these have not been fulfilled. The progressive extension of the money economy would have led to an enormous extension in the demand for money if its efficiency had not been extraordinarily increased by the creation of fiduciary media. The issue of fiduciary media has made it possible to avoid the convulsions that would be involved in an increase in the objective exchange value of money, and reduced the cost of the monetary apparatus. Fiduciary media tap a lucrative source of revenue for their issuer; they enrich both the person that issues them and the community that employs them. In the early days of the modern banking system they played a further part still by strengthening the credit-negotiating activities of the banks (which in those times could hardly have proved profitable if carried on for their own sake alone) and so brought the system safely past those obstacles which obstructed its beginnings.
Prohibition of the issue of all notes except those with a full backing and of the lending of the deposits which serve as the basis of the check-and-clearing business would mean almost completely suppressing the note issue and almost strangling the check-and-clearing system. If notes are still to be issued and accounts opened in spite of such a prohibition, then somebody must be found who is prepared to bear unrecompensed the costs involved. Only very rarely will this be the issuer, although occasionally such a thing happens. The United States created silver certificates in order to relieve the business world of the inconveniences of the clumsy silver coinage and to remove one of the obstacles in the way of an extended use of the silver dollar, which it was thought desirable to encourage for reasons of currency policy. Similarly for reasons of currency policy, gold certificates were created, so as to bring gold money into use despite the public preference for paper.45
Sometimes the public may be willing to use notes, checks, or giro transfers for technical reasons, even if it has to make a certain payment to the bank for the facility. There are sometimes objections to the physical use of coins, which are not involved in the transfer of claims to deposited sums of money. The storage of considerable sums of money and their insurance against risk from fire and flood and from robbery and theft are not always a small matter even for the individual merchant, and still less so for the private person. Warrants payable to order and checkbooks whose folios have no significance until they have been signed by an authorized person are less liable to dishonest handling than are coins, whose smooth faces tell no tales of the methods by which they have been acquired. But even banknotes, which retain no relationships to individuals, are yet easier to preserve against destruction and to secure against depredation than are bulky pieces of metal. It is true that the large accumulations of money deposited in the banks constitute all the more profitable and therefore attractive an objective for criminal enterprise; but in their case it is possible to take such precautionary measures as will afford almost complete safety, and it is similarly easier to safeguard such large deposits against the risk of accidental damage by the elements. It has proved a more difficult matter to withdraw the coffers of the banks from the grasp of those in political power; but even this has eventually been achieved, and such coups de main as those of the Stuarts or Davousts have not been repeated in modern times.
A further motive for the introduction of payment through the mediation of the banks has been provided by the difficulty of determining the weight and fineness of coins in the ordinary course of daily business. In this way debasement of the coinage led to the establishment of the famous banks of Amsterdam and Hamburg. The commission of one-fortieth percent which the customers of the Bank of Amsterdam had to pay on each deposit or withdrawal46 was far outweighed by the advantages offered by the trustworthiness of the bank currency. Finally; the saving of costs of transport and the greater handiness are other advantages of banking methods of payment that have similarly entered into consideration, especially in countries with a silver, or even a copper, standard. Thus in Japan as early as the middle of the fourteenth century, certain notes issued by rich merchants were in great demand because they offered a means of avoiding the costs and inconveniences involved in the transport of the heavy copper coinage.47 The premium at which banknotes sometimes stood as against metallic currency before the development of the interlocal check-and-clearing business and the post-office-order service can most easily be explained along these lines.48
It is clear that prohibition of fiduciary media would by no means imply a death sentence for the banking system, as is sometimes asserted. The banks would still retain the business of negotiating credit, of borrowing for the purpose of lending. Not consideration for the banks, but appreciation of the influence of fiduciary media on the objective exchange value of money; is the reason why they have not been suppressed.
The Redemption Fund
A person who holds money substitutes and wishes to transact business with persons to whom these money substitutes are unfamiliar and therefore unacceptable in lieu of money is obliged to change the money substitutes into money. He goes to the body that is responsible for maintaining equivalence between the money substitutes and money and proceeds to enforce the claim that the money substitutes embody. He presents the notes (or token coins or similar form of currency) for conversion or withdraws his deposits. It follows from this that whoever issues money substitutes is never able to put more of them into circulation than will meet the needs of his customers for business among themselves. All issues in excess of this will return to the issuer, who will have to accept them in exchange for money if he does not wish to destroy the confidence on which his whole business is built up. (In view of what has been said in the preceding chapter and remains to be said in the following chapter, it should not be necessary to state expressly in this place also that this is true only when several coexisting banks issue money substitutes which have a limited capacity of circulation. If there is only a single bank issuing money substitutes, and if these money substitutes have an unlimited capacity of circulation, then there are no limits to the extension of the issue of fiduciary media. The case would be the same if all the banks had a common understanding as to the issue of their money substitutes and extended the circulation of them according to uniform principles.)
Thus, in the circumstances assumed, it is not possible for a bank to issue more money substitutes than its customers can use; everything in excess of this must flow back to it. There is no danger in this so long as the excess issue is one of money certificates; but an excess issue of fiduciary media is catastrophic.
