Front Page Titles (by Subject) CHAPTER 6: RISING PRICES AND THE STANDARD - Economics, vol. 2: Modern Economic Problems
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CHAPTER 6: RISING PRICES AND THE STANDARD - Frank A. Fetter, Economics, vol. 2: Modern Economic Problems 
Economics, vol. 2: Modern Economic Problems, 2nd edition, revised (New York: The Century Co., 1923).
Part of: Economics, 2 vols.
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RISING PRICES AND THE STANDARD
§ 1. Rising prices, 1896-1913. § 2. Rising prices in Europe, 1914-1920. § 3. Causes of European inflation. § 4. Gold stocks of belligerents. § 5. Redistribution of European gold stocks. § 6. The flood of gold to America, 1915-1917. § 7. The gold embargo in the United States. § 8. Gold depreciation and gold production. § 9. The high cost of living, 1919-1920. § 10. Various ideal standards suggested. § 11. The tabular or multiple standard. § 12. Fluctuating standard and the interest rate.
§ 1. Rising prices, 1896-1913. The free-silver advocates got what they desired, a reversal of the movement of general prices, through an occurrence for which no political party could justly claim the credit. In 1883 the gold production of the world was less than $100,000,000. From that date, with the opening of new gold-yielding territory in South Africa and in the Klondike, the annual output of gold had been increasing rapidly and almost steadily. The methods of extracting gold theretofore had still been in large part of a primitive sort. But intricate machinery was taking the place of crude tools, chemical processes had been introduced (notably the cyanide process), and the principal product began to come from the regular and certain working of deep mines rather than from chance surface discoveries. In many parts of the world there were enormous deposits of low-grade ores, before useless, that could be worked economically by the new methods. It is noteworthy that the very year 1896, which marked the height of the political agitation to abandon the gold standard for silver, saw the gold production for the first time in all history surpass the $200,000,000 mark. The gold output had not only caught up with, but had begun to surpass, the normal monetary demands of the world, meaning by that phrase the amount of gold needed to maintain a stationary level of prices.
A study of Figure 1, chapter 6, will help to an appreciation of the enormous increase in the world’s production of gold after 1850. The production of gold from the discovery of America to 1850 doubtless was much greater than it had ever been in any equal period. But this amount was duplicated in the next quarter of a century, again duplicated in the next twenty-five years, and more than doubled in the following eighteen years. The annual average output in the 357 years ending 1850 was $8,700,000, in the quarter century following 1850 was $124,000,000, from 1876 to 1900 was $140,000,000, and from 1901-1918 was $405,000,000.
The whole character of the monetary problem was changed. A period of rising prices set in, as is shown graphically in Figure 2, chapter 6. By 1913 prices had risen just about 50 per cent above the low level of 1896. The rise was at the average rate of nearly 3 per cent each year. This caused a reversal of the former positions of advantage and disadvantage on the part of debtor and creditor respectively. The burden of the average debt began relatively to decrease. A wide field for enterprisers’ profits was opened up by the rapid displacement of prevailing prices in all quarters of the industrial world. The price of manufacturers’ products rose in advance of the rise of costs of many raw materials and especially of the labor costs of manufacture. The average enterpriser’s gain was the average wage-worker’s loss. Wages (and salaries), as nearly always in the case of a change of price levels, moved more slowly than did the prices of most of the commodities that are bought with wages, thus causing great hardship to large classes living on comparatively slowly moving incomes.1 Extremes meet, and these classes include both those living on passive investments and those dependent on their daily labor for a livelihood.
§ 2. Rising prices in Europe, 1914-1920. The year 1913, the last before the outbreak of the World War, marks a new era in price history, and is now usually taken as the base from which are measured in the various countries the remarkable series of price changes that followed. The year 1914 was one in which the political outlook was disquieting, and the European state banks and treasuries were quietly building up their gold reserves to meet possible emergencies, thus contracting the circulation. The annual average index numbers in all the leading countries were nearly the same in 1914 as in 1913.
