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

I. Automatic vs. Managed Currencies

The assumption of a simple specie currency followed in the preceding chapter made it possible to deal with the international mechanism as an “automatic” mechanism, if by “automatic” is meant freedom from discretionary regulation or management. But if there are non-specie elements in the currency, and if the ratio of the non-specie to the specie elements is variable and subject to the discretionary control of a central authority, there result differences of some importance in the short-run mode of operation of the mechanism from the manner in which it would operate under a simple specie currency. Although most presentday writers seem to believe either that the non-automatic character of the modern gold standard is a discovery of the post-war period or that it was only in the post-war period that the gold standard lost its automatic character, currency controversy during the entire nineteenth century concerned itself largely with the problems resulting from the discretionary or management elements in the prevailing currency systems. The bullion controversy at the beginning of the nineteenth century turned largely on the difference in the mode of operation in the international mechanism of a managed paper standard currency, on the one hand, and of a convertible paper currency, on the other, with the latter treated generally, but not universally, as if it were automatic. Later, the adherents of both the currency and the banking schools distinguished carefully between the way in which a supposedly automatic “purely metallic” currency (which, in addition to specie, included bank deposits but not bank notes) would operate and the way in which the Bank of England was actually operating a “mixed” currency (which, in addition to specie and bank deposits, included bank notes). Both schools were hostile to discretionary management. The currency school thought that the currency could be made nearly automatic again merely by limiting the issue of bank notes uncovered by specie. The banking school held that there was no acceptable way of escape from the discretionary power of the Bank of England over the volume of deposits, although the “banking principle,” according to which the issue of means of payment could not be carried appreciably beyond the needs of business under convertibility, set narrow limits to this discretionary power. Later discussion centered largely about the rules which the Bank of England should follow in using the discount rate and its other instruments of control to regulate the currency.

Even the terms “automatic,” “self-acting,” “managed,” “discretionary,” or their equivalents, as applied to currency systems are of long standing, as the following sample quotations from the literature of the currency school-banking school controversy show:

In the case of a [convertible] paper currency an attempt is made from considerations of convenience and economy to substitute paper notes in the place of metallic coins. In making this exchange we adopt a circulating medium which has no intrinsic value, and we therefore lose that self-acting security which we had with a metallic circulation, for the due regulation of its amount and the maintenance of its value. It therefore becomes necessary that we should resort to some artificial system or rule, which shall secure with respect to a paper currency that regulation of its amount which in a metallic currency necessarily results from its intrinsic value.1

... from the moment that we employ figurative language at all, and speak of gold “flowing” and “fluctuating” as if it were water, or “circulating” as if it were blood, no metaphor seems so significant, or to apply so aptly to the character of the notion of the precious metals as the expression “automatic.” This word indicates an action which is not determined by any particular exercise of an extrinsic volition, but one proceeding from, and attaching to, the functional, intrinsic and uncontrollable energies of the organ, or thing, which acts. The thing which acts in this case is the universal appetite of the human mind, and the effects produced on gold make it seem to be animated by that appetite, and to seek its end in active obedience to it.... I conclude therefore thus far that the idea of a safe paper currency is incompatible with the idea of any thing savoring of control, guidance, discretion, or government, and that it is a principle essential to a safe paper currency that the issue and resorption of it should be purely automatic.2

There are some who object in limine to all “regulation of the currency,” as it is termed, but such objection is founded in error; because currency being legal tender it ... is the creature of law or “regulation”; wherefore to withdraw “regulation” altogether would be to cease to have legal tender; an impracticable alternative....

But regulation is of two kinds, viz., discretionary, and self-acting. Thus, on the one hand, the Bank of England both possesses and exercises the power of regulating the currency at its discretion, by altering its rate of discount.... Whilst, on the other hand, self-acting regulation is afforded by the exportation of gold at one time in relief of excess, and its importation at another, in relief of insufficiency, such operations being undertaken upon ordinary mercantile principles; the trader simply seeking his own profit, and not concerning himself in the least about the regulation of anything whatever.34

If a currency system could be imagined under which the specie reserves of the banking system as a whole were always maintained without central bank regulation at a constant ratio to its demand liabilities to the public, there would be only one significant difference between such a currency and a simple specie currency as far as the international mechanism was concerned. Whereas under a simple specie currency fluctuations in the quantity of specie would result in equal fluctuations, both absolutely and relatively, in the amount of means of payment, under a fixed fractional reserve currency fluctuations in the quantity of specie would result in equi-proportional but absolutely greater fluctuations in the amount of means of payment. The absolute amount of specie movement necessary for adjustment of the balance of payments to a disturbance of a given monetary size would be less under a fractional reserve currency than under a simple specie currency.

Under both types of currency the international mechanism would be “automatic” in the sense that its mode of operation would not be influenced by the discretionary management of a central authority, but would be the result of the voluntary responses of a host of individuals to changes in prices, interest rates, money incomes, money costs, and so forth. Under both types of currency, therefore, it would be possible to formulate a fairly precise description of the mechanism of international adjustment on the basis either of assumptions as to the nature of rational individualistic behavior under the circumstances specified or of the assumption of persistence in the future of such patterns of behavior, whether rational or not, as had been found upon investigation to have prevailed in the past.