Consequently the chief rule to be observed in the business of a credit-issuing bank is quite clear and simple: it must never issue more fiduciary media than will meet the requirements of its customers for their business with each other. But it must be admitted that there are unusually big difficulties in the practical application of this maxim for there is no way of determining the extent of these requirements on the part of customers. In the absence of any exact knowledge on this point the bank has to rely upon an uncertain empirical procedure which may easily lead to mistakes. Nevertheless, prudent and experienced bank directors—and most bank directors are prudent and experienced—usually manage pretty well with it.
It is only exceptionally that the clienteles of the credit-issuing banks as such extend beyond political boundaries. Even those banks that have branches in different countries give complete independence to their individual branches in the issue of money substitutes. Under present political conditions, uniform administration of banking firms domiciled in different countries would hardly be possible; and difficulties of banking technique and legislation, and finally difficulties of currency technique, stand in the way also. Furthermore, within individual countries it is usually possible to distinguish two categories of credit banks. On the one hand there is a privileged bank, which possesses a monopoly or almost a monopoly of the note issue, and whose antiquity and financial resources, and still more its extraordinary reputation throughout the whole country, give it a unique position. And on the other hand there is a series of rival banks, which have not the right of issue and which, however great their reputation and the confidence in their solvency, are unable to compete in the capacity for circulation of their money substitutes with the privileged bank, behind which stands the state with all its authority. Different principles apply to the policies of the two kinds of bank. For the banks of the second group, it is sufficient if they keep in readiness for the redemption of those money substitutes which are returned to them a certain sum of such assets as will enable them to command on demand the credit of the central bank. They extend the circulation of their fiduciary media as far as possible. If in so doing they exceed the issue that their customers can absorb, so that some of their fiduciary media are presented for redemption, then they procure from the central bank the necessary resources for this by rediscounting bills from their portfolio, or by pledging securities. Thus the essence of the policy that they must pursue to maintain their position as credit-issuing banks consists in always maintaining a sufficiently large quantity of such assets as the central bank regards as an adequate basis for granting credit.
The central banks have no such support from a more powerful and distinguished institution. They are thrown entirely upon their own resources, and must shape their policy accordingly. If they have put too many money substitutes into circulation so that holders apply for their redemption, then they have no other way out than that provided by their redemption fund. Consequently, it is nec essary for them to see that there are never more of their fiduciary media in circulation than will meet the requirements of their customers. As has already been said, it is not possible to make a direct evaluation of these requirements. Only an indirect evaluation is practicable. The proportion of the total demand for money in the broader sense that cannot be satisfied by fiduciary media must be determined. This will be the quantity of money that is necessary for doing business with the persons who are not customers of the central bank; that is, the quantity required for purposes of foreign trade.
The demand for money for international trade is composed of two different elements. It consists, first, of the demand for those sums of money which, as a result of variations in the relative extent and intensity of the demand for money in different countries, are transported from one country to another until that position of equilibrium is reestablished in which the objective exchange value of money has the same level everywhere. It is impossible to avoid the transfers of money that are necessary on this account. It is true that we might imagine the establishment of an international deposit bank in which large sums of money were deposited, perhaps even all the money in the world, and made the basis of an issue of money certificates, that is, of notes or balances completely backed by money. This well might put a stop to the physical use of coins, and might in certain circumstances tend to a considerable reduction of costs; instead of coins being used, notes would be sent or transfers made in the books of the bank. But such external differences would not affect the nature of the process.
The other motive for international transfers of money is provided by those balances that arise in the international exchange of commodities and services. These have to be settled by transfers in opposite directions, and it is therefore theoretically possible to eliminate them completely by developing the clearing process.
In foreign-exchange dealings and the related transactions that in recent times have been united with them, there is a fine mechanism which cancels out nearly all such transfers of money. It is only exceptionally nowadays that two ships meet at sea, one of them taking gold from London to New York and the other bringing gold from New York to London. International transfers of money are controlled as a rule merely by variations in the ratio between the de mand for money and the stock of money. Among these variations, those with the greatest practical importance are those which distribute the newly mined precious metals throughout the world, a process in which London often plays the part of a middleman. Apart from this, and provided that no extraordinary cause suddenly alters the relative demand for money in different countries, the transference of money from country to country cannot be particularly extensive. It may be assumed that, as a rule, the variations that occur in this way are not so great as those variations in stocks of money that are due to new production, or at least that they do not exceed them by very much. If this is true—and it is supported only by rough estimates—then the movements which are necessary for bringing the purchasing power of money to a common level will consist largely or entirely of variations in the distribution of the additional quantity of money only.
It is possible to estimate on empirical grounds that the relative demand for money in a country, that is, the extent and intensity of its demand for money in relation to the extent and intensity of the demand for money in other countries (this phrase being interpreted throughout in the broader sense), will not decrease within a relatively short period to such an extent as to cause the quantity of money and fiduciary media together in circulation to sink below such and such a fraction of its present amount. Of course, such estimates are necessarily based upon more or less arbitrary combinations of factors and it is obviously never out of the question that they will be subsequently upset by unforeseen events. But if the amount is estimated very conservatively, and if due account is also taken of the fact that the state of international trade may necessitate transfers of money from country to country if only temporarily, then, so long as the quantity of fiduciary media circulating within the country is not increased beyond the estimated amount and no money certificates are issued either, the accumulation of a redemption fund might prove altogether unnecessary. For so long as the issue of fiduciary media does not exceed this limit, and assuming of course the correctness of the estimate on which it is based, there can arise no demand for redemption of the fiduciary media. If, for example, the quantity of the banknotes, treasury notes, token coins, and deposits at present in circulation in Germany were reduced by the sum deposited as cover for it in the vaults of the banks, the money and credit system would not be changed in any way. Germany’s power to transact business through the medium of money with foreign countries would not be affected.49 It is only the notes, deposits, and so forth, that are not covered by money that have the character of fiduciary media; it is these only and not those covered by money that have the effects on the determination of prices which it is the task of this part of our book to describe.