In the warring countries, however, wholesale prices began at once in August to rise rapidly, attaining in the last quarter of 1914 the figure of 107 in France and 108 in Great Britain. Retail price changes in every country lagged behind the wholesale, not infrequently being retarded a year or more. This rise of prices continued, with hardly an interruption, in all countries, reaching the maximum about the middle of 1920.
In the United States prices fell quickly to 98 in the last quarter of 1914, as gold was clamorously (and foolishly) demanded by European bankers, and a brief financial panic occurred. But the average of prices continued in the United States almost stationary until the last quarter of 1915 (that is, about one year after the war began in Europe), when they began to rise sharply, for reasons that will be indicated in the next section. The changes are shown graphically in Figures 3 and 4, Chapter 6.
§ 3. Causes of European inflation. Changes in index numbers reflect changes in the relation of the quantity of goods to be exchanged, expressed in their prices, and the quantity of money used in exchanging them. Therefore the explanation of any particular rise in the price level may be found in the factor of goods, (a) in a reduction of their amount or (b) a lessened need to exchange them by means of money; or may be found in the factor of money, (x) in an increase in the amount of money or (y) in an increased use of substitutes for money, such as banking credit. At the outbreak of the war the popular explanation of rising prices is the lack of goods—that is, (a). Attention is drawn dramatically to the number of men taken out of industry to go into war service, at the front or behind the lines. But these comprise only a small percentage of the total population; their places are in large part taken by women and by older men, inspired by patriotic motives, and the exercise of war-time economies largely reduces the demand for many kinds of goods.
Factor (b) doubtless has some validity: withdrawing men from ordinary industry, where they receive wages in money and spend it in retail purchases, and putting them into the army, where their food, clothing, and other wants, are supplied by the government, reduces the monetary demand of the community. At the same time, the use by the government, factor (y), of the facilities of the banks in its war purchases reduces the field within which money is required in war-time as compared with ordinary peace-time business.
Much the larger part of the explanation sought is to be found in (x). Immediately on the outbreak of war all the warring countries began to issue paper money, usually through the agency of their central state banks. They continued to issue it in larger and larger amounts not only until the armistice in November, 1918, but, under the pressure of financial need, after the armistice. Even England and France, whose prices were already up to 235 and 330, respectively, at the armistice (on the basis of 1913 prices), each increased their note issues about 130 per cent. between the armistice and the middle of 1920. The effect is seen in the mounting price curves. Though it is impossible to estimate exactly the amount of paper money issued, because of different agencies, governmental and banking, through which it was done, the rise in prices probably fell short of the paper money inflation; but it must be considered that this was in part offset by the complete withdrawal of gold and silver from circulation.
§ 4. Gold stocks of belligerents. The depreciation of the paper currency was not due to the absence of gold in these countries. They all alike made strenuous efforts to impound in their central treasuries all the gold that was in the countries. A strong patriotic appeal was made to all citizens. Some gold that had been in circulation was exchanged for paper issued by the banks; in many cases old coins that had been hoarded for generations (as is not uncommon in Europe), and therefore having no more effect on prices than so much gold in the earth, were brought out of hiding and into the banks. Family plate, ornaments, and jewelry were brought to the mints, were melted and assayed, the owners not only being paid in bank-notes, but receiving certificates of patriotic service, and often, besides, some valued privilege, such as that of driving a nail into the Hindenburg wooden statue in Berlin. This process of getting gold has been called “mining it out of the pockets of the people.”
The total gold held by all European banks and state treasuries between 1914 and 1919 increased every year (excepting in 1916). Most of this increase took place in the neutral countries, notably Spain, Holland, and the Scandinavian countries, to which it was shipped to pay for war supplies. But France and Italy nearly held their own, and England and Germany each largely increased their gold stocks. Russia and Austria, however, lost a large part of their gold stocks, Russia by export to buy goods under the Bolshevik régime, and Austria by forced deposit with Germany as a condition of financial assistance.
