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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

II. Primary and Secondary Expansion of Means of Payments

Under a metallic standard currency system which contains both specie and non-specie elements, changes in the total stock of means of payment in the country may result either from changes in the amount of specie or from changes in the amount of non-specie currency, or from both. The amount of specie can increase as the result of an inflow of specie or bullion from abroad, of the coining of domestically-produced bullion, or of the diversion of

bullion from industrial to monetary use. The amount of non-specie currency (assuming foreign issues are not generally accepted) can increase through increased issue of paper money by the government to meet current expenditures or to redeem debt obligations, or through an increase by the banking system as a whole of its note and/or deposit liabilities to the outside public by the grant of loans, purchase of securities, or payment of its own operating losses or unearned dividends in “bank money.” Changes in the amount of means of payment will be here distinguished as “primary” or “secondary” according as they result from changes in the amount of specie or from changes in the amount of uncovered non-specie currency, and an attempt will be made to demonstrate that examination of the international mechanism with the aid of this distinction serves both to expose some current misinterpretations of the doctrines of the older writers and to bring out more clearly the nature of the banking aspects of the mechanism under modern conditions. To simplify the exposition, the following assumptions, involving only minor quantitative departures from the actually prevailing conditions under the gold standard, will be made: (1) that changes in the amount of specie result only from international movements of specie or bullion; (2) that bullion or specie is never borrowed or lent internationally by banks on their own account; and (3) that non-specie currency, including both notes and deposits, is issued only by banks and only as loans, in the purchase of securities, or in the exchange of one form for another form of currency. Further to simplify the exposition, it will be assumed that all actual specie is in bank reserves and that there is no non-monetary use of gold.

Given these assumptions, primary expansion or contraction of the means of payment can result only from, and must be equal to, the inflow or outflow of specie from or to the outside world. Let us suppose that as the result of increased commodity exports an inflow of specie occurs, and that the owners of such specie exchange it at the banks for either bank notes or bank deposits. This constitutes a primary expansion of the currency. If the banks increase their loans and investments—whether or not because of the increase in their specie reserves is immaterial—a further increase in bank money occurs which constitutes a secondary expansion. If for any reason the banks should reduce the amount of their loans and investments while their specie holdings were increasing, the primary expansion would be at least in part offset, and could conceivably be more than offset, by a simultaneous secondary contraction, so that the net expansion, if any, of the currency would be smaller than the primary expansion.

In tracing the development of doctrine with relation to the respective roles in the international mechanism of what are here designated as primary and secondary fluctuations of the currency, it is important to take note of the assumptions of the writers as to the kinds of means of payment comprised in the currency system. In the earliest expositions of the international mechanism, such as those of Hume and his predecessors, the analysis was as a rule carried on in terms of a simple specie currency, where there could be only primary expansion or contraction, and analysis in these terms continued to be common, both among the writers of the classical period and to the present day, when the objective was a simple and concise formulation with emphasis on other than the banking aspects of the mechanism. The further back in time we go, therefore, the greater the stress on primary fluctuations, with secondary fluctuations often left completely unmentioned. Systematic analysis of the international mechanism in terms of the role of fluctuations in the non-specie as well as in the specie elements of the currency began only1 with the bullionists, including Ricardo. The bullionists commonly, though not universally, failed to give attention to deposits as a part of the national stock of means of payment, but their discussion of the mechanism under a metallic standard was expounded in terms of a predominantly paper circulation, with fractional specie reserves generally assumed to be maintained at a constant ratio of the total circulation. The bullionists therefore held that under a metallic standard specie movements would be accompanied by absolutely greater fluctuations in the amount of the total (specie and note). circulation, i.e., that, in the terminology here used, both primary and secondary fluctuations in the currency, in the same direction, were a part of the international mechanism. Later, the currency school held that: (1) in the absence of statutory regulation the relation between the short-run fluctuations in the total (specie and note) circulation and the fluctuations in specie was a variable one as to both direction and degree and subject to the caprice of the Bank of England; (2) the proper relationship was one in which the fluctuations in total (specie and note) circulation would be in the same direction as and absolutely equal to the fluctuations in the national stock of specie, i.e., there should be no secondary expansion or contraction through the medium of note issue; and (3) this rule would be violated if the Bank allowed an external drain of gold to operate, in part or in whole, on the amount of its deposit liabilities instead of on the amount of its note circulation. The currency school thus called for the same relationship between fluctuations in total note circulation, on the one hand, and fluctuations in specie reserves, on the other, which the Palmer rule required for fluctuations in total note and deposit circulation, on the one hand, and fluctuations in specie reserves, on the other hand. Since ordinarily, in case of an outflow of specie, if the Bank remained passive the primary contraction would be divided between the note circulation and the deposits, the currency school, and the Bank Act of 1844, in effect insisted upon a procedure which would require the Bank to support primary contraction by additional secondary contraction, whereas the Palmer rule called only for primary contraction. The banking school, on the other hand, held that it was possible for the Bank, without violating the currency principle or the Bank Act of 1844, to offset a primary contraction through the note issue by a secondary expansion through the deposits, so that the total stock of means of payment could still fluctuate differently in degree, and even in direction, from the total stock of specie, a position theoretically valid if the contention of the banking school be granted that the proportions of payments by notes and payments by checks could be freely varied by the banking system or by the public to counteract the restrictions on the amount of note issue.

