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Jacob Viner, Studies in the Theory of International Trade [1937]

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Jacob Viner, Studies in the Theory of International Trade (New York: Harper and Brothers, 1965).

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About this Title:

A magisterial history of the theory of international trade. Viner shows where economists went wrong and were they were right in the understanding of this idea. Along the way he refutes the fallacies of mercantilism, just as Adam Smith had done in The Wealth of Nations in 1776.

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This material is put online to further the educational goals of Liberty Fund, Inc. Unless otherwise stated in the Copyright Information section above, this material may be used freely for educational and academic purposes. It may not be used in any way for profit.

Table of Contents:

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Also Published in Reprints of Economic Classics

by Jacob Viner

dumping \1923] guide to john rae's live of adam smith \1965]

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JACOB VINER Professor of Economics, University of Chicago
Reprints of Economic Classics
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Library of Congress Catalogue Card Number 60–20928

Printed in the United States of America by Sentry Press, New York, N. Y. 10019

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To F. W. Taussig, Teacher and Friend

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  • Preface xiii
    • I. Introduction 1
    • II.MercantilismandBullionism3
    • III. The Balance-of-Trade Doctrine 6
      • The Concept and Its Application. 6
      • General and Partial Balances. 10
      • Constituent Items in the Balance. 13
    • IV. Reasons for Wanting More Bullion 15
      • The Mercantilist Concept of Wealth. 15
      • State Treasure as an Emergency Reserve. 22
      • The Precious Metals as a Store of Wealth. 26
      • Money as Invested Capital. 31
      • The Analogy from Personal Finance. 32
      • More Money in Order to Have Higher Prices. 33
      • More Money in Circulation Means More Trade. 36
      • The Quantity Theory of Money. 40
      • The Mercantilists on Hoards and Plate. 45
    • V. Employment and the Balance of Trade 51
    • I. Legislative Proposals of Mercantilists 58
      • Introductory. 58
      • Bullionist Proposals. 60
      • Prohibitions vs. Duties. 62
      • Discriminatory Treatment of Domestic Industries. 66
      • The Reexport Trade. 68
      • Export Bounties. 69
      • Infant Industry Protection. 71
      • Mercantilism and Protectionism. 73
    • II. The Collapse of Mercantilist Doctrine 74
      • The Self-regulating Mechanism of Specie Distribution. 74 Edition: current=; Page: [viii]
      • Scarcity of Money. 87
      • Thrift. 90
      • Laissez-Faire and Free Trade. 91
      • International Division of Labor. 103
    • III. Some Modern Interpretations of English Mercantilism 110
    • I. The Participants in the Controversy 119
    • II. The Factual Background 122
    • III. Premium on Bullion as Evidence of Excess Issue: The Bullionist Position 124
    • IV. Qualifications Conceded by the Bullionists 127
    • V. Possible Objections to the Bullionist Position 130
    • VI. The Anti-bullionist Position 136
    • VII. The Balance of Payments Argument 138
    • VIII. The Possibility of Excess Issue by Banks 148
    • IX. Responsibility for the Excess Issue: Bank of England vs. Country Banks 154
    • X. Responsibility for Excess Issue: The Credit Policy of the Bank of England 165
    • I. The Resumption of Cash Payments 171
    • II. Responsibility of Resumption for the Fall in Prices 174
    • III. The Economic Effect of Changing Price Levels 185
    • IV. Ricardo's Position on the Gold Standard 200
    • V. Reform without Departure from the Metallic Standard 203
    • VI. Paper Standard Currencies 209
    • I. Introduction 218
    • II. The “Currency School” -“Banking School” Controversy 220
    • III. The “Palmer Rule” 224
    • IV. The Bank Act of 1844 229
    • V. The Possibility of Overissue of Convertible Bank Notes 234 Edition: current; Page: [ix]
    • VI. The Role of Deposits, Bills of Exchange, and “Credit” in the Currency System 243
    • VII. The Technique of Credit Control 254
      • The Record of the Bank of England 254
      • Variations in Discount Rate vs. Rationing 256
      • Open-Market Operations 257
      • Internal and External Gold Drains 261
      • Adequate Reserves 264
      • Foreign Securities as a Secondary Reserve 270
      • Silver as a Reserve Metal 272
      • Cooperation between Central Banks 273
    • VIII. The Relation Between Bank of England Operations and Specie Movements 276
    • IX. Currency Reform Proposals 280
    • I. Introductory 290
    • II. The Mechanism According to Hume 292
    • III. An Omitted Factor? Relative Changes in Demand as an Equilibrating Force 293
      • Wheatley, Ricardo. 295
      • Longfield, Torrens, Joplin. 297
      • J. S. Mill, Cairnes. 300
      • Bastable, Nicholson. 302
      • Taussig, Wicksell. 304
      • “Canada's Balance.” 305
      • Keynes, Ohlin. 307
    • IV. Prices in the Mechanism: the Concept of “Price Levels” 311
    • V. The “Terms-of-Trade” Concept 319
      • Irish Absenteeism. 320
      • Tariff Changes. 322
    • VI. The Prices of “Domestic” Commodities 323
    • VII. The Mechanism of Transfer of Unilateral Payments in Some Recent Literature 326
    • VIII. A Graphical Examination of Pigou's Analysis 338
    • IX. Some Elaborations on the Basis of Pigou's Analysis 344 Edition: current; Page: [x]
    • X. An Alternative Solution 354
    • XI. Types of Disturbance in International Equilibrium 360
    • XII. Specie Movements and Velocity of Money 365
    • XIII. Commodity Flows and Relative Price Levels 374
    • XIV. Exchange Rates 377
    • XV. A Criticism of the Purchasing-power-parity Theory 379
    • I. Automatic vs. Managed Currencies 388
    • II. Primary and Secondary Expansion of Means of Payments 394
    • III. Short-term Loans in the International Mechanism 403
    • IV. Primary and Secondary Expansion in Canada, 1900–13 413
      • “Canada's Balance.” 413
      • Angell's Criticism of the Account in “Canada's Balance.” 414
      • Angell's Statistical Analysis. 421
      • A Statistical Reexamination of the Canadian Experience. 426
    • V. The International Mechanism and Business Cycles 432
    • I. The Nature and Origin of the Doctrine 437
    • II. The Division of the Gain from Trade 444
      • An Alleged Error in Ricardo. 444
      • Relation of Comparative Costs to the Terms of Trade 446
      • Trade at One of the Limiting Ratios. 448
      • The Possibility of Partial Specialization. 449
    • III. Trade in More Than Two Commodities 453
    • IV. Trade between More than Two Countries 462
    • V. Transportation Costs 467
    • VI. Increasing and Decreasing Costs 470
    • VII. Prices, Money Costs, and Real Costs 483
    • VIII. Dependence of Comparative Cost Doctrine on a Real-Cost Theory of Value 489 Edition: current; Page: [xi]
    • IX. Differences in Wage Rates in Different Occupations 493
    • X. Variable Proportions of the Factors and International Specialization 500
    • XI. Variable Proportions of the Factor and Comparative Real Costs 508
    • XII. “Opportunity Cost” Analysis as a Substitute for Real Cost Analysis 516
    • I.Mass of Commodities” and “Sum of Enjoyments”: Ricardo and Malthus 527
    • II. Reciprocal Demand and the Terms of Trade 535
      • John Stuart Mill. 535
      • Marshall. 541
      • Edgeworth. 546
      • Graham. 548
    • III. Terms of Trade and the Amount of Gain from Trade 555
      • Terms of Trade as an Index of Gain from Trade. 555
      • Different Concepts of Terms of Trade. 558
      • Terms of Trade and the International Division of Gain from Trade. 564
      • Statistical Measurement of the Trend of the Terms of Trade. 565
    • IV.Net Benefit” in International Trade: Marshall 570
    • V. Total Net Utility Derived from International Trade: Edgeworth 576
    • VI. The Gain from Trade Measured in Money 582
      • Marshall's Curves and Monetary Curves. 582
      • Cournot's Theory. 586
      • Barone's Graphical Technique. 589
      • Auspitz and Lieben. 592
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In this book I first endeavor to trace, in a series of studies of the contemporary source-material, the evolution of the modern “orthodox” theory of international trade, from its beginnings in the revolt against English mercantilism in the seventeenth and eighteenth centuries, through the English currency and tariff controversies of the nineteenth century, to its present-day form. I then proceed to a detailed examination of current controversies in the technical literature centering about important propositions of the classical and neo-classical economists relating to the theory of the mechanism of international trade and the theory of gain from trade. The annual flow of literature in this field has become so great in the last few years, and the claims on my time and energy from other unfortunately unavoidable activities of a quite divergent sort have been so heavy, that the completion of this book and the rendering of full justice to the recent literature have proved to be incompatible objectives. I hereby present my sincere apologies to the substantial number of economists who have in recent years made valuable contributions to the theory of international trade which are here either wholly neglected or treated more summarily than they deserve.

This book is not presented as a rival to, or substitute for, the excellent textbooks on the theory of international trade which are at last available. The main contributions of a good textbook are usually its contribution to general synthesis of doctrine, its illustrative material, and its restatement in compact, simplified, and systematic form of materials familiar to scholars. My objectives have been, rather, to resurrect forgotten or overlooked material worthy of resurrection, to trace the origin and development of the doctrines which were later to become familiar, and to examine the claims to acceptance of familiar doctrine. Since, until recent years, it was at first almost solely English writers, and later almost solely English and American writers, who were responsible for the development of the theory along the classical lines, there is but little reference to writings by Continental economists antedating the War. While my main objective in writing this book Edition: current; Page: [xiv] was that it should prove a useful supplement, for both teachers and students, to the textbooks on the theory of international trade, I hope that the extensive discussion of early monetary theories will make it of interest also to students of monetary and banking theory.

Acknowledgments are due to the University of Chicago Press and to the editors and publishers of Weltwirtschaftliches Archiv for their kind permission to include in this book the material which appeared in my articles “English theories of foreign trade before Adam Smith,” Journal of Political Economy, XXXVIII (1930), 249–310, 404–57, and “The doctrine of comparative costs,” Weltwirtschaftliches Archiv, XXXVI (1932, II), 356–414. Both articles, however, and especially the latter, have been substantially revised, recast, and extended, in the process of incorporation in this book.

My heaviest intellectual indebtedness is to Professor F. W. Taussig, who first aroused my interest in the field of international trade as long ago as 1914, who has done much by his writings and oral discussion to sustain it since and to set the mold for my thinking, and to whose teachings I have remained faithful in my imperfect fashion. As a gesture of gratitude in this connection, I have taken the liberty of dedicating the book to him. To Professor Bertil Ohiin's persistent refusal willingly to accept the same mold for his thinking in this field, and to his consequent persistent refusal to agree with me, I am also greatly indebted, for it has forced me repeatedly to think problems through more thoroughly than I would otherwise have done, and to revise—and perhaps even upon occasion to abandon—doctrines to which I was disposed to cling as long as it was still possible to do so without violating the intellectual decencies. I am greatly indebted also to a long line of able and sceptical students, who have pointed out my errors to me in the hope, not always realized, that I would find ways of correcting them. I am especially indebted to the following students, past and present, who have at one time or another accepted the responsibility of assisting me in checking my references, in meeting the physical burden of using libraries, and in keeping my errors of fact and analysis within the accustomed limits of tolerance: Leroy D. Stinebower, Michael L. Hoffman, Virginius F. Coe, Henry J. Wadleigh, Lily M. David, Benjamin F. Brooks, Arthur I. Bloomfield, The charts were drawn Edition: current; Page: [xv] for me by Y. K. Wong, who has once more been patient with my mathematical ineptitude while refusing to make concessions to it. My thanks are due also to the Social Science Research Committee of the University of Chicago, who provided the funds which enabled me to recruit the aid of these students and also furnished the typing facilities.

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All antient or scarce Pieces may justly be esteem'd curious and valuable, either on account of their own intrinsick Perfection, or out of respect to the great Names which they go under or purely on account of their relation to the Times and nice Conjuctures in which they were compos'd: and tho mean and inconsiderable in the stile and manner of writing, in comparison with some modern Composures, may yet deserve to be perpetuated and transmitted to Posterity, if they manifestly discover the Seeds and Principles from which the greatest Events, and perhaps Revolutions in Church and State, have taken their rise. These Characters, singly or all together, have been our Rule in the present Collection.—The Phenix: or, A Revival of Scarce and Valuable Pieces No where to be found but in the Closets of the Curious, II (1708), preface, iii-iv.

I. Introduction

A study of the theories of foreign trade before Adam Smith must of necessity consist of an examination of the mercantilist doctrines with respect to foreign trade and of the contemporary criticisms thereof. It is a common impression that they have already been sufficiently studied, but the economic historians and the economists of the German historical school have been almost alone in studying the mercantilists, and they have generally been more interested in the facts than in the ideas of the mercantilist period, have often based sweeping generalizations as to the character of mercantilist doctrine on what they found in a handful of the mercantilist writings, have displayed neither interest in, nor acquaintance with, modern economic theorizing with respect to monetary and trade process, and have almost without exception shown a tendency to defend the mercantilist doctrines by reasoning itself of decidedly mercantilist flavor. The severe critics of mercantilist doctrine have generally been economic theorists of the Edition: current; Page: [2] English classical-school tradition, and they have usually relied on Adam Smith's account plus the vague mass of nineteenth-century tradition for their information as to the contents of mercantilist doctrine.

The present study, is therefore, primarily an inventory of the English ideas, good and bad, with respect to trade prevalent before Adam Smith, classified and examined in the light of modern monetary and trade theory. Its aim is rather to discover and explain the divergencies of doctrine than to formulate inclusive and simple formulas descriptive of mercantilist doctrine en masse, formulas which are almost necessarily half-truths at best or empty. It is based on a careful study of such of the actual economic literature of the period as was available to me, and its findings will be supported by as much of the evidence derived from that literature, in the form of quotations and references, as space limitations permit.

No attempt will be made to compare in detail the results of this investigation with the findings of other modern commentators on English mercantilism, but those who are sufficiently interested to make such comparisons for themselves will find, I believe, that the differences as to fact and interpretation are numerous and of some importance, and that new information is presented on a number of points.1 To keep the study within manageable proportions, the doctrines of the period with respect to the fisheries, Edition: current; Page: [3] population, and colonies will be ignored even when they are closely related to the general foreign-trade theories.

II. “Mercantilism” and “Bullionism”

In the English economic literature prior to Adam Smith, the most pervasive and the most emphasized doctrine is the importance of having an excess of exports over imports. To this doctrine and the trade regulations which it inspired, Adam Smith, following the usage of some of the Physiocrats,1 gave the name of the “commercial” or “mercantile” system, which later became, with the aid of the Germans, the now familiar “mercantilism.” 2 Many writers, however, assign “mercantilism” only to the period after about 1620, and distinguish with varying degrees of emphasis between the “bullionist” doctrines of the earlier period and the “balance-of-trade” doctrines of the later period. The grounds most commonly given for distinguishing between the two periods are as follows: (1) that, before 1620, stress was put on the importance of a favorable balance in each transaction of each merchant, whereas in the later period the emphasis was on the aggregate or national balance of trade; (2) that, before 1620, concern about the state of the individual balances was due to anxiety that the country's stock of bullion be not reduced, whereas in the later period there was anxiety that it be increased; (3) that, before 1620, the chief economic objective of trade policy was to protect the national currency against exchange depreciation, whereas after 1620 this was a minor objective, if a matter of concern at all; (4) that, in the early period, the means advocated and employed to carry out the objectives of the prevailing trade Edition: current; Page: [4] policy were close regulation of the transactions of particular individuals in the exchange market and in coin and bullion, while in the later period the policy recommended and put into practice was to seek the objective of a greater stock of bullion indirectly by means of regulation of trade rather than directly through restrictions on exchange transactions and on the export of coin and bullion.

The actual course of official policy seems to give no strong support to this chronological contrast between the bullionist and the balance-of-trade doctrines. In the earlier period, it is true, regulation of the foreign trade and exchange transactions of the merchants had been stricter and more detailed than it subsequently became. But the outstanding changes in legislation and in administrative practice extended over a long period, and all of any importance occurred long before 1620 or did not occur until long after. The institution of the Staple, which served as an instrument of regulation of individual transactions, finally expired with the loss of Calais in 1558, although it had already been moribund. The Statutes of Employment, requiring foreign merchants to pay for the English commodities which they bought, in part at least, in coin or bullion, had become inoperative long before the end of the sixteenth century. The Royal Exchanger, with his control over exchange transactions, went out of existence practically, if not legally, when Burleigh, in the reign of Elizabeth, refrained from exercising his prerogative of nominating the holder of the office, although Charles I attempted unsuccessfully to revive the institution as late as 1628. The restrictions on the export of coin and bullion had been relaxed during the reign of Elizabeth. They were more strictly enforced, as far as gold was concerned, in the reign of James I, in accordance with a proclamation of 1603, but even stricter regulations were laid down by Charles I in 1628, and it was not until 1663 that gold and silver bullion and foreign coin could be freely exported, and not until 1819 that English coin or bullion derived therefrom could be legally exported. In other words, the “bullionist” regulations were either repealed or had become obsolete long before 1620, or persisted and even were strengthened long after 1620. Prohibitions and customs duties on imports and exports imposed for trade regulative purposes originated centuries before 1620, and although the customs system was revised during the reign of Edition: current; Page: [5] James I, and again by Walpole in the 1720's, in order that it might more effectively serve the purpose of procuring a favorable balance of trade, it continued until late in the nineteenth century to be a medley of provisions of miscellaneous character serving in unascertainable proportions the largely contradictory purposes of fiscal needs, trade regulation, special privileges to favored individuals or groups, and foreign diplomacy.

If, however, the dividing line be set at about 1560, instead of about 1620, the contrast may be made with respect to actual trade regulation that such devices as the Staple, the Royal Exchanger, and the Statutes of Employment had been important in the first period, and were repealed or permitted to become inoperative in the later stage. For the earlier period also, it can be said that there was much more concern about the menace to the national stock of bullion from the operations of brokers and merchants in paper exchange than there was in the later period, and on this question 1620 serves fairly well as the approximate date at which doctrinal controversy cleared away many of the older illusions about the consequences of unregulated exchange transactions. No attempt will be made here to examine the bullionist reasoning with respect to the exchanges, of which an excellent summary has been given by Tawney.3 In the controversy over the exchanges at the beginning of the seventeenth century, the new views which were expounded chiefly by Misselden and Mun won a definitive victory over the old views as presented by Malynes and Milles, and in the later literature a spokesman for the older views is only rarely to be encountered. Perhaps for the first time, a matter of economic policy was made the occasion for a war of tracts, and the tracts seem, moreover, to have exerted an immediate and traceable influence on government policy. But commentators who have not explored the earlier literature nor examined carefully the later literature have applied to the entire contents of these tracts what was true only, if at all, of their arguments with respect to paper exchanges, and have attributed to Misselden and Mun priority with respect to doctrines which were already old and established and to Malynes and Milles final utterance of doctrines which still had a long life to live.

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III. The Balance-of-Trade Doctrine

The Concept and Its Application.1—The most pervasive feature of the English mercantilist literature was the doctrine that it was vitally important for England that it should have an excess of exports over imports, usually because that was for a country with no gold or silver mines the only way to increase its stock of the precious metals. The doctrine is of early origin, and some of the mercantilists, in the earlier period when it was still customary to scatter miscellaneous tags of classical wisdom through one's discourse, succeeded in finding Latin quotations which seemed to expound it. It was clearly enough stated as far back as 1381 by Richard Leicester, a mint official, in answer to an official inquiry as to the cause of, and remedy for, the supposed drain of gold out of England:

First, as to this that no gold or silver comes into England, but that which is in England is carried beyond the sea, I maintain that it is because the land spends too much in merchandise, as in grocery, mercery and peltry, or wines, red, white and sweet, and also in exchanges made to the Court of Rome in divers ways. Wherefore the remedy seems to me to be that each merchant bringing merchandise into England take out of the commodities of the land as much as his merchandise aforesaid shall amount to; and that none carry gold or silver beyond the sea, as it is ordained by statute.... And so me-seems that the money that is in England will remain, and great quantity of money and bullion will come from the parts beyond the sea.2

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The following citations from sixteenth-century sources show that the doctrine was current throughout that century:

The whole wealth of the realm is for all our rich commodities to get out of all other realms therefor ready money; and after the money is brought in to the whole realm, so shall all people in the realm be made rich therewith.3

But it is an infallible argument that if we send yearly into beyond the seas one hundred thousand pounds worth of wares more than we receive yearly again, then must there needs be brought into this realm for the said hundred thousand pounds worth of wares so much in value either of gold or silver.... The only means to cause much bullion to be brought out of other realms unto the king's mints is to provide that a great quantity of our wares may be carried yearly into beyond the seas and less quantity of their wares be brought hither again.4

... for if England would spend less of foreign commodities, than the same [i.e., English] commodities will pay for, then the remain must of necessity be returned of silver or gold; but if otherwise, then it will fare in England in short time, as it doth with a man of great yearly living that spendeth more yearly than his own revenue and spendeth of the stock besides.5

If we keep within us much of our commodities, [because of heavy duty on wool exports] we must spare many other things that we have now from beyond the seas; for we must always take heed that we buy no more of strangers than we sell them; for so we should impoverish ourselves and enrich them.6

And another [object of policy] is that the things which we carry out do surmount in price the things which we bring in; else shall we soon make a poor land and a poor people.7

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Although the concept of a national balance of trade was already common in the sixteenth century, the exact term itself seems to have first been coined in 1615, when it almost immediately passed into common usage.8 In that year two customs officials, Wolstenholme and Cranfield, were instructed to compute the exports and imports for the two preceding years, in order to ascertain the effect on foreign trade of “Alderman Cockayne's Project” restricting the export of undyed or undressed woolens. The results of their computations are still extant in manuscript, indorsed as follows: “A computation of all merchandises exported and imported into England one year by Mr. Wolstenholme 21 May 1615” and “Sir Lionell Cranfield his balance of trade 21 May 1615.” 9 In the next year, Sir Francis Bacon, who was acquainted in his official capacity with these computations, in his “Advice to Sir George Villiers” wrote as follows:

This realm is much enriched, of late years, by the trade of merchandise which the English drive in foreign parts; and, if it be wisely managed, it must of necessity very much increase the wealth thereof; care being taken, that the exportation exceed in value the importation; for then the balance of trade must of necessity be returned in coin or bullion.10

The first appearance in print of the phrase appears to have been in the title and text of a pamphlet by Misselden published in 1623, The Circle of Commerce, or the Balance of Trade. It is to be found ad nauseam in the subsequent literature. The term was, of course, borrowed from the current terminology of bookkeeping, Edition: current; Page: [9] into which the word “balance” had apparently been incorporated from the Italian about 1600. Prior to 1615, such terms as “overplus,” 11 “remayne,” 12 “overvallue” 13 were used to signify the excess of exports over imports, or vice versa, and Malynes,14 in 1601, and Cotton in 1609,15 used the term “overballancing” for the same purpose. A memorandum of 1564 spoke of exports sufficient “to answer the foreign commodities” to mean exports adequate to balance the imports,16 and John Stow in 1598 used “overplus” and “countervail” for the two meanings of “balance.” 17 Nothing was invented or discovered in 1615 except the precise term “balance of trade.” There is no evidence that when in that year attempts were made to compute the actual balance any person regarded it as the application of a novel idea. Misselden, in 1623, did write of “this balance of trade, an excellent and politic invention, to shew us the difference of weight in the commerce of one kingdom with another,” 18 but what he regarded as novel was not the notion of a balance but its actual measurement in the absence of periodic trade statistics such as those with which we are now familiar. Malynes did criticize Misselden's balance-of-trade argument, but not because the notion of a balance between exports and imports was unfamiliar or objectionable to him, for he had himself stressed the concept years before. What Malynes was criticizing was the overemphasis which Misselden was giving to the mere computation of the actual balance, since “the conceited balance of trade proposed by Misselden, can be but a trial and discovery of the overbalancing of trade, without that it can Edition: current; Page: [10] produce any other benefit to the commonwealth,” 19 and in any case was likely to be highly inaccurate.20

The term “favorable balance of trade” now so common, and so commonly attributed to the mercantilists, seems first to have been used in 1767 by Sir James Steuart,21 although the phrase “balance in our favor” had been used by Cary22 in 1695, Pollexfen in 1697,23 and Mackworth24 in about 1720, and corresponding terms were used by many other writers.25

General and Partial Balances.—There is no historical basis for the distinction which some writers have tried to make between a balance-of-individual-bargains stage and a chronologically later general balance-of-trade stage in the evolution of mercantilist doctrine. Richard Jones coined the phrase “balance-of-bargain” in order to distinguish between means and not ends: “To effect their purposes, they [i.e., the early politicians] adopted a very complicated system, which we may call the balance-of-bargain system; and which, though its object was precisely the same with that of the balance-of-trade system long subsequently established, yet sought to attain that object by very different means.” 26 An influx of bullion resulting from an excess of exports over imports was the common objective both of the earlier and of the later period. To the extent that the methods advocated or actually applied to attain this end differed, it is more accurate to say that the early bullionist regulations dealt directly with the transactions in coin and bullion and foreign exchange, whereas the later customs Edition: current; Page: [11] regulations sought the same results indirectly by regulating the commodity imports and exports. No trace is to be found in the early literature of anything even approaching a theory of the importance of the individual balances except as items in a clearly conceived national balance and it is only as inference from the character of the bullionist regulations that the prevalence of the notion that such a theory was once expounded can be explained.

In some of the modern literature on mercantilism there is to be found an exposition of the evolution of the balance-of-trade doctrine in terms of three chronological stages: first, the individual bargain; then an intermediate stage in which the notion of the balance of trade with particular countries, but not the total balance of trade, had been grasped; and, finally, the emergence of the concept of the national or aggregate balance. This is all the product of vivid imagination. In the seventeenth and eighteenth centuries there was much controversy about the state of the balances with particular countries, but always with reference to their bearing on the aggregate balance. In the seventeenth century the state of the balance in the East India trade was the principal object of controversy in this connection; in the eighteenth century it was the balance with France which gave rise to most misgiving. The East Indian balance was indisputably “unfavorable,” and the East India Company was attacked on this ground. Its spokesmen tried to meet the attack by the contention that, although the balance was immediately unfavorable, the East India trade had indirect effects, such as the reexport at a profit of commodities imported from India and the substitution of imports from India for imports to greater value from other countries, which made its net result, direct and indirect, a favorable instead of an unfavorable contribution to the total national balance.27 It Edition: current; Page: [12] would be difficult to demonstrate such a theory to determined critics, even if it were in accord with the facts, and when this method of argument failed to be effective, the defenders of the company, while still conceding in the abstract that any trade was harmful if it did not contribute, directly or indirectly, to a favorable balance for the country, resorted to questioning the possibility of applying the test with sufficient accuracy to warrant the condemnation of any trade.28 When this argument also failed to subdue criticism, the defenders of the company were finally driven to questioning and even to explicitly rejecting the validity of the balance-of-trade test, however qualified, as a measure of the value of trade.29 But none of the writers on either side of the controversy claimed that the particular balance of trade was to be judged except in terms of its contribution to the total balance, Edition: current; Page: [13] and there was certainly none who argued about particular balances without first having conceived of the notion of a total balance. On this question there was no conflict of doctrine, but only disagreement as to the facts and as to the possibility of ascertaining them.

Constituent Items in the Balance.—The mercantilists have sometimes been charged with failure to see that the international balance does not consist only of commodity exports and imports,30 and many suppose that the “invisible items” are a recent discovery. But most of the important writers of the seventeenth and eighteenth centuries took care to point out that allowance must be made for non-commodity items in explaining the net balance payable in bullion. Reference to an “invisible” item is to be found as far back as 1381, when both Aylesbury and Lincoln explained the drain of gold as due partly to remittances to Rome.31 An early writer argued that if foreign merchants were required to come to England to buy English cloth instead of being permitted to buy it abroad, their living expenses in England would be an item in England's favor.32 Misselden, in 1623, mentioned the profits from the fisheries, reexport trade, and freight earnings as items to be added to the commodity statistics in computing the balance.33 Malynes,34 in the same year, pointed out that interest payments on foreign loans should be included in the balance. Robinson,35 in 1641, included diplomatic expenditures abroad, travelers' expenses, and freight charges. Mun, writing in about the year 1630, listed almost all the items which would be included today: freight earnings, military expenditures abroad, marine insurance payments, gains from fisheries, losses at sea of outward and inward shipments of goods, Catholic remittances to Rome, travelers' expenses, gifts, and the excess over their living expenses in the country for which the balance is being computed of payments to foreigners for exchange commissions, interest, and life and commodity Edition: current; Page: [14] insurance.36 Child,37 in 1690, added absentee incomes and losses from bad debts. Hugh Chamberlain, in 1606, listed, in addition to commodity trade, the earnings of migratory labor abroad, tourist expenditures (“what foreign travellers spend here to see the country”), diplomatic and military expenditures abroad, and other items.38

The mercantilists were most interested in the “balance of payments” in its strict sense of a net balance of immediate obligations payable in specie, and the specie flows inward or outward resulting from the balance of payments were their primary concern. Payments on account of shipping freights or interest payments on foreign indebtedness were therefore recognized as having, value for value, the same significance as payments for commodity imports. But it was long before separate terms were coined to distinguish between the commodity balance of trade and the total balance of payments, and the writers of the period ordinarily used the term “balance of trade” to mean at one time one of these balances, at another time the other. John Pollexfen,39 however, referred to the “balance of accompts” as meaning the total balance inclusive of both commodity and non-commodity items, and Justice40 and Harris41 later used the same term in the same sense. Steuart spoke of “the whole mass of reciprocal payments” and their “balance,” 42 and at one point used the actual phrase, “balance of payments,” in its modern sense: “We must always carefully avoid confounding the grand balance of payments with the balance between importation and exportation, which I consider as the balance of trade.” 43 Arthur Young in 1772 used the phrase “temporal balance of remittance” to signify Edition: current; Page: [15] the immediate balance of payments.44 The term “balance of indebtedness” seems not to have been used until the nineteenth century. Adam Smith, however, approached it at one point, where he referred to the “state of debt and credit.” 45

IV. Reasons for Wanting More Bullion

The Mercantilist Concept of Wealth.—The mercantilists wanted an export surplus primarily because they wanted more bullion and because they saw that for a country without gold or silver mines a favorable balance of trade was the only means available to procure bullion. The central problem in the interpretation of the mercantilist theories is the discovery of the grounds on which their belief in the desirability of an indefinite accumulation of the precious metals was based. The most common criticism of the mercantilists is that they regarded the precious metals as the sole constituents of the wealth of the nation. Adam Smith made this charge a central feature of his criticism of the mercantilist doctrines, and he has been accused, by modern apologists for mercantilism, of inexcusable misinterpretation of their doctrines.1 On behalf of the mercantilists they assert that the doctrine of the identity of wealth and bullion is so absurd as to make it incredible that able men, to whom the fable of Midas must have been familiar, should have adhered to it, and they either refer to passages in writings of the period revealing a broad concept of wealth, or else deny that the words “wealth,” “riches,” or “treasure” had the same meaning then which they have now.2 But the Edition: current; Page: [16] only reference to the Midas fable I have found in the literature prior to 1760 is in a work sharply critical of the mercantilist doctrines,3 and, although unobjectionable definitions of wealth are to be found, they are usually offered by moderate or skeptical writers as criticisms of the prevailing views. “Riches,” “wealth,” “treasure” had ambiguous meanings in the seventeenth and eighteenth centuries. They meant money, jewels, and other especially precious commodities at one moment, and all goods useful to man at another moment. Very often this shift of meaning occurred within the limits of a single paragraph or even sentence, and reasoning involving, and obtaining what plausibility it has from, such shifts in the meaning given to terms constitutes a large portion of the mercantilist argument, and especially of the balance-of-trade doctrine.

The mercantilists did not have in mind the possibility that a country may make investments abroad or may borrow from abroad, and there is no mercantilist writer who explains his desire for a favorable balance of trade as a desire that his country should export capital abroad rather than borrow abroad.4 If indebtedness is disregarded, the one difference between an export surplus and an import surplus is that there is a net exchange of goods for money in the first case, and of money for goods in the second case. It is impossible, therefore, to understand such common mercantilist arguments as that foreign trade was the only path to national wealth, that a country can gain from foreign trade only if it results in a favorable balance payable in bullion, that an export surplus is both the proof and the measure of gain from trade, and that an import surplus is both the proof and the measure of national loss,5 unless they believed, momentarily at Edition: current; Page: [17] least, that all goods other than money were worthless, or were of value only as they served as means of securing money. If it be replied that the mercantilists meant by “wealth,” “treasure,” “riches,” “gain,” “loss,” “poverty,” “prosperity,” “profit,” etc., only money or absence of money, their arguments generally become merely laborious tautologies, and it becomes a mystery: (a) why they should have thought it necessary to present so earnestly and at such great length arguments reducing to the assertion that the only way for a country without gold or silver mines to get more bullion is to obtain it from abroad in return for goods, and (b) what terms they used when they were thinking of what we mean today when we speak of riches, wealth, gain, prosperity.

Statements involving either the attribution of value to the precious metals alone, or else the use of all the terminology now associated with the notion of wealth to mean merely money, abound in the mercantilist literature, and only a few heretics were never guilty of the confusion, real or terminological, between mere money and wealth. There follow some representative passages, taken from the writings of prominent mercantilists, which cannot, I feel certain, be absolved from the charge that they reveal confusion between quantity of money, on the one hand, and degree of wealth, riches, prosperity, gain, profit, poverty, loss, on the other. It would be easy to multiply the number of such citations.

... the wealth of the realm cannot decrease but three manner of ways, which is by the transportation of ready money or bullion out of the same; by selling our home commodities too good cheap; or by buying the foreign commodities too dear, wherein chiefly consisteth the aforesaid overbalancing. ... 6

If the native commodities exported do weigh down and exceed in value the foreign commodities imported, it is a rule that never fails, that then the Kingdom grows rich, and prospers in estate and stock; because the overplus thereof must needs come in, in treasure.7

The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value.8

Edition: current; Page: [18]

... the only way to be rich, is to have plenty of that commodity to vent, that is of greatest value abroad. ... 9

Foreign trade is the only means to enrich this Kingdom.... Where the consumption of things imported, does exceed in value the things exported, the loss will be as the excess is.10

For exportation is gain, but all commodities imported is loss, but ready silver or such commodities, that being carried out again bring in silver from other nations.11

... gold and silver is the only or most useful treasure of a nation ... nothing but bullion imported, can make amends for bullion exported.12

If we export any value of our manufactures for the consumption of a foreign nation, and import thence no goods at all for our own consumption, it is certain the whole price of our own manufactures exported must be paid to us in money, and that all the money paid to us is our clear gain.13

... to take the right way of judging of the increase or decrease of the riches of the nation by the trade we drive with foreigners, is to examine whether we receive money from them, or send them ours; ... 14

Mr. Deslandes says his country has a balance in trade of 7,000,000l. Sterling per annum; which, if true, is infinitely more than Britain can pretend to: It will follow from hence, that the French must be much richer than the English; ... 15

The general measures of the trade of Europe at present are gold and silver, which, though they are sometimes commodities, yet are the ultimate objects of trade; and the more or less of these metals a nation retains, it is denominated rich or poor.... Therefore, if the exports of Britain exceed its imports, foreigners must pay us Edition: current; Page: [19] the balance in treasure, and the nation grow rich. But if the imports of Britain exceed its exports, we must pay foreigners the balance in treasure, and the nation grow poor.16

Adam Smith, however, did exaggerate the extent of the dependence of the mercantilist case on the absolute identification of money and wealth, inasmuch as he failed to make clear that there were some mercantilists who were never guilty of such identification and few mercantilists who were never guiltless of it. Certainly, few writers of any prominence relied solely on this identification in arguing for the desirability of the indefinite accumulation of bullion, even though few failed to fall back on it to ease the course of their argument at critical points and to give it an axiomatic appearance both to themselves and to their readers.