§ 5. Redistribution of European gold stocks. The net gain of gold, expressed in terms of American dollars, in leading European banks and central treasuries was approximately as follows (not including Russia, the data for which are uncertain):
Classified by groups of countries,2 it appears that in the war period the Central Empires gained net about 6 per cent (Austria losing nearly all and Germany more than doubling its stock), the Allies (England, France, and Italy) gained net 28 per cent (France and Italy, which had large stocks at the beginning, losing little, and England, which had a small stock, more than trebling), and European neutrals gained net 66 per cent, of which Spain got $338,000,000, Holland $216,000,000, the Scandinavian countries $102,000,000, and Switzerland $47,000,000 value.
It is apparent that the gold that was collected by the belligerents did not, as it is often assumed, serve “to support” the value of the paper money which had been issued in excess. Indeed, it may be said that it did not in the least so serve. What it did do was to give to these countries a valuable exportable commodity to exchange with neutrals for much-needed supplies of goods, and to afford the readiest of assets for post-war financing. Error will be avoided by clearly recognizing that these European stocks of gold had ceased to be money for domestic purposes, and that their essential use was to be found only in international trade as long as specie payments were suspended.
§ 6. The flood of gold to America 1915-1917. The United States lost some gold to Europe in the first months of the war; but thereafter, while it remained neutral, it received large quantities of gold from Europe. In the first month of the war, August, 1914, and increasingly in the following months, contracts for food and supplies of all kinds were placed in America by European countries, and soon a large and steadily swelling stream of exports was moving toward Europe. The Central Empires were prevented by the Allied blockade from getting many of these goods directly, but large amounts got into Germany and Austria through bordering neutral countries, which profited greatly by this trade. As England and France accumulated rapidly large debits in America, they not only floated loans of various kinds to satisfy these for the time, but also shipped here gold in unprecedented amounts. For two years our gold stock had been almost unchanging; but between July 1, 1915, and the end of June, 1917, the net increase of gold stocks in the United States was about one and a quarter billion dollars—a veritable “flood of gold” borne upon which prices rapidly rose.
This inflow continued until after our entry into the war (in April, 1917), when our large loans to the Allies reduced their need of sending us gold, and at the same time our increasing purchases from Spain, South America, and Asiatic countries made some net exports of gold necessary, first in May, and then after June in increasing amount. The movement of gold by years is shown graphically in Figure 5, chapter 6.
§ 7. The gold embargo in the United States. Moved by mistaken fear, the Federal Reserve Board imposed an embargo on the export of gold (made its export illegal). This policy of gold-fetichism, which remained in force from September, 1917, to June, 1919, involved a deplorable lapse from sound monetary principles. The gold embargo had the evil effect of introducing into conditions already bad, a new and artificial element of inflation. However, trade conditions were such that the general world balance of gold payments would, on the whole, have been little away from America, otherwise the embargo would have been still more difficult to enforce. As far as it was enforceable (which it was probably, for the time, in large part), the embargo could have only the evil effects of disrupting the exchange rates (as it did) with countries to which we had international balances, notably Argentine, Spain, and Japan. Indeed, in principle, it is suspension of specie payments in international trade, and this is an abandonment of the international gold standard. Our exchanges with a few foreign countries that were selling us largely were thrown into disorder. In the twenty-month period of the embargo, our net loss of gold was only $5,000,000. Just as the embargo was removed these conditions were already changing. In the next ten months (June 1, 1919, to April 1, 1920) our net exports of gold were more than $400,000,000, which served to restore the value of the dollar in those countries where it had depreciated. Then, again, after a few months of fluctuating balances, began, in September, 1920, a new flood of gold to the United States, which by the end of May, 1921, amounted to more than $480,000,000. The exports of gold from the United States between November, 1918, and August, 1920, have gone largely to Japan, China, British India, Hongkong, Spain, Argentine, and Mexico. Imports since September, 1920, however, have been largely sent by England, France, Sweden, and Canada, not merely to pay their trade balances, but because the United States has become the most important free gold market in the world, and “dollar exchange,” the best international currency, is eagerly desired by producers and owners of gold everywhere.