Some recent writers have interpreted the classical doctrine as wholly overlooking what is here designated as primary fluctuations and as assigning to secondary fluctuations alone a direct role in the international mechanism. This interpretation appears to rest on the notion that the older writers regarded specie flows into or out of the reserves of the banks as having no effect on the total circulating medium except as, by affecting the reserve status of the banks, they induced the banks to expand or contract their loans, or, in other words, to engage in secondary expansion or contraction. In fact, however, the writers of the first half of the nineteenth century tended, as has been argued above, to over-emphasize the role of primary fluctuations in the mechanism and to ignore or minimize the role of supporting secondary expansion or contraction, and, except in the case of the banking school, this was especially true for secondary fluctuations which took the form of fluctuations in the amount of deposits. That writers of the period explicitly recognized that flows of specie into or out of the banks constituted direct changes in the amount of the national stock of means of payment when the banks acquired specie through the surrender of notes or deposits or surrendered specie in exchange for notes or checks on deposits, the following citations should suffice to demonstrate:

If, during the prevalence of an unfavorable foreign exchange, the balances [of London bankers with the Bank of England] are reduced by cheques drawn upon the Bank, and finally by payments in gold, for exportation, then—unless the bankers themselves export the gold on their own account, which seldom or never happens—the balances due to their various depositors, and consequently the quantity of money in the metropolis, is as effectually reduced as if the outstanding notes of the Bank were reduced by the redemption of securities in its possession, and the bankers' deposits at the Bank to remain unaltered.

On the other hand, during the prevalence of a favorable foreign exchange, and the consequent influx of gold from abroad, whether the imported gold is held by the bankers, or placed by them in deposit at the Bank, the quantity of money in the metropolis is as effectually increased as it would be if the Bank of England were to give notes in exchange for the gold.2

... let us assume ... that the bank, while holding £1,000,000 in coin, discounts bills and opens cash credits to the amount of £2,000,000. Now it is evident that in this case the 1,000,000 sovereigns deposited with the bank perform a double function. They constitute a money-in-hand power of purchasing, as regards the original depositors, who may draw them out on demand [i.e., primary expansion], and they form the basis of the credit-power of purchasing, which the holding of them enables the banker to extend to the customers to whom he grants discounts and cash credits [i.e., secondary expansion].3

[In case of a crop failure] the first import of provisions would very probably be paid for in bullion. I will assume that it is paid for at once, to the extent of £4,000,000; the effect of that is, that £4,000,000 of notes are canceled; the money of this country is diminished £4,000,000 in amount.4