To most of the moderate mercantilists the distinction between money and wealth was clear enough, if not always at least in moments of enlightenment and when recognition of the distinction would not hamper them and might even help them to make the point at issue at the moment. Thomas More had already, in 1516, tried to destroy the current illusions about the importance of gold and silver and in his ideal commonwealth they were to be relegated to use in the hire of foreign mercenaries and in the making of vessels serving lowly and unromantic purposes indeed, in order to free the Utopians from the tendency to exaggerate their importance: “And these metals, which other nations do as grievously and sorrowfully forego, as in a manner their own lives, if they should altogether at once be taken from the Utopians, no man there would think that he had lost the worth of one farthing.” 17 The following quotation from another sixteenth-century writer illustrates the use of the word “treasure” to signify more than merely the precious metals:

But he that hath treasure, gold, silver, house and land, He shall be obeyed as lord with young and old, ... 18

There follow some quotations from writers who had a broad concept of wealth and who used to signify wealth the same terms Edition: current; Page: [20] which we now use but which the apologists claim then had a different and narrower meaning. It is to be noted, however, that the authors cited were all critics of at least the more extreme monetary doctrines of the mercantilists.

... all men do know, that the riches or sufficiency of every kingdom, state, or commonwealth, consisteth in the possession of those things, which are needful for a civil life.19

It is true that usually the measure of stock and riches is accounted by money; but that is rather in imagination than reality.... The stock or riches of the kingdom doth not only consist in our money, but also in our commodities and ships for trade, and in our ships for war, and magazines furnished with all necessary materials.20

By riches, is meant all such things as are of great value. By value, is to be understood the price of things; that is, what anything is worth to be sold....21

It is a very hard thing to define what may be truly called the riches of a people.... We esteem that to be treasure, which for the use of man has been converted from gold and silver into buildings and improvements of the country; as also other things convertible into those metals, as the fruits of the earth, manufactures, or foreign commodities and stock of shipping. We hold to be riches, what tends to make a people safe at home and considerable abroad, as do fleets and naval stores. We shall yet go farther, and say that maritime knowledge, improvement in all kind of arts, and advancing in military skill, as also wisdom, power and alliances, are to be put into the scale when we weigh the strength and value of a nation.22

We commonly count money and bullion riches, whereas they are not riches in themselves, but the instruments and conveyances of them.... The riches therefore of a man consist in the abundance of those things that are in themselves useful to our delight or sustenance.... The riches of a nation consist in the plenty of those commodities which are most useful in human life, whose air is healthy, whose soil is fruitful, whose people are diligent and ingenious, and busied in manufactures, whose ports are open and free for commerce with the nations about it. This nation is rich, tho' it has not in it an ounce of gold and silver....23

The abuse or indefinite use of words, has in no one article of Edition: current; Page: [21] human reasoning caused greater confusion in ideas, than the calling wealth or riches by the name of money:—Riches, in respect to a nation, are the universal plenty of all necessaries, as food, raiment, houses, and furniture, provision for war, etc. Money, as gold or silver coin, are properly the medium of exchange, but by its quantity may become, and is an article of commerce itself; yet, where it most abounds, as in Portugal, it makes but a small proportion of the riches of that country, though the country itself is extremely poor. And nothing is so erroneous, as to judge of the riches of a country by the quantity of gold and silver in it.24

Similar passages can occasionally be found in the works of even the extreme mercantilists, but if they are examined in their context it will generally be found that they justify including other things than gold and silver as wealth only because gold and silver can be obtained in exchange for them;25 or defend the inclusion of other things on less than parity with the precious metals, on the ground that it cannot with certainty be assumed that these other things can and will be sold abroad in exchange for bullion.26

Identification of wealth with the precious metals, whether explicitly or as a tacit assumption underlying their reasoning, is to be regarded, however, as an extreme phase of mercantilist doctrine, prominent in the literature, and contributing largely, no doubt, to its hold on public opinion, but resorted to somewhat Edition: current; Page: [22] apologetically by its faint-hearted adherents, and not present at all, and even expressly repudiated, in the writings of a few of the most enlightened mercantilists, whose enlightenment, however, tended to take the form of an abandonment of some of the central propositions of mercantilism. Some of the apparent identification may have been purely terminological, although it must be repeated that the ambiguity of terminology was closely associated, as both cause and effect, with genuine confusion of thought. Much more important in the writings of the abler mercantilists than the absolute identification of wealth with gold and silver was the attribution to the precious metals of functions of such supreme importance to the nation's welfare as to make it seem proper to attach to them a value to the commonwealth superior to that of other commodities of equal exchange value. These functions, of which different ones or combinations were stressed by different writers, were to serve as state treasure, as private stores of wealth, as capital, and as a circulating medium. In the following sections, the mercantilist theories with respect to these functions of the precious metals will be examined.

State Treasure as an Emergency Reserve.—The mercantilist argument for the importance of accumulating precious metals which is logically most easily defended is that resting on the value to the state of having a financial reserve on hand in liquid form immediately available in case of emergency. When monetary transactions had become the normal state of affairs, but before public borrowing could be relied upon as a quick and dependable source of funds, and before taxation had become a regular source of revenue quickly responsive to changed fiscal needs, there was much to be said for the accumulation of a state treasure consisting of a stock of the precious metals. This was a common practice in the medieval period, and it has had survivals into modern times, notably in Prussia. It is an important element in present-day monetary policy. The maintenance intact of a state treasure required, however, the exercise by the monarch of a certain degree of restraint in his expenditures, and the profligacy of Henry VIII resulted in the dissipation of the treasure which he had inherited from his predecessor, and the disappearance of the institution as a phase of English state finance. Later monarchs, without exception, relied upon borrowing and special taxation to finance their wars. Even if a state treasure were maintained, Edition: current; Page: [23] moreover, it would call, not for an indefinite accumulation of the precious metals, but only for an amount sufficient for the probable needs. The requirements for the upbuilding of a state treasure could not logically have served, therefore, as a sufficient basis for the mercantilist insistence upon the urgent need of an indefinite augmentation of the national stock of the precious metals No state treasure, moreover, was in existence or projected during the seventeenth century, and even the most loyal adherent of the Stuarts could have had no great confidence in their ability to restrain themselves from encroaching for current purposes upon any state treasure which they might inherit or have bestowed upon them. In fact there is little mention of state treasure in the mercantilist literature, and its use as an argument for the importance of a favorable balance of trade is extremely rare. The common impression that it played an important part in English mercantilist doctrine has no historical basis.

Even the few references to state treasure which do occur in the literature of the period are not enthusiastic in tone. Sir Thomas More refers to state treasure only to urge the need of subjecting it to a maximum limit, to keep the king from becoming avaricious, and so that “his people should not lack money, wherewith to maintain their daily occupying and chaffer.” 27 Another early sixteenth century writer also recommends that the king should limit his accumulation of treasure in due proportion to the amount of gold and silver that was in the country or could be procured from abroad in return for English commodities, as otherwise there would be scarcity of money for the people and impairment of their capacity to produce.28 Mun discusses the desirability of a state treasure more fully than any other mercantilist writer. He defends the institution against unnamed critics, but seems to urge it more as an inducement to frugality on the part of princes in dealing with their ordinary revenues in times of plenty than as an emergency reserve deliberately built up by special exactions or taxes. He advises, very much along the same lines as the sixteenth century writers referred to above, that the prince should not add to his treasure annually, in the form of gold and silver, more than the amount of the year's excess of exports over imports, Edition: current; Page: [24] even if his revenues exceed his expenditures by more than that amount, since otherwise he would draw into the treasure all the money needed for trade and industry. He states that it is not necessary, or even desirable, for all the state reserve to be accumulated in the form of a stock of the precious metals, for it can better and more profitably be used to build ships of war, to store up grain against periods of dearth, and to accumulate war supplies, or lent to citizens for productive use. He writes:

... although treasure is said to be the sinews of the war, yet this is so because it doth provide, unite and move the power of men, victuals, and munition where and when the cause doth require; but if these things be wanting in due time, what shall we then do with our money?29

Except for minor references to state treasure,30 the only other discussions of it that I have found in the literature of the period are by John Houghton and Henry Home. Houghton, in the course of a plea that Parliament vote Charles II whatever funds he should ask for, deals with the possible objection that the king might hoard the money. He argues that such a hoard would lend prestige and power to the king in his dealings with foreign countries. He claims that Henry VII was the only English king who accumulated a great hoard, and that no ill resulted to the country in that case. He argues that by making money dear in England, hoarding would lead to the import of further supplies of bullion from abroad. But he concedes that hoarding would be the worst use to which the king could put his revenue, except expenditure on sinful purposes.31 Home supports the maintenance of a state treasure, but contingent upon the existence of wise and good government: “In the hands of a rapacious ministry, the greatest treasure would not be long-lived: under the management of a British ministry, it would vanish in the twinkling of an eye; and do more mischief by augmenting money in circulation above what is salutary, than formerly it did good by confining it within moderate bounds.” His chief reason for supporting a state treasure, Edition: current; Page: [25] moreover, would have seemed paradoxical to the ordinary mercantilist. Its virtue was that it could absorb a redundancy of currency, which otherwise would get into circulation, raise prices, and thus hamper trade. Where there was no redundancy of currency, the accumulation of treasure, he held, would be prejudicial to commerce. Its availability as a reserve in emergencies was apparently a minor factor to him32

There are other passages in the mercantilist literature which may have state treasure in mind, even though they do not explicity refer to it. Such perhaps are the frequent references to money as the “sinews of war,” and especially to its importance in diplomacy and in conducting war in foreign territory with mercenary troops. But money procured through current taxation or borrowing would serve as well, and the emphasis may therefore be intended to be rather on the importance of plenty of gold and silver within the country thán specifically in the state treasure.33 Many of these passages, moreover, seem to identify money with the things which money can buy, and financial power with the size of the stock of the precious metals.34

Edition: current; Page: [26]

The Precious Metals as a Store of Wealth.—The really important bases of the mercantilist belief in the desirability of the indefinite accumulation of the precious metals still remain to be dealt with. They divide the mercantilist writers into two fairly distinct groups, holding different and, to a large extent, conflicting views as to the important functions of the precious metals. The first group attached great significance to the precious metals because they held saving or the accumulation of wealth as the chief objective of economic activity and, failing to understand the nature of the process of productive investment, believed that the only, or the most practicable, form in which wealth could be accumulated was in an increase in the national stock of the precious metals.

The disparagement of consumption and the exaltation of frugality and thrift were common doctrines of the period, not wholly dependent upon economic reasoning but deriving much of their vitality from moral and religious principles and class prejudices. The Puritans disapproved of luxury and regarded thrift and saving as one of the major virtues on moral and theological, as well as on economic, grounds. The landed gentry, on the other hand, were typically not Puritans themselves either in their religion or in their mode of life, but they tended to regard extravagance and expensive display as the exclusive prerogatives of the hereditary aristocracy, and thrift and frugality as the appropriate virtues of the middle and lower classes. Eulogy of frugality and thrift and condemnation of luxury are common throughout the mercantilist literature, and only a few instances need be cited. Sir William Temple praises the Dutch and, following a custom which seems already to have become established at the beginning of the seventeenth century and to have persisted until late in the eighteenth, sets them up as a model to be followed by the English in economic matters, because, among other virtues, “they furnish infinite luxury, which they never practice, and traffic in pleasures, which they never taste.” 35 Petty stresses saving above all other means of acquiring wealth:

But above all the particulars hitherto considered, that of superlucration Edition: current; Page: [27] ought chiefly to be taken in; for if a prince have never so many subjects, and his country be never so good, yet if either through sloth, or extravagant expenses, or oppression and injustice, whatever is gained shall be spent as fast as gotten, that state must be accounted poor; ... 36

The emphasis on saving is shown also by the frequent exclusion of consumable goods, or goods destined for consumption instead of for accumulation, from “riches,” the latter term being confined to saved or accumulated goods. The following passages are representative of such verbal usage:

The two great principles of riches are land and labor; ... whatever they [i.e., the people] save of the effects of their labor, over and above their consumption, is called riches....37

And this increase of wages is the greatest tax on the nation, though the receiver is made no richer, only sprucer and lazier.38

... By what is consumed at home, one loseth only what another gets, and the nation in general is not at all the richer; ... 39

The notion that saving consisted of the piling-up of valuable goods led naturally to an identification of saved wealth or “riches” with stored-up goods of a special kind suitable for accumulation and not capable of, or destined for, current consumption. Commodities of high value and of great durability and not liable to loss of value through change of fashion would be specially suitable as the constituent items of stored-up wealth. The exaltation of saving led in turn to the attachment of superior importance to such commodities than to more perishable commodities and those destined for current consumption. The precious metals met these tests of suitability as stores of wealth better than any other commodities. Here is an important element in the explanation of the Edition: current; Page: [28] importance attributed to gold and silver by the mercantilists. There follow a few quotations, illustrating the attachment of superior importance to the precious metals than to other commodities because of their greater suitability as stores of wealth:

Also they [i.e., foreign merchants] bear the gold out of this land And soak the thrift away out of our hand; As the waffore sucketh honey from the bee, So minceth our commodity.40

... gold and silver are ... the most necessary and lasting instruments to procure all things that are, or shall be found useful, or any ways serviceable to mankind, being portable and durable, when most other goods are burthensome, subject to perish and decay.... Silver and gold being preferable to house and land, and the only instruments that have increased and improved trade.41

The great and ultimate effect of trade is not wealth at large, but particularly abundance of silver, gold, and jewels, which are not perishable, nor so mutable as other commodities, but are wealth at all times, and all places: whereas abundance of wine, corn, fowls, flesh, etc., are riches but hic & nunc, so as the raising of such commodities, and the following of such trade, which does store the country with gold, silver, jewels, etc., is profitable before others.42

All other commodities end with the consumer, but money still lives, and the more hands it runs through the better; so that in a sense the use doth not destroy it, as it doth other commodities, but leaves it as it were immortal.43

Gold and silver, for many reasons, are the fittest metals hitherto known for hoarding: they are durable; convertible without damage into any form; of great value in proportion to their bulk; and being Edition: current; Page: [29] the money of the world, they are the readiest exchange for all things, and what most readily and surely command all kinds of services.44

As gold is a treasure, because it decays not in keeping ... no other metals are a treasure, because they either decay in keeping, or are in too great plenty.45

If the only possible or practicable means of saving is by the accumulation of a hoard of the precious metals, it becomes obvious that the accumulated wealth of a country is limited to its stock of the precious metals and can increase only through an increase in the latter. If that country is without gold or silver mines, it can therefore add to its saved wealth only through a favorable balance of trade payable in bullion. Reasoning such as this explains—and exposes—the balance-of-trade theories of an important and numerous group of the English mercantilist writers. There follow several representative passages in which the ideas of riches as saved wealth, of saving as the piling-up of the precious metals, and therefore of a favorable balance of trade as necessary for an increase of riches, are stated or clearly implied:

... no trades carried on by the exportation of [our] own products and manufactures, or those from our plantations, though what brought back in return be all perishable commodities, can diminish our riches, for all such goods of ours (unless some objection be made as to tin and lead) would have perished by time, if had been kept here; but a great distinction ought to be made, between trades carried on by the exportation of our products, and trades carried on by the exportation of our bullion, to purchase perishable commodities, because in such case we exchange what is durable, and most useful, for what cannot long do us any service.46

That silks, woolen goods, wines, etc., may be esteemed riches between man and man, because may be converted into gold and silver, yet do not deserve to be esteemed the riches of the nation, till by exportation to foreign countries are converted into gold and silver, and that brought hither, because are subject to corruption, and in a short course of years will consume to nothing, and then of no value.47

Now it falls out in the natural course of things, that whilst men Edition: current; Page: [30] are employed in searching after the necessaries of life, they find riches: for the earth is grateful, and repays their labor, not only with enough, but with abundance; and out of the plenty of these materials, plenty of things are formed to supply the wants of mankind. Now the more of these things any nation has, the more comfortably the people live; and whatever they have of them more than they consume, the surplus is the riches of that nation, I mean, the intrinsic riches of it. This surplus is sent to other nations ... and is there exchanged or sold; and this is the trade of a nation. If the nation, to which it is sent, cannot give goods in exchange to the same value, they must pay for the remainder in money, which is the balance of trade; and the nation that hath that balance in their favor, must increase in wealth; for this is the only way to bring money into any nation, that has no natural fund of it in mines in its own bowels; and the only way to keep it in any nation that has.48

The doctrine of thrift also led to emphasis on the importance of a favorable balance of trade through another chain of reasoning. Throughout the mercantilist period, the imports into England consisted largely of expensive luxuries and conveniences which contributed more to the pleasures and comforts of life than to the dull but virtuous process of enrichment through thrift. Also if Englishmen were sparing in their consumption of even domestic goods, there would result, it was claimed, either unemployment or the piling-up of unsold and perishable commodities, unless the surplus stocks of domestic goods were exported abroad. Small imports and large exports were therefore a necessary adjunct of thrift and enrichment. These views were widely prevalent, and they are sufficiently illustrated by passages cited in other connections.

Protests against the importation of “apes and peacocks,” “toys and baubles” recur throughout the mercantilist period and were already common in the sixteenth century. Thus Starkey makes one of the participants in his dialogue reproach as “ill-occupied” “all such merchants which ... bring in ... vain trifles and conceits, only for the foolish pastime and pleasure of man,” although his adversary does say something in defense of the joys of life.49

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Money as Invested Capital.—With only a few exceptions, the mercantilists either identified or failed clearly to distinguish between money, on the one hand, and capital or “stock” employed by its owner or lent out at interest, on the other. They always wrote of direct employment of capital and of loans at interest in monetary terms, and as a rule they showed no signs that they had penetrated in their analysis beneath the monetary surface. Verbally, at least, they identified money with capital; much of their argument can be explained only if they regarded money and capital as identical in fact as well as in name. This is most clearly brought out in the important doctrines of the period: that interest was paid for the use of money, that the rate of interest depended on the quantity of money, and that high interest rates were proof of the scarcity of money, doctrines which were questioned by very few writers before Hume.50 Several passages illustrating the common confusion of money with capital follow:

That by the plenty of money [resulting from raising the nominal value of English coin and thus keeping it from being exported] the price of usury may of course decrease and the price of lands be improved.51

It is an infallible sign that money abounds, and is plentiful, when the interest thereof is low, for interest or forbearance is the price of money....52

Now, I think, the natural interest of money is raised two ways: first, when the money of a country is but little, in proportion to the debts of the inhabitants, one amongst another.... Secondly, that, which constantly raises the natural interest of money, is, when money is little, in proportion to the trade of a country. For in trade everybody calls for money, according as he wants it, and this disproportion is always felt. For, if Englishmen owed in all but one million, and there were a million of money in England, the money would be well enough proportioned to the debts: but, if two millions were necessary to carry on the trade, there would be a million wanting, and the price of money would be raised, as it is of any other commodity Edition: current; Page: [32] in a market, where the merchandise will not serve half the customers, and there are two buyers for one seller.53

This confusion of money with capital contributed directly to the attachment of great importance to the size of the national stock of money, and indirectly to emphasis on the importance of a favorable balance of trade as the only way in which that stock could be increased.

The Analogy from Personal Finance.—All the variants of the mercantilist doctrine which rest on an identification of money with wealth, or with accumulated and stored wealth, or with loanable capital, found support for their position in a superficially plausible analogy with personal finance which with unimportant modifications recurs repeatedly in the mercantilist literature from the earliest to the latest writers, and is frequently supported by citations from classical writers. Two early statements of the analogy follow:

... we must always take heed that we buy no more of strangers than we sell them; (for so we should empoverish ourselves and enrich them). For he were no good husband that hath no other yearly revenues but of husbandry to live on, that will buy more in the market than he selleth again.54

The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule; to sell more to strangers yearly than we consume of theirs in value.... By this order duly kept in our trading, we may rest assured that the kingdom shall be enriched yearly two hundred thousand pounds, which must be brought to us in so much treasure; because that part of our stock which is not returned to us in wares must necessarily be brought home in treasure.

For in this case it cometh to pass in the stock of a kingdom, as in the estate of a private man; who is supposed to have one thousand pounds yearly revenue and two thousand pounds of ready money in Edition: current; Page: [33] his chest. If such a man through excess shall spend one thousand five hundred pounds per annum, all his ready money will be gone in four years; and in the like time his said money will be doubled if he take a frugal course to spend but five hundred pounds per annum, which rule never faileth likewise in the Commonwealth....55

There was little contemporary criticism of this analogy, obvious though its shortcomings seem to be both as an analogy and as an interpretation of personal finance. Papillon pointed out that it was foolish for a person managing a farm to buy less than he sells in order to accumulate a stock of money.56 Barbon tried to meet it by the argument that although the “stock” of a person is finite, and therefore exhaustible, that of a country is infinite, and “what is infinite can neither receive addition by parsimony nor suffer diminution by prodigality.” 57 Mandeville conceded that frugality or “saving” was the most certain method to increase an estate, but he denied, on “make-work” grounds, that this also held true for a nation.58 Hume pointed out, on quantity theory of money grounds, that while an individual would be richer if he had more money, the same would not hold for a country.59

More Money in Order to Have Higher Prices.—In the modern literature on mercantilism, the desire of the mercantilists for more money is sometimes explained as largely due to a prevailing desire for higher prices, and the apologists find economic justification for such a desire in the circumstances which they Edition: current; Page: [34] allege then prevailed, for example, the necessity for increase in the national stock of money if the period of transition from a barter to a money economy were not to be accompanied by the evils of falling prices. But even in the literature of the early seventeenth century, barter is already referred to as a system characteristic of a primitive economy from which England had long since emerged. From early in the sixteenth century to late in the eighteenth, the general trend of English commodity prices was decidedly upward rather than downward, although the economic historians do seem to be agreed that there were intervals of some length during which prices were falling. But throughout the period the complaints of scarcity of money were unintermittent. I can find in any case very few mercantilists who wanted higher prices and wanted more money as a means of obtaining a higher price level. For such to have been the case, recognition of the dependence of prices on the quantity of money would have been necessary, and many mercantilists showed no trace of such recognition, while others denied the existence of any such relationship between the quantity of money and the price level.60 Some mercantilists, moreover, who shared in the general desire for more money, complained of high prices and wanted lower instead of higher prices. To them high prices were an evil which they did not associate with the quantity of money, or which they thought could be remedied by more money, or which created a need for more money if trade was to be carried on and the poor were to be able to buy the necessaries of life. Two typical complaints that prices were too high, made by writers who nevertheless were anxious that England have a favorable balance of trade in order that bullion should flow in, are cited below:

... the high price of all things is not only the greatest matter that the people grudge at; and one of the principal occasions of poverty and famine; but also the chiefest cause that the king's majesty cannot without expense of wonderful great sums of money maintain his wars against his enemies....61

... cheap wares do increase trade, and dear wares do not only cause their less consumption, but also decline the merchant's trade, impoverish the Kingdom of treasure, lessen his Majesty's customs Edition: current; Page: [35] and imposts, and abate the manufactures and employments of the poor in shipping, clothing, and the like....62

There were very few price inflationists among the English mercantilists, and even the advocates of paper money did not want higher prices. Many mercantilists claimed that if their projects were adopted land values would rise, but such claims were made in order to win the support or weaken the opposition of the landed classes to their proposals. In any case, they were usually based on the argument that more money meant lower interest rates, and lower interest rates meant higher land values, or on the argument that more money meant more trade and therefore a readier sale for agricultural products, or more production and therefore greater exports, and rarely made specific reference to higher commodity prices. Some mercantilists argued, on what would now be called “terms-of-trade” considerations, that it was desirable that export prices should be high and import prices low.63 But one of these writers said that it did not matter what domestic prices were,64 and others argued that even with respect to exports low Edition: current; Page: [36] prices were desirable if, or because, high prices would mean a small volume of sales.65 I have found very few mercantilist writers who unambiguously expressed a desire for higher prices in general,66 although there were probably many mercantilists who would not have regarded higher prices as an evil if accompanied by at least an equal increase in money, stocks or incomes. Such seems to have been Misselden's position in his answer to the possible objection, against his proposal to raise the denomination of English coin, that it would result in an increase in commodity prices:

And for the dearness of things, which the raising of money bringeth with it, that will be abundantly recompensed unto all in the plenty of money, and quickening of trade in every man's hand. And that which is equal to all, when he that buys dear shall sell dear, cannot be said to be injurious unto any. And it is much better for the kingdom, to have things dear with plenty of money, whereby men may live in their several callings, than to have things cheap with want of money, which now makes every man complain.67

More Money in Circulation Means More Trade.—Many of the mercantilists, some of whom also used the arguments already discussed, wanted more money because they regarded money, not merely as a passive medium of exchange, but as a force acting through its circulation from hand to hand as an active stimulus to trade. An increased amount of money in circulation, they believed, meant (or caused) an increased volume Edition: current; Page: [37] of trade, and since men would produce only what they could sell a quickening of trade meant an increase of production and therefore a wealthier country. Here, it should be noted, money is valued as an instrument or stimulus of trade rather than for its own sake. The writers who stressed “circulation” as the valuable service of money often shifted, however, from the concept of money circulating as a medium of exchange to money passing from the hands of a lender to those of a borrower, and rarely distinguished clearly between them. The underlying reasoning is often presented in the form of analogies, especially with the circulation of the blood, which William Harvey had discovered not long before.68

Stress on the importance of an abundance of money in circulation if trade was to flourish is already to be found in very early writers.69 The most elaborate expositions of the “circulation” argument were made by William Potter70 and John Law.71 Potter's argument seems to reduce to this: The wealth of a country is equal to the value of the goods of all sorts therein, money being valuable only as it serves to bring about the production of more goods.72 The more money men have, the more they spend and the Edition: current; Page: [38] faster they spend it. If men acquire more money and spend it as fast as they receive it, the sales of merchants and manufacturers will increase proportionately. If they sell five times as much in money value, they will produce five times as much, and even more, in physical quantities, since they can afford to charge lower prices on the greater volume of sales.73

... in reference to a commonwealth, or any society of men, the greater quantity there is amongst them, of money, credit, or that which is taken by them for commodities, the more commodity they sell, that is, the greater is their trade. For whatsoever is taken amongst men for commodity, though it were ten times more than now it is, yet if it be one way or other laid out by each man, as fast as he receives it, it must needs come to pass, that (resting nowhere) it doth occasion a quickness in the revolution of commodity from hand to hand, that is trade, proportionable to the greatness of its quantity.74

John Law's argument is essentially the same, although stated more conservatively.75 The most enthusiastic advocates of the circulation argument, Potter and Law included, were advocates of paper money. But if paper money were accepted as of equal value to metallic money, the great reason for desiring a favorable balance of trade, that it results in an inflow of bullion, should lose its force. Such in fact was the case with some of them, as the following extracts show:

... for whether a nation have any silver amongst them or no, yet if they can trade as well without it, what need they care? for their estates in vendible commodities (and consequently their credit) is of as real value as if it were in money.76

Whatsoever quantity of credit shall be raised in this office, will be as good, and of as much use, as if there were so much money Edition: current; Page: [39] in specie added to the present stock of the nation ... 'tis more prudent and advantageous to a nation, to have the common standard or medium of their trade within their power, and to arise from their native product, than to be at the mercy of a foreign prince for his gold and silver, which he may at pleasure behold.... Credit can neither be hoarded up, nor transported to the nation's disadvantage; which consequently frees us from the care and necessity of making laws to prevent exportation of bullion or coin, being always able to command a credit of our own, ... as useful, and as much as shall be necessary.77

The only necessity of a foreign trade for England is because we make a foreign commodity (gold and silver) the standard of all ours, and the only medium of commerce, which (as long as it continues so) if we want, all trades must cease; but if we can find out another and safer medium of exchange (as this credit) appropriated to the place where we live and not subject to such obstruction as the other, why should we not readily embrace it?78

And if the proprietors of the bank can circulate their fundation of twelve hundred thousand pounds, without having more than two or three hundred thousand pounds lying dead at one time with another, this bank will be in effect, as nine hundred thousand pounds, or a million of fresh money, brought into the nation....79

Whether in any one year half a million is brought into a commercial country by trade, or issued out by banks, in notes, upon good security, it will serve for the same purposes.80

Some advocates of paper money made little or no reference to the balance of trade or to trade policy in their tracts. This freedom from the prevailing obsession with the state of the balance of trade may have been due to a loss of interest in a policy of securing laboriously through the complicated regulation of trade the increase of money which could be secured more quickly, with greater certainty, and with less effort, by means of the printing press. But some of the advocates of paper money displayed loyalty to the current belief in the importance of a favorable balance of Edition: current; Page: [40] trade, either because of blind acceptance of traditional doctrine, or on the basis of the store of wealth argument or the analogy from personal finance that one should buy less than one sells, and these writers claimed that an increase of paper money would not drive bullion out of the country, but on the contrary would make the balance of trade more favorable through its beneficial effect on production and trade.81

The Quantity Theory of Money.—Those mercantilists who sought an increase in the supply of money because they wanted more circulation or more invested capital clearly wanted genuine physical increases in trade or capital and not merely nominal increases in terms of a depreciated monetary unit. Their doctrines, therefore, would seem to come into sharp conflict with any theory of the value of money which makes it vary inversely with its quantity, whether proportionately or not.82 Only for those mercantilists who wanted an increase of money for use as hoards or stores of wealth would acceptance of a quantity theory of money involve no problem of reconciliation. Many of the mercantilist writers gave no evidence of recognition of the dependence of the value of money upon its quantity. A few of them, in fact, wanted more money as a cure for the evils resulting from high prices. But, although Locke is sometimes credited with the first clear English formulation of the quantity theory, many of the mercantilists, from the beginning of the seventeenth century on, did present, in one connection or another, some simple version of the quantity Edition: current; Page: [41] theory,83 although in most cases they failed to incorporate it as an integral part of their foreign-trade doctrine and failed also to show any concern about its consistency with the rest of their doctrine. There follow quotations from writings antedating Locke by some forty to ninety years which present some form of quantity theory of the value of money:

... plenty of money maketh generally things dear, and scarcity of money maketh likewise generally things good cheap. Whereas things particularly are also dear or good cheap according to plenty or scarcity of the things themselves, or the use of them.84

... even as plenty of money maketh things dear, and scarcity of money maketh things good cheap: even so plenty or scarcity of commodities maketh the price thereof to rise and fall according to their use more or less.85

It is a common saying, that plenty or scarcity of money makes all things dear or good or cheap ... 86

Gold and silver ... in the intrinsic ... are commodities, valuing each other according to the plenty or scarcity; and so all other commodities by them; and that is the sole power of trade.87

... money through want or plenty raises or diminishes the price of all things ... 88

... in those countries where monies are scarce, there the lands and native wares are cheap, so likewise where money doth abound, there the lands and wares are dear; ... 89

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Several mercantilists faced squarely the apparent conflict between the quantity theory of money and their doctrines and attempted to meet the issue either by arguing that they could be reconciled or by denying the truth of the quantity theory.90 Apparently the first of these was William Potter, who has not received the attention which he deserves in this connection.91 Potter, as has been shown,92 claimed that an increase of money in circulation would result in an even more than proportionate increase in trade and production, or in goods in circulation. In order to refute it, he states a quantity theory of money in its simplest one-sided form:

If then, in opposition to what is thus undertaken to be proved, it should be objected, that an increase of money would occasion an increase in the price of commodities, proportionable to such increase of money, (that is, if the money were twice as much, commodity would be twice as dear) consequently (going never the further in commodity by the increase thereof) would not occasion any increase in the sale of commodity: therefore not any increase of trade; and yet (by causing the price of commodities to rise) incur an inconvenience, contrary to what is before affirmed.93

His answer is elaborate and not always intelligible. He assumes the basis of the theory of money he is attacking to be that an increase of money increases prices by increasing the (physical?) volume of sales (by increasing the demand for commodities?). Edition: current; Page: [43] He replies that if, when money is doubled, the prices of commodities are also doubled, there will be no increase in the (physical?) amount of sales. The theory therefore involves a contradiction.94 He then attempts to meet it by another line of reasoning. Quick trade permits of a small profit, and therefore a lower price. Quick sales enable artisans and others to produce more quickly, and if they sell more they can afford to charge a lower price. The increase in the amount of commodities resulting from the stimulus to trade of an increase in money, instead of raising prices, will therefore lower them. Prices will rise only if the increase in commodities is proportionately less than the increase in money, which is not likely to be the case. But even if prices should rise somewhat, it is better to have an abundance of comforts, though dear, than a smaller amount thereof, though never so cheap.95

Another advocate of paper money, John Asgill, denied the truth of the quantity theory of money on different and exceedingly slender grounds: an increase in money would lower the rate of interest and therefore raise land values, but not the prices of commodities in general, because “the price of corn and cattle don't rise and fall with the interest of money.” 96 John Law attacked it, partly by arguments closely resembling those of Potter, partly on reasoning peculiarly his own. The stimulus to trade and industry resulting from an increase in money would result in an increase in commodities. Because money would be easier to borrow, merchants would be able to increase the extent of their operations and to sell at lower rates of profit, and therefore the value of the money would not fall, i.e., prices would not rise.97 Money falls in value only when given to a people in greater quantity than there is demand for; if the money is issued only as there is demand for it, its value will not depreciate, “the Edition: current; Page: [44] quantity and demand increasing and decreasing together.” 98 Law concedes that if the quantity of money in any particular country “should increase beyond the proportion that country bears to Europe,” prices would rise there, but the rise of prices would spread elsewhere, so that the value of money would become the same, or about the same, everywhere. The country which had acquired the increase of money would profit greatly thereby, “for that country would have the whole benefit of the greater quantity, and only bear a share of the lesser value, according to the proportion its money had to the money of Europe.” 99 What would make the prices rise elsewhere, he does not explain.