§ 8. Gold depreciation and gold production. In explanation of the changes in price levels in the various countries, a distinction should be made between gold depreciation and paper depreciation—or, otherwise expressed, between gold inflation and paper-money inflation. The one expression refers to the value of gold in terms of goods, the other to paper prices expressed in gold. In the United States (except during the embargo, to a slight degree) and several other countries gold has continued to be the standard money in international trade, and the rising index number has reflected a real fall in the purchasing power of gold. The main reasons for this are: (1) the transfer of large amounts of gold from the countries where for the time being it has been in fact demonetized, to the countries still maintaining the gold standard; our own gold stock in two years increased by the amount of the world’s total production for three years; (2) the increased use of banking credit under the Federal Reserve system has enabled an equal amount of gold to perform more monetary services; and (3) the world’s production of gold, which reached its highest peak in 1915, continued, relative to the narrowed field of its monetary uses, to be larger until 1920 than it had ever before been in history. This is shown in Figure 6, chapter 6.
Higher prices in terms of gold mean higher wages, higher costs for machinery and supplies, in short, higher costs of every kind in gold-mining. Many mines formerly profitable must be abandoned, one after the other, until the costs of mining on the marginal mines are brought into accord with the value of the gold produced. The folly, at such a time, of proposals for governmental subsidies and bonuses to gold-mining to keep up the quantity of gold ought to be apparent to any one with the most elemetary understanding of monetary principles. Yet such a proposal was presented in a bill in Congress, and strongly supported, as it was said, “to aid us to maintain the gold standard.”
The increase of index numbers in countries with paper currencies is in every case greater than that in gold-standard countries. The difference measures, pretty exactly, reciprocally the depreciation of the paper in terms of gold, and the abnormal rise of foreign exchange rates.
§ 9. The high cost of living, 1919-1920. The curve of general wholesale prices that began to rise in the United States about July, 1915, reached its peak in May, 1920, at a point 172 per cent above the level maintained from 1913 to June, 1915. Retail prices (estimated as “cost of living” on a standard family budget) followed on the up-swing, but, as usual, lagged behind, reaching a maximum in the middle of 1920, a little more than 100 per cent above the 1913-15 level. A very large part of this increase both of wholesale and of retail prices occurred in the post-war period of great speculation between March, 1919, and May, 1920. This movement was world-wide, as the result partly of great increases of paper money and bank credits, in the European countries, necessary because of the desperate state of their finances, and needlessly assisted in America by those having ultimate authority in the Federal Reserve system. Prices ran the usual course as a financial crisis approached, goods being bought and contracts made with borrowed funds in the hope of a further rise of prices. It was for many a veritable financial joy-ride.
Such a rapid rise affected different classes of persons in business and different classes of goods very unequally. Cases of extravagant expenditures (relative to former standards) were conspicuous in working class circles, where wages rose faster than the cost of living, and among the newly-rich employers who had “profiteered” in the war and the post-war period of speculation. Less conspicuously, great numbers of wage-earners and salaried and professional workers felt keenly and suffered greatly from the higher cost of living (popularly denominated the H. C. L.). The different elements in the cost of living moved at various rates, as is shown in Figure 8, chapter 6.
Among the industries that profiteered most for the time were those engaged in producing clothing, furniture, and food, including nearly all agricultural products. Among those that were losers in the purchasing power of their incomes were many active enterprisers whose products rose in price more slowly than the average (or than their wage bills and other costs) and all public utilities fixed by charter or controlled by price-fixing commissions. Many railroads, trolley lines, gas and electric companies were brought to the verge of bankruptcy or beyond.