If the amount of fiduciary media in circulation were kept at a level below the limit set by the presumable maximum requirements of foreign trade, then it would be possible to do without a redemption reserve altogether, if it were not for a further circumstance that enters into the question. This circumstance is the following: if persons who needed a sum of money for foreign payments and were obliged to obtain it by the exchange of money substitutes could do this only through numerous money-changing transactions, perhaps involving an expenditure of time and trouble so that the procedure cost them something, this would militate against the complete equivalence of money substitutes and money, causing the former to circulate at a discount. Hence, if only on this account, a redemption fund of a certain amount would have to be maintained, even though the quantity of money actually in circulation was enough for trade with foreign countries. It follows from this that the fully backed note and the fully covered deposit, originally necessary in order to accustom the public to the use of these forms of money substitute, have still to be retained nowadays along with the superficially similar but essentially different fiduciary medium. A note or deposit currency with no money backing at all, that is, one which consists entirely of fiduciary media, still remains a practical impossibility.
If we look at the redemption funds of the self-sufficing banks, we shall observe in them an apparently quite irregular multifariousness. We shall observe that the kind and amount of cover of the money substitutes, especially those issued in note form, are regulated by a series of rules, constructed on quite different lines, partly by mercantile usage and partly by legislation. It is hardly correct to speak of different systems in this connection; that ambitious designation is little suited to empirical rules that have for the most part been founded on erroneous views of the nature of money and fiduciary media. There is, however, one idea that is expressed in all of them; the idea that the issue of fiduciary media needs to be limited by some kind of artificial restriction since it has no natural limits. Thus the question underlying all monetary policy, whether an unlimited increase of fiduciary media with its ineluctable consequence of a diminution in the objective exchange value of money is a thing to be encouraged, is implicitly answered in the negative.
Recognition of the need for an artificial limitation of the circulation of fiduciary media is, both on strictly scientific grounds and also on grounds of practical expediency, a product of economic inquiry during the first half of the nineteenth century. Its triumph over other views ended decades of such lively discussion as our science has seldom known, and at the same time concluded a period of uncertain experiment in the issuing of fiduciary media. During the years that have since elapsed, the grounds on which it was based have been subjected to criticism, sometimes ill founded, sometimes founded upon real objections. But the principle of limiting the issue of uncovered notes has not been abandoned in banking legislation. Nowadays it still constitutes an essential element in the banking policy of civilized nations, even if the circumstance that the limitation only applies to the issue of fiduciary media in the form of notes and not to the constantly growing issue in the form of deposits may make its practical importance less than it was some decades ago.
Limitation of fiduciary media also forms part of the money and credit system in India, the Philippines, and those countries that have imitated them, although in a different garb. No direct numerical proportion has been set up between the redemption fund administered by the government and the quantity of fiduciary media in circulation; any attempt to do this would have met with technical difficulties if only because it was impossible to calculate exactly what the quantity of fiduciary media was at the time of the transition to the new standard. But the further issue of fiduciary media in the form of legal-tender coinage is reserved to the state (it mostly requires special legislation) in a similar fashion to that in which the issue of token coinage and the like is regulated elsewhere.
The So-called Banking Type of Cover for Fiduciary Media
The expressions solvency and liquidity are not always used correctly when they are applied to the circumstances of a bank. They are sometimes regarded as synonymous; but orthodox opinion understands them to refer to two different states. (It must be admitted that a clear definition and distinction of the two concepts is usually not attempted.)
A bank may be said to be solvent when its assets are so constituted that a liquidation would necessarily result at least in complete satisfaction of all of its creditors. Liquidity is that condition of the bank’s assets which will enable it to meet all its liabilities, not merely in full, but also in time, that is, without being obliged to ask for anything in the nature of a moratorium from its creditors. Liquidity is a particular sort of solvency. Every enterprise—for the same is true of any body that participates in credit transactions—that is liquid is also solvent; but on the other hand not every undertaking that is solvent is also liquid. A person who cannot settle a debt on the day when it falls due has not a liquid status, even if there is no doubt that he will be able in three or six months’ time to pay the debt together with interest and the other costs in which the delay is meanwhile involving the creditor.
Since ancient times commercial law has imposed on everybody the obligation to have regard to liquidity throughout the whole conduct of his business. This requirement is characteristically expressed in mercantile life. Anyone who has to approach his creditor for permission to defer the payment of a debt, anyone who allows matters to reach the point of having his bills protested, has imperiled his business reputation, even if he is afterward able to meet all his outstanding obligations in full. All undertakings are subject to the rule that we have already encountered as the business principle of the credit-negotiating banks, that steps must be taken to permit the full and punctual settlement of every claim as it falls due.50
For credit-issuing banks, regard to this fundamental rule of prudent conduct is an impossibility. It lies in their nature to build upon the fact that a proportion—the larger proportion—of the fiduciary media remains in circulation and that the claims arising from this part of the issue will not be enforced, or at least will not be enforced simultaneously. They are bound to collapse as soon as confidence in their conduct is destroyed and the creditors storm their counters. They, therefore, are unable to aim at liquidity of investment like all other banks and undertakings in general; they have to be content with solvency as the goal of their policy.