Another writer, James Hodges, who complained of scarcity of money, wanted plate called in and coined and the monetary value of the English standard coin raised as a remedy for this scarcity. He claimed that these measures would result in higher prices only after they resulted in an increase in the number of coins in circulation. The effect on prices would therefore be gradual, and meanwhile there would be a stimulus to trade. After a short time the value of the coin could be gradually lowered, and the surplus bullion returned to be made into plate again if its owners so desired. His argument is interesting as an anticipation of Hume's doctrine that rising prices are a stimulus to trade, and for its endeavor to find a method of obtaining this stimulus without involving a permanent increase in the price level. The difficulty with the scheme, granting its logic, is, of course, that the period of stimulus would be followed by a period of at least corresponding depression.100

Both Potter and Law claimed that an increase of (paper) money would make the balance of trade more favorable and would lead to an inflow of bullion. Potter argued that the beneficial effects of an increased quantity of money would enable Edition: current; Page: [45] England to outsell other countries, for “the greater trade of one country hath a capacity of undermining and eating out the lesser trade of other countries.” 101 For reasons not explained, unless it be the fall in English prices alleged to result from an increase in the quantity of money, both foreign and English commodities would fall in price in England, but not abroad. Exports would therefore be paid for with bullion (and presumably imports would be paid for with English commodity exports), and the bullion could be coined into English money without loss. But with unusual consistency Potter admits that when paper money or credit is available as a substitute, metallic money would be of little importance to England.102 Law showed more concern than did Potter about the state of the balance of trade, but he also claimed that an increased amount of money through the issue of paper money would make the balance favorable: “Most people think scarcity of money is only the consequence of a balance due; but ‘tis the cause as well as the consequence, and the effectual way to bring the balance to our side, is to add to the money.” 103 More money, by employing more people, would make a surplus of goods available for export, and if sufficient money was issued production would reach a level at which more would be exported than imported. Conversely, if the amount of money was reduced, some of the laborers would be rendered idle, the domestic output would shrink, exports would fall, and an unfavorable balance would result.104 These results of a change in the quantity of money he would apparently expect not to be transitory but to persist as long as the new quantity of money persisted.

The Mercantilists on Hoards and Plate.—Because the mercantilists differed among themselves as to the character of the benefit which resulted from an increase in the amount of bullion in a country, they also differed in their attitudes toward the miser, the collector of gold or silver plate, the usurer, and the spendthrift. Those mercantilists for whom the chief virtue in an increased supply of bullion lay in its stimulus to circulation condemned private hoards as an evil, and also regarded other practices Edition: current; Page: [46] which kept bullion from circulating as money, such as its use in the manufacture of plate, as objectionable.105 Vaughan condemned hoarding and the use of plate as contributing factors to the scarcity of money, and recommended sumptuary legislation to check the melting of money and its manufacture into plate.106 An anonymous writer criticized the Established church on the ground that it hoarded riches which should circulate, so that “the money that before ran current in trading, is dammed up in their coffers.” 107 Another pamphlet, written as an answer to this one, condemned the excess of silver plate for the same reason, but claimed that there was no occasion for alarm about hoarding, as there was not much of it, and urged in the defense of the church that it could be charged with responsibility for the prevailing scarcity of money only if the clerics kept “banks of money dead by them,” which was not the case. Complaint against the usurer as a hoarder of money was likewise without basis, since “his money walks, though upon other legs, either serving the tradesman or the gentleman, for preparing commodities to export, or to buy what is imported for his expenses.” 108 Manley found fault with the miser, because “money locked up in the miser's coffers is like dung in a heap, it does no good, but being dispersed, and orderly disposed abroad, enricheth the land.” 109 An anonymous writer wanted misers’ hoards taxed, in order to draw some of their money into circulation, especially in time of war when trade was slack. “I know no difference,” he wrote, “betwixt bringing treasure out of an iron chest by a good law, and Edition: current; Page: [47] plowing the seas by long and dangerous voyages” in order to secure bullion through foreign trade.110 One of Locke's objections to the reduction of the interest rate by law was that it would result in men keeping their money “dead” by them, instead of lending it, with resultant loss to trade.111 Petty expressed a preference for money over plate, because it served trade better,112 as did also Hugh Chamberlain: “Money is living riches, plate but dead; that being capable of turning and improving trade, when this is not.” 113

Hodges's scheme for a forced three-year surrender of plate in return for “raised” money, with prohibition of ownership of plate in the interval, in order for a time to secure relief from the prevailing scarcity of money, and to obtain the stimulus to trade of slowly rising prices, has already been referred to.114 Another writer urged a similar scheme for raising money 5 per cent, in order to draw hoards of the old, and therefore undervalued, coins into circulation.115 One writer made the same sort of contrast between hoarded and circulating money, hoarded credit being the exchequer bills which, because of the high rate of interest they carried, were held instead of being used as money: “... in the frequent passing of credit from hand to hand, consists its great usefulness in trade; for when either money or credit is hoarded up, it may more properly be said to stagnate, than to circulate.” 116 Postlethwayt, in a curious argument, claimed that lending of money at interest involved hoarding and therefore on circulation grounds was to be condemned. If some money is hoarded, the volume of trade will fall. In order to bring the hoarded money back into trade, those in great need of it will offer interest (“profit”) for its loan. The result will be that other moneyed men, instead of “circulating their money” in trade, will “lock it up,” while awaiting the opportunity to lend it, preferring to get their income by usury instead of by trade. Eventually the Edition: current; Page: [48] money so withdrawn from trade would be lent and would thus return to trade, but bearing an interest charge which would act as a restraint on trade.117

Some writers objected, on similar grounds, to the establishment of banks, holding that they monopolized money, and kept it from circulating. Child, for example, maintained that “principally this seeming scarcity of money proceeds from the trade of bankering, which obstructs circulation.” 118 Strangely enough, considering his views on the effect of lending at interest on monetary circulation referred to above, Postlethwayt made the most effective rejoinder to this argument which I have found:

It may be here requisite to take notice of that erroneous notion entertained by some, that banks and bankers engross the money, hoard it up, and hinder its circulation in trade; but, if such will consider this matter in its true light, they will easily be convinced, that the money lodged in banks, and in the hands of bankers, is the most constantly employed of any; for, though the specie should lie still till called for, yet the notes given out for its value, are continually circulating; whereby is done abundantly more service to trade, than if the same lay dormant in private hands; and yet the necessities of the depositors are effectually answered.119

Once hoarding and the use of coin or bullion in the making of plate were attacked, there were few to come to their defense, and the use of gold and silver in the making of thread or in gilding met with almost general condemnation. Mun, however, opposed restrictions on the melting-down of coin into plate on the ground that gold and silver were more apt to be carried out of the kingdom in payment of purchases of foreign goods if in Edition: current; Page: [49] the form of coin than if kept in the form of plate,120 and Misselden before him, while conceding that too much plate in the kingdom would cause scarcity of money, nevertheless held that it was better to have bullion kept in the form of plate than to turn it into coin and thus turn it out of the kingdom because of the undervaluation of coin which he alleged then prevailed in England.121 A sixteenth-century writer condoned the use of bullion for plate, because it resulted in the formation of a sort of secondary national reserve for emergencies, upon which the king, in case of a great war, could draw “without any grouching of the Commons.” 122 The same argument is to be found occasionally in the later literature, and is made by Briscoe to serve as a defense of private hoards. Hoarded treasure, bullion and coin, is part of the “capital stock of national treasure” and can be drawn upon in a national emergency. Private hoarding is as good as having treasure stored by the king.123

Toward the end of the seventeenth century there appeared a new doctrine of the existence of a “due proportion” between money and goods, and therefore of the possibility of excess of money as far as trade needs were concerned. The quantity theory of money also tended to lead to the conclusion that an increase in the amount of money by increasing prices would reduce exports and thus eventually be lost to the country. Writers who on “due proportions of money to trade” or on quantity-theory grounds conceded that there was under any given set of circumstances a maximum amount of money which could be kept in circulation, and who still attached special importance to the precious metals, were likely to approve of turning the money into plate or of its hoarding as a means either of stimulating the further import of bullion or of, checking an outflow. It was doubtless such reasoning which led John Houghton to the conclusion that “if the King should hoard up much money, it would for the present make it dearer, that dearness would make it be brought in more plentifully, and that would make it more plentiful than it was before.” 124 Petty wrote: “For there may be as well too much money Edition: current; Page: [50] in a country, as too little. I mean, as to the best advantage of its trade; only the remedy is very easy, it may be soon turned into the magnificence of gold and silver vessels.” 125

On similar grounds another writer would tolerate the increased use of plate if there was more money than was necessary to carry on trade and “defray the expense of living,” 126 and Vanderlint, who accepted the quantity theory and wanted low prices but at the same time wanted a favorable balance of trade payable in specie, recommended as a means of attaining these apparently conflicting objectives that the private hoarding of gold and silver and their use in plate, and even in gold and silver cloth and gilding, be encouraged. He cited with approval the practice of the East Indians of hoarding the silver they receive, with the result that prices remained low there, exports continued to exceed imports, and the balance was paid in still more silver.127 Harris presents a similar solution of the same dilemma. If the inflow of bullion resulting from a favorable balance of trade is kept:

as a dead stock, either by turning it into plate or by any other method, so as to prevent its getting into trade as money; it may continue to go on increasing in more bullion, which in this case will be a real increase of wealth.... Let an increased stock of bullion get out again into trade, and it will soon turn the balance the other way.128

But gold and silver can be best stored up in the form of plate:

But people in general will not hoard up cash; all like to display their wealth, and to lay out their superfluities in some costly things. There seems then no method so effectual for the securing of a dead stock of treasure in any country, as the encouraging the use of plate, by making it fashionable, preferable to more brittle or more perishable commodities. Plate would be a national resource in case of emergency, and not the less so, because the precious metals had not as yet received the shape of coins.129

Hume in 1752 claimed that state hoarding was the only expedient by which a country could raise its supply of the precious metals above the equilibrium level, but commented that this was Edition: current; Page: [51] “a practice which we should all exclaim against as destructive, namely, the gathering of large sums into a public treasure, locking them up, and absolutely preventing their circulation.” 130

Henry Home accepted so whole-heartedly the lesson of the quantity theory of money that he looked upon an export surplus alike with an import surplus as dangerous to the country. The latter meant an outward drain of money, with a consequent fall of prices and stoppage of industry. The former meant an influx of specie, extravagance, rise in prices, and finally a fall in exports, rise in imports, an unfavorable balance again, and a recurrence of the drain of specie. What was to be desired was an even balance. Therefore, “let the registers of foreign mints be carefully watched, in order that our current coin may not exceed that of our industrious neighbors.” But it was not the quantity of gold and silver in a country that determined the price level, but the quantity of money in circulation. Still retaining some traces of the mercantilist attachment for the precious metals, he therefore advocated the conversion of money into plate and even, under favorable circumstances, the formation of a state treasure.131

V. Employment and the Balance of Trade

The mercantilist arguments for a favorable balance of trade so far considered all rest upon the desirability of more bullion. But there was one mercantilist argument which was not dependent upon the attachment of superior economic importance to the precious metals than to other commodities of equal exchange value, namely the “employment” argument. Exports were the product of English labor whereas imports, especially if they consisted of finished products and of commodities competitive with home products, displaced English labor. The greater, the exports, and the smaller the imports, the greater, therefore, was the employment of English labor. This argument was not, as is sometimes supposed, of late seventeenth-century origin. It is to be found in the very earliest mercantilist writings,1 and it persists Edition: current; Page: [52] without break throughout the literature of the seventeenth and eighteenth centuries. It is not even clear that it was more emphasized in the eighteenth- than in the seventeenth-century mercantilist literature, and it could even be argued that the sixteenth-century writers stressed it most of all. Of all the mercantilist reasoning, it withstood criticism most successfully, and persisted into the nineteenth and twentieth centuries as an important element in the protectionist doctrine.

The stress on employment led to an appraisal of exports not merely in terms of their value, or of their value relative to imports, but in terms of the amount of labor they represented. Exports of manufactured articles were rated more highly than exports to the same value of raw materials, because the former embodied a larger proportion of labor. The stress on employment sometimes took the form of measuring the gain from trade by the exports alone, and in a few cases the argument even went to the extreme of recommending production of goods simply to employ labor, even though the product of their labor were burnt upon their completion.2 In the case of a few later writers, the employment argument gave rise to a new balance-of-trade concept, in which the amounts weighed against each other were not the values respectively of the exports and the imports, but the respective amounts of labor or employment they represented, i.e., the “balance of labor” or the “balance of employment.” Barbon seems to have been the first to come close to this concept. The measure of benefit from different exports is the amount of employment they had given to English labor, and, similarly, the measure of benefit from imports is the amount of employment to which they will give rise in their further manufacture. His employment test leads him at times to liberal conclusions. Imports of Edition: current; Page: [53] raw silk are more profitable than imports of gold and silver, because more hands are employed in the manufacture of the first than in working the latter. If woolen goods are exported for Westphalian bacon and then the import of the latter is prohibited, England would lose even if the consumption of English bacon increased, because woolen cloth employs more hands in its production than does bacon.3

Tucker stated the argument somewhat differently. The balance of trade for country A is the excess of the number of laborers working up manufactures for country B in A as compared to the number of laborers working up manufactures for A in B:

... when two countries are exchanging their produce or manufactures with each other, that nation which has the greatest number employed in this reciprocal trade, is said to receive a balance from the other; because the price of the overplus labor must be paid in gold and silver. ... This is the clearest and justest method of determining the balance between nation and nation: for though a difference in the value of the respective commodities may make some difference in the sum actually paid to balance accounts, yet the general principle, that labor (not money) is the riches of a people, will always prove, that the advantage is on the side of that nation which has most hands employed in labor.4

A closely similar doctrine is presented also by Harris, Steuart, and Arthur Young:

... a nation that pays ultimately upon its trade a balance in bullion, is a loser of so much of its dead stock; and a loser also, if its exports maintained fewer of its own inhabitants, than its imports did of those foreign nations.5

In all trade two things are to be considered in the commodity sold. The first is the matter; the second is the labor employed to render this matter useful. The matter exported from a country is what the country loses; the price of the labor exported is what it Edition: current; Page: [54] gains. If the value of the matter imported be greater than the value of what is exported the country gains. If a greater value of labor be imported, than exported, the country loses. Why? Because in the first case, strangers must have paid, in matter, the surplus of labor exported; and in the second case, because the country must have paid to strangers, in matter, the surplus of labor imported. It is therefore a general maxim, to discourage the importation of work, and to encourage the exportation of it.6

A balance in our favor is a proof that foreigners take more products and fabrics from us than we do from them, which is an advantage of the highest consequence, because it suggests at least a strong probability that they employ more of our poor than we do of theirs.7

These writers apparently would compare the amount of English labor embodied in the exports with the amount of foreign labor represented by the imports in computing the English “balance of labor.” On this basis, a given trade balance measured in money would have to be regarded as more favorable the lower the prices at which English exports were sold and the lower the wages earned by English labor engaged in their production, although it is not evident that these writers saw this implication of their doctrine. The objective they had in mind, to the exclusion of other considerations, was employment of English labor, and in the case of Young the assumption is fairly clear that the labor engaged in the production of exported goods would in the absence of such exports remain idle. He states that “whatever is paid to other countries in bullion, as a balance upon the year's trade, is just so much loss to any nation that has unemployed poor or unpurchased commodities,” but he concedes to Hume that the loss of the bullion is important only as it is a sign “that we do not export a due quantity of products and labor.” 8

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The balance-of-labor doctrine is of course absurd and probably even more absurd than the earlier and at the time still dominant balance-of-trade doctrine. It nevertheless can be regarded as a stage of some importance in the evolution toward more sensible doctrine. In the first case, any criticism of or substitution for the dominant balance-of-trade doctrine helped to promote the disintegration of the mercantilist errors, and thus was a service even if it proposed an even less satisfactory alternative doctrine, provided the criticism survived and the proposed substitute did not survive. Secondly, the balance-of-labor doctrine reversed the roles of employment and foreign trade as compared to the conventional balance-of-trade doctrine. In conventional mercantilism increased population, increased employment, improvement in the arts, in roads, canals, in the energy and skill of labor, were all welcomed because they would make possible increased production of goods for export or in lieu of imports from abroad, and would thus promote a favorable balance of trade. In the balance-of-labor doctrine the end was employment, and the favorable balance was the means, and even if its exponents did not themselves see clearly that income and consumption were in turn the rational ends of employment, and of economic activity in general, they at least made it easy for Adam Smith and later writers to take the next step and thus to bring about a revolutionary change in the orientation of economic thought.

One student of English mercantilism, E. A. Johnson, nothing the indisputable—and undisputed—fact that the mercantilists approved of a large working population, hard work on the part of laborers, the progress of skill in the application of labor, improvements in transportation and industry, and so forth, has concluded that serious injustice has been done to them by accounts such as presumably the present one of their doctrines:

All of which should prove that the ultimate concern of the mercantilists was the creation of effective factors of production. Not ten per cent of English mercantilist literature is devoted to the ill-fated doctrine of the balance of trade. [Let anyone who doubts this assertion turn through the pages of the English mercantilist literature and be convinced!] Their ardent passion for productive efficiency is shown by their advocacy of improvement of lands, mines and fisheries, Edition: current; Page: [56] and by their encouragement of inland communication and canal building. Industry was to be encouraged, idleness to be repressed. ... 9

But evidence that the mercantilists desired efficient production, be it piled up mountain high, of itself proves nothing as to their “ultimate concern.” They may have desired, and did desire, increased production, because they thought that it would promote a favorable balance of trade, even though they also desired it for other reasons. Such quantitative propositions have an unearned air of precision, but on the basis of my turning of the pages of English mercantilist literature I venture the conclusion that not ten per cent of it was free from concern, expressed or clearly implied, in the state of the balance of trade and in the means whereby it could be improved.

The labor doctrines of the English mercantilists need not be examined at length here, since they have been ably dealt with by other writers.10 On only one point, it seems to me, is critical comment on their exposition called for. The mercantilists, as they point out, were led by their obsession with the balance of trade and also, perhaps, by unconscious class sympathies, to deal with questions affecting labor as if laborers were a set of somewhat troublesome tools rather than human beings whose own comfort and happiness were a proper and primary object of concern for statesmen. The dominant doctrine, in consequence, advocated low wages, as a means of stimulating the worker to greater effort and of increasing England's competitive strength in foreign trade by lowering the money costs of English products. Sir James Steuart was merely expressing in blunter fashion than was common the position implicit in much of the mercantilist treatment of the labor question when he stated that “the lowest classes of a people, in a country of trade, must be restrained to their physical-necessary.” 11 But Furniss and Gregory fail to do full Edition: current; Page: [57] justice to the size and importance of the dissenting group, who on grounds either of economic analysis or humanitarian sentiment opposed the dominant doctrine that low wages were desirable. Such important writers as Cary, Coke, Davenant, and Defoe belonged to this group, and in the latter part of the eighteenth century the growth of humanitarianism operated to give even stronger challenge to the prevailing views.12 Representative of the opposition on humanitarian grounds was the complaint of an anonymous writer: “it is a great pity the laboring poor have not better encouragement, the cries of those unskillful men, who made a clamor of labor being too high, is a doctrine propagated more by theory than practice.” 13 Hume conceded that high wages resulted in some disadvantage in foreign trade, but insisted that “as foreign trade is not the most material circumstance, it is not to be put in competition with the happiness of so many millions.” 14 Since Hume was an enlightened critic of mercantilism, this is not of great significance, but Wallace, who was a mercantilist, agreed with Hume's doctrine, as “a maxim ... suitable to a humane disposition. Agreeably to such a benevolent sentiment, we ought to extend our notions of trade, and consider not only how much money it gains to a nation, but how far it is conducive to the happiness of the people.” 15

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He shewed me a very excellent argument to prove, that our importing lesse [gold?] than we export, do not impoverish the kingdom, according to the received opinion: which, though it be a paradox, and that I do not remember the argument, yet methought there was a great deal in what he said.—Samuel Pepys, Memoirs, February 29, 1663/4.

I. Legislative Proposals of Mercantilists

Introductory.—The mercantilist writers were often critics of the prevailing legislation, and they cannot be understood unless this is constantly borne in mind. The actual body of statutes and proclamations in force at any one time was always an uncoordinated accumulation of measures adopted at various periods and for various reasons, and was far from conforming to any self-coherent set of ideas or principles with respect to trade policy. Of these laws and proclamations there were always a number which were non-enforced or were only spasmodically enforced, either because their legal status was questionable or because change of circumstances or of official or public opinion made their strict enforcement inconvenient or impossible. There were others which were flagrantly violated, sometimes in spite of efforts to enforce them, sometimes with the connivance of corrupt or unsympathetic officials.

The laws and proclamations were not all, as some modern admirers of the virtues of mercantilism would have us believe, the outcome of a noble zeal for a strong and glorious nation, directed against the selfishness of the profit-seeking merchant, but were the product of conflicting interests of varying degrees of respectability. Each group, economic, social, or religious, pressed constantly for legislation in conformity with its special interest. Edition: current; Page: [59] The fiscal needs of the crown were always an important and generally a determining influence on the course of trade legislation. Diplomatic considerations also played their part in influencing legislation, as did the desire of the crown to award special privileges, con amore, to its favorites, or to sell them, or to be bribed into giving them, to the highest bidders. After the Revolution the crown's authority in matters of trade regulation was largely shorn away, and factional jealousies and party rivalries replaced the vagaries of monarchical whim as a controlling factor in trade policy.

The mercantilist literature, on the other hand, consisted in the main of writings by or on behalf of “merchants” or businessmen, who had the usual capacity for identifying their own with the national welfare. Disinterested exposition of trade doctrine was by no means totally absent from the mercantilist literature, and in the eighteenth century many of the tracts were written to serve party rather than self. But the great bulk of the mercantilist literature consisted of tracts which were partly or wholly, frankly or disguisedly, special pleas for special economic interests. Freedom for themselves, restrictions for others, such was the essence of the usual program of legislation of the mercantilist tracts of merchant authorship.

There follows a survey of the specific legislative proposals of the mercantilist writers with respect to the regulation of foreign trade proper. A complete survey would require consideration also of their recommendations for dealing with the fisheries, the colonial trade, the interest rate, and poor relief, as well as with the monopolies and the internal regulation of manufacture, for all of these subjects were approached more or less in terms of their bearing on the balance of trade. Space limitations, however, prevent such extension of this essay as would be necessary to deal with these even sketchily, and in any case the mercantilist doctrines with respect to most of these topics have been ably and comprehensively dealt with in their special literatures and in Heckscher's masterly treatise. Sufficient has already been said to make clear the relationship to mercantilist trade doctrine of proposals for restricting hoarding or the conversion of bullion into plate, for prohibiting or subjecting to heavy taxation use of the precious metals for making thread or cloth or for gilding, and for increasing the monetary circulation through the introduction Edition: current; Page: [60] of paper money, to make unnecessary further discussion of such proposals.

Bullionist Proposals.—Following the common usage, the term“bullionist” will be applied to the measures intended to promote the mercantilist objectives through direct regulation of transactions in the exchanges and in the precious metals. Even prior to 1600 opinion in support of the policy of controlling specie movements indirectly through control of trade, instead of directly by regulation of exchange and specie transactions, seems already to have been fairly common. As early as 1381, Aylesbury said that the way to prevent a drain of specie was to prevent more merchandise from coming into England than was exported from it.1 An anonymous writer in 1549 stated that regulation of trade so as to bring about a surplus of exports over imports was the only means of securing an influx of bullion.2 An official memorandum of 1559, justifying the restoration of the currency to its former metallic content, denied the efficacy of raising the nominal value of the standard coin as a means of preventing its export.3 In the sixteenth-century manuscripts discovered by Pauli there are to be found both bullionist and non-bullionist proposals. Revival of the staples and enforcement of the Statutes of Employment are recommended. The acceptance by English sellers of wool of exchange in lieu of specie in payment for their wool should be prohibited. English coin should be overvalued in exchange for foreign coin, so as to attract foreign gold and silver. But imports of unnecessary foreign goods are to be restrained.4 Hales had made one of the participants in his dialogue urge that some English commodity be made salable to foreigners only in exchange for specie in whole or in part, but in the course of the discussion heavy export duties on wool, the prohibition of the export of unwrought goods, and either prohibition of import of competitive Edition: current; Page: [61] foreign goods or duties high enough to make them more costly than similar domestic goods, are recommended.5

Bullionist proposals, on the other hand, are still to be encountered in the seventeenth century. Malynes advocated the revival of the Royal Exchanger, with a monopoly over exchange transactions, the maintenance of the mint par by royal proclamation as the actual rate of exchange, and prohibition of the export of bullion.6 Revival of the official regulation of exchange rates was urged also by Milles,7 Maddison,8 and Robinson;9 and Rowe, following Malynes, suggested that exchange rates be fixed by treaty with foreign governments.10 Mun in his first book11 (though not in his second),12 Rowe,13 and Violet14 wanted enforcement of the old Statutes of Employment. Many writers until late in the seventeenth century urged the enforcement of the prohibitions of the export of coin and bullion or after 1663, when the export of bullion and of foreign coin was legalized, their revival.15 But with the exception of a minor lapse by Edition: current; Page: [62] Steuart,16 there does not appear to have been any support of any of the bullionist devices among the prominent eighteenth-century writers.

Prohibitions vs. Duties.—The principal non-bullionist measures proposed by the mercantilists as means to secure a favorable balance of trade consisted of: restraints on the importation of foreign goods, especially manufactured goods and luxuries; encouragements to the export of English manufactured products; restraints on the export of raw materials; encouragements to the reexport trade; and restrictions on English industries which interfered with other industries or with trades which, on mercantilist or other grounds, were regarded as of greater importance.

Imports could be restricted either by the imposition of duties or by absolute prohibitions. Both methods were used and advocated, and many writers revealed no clear preference as between them. But they were more different in appearance than in fact. When writers asked for duties rather than prohibitions, they often wanted duties high enough to be prohibitive of import, or nearly so. When the government imposed prohibitions rather than duties, it often granted to particular trading companies or individuals special licenses to import. Many of the prohibitions were undoubtedly established primarily to obtain revenue by the sale of licenses to import rather than to promote a favorable balance of trade.17 Some writers expressed a preference for import duties rather than prohibitions without stating their reasons, but probably because duties seemed less severe.18 Other writers recommended Edition: current; Page: [63] moderate duties rather than high duties or prohibitions, because the latter were too severe and would lead to fraud, whereas duties could be enforced and would at least produce revenue.19 But other writers objected to the sacrifice of trade interests to fiscal considerations,20 while Steuart suggested that prohibitions could be more effectively enforced than duties if the latter would have to be high.21

Some writers advised that restrictions on imports should not be carried too far, lest they excite foreign retaliation against English exports.22 Other writers replied, however, that there was little or no danger of foreign retaliation. England exported necessaries and imported “toys,” and therefore had nothing to fear.23 Other countries already restricted the imports of things they could produce themselves; other things must be got somewhere, and they would hurt themselves if they refused to buy them where they could best be got. Most-favored-nation clauses in commercial treaties, moreover, prevented them from discriminating against England in their trade regulations.24 “No wise nation takes from another what they can be without; and what they cannot be without, they must take, prohibit what you please.25

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One argument made repeatedly by the opponents of the French treaty of 1713 in support of treating Portuguese wines more favorably than French wines was that the balance of trade was more favorable with Portugal than with France, and that lighter duties should be imposed on the imports of the former, either because retaliation would therefore be more injurious to England in the case of Portugal,26 or because Portugal's capacity to buy English goods would be reduced if England did not take her wine.27

Those who urged restraints on the exportation of raw materials—especially wool—almost invariably advocated prohibitions, probably because on mercantilist grounds a stronger case could be made for shutting-off access of foreigners to English raw materials than for completely shutting-out foreign imports, with the resultant danger of foreign retaliation, loss of shipping traffic, and so forth. It was always assumed by advocates of export prohibitions on raw materials that if foreigners could not take them unmanufactured they would be forced to buy them in manufactured form, so that trade would gain instead of lose thereby.28 Tucker, consistently with his balance-of-labor doctrine, recommended that taxes on exports should vary inversely with their completeness of manufacture, even to the extent of absolute prohibitions of export for raw materials, while the taxes on imports should vary directly with their completeness of manufacture.29

There were few criticisms of the absolute prohibition of export of raw materials, and especially wool, and these came chiefly from spokesmen for the agricultural interest.30 But the objection was sometimes made that the Continental weavers were not as dependent Edition: current; Page: [65] on English wool as the advocates of the prohibition claimed, and that the prohibition would not be effective, therefore, in preventing the development of a continental wool industry. Sheridan also recommended “vast” duties on the export of raw material, especially wool, with additional duties when attempt was made to export without paying the tax, in preference to the absolute prohibition then in force, infraction of which was a felony punishable by death. If the penalty for violation were a fine, instead of death, many would turn informers “who now out of tenderness of men's lives forbear the discovering this injurious practice.” 31 Petty asked whether when English clothiers could not sell all the woolens that were already produced, it would not be better to lessen sheep-raising and transfer the labor to tillage. If additional corn was not needed, and there were no idle hands and more wool than could be worked up, it would be proper to permit the export of wool. But if the advantages of the Dutch in making woolens exceeded those of the English by only a little, so that it would be easy to turn the scale in favor of English woolens, he favored the prohibition of export of wool.32 Brewster opposed the prohibition of the export of wool on the ground that England had an oversupply of it.33 Henry Home urged that the export of wool should be made subject to a moderate duty instead of to an outright prohibition. The French had alternative sources of supply, and absolute prohibitions stimulated smuggling. Freedom to export would result in an increased output of wool, and therefore in lower prices to English woolen manufacturers. The export could be prohibited at times of high prices, and thus difficulties created for the foreign rivals of English woolen manufacturers at critical times when the raw material was scarce. The revenue from export taxes on wool could be used to pay an export bounty on wool cloth.34 In general, Home favored the restriction of the export of raw materials only when free export Edition: current; Page: [66] would not lead to increased output and therefore to a lower price for English manufacturers.35

Discriminatory Treatment of Domestic Industries.—The argument for international specialization in industries is, of course, the central point in free-trade doctrine. There were some instances, however, of writers who were so anxious that England specialize in some particular industry or industries that they proceeded to the length of a sort of inverted protectionism, and proposed that other domestic industries which competed with the ones they regarded as of special importance to England should be suppressed or limited. As early as 1564 Cecil suggested that it would be good for England to make and export less cloth, so that corn should not have to be imported, because clothmakers were harder to govern than farmers, and because so many were employed in making cloth that labor had become scarce for other occupations.36 One writer would have suppressed stagecoaches, because they led to less drinking in inns, fewer privately-owned horses, and other similarly objectionable consequences.37 An anonymous writer in 1691 opposed any attempt to set up a linen industry in England, because it would interfere with the woolen industry by causing an increase in spinning wages.38 Another writer argued that:

... the woolen and silk manufacturers of this kingdom being the staple of our trade, and the most considerable and essential part of our wealth, ... it is therefore the common interest of the whole kingdom to discourage every other manufacture, whether foreign or assumed [i.e., domestic?] so far as those manufactures are ruinous to and inconsistent with the prosperity of the said British manufactures of wool and silk.39

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Defoe approved of encouraging all manufactures that could be set up in England, but “with this one exception only, namely, that they do not interfere with, and tend to the prejudice of the woolen manufacture, which is the main and essential manufacture of England.” 40 Arthur Young argued that because agriculture was more valuable to England than manufactures, no encouragement should be given to the increase of manufactures until England was completely cultivated, “it being proved that, until such cultivation is complete, the generality of them [i.e., manufactures] are a prejudice to the state, in that circumstance of not being employed about the most important concern of it.” 41

Those who presented such arguments were usually, of course, special advocates of some particular industry rather than disinterested students of the general welfare, but it is of interest that they should have thought it possible to appeal to the public by such reasoning. There was, in fact, some actual legislation based on the principle of discouraging industries which interfered with other industries regarded as of superior importance. Defoe cited the prohibition of the cultivation of tobacco on the ground that it would use land useful for raising wool,42 and alleged (apparently without basis in fact) that the mining of inland coal was not permitted in certain localities because it would injure the shipping trade, as examples of actual measures based on this principle. From 1699 to 1720 a series of acts was passed prohibiting covering buttons with wool, or with silk or mohair imported from other countries than Turkey, in order to promote the English silk industry and the trade with Turkey, with which country the balance of trade was favorable. Further examination of the trade legislation would no doubt reveal additional measures involving the deliberate discouragement of one English industry in order to benefit another.

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The Reexport Trade.—To foster the reexport or entrepôt trade, and to win the carrying trade away from the Dutch without opening the domestic market to foreign goods, free ports, drawbacks, and bonded warehouses were generally approved by even the extreme mercantilists,43 but some writers approved of the prevailing restriction of drawbacks of import duties to commodities which could not be conveniently manufactured at home.44

A more important and radical proposal, however, was that all import and export duties be abolished, and that there be substituted, both for fiscal and for trade regulatory purposes, internal excises on the consumption of foreign manufactured products. This would free the merchants engaged in reexport trade from the inconveniences and expense of the drawback system, and thus enable them to compete more effectively with their foreign rivals.45 Edition: current; Page: [69] It would at the same time get rid of the customs duties imposed on English goods for fiscal reasons and inconsistently with mercantilist doctrine.46 Walpole was sympathetic to such a policy, and under his administration the customs system was overhauled in the direction of freeing imports of raw materials from duty and abolishing export taxes except on commodities such as lead, tin, and leather, with respect to which it was supposed that the dependence on English supplies would force the foreigner to bear the tax. On several foreign commodities, also, import duties were replaced by excises on domestic consumption. In 1733, Walpole proposed to move farther in the same direction by substituting internal excises for the import duties on tobacco and wine. In support of his proposal, he pointed out that it would leave the reexport trade in those commodities wholly free from taxation and from the inconveniences and expense of the drawback system.47 The proposal has not appeared objectionable to later commentators, but Walpole's political opponents, appealing to the traditional connection of excises with the exercise of arbitrary power by the government against the people, and stressing the inconveniences which would result if, as alleged, acceptance of this limited excise would quickly lead to its wide extension, succeeded in arousing violent opposition to the measure, and in forcing its abandonment.

Export Bounties.48—In 1673, an export bounty was granted on corn. It remained in effect, however, only for some five Edition: current; Page: [70] years, but a new bounty was established by the famous corn law of 1689, and continued in effect, except for temporary suspensions, until 1814. Later, other export bounties were granted on linen and silk manufactures, sailcloth, beef, salt pork, and other commodities, and these were not repealed until the nineteenth century.

Until the second half of the eighteenth century the export bounties do not appear to have aroused much comment, favorable or unfavorable, in the contemporary literature, perhaps because the circumstances were then such that they had little practical importance. After 1750, however, there was considerable opposition to the corn bounties, especially in periods of short harvests, and the poorer classes repeatedly engaged in violent rioting in protest.