§ 10. Various ideal standards suggested. Price history since 1873, however varied, teaches one lesson clearly: that our “standard” unit of price has in fact been subject to great fluctuations in its value. We escape the evils of a rising standard of deferred payments (falling prices) only to meet those of a falling standard (rising prices). And as long as we have so fluctuating a standard these difficulties must arise again and again, continually repeated, causing unmerited gains and undeserved losses to individuals. But what standard would be better than that of gold? It may, perhaps, be agreed that the ideal standard of deferred payments is one that would insure justice between borrower and lender. Yet different views may be and have been taken as to what constitutes justice in this matter. The suggestion is attractive that repayment should involve the return of enjoyment equal to that which could be purchased with the sum at the time of the loan. Such a standard is impossible of perfect realization in any general way, for men’s circumstances are constantly changing. To insure even to the average man the same amount of enjoyment is only roughly possible. The same goods do not afford the same enjoyment when conditions, either subjective or objective, have changed. Another suggestion is that the goods returned should represent the same sacrifice as those lent. Here again the difficulty is in the lack of a standard applicable to all men. Whose sacrifice? That of the lender, who may be rich, or that of the borrower, who may be poor? Some have supposed that the condition of equal sacrifices was met by the labor standard, according to which the sum returned should purchase the same number of days of labor as when borrowed. But what kind of labor is to be taken, that of the lender, or that of the borrower, or that of some one else? Labor is of many different qualities, which can be exactly compared only through their objective value in terms of some one good.3
It must be recognized that any possible concrete standard of deferred payments will sometimes work hardship in individual cases. The best average results for justice and social welfare will be secured by measuring debts in some standard that will change least often, and least rapidly, in relation to the great majority of people of all classes in the community.
§ 11. The tabular or multiple standard. Gold is the best standard yet devised and put into actual practice, but it is very imperfect. A standard better than a single metal, more stable than a single commodity, is desirable if it can be found. Apart from the difficulties of its practical operation, such a standard would be a tabular standard, consisting of a number of leading commodities in fixed proportions, such as is used in calculating index numbers expressing the general scale of prices. This averages the fluctuations of particular goods and would give a fair approximation in practice to the ideals of equal sacrifice and equal enjoyment (on the average, though not in individual cases). While some natural materials are growing more scarce and call for more sacrifice, other products are by industrial progress becoming more plentiful. This kind of standard has been viewed with favor by many monetary authorities, and, despite the administrative difficulties, ways may yet be found for putting it into practice.
After choosing the components of the multiple standard, the actual regulation of the quantity of money to make prices conform to the standard might be accomplished in one of several ways. It might be done by letting the value of the gold dollar fluctuate as it does now, while requiring a greater or less number of dollars to be given in fulfillment of all outstanding contracts. For example, if prices by the multiple standard fell from 100 to 95 in the time between the origin of a debt of $100 and its payment, the debt would be discharged by paying $95; if prices rose to $110, the debt would be discharged only by the payment of $110.
Another plan is that of a “compensated gold dollar.” By this plan the legal weight of gold coins would be increased or decreased from time to time to conform with the changing index numbers. Still a third method would be to regulate the issue of standard paper money, contracting and expanding its amount by issue and redemption, by deposit in and withdrawal from depository banks, at regular intervals to bring prices into conformity with the tabular standard. These are as yet but distant possibilities, and for some time to come gold will continue to serve as the standard money in the same manner as in the past.
§ 12. Fluctuating standard and the interest rate. In connection with the standard of deferred payments there is presented a problem of the effect that fluctuations of the standard may have upon the interest rate.4 As the general price level falls or rises, the monetary standard conversely appreciates or depreciates.5 If these changes are slight in amount and imperceptible in their direction they may not affect considerably the motives of borrowers and lenders. Therefore, the rate of interest this year in long-time loans would be just that resulting from the expectation, on all hands, of a stationary level of general prices. Suppose that rate to be 5 per cent on the standard investment (such as real-estate loans and good bonds). Then the lender of $1000 will receive each year a $50 income and at the end of the investment period $1000 principal, each dollar of which will purchase the same composite quantum of goods that a dollar would have purchased at the time the loan was made. Likewise, the borrower would pay interest and principal in a standard that reflected an unchanging general level of prices. But, now, if the general level of prices unexpectedly falls 1 per cent within the year, the creditor of a loan maturing at the end of the year would receive (principal and interest) $1050, which will purchase 1 per cent more goods per dollar than the sum he lent, or (approximately) $1060 worth of goods. Hence, he has received, in quantum of goods, a yield of 6 per cent on his investment. If this change continues for five years, the lender of a five-year loan would receive each year $50, having a purchasing power successively 1, 2, 3, 4, and 5 per cent greater than the same sum had at the making of the loan; and at the end of the five years would collect the principal, having a purchasing power 5 per cent greater. The borrower, on his part, would have to pay interest and repay the principal in a money that is to be obtained only in exchange for a larger sum of goods than that which could be bought with each dollar that he borrowed. This means that, with individual exceptions, creditors generally gain and debtors lose by falling prices.