Where the ratio of the amount of the currency to the amount of specie is subject to the discretion of a central authority, however, the international mechanism becomes subject to the influence of the decisions or activities of this authority and thus loses some at least of its automatic character. If the controlling agency were operating on the basis of a clearly formulated and simple policy or rule of action, which was made known to the public, it would be possible to describe the international mechanism as it would operate under such policy. But central banks do not ordinarily disclose their policy to the public, and the evidence seems to point strongly to a disinclination on the part of central bankers as a class to accept as their guide the simple formulae which are urged upon them by economists and others, or to follow simple rules of their own invention. All central banks find themselves at times facing situations which appear to demand a choice between conflicting objectives, long-run versus short-run, internal stability versus exchange stability, the indicated needs of the market versus their own financial or reserve position, and so forth, and they seem universally to prefer meeting such situations ad hoc rather than in accordance with the dictates of some simple formula. Whatever may be the merits of this attitude, it results in practice in behavior by central banks which fails to reveal to the outsider any well-defined pattern upon which can be based predictions as to their future behavior. Theorizing about the nature of the international mechanism in so far as it is subject to influence by the operations of central banks cannot therefore be forthright and categorical, but must resort to analysis of the consequences for the mechanism in different types of situations of the particular choices which central bankers may conceivably make among the various species of action—or inaction—available to them in such situations. But whatever central banks do or refrain from doing, and for whatever reasons or absence of reason, their mere existence with discretionary power to act suffices to give some phases of the international mechanism, and especially the specie-movement phase, a “managed” and variable and largely unpredictable relationship to the other phases of the mechanism.

If there is no central bank or its equivalent, and if there are a large number of genuinely independent banks with power to issue bank money, whether in the form of demand deposits or of notes, and with their specie reserves left completely or substantially free from statutory regulation, the specie-movement phase of the international mechanism can still be regarded as automatic if the average specie reserve ratio of the banking system as a whole is at any moment determined by the aggregate effect of the autonomous decisions of a large number of individuals or firms. The ratio under such circumstances of the total amount of means of payment to the amount of specie will be a variable one, but there will be some elements of regularity in this variability, discoverable by historical investigation if not by a priori cogitation alone. But this does not seem to be a common situation. In the absence of a central bank, as in the United States before the establishment of the Federal Reserve system or in Canada before 1935, either the great bulk of the banking business was in the hands of a small number of large banks necessarily following, because of their size and fewness, an essentially uniform course with respect to reserve ratios, or a few of the largest banks operated as rediscount agencies for the many small banks and the latter adhered closely to a customary or legal minimum cash reserve ratio, leaving to a few large banks the chief responsibility for the maintenance of adequate national specie reserves. From the point of view of the international mechanism, it is by no means clear that such a system differed significantly in practice from a system operating under formal central discretionary control, or that what differences did exist were uniformly such as to point to the desirability of formal central control as it has been exercised in the past. In any case, there is ordinarily under both systems some measure of more or less centralized and discretionary control over the amount of means of payment and its ratio to the amount of specie, and the mode of operation of this control is under both systems unlikely to follow any simple pattern.

Under an international metallic standard, there are various possible objectives of the central bank. (1) It may be the policy of the bank to enforce adherence of the banking system to a fixed minimum (and possibly also maximum) specie reserve ratio. (2) Or its objective may be to minimize the amount of its own non-income-earning specie reserves while maintaining at all times unquestioned convertibility of its demand liabilities. This objective calls for frequent and prompt central bank intervention to check inward or outward specie movements, with a general tendency to force close correspondence in timing and direction between the fluctuations in the national stock of means of payment and the fluctuations in the foreign exchanges. It seems to have been a dominant element in the policy of the Bank of England during the nineteenth century. (3) Another possible objective may be to minimize the frequency of central bank intervention, and to confine intervention to those occasions when price or other rigidities or the prevalence of distrust result in a dangerous depletion of reserves or in an accumulation of excess reserves to an extent burdensome to the central bank or dangerous to the position of foreign central banks. The Banque de France appears to have followed this objective with substantial constancy during the latter half of the nineteenth century. It operates to reduce the significance of the central bank, whose powers are used to support the automatic processes only to protect itself from danger and to counteract the automatic processes only to protect its profits or to protect other central banks from danger. (4) Finally, another possible objective is to exploit the possibilities of internal stabilization, whether of prices, or of amount of means of payment, or of physical volume of business activity, through control of the quantity of means of payment within the limits set by adherence to an international monetary standard. Under such a policy the automatic forces would be left alone or reinforced when they were operating in a stabilizing direction, but would be counteracted when they were acting in an unstabilizing direction, within the limits of safety with respect to maintenance of convertibility. Pursuit of this objective would involve willingness of the central bank to accumulate idle specie reserves or to permit without interference the substantial depletion of reserves. While this objective has undoubtedly been upon occasion a factor in determining the operations of central banks, it does not seem ever, at least during the nineteenth century, to have been a formally adopted and consistently applied aim of central bank policy, with the brief, and partial, exception of the period of adherence by the Bank of England to the “Palmer rule.”

In terms of the distinction, examined in detail in later sections, between primary fluctuations in the amount of means of payment or those resulting directly from specie flows, on the one hand, and secondary fluctuations in the amount of means of payment, or those resulting from fluctuations in the volume of loans and investments of the banking system, gold outflows would always tend to involve primary contraction and gold inflows to involve primary expansion, but whether these primary fluctuations would be accompanied by operations of the central banks tending to produce secondary fluctuations and whether these secondary fluctuations would be in a direction supporting or offsetting the primary fluctuations, would depend on what objectives the central bank was pursuing. In terms of the classification of possible objectives of central bank policy made above, the appropriate operations of the central banks would be as indicated in tabular form on page 395.

[1]Overstone, Further reflections on the state of the currency, 1837, pp. 33-34.

[2]John Welsford Cowell, Letters ... on the institution of a safe and profitable paper currency, 1843, pp. 45-46.

[3]Edwin Hill, Principles of currency, 1856, pp. 2-3.

[4]The types of secondary-operations of an offsetting character should perhaps be further subclassified, so as to distinguish partially offsetting, exactly offsetting (“neutralizing”), and over-compensating secondary fluctuations.