In so far as the export bounties stimulated the production and export of the bounty-fed commodities, the mercantilist would of course be predisposed to favor them, and on these simple grounds John Houghton defended the first corn bounty,49 and later writers,50 not all of whom were frank partisans of the agricultural interest, defended the later bounties. Henry Home supported the export bounty on corn both on these grounds and on the grounds that it had hurt French agriculture and therefore weakened France in case of war. In the same spirit he recommended a bounty on exports of manufactures to the colonies, “which by underselling them in their own markets, would quash every attempt to rivalship.” 51

The corn bounties were attacked on the grounds that by making corn dearer in England they resulted in a raising of wages and in the general cost of living, and thus impaired the capacity of the English to compete with other countries in non-subsidized Edition: current; Page: [71] commodities, and especially manufactures.52 But some of the supporters of the corn bounties denied that they had in fact made the price of corn higher in England or lower abroad than it would otherwise have been.53

Infant Industry Protection.—Modern writers usually credit Alexander Hamilton or Friedrich List, or even John Stuart Mill, with the first presentation of the “infant industry” argument for protection to young industries. It is of much earlier origin, however, and is closely related both in principle and in its history to the monopoly privileges granted to trading companies opening up new and hazardous trades and to inventions (the “patents of monopoly”). A complaint of 1645, that the circumstances which originally justified the grant of trading monopolies were no longer present, reveals the probable origin of the infant industry argument for bounties or import duties:

Those immunities which were granted in the infancy of trade, to incite people to the increase and improvement of it, are not so proper for these times, when the trade is come to that height of perfection, and that the mystery of it is so well known. ... 54

Some early presentations of the argument for temporary protection or bounties to “infant industries” follow:

And that the linen and iron manufactures may be so encouraged here by a public law, as that we may draw these trades solely to us, which now foreign nations receive the benefit of, there ought in the first place to be a tax or custom at least of four shillings in the pound put on all linen yarn, threads, tapes, and twines for cordage that shall be imported into England, and three shillings in the pound upon all linen cloths under four shillings the ell; and this law to continue and be for seven years. And by virtue of this tax or imposition, there will be such advantage given to the linen manufacture Edition: current; Page: [72] in its infancy, that thereby it will take deep rooting and get a good foundation on a sudden. ... 55

[I am] fully convinced ... that all wise nations are so fond of encouraging manufactures in their infancy, that they not only burden foreign manufactures of the like kind with high impositions, but often totally condemn and prohibit the consumption of them. ... 56

Upon the whole, premiums are only to be given to encourage manufactures or other improvements in their infancy, to usher them into the world, and to give an encouragement to begin a commerce abroad; and if after their improvement they can't push their own way, by being wrought so cheap as to sell at par with others of the same kind, it is in vain to force it.57

I have now, I think, shewn, Sir, that the linen manufacture ... is but in its infancy in Britain and Ireland; that therefore it is impossible for our people to sell so cheap, or to meet with such a ready sale even here at home, as those who have had this manufacture long established among them, and that for this reason, we cannot propose to make any great or quick progress in this manufacture, without some public encouragement.58

... it must be ridiculous to say to an infant manufacture, or while it is in its progress toward maturity, you have no occasion for any public encouragement, because as soon as you can make the quantities and qualities wanted, and sell them as cheap as those who have been long in possession of the manufacture, you will certainly find a vent for all you can make.59

All manufactures in their infancy require not only care, but considerable expense, to nurse them up to a state of strength and vigor. The original undertakers and proprietors are seldom able to lay down at once the necessary sums; but are obliged to take time, struggle with difficulties, and enlarge their bottoms by degrees.60

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Mercantilism and Protectionism.—It is not easy to make a sharp distinction between mercantilism as commercial policy and the modern doctrine of protection, for they differ more in their distribution of emphasis than in their actual content. The modern protectionist urges the importance of restricting the imports of foreign goods of a kind which can be produced at home in order that domestic production and employment may be fostered. He does not stress as much as did the mercantilist, and he may refrain from discussing, and may even reject, the balance-of-trade doctrine. Except in its more popular manifestations, modern protectionism does not lay special stress on the desirability of increasing or maintaining the national stock of bullion. But most of the arguments commonly used by modern protectionists were already current in the mercantilist period. Even during the seventeenth century, and frequently during the eighteenth century, tracts were written which made no reference to the balance of trade or to monetary considerations, and dealt only with the desirability of protecting domestic industries in order to increase employment and production.61 Usually, however, the balance-of-trade argument was invoked to reinforce the employment-production argument for import restrictions. Few writers, apparently, saw any possibility of conflict between these arguments. But the “balance-of-employment” argument, when it asserts that the “balance of work” is a better test than the balance of trade of whether trade is beneficial or not, can be interpreted as a plea for the greater importance of the protectionist than the monetary phases of mercantilist doctrine, and one author condemned the East India Company because it brought in silks to be consumed in England in place of English silks and woolens even if its activities did result in more gold coming into England than it took out.62 There are no important differences, also, between the legislative devices of the mercantilist and those of modern protectionism. The chief differences appear to be that: absolute prohibitions of import are less common, and commercial treaties and tariff bargaining relatively more important, now than then; export prohibitions have almost completely disappeared; rates of duty are generally much Edition: current; Page: [74] higher now than then (although a contrary impression is prevalent); and there has been a substitution for some of the old arguments of new or partially new ones of comparable intellectual quality.

II. The Collapse of Mercantilist Doctrine

The Self-regulating Mechanism of Specie Distribution.1—After Hume and Smith had written, mercantilism was definitely on the defensive and was wholly or largely rejected by the leading English economists. That their victory was as great as it was, was due largely, of course, to the force of their reasoning and the brilliance of their exposition, but it was due also in large part to the fact that, even before they wrote, mercantilism as a body of economic doctrine had already been disintegrating because of dissension within the ranks of its adherents and attacks by earlier critics. An important element in its collapse, especially in its monetary phases, was the development of the theory of the self-regulating mechanism of international specie distribution. The most influential formulation of this theory in England2 prior to the nineteenth century was by Hume. But its most important constituent elements had been stated long before Hume, and several earlier writers had brought them together much as he did.

Stated briefly, the theory is that a country with a metallic currency will automatically get the amount of bullion it needs to maintain its prices at such a level relative to the prices prevailing abroad as to maintain an even balance between its exports and imports. Should more money than this happen to come into that country, its prices would rise relatively to those of other countries; its exports, consequently, would fall, and its imports increase; the resultant adverse balance of payments would have to be met in specie; and the excess of money would thus be drained Edition: current; Page: [75] off. If, on the other hand, a country's monetary supply should happen to fall below the amount necessary to maintain equilibrium, its prices would fall relative to those abroad, exports would rise and imports fall, and the resultant favorable balance of payments would bring in an amount of specie from abroad sufficient to restore equilibrium. For its formulation and its use as a basis for repudiation of certain of the monetary phases of mercantilist doctrine, five stages had to be achieved:

  • 1. Recognition that net international balances of payments must be paid in specie.
  • 2. Recognition that the quantity of money is a determinant of the level of prices.
  • 3. Recognition that the volume of exports and the volume of imports depend on the relative levels of prices at home and abroad.
  • 4. Integration of the three preceding propositions into a coherent theory of a self-regulating international distribution of the money metal.
  • 5. Realization that this theory destroyed the basis for the traditional concern about the adequacy of the amount of money in circulation in a country, at least as a long-run matter.

The first proposition was an important element in the mercantilist doctrine, and was universally accepted. A quantity theory of the value of money, as has already been shown, was held by many of the mercantilists, and there were few who rejected it once they became aware of it. There remains to be examined only the progress made toward attainment of the last three stages. Vague statements suggestive of the existence of a self-regulating mechanism of specie distribution but not specific as to its character will be disregarded.3

Recognition that low prices were conducive to large exports and high prices to large imports was fairly common even, in the early mercantilist literature, but I have not been able to find any generalized Edition: current; Page: [76] statement setting forth the dependence of the trade balance on the comparative level of prices until the end of the seventeenth century. Malynes at one point approached surprisingly close to a grasp of the self-regulating mechanism, especially if one considers his general obtuseness and obscurantism. He argues that if the manipulations of exchange dealers forced English currency below its mint par, coin would be exported, home prices would consequently fall, and foreign commodities would rise in price because of the increase of money abroad.4 Had he proceeded to consider the effect of these price changes on the balance of trade and on the flow of specie, he would have presented a complete formulation of a full cycle of the self-regulating mechanism. He proceeded, instead, to denunciation of the exchangers. Except for the development of the quantity theory of money, I can find no real traces of further progress in this connection until the last decade of the seventeenth century.5

Locke is sometimes credited, wrongly I believe, with having come close to a satisfactory statement of the self-regulating mechanism, although he did make some advance in that direction. He states that a country in commercial relations with, and using the same metal for currency as, the rest of the world requires under given circumstances a certain (presumably minimum) amount of money if a certain volume of trade is to be carried on at all, or is to be carried on without loss:

That in a country, that hath open commerce with the rest of the world, and uses money, made of the same materials with their neighbors, any quantity of that money will not serve to drive any quantity of trade; but there must be a certain proportion between their money and trade. The reason whereof is this, because to keep your trade going without loss, your commodities amongst you must keep an equal, or at least near the price of the same species of commodities in the neighboring countries; which they cannot do, if your money be far less than in other countries; for then either your commodities must be sold very cheap, or a great part of your trade must Edition: current; Page: [77] stand still, there not being money enough in the country to pay for them (in their shifting of hands) at that high price, which the plenty, and consequently low value of money, makes them at in another country. ... 6

He proceeds to illustrate by imagining that England loses half its money, other things there and elsewhere remaining unaltered. Either half the trade, employment, etc., would cease, or prices, wages, rents would be cut in half. If the latter should result, domestic commodities would be sold abroad cheap and foreign commodities would be bought dear, to the loss of the country,7 and labor might emigrate to where wages were high. Eventually, because of the relatively high foreign prices, foreign goods would become scarce (i.e., imports would fall?). He says nothing as to the necessary as distinguished from the possible and the desirable relations between prices at home and abroad, and he gives not even a hint that the departure from the initial and desirable situation will breed its own correctives, through its influence on price levels, commodity balances, and specie flows.8 All that Locke had of the elements of the self-regulating mechanism was the quantity theory of money, with even here the defect that at the critical point he failed to make use of it and implied instead that a serious maladjustment between prices and the quantity of money was as likely to be corrected, presumably permanently, by a consequent change in the volume of trade as by a change in prices.

In dealing with the factors determining the exchange rates, Locke was much more penetrating. He explains the exchange rate between two countries as due to: (1) “the overbalance of the trade,” which, the context shows, means the balance of payments Edition: current; Page: [78] resulting from past transactions; and (2) the relative plenty of money (identified with liquid capital) which affects inversely the opportunities for profitable investment of surplus funds, and therefore determines to what country they will flow. He states fairly clearly the limits beyond which exchange rates cannot move without leading to specie flows.9

North, in 1691, presented a concise formulation of an automatic and self-regulating mechanism, which provides a country with the “determinate sum of specific money” required for carrying on the trade of the nation.10 It is not, however, the mechanism described in the modern theory, and is not, explicitly at least, an explanation of the international distribution of money.11 The mechanism which he presents consists of an automatic ebb and flow of money into and out of circulation according to the unexplained specific requirements of trade. When because of troubled conditions money is hoarded, the mints coin more bullion, whose source is not explained. When peace returns, money comes out of the hoards, the mints cease to coin bullion, and the excess of money is melted down “either to supply the home trades or for transportation abroad. Thus the buckets work alternately; when money is scarce, bullion is coined; when bullion is scarce, money Edition: current; Page: [79] is melted.” He fails to relate this process either to price movements or to movements in the balance of trade.

Samuel Pratt, in 1696, urged that funds be voted to the king to meet the expenses of his Continental armies and denied that the consequent remittances to the Continent would drain England of its silver by an argument which not only corrects the “sinews-of-war” emphasis on money but, in spite of its compactness, is a satisfactory statement of the self-regulating mechanism if, as seems to me reasonable, “cheapness of silver” may be interpreted as meaning high commodity prices:12

Which uncoined silver will for the most part find its way back again, because the carrying over so much every year will glut that place to which ‘tis carried so that silver will become cheap there, and they must disgorge at the best market; which England, in all probability, will be. And the effect of that overbalance which foreigners must, as cases now stand, get by us, cannot be carried out of the nation but in other commodities besides silver.13

William Wood supposes that by accident forty-odd millions of public money were to be found in specie under the ruins of Whitehall, and were paid out to the public creditors, and proceeds to trace the consequences. Interest would fall; either the added bullion would be hoarded or converted into plate, or else prices and wages would rise and exports consequently fall. If the free export of money were not permitted, England, since it now had smaller exports and high prices, would therefore now be worse off instead of better, with the implication that if it were permitted money would be exported in consequence of an unfavorable balance of payments. From which he concludes that a favorable balance of trade is the only way to keep bullion at home.14

In 1720, there appeared a remarkable essay of some thirty-odd pages by one Isaac Gervaise, apparently his only publication, in which there is presented an elaborate and closely-reasoned exposition of the nature of international equilibrium and of the self-regulating Edition: current; Page: [80] mechanism whereby specie obtained its “natural” or proper international distribution.15 In spite of the peculiarities of terminology and the occasional obscurities of exposition by which it is marred, the essay marks a great advance over earlier doctrine in this field. The brilliance of its contents, and its complete oversight by other scholars, due presumably to its rarity, warrant its being dealt with in some detail.

Gervaise starts out with the proposition that gold and silver, which he calls “the grand real measure or denominator of the real value of all things,” tend to be distributed internationally in proportion to population, on the ground that only labor (i.e., the product of labor) can attract specie. He proceeds immediately to qualify this proposition in a manner which indicates that he believes that it is in proportion to national value productivity or real income, and to population only as that is an index of real income, that specie tends to be distributed:

Whenever I mention the quantity of inhabitants, I always suppose that regard which ought to be had to the situation and disposition of the different countries of the world; the same quantity of inhabitants not producing the same effect in all countries, according as their dispositions differ....16

If a country should for a time have more than its proportion of specie, this would break the balance between consumption and production. Consumption would exceed production, the excess being met by increased imports or decreased exports. An unfavorable balance of payments would result, which would continue until the proper proportion was restored:

When a nation has attracted a greater proportion of the grand denominator of the world than its proper share, and the cause of that attraction ceases, that nation cannot retain the overplus of its proper proportion of the grand denominator, because in that case the proportion of poor and rich of that nation [i.e., of producers and consumers] is broken; that is to say, the number of rich is too great, in proportion to the poor, so as that nation cannot furnish unto the Edition: current; Page: [81] world that share of labor which is proportioned to that part of the grand denominator it possesses: in which case all the labor of the poor will not balance the expense of the rich. So that there enters in that nation more labor than goes out of it, to balance its want of poor: and as the end of trade is the attracting gold and silver, all that difference of labor is paid in gold and silver, until the denominator be lessened, in proportion to other nations; which also, and at the same time, proportions the number of poor to that of rich.17

Gervaise then proceeds to consider the effects of “credit,” or “that time which is allowed in trade.” “As all men one with the other are equally subject to the same passions,” the “denominators,” or currencies, of all the countries are increased in amount by credit in equal proportions: “Credit increases the denominator, and adds unto all things an increase of denomination of value proportioned to the increase of the denominator by credit,” i.e., prices rise in proportion to the increase in currency through credit.18 If a country should, however, add to its currency by credit in more than due proportion, that increase of credit will act on that nation as if it had drawn an equal sum from a gold or silver mine. It will retain only its proportion of the increase; “so that the rest thereof will in time be drawn off by the labor of other nations, in gold or silver.” The mechanism whereby this will be brought about is explained as follows: the increase in the holdings of currency will lead the holders to increase their consumption of goods; less goods will therefore be available for export; the adverse trade balance will be met by an export of specie. The reverse happens when a country decreases the amount of credit below its due proportion; by a corresponding process gold and silver will be drawn from abroad until its “denominator,” including “credit,” has recovered its proper proportion to that of other countries.19 Gervaise concedes, however, another temporary possibility: an even balance may be maintained in the foreign trade even though there is increased consumption at home through the surrender (whether for domestic consumption or for export is not indicated) of the nation's “store or capital of exportable labor,” by which Gervaise apparently means that the normal stocks of materials and finished goods may be allowed to Edition: current; Page: [82] run down. But once the available specie and stores of goods had been exhausted, credit would have to be contracted until the “denominator” was again in due proportion.20

A relative excess of the “denominator,” or of currency, on the part of a particular country results, through its effect on the trade balance, in a decline in the foreign exchange value of its currency. If its excess of currency is great, so that coin becomes scarce and the exchange value of its currency is low, foreigners having claims for payment against that country in terms of its currency try to reduce their losses by accepting payment in goods and disposing of them abroad for specie. But this results in a rise in the wages of its labor and therefore also (by implication) in the prices of its commodities in terms of that country's currency, and the foreign creditors find that wages and prices abroad are relatively lower, and must therefore dispose of these commodities at a loss. They therefore “cease to credit this nation, by importing into it no more labor than they are sure to export out of it.” In the meanwhile, foreign manufacturers find that because of the reduced value on the foreign exchanges of the currency of the country which has expanded its currency they can afford to pay a high price in its own currency for that country's materials, until the prices of those materials rise more than sufficiently to offset the discount on the exchanges. At this point, where he seems to be well embarked upon an explanation of the manner in which equilibrium is established between a country with a depreciated “credit” currency and a metallic standard outside world, Gervaise unfortunately stops short.21

This summary of Gervaise's analysis, which does not do full justice to it, should nevertheless be sufficient to indicate how striking an advance he had made toward a satisfactory exposition of international equilibrium. Although Hume's exposition was superior in its freedom from obsolete terminology and much clearer in its exposition, not until the nineteenth century was there to be a match for the comprehensiveness of Gervaise's account, with its specific provision for the necessity, under equilibrium, of balance between a country's exports and its imports and between its production and its consumption, and with its description of the role of wage rates and exchange rates in the mechanism Edition: current; Page: [83] whereby a disturbed equilibrium is restored.22 Gervaise, in fact, in approaching the problem from the income rather than from the price angle, proceeded in a manner which many recent writers have found more to their liking than that adopted by Hume and predominantly followed by the classical school, and in this sense was more “modern” than his successors of a century or so later.

Prior, in 1730, expounds one-half of the self-regulating mechanism unobjectionably. After pointing out that the East India trade draws silver from Europe, and thereby creates a scarcity of it in Europe, apparently in relation to both gold and commodities, he says:

And if so much treasure shall flow for any considerable time in the same channel, it may put an end to that trade: for such large remittances in silver must in time make this metal plenty in those parts, and as its quantity increases, its value will lessen; so that by degrees silver may come to bear the same proportion to gold in the East Indies as it does in Europe, and their commodities will rise in proportion.23

Jacob Vanderlint, in 1734, states the mechanism well, although his exposition of it is so scattered through his book that it is not possible to quote a compact statement of it. In the following passage, he comes closest to a unified exposition of the mechanism:

But no inconvenience can arise by an unrestrained trade, but very great advantage; since if the cash of the nation be decreased by it, which prohibitions are designed to prevent, those nations that get the cash will certainly find every thing advance in price, as the cash increases among them. And if we, who part with the money, make our plenty great enough to make labor sufficiently cheap, which is always constituted of the price of victuals and drink, our manufactures, and everything else, will soon become so moderate as to turn the balance of trade in our favor, and thereby fetch the money back again.24

Vanderlint does not approve of this automatic mechanism when Edition: current; Page: [84] it operates to raise prices, and advocates the encouragement of the use of gold and silver in the arts as a means of preventing a rise of prices when the balance of trade is favorable.25

When Hume published his Political Discourses, in 1752, therefore, all the essential elements of the theory of the self-regulating mechanism were already available in previous literature, and several fairly satisfactory attempts to bring them together into a coherent theory had been made. Hume, however, stated the theory with a degree of clarity, ability of exposition, emphasis on its importance, and consistent incorporation with the remainder of his economic views, which most of these earlier writers did not even distantly approach.26 Since his account of the mechanism is reexamined in a later chapter, attention need be called here only to some particular phases of his analysis. He includes in the general mechanism as an additional equilibrating factor the influence of variations in the exchange rates on commodity trade,27 a point which apparently no one had hitherto brought directly into an exposition of the larger mechanism of adjustment. He remarks that the mechanism is not peculiar to international trade, but also operates internally between the districts of a single country.28 He does not quite follow out the consequences of his analysis to what later exponents of it regard as its logical significance for long-run policy, namely, lack of concern about the quantity of money in a country; for without stating the qualifications which would possibly justify his position, he disapproves of paper money which is not merely a certificate of deposit of an equivalent amount of metallic money, because it drives hard money out of the country;29 he concedes that for wars conducted on foreign soil, and in negotiations with foreign nations, a country derives benefit from an abundance of metallic money at home;30 and he concedes Edition: current; Page: [85] that an increasing amount of money acts as a stimulus to industry.31

After Hume, the self-regulating mechanism was much more frequently and more clearly stated than before. Patrick Murray (Lord Elibank) disapproves of paper money because, on quantity-theory grounds, it results in a rise of prices, a check to exports, and consequent depression, but:

These inconveniences, when arising from a plenty of real money, are fully compensated by the riches which occasioned them, and the above stagnation of trade will last no longer than other states continue to undersell us, which cannot be very long; for the trade of any state will be an inlet to riches, and money will flow in upon it till that state be likewise full, and its entrance be stopped by the same repletion; from that state it will go to another, and so on, till it becomes on a perfect level and equality throughout the whole.32

Harris presents an excellent statement of the self-regulating mechanism.33 Like Vanderlint, however, Harris is too much of a mercantilist to accept with equanimity the consequences of the mechanism when it results in an outward drain of money, and recommends hoarding and conversion of bullion into plate as means of withdrawing bullion from circulation when otherwise an outward drain would ensue.34 A good statement of the mechanism, in this case free from any mercantilist qualification, is to be found also in Whatley.35

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Vanderlint, Wood, and Harris, as has been shown, accepted the automatic regulation of the amount of money in circulation, but still retained the mercantilist preoccupation with the amount of bullion in the country, as did Hume also to some extent. A few mercantilists after Hume tried to find a basis for rejecting the automatic mechanism, but with meager results. Wallace replies to Hume that if the amount of paper money increases, trade will increase. Making an unconscious substitution of “export trade” for “trade,” he concludes: “And, as they don't take paper in payment from foreign nations, if they are gainers by trade, they must receive the balance in silver and gold.” 36 Steuart rejects the quantity theory of money, on the ground that prices depend on the demand for, and supply of, commodities, and not on the quantity of specie. He tries half-heartedly to meet Hume's exposition of the self-regulating mechanism by stressing the transitory effects, with reference to hoarding and the volume of production, of the sudden change posited by Hume in the quantity of money. The removal of four-fifths of the money in circulation would annihilate both industry and the industrious. If as a result of the lower prices (all of ?) the stock of English goods were to be exported, it would mean the starvation of the English people.37 If the quantity of money increases, on the other hand, hoarding will prevent this increase from acting on prices. In any case “reason and experience” refute the quantity theory.38 At one point he suggests a self-regulating mechanism, whereby money goes into hoards when in excess and comes out when there is scarcity, essentially like North's except that Steuart explains the movement of specie into and out of hoards as governed by the possibility of lending it at interest:

While there is found a sufficient quantity of money for carrying Edition: current; Page: [87] on reciprocal alienations, those money gatherers will not be able to employ their stagnated wealth within the nation; but so soon as this gathering has had the effect of diminishing the specie below the proportion found necessary to carry on the circulation, it will begin to be lent out, and so it will return to circulate for a time, until by the operation of the same causes it will fall back again into its former repositories.39

Tucker, in the course of an attempt to refute Hume's argument, follows Hume's ambiguous terminology too closely, and in consequence shifts unconsciously from a discussion of the effects on trade of more money to the effects of more wealth, and proceeds to a discussion of whether a rich country can compete successfully with a poor one,40 and Hume, in an unsatisfactory reply, himself follows this shift in issues.41

One of the mysteries of the history of economic thought is that Adam Smith, although he was intimately acquainted with Hume and with his writings, should have made no reference in the Wealth of Nations to the self-regulating mechanism in terms of price levels and trade balances, and should have been content with an exposition of the international distribution of specie in the already obsolete terms of the requirement by each country, without specific reference to its relative price level, of a definite amount of money to circulate trade. When a country has more money than it needs to circulate its trade, the “channels of circulation” will overflow, and the surplus money will be sent abroad “to seek that profitable employment which it cannot find at home.” 42 What adds to the mystery is that Smith had in his earlier Lectures presented approvingly a good summary of Hume's analysis.43

Scarcity of Money.—It was the constant complaint of the mercantilists that England was suffering from “scarcity of money,” and the main objective of the mercantilist proposals, at least during the earlier period, was to relieve this scarcity. Many modern writers accept these complaints at their face value, and cite dubious historical facts as the cause of this scarcity, without Edition: current; Page: [88] either investigating what those who complained meant by “scarcity of money” or analyzing the notion for themselves. The mercantilists who voiced such complaints rarely made clear precisely what they had in mind. But where the context reveals what they were thinking of, they meant by scarcity of money some one or some combination of the following things: men not having enough “money” to buy the things they wanted—i.e., general poverty; merchants not being able to sell their goods in adequate volume—i.e., “slack trade”; merchants not having, or not being able to borrow at moderate rates of interest, enough “money” adequately to finance their operations—i.e., shortage of capital; high interest rates—i.e., scarcity of capital; money of some denominations scarce relative to other denominations—i.e., either a mismanaged currency, or the ordinary condition of a bimetallic currency whenever the market ratios of gold and silver diverge from the mint ratios; low prices; prices too high for the existing supply of money—an impossibility as a continuing phenomenon.

Even contemporary writers saw that these complaints rested on confused or inadequate economic analysis and heaped ridicule upon them. More criticized the notion of scarcity of money as early as 1523;44 Starkey makes one of the participants in his dialogue deal disrespectfully with it; and Mun and Child, among others, refused to take it seriously:

Lupset: “For, as touching wool and lead, tin, iron, silver and gold, yea, and all things necessary for the life of man, in the abundance whereof standeth very true riches, I think our country may be compared with any other.”

Pole: “... All with one voice cry they lack money, ... and it is nothing like that all should complain without a cause.”

Lupset: “... Men so esteem riches and money, that if they had thereof never so great abundance and plenty, yet they would complain....” 45

And first concerning the evil or want of silver, I think it hath been, and is a general disease of all nations, and so will continue until the end of the world; for poor and rich complain they never have enough; but it seemeth the malady is grown mortal here with us, and therefore it cries out for remedy. Well, I hope it is but imagination Edition: current; Page: [89] maketh us sick, when all our parts be sound and strong ... 46

... money seems to vulgar observers most plentiful when there is least occasion for it; and on the contrary, more scarce, as the occasions for the employment thereof are more numerous and advantageous; ... from the same reason it is, that a high rate of usury makes money seem scarce....47

I can say in truth, upon my own memory, that men did complain as much of the scarcity of money ever since I knew the world as they do now; nay, the very same persons that now complain of this, and commend that time.48

The common confusion between money and what could be bought with money or was valued in terms of money, which was usually the explanation of complaints of scarcity of money, was pointed out by North49 and by the author of Considerations on the East-India Trade.50 At least two writers before Hume explained the process of saving, to show that it need not consist merely of the piling-up of a stock of actual money.51 As has already Edition: current; Page: [90] been shown, arguments for the need of more money for the building-up of a state treasure had become wholly academic after Henry VIII squandered his inheritance, and played little part in later mercantilist discussion. The advocates of paper money and of credit banking helped to undermine the prestige of the precious metals, especially when they claimed that credit and paper money could perform all the functions of metallic money. These considerations, combined with the development of the doctrine of an automatic regulation of monetary supplies, left the monetary doctrines of the mercantilists in a sad state of disrepair, and prepared the way for their definitive exposure by Hume and Smith.

Thrift.52—The prevailing glorification of thrift and the acceptance of the accumulation of wealth as the end of production operated in a twofold way to strengthen the hold of the mercantilist doctrines on public opinion. On the one hand, identification of the saving process with the accumulation of the precious metals made acquisition of a greater supply of them the positive side of thrift. The stress on frugality, on the other hand, helped to create a prejudice against imports, which then consisted largely of luxuries. But the force of these considerations was weakened by counter-arguments justifying consumption of luxuries, either for their own sake, on the ground that the end of economic activity was neither production, nor the accumulation of wealth, but consumption, or enjoyment of the good things of life;53 or as a Edition: current; Page: [91] stimulus to productive activity, whether because free spending quickens trade and circulation,54 or because the prospect of enjoyment is an incentive to labor and to risk-taking.55

Laissez-Faire and Free Trade.—The antecedents of Smith's laissez-faire and free-trade views are probably rightly to be sought mainly in the philosophic literature, and perhaps also in the writings of the physiocrats, rather than in the earlier English economic literature. Hume, no doubt, was an important influence on Adam Smith. But Hume was primarily a philosopher, rather than an economist, and although he must have helped Smith to develop Edition: current; Page: [92] his free-trade views, he remained a moderate protectionist himself. But if Adam Smith had carefully surveyed the earlier English economic literature, including, however, tracts apparently always obscure and already scarce by his time, he would have been able to find very nearly all the materials which he actually used in his attack on the protectionist aspects of the mercantilist doctrine. He would, however, have found them scattered, often imbedded in crudely mercantilist analysis, and often consisting only of stray and vague anticipations of later doctrine of whose full significance their authors showed little or no awareness. Caution is necessary lest more be read into such passages than was really intended by their authors, and there has been great exaggeration of the extent to which free-trade views already prevailed in the English literature before Adam Smith. North, Paterson, the author of Considerations on the East-India trade (1701), Isaac Gervaise, and Whatley are the only writers prior to Adam Smith whom I have found who seem really to have been free traders.56 But certain elements of doctrine tending to lead to free-trade views were fairly widely prevalent before the publication of the Wealth of Nations. Some of these have already been discussed, for the mercantilist doctrines with respect to the importance of money and of a favorable balance of trade were inconsistent with the principles upon which a free-trade argument could be based, and their refutation was a necessary preliminary to successful formulation of a free-trade doctrine. The formulation of the quantity theory of money and the criticisms and qualifications of the balance-of-trade doctrine prepared the way, therefore, for the emergence of a comprehensive free-trade doctrine. There were other ideas, more immediately related to Adam Smith's argument for free trade, which had attained some degree of currency before he wrote.

There was general agreement that the profit motive was the controlling factor in economic behavior, especially of merchants: “No man in England never seeketh for no common weal, but all and every for his single weal”;57 “For merchants travail for gain Edition: current; Page: [93] and when gain ceaseth they travail no more”;58 “Every man will sell his wares at the highest price he may”;59“And where it is said that he is a merchant, and that he ought to have the sea open and free for him, and that trades of merchants and merchandise are necessary to export the surplus of our commodities, and then to import other necessaries, and so is favorably to be respected, as to that it is well known that the end of every private merchant is not the common good, but his particular profit, which is only the means which induceth him to trade and traffic”;60 “Every man almost is taken with the attention to profit. Love doth much, but money doth all”;61 “Men in trade, more especially than the rest of mankind, are bound by their interest; gain is the end of commerce”;62 “I am afraid there are but few men in any country who will prefer the public good to their private interest, when they happen to be inconsistent with one another.” 63

The concept of the “economic man,” instead of being, as is often alleged, an invention of the nineteenth-century classical school, was an important element in the mercantilist doctrine. Between the attitudes of the two schools toward the “economic man,” if the extreme positions of both may be taken for purposes of contrast, there was this important difference, however, that the classical economists argued that men in pursuing their selfish interests were at the same time, by a providential harmony of interests, either rendering the best service of which they were capable to the common good or at least rendering better service than if their activities were closely regulated by government, whereas the mercantilists deplored the selfishness of the merchant and insisted that to prevent it from ruining the nation it was necessary to subject it to rigorous control. When Malynes made the title of one of his tracts read The center of the circle of commerce, or, a refutation of a treatise, intituled the circle of commerce, he did so in order to emphasize his thesis that “gain” was Edition: current; Page: [94] the “center” or objective of those engaged in economic activities, and that the only way to prevent merchants from bringing ruin to the commonwealth by their selfish pursuit of gain was to eliminate by restrictions or penalties the profitability to individuals of certain types of transactions which were opposed to the common interest.64 In extreme cases this attitude tended to lead to wholesale denunciation of the merchant,65 and the belief that merchants were governed only by self-interest underlay the fundamental mercantilist doctrine of the need for state regulation of commerce. As Fortrey put it, “the public profits should be in a single power to direct, whose interest is only the benefit of the whole,” i.e., the statesman.66

There was nobody to deny that merchants were governed only or predominantly by self-interest, but some spokesmen for the merchants replied that so were the other classes, and asked the old question: quis custodiet custodes? or warned that those who counseled interference by government with the operations of merchants, especially if they were merchants themselves, probably had some private ax to grind. There follow a few citations illustrating these points of view:

And in general all those who are lazy, and do not, or are not active enough, and cannot look out, to vent the product of their estates, or to trade with it themselves, would have all traders forced by laws, to bring home to them sufficient prices, whether they gain or lose by it.67

There is hardly a commerce, but the dealers in it will affirm, we Edition: current; Page: [95] lose by all the rest; and yet it is evident that in time of peace the kingdom gets by trade in general.68

... most of the laws that have been made relating to trade, since the Act of Navigation, may be presumed were calculated rather for particular interests than public good; more to advance some tradesmen than the trade of the nation.69

... only to manage a little conceit or selfish intrigue, to encourage and procure a monopoly, exclusion, pre-emption, and restraints or prohibitions; ... to restrain, prohibit, and disjoin, not [only] the industry of His Majesty's subjects with other nations, but even with and respect to one another. They will find that all these and many more pretended encouragements are so far from the things they are called, that they are not only intrigues to make private advantage from the ruin of the public, and arise from the mistaken notions and conceits of unthinking men, who neither have temper nor allow themselves time or opportunity to consider things as they are, —but only take them as they seem to be,—a sort of presumptuous meddlers, who are continually apt to confound effects with causes, and causes with effects, —and not to measure the trade, or improvement of house, family, or country, and even that of the universe, by the nature and extent of the thing, but only by their own narrow and mistaken and meán conceptions thereof....70

Most of the statutes ... for regulating, directing, or restraining of trade have, we think, been either political blunders, or jobs obtained by artful men, for private advantage, under pretense of public good.71

Conflicting counsel was offered as to how to solve this familiar dilemma of public administration, namely, how to regulate in the public interest the selfish activities of individuals while averting the danger lest the regulations themselves be the product of advice or pressure from interested groups. The problem was made to appear even more serious by the general agreement among merchants of all shades of opinion that politicians and landed gentlemen were not competent to regulate trade on the basis of their own judgment. To the solution offered by some that the statesman Edition: current; Page: [96] should take the advice of the merchant,72 others replied that the merchant was a bad councilor because he always had private interests to serve. Child advised that neither merchants, shopkeepers, nor manufacturers should be accepted as guides until they had become rich, retired from trade, and “by the purchase of lands, become of the same common interest with most of their countrymen.” 73 But this was an argument to suit the occasion of the moment, and intended to discredit particular types of proposals by merchants which did not fit in with his own commercial ambitions. Child had no high opinion of the sort of regulation of trade which would result from the unaided wisdom of the landowner. To a subordinate in the East India Company, who had objected against certain instructions that they seemed to be in violation of the law, Child is reported to have replied:

that he expected his orders were to be his rules, and not the laws of England, which were a heap of nonsense, compiled by a few ignorant country gentlemen, who hardly knew how to make laws for the good government of their own private families, much less for the regulating of companies and foreign commerce.74

The general effect of this common discrediting of all advice except such as emanated from one's self must have been to weaken confidence in the possibility of obtaining sound and disinterested advice as to the regulation of trade from any source.