But this is fully true only in respect to loans already made. For, just to the extent that such a movement of prices comes to be more or less regularly in the same direction, both borrowers and lenders are able to take it into account, and, as experience shows, do take it into account.6 When prices fall men become more eager to sell wealth, to lend the proceeds, and more reluctant to borrow for investment at the prevailing rate of interest and at the prevailing prices. There is an incentive to divest one’s self of ownership (e.g., by selling stocks) and to become a lender (e.g., by buying bonds). This whole situation is reversed in a period of rising prices. The result is that the rate of interest in any long-continued period of falling prices (such as from 1873 to 1896) has a trend downward and in a period of rising prices (such as from 1897 to 1915) has a trend upward. This movement of readjustment would not go on indefinitely, even if the same trend of prices continued; for in the strict theory of the case the adjustment would be complete when the interest rate had changed by just the amount of the annual change in the level of prices. For example, if 5 per cent is the static normal rate of interest, then when prices are falling 1 per cent each year, the adjusted rate of interest would be 4 per cent; and when prices were rising 1 per cent each year, the adjusted rate of interest would be 6 per cent. Such adjustments serve to some extent to neutralize the effects of changes in the standard of deferred payments as far as concerns new loans made in view of just such a change and in expectation of its continuance. But no one can foresee exactly, and most persons take little account of, such a change until it has continued for several years in the same direction. The adjustment is therefore never very prompt or very exact. In some years the general level of prices has risen more than 5 per cent, or more than enough to offset the entire interest received by most lenders. The principal and interest combined have no greater purchasing power at the end of the period than the principal alone had at the beginning of it. It is the same as if the dollars had been buried during a period of stationary prices.7
BANKING AND INSURANCE
[1 ]This happened to coincide with a relative increase of the prices of food-products and of other necessities of daily life at a greater rate than general prices. This aspect of the much-discussed rising cost of living must be carefully distinguished from that of the change of the general price level, and also from that of the relatively slower change of wages. See Vol. I, pp. 437, 445-446 on population and food supply.
[2 ]These figures are from a different source; the relatively small discrepancy in the total does not necessarily indicate an error, but a slight difference in the data, or the inclusion of some minor countries in the figures.
[3 ]See on the labor theory of value, Vol. I, pp. 210, 228-229, 502.
[4 ]This could not be treated in connection with the interest rate in Vol. I, Part IV, for the reason that even its elementary treatment must presuppose the fuller study of the nature of money and the study of changes in the level of prices, that has just been given in this and the three preceding chapters. The theory of interest in Vol. I, therefore, is a static theory in respect to the standard of deferred payments, and requires adjustment to apply to a condition of a changing price level.
[5 ]See ch. 5, § 1.
[6 ]Mention was made in Vol. I, of the prospect of profit as affecting the motives of commercial borrowers; e.g., pp. 298, 335, 348, 495.
[7 ]The modern explanation of this phenomenon was worked out in the period of falling prices before 1896, and hence was referred to as the theory of “appreciation and interest” (meaning the relation of the appreciating dollar to a falling rate of interest). More generally the theory is that of the relation of a changing standard of deferred payments and the rate of interest.