This is customarily overlooked when the covering of the issue of fiduciary media by means of short-term loans is referred to as a method that is peculiarly suited to their nature and function, and when the appellation “characteristically banking type of cover” is applied to it,51 because it is supposed that consistent application of the general rule about liquidity to the special circumstances of the credit-issuing banks shows it to be the system of investment that is proper to such banks. Whether the assets of a credit-issuing bank consist of short-term bills or of hypothecary loans remains a matter of indifference in the case of a general run. If the bank is in immediate need of large sums of money it can procure them only by disposing of its assets; when the panic-stricken public is clamoring at its counters for the redemption of notes or the repayment of deposits, a bill that has still thirty days to run is of no more use to it than a mortgage which is irredeemable for just as many years. At such moments the most that can matter is the greater or lesser negotiability of the assets. But in certain circumstances, long-term or even irredeemable claims may be easier to realize than short-term; in times of crisis, government annuities and mortgages may perhaps find buyers more readily than commercial bills.
It has already been mentioned that in most states two categories of banks exist, as far as the public confidence they enjoy is concerned. The central bank-of-issue, which is usually the only bank with the right to issue notes, occupies an exceptional position, owing to its partial or entire administration by the state and the strict control to which all its activities are subjected.52 It enjoys a greater reputation than the other credit-issuing banks, which have not such a simple type of business to carry on, which often risk more for the sake of profit than they can be responsible for, and which, at least in some states, carry on a series of additional enterprises, the business of company formation for example, besides their banking activities proper, the negotiation of credit and the granting of credit through the issue of fiduciary media. These banks of the second order may under certain circumstances lose the confidence of the public without the position of the central bank being shaken. In this case they are able to maintain themselves in a state of liquidity by securing credit from the central bank on their own behalf (as indeed they. also do in other cases when their resources are exhausted) and so being enabled to meet their obligations punctually and in full. It is therefore possible to say that these banks are in a state of liquidity so long as their liabilities as they fall due from day to day are balanced by such assets as the central bank considers a sufficient security for advances. It is well known that some banks are not liquid even in this sense. The central banks of individual countries could similarly attain a state of liquidity if they only carried such assets against their issues of fiduciary media as would be regarded as possible investments by their sister institutions abroad. But even then it would remain true that it is theoretically impossible to maintain the credit bank system in a state of liquidity. A simultaneous destruction of confidence in all banks would necessarily lead to a general collapse.
It is true that the investment of its assets in short-term loans does make it possible for a bank to satisfy its creditors within a certain comparatively short period. But this would prove adequate in the face of a loss of confidence only if the holders of notes and deposits did not apply simultaneously to the bank for immediate payment of the sums of money owing to them. Such a supposition is not very probable. Either there is no lack of confidence at all or it is general. There is only one way in which liquidity of status might be at least formally secured with regard to the special circumstances of credit-issuing banks. If such banks made loans only on the condition that they had the right to demand repayment at any time, then the problem of liquidity would of course be solved for them in a simple manner. But from the point of view of the community as a whole, this is of course no solution, but only a shelving, of the problem. The status of the bank could only apparently be kept liquid at the expense of the status of those who borrowed from it, for these would be faced with precisely the same insurmountable difficulty. The banks’ debtors would not have kept the borrowed sums in their safes, but would have put them into productive investments from which they certainly could not withdraw them without delay. The problem is thus in no way altered; it remains insoluble.
The Significance of Short-Term Cover
Credit-issuing banks as a rule give preference to short-term loans as investments. Often the law compels them to do this, but in any case they would be forced to do it by public opinion. But the significance of this preference has nothing to do with the greater ease with which it is generally, but erroneously, supposed to allow the fiduciary media to be redeemed. It is true that it is a policy that has preserved the bank-credit system in the past from severe shocks; it is true that its neglect has always avenged itself; and it is true that it still is important for the present and future; but the reasons for this are entirely different from those which the champions of short-term cover are in the habit of putting forward.
One of its reasons, and the less weighty, is that it is easier to judge the soundness of investments made in the form of short-term loans than that of long-term investments. It is true that there are numer ous long-term investments that are sounder than very many short-term investments; nevertheless, the soundness of an investment can as a rule be judged with greater certainty when all that has to be done is to survey the circumstances of the market in general and of the borrower in particular for the next few weeks or months, than when it is a matter of years or decades.
The second and decisive reason has already been mentioned.53 If the granting of credit through the issue of fiduciary media is restricted to loans that are to be paid back after a short space of time, then there is a certain limitation of the amount of the issue of fiduciary media. The rule that it is desirable for credit-issuing banks to grant only short-term loans is the outcome of centuries of experience. It has been its fate always to be misunderstood; but even so, obedience to it has had the important effect of helping to limit the issue of fiduciary media.
The Security of the Investments of the Credit-issuing Banks
The solution of the problem of soundness is no more difficult for the credit-issuing banks than for the credit-negotiating banks. If the fiduciary media are issued only on good security and if a guarantee fund is created out of the bank’s share capital for the purpose of covering losses, for even under prudent management losses cannot always be avoided, then the bank can put itself in a position to redeem in full the fiduciary media that it issues, although not within the term specified in its promises to pay.