Tending further to weaken confidence in the possibility of the beneficial regulation of trade by government was the frequently repeated argument that such regulation went counter to human nature, and could not succeed as against the power of the profit motive.75 Some representative instances follow:

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... the trade of the world will not be forced, but will find or make its own way free to all appearance of profit....76

... if the matter in England, is so prepared for an abatement of interest, that it can not be long obstructed, as he [i.e., “I.C.,” the author of an unnamed contemporary tract—probably Josiah Child] saith it is, we need no law for stating it, for nature will have its course with us, as well as in other countries, and he cannot instance, in any country, where by a law, interest is set under 6 per cent and nature is best let alone unforced.77

To pretend after this, that parties shall govern mankind against their gain, is to philosophize wisely upon what may be, and what would be politic to bring to pass; but what no man can say was ever put in practice to any perfection; or can be so by the common principles that govern mankind in the world.... That tradesmen should cease to seek gain and usurers to love large interests; that men that have gain'd money should leave off desiring to get more; and that zeal to a party should prevail over zeal to their families; that men should forfeit their interest for their humor, and serve their politics at the price of their interest.... No, no, it is not to be done; the stream of desire after gain runs too strong in mankind, to bring any thing of that kind to perfection in this age. The thing is so impracticable in its nature, that it seems a token of great ignorance in the humor of the age to suggest it; and a man would be tempted to think those people that do suggest it, do not themselves believe what they say about it.78

There is nothing weaker, than pretending to offer particular rules how a country may thrive by foreign traffic. Trade must be suffered to take its own course, and will find its own channel.79

... unless our own manufactures are as good of their kinds, and as low in their prices as the same goods of other nations are, they will not sell either abroad or at home. Trade cannot be forced, but manufacture may be improved.80

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The objections so far considered against government regulation, in the public interest, of the selfish activities of the merchant rested on the incompetence of the regulators, or the unavailability of unbiased advisers, or the inability of government to cope with the strength of the profit motive.81 A few writers, however, anticipated Adam Smith more or less clearly in formulating his fundamental principle that man in pursuing his own ends was at the same time usually serving the general good, and that unregulated trade was therefore desirable, not merely because it was the lesser of two evils, but because it was positively the servant of the public welfare.82 The idea of the natural harmony of interests appears already to be present in the following passage from Misselden:

And is it not lawful for merchants to seek their Privatum Commodum in the exercise of their calling? Is not gain the end of trade? Is not the public involved in the private, and the private in the public? What else makes a common wealth, but the private-wealth, if I may say so, of the members thereof in the exercise of commerce amongst themselves, and with foreign nations?83

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North states it clearly: “That there can be no trade unprofitable to the public; for if any prove so, men leave it off; and wherever the traders thrive, the public, of which they are a part, thrives also.” 84 It is implied in a tract attributed to Child: “... trade is a free agent, and must not be limited or bounded; if it be so in any nation, it will never prosper.” 85 Davenant subscribed to it, although not wholly unqualifiedly:

Trade is in its nature free, finds its own channel and best directeth its own course; and all laws to give it rules and directions, and to limit and circumscribe it, may serve the particular ends of private men, but are seldom advantageous to the public.86

More important, in preparing the way for Adam Smith, was Mandeville's more elaborate reasoning in support of individualism and laissez faire, resting on his famous argument that “private vices” such as “avarice” and luxury were “public benefits.” 87 In Hume's economic writings the laissez-faire doctrine is to be found only by implication if at all. Tucker, although in the field of foreign trade policy he continued to be a protectionist of a somewhat extreme type, at one point vigorously asserted the identity of private and public interests and drew laissez-faire conclusions therefrom:

For let the legislature but take care not to make bad laws, and then as to good ones, they will make themselves: that is, the self-love and self-interest of each individual will prompt him to seek such ways of gain, trades, and occupations of life, as by serving himself, will promote the public welfare at the same time. The only thing necessary to be done by positive institutions is, to enforce the observance of voluntary contracts by legal penalties speedily levied....

Indeed, it must be acknowledged with gratitude and pleasure that the legislature of late years hath enacted many excellent laws which Edition: current; Page: [100] have promoted commerce, increased industry, and extended manufactures ... but then the laws in question are such, whose true excellence consists rather in the repeal of absurd and bad laws formerly made, than in any particular positions or maxims of commerce.88

But shortly before the publication of the Wealth of Nations, Whatley, obviously under physiocratic influence, made a specific plea for laissez faire on the basis, in part, of the existence of an identity of interest between the individual traders and the state:

Now, though it is hardly to be expected, as above hinted, that princes should allow of a general free trade or intercourse, because they seldom know their own true interest....89

Perhaps, in general, it would be better if government meddled no farther with trade, than to protect it, and let it take its course.... It were therefore to be wished, that commerce were as free between all the nations of the world, as it is between the several counties of England: so would all, by mutual communication, obtain more enjoyments.90

In the ancient Greek and Roman classics is to be found the doctrine that differences in natural conditions in different countries made trade between these countries mutually profitable. The early Christian philosophers took over this doctrine and gave it a theological flavor. God had endowed different regions with limited but varied products in order to give mankind an incentive to trade, so that through a world economy they would become united in a world society, and as children of one God they would learn to love each other.91 This was apparently common doctrine among the English theological writers of the sixteenth century and later.92 This doctrine was taken over to some extent by the lay writers Edition: current; Page: [101] on commercial matters, but they managed ingeniously to adapt the intent of Providence to their own particular views. Extreme mercantilists, who in general were pleading for new or added restrictions on trade, used the doctrine either to justify the restriction of certain products to Englishmen, on the ground that Providence had assigned them to this country, or appealed to the doctrine in support of that branch or type of trade which they wished to have fostered, while conveniently forgetting the doctrine when attacking other branches or types of trades. William Cholmeley at first states the doctrine fairly, bringing out clearly its implication that a tolerant attitude toward imports and raw material exports was proper:

But when I considered how the unsearchable purpose of God hath, by the lack of necessary commodities, driven all the nations of the earth to seek one upon another, and thereby to be knit together in amity and love, I thought, that as this realm lacketh (and that naturally) things necessarily required to the perfecting of our commodities, it might also be a thing natural to the English nation, to be so imperfect of wit that we could never be able to attain to the knowledge of true and perfect workmanship, because God would drive us thereby to suffer other nations to have a commodity by making our commodities [im?]perfect?93

Since his main concern, however, was that English wool should be exported only in the form of finished cloth, instead of as raw wool or as undyed cloth, he found a means of reconciling his theology and his patriotism. It would be ingratitude to God to attribute to him the intention of withholding from Englishmen “the aptness of wytt” to become perfect workmen in the weaving and dyeing of cloth, and their failure to do so was not because God intended England to supply foreign weavers and dyers with the necessary wool, but because the English craftsmen were selfish and indolent: “we being beastly minded, and seeking to again much by doing little, every man seeking his own private commodity, without regard of the weal public, do not diligently apply our good wits to the searching out of good knowledge, but to the inventing of subtle deceit (wherein we excel all other nations), Edition: current; Page: [102] to our private advancement, but the decay of the public weal of our country.” 94

Misselden similarly expounded the benevolent attitude of God toward trade between nations, in the course of a defense of the trading activities of the Merchant Adventurers, of which he was an employed official, but did not let it trouble him in his advocacy of stringent restrictions on branches of trade in which the Merchant Adventures were not directly concerned.95 Another writer derived from the doctrine the lesson that Providence had assigned wool-raising and the woolen industry to England, and therefore that England should concentrate her efforts on it,96 and several later writers did call upon it for support of their more liberal views with respect to freedom of trade as against the more extreme mercantilists, much as did Adam Smith in his two famous references to the “invisible hand.”

For it is not the having all things of our own growth on the one hand, and the saving of our money on the other, can make us rich; neither can our increase and plenty in some sense be said to be our wealth, if we have not a suitable vend and consumption thereof; besides, nature hath otherwise provided, and so furnished each particular part of the world with something which the rest want, whereby to preserve a friendship and commerce together.97

The various products of different soils and countries is an indication that Providence intended they should be helpful to each other, and mutually supply the necessities of one another.98

By the wise appointment of divine Providence, a mutual intercourse and commerce amongst men is both conducive and necessary to their well being. Every man stands in need of the aid of others; and every country may reap advantages by exchanging some of its Edition: current; Page: [103] superfluous products, natural or artificial, for those which it wants of foreign growth.99

In a remarkable passage, Henry Home gives credit to Providence for the self-regulating mechanism of international specie flows, as the means by which it is provided that commerce shall be mutually profitable:

It appears the intention of Providence that all nations should benefit by commerce as by sunshine; and it is so ordered, that an unequal balance is prejudicial to the gainers as well as to the losers; the latter are immediate sufferers; but not less so ultimately are the former. This is one remarkable instance, among many, of providential wisdom in conducting human affairs, independent of the will of man, and frequently against his will. The commercial balance held by the hand of Providence is never permitted to preponderate much to one side; and every nation partakes, or may partake, of all the comforts of life. Engrossing is bad policy; and men are prompted, both by interest and duty, to second the plan of Providence, and to preserve, as near as possible, equality in the balance of trade.100

International Division of Labor.—A few writers prior to Adam Smith stated or approached closely some of the specific economic arguments for unrestricted trade which were later to serve as the core of the free-trade doctrine of Adam Smith and the English classical school. John Houghton, in 1677, in a tract of free-trade flavor, argued that the same sort of reasoning should be applied to foreign as to domestic trade, since both alike consisted of a mutual exchange of goods, presumably to mutual advantage.101 Barbon claimed that a reduction of imports as a result of prohibitions would cut off an equivalent amount of exports.102 Davenant made explicitly a point vital to the free-trade Edition: current; Page: [104] doctrine, but which the nineteenth-century economists often assumed implicitly, namely, that labor had adequate occupational mobility. He claimed that if domestic labor is displaced as a consequence of imports of foreign commodities “these hands can shift from one work to another, without any great prejudice to themselves, or the public.” 103

Several writers presented arguments in support of the international division of labor, and it requires only mildly generous interpretation to justify the conclusion that they approached more closely than did Adam Smith the high point of free-trade reasoning, the statement of the benefit of regional specialization in terms of comparative advantage. Davenant maintained that the artificially stimulated production of goods for which neither the soil nor the general bent of the people were adapted is never wise, and that the silk and linen industries were suitable only for countries where wages were low. “It is the prudence of a state to see that this industry, and stock, be not diverted from things profitable to the whole, and turned upon objects unprofitable, and perhaps dangerous to the public.” 104 The unknown author of Considerations on the East-India Trade (1701), who has been rightly praised by a number of modern writers, reveals almost no trace of the mercantilist or protectionist fallacies. He meets all objections against the export of bullion or the import of foreign commodities by regarding trade as a voluntary exchange of considerations. If bullion is voluntarily exchanged for Indian manufactures, it must be because the latter are of more value. “To exchange bullion for cloth is to exchange for the less for the greater value.” Cheap imports, he asserts, are the valid objective of foreign trade. He even draws an analogy between foreign trade and labor-saving devices. The fact that Indian wares can be gotten through trade with less expenditure of labor than their production at home would require means that labor is saved and made available for other purposes:

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If nine cannot produce above three bushels of wheat in England, if by equal labor they might procure nine bushels from another country, to employ these in agriculture at home, is to employ nine to do no more work than might be done as well by three; ... is the loss of six bushels of wheat; is therefore the loss of so much value.105

Isaac Gervaise claimed that for each country, according to the “disposition” or productive capacities of its people and their geographical situation, there was a “natural” apportionment among different industries of its productive resources. If consumption demands were such that with this “natural” apportionment of production some commodities would not be produced in adequate quantities to satisfy the demand, it was best to meet such deficiencies of production by permitting free importation of such commodities from abroad:

Taxes on imports being no more than a degree of prohibition, and prohibition only forcing those manufactures to extend themselves beyond their natural proportions, to the prejudice of those which are, according to the disposition of the country, natural beyond the entire demand of the inhabitants; which lessens or hinders their exportation, in proportion to the prejudice they receive by the increase of those manufactures which are but in part natural, and whereof the importation is prohibited.

This considered, we may conclude, that trade is never in a better condition than when it's natural and free; the forcing it either by laws or taxes being always dangerous: because though the intended benefit or advantage be perceived, it is difficult to perceive its countercoup, whichever is at least in full proportion to the intended benefit: nature not yielding at once, sharpens those countercoups, and commonly causes a greater evil than the intended benefit can balance. Moreover, trade being a tacit and natural agreement to give or furnish a proportion of certain denominations of labor, to be drawn back in like proportion in such other denominations as best suits necessity or fancy, man naturally seeks, and finds, the most easy Edition: current; Page: [106] and natural means of attaining his ends, and cannot be diverted from those means but by force and against his will.106

Similar reasoning was presented by Patrick Lindsay. Scotland should discourage rather than encourage industries, such as woolens, which would interfere with the progress of the only “staple,” linen. These other industries had no chance of success in Scotland, and it was better to buy their products from abroad than to attempt to make them at home:

We may then reasonably suppose, on the lowest computation, that we can buy ... those woolen goods 10 and 15 per cent cheaper in England, than we can make them at home; and if we can make linen cloth, and sell it in England from 5 to 10 per cent profit, and purchase, in exchange for it, woolen goods 10 and 15 per cent cheaper than we can make them at home, then are we gainers by this trade from 15 to 20 per cent, and of consequence, so many hands as are employed in the woolen, who might be employed in the linen, just so much does the country lose by their labor.107

A few writers were in the rather paradoxical position of adhering to crudely mercantilistic doctrines with respect to the balance of trade, the superiority of exports over imports, or the importance of money, while advocating complete or very nearly complete free trade. Houghton108 and Vanderlint109 appear to belong to this group, and also Decker, who advocated free trade as a means of procuring a more favorable balance of trade.110 Roger Coke was an out-and-out mercantilist in his general analysis, but he nevertheless disapproved of monopolies, the Navigation acts, the restriction of import of cattle from Scotland, and the restrictions Edition: current; Page: [107] on the Irish trade, and did not give explicit support to any trade restrictions in any of his writings that were available for examination.111 There were other writers who adhered to the mercantilist doctrines without revealing their attitude toward trade regulation.

A constant note in the writings of the merchants was the insistence upon the usefulness to the community of trade and the dignity and social value of the trader, and in the eighteenth century it appears to have become common for others than the traders themselves to accept them at their own valuation.112 Very often “trade” is not more definitely specified, but no doubt most of the writers who argued for the value of trade meant foreign trade, or even only export trade. But in the general glorification of trade, some of the tracts made no reference to the quantity of money, the balance of trade, or other phases of the mercantilist doctrines. In some cases there was explicit inclusion of imports on a parity with exports as deserving of encouragement, and support of low customs, without explicit discrimination between export and import duties, as a means of fostering trade.113 The general tendency of such discussion must have been to weaken faith in legislative restriction of trade, and to prepare the way for the acceptance of free-trade views on explicitly stated economic grounds, although on the other side it is to be said that the chief advocates of particular restrictions were merchants.114

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Free-trade doctrine, however, continued to be a rank heresy, and there were probably some who subscribed to it but who did not dare to expose their peculiar views in print. Violet relates with horror that some men in high positions held such views:

... some men are of an opinion, that they would have trade free, to import all commodities, and export all without any restraint, not for leather, fuller's earth, corn, wool, ammunition, gold and silver, horses, and all other things that are staff and stay of this nation. I would not write it, but I have it affirmed by men of great quality, that this is the opinion of some men that are in place and power.115

I believe I have succeeded in showing that all the important elements in Adam Smith's free-trade doctrine had been presented prior to the Wealth of Nations. These were often, however, to be found only in isolated passages not wholly consistent with the views expounded in the surrounding text. There is little evidence that these early expositions had much influence on public opinion in the mass, or even on Hume and Smith. Hume himself discarded the monetary and balance-of-trade doctrines of his time while adhering to protectionism,116 and Adam Smith both in his Lectures and in the Wealth of Nations relapsed at times into rather crude versions of the mercantilist monetary and balance-of-trade doctrines, as well as into protectionism.117 In so far as Edition: current; Page: [109] Hume and Smith did not develop their foreign-trade doctrines for themselves, it seems likely that their chief indebtedness was to the philosophers, rather than to the earlier English economic literature. In the literature before Hume there is scarcely any discussion of the anticipations of free-trade doctrine examined in the foregoing, even for purposes of refutation,118 and most of the controversy is between exponents of rival schemes of regulation, or between extreme and moderate mercantilists, rather than between mercantilists and free traders.

In many respects, indeed, as the mercantilist argument became more elaborate and involved, it became more objectionable from the point of view of modern doctrine, and, except with reference to the bullionist doctrines, a strong argument could be presented in defense of the thesis that the mass of ordinary tracts on trade of the first half of the eighteenth century showed a more extreme and confused adherence to the fallacies of mercantilism than did the writings of the sixteenth and early seventeenth centuries. The simplicity and brevity of the early analysis at least resulted in fallacies of comparable simplicity, but the later writers were able to assemble a greater variety of fallacies into an elaborate system of confused and self-contradictory argument. In so far as trade theory was concerned, such progress as occurred was due almost solely to a small group of capable writers, able to analyze economic problems more acutely and logically than their predecessors, but not able to make a marked impression upon their contemporaries or even to attract their attention. Even Hume made few converts in England, and his influence on the physiocrats was more apparent than on the English writers of his own generation. On legislation, it is not evident that the critics of mercantilism had much influence, and it could be seriously argued that, with the exception of the disappearance of the bullionist regulations, Edition: current; Page: [110] the general course of foreign-trade legislation from 1600 to after Adam Smith was, without important exception, away from, rather than toward, conformity with the doctrines of the critics of mercantilism.

III. Some Modern Interpretations of English Mercantilism

There has been a marked tendency in recent years, more especially perhaps on the part of German economists and of economic historians, toward a more favorable appraisal of English mercantilist doctrine than has prevailed among the economic theorists of the English classical tradition. Much of this tendency can be explained away as due to participation in the interventionist, protectionist, or aggressively nationalistic sentiments of the mercantilist writers, to misconceptions of what the economic doctrines of the English mercantilists really were, or to absence of knowledge of, or interest in, the grounds for rejecting the mercantilist doctrines afforded by modern monetary and trade theory. To those apologists who defend the mercantilist doctrines on the ground either that they were not what their critics allege them to have been, or that the theoretical objections of the critics can be successfully refuted, the foregoing presentation of the mercantilist reasoning must suffice as an answer.

The modern apologies for mercantilism, however, are also supported by several arguments which do not clash directly with the propositions of modern trade and monetary theory, and these arguments are entitled to more respectful treatment. The economic historians, for instance, seem to derive from their valid doctrine, that if sufficient information were available the prevalence in any period of particular theories could be explained in the light of the circumstances then prevailing, the curious corollary that they can also be justified by appeal to these special circumstances. There are some obvious obstacles to acceptance of this point of view. It would lead to the conclusion that no age, except apparently the present one, is capable of serious doctrinal error. It overlooks the fact that one of the historical circumstances which has been undergoing an evolution has been the capacity for economic analysis. More specifically, to be involved successfully in defense of mercantilist doctrine it needs to be supported Edition: current; Page: [111] by demonstration that the typical behavior of merchants, the nature of the gains or losses from trade, the nature of the monetary processes, and the economic significance of territorial division of labor have changed sufficiently since 1550, or 1650, or 1750, to make what was sound reasoning for these earlier periods unsound for the present-day world.

It has been claimed also for the mercantilists that they were presenting short-run doctrines and proposals, whereas their later critics had only long-run considerations in mind. It must be conceded that some of the mercantilist doctrine would not be quite so absurd if appraised from the short-run point of view. But I have found no evidence that the mercantilists intended their analysis and proposals to be regarded as holding true for the short run only, and there is abundant evidence that they were ordinarily not aware of any distinction between what was desirable monetary or trade practice, to meet a temporary situation, on the one hand, and as permanent policy, on the other.

It has been argued also, in answer to the criticisms of mercantilist doctrine by economic theorists, that the primary objective of mercantilist policy was not economic prosperity but national unity and power. In dealing with this interpretation of mercantilism, it is important to distinguish between the official and the unofficial expositions of the doctrine, between the actual policies and the reasoning by which they were supported, and between Continental and English mercantilism. In each case, it is only the latter with which this essay is concerned. Government policy, no doubt, was never governed solely by economic considerations, but for the unofficial writers this was a subject for complaint rather than for approval. Even in the unofficial literature, however, political and religious considerations were mingled with the economic to a degree without parallel in modern economic literature. But in England a strong and centralized government and an aggressive national spirit had been established long before the appearance of an important mercantilist literature, and whatever may have been the situation on the Continent the primary emphasis of the English mercantilist writers was on the means by which England's wealth could be augmented. Many writers, it is true, urged in support of the measures which they advocated that they would not only contribute to England's prosperity but would also promote her prestige and power, injure her rivals, Edition: current; Page: [112] and protect her national faith against its enemies, internal and external. But the appeal to political and religious considerations seems often to have been intended to win the support of the less commercial-minded official and landed classes for the proposals of the “merchants” or businessmen, and seems only rarely to have expressed what was really the primary concern of their authors. Especially important as a safeguard against applying erroneously to the English mercantilist literature generalizations which may be true of the Continental writers, it should be borne in mind that English mercantilist doctrine was the product of merchants to an extent without parallel on the Continent. On economic matters even the landed classes in England found their ablest spokesmen in merchants such as Child and North. And the merchants were typically impatient of official policy when it failed to place primary emphasis on the economic aspects of the matters with which it dealt, and especially when it appeared to subordinate economic to political or religious considerations.

Even if it be granted, however, that the principal objective of the English mercantilist writers was a great and powerful England rather than a prosperous England, it does not follow that appraisal of their reasoning on strictly economic grounds is unwarranted or irrelevant. It would be difficult to find convincing evidence that any of the prominent mercantilists regarded power and prosperity as generally conflicting and inharmonious objectives of national policy. On the contrary, it was a matter of general agreement among them that for England the only certain path to national power and glory was through promotion of trade and increase of wealth. Child's formula, which was often quoted approvingly, expresses accurately the mercantilist position: “Foreign trade produces riches, riches power, power preserves our trade and religion.” 1 After the Revolution, in fact, trade and wealth seem to have become almost an obsession of the mercantile classes, and the emphasis which they placed on the economic phases of national policy was, if anything, excessive. I suspect that the “trade wars” of the seventeenth and eighteenth centuries were such more in the imagination of the mercantile writers than Edition: current; Page: [113] in the intent of the governing classes who embarked upon them, and that just as the merchants appealed to non-economic considerations to make their proposals attractive to the landed classes, so the government appealed to the cupidity of the merchants to win their support for wars embarked upon for dynastic or political reasons.2 Even the official classes in England, however, were probably more trade-minded, and probably gave greater weight to economic considerations, than the corresponding classes on the Continent. Such, at least, appears to have been the opinion of eighteenth-century Continental observers.3

Not only is there little evidence that the mercantilist writers were prepared to sacrifice national economic to political interests, but a good deal of the mercantilist literature can be plausibly explained as special pleading for limited economic interests. The Edition: current; Page: [114] most ardent advocates in the seventeenth century of the revival or enforcement of the bullionist restrictions had a personal interest of one sort or another in these regulations. Malynes is said to have had expectations of getting a remunerative contract in connection with the currency if the office of the Royal Exchanger were revived. Milles was a customs official among whose duties would be the enforcement of any bullionist regulations. Violet had been a “searcher” and informer in connection with the regulations prohibiting the export of bullion, and his appeals for stricter enforcement were accompanied by pleas that he again be employed to discover violations of the regulations.4 Wheeler was secretary and Misselden an important member of the Merchant Adventurers, and their tracts were written in defense of their exchange transactions against the attacks of Milles and Malynes. The East India Company, in its charter of 1600, was granted the right to export a limited amount of bullion, and in its early as in its later operations bullion constituted the bulk of its exports from England. This led to attacks on the company of which Robert Keales' The Trades Increase (1615) was typical. Digges, a member of the company, wrote his Defence of Trade (1615) as a reply to Keales, and Mun, an officer of the company, wrote his tracts and presented a “remonstrance” to the government primarily to ward off hostile measures against the company. Throughout the history of the company its officers and employees were publishing tracts in its defense which were important contributions to the literature of mercantilism. Toward the end of the seventeenth century, when attacks on the company turned mostly on its monopolistic character, its imports of East Indian silks and calicoes to the alleged injury of English industry, and its unfavorable balance of trade, Child and Papillon, officers of the company and with much of their private fortunes invested therein, wrote in its defense. Much of the mercantilist literature from 1670 on, written in opposition to the company, was the work of rival merchants who wanted to participate in the East India trade or of persons connected in some way with the domestic textile industries which were feeling the effects of East Indian Edition: current; Page: [115] competition. Tracts were written by factors in the woolen industry urging or supporting the prohibition of the export of wool and were answered by spokesmen for agricultural interests. John Houghton, Charles Smith, Arthur Young, and many others wrote in support of the bounties on the export of corn with an evident agrarian bias. The literature on taxation consisted in large part of tracts written by traders who wanted the main burden of taxation to rest on land, or by landed men who wanted it to rest on trade. There were contemporary charges that some of those who were urging the legal limitation of the rate of interest were rich merchants who had ample funds to finance their own activities and hoped that the reduction of the rate of interest by law would make it impossible for their poorer competitors to borrow the funds necessary for the conduct of their affairs. Pleas for special interests, whether open or disguised, constituted the bulk of the mercantilist literature. The disinterested patriot or philosopher played a minor part in the development of mercantilist doctrine.5

After the Revolution, when control of commercial policy had definitely passed from the crown to Parliament, commercial affairs became the football of party politics, and factional rivalries and conflicting economic interests were likely to be involved in any important issue of commercial policy in a complex way. If I may venture to take the controversy waged around the commercial clauses of the Treaty of Utrecht (1713) as an illustrative instance, the situation seems to have been somewhat as follows:6 From the early decades of the seventeenth century, the trade between England and France had been greatly restricted by both countries, either by discriminatory duties of prohibitive severity or by absolute embargoes. When in 1713 a Tory government concluded peace with France, it proposed also to reestablish open trade with France. The Tories represented the landed classes and Edition: current; Page: [116] the Anglicans, and also received the support of the surviving Catholics as being less hostile to them than the Whigs. The Whigs in the unreformed Parliament of the time were also predominantly members of the landed gentry, but in order to secure a popular footing they had sought the support of the nonconformist or Low Church yeomen by adopting a policy of tolerance to dissenters and extreme opposition to Catholics, of the moneyed classes by their support of the Bank of England, and of the independent merchants and the manufacturers by opposition to the monopoly companies and by support of extreme mercantilism. The Tories, on the other hand, came to terms with the East India Company, whereby in return for support of the endeavors of the company to preserve its monopoly privileges and to be allowed to import East Indian cloth, the latter gave financial support to the crown through loans, and to its defenders in Parliament through private bribes.

On the specific issue of the resumption of trade relations with France, the Tories were favorable and the Whigs opposed. In so far as it was not a matter merely of factional rivalry, this alignment seems to have followed economic interests fairly closely, although other considerations were also important. Support for the resumption of freer trade appears to have been confined to the landed classes and to have been due mainly to three considerations: a greater trade with France would mean greater custom revenues to the crown, of which they were at the time the supporters; it would mean cheaper claret and silks; and, as a minor factor, it would be a check to the growing power of the trading classes, who were objectionable as “upstarts” and as Whigs, as enemies of the landed interest, and as exponents of a trade policy which made the cost of luxurious living higher for the country gentleman. The Whigs opposed the commercial treaty in part to embarrass the crown, in part because they were traditionally hostile to France as the leading Catholic monarchy.7 They were supported by the independent “merchants” 8 and by Edition: current; Page: [117] the domestic manufacturers of liquors and cloth. The Whigs succeeded in stirring up violent opposition to ratification of the commercial treaty. In the controversies at the end of the seventeenth century, when the Tories supported both the continuance of monopoly control by the East India Company of the trade with East India and the limitation of the restrictions and duties on East Indian cloth to modest proportions, they had found in the ranks of the company itself and elsewhere able advocates, including such men as Child, North, Davenant, and Barbon. In the controversy about the Treaty of Utrecht, however, the level of argument on both sides was low. Daniel Defoe was allegedly hired by the Tories to defend the treaty in a periodical, Mercator, established for the purpose, and the Whigs replied in another periodical, the British Merchant, to which the principal contributors were prominent merchants with extreme mercantilist views. Defoe was too much of a believer in the mercantilist doctrines himself to be able effectively to meet criticism of the treaty on mercantilist grounds, and as far as public opinion was concerned the British Merchant had much the best of the argument. Whether or not the battle in the periodicals and tracts had much to do with the outcome, the commercial treaty failed of ratification in Parliament by a narrow margin of votes, and its defeat tended to strengthen the hold of mercantilist doctrine on the English merchant classes, and to sharpen the conflict of interest and opinion between the landed classes and the trading and industrial classes.9

While non-economic considerations unquestionably played an important part in this controversy, no one, as far as I could discover, conceded that these considerations clashed with the economic ones. On the basis of modern theory, the Tories had the stronger economic case. But the country gentlemen who constituted that party had no effective reply to mercantilist doctrine, and at this critical stage were without competent aid from the ranks of other classes. The ignorance and inarticulateness of the Edition: current; Page: [118] English landed classes made them impotent in 1713 to prevent their victimization by a mercantilist policy which they vaguely sensed to be hostile to their interest, although they were in overwhelming control of Parliament. Over a century later, when the change in the status of English agriculture had made them the beneficiaries instead of the victims of mercantilism, their failure to produce spokesmen able to cope with the orators of the merchant class was a factor in their failure, in a Parliament in which they were still in the majority, to prevent the spectacular overthrow of mercantilism. Anyone who attempts an interpretation of the evolution of English trade theory solely in terms of objective historical circumstances faces the task of reconciling his account with the part played by the evolution of capacity for economic analysis. Objective fact played its part. But if the Tories had had the services of North and Barbon in 1713, they might have dealt a fatal blow to mercantilism then by showing that what was in their private interest was also in the national interest. And if Peel had been less public-spirited and intelligent in 1846, or if there had been among the back-bench squires men able to cope in debate with Cobden and Bright, the reign of mercantilism in England might not have had its 1846 to 1916 intermission.

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  • What must we for a standard own,
  • By which the price of things are known?
  • ‘Twas thought, time past, by men of sense,
  • ‘Twas guineas, shillings, pounds and pence;
  • The Bank has said, and says so still
  • ‘Tis nothing but a paper bill;
  • ‘Tis in Sir Francis Burdett's head
  • The standard is a loaf of bread,
  • Whilst Adam Smith did always say,
  • It was the labor of a day.
  • —(“William Pitt,” The bullion debate; a serio-comic satiric poem, 1811, p. 7.)

I. The Participants in the Controversy

The suspension of specie payments by the Bank of England in 1797, and the currency, exchange, and price phenomena which followed it, gave rise to a controversial literature of great extent and, on the whole, of surprisingly high quality. Until the resumption of specie payments was approaching, the general trend of prices and of prosperity was upward; but resumption was followed by a long and trying period of falling prices and of economic distress. The change in circumstances led to a marked difference in the distribution of emphasis on the issues involved, and, in a number of instances, to a sharp reversal of doctrinal position by participants in the controversies of both periods. It will be convenient, therefore, to deal separately with the literature of the earlier and the later periods, which can be distinguished as the inflation and deflation periods, respectively.

Of all the older controversies in the field of international trade theory, the inflation phase of the bullionist1 controversy has probably Edition: current; Page: [120] been most fully and competently canvassed by modern writers.2 But there is still room for a resurvey of the controversy.

The contemporary literature of the bullionist controversy is of great importance for the history of the theory of international trade in its monetary aspects. The germs at least of most of the current monetary theories are to be found in it. It embodies the first detailed analysis of the relationships between currency phenomena and international balances, exchange rates, and price levels, under both metallic and inconvertible paper currencies. Foreign exchange theory is carried substantially forward, and the theory of the mechanism of adjustment of international balances is advanced substantially beyond the stage at which it was left by Hume. There are also discussions of a truly pioneer character of the functions of a central bank in a complex credit economy with respect to the maintenance of international monetary equilibrium and of internal business stability.

The contemporary participants in the controversy arrayed themselves fairly sharply in two opposing groups: the “bullionists” or “anti-Restrictionists” on the one hand, who criticized the course of monetary events, and the “anti-bullionists” on the other hand, who defended the government and the Bank of England against the attacks of the bullionists. But as will be seen, there were important divergences of opinion within each group. The essential doctrines of the bullionists were expressed by a small group of writers, of whom Boyd,3 King,4 Thornton,5 Wheatley,6 Edition: current; Page: [121] and Horner,7 were most important, during the first period, 1801 to 1803, of marked premium on bullion and fall in the exchanges. Similar phenomena, even more marked in degree, in connection with the Bank of Ireland gave rise to a parliamentary inquiry8 and to the bullionist publications of John Leslie Foster,9 Henry Parnell,10 and Lord Lauderdale.11 The reappearance from 1809 on of a high premium on gold and a substantial fall in the exchanges gave rise to a flood of tracts and pamphlets, of which the most important on the bullionist side, in addition to the Report of the Bullion Committee of 1810, were the contributions of Ricardo, his first appearance in print as an economist,12 T. R. Malthus,13 Robert Mushet,14 and William Huskisson.15

The most effective statements of the anti-bullionist position were in speeches in Parliament by Nicholas Vansittart16 and George Rose,17 and in tracts by Henry Boase,18 Bosanquet,19 Coutts Trotter,20 and J. C. Herries.21

Edition: current; Page: [122]

Ricardo made but few additions to the analysis of his predecessors,22 and, as will be shown later, on some important points he committed errors from which some of the earlier supporters of the bullionist position had been free. But the comprehensiveness and the force and skill of his exposition and the assurance and rigor of his reasoning made him at once the leading expositor of the bullionist position. It was largely through Ricardo's writings, moreover, that the bullionist doctrines exercised their influence on the subsequent century of monetary controversy. Special attention is given, therefore, to Ricardo's position in the following account of the bullionist controversy.

II. The Factual Background

An excellent statistical compilation of the significant banking, price, and exchange rate data relating to the suspension of cash payments, presented in both tabular and graphical form, is to be found in Silberling's essays, and much of this material is reproduced by Angell. Silberling has computed and compiled some of the important series from original data not hitherto available in print or available only in raw shape. There need be presented here, therefore, only the minimum amount of information as to the nature of the currency and banking system of the time and the course of monetary events essential for an understanding of the theoretical issues raised in the course of the controversy.