In the earlier literature on the international mechanism there is one element of doctrine which does appear to give some semblance of validity to the interpretation of the classical school doctrines as ignoring the primary phase of the fluctuations in the currency resulting from specie movements, namely, the “hoards” doctrine of Fullarton, Tooke, and their followers, including, with qualifications, John Stuart Mill. These writers held that gold drains ordinarily come out of the hoards, consisting mainly of banking reserves, rather than out of the active coin or note circulation, and that the specie may be more largely withdrawn through checks on deposits than by presentation of notes for conversion into gold. It is by no means clear, however, that by their hoards doctrine these writers intended to deny that specie movements ordinarily involved corresponding primary fluctuations in notes and deposits combined. J. S. Mill did, at one point, state that if the Bank of England kept adequate specie reserves a temporary gold drain could be met from these reserves without involving a “contraction either of credit or of the circulation.” 5 But as I understand the context, what Mill had in mind was that if the Bank had adequate reserves it would be in a position to permit gold to go out by way of its deposits without either a reduction in its note circulation or a reduction in its “credit” or the amount of its loans and investments, i.e., that while a gold outflow would under these circumstances involve a primary contraction of the deposits it would not be necessary to make it result also in a secondary contraction of the notes or deposits. Fullarton also does not seem to have intended to deny that an inflow of gold into the Bank's reserves would constitute, or involve, a corresponding primary expansion of the circulation;6 what he claimed was that this primary expansion would, or might, soon thereafter be offset by a counter secondary contraction.7

It was the later rather than the earlier, or classical, writers who tended to neglect the primary fluctuation phase. The growth of deposit banking in England resulted in a rapid growth of the ratio of bank money to specie, and in the latter half of the nineteenth century the total specie reserves appear always to have constituted less than five per cent of the total note and deposit liabilities to the public of the English banking system. Under these circumstances the primary effects of specie movements on the amount of the national stock of means of payment, unless they were of highly abnormal magnitude, could not be an important factor in maintaining international equilibrium, and it would be the supporting secondary expansion or contraction of means of payment which would bear the main responsibility for keeping or restoring an even balance of payments. There resulted from these conditions a natural tendency for writers to pass over lightly or even wholly to ignore the primary effects of specie movements on the size of the national stock of means of payment, and to lay sole or main emphasis upon the secondary expansion or contraction induced by changes in the specie reserve position of the banking system.

The following passage from Sidgwick presents an early and unusually clear instance of total omission of—and therefore at least an implied denial of the operation of—the primary effects of specie movements:8

An increased supply of gold ... tends ultimately to lower the purchasing power of money relatively to commodities generally; but, in the first stage of the process that leads to this result, the increment of coin—or in England of notes representing the new gold in the issue department of the Bank—must pass through the hands of bankers,9 and so increase the amount of the medium of exchange that they have to lend. Hence the price paid for the use of money will tend to fall, and this fall to cause increased borrowing, and consequent extended use of the medium of exchange; and then through the resulting rise in prices generally, the greater part of the new coin or bank-notes will gradually pass into ordinary circulation. Thus the fall in the purchasing power of money, consequent on an influx of gold, will normally establish itself through an antecedent and connected fall in the value of the use of money.

In most modern expositions of the international mechanism, both English and American, the primary effects of specie movements are similarly left unmentioned, or by implication denied. Explicit denial of the role of primary fluctuations, however, appears to be about as rare as explicit recognition of their role. Laughlin expressly denied that specie flowing into bank reserves would operate to raise prices if it did not result in increased bank loans,10 and Whitaker agreed with him on this point, but claimed that the inflow of specie would result in an increase in bank loans.11 Marshall, on the other hand, apparently alone among modern writers until very recently, mentioned specifically both the primary fluctuation and the secondary fluctuation of the mechanism. He pointed out that while for England with its low ratio of specie to bank money the primary phase was unimportant, this might not be true for other countries where the actually circulating medium still consisted in large part of specie:

England is, in my opinion, but I speak with great diffidence, a specially bad example for India to follow in matters of currency. For, first, currency is but a small part of the means of payment used in England; and under most, though not all, conditions, bank money is the main means of payment; and that is elastic. Secondly, an imperative demand for increased currency is rare in England; and, when it does occur, it is on a very small scale relatively to England's total business and resources. The importation of the amount of ten millions of sovereigns makes an enormous difference in Lombard Street, but it is a mere nothing relatively to England's total business. Whereas, if the same difficulty arises in a country in which the main payments have to be made with currency itself, you want an importation of currency, or an increase of currency, standing in some moderately high relation to the total business of the country....12

The following passage from Henry Seager seems to indicate recognition by him of both primary and secondary phases of the gold-flow mechanism:

Suppose ... that the importation of gold has been induced by the low prices at which commodities are being sold in the importing country. Such importation will before long itself cause prices to rise, there being more money to serve as a medium of exchange than before, while the withdrawal of gold from other countries will in time cause their prices to fall. These results will follow the more promptly because ordinarily the new gold will find its way into bank reserves and will add to the use of credit as a medium of exchange much more largely than it adds to the country's supply of standard money. In the same way its exportation will serve ordinarily to deplete bank reserves and to cause a contraction of credit that will lessen the supply of media of exchange by much more than the amount of gold lost.13

[1]Cf., however, Isaac Gervaise's treatment of “credit,” in 1720, supra, p. 81.

[2]James Pennington, in a letter published in Tooke, A History of Prices, II (1838), 377-78.

[3]Torrens, Reply to the objections of the Westminster review, 1844, p. 12.

[4]The evidence, given by Lord Overstone, before the Select Committee ... of 1857, 1858, p. 181.

[5]Principles, Ashley ed., p. 670.

[6]Cf. On the regulation of currencies, 2d ed., 1845, p. 78: “for every ounce of gold received into the Bank of England, a corresponding weight in coin, or an equivalent in bank-notes [or in deposits?], is issued to the public.”

[7]Cf. ibid., p. 79: “The Bank meanwhile will have its notes flowing in fast, in payment of the bills of exchange previously in its hands, as they successively become due, while there will be no vent for its notes in fresh discounts; and the result of the whole will be, that, at the end perhaps of a week, the Bank will find itself with a million more of coin in its coffers, and a million less of securities.” (I.e., the primary expansion of £1,000,000 would, after a week, be offset by a secondary contraction of £1,000,000.)

[8]Henry Sidgwick, The principles of political economy, 1st ed., 1883, p. 265. The same passage appears unchanged in the later editions.

[9]Angell comments on this passage: “No particular proof is offered to show why this is necessarily so. What we should now call the ‘direct’ effects of influxes of gold are rather passed by; that is, the effects proceeding from outlays by the gold importers themselves, other than through the mediation of the banks.” (Theory of international prices, p. 118, note.) This seems to be recognition of the omission by Sidgwick of what I call the “primary expansion” phase of the mechanism. But Angell comments on the passage as a whole, apparently with reference to Sidgwick's recognition of the role of interest rate fluctuations in the mechanism, that “it is at once apparent ... that we have here something quite new in English theory.” (Ibid., p. 118.) As has been shown above, however, recognition of the part played by interest rate fluctuations was common during the currency controversies earlier in the century.

[10]J. L. Laughlin, Principles of money, 1903, p. 387.

[11]A. C. Whitaker, “The Ricardian theory of gold movements,” Quarterly journal of economics, XVIII (1904), 241ff.

[12]Alfred Marshall, “Evidence before the Indian Currency Committee” [1899], reprinted in Official papers by Alfred Marshall, 1926, p. 282. (“Currency” is to be interpreted here as specie.) Cf. also ibid., Money credit & commerce, 1923, p. 229.

[13]Principles of economics, 1913, p. 370.