Nevertheless, the soundness of the cover is only of subordinate importance as far as fiduciary media are concerned. It may disappear entirely, at least in a certain sense, without prejudicing their capacity of circulation. Fiduciary media can even be issued without any cover at all. This occurs, for example, when the state issues token coins and does not devote the seigniorage to a particular fund for their redemption. (Under certain circumstances, the metal value of the coins themselves may be regarded as partial security. And of course the state as a whole has assets that provide far greater security than any sort of special fund could offer) On the other hand, even if the fiduciary media are completely covered by the assets of the issuer, so that only the time of their redemption and not its ultimate occurrence is open to question, this cannot have any sort of influence whatever in support of their capacity for circulation; for this depends exclusively upon the expectation that the issuer will redeem them promptly.
To have overlooked this is the error underlying all those proposals and experiments which have aimed at guaranteeing the issue of fiduciary media by means of funds consisting of nonliquid assets, such as mortgages. If those money substitutes that are presented for redemption are immediately and fully redeemed in money, then, beyond the cash reserve necessary for this redemption, no stock of goods is needed for maintaining equivalence between the fiduciary media and money. If, however, the money substitutes are not fully and immediately redeemed for money, then they will not be reckoned as equivalent to money just because there are some goods somewhere that will at some time be used to satisfy the demands that the holders of the money substitutes are entitled to make on the ground of the claims that the money substitutes embody. They will be valued at less than the sums of money to which they refer, because their redemption is in doubt and at the best will not occur until after the passage of a period of time. And so they will cease to be money substitutes; if they continue to be used as media of exchange, it will be at an independent valuation; they will be no longer money substitutes, but credit money.
For credit money also, that is for unmatured claims which serve as common media of exchange, “cover” by a special fund is superfluous. So long as the claims are tendered and accepted as money, and thus have obtained an exchange value in excess of that which is attributed to them as mere claims, such a fund has no bearing on the matter. The significance of the regulations as to cover and the funds for that purpose lies here, as with fiduciary media, in the fact that they indirectly set a limit to the quantity that can be issued.54
Foreign Bills of Exchange as a Component of the Redemption Fund
Since it is not the object of a redemption fund to provide for the redemption of such money substitutes as are returned to the bank because of lack of confidence in their goodness, but only to provide the bank’s customers with the media of exchange necessary for dealing with persons who are not among its customers, it is obvious that such a fund might be composed at least in part of such things as, without being money, can be used like money for dealings with outsiders. These things comprise not only foreign money substitutes but also all such claims as form the basis of the international clearing business, primarily, that is to say, foreign bills, that is, bills on foreign places. The issue of money substitutes cannot be increased beyond the quantity given by the demand for money (in the broader sense) of the customers of the bank for intercourse within the clientele of the bank. Only an extension of the clientele could prepare the way for an extension of the circulation; for the national central bank-of-issue, whose influence is limited by political boundaries, such an extension remains impossible. Nevertheless, if part of the redemption fund is invested in foreign banknotes, or in foreign bills, foreign checks, and deposits at short notice with foreign banks, then a larger proportion of the money substitutes issued by the banks can be transformed into fiduciary media than if the bank held nothing but money in readiness for the foreign dealings of its customers. In this way a credit-issuing bank may even transform into fiduciary media almost all the money substitutes that it issues. The private banks of many countries are now no longer far removed from this state of affairs; they are in the habit of providing for the prompt redemption of the money substitutes issued by them by holding a reserve itself consisting of money substitutes; only so far as these covering money substitutes are money certificates do the issued money substitutes not bear the character of fiduciary media. It is only fairly recently that the central banks-of-issue also have begun to adopt the practice of admitting money substitutes and foreign bills into their conversion funds.
Just as the goldsmiths once began to lend out part of the moneys entrusted to them for safekeeping, so the central banks have taken the step of investing their stock of metal partly in foreign bills and other foreign credits. An example was set by the Hamburg Giro Bank, which was accustomed to hold part of its reserve in bills on London; it was followed during the last quarter of the nineteenth century by a series of banks-of-issue. It was with regard to their profits that the banks accepted this system of cover The investment of a part of the redemption fund in foreign bills and other foreign balances that could be easily and quickly realized was intended to reduce the costs of maintaining the reserve. In certain countries the central banks-of-issue acquired a portfolio of foreign bills because the domestic discount business was not sufficiently remunerative.55 Generally speaking, it was the central banks-of-issue and the governmental redemption funds of the smaller and financially weaker countries that tried to save expense in this way. Since the war, which has made the whole world poorer, their procedure has been widely imitated. It is clear that the policy of investing the whole redemption fund in foreign claims to gold cannot become universal. If all the countries of the world were to go over to the gold-exchange standard and hold their redemption funds not in gold but in foreign claims to gold, gold would no longer be required for monetary purposes at all. That part of its value which is founded upon its employment as money would entirely disappear. The maintenance of a gold-exchange standard with the redemption fund invested in foreign bills undermines the whole gold-standard system. We shall have to return to this point in chapter 20.
Money, Credit, and Interest
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.
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.
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.
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.
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.
Problems of Credit Policy
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
Problems of Credit Policy Before the War80
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.
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.
The Gold-Premium Policy89
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.
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.
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
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.
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.
Problems of Credit Policy in the Period Immediately After the War
The Gold-Exchange Standard107
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.
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.