From the outbreak of the war with France in 1793, the Bank of England had been under a strain mainly because of the great demands for advances made upon it by the government, which it had resisted, but unsuccessfully. Early in 1797, a general panic, induced apparently by rumors of a French landing on English soil, and accentuated by failures and suspensions on the part of the country banks, led to a general clamor for gold. On February 25, 1797, there were only £1,272,000 of specie and bullion in the Bank, as compared to ordinary reserves of £5,000,000, or over. On February 26, 1797, the government, at the request of the Bank, issued an Order in Council prohibiting specie redemption of its notes by the Bank. By an Act of May 3, 1797, the restriction of cash payments was validated and continued in effect, Edition: current; Page: [123] subject to minor qualifications, until June 24, 1797, and by a succession of later acts the suspension of specie payments was enforced until after the end of the war. With the factors responsible for the suspension of specie payments in 1797, we need not here concern ourselves.1 The suspension of specie payments was quickly followed by an inward flow of bullion, recovery of the Bank from its strained condition, and general restoration of confidence, and it was not until toward the end of 1799 that the exchange on Hamburg fell substantially below the pre-Restriction par and a premium was quoted on bullion over paper. From 1804 to 1808 the exchanges were again at or near parity, and paper was at no or a small discount in relation to bullion. But from 1809 to the end of the war there again prevailed low sterling exchanges and substantial premiums of bullion over paper.2

England, prior to the Restriction, although legally on a bimetallic basis, had for some time been in effect on a gold standard basis, since the mint ratio of silver to gold was such as generally to undervalue silver and thus keep it out of circulation. The metallic currency consisted of guinea pieces (= 21 shillings) and multiples and subdivisions thereof, and of silver coins from the crown (= 5 shillings) down. Of the silver coins, only the underweight coins remained in circulation. Except for coins surviving from ancient issues, the sovereign (= 20 shillings) was only a money of account. English coin could not legally be melted down unless underweight, and was not legally exportable, and gold bullion was exportable only subject to oath that it had not been obtained by melting down English coin. The metallic currency was supplemented by Bank of England notes in denominations of £5 or over, redeemable in specie upon demand, and by country bank notes, also in denominations of £5 or over, payable upon demand in specie or in Bank of England notes. London bankers had in 1793 voluntarily ceased to issue their own notes. Outside of the London area the Bank of England notes circulated freely only in Lancashire, where the local banks did not issue notes but where bills of exchange of small denominations were extensively employed as a medium of exchange. Bank deposits subject to check were also in existence, and constituted a part of what would Edition: current; Page: [124] today be regarded as the circulating medium, although this was not yet widely recognized. Checks payable to order had only recently come into common use even in London and only for large payments. The private or non-governmental deposits at the Bank of England were small in amount throughout the Restriction period, and for the years after 1806, for which alone their precise amounts are known, they reached a yearly average of £2,000,000 in only one year.3 In the provinces also deposits seem to have been relatively unimportant, and to have been drawn upon mainly for cash, but the available evidence on this point is conflicting.4

III. Premium on Bullion as Evidence of Excess Issue: The Bullionist Position

The central issue of the controversy was made to turn on the question of whether the paper pound was depreciated, the bullionists insisting that it was depreciated, and most—though not all—of the anti-bullionists denying this. The answer to such a question obviously depends on how “depreciation” is defined, and the controversy suffered from a constant tendency to degenerate into merely terminological issues. As one bullionist writer caustically remarked: “Whether reduction of prices [of paper in gold] be depreciation or not, or equivalent to it, is a verbal question very fit to be argued in ‘Change Alley.’” 1 But always present, Edition: current; Page: [125] even when not clearly brought into the foreground of the discussion, were genuine and important issues of fact and policy.

For the bullionists the paper currency was depreciated if issued to excess, and many of the anti-bullionists also accepted this quantitative criterion of depreciation, or at least did not explicitly reject it. Defining depreciated currency as a currency issued to excess might seem merely to substitute one term of doubtful meaning for another. But the question, What is the proper amount of currency a country should have? Is an important one. To this question, as Hollander points out,2 Adam Smith had given no answer beyond saying vaguely that it was determined by “effectual demand,” 3 and the participants in the bullionist controversy were the first seriously to tackle it. The bullionists argued, or more often simply asserted, that a circulation exceeding in amount what, under otherwise like conditions, could have been maintained under a metallic standard, was in excess. There was little express objection to this criterion of a properly-regulated currency during the inflation phase, and serious discussion of its adequacy came only with the deflation phase of the controversy.

During the inflation phase the main issue in controversy was as to the proper method of determining the existence of excess of issue. The chief test of excess issue used by the bullionists was the existence of a premium on bullion over paper currency, although since they held that the level of prices was determined by the amount of currency and that the amount of premium of bullion over paper and the amount of discount of sterling exchange from the metallic parities were closely related, they also held that a relative rise of prices in England as compared to abroad and a fall in the sterling exchanges below parity were evidence of depreciation. The bullionist position was well expressed by Boyd: “The premium on bullion, the low rate of exchange, and the high prices of commodities in general, [are] ... symptoms and effects of the superabundance of paper.” 4 Edition: current; Page: [126] Their conclusions rested on the following reasoning: the rate of exchange between two currencies depended solely or mainly on their relative purchasing power over identical transportable commodities in the two countries; on quantity theory of money grounds, prices in the two countries depended on the quantities of money circulating therein; the price of bullion in paper currency was governed by the exchange rates with metallic standard currencies; therefore, if the exchanges were below metallic parity, and if there was a premium on bullion over paper, this was evidence that prices were higher in England, and the quantity of currency in circulation greater, than would have been possible under the metallic standard prevailing prior to suspension of convertibility.5

While Wheatley and Ricardo held that the relative rise of the prices of particular commodities in England, as compared to the prices of the same commodities in foreign countries having metallic standard currencies, would be proportional to the degree of excess of the English currency, they did not suggest that the existence of excess issue could in practice be tested by such price comparisons.6 The notion of an index number was still in its infancy. Evelyn had published his crude index number of English prices for the preceding two centuries in 1798, and Wheatley had commented on it in laudatory terms.7 But no current index number yet existed for England, and there was but little information as to the prices prevailing in other countries. To Ricardo, moreover, it seemed an absurd notion that the trend of prices in Edition: current; Page: [127] general, or of the general purchasing power of money, could be measured. Since prices fluctuated even under a metallic standard, he conceded that their fluctuations under an inconvertible currency could not be attributed solely to changes in the degree of excess of the currency. The only test from English prices alone of the existence of depreciation which he could consistently have accepted, therefore, would have been a comparison of the prices prevailing under inconvertibility with the prices which would have prevailed under convertibility, other conditions remaining the same, and in his treatment of arguments from price data Ricardo always adhered to this position.8 But Ricardo held that since the premium on bullion measured the degree of excess of the currency,9 it measured also the degree in which prices at anytime, say 1810, during the suspension of cash payments were higher, not than they had been in 1797, but than they would have been in 1810 if the currency were in 1810 at the amount which could then have been maintained in circulation under a metallic standard. Ricardo, however, put much stress on the question of the extent of the depreciation, as providing an answer to the question of how great a reduction in the currency would be needed to end the depreciation.

IV. Qualifications Conceded by the Bullionists

The bullionists were prepared to make several qualifications to this reasoning and therefore to concede that the existence of a premium on bullion over paper, or of a discount of sterling exchange from metallic parity, was not an absolute proof of excess issue, and was strong presumptive evidence of excess issue only Edition: current; Page: [128] if it was substantial and prevailed for a considerable period of time.

There was first the question as to whether the price of gold or the price of silver bullion should be taken as the test. Since the bullionist comparison was always with the amount of circulation possible under the metallic standard prevailing in 1797, and since it was generally, though not universally, agreed that England had then been in fact on a gold standard basis, the bullionists preferred to use the price of gold as their test. There were fairly substantial variations in the relative prices of gold and silver on the English market, and therefore also in the extent of the premiums over paper which they respectively commanded. But as during this period a substantial premium on the one was always accompanied by a substantial premium on the other, it did not matter for practical purposes which was taken as the test of the existence of excess currency, although it would have mattered if what were in question was the degree of excess.

Secondly, when the bullionists used the exchange rates as an alternative or supplementary test of the existence of depreciation, they conceded that since even under a metallic standard the exchanges could fall below the mint parity to the limit of the cost of shipping bullion, a fall in the exchanges which did not go beyond this limit was not proof that there was excess of currency under inconvertibility.1 Moreover, whereas England had been on a gold standard basis prior to the Restriction, Hamburg, Amsterdam, and Paris, the most important quotation points for the exchanges during the Restriction, were on a silver standard basis. Ricardo and other bullionists pointed out that since the relative values of gold and silver were not constant, the exchange parties between gold and silver currencies also were not constant, and that in computing the deviation of, say, the London-Hamburg exchange from parity it was necessary to make allowance for any alteration in the relative market values of the two metals. But the general trend of the price of silver as compared to gold was downward during the later stage of the controversy, and Edition: current; Page: [129] Ricardo pointed out that comparisons of the trend of the Hamburg exchange during the Restriction period which used the prevailing rate before the Restriction as the base therefore underestimated the extent of the real fall in the exchange value of English paper currency in terms of gold bullion abroad.2

Thirdly, even before 1797, English gold coin, or bullion derived therefrom, was not legally exportable, and at a time when the exchanges were against England exportable bullion would command a premium over its mint price in coin or in paper. Ricardo and other bullionists insisted, however, that the prohibition of export of English coin or bullion could not be successfully enforced and that a small premium would in practice suffice to compensate for the risks involved in melting and false swearing, or in smuggling English bullion out of the country. They conceded that a premium on gold not exceeding this risk-premium was not necessarily indicative of excess. Bullion also could command a premium over coin and paper even under convertibility if the coinage was generally underweight as compared to its nominal standard, and for this also the bullionists were willing to make allowances. But the gold coinage was in good condition in 1797, and only a minor allowance was called for on this account.3 The bullionists tended to agree that 5 per cent premium on gold was ample allowance for both these factors, and it seems that in the years prior to 1797 the premium on gold at no time exceeded this except in isolated and special transactions.4

Fourthly, the bullionists recognized that the substitution in England of paper for gold and the export of the displaced gold would tend to result in a rise of prices in other countries in terms of gold, and that England could share in this rise of prices, and could therefore circulate a greater quantity of currency than before, other things remaining the same, without suffering a Edition: current; Page: [130] premium on gold or fall in the exchanges.5 They did not attach any importance to this factor, however, presumably on the ground that any such release of gold would be negligible in comparison to the world supply.6 Since to the extent that this consideration had weight it would tend to make the bullionists' tests of excess as they defined it too generous rather than too exacting, the anti-bullionists also made no use of it, although it became an important element in the controversy of the deflation period.

V. Possible Objections to the Bullionist Position

In addition to the qualifications which the bullionists themselves made to their argument that the existence of a premium on bullion over paper, or a fall of the exchanges below the metallic parity, was a demonstration of the existence of excess issue as compared to what could have been maintained in circulation under convertibility, there were other valid qualifications which they either deliberately abstracted from or overlooked.

Throughout the controversy, currency was generally taken to mean metallic money and bank notes, bank deposits either being overlooked or else held not to be currency. It would, of course, be possible for bank notes to depreciate even if drastically reduced in volume if at the same time deposits were increased in relatively even greater degree. But unless there was reason to suppose that mere departure from convertibility would result in a change in the relative importance of currency proper and bank deposits, the failure to give consideration to the latter would be of no significance for the main theoretical issue in controversy.

Similarly, a currency might depreciate because of an increase in its velocity of circulation, its amount meanwhile remaining constant or even falling. This was generally recognized at the time, but it was tacitly assumed, then and later, not that velocity remained constant—for it was known that it was subject to variation with the state of business confidence, with improvements in the means of communication, and with the development of clearinghouse Edition: current; Page: [131] and other arrangements for “economizing currency,” 1 but that velocity would not be altered merely by the suspension of convertibility. If changes in velocity due to changing degrees of confidence in the future of the currency be disregarded, this assumption could not be expected to be a source of serious error. Under convertibility the actually circulating medium, if deposits and bills of exchange be disregarded, was partly coin, partly paper; under inconvertibility it was wholly paper. It is conceivable that individuals would tend to hold smaller cash balances in proportion to the volume of their transactions if the currency was paper than if it was coin. Holding of paper involved risk of loss through fire, or through failure of the issues. Paper money could be shipped from one point to another more promptly, more safely, and if in small quantities more economically, than could specie, for paper money could be sent by post, whereas specie remittances required private couriers, who had to be convoyed because of the danger of robbery on the highways. This would tend to lead to the holding on the average of larger cash balances relative to volume of transactions if the currency were specie than if it were paper.2 But it seems doubtful that this could have been an important factor.

On both a priori and empirical grounds, however, velocity should be expected to rise as the volume of means of payments and the price level was rising, and thus measurement of the percentage of excess of currency from the percentage of discount of paper in terms of gold would tend to exaggerate the degree of excess during rising prices and to underestimate it during falling prices.

A more serious qualification to the validity of the bullionist position lies in the fact that under inconvertibility speculative anticipations of depreciation or appreciation of the currency would affect the willingness of individuals to hold the currency and would thus influence its velocity of circulation and its value in Edition: current; Page: [132] relation to gold, to foreign currencies, and to commodities, independently of the effects of variations in its quantity. In modern times, as we now know only too well, such speculative factors can dominate for an appreciable length of time the metallic or exchange value of an inconvertible paper currency. There is every reason to believe that such speculative factors were also operative in some degree during the period of the bullionist controversy.

Both the bullionists and the anti-bullionists were aware of the possibility that speculative factors were influencing the value of the paper pound. Neither side, however, openly charged—or conceded—that such factors were an actual influence in lowering the value of the paper pound. It may be that neither side was altogether frank in dealing with this question, which under the circumstances prevailing was a delicate one. The anti-bullionists could not maintain as they did that the management of the currency was beyond criticism and at the same time admit that there was sufficient lack of confidence in its immediate future to lead to flights from the currency to hoarded bullion, to commodities, or to foreign currencies. The bullionists, on the other hand, may have feared that if they made such a charge they would lay themselves open to attack on the ground that they were attempting to bring the national currency into “discredit” at a time of national emergency, and therefore may have refrained from saying all that they believed, although I have not found any evidence of this. In any case, the bullionists, whether from discretion or from conviction, took pains to concede that the paper currency was not “discredited.”

Silberling and Angell misread into the bullionist writings in general the positive charge that the depreciation of the paper pound in relation to bullion was in part at least a “qualitative” depreciation, and they find something absurd in such a charge. Silberling claims to find in Ricardo's writings the doctrine, which he clearly regards as a strange one, that the “fall” in paper money was due to “a mere inherent debasement in quality” of the paper currency rather than to its issue to excess. He concedes that “debasement” could readily be translated into “excess,” if by excess is meant the amount exceeding the quantity at which the price of gold in paper would be at its mint par.3 But Ricardo Edition: current; Page: [133] repeatedly and uniformly insisted that he meant just this by excess.

Angell follows Silberling in finding among the bullionists adherence to the notion of a qualitative depreciation of the currency, and in treating it as an absurd notion, but his interpretation of the bullionist position in this connection is different from Silberling's. Angell claims that Boyd, Ricardo, and other bullionists held that an excess of currency led first to “a positive degradation of the standard” and that this degradation in turn led to a rise in prices, “the degradation thus being a distinct and ‘intermediate’ step between the increase in currency and the rise in prices.” 4 Angell gives no specific references to Ricardo, but he refers to the following passage in Boyd:

He would say, that not only the currency of the country had been changed from a certain to an uncertain standard, but that the quantity of it, in all probability, had been greatly augmented by the issuing of paper, without the obligation of paying it on demand, and that thus the prices of all objects of exchangeable value necessarily feel the influence of a positive degradation of the standard, and of a probable augmentation of the quantity of money in the country, any one of them amply sufficient to discount for a considerable rise, but both united, adequate to still greater effects than any that had already been produced.5

Boyd here clearly assigns to “degradation” a distinct influence on prices over and above that resulting from any increase in the quantity of the currency. But there is no trace here of the time-sequence imputed to him by Angell. The context shows that the word “positive” which qualifies “degradation” is to be understood to mean “certain,” as contrasted to the “probable” increase of the amount of the currency. At the time Boyd wrote no report had been made as to the issues of the Bank since the Restriction, and increase in such issue could be only a matter of inference from circumstantial evidence. The question remains, what did Boyd mean by “degradation” ? No light is afforded by the context, but a reasonable explanation which makes his position intelligible Edition: current; Page: [134] is made possible by reference to a doctrine of other contemporary writers. Henry Thornton in 1797 had argued that the quantity of notes which it was proper at any time to issue depended much “on the state of the public mind, that is, on the disposition of persons to detain them.” Thus an impairment of the general credit “while Bank notes sustain their credit” would make possible, and desirable, an increase of the issue of notes without any impairment of their value.6 In 1802 he repeated this argument and supported it by reference to the effect of confidence in the paper money on the velocity of its circulation and on the size of the cash balances generally held by individuals.7 He pointed out, moreover, that while paper was falling in value, foreigners generally would expect “that the paper, which is falling in value, will, in better times, only cease to fall, or, if it rises, will experience only an immaterial rise, and this expectation serves of course to accelerate its fall.” 8 Thus the suspension of cash payments could conceivably result in a premium of bullion over paper even if no increase in the issue of paper had occurred. But Thornton denied that the loss of confidence in the English currency which could bring this about had occurred.

Lord King and George Woods expressed similar views:

But when the obligation to pay in coin ceases, the currency no longer retains this determinate value, but is in danger of being depreciated from two different causes; viz., by want of confidence on the part of the public, and an undue increase of the quantity of notes.... Though the persons who have the regulation of a currency not payable on demand should confine their issues within the most just and reasonable limits; yet if their credit or solvency is doubted, it is impossible that their notes can circulate at the full nominal value.9

Whether the depreciation of bank notes be owing to excess of issue or to the ticklish foundation upon which their present validity is built, the ever-varying standard of public opinion, the fact itself ... [i.e., of depreciation of paper in terms of bullion] is undeniable.... If it be alleged that the issues of the Bank, compared Edition: current; Page: [135] with the wants of the public, are not greater now than formerly, I answer, that this reasoning may imply a decreased confidence in the Bank of England, but that it does not throw the smallest light upon the question of depreciation.10

Ricardo likewise disclaimed any belief that in 1810 lack of confidence in the paper pound was a factor in its depreciation: “I am not aware of any causes but excess, or a want of confidence in the issues of the paper (which I am sure does not now exist), which could produce such effects as we have for a considerable time witnessed.” 11

The bullionists on this point were in error. Their error, however, lay not, as Silberling and Angell claim, in attributing some of the depreciation of the paper pound to loss of confidence in it, but in their refusal to do so, although this refusal may have been due to prudential considerations. For as Horner and Ricardo later acknowledged,12 some of the sharp fluctuations in the premium on gold could not be adequately explained as due to corresponding fluctuations in the quantity of paper money, and could be adequately explained only with reference to changes in anticipations as to the future of the paper pound, resulting in changes in willingness of Englishmen to hold cash balances in paper and of foreigners to hold securities payable in sterling.

The bullionist position is open to one further correction, but one of probably minor practical importance. Under a metallic standard, if due to foreign remittances or abnormally heavy grain imports there occurs a temporary rise in the relative demand for Edition: current; Page: [136] foreign bills, an export of specie will tend to occur, which will operate both to lower the amount of the domestic circulation and directly to increase the supply of foreign bills by the amount for which the exported specie itself can be exchanged. Under an inconvertible currency which has been on a depreciated basis for some time, so that all the bullion has already either been exported or passed into more or less permanent hoards, there will be no specie export to constitute a direct equilibrating element in the international balance of indebtedness. With the same volume of foreign remittances to be made, a greater contraction of the currency, therefore, will be necessary under inconvertibility than under a metallic standard if the exchanges are to be kept from falling by more than the cost of shipping gold, and conversely, a fall of the exchanges by more than the cost of shipping gold will not be absolute proof that the currency has been contracted in less degree than would have been necessary if the standard were metallic.

VI. The Anti-Bullionist Position

By no means all of the anti-bullionists were willing to accept as the criterion under all circumstances of the proper amount of currency that amount which could circulate under a metallic standard, and to concede, therefore, that if it could be shown that the circulation was actually greater than could be maintained under a metallic standard the currency would thereby have been demonstrated to be in excess. But criticism of the bullionist position based on rejection of the metallic standard as the best criterion for regulation of the currency became much more widespread and important during the deflation period than it had been during the period of rising prices, and it will be convenient therefore to postpone an examination of such criticism.

The anti-bullionists often attempted to show from statistics as to Bank of England note issues either that the issues had not increased or that there was no relation in time or degree between the fluctuations in issue and the fluctuations in the premium on bullion or the exchanges. But Ricardo was able to show that even if the data were as alleged—as they often were not—they did not refute his argument. He was claiming not that the currency had been increased during the Restriction, but that it existed in an Edition: current; Page: [137] amount greater than could have been maintained at that time, other things remaining the same, if convertibility had been maintained. Whether the amount of actual issue in say 1810 was greater or less than in 1797 was beside the point if it was greater than could have been maintained under convertibility in 1810:

I do most unequivocally admit, that whilst the high price of bullion and the low exchanges continue, ... it would to me be no proof of our currency not being depreciated if there were only 5 millions of bank notes in circulation [as compared to about 10 millions in 1797 and 23 millions in 1810]. When we speak, therefore, of an excess of bank notes, we mean that portion of the amount of the issues of the Bank, which can now circulate, but could not, if the currency were of its bullion value.1

Some of the anti-bullionists contended that to prove depreciation it was necessary to prove that gold coin commanded a premium over paper, since bullion was only a commodity and its price therefore of no special significance.2 Since it was unlawful to melt or export English coin, and since persons buying such coin at a premium would come under suspicion of intent to violate the law, it is not surprising that there were no open dealings in gold coin at a premium over paper.3 What happened was that the full-weight coin quietly but rapidly passed out of circulation and was either exported on government account or went into hoards or into the melting pot for industrial use or for illegal export abroad. As Ricardo pointed out, if the law against melting and export had been repealed, gold coin and gold bullion would have commanded the same premium over paper money;4 on the other hand, if the law against melting and export could have been fully enforced, exportable bullion would have commanded the same premium over coin and paper money.5

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VII. The Balance of Payments Argument

The anti-bullionists, however, had a more serious objection to raise against the acceptance of the premium on bullion over paper as a proof of excess currency. It was agreed on both sides that under an inconvertible as under a convertible standard the price of bullion was governed by the foreign exchanges. Both sides were also agreed that under convertibility the exchanges could not ordinarily fall below the gold export point, since below that point, representing by its distance from mint parity of the two currencies the cost of transmitting bullion, it would be more profitable to ship bullion than to buy foreign bills. The anti-bullionists argued, however, that under inconvertibility this limit to the fall in the exchanges did not exist; that the exchanges and the premium on bullion would be governed solely by the state of the balance of international payments;1 and that in a period when heavy military remittances and extraordinary importations of grain because of deficient English harvests had to be made, there was no definable limit beyond which the exchanges could not fall or the premium on bullion rise without demonstrating that the currency was in excess.

In their treatment of this crucial issue, the bullionists were divided into two groups, offering different answers. One of these groups consisted of only two men, Wheatley and Ricardo.2 To Edition: current; Page: [139] the argument that foreign remittances would under inconvertibility operate to depress the exchanges, Wheatley and Ricardo both replied that foreign remittances would have no effect on the exchanges whether under convertibility or inconvertibility; in both cases, they maintained, the demands of England and the rest of the world for each other's products would so adjust themselves automatically to the remittances that they would be transferred in goods without changes either in relative prices or in exchange rates. If under inconvertibility, therefore, there appeared a depreciation of sterling exchange, this was evidence of excess issue of currency. Ricardo later made some minor concessions to his critics,3 but Wheatley adhered rigidly to this doctrine to the end.4 The other bullionists took an intermediate position. They conceded that foreign remittances would affect the exchange rates, and conceded also, though without adequately explaining why, that while such remittances were under way a premium on bullion and exchanges below parity were not proof that the amount of currency in circulation was in excess of what could be maintained under a metallic standard currency. They confined themselves to the argument that a continued and substantial premium of gold over paper, and fall of the exchanges below parity, established strong presumptions that the currency was in excess of what could be maintained under a metallic standard. The Bullion Report, for instance, cited the persistence of a high premium on gold and low foreign exchanges “for a considerable time” as the evidence pointing to the existence of excess currency.5

It is arguable that the above account exaggerates the difference between Ricardo and the other bullionists, although the publications of the latter and Ricardo's correspondence show that they were conscious of their existence and were unable to reach a mutually satisfactory reconciliation. Ricardo could very rarely interest himself in the immediate and transitory phases of an economic process sufficiently to trace it in detail through its successive stages, and he frequently confined his analysis to the end results, either passing over without mention or even denying the existence Edition: current; Page: [140] of the intermediate stages. Ricardo, moreover, tended to omit at times explicit mention of qualifications whose validity he was prepared to acknowledge, if he regarded these qualifications as of minor importance or if he had already in some other connection conceded them. The result of these two habits was a rigor and a precision in his formulation which perhaps gave added force to his exposition when he was dealing with the general public, but which enabled more sophisticated critics to expose him to rebuttal often more damaging in appearance than in fact. These characteristics of Ricardo's methods of thought are now familiar to economists, and Ricardo was to some extent conscious of them himself.6 They are well illustrated by the following passages from Ricardo, of which the first appears to involve an absolute denial of the existence of intermediate stages in the process of international adjustment to a currency disturbance, while the second recognizes their existence but reveals that his interest lay wholly in what occurs after they have fully worked themselves out:

To me ... it appears perfectly clear, that a reduction of bank notes would lower the price of bullion and improve the exchange, without in the least disturbing the regularity of our present exports and imports.... Our transactions with foreigners would be precisely the same....7

I am not disposed to contend that the issues of one day, or of one month, can produce any effect on the foreign exchanges; it may possibly require a period of more permanent duration; an interval is absolutely necessary before such effects would follow. This is never considered by those who oppose the principles of the Committee. They conclude that those principles are defective, because their operation is not immediately perceived.8

After a time Ricardo gave way somewhat to the pressure of dissent from his views not only by the anti-bullionists but by the bulk of the bullionists. In response to criticism by Malthus, he conceded that when remittances were under way the currency in the remitting country would be in excess unless it were reduced Edition: current; Page: [141] in the proportion which the commodity export surplus constituted of the total stock of goods in that country, which still implied that the remittances could be effected under a convertible standard, or without depreciation of the currency under an inconvertible standard, without involving a relative fall in the level of prices in the remitting country.9 He later introduced into his exposition qualifying words and phrases of a kind not to be found in his first writings and which brought him closer to the position of the other bullionists.10

The bullionists other than Wheatley and Ricardo conceded that extraordinary remittances would affect the exchanges adversely, but insisted, as against either the express denial of or the failure to give consideration to this factor by the anti-bullionists, that the quantity of note issues, through its effect on commodity prices, and thus on the trade balance, was an additional factor determining the exchange value of the English currency, and ordinarily would be the dominant factor.11 Perhaps the best brief statement of the moderate bullionist position was the following by Malthus:

The real state of the case seems to be, that though the effects of a redundancy of currency upon the exchange are sure, they are slow, compared with the effects of those mercantile transactions not Edition: current; Page: [142] connected with the question of currency; and, while the former of these causes is proceeding in its operations with a steady and generally uniform pace, the more rapid movements of the latter are opposing, aggravating or modifying these operations in various ways, and producing all those complex, and seemingly inconsistent, appearances, which are to be found in the computed exchange.12

Wheatley and Ricardo, it appears to me, were clearly wrong in their denial that extraordinary remittances would operate to depress the value of the English currency on the exchanges and in their insistence that in the absence of currency changes the demands of England and the rest of the world for each other's products would necessarily so immediately and completely adjust themselves to extraordinary remittances as to result under both a metallic and an inconvertible paper standard in the maintenance of equilibrium in the balance of payments without the aid of specie movements, changes in the relative level of prices in the two areas, or movements of the exchange rates. The theoretical grounds for holding these views to be erroneous are presented at length in a later chapter.13 Silberling and Angell, moreover, have shown, in the case of Silberling by a comparison of the English foreign remittances with the price of silver in English paper currency, and in the case of Angell by a comparison of the premium on silver and the Hamburg exchange, that there was a close correlation between these remittances and the status of the English currency. These comparisons are reproduced in table I and chart I. Adequate data do not exist to permit a tabulation of the international balance of payments of Great Britain for the period, or even of its trade balance. In the absence of such data, it is reasonable to assume that the extraordinary remittances are a fair presumptive index of the degree of pressure operating to force upwards the foreign exchanges and the price of silver in terms of English paper currency. The correlation shown is in fact closer than could reasonably have been expected, given the partial character of the data made use of for the purpose of the comparison, and I know of no equally striking results from similar comparisons for other countries or periods. Whether by design or by accident the English paper currency remained at or near parity with silver and with foreign metallic currencies in the years in

Edition: current; Page: [143]
Edition: current; Page: [144]
Table I (data of Chart I) Extraordinary Remittances, Price of Silver, and Hamburg Exchange, 1795–1820
Year Extraordinary remittancesa (In Millions of Pounds) Price of Silverb (Par = 100) Exchange on Hamburgc 36s. banco = 100
a Silberling. “Financial and monetary policy of Great Britain,” Quaterly journal of economics XXXVIII (1924), 227. (Government remittances to Continent plus value of grain imports into Great Britain in excess £2,000,000.)
b lbid. (Spanish silver dollars.)
c Hawtrey, Currency and credit, 3d ed., 1928, p. 335. and Reports by the Lords Committee. . .[on] the expediency of the resumption of cash payments, 1819, p. 330.
1795........... 9.4 102.4 107
1796........... 7.0 104.2 106
1797........... 1.6 101.7 98
1798........... 0.3 99.0 96
1799........... 3.4 105.1 103
1800........... 11.3 111.2 113
1801........... 12.0 115.9 113
1802........... 1.5 109.5 109
1803........... 0.3 107.8 105
1804........... 0.7 107.0 101
1805........... 4.5 107.1 103
1806........... 1.8 110.0 105
1807........... 2.6 109.7 104
1808........... 6.6 107.2 106
1809........... 9.1 110.2 121
1810........... 14.1 114.4 120
1811........... 13.8 121.1 144
1812........... 14.8 128.0 128
1813........... 26.3 138.2 130
1814........... 23.1 126.4 119
1815........... 11.9 118.4 114
1816........... 2.9 102.3 100
1817........... 4.4 105.4 102
1818........... 8.9 111.6 105
1819........... 2.2 107.2 102
1820........... 0.7 101.5 ...

which no, or small, foreign remittances had to be made, and departed from parity in roughly corresponding degree in the years in which heavy foreign remittances were necessary.14

Edition: current; Page: [145]

Ricardo could, however, have conceded to his opponents the point that extraordinary remittances tend to depress the exchanges without surrendering his main contention that actual depreciation of the exchanges was evidence of greater issue of currency than could be maintained in circulation under a metallic standard. Extraordinary remittances tend to depress the exchanges alike under a metallic and under a paper standard, but under a metallic standard this depreciation is prevented from going beyond the gold export point by contraction of the currency. If speculative factors be abstracted from, or if it be assumed that their mode of degree of operation is not affected by extraordinary remittances, then such remittances, if accompanied by equal contractions of the currency of the remitting country in the two cases, should not result in appreciably greater15 depreciation of the exchange under a paper than under a metallic standard. It was primarily because under the paper standard the English currency was not contracted as it would necessarily have been contracted under a metallic standard that the foreign remittances resulted in such marked depreciation of the paper pound on the exchanges.

If Wheatley and Ricardo erred in their exposition of the relation under inconvertible currency between the exchange rates and the state of the balance of payments, the anti-bullionists erred more grievously. The anti-bullionists insisted rightly that under inconvertibility the exchanges were immediately determined solely by the demand for and supply of foreign bills, but failed to see that this was equally true of a metallic standard and that a very important factor determining the relative demand for and supply Edition: current; Page: [146] of foreign bills was the relative level of prices in the two countries, which in turn was determined largely by the relative amounts of currency. Many of the anti-bullionists, moreover, must have thought that in some way a fall in the foreign exchanges made possible the payment of foreign remittances without the need of a commodity export surplus. No other explanation is available of their repeated insistence that throughout the period of low exchanges England either had an unfavorable balance of payments on trade account, or else had a balance insufficiently favorable to offset the military expenditure abroad. As Ricardo pointed out, in reply to reasoning of this sort by Bosanquet, this left it a mystery how the military expenditures abroad were actually met, since specie was not available.16

Not all the anti-bullionists, however, were confused on this point. One of them stated very compactly and clearly the possibilities under such circumstances:

[Under a depreciated paper currency] it would be literally impossible that the balance of payments should be any longer against us, because we could have no means of paying an unfavorable balance. Our receipts from, and payments to, foreign nations must therefore be reduced to an equality (or the balance must be turned in our favor) either by an increase of our exports of merchandise, a diminution of our imports and of the foreign expenditure of government, or by some ... international transfers of capital....17

Another anti-bullionist, Herries, explained that foreign remittances could exceed the export surplus for a time if the balance was met by borrowing abroad, and, writing no doubt from first-hand knowledge, since he had been engaged in the task of making the remittances for the government, said: “This is, probably, the case, with respect to our drafts from abroad at this time:—we are borrowing money to carry on our foreign expenditure, at a high rate of interest.” 18

There are passages in Silberling's critique of the bullionists which seem to indicate that Silberling also subscribes to the notion that the fall in the exchange value of a remitting country's currency Edition: current; Page: [147] can operate to supply it with foreign funds with which to meet its foreign liabilities in some other way than by stimulating its exports and restricting its imports.19 Silberling cannot consistently fall back on the argument that a decline in the exchanges under inconvertible currency would lead to a debt-liquidating shipment of bullion, for he and Angell have characterized this as one of the erroneous doctrines of the bullionists, and especially of Ricardo. As I have elsewhere shown,20 Ricardo distinguished carefully between an inconvertible paper currency depreciated in terms of bullion and one not so depreciated—a distinction which Silberling and Angell fail to make—and denied the possibility of bullion shipments as a part of the regular mechanism of adjustment of international balances in the case of the former. Curiously enough, both Silberling and Angell place some emphasis on bullion shipments as part of the regular mechanism of adjustment of international balances in the case of the former. Curiously enough, both Silberling and Angell place some emphasis on bullion shipments as part of the explanation of the phenomena of the Restriction period, and tacitly, and probably wrongly, assuming that the Bank of England's gold losses were mainly to the government, that when the Bank sold gold it ordinarily did not charge the market price, and that most or all of the gold exported while the Restriction was in effect came from the Bank's holdings instead of from private stocks, cite these bullion shipments as an item in the meritorious record of the Bank of England during the period of suspension of cash payments.21

The notion that even under depreciated inconvertible paper exchange fluctuations will give rise to bullion movements as an ordinary everyday occurrence is not as absurd on a priori grounds as Silberling and Angell regard it for any inconvertible currency. Edition: current; Page: [148] While there is no internal demand for bullion for monetary purposes at a market price in excess of the mint price, there still remains an internal demand for industrial use, for hoarding, and for speculative purposes. A rise in the paper premium on bullion resulting from a fall in the exchanges will operate to induce some of the holders of bullion to offer it for sale for export. There is considerable evidence, both for the Restriction period in England and for other past and present cases of countries with depreciated paper currencies, that, where legal restrictions do not prevent, bullion moves fairly freely into and out of such countries in response to changes in its paper price.22 It is quite conceivable that the net export of bullion from England during the suspension period was even greater than it would have been if the metallic standard had been retained, and that the absence of the direct debt-liquidating effect of bullion shipments cannot therefore be invoked as even a partial explanation of the depreciation of the paper currency.