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
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 yet111 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:
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.
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.
[1. ]See Bagehot, Lombard Street (London, 1906), p. 21.
[2. ]Knies, Geld und Kredit, (Berlin, 1876), vol. 2, Part II, p. 242. See further, Weber, Depositen- und Spekulationsbanken (Leipzig, 1902), pp. 106 f.; Sayous, Les banques de depêt, les banques de crédit et les sociétés financières, 2d ed. (Paris, 1907), pp. 219 ff.; Jaffé, Das englische Bankwesen, 2d ed. (Leipzig, 1910), p. 203.
[3. ]See Macleod, The Elements of Banking (London, 1904), p. 153.
[4. ]See Fullarton, On the Regulation of Currencies, 2d ed. (London, 1845), p. 39; Mill, Principles of Political Economy (London, 1867), p. 314; Jaffé, op. cit., p. 175.
[5. ]See Jaffé, op. cit., p. 153.
[6. ]This is the “surplus profit” (Übergewinn) of the business of banking, referred to by Hermann (op. cit., pp. 500 f.).
[7. ]As, for example, even Wicksell does (Geldzins und Güterpreise [Jena, 1898], p. 57).
[8. ]See Torrens, The Principles and Practical Operation of Sir Robert Peel’s Act of 1844 Explained and Defended, 2d ed. (London, 1857), pp. 16 ff.
[9. ]Ibid., p. 18.
[10. ]Since the appearance of the first edition of the present work numerous books have been published that still do not recognize the problem of circulation credit. Among the works that have grasped the nature of this problem the following should be mentioned: Schumpeter, Theorie der wirtschaftlichen Entwicklung (Leipzig, 1912), pp. 219 ff.; Schlesinger, Theorie der Geld- und Kreditwirtschaft (Munich and Leipzig, 1914), pp. 133 ff.; Hahn, Volkswirtschaftliche Theorie des Bankkredits (Tübingen, 1920), pp. 52 ff.
[11. ]Thus Lexis, Allegemeine Volkswirtschaftslehre (Berlin, 1910) (Hinnenberg, Die Kultur der Gegenwart, section II, vol. 10, Part 1), p. 122; Lexis, Geld und Preise (Riesser-Festgabe, Berlin, 1913), pp. 83 f. Similarly, with regard to the clearinghouse business, Schumacher, Weltwirtschaftliche Studien (Leipzig, 1911), pp. 53 f. and the writings there referred to.
[12. ]See Lotz, Geschichte und Kritik des deutschen Bankgesetzes vom 14. März 1875 (Leipzig, 1888), pp. 72 f.
[13. ]See for example on the Swiss currency reserve fund established by article 8 of the Currency Act of January 31, 1860, Altherr, Eine Betrachtung über neue Wege der schweizerischen Münzpolitik (Bern, 1908), pp. 61 ff.
[14. ]See Knies, Geld und Kredit, (Berlin, 1876), vol. 2, Part I, pp. 268 ff.
[15. ]See l. 21, sec. 1 D. de liberatione legata 34, 3. Terentius Clemens libro XII ad legem Juliam et Papiam.
[16. ]See l. 1 D. der compensationibus 16, 2. Modestinus libro sexto pandectarum.
[17. ]See Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (London, 1802), pp. 39 ff.
[18. ]See Baird, The One Pound Note, Its History, Place and Power in Scotland, and Its Adaptability for England, 2d ed. (Edinburgh, 1901), pp. 9 ff.; Graham, The One Pound Note in the History of Banking in Great Britain, 2d ed. (Edinburgh, 1911), pp. 195 ff.; Nicholson, A Treatise on Money and Essays on Present Monetary Problems (Edinburgh, 1888), pp. 177 ff.; Jevons, Investigations in Currency and Finance (London, 1909), pp. 275 ff.
[19. ]See Lindsay, A Gold Standard Without a Gold Coinage in England and India (Edinburgh, 1879), pp. 12 ff. I have not been able to obtain access to a second pamphlet by the same author which appeared anonymously in 1892 under the title Ricardo’s Exchange Remedy.
[20. ]See Probyn, Indian Coinage and Currency (London, 1897), pp. 1 ff.
[21. ]See Report of the Indian Currency Committee 1898 (in Stability of International Exchange, Report on the Introduction of the Gold-Exchange Standard into China and Other Silver-using Countries submitted to the Secretary of State, October 1, 1903, by the Commission on International Exchange [Washington, D.C., 1903], Appendix G), pp. (315).; Heyn, Die indische Währungsreform, (Berlin, 1903), pp. 54 ff.; Bothe, Die indische Währungsreform seit 1893 (Stuttgart, 1906), pp. 199 ff.
[22. ]On the fate of the Indian currency in the period of inflation during the Great War, see Spalding, Eastern Exchange, Currency and Finance, 3d ed. (London, 1920), pp. 31 ff.
[23. ]See Conant, “The Gold Exchange Standard in the Light of Experience,” The Economic Journal 19 (1909): 200.
[24. ]In the pamphlet published in 1816, “Proposals for an Economical and Secure Currency with Observations on the Profits of the Bank of England,” in Works, ed. McCulloch, 2d ed. (London, 1852), pp. 404 ff.