VIII. The Possibility of Excess Issue by Banks

There were among the anti-bullionists some crude inflationists for whom no amount of currency could be too great. Most of the anti-bullionists, however, recognized that there were limits beyond which it was not desirable to go in the issue of currency. What these limits were, they failed to specify, except in terms of the “needs of business.” They claimed that as long as currency was issued only by banks, and was issued by them only in the discount of genuine and sound short-term commercial paper, it could not be issued in excess of the needs of business, since no one would borrow at interest funds which he did not need. If currency should perchance be issued to excess, it would rapidly return to the banks either in liquidation of bank loans or, under convertibility, for redemption in specie.1 To this doctrine the directors of Edition: current; Page: [149] the Bank of England and prominent members of the Cabinet also subscribed, and the authority of Adam Smith was appealed to in support thereof.2

The bullionists explicitly denied the validity of this doctrine, at least for an inconvertible currency. Thornton in 1797 had objected against the usury laws that they limited the Bank of England to a rate at which “there might be a much greater disposition to borrow of the Bank ... than it might become the Bank to comply with,” 3 and in 1802 he pointed out that the extent to which the charge of interest acted as a check on the demand for discounts depended on the rate of interest which was charged; the Bank of England was prevented by the usury laws from charging more than 5 per cent, and if the prevailing rate of commercial profit were higher than that, the demand for loans would be greater than the Bank should meet.4 Lord King put it more strongly: when the market rate of interest exceeds the bank rate, the demand for discounts “may be carried to any assignable extent,” 5 and in this somewhat extreme form it was repeated by other bullionists.6 In a speech in the House of Commons on May 7, 1811, Henry Thornton expounded with great ability, and with interesting references to the experience of other central banks, the mode of operation of the rate of interest as a regulator of the volume of note issue. He pointed out that even John Law's Edition: current; Page: [150] bank had issued only on loans at interest, and that it was Law's error that “he considered security as every thing and quantity as nothing” and failed to see the significance of the rate at which he offered to lend.7 Thornton argued, moreover, that during a period of rising prices the real rate of interest was less than the apparent rate; while businessmen did not generally perceive this, they did realize that borrowing at such times was usually profitable, and therefore increased their demands for loans if the bank rate did not rise.8

Ricardo agreed with the other bullionists that the “needs of commerce” for currency could not be quantitatively defined, and that through a resultant change in prices commerce could absorb whatever amount was issued.9 But he ordinarily denied any relationship between the rate of interest and the quantity of money, and presumably also between the rate of interest and the demand for loans: “Whilst the Bank is willing to lend, borrowers will always exist, so that there can be no limit to their overissues, but that which I have just mentioned,” i.e., convertibility.10 In a speech in Parliament he expressly denied that the rate of interest was a check to the amount of issues: “For ... what the directors thought a check, namely, the rate of interest on money, was no check at all to the amount of issues, as Adam Smith, Mr. Hume, and others had satisfactorily proved.” 11 Here once more Ricardo was applying long-run considerations to a short-run problem. But in his Principles we find Ricardo at one point expounding the same views as the other leading bullionists:

The applications to the Bank for money, then, depend on the comparison between the rate of profits that may be made by the employment of it, and the rate at which they are willing to lend it. If they charge less than the market rate of interest, there is no amount of money which they might not lend,—if they charge more Edition: current; Page: [151] than that rate, none but spendthrifts and prodigals would be found to borrow of them. We accordingly find, that when the market rate of interest exceeds the rate of 5 per cent at which the Bank uniformly lends, the discount office is besieged with applications for money; and, on the contrary, when the market rate is even temporarily under 5 per cent, the clerks of that office have no employment.12

To the denial by the bullionists that the charge of interest on loans was a sufficient guarantee, irrespective of the rate charged, against overissue, the anti-bullionists apparently never attempted to reply.13 In evidence before the Bullion Committee, Bank of England officials had emphatically denied that the security against overissue by the Bank would be reduced if the discount rate were to be lowered from 5 to 4 or even to 3 per cent. No person, they insisted, would pay interest for a loan which he did not need, whatever the rate, unless it were for the purpose of employing it in speculation, “and provided the conduct of the Bank is regulated as it now is, no accommodation would be given to a person of that description.” 14

That the quantity of bank loans demanded is dependent on the rate of discount is now universally accepted by economists and need not be further argued. On the question whether or not the rate of 5 per cent uniformly charged by the Bank of England during the Restriction was lower than the market rate, there is, Edition: current; Page: [152] however, a conflict of opinion. The usury laws would operate to prevent any overt charge of more than 5 per cent, and the uniform 5 per cent rate which is often said to have prevailed during the Restriction period15 may have been only nominally that. There is contemporary evidence that bankers found means of evading the restrictions of the usury laws. In 1818, the Committee on the usury laws stated in its Report that there had been “of late years ... [a] constant excess of the market rate of interest above the rate limited by law.” 16 Thornton notes that borrowers from private banks had to maintain running cash with them, and borrowers in the money market had to pay a commission in addition to formal interest, and that by these means the effective market rate was often raised above the 5 per cent level.17 Another writer relates that long credits were customary in London and a greater discount was granted for prompt payment than the legal interest for the time would amount to.18

More convincing evidence that the 5 per cent rate was not of Edition: current; Page: [153] itself always an effective barrier to indefinite expansion of loans by the banks is to be found in the fact that the directors of the Bank of England, although they professed that they discounted freely at the rate of 5 per cent all bills falling within the admissible categories for discount,19 in reply to questioning admitted that they had customary maxima of accommodation for each individual customer and occasionally applied other limitations to the amount discounted.20

Even if it were conceded that the Bank rate was never lower than the market rate of discount for the same classes of loans, it might still be low enough to permit or even to foster a wild inflation, if the Bank rate was low absolutely, and if it was the Bank rate which determined the market rate. On important classes of loans the Bank of England was a direct competitor with other lending agencies, and it was certainly important enough as a lending agency to exercise at least an important influence on the market rate. Also, by lowering its credit standards, or offering its credit to a wider range of applicants for commercial loans, it could actively promote currency expansion without lowering its interest rate below the hitherto prevailing level. It may be accepted, therefore, that the 5 per cent rate was not necessarily an adequate check to the volume of bank credit extended to commercial borrowers.

The powers of the Bank of England to expand its note issues, moreover, were not confined to its commercial discount activities. The Bank could also, and did, get its notes into circulation by advances to the government, by purchases of exchequer bills and public stocks in the open market, and by advances to investors in new issues of government stocks. Since even many of the anti-bullionists conceded that there was no automatic check to excess issue where the issues were made in connection with loans to the government, there should have been no occasion for extended controversy as to the existence of a possibility of excess issue.21

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IX. Responsibility for the Excess Issue: Bank of England vs. Country Banks

Since bank notes were issued both by the Bank of England and the country banks, responsibility for any excess issue of paper currency could lay with either or with both. With the exception of Wheatley, who held the country banks largely responsible,1 the bullionists were united in assigning responsibility for the excess, as between the Bank of England and the country banks, wholly or predominantly to the former. Boyd, in 1801, laid down the formula which was to be the text of the bullionists: “The Bank of England is the great source of all the circulation of the country; and, by the increase or diminution of its paper, the increase or diminution of that of every country bank is infallibly regulated.” 2 His argument rested on the postulate that the country banks must keep a fixed percentage of reserves against their own note circulation in Bank of England notes, whereas the Bank of England was not subject to such a limitation.3 In a note added to the second edition, he conceded that the country banks, by allowing their reserve ratio to fall, may have contributed independently to the then existing excess of currency, but he blamed the Restriction, which left to holders of country bank notes the possibility only of converting them into Bank of England notes with which they were not familiar, for making this fall in reserve ratio possible. He apparently believed that once this fall had taken place, the Bank of England would again have control, through Edition: current; Page: [155] regulation of its own issues, over the volume of country bank issues.4

Thornton reached the same conclusion, that the volume of Bank of England issues regulated the volume of country bank note issues, but by a more elaborate chain of reasoning. He applied to different regions within a country the Hume type of analysis of adjustment of international balances of payments.5 If country banks took the initiative in increasing their issues, country prices would rise; the provinces would buy in London commodities which formerly they had bought locally; there would result an adverse balance of payments on London, which would be met through shipment of Bank of England notes to London or by drafts on the balances of country banks with London bankers. The impairment of their reserves would force the country bankers to contract their note issues.6

Thornton pointed out, however, that this did not mean that the proportion of country bank notes to Bank of England notes must always remain the same. This would hold true only if the areas of circulation of the two types of notes and also the relative volumes of payments to be made in the respective areas remained unaltered:

By saying that the country paper is limited in an equal degree, I always mean not that one uniform proportion is maintained between the quantity of the London paper and that of the country paper, but only that the quantity of the one, in comparison with the demand for that one, is the same, or nearly the same, as the quantity of the other in proportion to the call for the other.7

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Similar views were expressed by Horner,8 King,9 Ricardo,10 the Bullion Committee,11 Malthus,12 and other bullionists.

Since the anti-bullionists denied any excess in the currency as a whole, they ordinarily showed little interest in the attempts of the bullionists to apportion responsibility for such excess. Some of the anti-bullionists agreed that convertibility of country bank notes into Bank of England notes was as effective a restriction on country bank note issue as convertibility into gold.13 Others of them, however, apparently determined that if any blame was to be assigned it should not be to the Bank of England, denied that the amount of country bank notes was in any way dependent on the amount of Bank of England notes, and cited in confirmation the evidence of country bankers before the Bullion Committee that their reserves consisted only slightly of Bank of England notes and the apparent absence of correspondence between the fluctuations in the issues of the two types of paper money.14

Silberling and Angell reject the bullionist claim that the country bank note circulation was dependent on that of the Bank of England notes. Silberling ridicules the notion that if prices rise Edition: current; Page: [157] in the provinces, it will result in a shift of purchases from the provinces to London: “London and the rest of England were not then, and are not now economic areas producing identical wares. If the price of iron or hops or wool rose in the provinces by reason of liberal credit accommodation to farmers and speculators, ... it could not result in purchases from London of what London did not produce.” 15 This is a valid criticism of the manner in which the bullionists expressed their argument, but leaves the essence of the argument untouched. A relative increase in country bank note issues will not lead the provinces to increase their purchases in London of country products, but it will, nevertheless, lead to a debit balance of payments of the country with London. The increase in spendable funds in the country will lead to increased purchases of London products by the provinces, and the rise in prices in the provinces will lead to decreased purchases of country products by London. When two regions have currencies convertible into each other at fixed rates and have commercial relations with each other, one of these regions cannot issue currency to any extent, irrespective of what the other does, without encountering serious exchange and balance of payments difficulties, even if the two regions do not have a single identical product.16

Silberling and Angell object further that the explanation given by Thornton and Ricardo is unilateral, instead of bilateral; it fails to take account of the upward effect on London prices of the release by the country to London of Bank of England notes and Edition: current; Page: [158] balances with London bankers resulting from an expansion of country bank note issues. They contend, in rebuttal, that a rise in prices in the country resulting from an increased issue of country bank notes would spread to London.17

This is a valid criticism of Thornton.18 It is not applicable, however, to Boyd19 or Ricardo,20 for both of these writers took it for granted that it was necessary for the country banks to maintain constant cash reserve ratios whether in Bank of England notes or not. If the Bank of England did not increase its issues, then the country banks could not at the same time increase their circulation and maintain a constant reserve ratio. It is this assumption of constancy in the country bank reserve ratios, to which neither Silberling nor Angell refers, which is the vulnerable point in the bullionist argument. If, as Boyd conceded, the country banks allowed their reserve ratios to fall, they could, as long as their reserves were not wholly exhausted, force their issues even while the Bank of England remained passive. If they tolerated a lowering of their reserve ratio, they could bring about a new price equilibrium and a new equilibrium in the balance of payments between London and the provinces, with the circulation greater, and prices higher than before, in each area. Even if the country banks expanded rapidly and extravagantly, and the Bank of England did not follow suit, it might be some time, as Joplin later pointed out,21 before their reserves were exhausted, and in the interval before the collapse prices would be higher and the premium on bullion greater for England as a whole. The question still remains, however, as to what were the obligations of the Bank of England in such a situation.

Silberling further supports his argument that the issues of the country banks were not dependent upon those of the Bank of England by the claim that the country bank reserves consisted mainly of balances with London private bankers, while the reserves of the London bankers “were wholly uncontrolled by law and had never been more than very moderate sums; and their Edition: current; Page: [159] ability to create credits was now but very little controlled by the Bank of England.” 22 The London bankers, unless they were of a banking species hitherto unrecognized, must, in practice, have found it necessary to have on hand in case of need cash or its equivalent. But the only “cash” at the time was Bank of England notes, and its only equivalent at the time was a demand deposit with the Bank of England. The private bankers in London in fact began during the Restriction period the practice of opening accounts at the Bank of England and of rediscounting bills in their portfolios with the Bank, instead of, as before, selling exchequer bills or government stock on the open market, when they needed to replenish their cash reserves.23 The then deputy governor of the Bank admitted to the Bullion Committee, in reply to a searching question on this point, that a considerable amount of the bills discounted with the Bank of England by the London private banks was country bank paper.24 Willingness of the London bankers to allow their cash balances to run down would enable them to expand their credits to country banks in some degree, even if the Bank of England did not make available to them increased rediscount facilities. But since such expansion would involve a persistent drain of their cash to the Bank of England and to hand-to-hand circulation, it could not have been carried far without active Bank of England support. The Bank of England, moreover, could, by positive action, have prevented even such expansion of the volume of discounts of the London private banks as had been independent of increased discounts with the Bank of England.

Silberling and Angell fail completely to give any consideration to the proposition that while England had an inconvertible paper currency special responsibility attached to some agency, and presumably to the Bank of England as in effect a central bank, to keep the currency in good order, even if to do so it should prove necessary to countervail the activities of the country banks and the London private bankers. Silberling even goes to the length of characterizing as a “truly remarkable opinion,” unfortunately, however, without indicating why, Ricardo's argument (as summarized Edition: current; Page: [160] by Silberling) that “one of the causes of the ‘excess’ of Bank notes was the expansion of the country issues, which had thereby narrowed the field within which the Bank's issues could circulate; the latter overflowed, in other words, a contracted channel.” 25 The Bank of England, it is true, was organized as a profit-making establishment. But it enjoyed valuable special privileges, and whatever some of its shareholders may have thought,26 it was the general opinion of the time that it also had special obligations, what we should today term the obligations of a central bank. Silberling himself refers to the Bank of England of that period as a “central bank,” and states that the Bank claimed to be a “regulator” of the currency. The Bank could not plead financial inability to carry out these obligations, for the “supposedly enormous profits,” to which Silberling refers in a manner clearly intended to suggest that they existed only in the imagination of the bullionists, were genuine.27 There is nothing obviously remarkable in the proposition that a central bank should contract when the rest of the banking system is dangerously expanding, in order to check and to offset that expansion. It should, on the contrary, be obvious that there is a fatal conflict between the regulatory functions of a central bank and determination on its part to maintain, willy-nilly, its accustomed proportion of the country's banking business.28

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Silberling and Angell attempt also to demonstrate the lack of responsibility of the Bank of England for the increase in currency by an elaborate statistical comparison of the behavior of the Bank of England and the country banks. But if it is accepted that the Bank of England was a central bank, its responsibility for any excess of currency is ipso facto established, unless it can be shown that it used its powers of control to the utmost but that they did not suffice. What statistical analysis of this sort can at best show is the extent to which the actions of the other banks made it incumbent upon the Bank to exercise what powers of control it had, and in what degree and with what measure of success it did exercise them. Even such questions cannot be answered by a simple comparison of the short-term fluctuations of the two types of note issues. The Bank of England could have been wholly responsible for initiating and maintaining an inflationary trend during the period as a whole, while wholly irreproachable in its manner of dealing with short-term fluctuations about this trend. Allowance must be made, furthermore, for the changes in the areas of circulation of the two currencies and in the volume of trade and in the velocities of circulation in the two areas, and for the effects of the occasional collapses of the country bank circulation owing to discredit, before much can be learned from such comparison. These difficulties are disregarded by Silberling and Angell. But let us suppose them successfully surmounted. What then could be learned from a comparison of the fluctuations in the two types of issues?

The Bank of England could have followed any one of three alternative lines of policy with respect to the relationship between its own issues and those of the country banks, which can be distinguished as (1) regulatory, (2) passive or indifferent, and (3) sympathetic. If it followed a regulatory policy, this should show itself in a negative correlation between the fluctuations in the two types of issues, with the changes in the Bank's issues lagging behind those of the country banks. If the Bank took a passive or indifferent attitude toward the operations of the country banks, there should be no marked correlation, positive or negative, unless: Edition: current; Page: [162] (a) the country banks, either from policy or from necessity, followed the Bank of England, when there should be a positive correlation between the fluctuations in the two types of issues, with the changes in the country issues lagging after the changes in the Bank issues; or (b), both the Bank and the country banks responded to the same factors in the general situation pulling for credit expansion or contraction, when there should be positive correlation between the fluctuations in the two types of issues, with the existence and the character of a lag depending on the time-order in which London and the provinces, respectively, felt the stimuli to expansion or contraction and the rapidity with which they responded to such stimuli. Finally, if the Bank followed a sympathetic policy, there should be positive correlation between the changes in the two types of issues, but with the changes in the Bank of England issues lagging after the changes in the country bank issues. This does not, of course, exhaust the range of possible relationships, since the types of relationship distinguished above need not in practice have been mutually exclusive, but could have been present in varied and varying combinations.

From his examination of the statistical data Silberling concludes that “the quarterly cyclical fluctuations in the country notes preceded ... the discounts of the Bank of England (a much more accurate measure of accommodation than their notes).” 29 If this were the case, it would indicate that the Bank of England either had followed the “sympathetic” policy toward country bank issues, surely the least defensible of all if it was its function to keep the currency in order, or had had no policy at all but had reacted in the same way as the country banks, but more slowly, to the forces operating in the country at large to bring about a currency inflation. Silberling nevertheless presents this conclusion as an important element in his exoneration of the Bank from blame.

Angell, using Silberling's data, finds that the Bank of England note circulation “was a comparatively stable element” and that Edition: current; Page: [163] “the great element of fluctuation in the volume of currency was, rather, the issues of the country banks. These issues usually expanded greatly before and during a rise in prices, while they contracted even more abruptly before and during a fall,” 30 i.e., the Bank of England followed a passive policy.

The statistical conclusions of both writers rest, unfortunately, on faulty data with respect to the country bank note circulation. There was no record of the actual amounts of notes issued, but the notes had to carry tax stamps, and all contemporary estimates were based on the official statistics of the tax stamps, sold by the government, and on the estimated average life of the notes. Country bank notes were subject to tax only upon their original issue. Subject to some complex qualifications, prior to 1810 these notes could not be reissued after three years from the date of their original issue. This limitation was removed in 1810, on the assumption that on the average the notes would, because of wear and tear, have a life of about three years. If the notes could be presumed to last, prior to 1810, on the average for three years, if after 1810 all the notes could be presumed to last for the full three years, and if the country banks always succeeded in maintaining in circulation the full amount of notes for which they had purchased stamps, then the circulation at the beginning of any quarter would be equal to the amount of notes for which stamps had been sold during the preceding twelve quarters. There was no available mode of estimating the circulation which did not necessitate making doubtful assumptions of this kind.31 Silberling's estimate of country bank note circulation, which Angell also uses, has, moreover, a special and catastrophic defect of its own. It consists merely of the amount, for each quarter, of £1 and £5 notes for which stamps had been sold in such quarter, arbitrarily multiplied by ten, i.e., with the decimal point moved one place to the Edition: current; Page: [164] right, presumably as the result of an error in copying.32 It bears no resemblance in its fluctuations to the other available estimates of country bank note circulation, as the following table shows:

TABLE II Estimates of Country Bank Note Circulation for Specified Quaters (In Millions of Pounds)
Third quarter of year Based on aggregate sales of stamps during preceding twelve quartersa Sedgwick's estimateb Silberling's seriesc
a Report of Lords Committee [on] resumption of cash payments, 1819, appendix F. 1, p. 396 (£1 and £5 notes only).
b Ibid., appendix F. 8, pp. 408–15; based on assumption that in any given year there would be in circulation all the notes for which stamps had been sold during that year, two-thirds of the notes for which stamps had been sold in the preceding year, and one-third of the notes for which stamps had been sold in the next preceding year. (All notes.)
c Silberling, “British prices and business cycles,” loc. cit., p. 258 (£1 and £5 notes only).
1807............. 19.7   11.0
1808............. 17.5   14.9
1809............. 20.6 17.0 23.1
1810............. 22.9 21.8 13.1
1811............. 23.1 21.5 18.7
1812............. 19.2 19.9 15.3
1813............. 20.5 22.6 17.5
1814............. 22.1 22.7 14.5
1815............. 20.8 19.0 9.0

Silberling claims for his series that “since this stamp duty involved expense to the issuing bankers, it is wholly probable that Edition: current; Page: [165] the volume of notes stamped each quarter affords a safe index, at any rate, of the variability of the actual issues.” 33 But Silberling overlooks that the amount of stamps issued each quarter indicates at best only the amount of new notes which were issued during that quarter. Since it gives no indication of the amounts of old notes which went out of circulation during that quarter, it is a wholly unreliable index of the net change during the quarter in country bank note circulation. Silberling's series, as its method of compilation would lead one to expect, shows much greater quarter-to-quarter and year-to-year variability than do the other available estimates of country bank note circulation. These last do not indicate any appreciably greater instability in country bank note than in Bank of England note circulation. But even these other estimates are probably too defective to warrant any confidence on conclusions based on their use.34

X. Responsibility for Excess Issue: the Credit Policy of the Bank of England

Silberling finds other statistical evidence of the high quality of the Bank of England's management of its affairs during the Restriction: “the Bank's loans to the State tended to expand when discounts were moderate, and vice versa. In other words, the Bank granted accommodation to the government during the war rather sparingly and according to the state of their mercantile accounts. They put the business interests foremost and assumed a primary responsibility for the maintenance of British trade and industry, which, in an essentially commercial war, was of vast consequence.” 1 But as can be seen from chart II and table III, all that the data show is that there was somewhat of an inverse correlation between the short-run changes in commercial discounts and advances to the government. As they stand, the data will equally well support the conclusion that commerce got only what was left after the government's demands had been satisfied. An even more plausible explanation of the inverse correlation between commercial discounts and advances to government, because it does not involve the attribution to the Bank of England Edition: current; Page: [166] of any consistent regulatory policy, is that advances to the government supplied commerce with funds as effectively as, though less directly than, commercial discounts. When the government borrowed freely from the Bank, the borrowed funds flowed into commerce and consequently lessened the demand of businessmen for discounts.2 But while Silberling here praises the Bank for giving commerce a preference over the government, and for treating the latter only as a residual claimant for credit, he later attacks the bullionists for their alleged failure to recognize the extent to which the Bank's expansion of its credit was due to the demands made upon it by the government.3


Angell, from the same data, derives a substantially different defense of the Bank's operations. Instead of finding that the Bank treated the government as a residual borrower, he claims,

TABLE III (data of Chart II) Commercial Discounts and Advances to the Government by the Bank of England, 1795–1815 (In Millions of Pounds)
Year Commercial paper under discounta Advances to the governmentb
a Report from the [commons] Committee...on the Bank of England Charter, 1832, appendix no 59, p. 54.
b Reports by the Lords Committee...[on] the expediency of the resumption of cash payments, 1819, appendix A. 5. p. 309. (Yearly averages of returns for February and August of each year.)
1795.......... .......... ... 2.9 13.3
1796.......... .......... ... 3.5 11.6
1797.......... .......... ... 5.4 8.7
1798.......... .......... ... 4.5 9.6
1799.......... .......... ... 5.4 9.5
1800.......... .......... ... 6.4 13.0
1801.......... .......... ...  7.9 13.6
1802.......... .......... ... 7.5 13.9
1803.......... .......... ... 10.7 11.6
1804.......... .......... ... 10.0 15.0
1805.......... .......... ... 11.4 14.5
1806.......... .......... ... 12.4 14.6
1807.......... .......... ... 13.5 13.7
1808.......... .......... ... 13.0 15.0
1809.......... .......... ... 15.5 15.7
1810.......... .......... ... 20.1 16.4
1811.......... .......... ... 14.4 20.4
1812.......... .......... ... 14.3 22.3
1813.......... .......... ... 12.3 25.8
1814.......... .......... ... 13.3 30.1
1815.......... .......... ... 14.9 26.5

probably justly,4 that the Bank was not a free agent in deciding the amount of credit it should grant to the government, and concludes, from his analysis of the data, that the Bank in its commercial discounts, “that part of the credit extensions over which it had independent control,” exercised “a moderating policy, of restraint in boom times and of assistance in stringency.... The Bank of England, in so far as its independent and uncontrolled loan-extensions were concerned, was largely blameless.” 5

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What inverse correlation there was between the commercial discounts of the Bank and its advances to the government is consistent, in the absence of additional information, with a wide variety of interpretations of the credit policy of the Bank. All that can reasonably be inferred from the available data, statistical and non-statistical, with respect to the operations of the Bank is that during the Restriction period the Bank increased both its advances to the government and its commercial discounts substantially, that the increase in its commercial discounts was proportionately much greater than the increase in its advances to the government, that rising premiums on bullion, falling exchanges, and rising prices all failed to act as a check on the expansion by the Bank of its credit facilities of all types, and that the Bank directors told the truth when they insisted repeatedly that they followed no clearly-defined rule or principle in regulating their discounts except insistence that the commercial paper discounted should be “sound” and of short maturities. That the depreciation was, on modern, less exigent standards, only moderate, seems to have been due much more to the fact that the 5 per cent discount rate had become traditional and therefore was not lowered than to deliberate policy of the Bank. Even if it be granted that the Bank of England exercised a stabilizing influence, the evidence is lacking that it did so deliberately and as a matter of policy, and the record as to the premiums on bullion, the fall of the exchanges, and the rise of prices, demonstrates that it did not exercise it sufficiently, if these phenomena are regarded, as all the bullionists regarded them, as highly undesirable.

There is substantial ground for accepting Angell's plea in defense of the Bank's advances to the government that the Bank with respect to these was not a free agent. It nevertheless had much greater scope for regulating the currency through control of its commercial discounts than it made use of. Ample facilities for direct credit to private business had developed during this period outside the Bank of England both in London and in the provinces, and it is by no means clear that there was any longer any urgent need, as far as the nation's commerce and industry were concerned, for the Bank to grant any genuinely “commercial” discounts at all. Its “commercial discounts” increased, however, from 6.3 millions in 1800 to 15.3 millions in 1809 and Edition: current; Page: [169] 19.5 millions in 1810,6 amounts which were never again reached until after 1914! The proportion of the Bank's commercial discounts to its total advances increased, from an average of approximately 25 per cent during the years 1794 to 1796 inclusive, to 33 per cent for 1797 to 1800, 42 per cent from 1801 to 1805, 50 per cent from 1806 to 1810, and 36 per cent from 1811 to 1815;7 in 1820, after resumption, it fell to 19 per cent, a level which it appears barely to have maintained during the 1820's.8

Even these percentages apparently minimize the extent to which the Bank's expansion of its credit facilities provided funds for use by private industry rather than by government. The government during the Restriction kept a large proportion of the advances to it by the Bank, for the years 1807 to 1816 exceeding 50 per cent on the average,9 on deposit with the Bank, presumably as an emergency reserve. The commercial discounts, on the other hand, were in the main drawn out immediately in cash, and the private deposits at the Bank of England during the same period averaged under 12 per cent of the commercial discounts.10 It is likely, therefore, that the funds resulting from the commercial discounts had a greater velocity of circulation and consequently, pro rata, a greater influence on the level of prices, than the advances to the government.

Angell makes some attempt to determine the responsibility of price inflation in England for the fall in the exchanges and the premium on bullion by a comparison of their fluctuations with the fluctuations in the English price level, as shown by Silberling's index number of English prices for the period, but with admittedly inconclusive results.11 Such a comparison is by its Edition: current; Page: [170] nature without significance. Even a comparison of the fluctuations in the exchange rates with the relative fluctuations of English to foreign price levels would not yield conclusive results unless there was very marked agreement or disagreement in the fluctuations.12

That resort to price inflation is necessary if a great war is to be financed seems to Silberling so axiomatic that without argument he makes their failure to acknowledge this one of the most heavily stressed counts in his indictment of the bullionists.13 There is no need to debate this issue here, but several considerations of which the bullionists were aware call for notice. Contemporary writers pointed out that England had financed successfully the Seven Years' War and the American War, both of which involved fairly comparable financial strain, without resort to price inflation involving serious depreciation of the currency in terms of bullion. Napoleon financed his side of the war on a strictly metallic currency basis. There was, moreover, a substantial rise in English prices even in terms of gold and silver, and England could, therefore, have had a substantial inflation even if she had remained on the gold standard.

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The guinea was made for man, and not man for the guinea.

—Thomas Attwood, A letter on the creation of money, 1817, p. 95.

I. The Resumption of Cash Payments

The Bullion Report, which advocated resumption of cash payments at the old par within two years, was presented to Parliament on June 8, 1810, but was not taken up for discussion until July of the following year. In the latter part of 1810 there began a marked depression, the result largely of a collapse of the boom in the export trade which had followed the opening of Latin America to British trade. This depression continued into 1811, and was accompanied by the suspension of many country banks and by credit stringency. To relieve the situation the government, in March, 1811, issued £6,000,000 in exchequer bills to merchants on the security of commodities, in order to provide the merchants with acceptable paper for discount at the Bank of England or at other banks.1 In the meantime the premium on bullion had been rising, and was not to reach its peak until 1813 for gold and 1814 for silver. These circumstances tended to strengthen the opposition to an early resumption of cash payments, and in the parliamentary session of 1811 the Horner resolutions embodying the conclusions of the Bullion Report were defeated by large majorities.

In 1813 and 1814 commerce and industry were in a prosperous state, and as the termination of hostilities impended the price of bullion began to fall. Napoleon's return from Elba and the resumption of hostilities in 1815 resulted in a rise of the premium Edition: current; Page: [172] on bullion, but a financial crisis, and a fall in prices and in the premiums on gold and silver, followed the definitive defeat of Napoleon at Waterloo.

These rapid changes within a few years in the fortunes of the paper pound appear to have converted many influential persons to the desirability of a return to a metallic standard. In 1816 the government enacted measures preparatory to a return to the gold standard at the old par. Silver coins were definitely relegated to a subsidiary status, thus completing the legal progress toward a monometallic gold standard begun in 1774. It was provided also that the authorization, by the Act of 1797 and later continuing legislation, of the issue of bank notes of smaller denominations than £5, should terminate within two years after the resumption of cash payments. But the government continued to refuse to obligate the Bank of England to resume cash payments, and both government and Bank were obviously waiting for the course of events to disclose the auspicious occasion for resumption. In 1816 gold fell to little above its mint price, and the Bank bought quantities of it at the market price and had it coined at a loss. In January, 1817, on its own initiative, it began partial resumption at the old par, giving gold upon demand for certain categories of its notes, under the authority of a provision in the Restriction Act of 1797 permitting the banks to pay notes under £5 in cash. But the exchanges soon after turned against England, with a resultant drain on the Bank's newly replenished gold reserves, and early in 1819 Parliament, at the suggestion of the newly-appointed committee referred to below, forbade the Bank to redeem any of its notes in gold.

Promises having been made on five different occasions of eventual resumption of cash payments, the House of Commons finally, in 1819, appointed a committee, under the chairmanship of Robert Peel the younger, to inquire into the expediency of the resumption of cash payments: A similar committee was appointed by the House of Lords. The House Committee, after hearing testimony of witnesses who, with one exception, were all favorable to resumption, recommended resumption with only one dissenting vote. In its report it took the desirability of resumption at the old par for granted, and confined itself to recommendations as to the time and manner of resumption. It recommended a Edition: current; Page: [173] gradual return to cash payments at the old standard, along lines which Ricardo had proposed. The government left the decision to the House, which, after but little debate, passed the Act of July 2, 1819, repealing the ancient restrictions on the export of coin and bullion and requiring the Bank to pay its notes in gold bars of a minimum weight of 60 oz. each, at rates per standard ounce which were to attain, by graduated stages, the old rate of £3. 17 s. 10½ d. per ounce by not later than May 1, 1821; after May 1, 1822, the Bank could pay its notes in gold coin or in ingots upon demand as it chose.

The price of gold fell to the mint price almost immediately, the exchanges turned in favor of England, and gold began to flow into the Bank. There was no demand whatsoever for the gold bars, and early in 1821 an act was passed, at the request of the Bank, which did not like the ingot plan, permitting it to cash its notes in gold coin after May 1, 1821.2

From 1816 on, there was a long period of economic distress, although with short intervals of prosperity. There had been voices raised before resumption, warning that it would bring evil consequences.3 Once it was in effect, many persons attributed the distress to it, and there arose an extensive controversy over the expediency of the resumption and of the manner and occasion of bringing it about, which was actively to persist for many years, and was in fact not completely to end until after the middle of Edition: current; Page: [174] the century there occurred a reversal in the hitherto downward trend of the price level.

II. Responsibility of Resumption for the Fall in Prices

From a peak according to Silberling's index of 198 in 1814, the English price level fell to 136 in 1819, to 114 in 1822, to 106 in 1824, and to 93 in 1830. Ricardo had predicted that resumption would bring about a fall in prices not greater than the then prevailing premium on gold, or from 3 to 8 per cent.1 After the event Ricardo conceded that resumption had probably caused a greater fall in prices than he had anticipated. He still contended, however, that if resumption had been managed in accordance with the plan which he had proposed, it would not have caused a greater fall in prices than 5 per cent. If resumption had actually caused a fall in prices greater than this it was because the Bank of England had so mismanaged the resumption as unnecessarily to bring about a rise in the world value of gold.2 He held that there was no certain way of determining how much of the increase in the world value of gold was due to this mismanagement and how much to other causes, but he accepted as a plausible guess Tooke's estimate of 5 per cent as the additional fall in English prices resulting from the mismanagement of the Bank.3 This would make the total reduction in English prices which according to Ricardo could be attributed to the resumption some 8 to 13 per cent, with the remainder of the fall attributable to other causes operating simultaneously to raise the world value of gold. At other times, however, Ricardo assigned to the Bank's mismanagement responsibility for a greater portion of the deflation of prices than Tooke's estimate would indicate.4 In the absence of any index numbers, he could have had only a vague Edition: current; Page: [175] idea as to the extent of the fall in the price level which had occurred, and he seems to have seriously underestimated it.