[25. ]See Patterson, Der Krieg der Banken, trans. from the English by Holtzendorff (Berlin, 1867), pp. 17 ff.; Wolf, Verstaatlichung der Silberproduktion und andere Vorschläge zur Währungsfrage (Zurich, 1892), pp. 54 ff.; Wolf, “Eine international Banknote,” in Zietscrift für Sozialwissenschaft (1908), vol 11, pp. 44 ff.
[26. ]These words, written in 1911, need no addition today.
[27. ]See De Greef, “La monnaie, le crédit et le change dans le commerce international,” Revue economique internationale 4 (1911): 58 ff.
[28. ]See Smith, The Wealth of Nations, Cannan’s ed. (London, 1930), vol. 2, pp. 28, 78.
[29. ]See Ricardo, “The High Price of Bullion a Proof of the Depredation of Bank Notes,” in Works, ed. McCulloch, 2d ed. (London, 1852), pp. 263 ff.; “Proposals for an Economical and Secure Currency” in ibid., pp. 397 ff.; see pp. 324-25 above and 467-68 below.
[30. ]On the question of the dependence of economic fluctuations on credit policy, see pp. 445 f. below.
[31. ]See Jevons, Investigations in Currency and Finance, pp. 8, 151 ff.; Palgrave, Bank Rate and the Money Market in England, France, Germany, Holland and Belgium 1844-1900 (London, 1903), pp. 106 ff.; 138; J. Laughlin, The Principles of Money (London, 1903), pp. 409 ff.
[32. ]See Spiethoff, “Die Quantitätstheorie insbesondere in ihrer Verwertbarkeit als Haussetheorie,” Festgaben für Adolf Wagner (Leipzig, 1905), pp. 263 f.
[33. ]See Helfferich, Studien über Geld- und Bankwesen (Berlin, 1900), pp. 151 f.; Schumacher, Weltwirtschaftliche Studien (Leipzig, 1911), pp. 5 ff.
[34. ]See White, An Elastic Currency (New York, 1893), p. 4.
[35. ]See pp. 173 ff. above.
[36. ]See Tooke, An Inquiry into the Currency Principle (London, 1844), pp. 60 ff.; 122 f.; Fullarton, On the Regulation of Currencies, 2d ed. (London, 1845), pp, 82 ff.; Wilson, Capital, Currency and Banking (London, 1847), pp. 67 ff.; Mill, Principles of Political Economy (London, 1867), pp. 395 ff.; Wagner, Geld- und Kredittheorie der Peelschen Bankakte (Vienna, 1862), pp. 135 ff. On Mill’s lack of consistency in this question, see Wicksell, Geldzins und Güterpreise (Jena, 1898), pp. 78 f.
[37. ]See Laughlin, The Principles of Money (London, 1903), p. 412.
[38. ]See Wicksell, op. cit., p. v.
[39. ]See Fullarton, op. cit., p. 64.
[40. ]See Schumacher, op. cit., pp. 122 f.
[41. ]See Prion, Das deutsche Wechseldiskontgeschäft (Leipzig, 1907), pp. 120 ff., 291 ff.
[42. ]Part of the rediscounting done at the Reichsbank by the private banks shortly before the critical days of settlement is done not so much because the banks are short of capital but because they desire to pass on nearly matured bills to be called in by the Reichsbank, which is able to perform this task more cheaply than they are, thanks to its extensive network of branches. See ibid., pp. 138 ff.
[43. ]See Ricardo, “Proposals,” in Works, ed. McCulloch, 2d ed. (London, 1852), p. 406; Walras, Études d’économie politique appliquée (Lausanne, 1898), pp. 365 f.
[44. ]See for example, Tellkampf, Die Prinzipien des Geld- und Bankwesens (Berlin, 1867), pp. 181 ff.; Erfordernis voller Metalldeckung der Banknoten (Berlin, 1873), pp. 23 ff.; Geyer, Theorie und Praxis des Zettelbankwesens, 2d ed. (Munich, 1874), p. 227.
[45. ]See Hepburn, History of Coinage and Currency in the United States (New York, 1903), p. 418.
[46. ]See Dunbar, Chapters on the Theory and History of Banking, 2d ed. (New York, 1907), P. 99.
[47. ]See Kiga, Das Bankwesen Japans, Leipziger Inaug. Diss., p. 9.
[48. ]See Oppenheim, Die Natur des Geldes (Mainz, 1855), pp. 241 f.
[49. ]This example assumes the circumstances that existed before 1914.
[50. ]See pp. 296 ff. But the fact is often ignored that this “principle of the banking adequate cover” is valid not only for banks but similarly for all other undertakings. See, for example, Schulze-Gaevernitz, “Die deutsche Kreditbank,” Grundriss der Sozialökonomik, Part V, section 2, pp. 240 ff.
[51. ]See Wagner, System der Zettelbankpolitik (Freiburg, 1873), pp. 240 ff.—The “golden rule” found its classical expression with regard to the business of credit banks in the famous “Note expédiée du Havre le 29 Mai 1810, à la Banque de France, par ordre de S. M. l’Empereur, et par l’entremise de M. le comte Mollien, ministre du Trésor” (I quote from the reprint in Wolowski, La Question des Banques [Paris, 1864], pp. 83-87): “Il faut qu’une banque se maintienne en état de se liquider à tout moment, d’abord, vis-à-vis des porteurs de ses billets, par la réalisation de son portefeuille, et, apres les porteurs de ses billets, viv-à-vis de ses actionnaires, par la distribution à faire entre eux de la portion du capital fourni par chacun d’eux. Pour ne jamais finir, une banque doit etre toujours prête à finir” (p. 87). All the same, Mollien had no doubt on the point that a bank that does not issue its notes otherwise “qu’en échange de bonnes et valable lettres de change, à deux et trois mois de terme au plus” can only call in its notes from circulation “dans un espace de trois mois” (ibid., p. 84).
[52. ]In the United States, before the reorganization of the banking system under the Federal Reserve Act, the lack of a central bank in times of crises was made up for by ad hoc organizations of the banks that were members of the clearinghouses.
[53. ]See above, pp. 346 f.
[54. ]See Nicholson, A Treatise on Money and Essays on Present Monetary Problems (Edinburgh, 1888), pp. 67 f.
[55. ]See Kalkmann, “Holland’s Geldwesen im 29. Jahrhundert,” in Schmoller’s Jahrbuch, vol. 25, pp. 2249 ff.; Witten, “Die Devisenpolitik der Nationalbank von Belgien,” in ibid., vol. 42, pp. 625 ff.
[56. ]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.
[57. ]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.
[58. ]See, for example, Georg Schmidt, Kredit und Zins (Leipzig, 1910), pp. 38 ff.
[59. ]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.
[60. ]See, for example, Arendt, Geld—Bank—Börse (Berlin, 1907), p. 19.
[61. ]See Gilbart, The History, Principles and Practice of Banking, rev. ed. (London, 1904), vol. 1, p. 98.
[62. ]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.
[63. ]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.
[64. ]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.
[65. ]See Wicksell, op. cit., pp. 1 ff.
[66. ]See Fisher, The Rate of Interest (New York, 1907), pp. 94 f.
[67. ]See Böhm-Bawerk, Kapital und Kapitalzins, p. 622.
[68. ]See Fisher and Brown, The Purchasing Power of Money (New York, 1911), pp. 58 ff.
[69. ]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.
[70. ]See Wicksell, op. cit., pp. v ff.
[71. ]See ibid., pp. v ff., III; also “The Influence of the Rate of Interest on Prices,” Economic Journal 18 (1907): 213 ff.
[72. ]See Wicksell, “The Influence of the Rate of Interest,” p. 215.
[73. ]See Wicksell, Geldzins und Güterpreise, pp. 104 f.
[74. ]See Walras, Études d’économie politique appliquée (Lausanne, 1898), pp. 345 f.
[75. ]See Böhm-Bawerk, op. cit., pp. 611 ff.
[76. ]Ibid., pp. 151 ff.
[77. ]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.
[78. ]See p. 259-60 above.
[79. ][Some of the problems that have arisen since are referred to on pp. 23-31. H.E.B.]
[80. ][See editor’s Introduction, pp. 21-22, above. H.E.B.]
[81. ]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.
[82. ]See Tooke, An Inquiry into the Currency Principle (London, 1844), pp. 23 ff.
[83. ]See Wagner, “Banknote,” in Rentzsch, Handwörterbuch der Volkswirtschaftslehre (Leipzig, 1866), p. 91.
[84. ]See Wagner, “Kredit,” ibid., p. 201.
[85. ]See Schumacher’s criticism of this contradiction, Weltwirtschaftliche Studien (Leipzig, 1911), pp. 62 ff.
[86. ]See Cannon, Clearinghouses: Their History, Methods and Administration (New York, 1900), pp. 79 ff.
[87. ]The Federal Reserve Act has since provided the United States with a basis for issuing notes in order to allay a panic.
[88. ]See Sartorious von Waltershausen, Das volkswirtschaftliche System der Kapitalanlage im Auslande (Berlin, 1907), pp. 126 ff.
[89. ][See pp. 21-22 above. H.E.B.]
[90. ]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.
[91. ]See Kaufmann, Das französische Bankwesen (Tübingen, 1911), pp. 35 ff.
[92. ]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.”
[93. ]See Landesberger, Währungssystem und Relation (Vienna, 1891), p. 104.
[94. ]Ibid., p. 105, and Über die Goldprämienpolitik der Zettelbanken (Vienna, 1892), p. 28.
[95. ]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.
[96. ]See Koch, Der Londoner Goldverkehr (Stuttgart, 1905), p. 708.
[97. ]Ibid., pp. 81 f.
[98. ]See Clare, A Money Market Primer and Key to the Exchanges, 2d ed. (London, 1893), p. 22.
[99. ]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.
[100. ]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.”
[101. ]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.
[102. ]See Koch, op. cit., p. 79; Die Reichsbank 1876-1900 (Berlin, 190l), p. 146.
[103. ]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.
[104. ]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.
[105. ]See also Proebst, Die Grundlagen unseres Depositen- und Scheckwesens (Jena, 1908), pp. 1 ff.
[106. ]It is only in very recent years that views on this point in dominant circles have begun slowly to change.
[107. ][The reader will remember that this was written in 1924. H.E.B.]
[108. ]See Keynes, A Tract on Monetary Reform (London, 1923), pp. 163 ff.
[109. ]See Kant, Werke, vol. 5, Zum ewigen Frieden (Insel-Ausgabe), pp. 661 f.
[110. ]See Horn, Bankfreiheit (Stuttgart, 1867), pp. 376 f.
[111. ][It should be remembered that this was written in 1924. H.E.B.]
[112. ]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.
[113. ]See pp. 215 ff. and 232 ff. above.