In his ardent defense of resumption in principle, and also, though to a lesser extent, in his criticism of the management of resumption by the Bank, Ricardo occupied a somewhat isolated position. In the face of the depression which followed resumption, defenders of the resumption were few and these tended to rest their defense on the claim that a metallic standard of some sort was desirable, without undertaking to justify the restoration of the old par or to blame the Bank for the evils which they admitted had resulted from resumption as it had actually been brought into effect. Of the ardent bullionists who during the inflation period had insisted upon the desirability of a return to the metallic standard, some were now dead, or inactive as far as the currency controversy was concerned; and others, such as Wheatley and Lauderdale, when faced with falling prices, lost their earlier enthusiasm for a return to the metallic standard at the old par. Even so ardent a disciple of Ricardo as McCulloch thought that the return to cash payments at the old par had been a mistake. Much later in the century the Resumption Act of 1819 came to be generally regarded as a great achievement of economic statesmanship, but the economic distress which had followed it and the extensive literature of protest and criticism to which it gave rise had by then been largely forgotten.5

Ricardo, however, had given more hostages to fortune than the other bullionists. Not only had he been still active in 1819 in advocating resumption at the old par, when other bullionists had become silent or had advised devaluation, but he alone, or almost so, among the bullionists had insisted that the premium on bullion was a measure of the extent to which the suspension of cash payments had been responsible for the rise in English prices, and therefore he alone was now bound, if he were to be consistent, to maintain that it would also be a measure of the extent to which resumption of cash payments at the old par would lower prices. The other bullionists had not committed themselves to any quantitative estimate of the inflationary effect of suspension of cash Edition: current; Page: [176] payments. They were now free to reject Ricardo's measure of the deflationary effect of resumption.6

It was later frequently alleged, mainly on the evidence of Heygate, a vigorous opponent in Parliament of the Resumption Act, that Ricardo, shortly before his death in 1823, had admitted to friends that he had been wrong in forecasting that resumption would cause a fall in prices of only 5 per cent.7 This, however, seems doubtful. Ricardo, as we have seen, openly admitted that resumption, as actually carried out, had resulted in a greater fall of prices than 5 per cent, but he continued to deny, apparently to the end, that this greater fall had been an inevitable result of resumption.8 When Ricardo stated that resumption would cause a fall of 5 per cent in English prices, he did not mean that resumption might not be followed by a much greater fall in prices. Other factors might well be operating simultaneously, but independently, to lower prices. Ricardo, moreover, when forecasting in 1819 the effect of resumption on prices, assumed proper management of the resumption,9 and he always had reference to the level of prices and the premium on gold as they were in 1819, and not, as did some of his later critics, to the higher Edition: current; Page: [177] prices and higher premiums of the preceding years.10 Ricardo had been charged during the inflation period with exaggerating the extent of the depreciation of paper and of the rise in prices. He was now to be charged, sometimes by the same persons, with minimizing the extent to which paper had been depreciated and therefore also the extent to which resumption had been responsible for the fall in prices which followed it.11

Ricardo had proposed that convertibility should be restored in terms of ingots of bullion instead of coin, and that the actual circulating currency should consist wholly of paper. In this way a metallic standard could be reestablished with a minimum drain on the world's supply of gold, and therefore with a minimum appreciation of the world value of gold.12 The Bank, however, was unwilling to follow this plan and instead engaged in what Ricardo regarded as an unnecessary contraction of credit and accumulation of gold, thus raising its world value and forcing additional deflation of English commodity prices. Ricardo believed that if the Bank had acted in accordance with his plan it would not have found it necessary to add to the stock of gold which it already had in 1819: “There was nothing in the plan which could cause a rise in the value of gold, for no additional quantity of gold would have been required.” 13 This alleged mismanagement Edition: current; Page: [178] of resumption by the Bank aroused strong feeling on the part on Ricardo.14

Table IV presents some statistical data on the operations of the Bank during the critical years of preparation for and actual establishment of cash payments. They appear in general to lend confirmation to Ricardo's criticism. But although the Bank's holdings of bullion increased greatly after 1819, they had been unusually low in that year. It is difficult to find a basis for an estimate of what would have been a conservatively safe gold reserve for the Bank at that time, in the absence of data as to the extent of the credit superstructure for which the Bank's bullion holdings were the base. If we use the ratio of its gold holdings to its own total demand liabilities as a measure of the status of the Bank's gold reserves, it would seem fairly clear that from 1821 to 1825 the Bank maintained larger reserves than were necessary. But with reserves at their peak in 1825, the Bank barely managed to survive the crisis of 1826 without suspension of cash payments. Even if the Bank's difficulties in 1826 were due to inexcusably reckless credit expansion on its part, the rapidity and the extent of the drain on its bullion reserves demonstrated that large reserves were necessary, given the quality of the Bank's management and the nervous state of public opinion with respect to the solidity of the paper circulation in times of financial strain. Information is lacking as to what the Bank's motives were in accumulating gold and in pushing it out into circulation, but one consideration seems to have been its desire

Edition: current; Page: [179]
TABLE IV Price Level and Bank of England Activities, 1810–1830
Year Price levela Total advancesb Note circulationc Depositsc Bullionc Reserve ratiod
(1790 = 100) In Millions of Pounds Per Cent
a Silberling. “British Prices and Business Cycles, 1779–1850,” Review of economic statistics, preliminary volume v (1923), supplement 2, pp. 232–33.
b lbid., p. 255. Simple averages of quarterly data.
a Report from the [Commons] Committee...on the Bank of England charler, 1832, appendix no. 5, pp. 13–25. Simple averages of data for two dates in each year.
b Percentage of bullion to sum of note circulation and deposits.
1810. . .... . 176 35.7 22.9 13.1 3.4 9.4
1811......... 158 33.9 23.4 11.3 3.3 9.5
1812.. ....... 163 36.4 23.2 11.8 3.1 8.9
1813. ....... 185 38.5 24.0 11.3 2.8 7.9
1814 ......... 198 42.9 26.6 13.7 2.2 5.5
1815 ....... 166 42.5 27.3 12.2 2.7 6.8
1816. ...... 135 34.6 26.9 12.2 6.1 15.6
1817 ...... 143 27.0 28.5 10.0 10.7 27.8
1818......... 150 29.0 27.0 8.0 8.3 23.7
1819 ......... 136 27.2 25.2 6.4 3.9 12.3
1820. ........ 124 22.2 23.9 4.3 6.6 23.4
1821 .... ... 117 18.0 22.2 5.7 11.6 41.6
1822.......... 114 17.1 18.1 5.6 10.6 44.7
1823.......... 113 16.0 18.8 7.5 13.6 51.7
1824.......... 106 14.8 19.9 10.0 12.8 42.8
1825.......... 118 17.9 20.1 8.3 16.2 57.0
1826......... 103 17.6 23.6 7.1 4.7 15.3
1827......... 101 12.0 22.3 8.5 10.4 33.8
1828......... 97 10.8 21.7 9.7 10.4 33.1
1829......... 94 11.2 19.7 9.3 6.8 23.4
1830......... 93 10.6 20.8 11.2 10.2 31.9

to rebut the charge that it was unduly concerned about its own profits.15

The Bank's abandonment of the bullion standard was more assuredly a mistake. The Bank, and other critics of Ricardo's plan, cited the absence of any immediate demand for ingots as a demonstration of its impracticability. But under the bullion standard, and in the absence of domestic gold hoarding, there could have been a demand for ingots only for industrial purposes and Edition: current; Page: [180] for export. The fact, therefore, that from 1819 to 1821, when the Bank was contracting its discounts, when paper was not at a discount, and when the exchanges were favorable, there was no demand for ingots, in no way reflected on the practicability or the desirability of the bullion standard. If the Bank had not withdrawn its small notes from circulation, there would have been no demand for coin or ingots.16 The chief virtue of the ingot plan lay in the fact that at a time when the general return to metallic currencies was threatening to cause a price deflation, it would enable England to make her return to the gold standard with a minimum drain on the world supply of gold. It had the additional virtue that in times of depression, when there was still confidence in the paper currency but impaired confidence in the profitability of investment, the desire for cash liquidity could be met wholly in notes instead of in bullion, thus avoiding forced deflation by the Bank of England. It was open to the objection, however, that it would lessen the stabilizing influence of the pressure brought to bear on the Bank of England by an increase in active circulation during periods of credit expansion and of the leeway given to the Bank to expand credit in times of depression by the decline in active circulation and the consequent influx of gold to the Bank.

From February, 1819, to August, 1822, the Bank reduced its circulation of notes under £5 from £7,400,000 to £900,000, mostly by substituting gold coin for paper in circulation. This also was undoubtedly a mistake. In case of internal distrust, it was mostly the small notes which came back to the Bank for payment in gold, and these were therefore the part of the paper circulation which was most dangerous to the maintenance intact of the gold standard, and conservative opinion in England has always regarded notes of small denominations with misgivings. But the substitution of specie for paper could have been made more gradual Edition: current; Page: [181] without serious risk. Some writers argued, further, that the gold standard could not be safely operated unless there was a secondary reserve of gold in the form of circulating coin from which external drains could be met,17 but it is doubtful whether the Bank could ever draw in circulating gold quickly enough to serve as a means of meeting a severe external drain, and during an internal crisis in a country where gold circulates it is likely to be withdrawn from the banks into private hoards.

Samuel Turner, a director of the Bank of England at the time of the resumption, attempted to meet Ricardo's charge that the Bank after 1819 had added to the difficulties resulting from resumption by making excessive purchases of bullion by the argument that the Bank paid for the bullion in bank notes, and that in the absence of such purchase its owners would have taken the bullion to the mint to have it coined; the Bank's purchases therefore merely made the increase in circulation come more promptly than would have been the case if the holders of bullion had been obliged to wait until they could get coin in exchange for their bullion.18 But the data in table III make it appear probable that the bullion would not have come to England at all if the Bank had not contracted its discounts and withdrawn its small notes, and that, instead of being exchanged at the Bank for notes, the bullion imports were used, directly or indirectly, to cancel indebtedness to the Bank and as a substitute circulating medium for notes. The Bank was not a purely passive agent, as its defenders claimed, but by maintaining its discount rate unchanged,19 by substituting Edition: current; Page: [182] specie for small notes, and by reducing its holdings of public securities, it was promoting deflation.

The government, however, must share responsibility with the Bank for any mistakes that were made in connection with the resumption of cash payments, at least prior to 1822. The Bank had been hostile to resumption in 1819, and embarked upon it only because compelled to do so. The Resumption Act had not been a government measure, but the government had not opposed it, and there is probably some basis for Mathias Attwood's charge20 that the committee hearings of 1819 operated, whether intended to do so or not, to trap the opposition in Parliament to advocate measures which the government itself wished to have carried into effect, but for which it was reluctant to assume full responsibility. The committees and the government itself also yielded too readily, in spite of their misgivings,21 to the Bank's insistence upon a drastic reduction of its floating debt to the Bank, a measure deflationary in its effect. The substitution of gold coin for small notes was made necessary by the provision in the Act of 1816 terminating the Bank's right to issue small notes two years after resumption of cash payments.22 This provision received little or no mention when the Resumption Act was passed, and it has been suggested that its existence had been forgotten.23 But the government was no doubt aware of its existence and in Edition: current; Page: [183] any case was alone responsible for it, and it was probably also due in part to pressure from the government that the Bank had built up its gold reserves by gold purchases even when gold was still at a premium.24

Whether Ricardo overestimated the influence on the world price of gold of the accumulation of bullion after 1819 by the Bank of England it seems impossible to determine. Mathias Attwood pointed out that Ricardo was not consistent in his treatment of inflation and of deflation. In accepting the premium on gold as an adequate measure of the rise in English prices caused by the suspension of cash payments, Ricardo in effect denied any importance to the inflationary influence on world gold prices of the release of a quantity of gold from English monetary use. “But if a purchase of bullion on the part of the Bank be capable of preventing bullion from falling, with an advance in the value of the currency, it must be equally clear, that a sale of bullion by the same body can prevent bullion from advancing along with a depreciation [i.e., in the value] of the currency.” 25 It was Mathias Attwood's position, not that Ricardo was exaggerating the deflationary influence on prices of the Bank's accumulation of gold, but that, by virtue of his use of the premium on gold as a measure of the influence of the Bank's activities on prices, Ricardo had underestimated both the inflationary influence of suspension and the deflationary influence on prices of the Bank's accumulation of gold, since even at their peak the bullion holdings of the Bank of England were only an insignificant fraction of the estimated world stock of gold and silver, and since much of the gold acquired by the Bank had probably come out of English hoards rather than from the stocks of other countries.26 But the comparison should be between, on the one hand, the English absorption for monetary purposes of non-hoarded gold, including the gold which went into English circulation through the agency of Edition: current; Page: [184] the Bank, and, on the other hand, not the world's total stocks of gold and silver, but the world's monetary stocks of gold and silver, but with greater emphasis on gold. The fact that the greater part of the world was then in fact, if not in law, on a silver standard basis makes it seem at least plausible that resumption as it was carried out involved a significant absorption of gold by England.

But whether or not Ricardo did exaggerate the deflationary effect of the English absorption of gold on world gold prices, he probably underestimated rather than overestimated the deflationary influence on English prices of the resumption of cash payments. In taking 1819 for his base year, Ricardo overlooked the probability that the mere anticipation of early resumption would depress prices, and that the fall in the premium on gold and the decline in prices from 1816 to 1819 were also therefore to be regarded as in part at least the consequence of the agitation for resumption. One writer, George Woods, had pointed out some time before that prices would not rise in full proportion to the increase in paper issue, the physical volume of trade remaining the same, if “speculators ... invest their capital in bank paper ... in anticipation of being ultimately paid in specie or bullion.” 27 For the same reason prices could fall before actual resumption, the paper issues and the physical volume of trade remaining the same, if speculators were hoarding paper or dishoarding gold in anticipation of resumption. But Ricardo, like most of the writers of the period, paid little or no attention to the effects of speculative factors on the value of paper money in terms of bullion or of commodities. One writer claimed also that prior to the resumption of cash payments, mechanical inventions and the subsidy to labor from the poor rates had operated to keep the money costs and therefore the prices of exports, and thus to give a temporarily high exchange value to the English currency,28 but it is not clear that these factors ceased to operate, or operated in lesser degree, after 1819.

The defenders of the resumption were justified, however, in Edition: current; Page: [185] denying that it had been responsible for all of the decline in prices which occurred after 1816, or even after 1819, especially as this decline continued until the 1850's.29 Other countries which had been on a paper basis with inflated prices during the war returned to a metallic basis at old parities after its termination and therefore participated with England in the scramble for bullion, which was not available in sufficient quantities to support the existing price levels. The long-continued decline in the English price level after resumption is probably to be accounted for, moreover, by a failure, for the world as a whole, of the production of gold to keep pace with the growth of commerce and industry. The post-Napoleonic fall in prices appears not to have been confined to England, but to have been a world-wide phenomenon.

But whether or not the resumption of cash payments was causally responsible for part or all of the decline in the English price level, in resuming cash payments at the old par England was surrendering the means by which that downward trend could have been checked if not wholly avoided. This argument was at the basis of much of the criticism of the return to a metallic standard. Even Ricardo conceded that the Bank had some power to check a fall in prices, as long as its notes were inconvertible, which it did not have under a metallic standard, and that this was an advantage. But it was an advantage offset, according to him, by the disadvantages of an inconvertible currency.30

III. The Economic Effect of Changing Price Levels

There was general agreement at the time that changes in price levels resulted in arbitrary and inequitable redistribution of wealth Edition: current; Page: [186] and income. There appeared, however, during this period some new arguments in support of the doctrine that falling prices had adverse effects on the volume of wealth and production which made them particularly undesirable, and that rising prices might bring advantages for production and wealth-accumulation to compensate for their inequitable influence on distribution. The general trend of these arguments was such as to constitute at least a partial defense of the wartime inflation and to strengthen the opposition to resumption at the old par. Whether by implication or expressly, these doctrines gave encouragement to the advocates of a national paper currency free from the limitations to which an international metallic currency was subject. To Ricardo these doctrines were for this as well as for other reasons unpalatable, and later “orthodox” economists, following in his path, tended to ignore or to ridicule them. They were, no doubt, carried to extreme and even absurd lengths. They represent, nevertheless, a substantial contribution to economic analysis which in later years had to be rediscovered.

According to Thomas Attwood, it was the lack of uniformity in a fall in prices which made it injurious:

If prices were to fall suddenly, and generally, and equally, in all things, and if it was well understood, that the amount of debts and obligations were to fall in the same proportion, at the same time, it is possible that such a fall might take place without arresting consumption and production, and in that case it would neither be injurious or beneficial in any great degree, but when a fall of this kind takes place in an obscure and unknown way, first upon one article and then upon another, without any correspondent fall taking place upon debts and obligations, it has the effect of destroying all confidence in property, and all inducements to its production, or to the employment of laborers in any wav.1

A contraction of the currency, on the other hand, was injurious because the rigidity of costs prevented it from being followed immediately by a reduction in prices. During the interval consumers, finding themselves possessed of reduced funds, would buy less physical quantities of goods. Workmen would thus lose employment, “until the action of intense misery upon their minds, and of general distress upon all, shall so far have reduced their Edition: current; Page: [187] monied wages and expenses, as to reduce the price [of their product] ... within the reduced monied means of the capitalist.” 2

Wheatley, abandoning his original views, now argued similarly that falling prices, unless they resulted from increasing per capita output, were a burden on farmers and manufacturers because rent, wages, and taxes would not fall in proportion:

All the distress arises from an inability to make good the contracts, which individuals entered into with each other and the state when prices were high, and nothing can remove the embarrassment, but altering the contracts, lowering rent, wages, and taxes, according to the reduction of prices, or raising prices to their former standard by increasing our currency to its former amount.3

These and other writers argued in like manner that an increase in the quantity of money operates to increase employment and prosperity. The argument took two forms. In one of them, the “forced-saving” doctrine now first introduced in England,4 it is held that the increase in money results in an increase in commodity prices unaccompanied by a corresponding increase in the prices of the factors. There results a forced saving on the part of the recipients of the relatively fixed incomes, not in the monetary sense of an increase in the amount of unspent funds, but in Edition: current; Page: [188] the opposite sense of a decrease in the amount of real consumption while money expenditures are maintained. The increase in money is retained by entrepreneurs, who invest it in additional production. In the other form of the argument, commodity prices do not rise immediately or do not rise in as great proportion as the increase in money, and the money left over is available for additional expenditures and consequently for the employment of additional labor. This form of the doctrine, of course, was not novel, but goes back to Hume, and even earlier to William Potter and John Law,5 and rests on the assumption that there are idle resources.

The first stages of the development in England of the doctrine of forced saving have been ably traced by Hayek.6 He finds the first statement in print of the doctrine in the following passage from Henry Thornton:

It must be also admitted that, provided we assume an excessive issue of paper to lift up, as it may for a time, the cost [read prices?] of goods though not the price of labor, some augmentation of stock will be the consequence; for the laborer, according to this supposition, may be forced by his necessity to consume fewer articles, though he may be exercise the same industry. But this saving, as well as any additional one which may arise from a similar defalcation of the revenue of the unproductive members of the society, will be attended with a proportionate hardship and injustice.7

Jeremy Bentham had shortly before completed an extended exposition of the same doctrine, but it remained in manuscript form until published in 1843 as his Manual of political economy.8 According to Bentham, if an increase of money passes in the first instance into hands which employ it “productively,” it results in reduced consumption, because of higher prices, on the part of all who use their income for “unproductive expenditure,” until the new money reaches hands which will use it unproductively. During this interval the reduced consumption of wage earners and Edition: current; Page: [189] recipients of fixed incomes results in corresponding additions to the national stock of capital.9

Hayek refers also to reasoning along similar lines by Malthus, Dugald Stewart, Lauderdale, Torrens, and Ricardo,10 with the caution that he would “not be surprised if a closer study of the literature of the time revealed still more discussions of the problem.” Some important additions can be made to Hayek's citations, including both further discussions of the problem by the writers whom he has cited11 and discussions by other writers, and most notably by Joplin.12

In the other form of the doctrine that an increase in money meant an increase in production, it was argued that an increase in the quantity of money would increase the monetary volume of purchases more rapidly than it would increase prices, with the result that there would be a substantial interval during which the increase of spendable funds would be absorbed by increased employment in the production of consumers' goods rather than by increased prices.13 In this form of the doctrine, the increase Edition: current; Page: [190] in money results in increased real consumption, whereas in the forced-saving form it results in increased investment, but in both forms it makes possible increased employment.

The contributions of Joplin to the discussion are interesting because of the way in which, in the midst of much confused analysis, there appear concise statements anticipating some of the “innovations” in both terminology and concepts of present-day monetary theory. Hayek credits Wicksell with “a contribution of signal importance” by his rediscovery of Thornton's doctrine of the effect of the rate of interest, through its influence on the volume of bank loans, on the volume of money, and his combination therewith of the doctrine of forced saving resulting from an increase in the quantity of money.14 But Joplin has claims of priority in this respect. Hayek has himself pointed out15 that Joplin in 1823 and later had ably analyzed the influence of the rate of interest on the quantity of money. Joplin not only stated clearly the doctrine of forced saving, but on the basis of these two doctrines reached conclusions as to the proper criteria of currency management which in their essentials seem to anticipate Hayek's “neutral-money” doctrine.

Joplin stated the forced-saving doctrine in several of his writings. There follows one such statement:

If a person borrows one thousand pounds of a banker who issues his own notes, the banker has seldom any means of knowing whether he has lent him money that has been previously saved or not. He lends him his notes, and if either he or some other banker should not have previously had a thousand pounds' worth of notes deposited with them, he has at once added a thousand pounds to the capital and a thousand pounds to the currency of the country. To the party who has borrowed the money, he has given the power of going into the market and purchasing a thousand pounds' worth of commodities, but in doing this he raises their price and diminishes the value of the money in previous circulation to the extent of one thousand pounds, so that he acquires the commodities by depriving those of them who held the money by which they were represented and to whom they properly belonged. On the other hand, if a person pays a thousand pounds into the hands of a banker, and the currency is contracted to that extent, both one thousand pounds of capital and Edition: current; Page: [191] one thousand pounds of currency are destroyed. The commodities represented by the money thus saved and cancelled, are thrown on the market, prices are reduced, and the power of consuming them is obtained by the holders of the money left in circulation.16

Joplin does not approve of forced saving. It involves a fraud on those who were holders of money prior to the increase in its issue. At first it results in a stimulus to trade such as “in all probability would more than compensate the holders of the money in previous circulation for the loss they incurred,” but if the increase of issue continues, definite injury and injustice results.17 “Legitimately a banker can never lend money which has not been saved out of income. Money saved represents commodities which might have been consumed by the party who saves it. Interest is paid for the use of the commodities and not for the money.” 18 If banks have the power to issue money, the amount of such issue is determined by the rate of interest which the banks charge on loans. If forced saving is to be avoided, banks should charge “the natural rate of interest,” which he defines as the rate which keeps savings and borrowings equal.19 Under a purely metallic currency in its most perfect state, the quantity of money (and/or the scale of value) would be “fixed and unchangeable” and banks would be able to lend only what others had saved. But where banks acquired the right to issue paper currency not fully covered by gold, the quantity of money, “which ought, if possible, to be as fixed as the sun-dial, came to depend upon the credit of bankers with the public, and the credit of the public with the bankers, upon the supply of bills, the value of capital, and innumerable contingencies, which ought no more to affect the amount of currency in circulation than the motions of the sun.” 20 To remedy this situation he would confine the circulation of paper money to Edition: current; Page: [192] certificates of deposit of bullion exchangeable for and issued only in exchange for bullion.21

Other doctrines were presented during this period which tended similarly to lead to the conclusion that the inflation of the war period had contributed to the augmentation of the national wealth or the national income. Bentham had argued that if taxation fell on funds which otherwise would have been spent on consumption, and if the proceeds of the taxes were not spent unproductively by the government, the “forced frugality” on the part of the taxpayers would operate to increase the national wealth.22 Lauderdale, to the same effect, argued that the sinking-fund involved a “forced accumulation of capital ... annually raised by taxation,” thus “transferring from the hands of the consumers a portion of their revenues to commissioners, who are bound by law to employ it as capital, whilst, if it had remained in the hands to whom it naturally belonged, it would have been expended in the purchase of consumable commodities.” Like Bentham, Lauderdale disapproved of this “forced accumulation,” but not on the grounds of equity to which Bentham appealed. Lauderdale claimed that when the government's current expenditures fell below its revenues, there resulted a diminution of “effectual demand” and consequently of production. While the war continued, Edition: current; Page: [193] he wanted the government to carry on its increased wartime expenditures by borrowing, and without forcing individuals, through taxation, to decrease their expenditures.23 After the war had ended, he urged the government to offset the decline in military expenditures by increased civil expenditures on public works, in order to restore the demand for labor.24

William Blake similarly argued that increased government expenditures financed by borrowing operated to increase prices, profits, and production, by bringing into activity capital which if left in private hands would have remained “dormant,” by which he meant apparently that it would have been kept either as idle cash or as idle stocks of goods. He explained the post-war difficulties as due to “the transition from an immense, unremitting, protracted, effectual demand, for almost every article of consumption, to a comparative cessation of that demand.” 25

John Rooke believed that spending on consumption contributed to prosperity whereas savings, apparently even if invested, did not. He therefore held that the cessation of military expenditures, unless offset by deliberate currency inflation, would operate to cause deflation and depression, especially if these military expenditures had been financed by borrowing:

As the funds which had supported them [i.e., soldiers] in a military capacity, particularly in England, were partly derived from borrowed money, the savers who had supplied this money did not become spenders in the place of government; nor would the war-taxes which were remitted immediately pass into circulation through the medium of consumption, the basis of all income.26

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In one of his earliest essays, John Stuart Mill denied Blake's argument that it was the cessation of the government's war expenditures which brought about the depression:

... every argument is [fallacious] which proceeds upon the supposition that a fund becomes a source of demand by being spent, while it would not have become so by being saved. A loan is a mere transfer of a portion of capital from the lender to the government: had it remained with the lender it would have been a constant and perennial source of demand: when taken and spent by the government, it is a transitory and fugitive one.27

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Mill is here tacitly assuming that the government borrowed funds which the lenders would otherwise have themselves invested. But Blake had argued that if left in private hands these funds would have remained “dormant,” i.e., would have been kept either as idle hoards of cash or as idle stocks of commodities. He could even more effectively have argued that the funds borrowed by the government were in large part created by the banks for the purpose of being lent to the government and therefore might not have existed at all in the absence of the government borrowings.28 Mill also objected that Blake's contention that there could be oversaving rested on the reasoning that although the savers were the only persons who could purchase the (net?) products of their investment, men saved because they did not wish to consume. Mill replied, that on the contrary, men saved because they wished to consume more than they saved.29 Mill is here once more clearly identifying saving with investment. He overlooks the possibility that men may save without investing because for the time being they wish neither to consume nor to invest, but merely to preserve their capital resources without risk of loss through unprofitable investment, and that this is especially likely to be the case when prices are falling rapidly and no investment seems profitable or secure.30

It is not surprising that Ricardo, with his loyalty to the metallic standard and his temperamental reluctance to explore the shortrun and intermediate phases of economic process, also did not take kindly to these doctrines.31 His references to them are few, Edition: current; Page: [196] and tend to be obscurantist in nature. As in other cases, he alternated between outright denial of their validity, on the one hand, and qualified admission of their correctness for the short run but with minimization of their importance, on the other hand.

To Malthus's argument, that an increase in the quantity of money would operate to transfer purchasing power from those with fixed money incomes, an “idle and unproductive class,” to farmers, manufacturers, and merchants, and would thus result in an increase of capital, Ricardo replied that an increase of prices resulting from such increase of money, by reducing real fixed incomes, might reduce the savings of those receiving such incomes to an equal degree instead of reducing their consumption.32

In answer to questions put to him by the Lords Committee in 1819, Ricardo dealt further with the question of forced saving. He denied that bank credit created capital:

Credit, I think, is the means which is alternately transferred from one to another, to make use of capital actually existing; it does not create capital; it determines only by whom that capital should be employed ... Capital can only be acquired by saving.33

Asked what in his opinion was the difference between “a stimulus ... by fictitious capital34 arising from an overabundance of Edition: current; Page: [197] paper in circulation, and that which results from the regular operation of real capital employed in production,” he merely replied:

I believe that on this subject I differ from most other people. I do not think that any stimulus is given to production by the use of fictitious capital, as it is called.

He conceded that an increase in paper money circulation, by changing the proportions in which the national income is divided in favor of the saving classes, “may facilitate the accumulation of capital in the hands of the capitalist; he having increased profits, while the laborer has diminished wages.” This is not an acceptance of the forced-saving doctrine, for the increase of investment is held to result indirectly and voluntarily from the redistribution of real income from a non-saving to a saving group, rather than directly and involuntarily from the rise in the consumer's cost of living. Ricardo, moreover, added that “This may sometimes happen, but I think seldom does.” 35

Although Ricardo conceded that a sharp fall in prices was a serious evil, the only undesirable consequence of such a fall which he emphasized was the arbitrary redistribution of wealth which resulted therefrom.36 He admitted also that economic depression was likely to follow the end of war, but he attributed it to a relative shift in the demands for particular commodities, to which the capital equipment of the country had not yet had time to adjust itself.37 Ricardo's position on these questions was closely related to his acceptance of the James Mill-J. B. Say doctrine that production, if properly directed, created the demand for its product, and that a general insufficiency of demand to absorb all of the possible output of industry was impossible. This doctrine leads naturally to a denial that a fall in prices would operate to Edition: current; Page: [198] restrict production or a rise in prices to increase it. It rests on concepts of “supply” and “demand” too physical and an implicit assumption of price and money-cost flexbility too unrealistic to serve adequately the purposes of analysis of short-run disturbances in a monetary economy. If “supply” and “demand” are interpreted, as they should be, not as simply quantities of commodities but, in the modern manner, as schedules of quantities which would be produced or purchased, respectively, at specified schedules of prices, it becomes easy to see that if money costs are inflexible the schedules of demand prices may fall more rapidly than the schedules of supply prices, with a consequent reduction, not only in prices, but also in volume of sales, in output, in employment, in willingness of capitalists to invest, and in willingness of bankers to lend even if there were would-be borrowers.

Malthus was convinced that there was something wrong in the James Mill doctrine, including its Ricardian version. He failed, however, ever satisfactorily to expose the fallacy which underlay it, because he was himself insufficiently emancipated from the purely physical interpretation of “supply” and “demand.” In the following passage, confused though it is, it appears to me that he comes nearest to exposing this fallacy successfully:

The fallacy of Mr. Mill's argument depends entirely upon the effect of quantity on price and value. Mr. Mill says that the supply and demand of every individual are of necessity equal. But as supply is always estimated by quantity, and demand only by price and value; and as increase of quantity often diminishes price and value, it follows, according to all just theory, that so far from being always equal, they must of necessity be often very unequal, as we find by experience. If it be said that reckoning both the demand and supply of commodities by value, they will then be equal; this may be allowed; but it is obvious that they may then both greatly fall in value compared with money and labor; and the will and power of capitalists to set industry in motion, which is the most general and important of all kinds of demand, may be decidedly diminished at the very time that the quantity of produce, however well proportioned each part may be to the other, is decidedly increased.38

It was not Malthus39 but the two Attwoods, and especially Edition: current; Page: [199] Thomas Attwood, who first explained in reasonably satisfactory fashion the dependence of the “demand and supply” of price theory on the state of the currency:

... while it is certain that a reduction of the quantity of money in circulation necessarily occasions a reduction in the monied prices of all commodities; it is of equal necessity, that the price of no commodity whatever can decline, without some alternation in its relative proportion of supply and demand. The manner, therefore, in which a lessened quantity of money reduces monied prices, is by operating on those ulterior principles by which supply and demand are themselves governed. A scarcity of money makes an abundance of goods. Increase the quantity of money, and goods become scarce. The relative proportion between money and commodities can never alter without producing these appearances. Mr. Tooke, and Mr. Ricardo, will find in this obvious principle an exposition of many of the difficulties and inconsistencies in which they have involved the subject.40

Money is as necessary to constitute price, as commodities: increase the supply of money, and you increase the demand for commodities; diminish the supply of money, and you diminish the demand for commodities. The supply of commodities is the demand for money, and the supply of money is the demand for commodities. The prices of commodities, therefore, depend quite as much upon the “proportion” between the supply of, and demand for, money, as they do upon the “proportion” between the supply of, and demand for, commodities. This is a truth which Sir Henry Parnell has altogether overlooked, and his neglect in this respect has led him into a labyrinth of errors. He has considered the supply of, and demand for, commodities as acted upon by some obscure, uncontrollable, and capricious principles, having no reference to the state of the currency, and none to the legislative enactments, which, at one period, have introduced cheap money and high prices, and, when enormous monied obligations have been contracted in such cheap money, have then, at another period, introduced dear money and low prices, and have Edition: current; Page: [200] thus strangled the industry of the country by compelling it to discharge monied obligations which its monied prices will not redeem.41

IV. Ricardo's Position on the Gold Standard

Although Ricardo believed that stability of its purchasing power was the criterion for an ideal standard of value, the effect of the suspension of cash payments on the purchasing power of the pound received no emphasis in his appraisal of the consequences of the suspension. In the first place, he thought the measurement of general purchasing power impossible.1 Secondly, he attached great importance, on ethical grounds, to the maintenance of contractual obligations, and regarded it as vital that creditors should be enabled to collect, upon the maturity of their claims, the amount of gold specified by or contemplated by the contractors. He regarded it as unjust to withhold from a creditor the benefit of any rise in the purchasing power of his monetary claim as long as he was obliged to assume the risk of any fall in its purchasing power.2

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It is a mistake to suppose, however, that Ricardo assumed or believed that gold always maintained a constant purchasing power, and that a premium on gold over paper always meant that paper had fallen in value and never meant that gold had risen in value, views frequently attributed to him by anti-bullionists and apparently ascribed to him by Silberling in the following passage: “Ricardo assumed that gold was still effective as a legal standard and could never itself rise in price in terms of paper. It was always paper that fell, not gold ... that rose.” 3 Ricardo never denied that it was possible for the value of gold to fluctuate, and claimed for it only that it was more stable in value than any other commodity:

A measure of value should itself be invariable; but this is not the case with either gold or silver, they being subject to fluctuations as well as other commodities. Experience has indeed taught us, that though the variations in the value of gold and silver may be considerable, on a comparison of distant periods, yet, for short spaces of time, their value is tolerably fixed. It is this property, among other excellencies, which fits them better than any other commodity for the uses of money.4

Ricardo complained, in fact, that while all his argument rested on the fluctuations in the price of gold, his opponents insisted on raising objections based on the fluctuations in its value. Although he was justifiably skeptical of it, he did not deny that an increase in the value of gold had occurred during the war; he claimed only that it was irrelevant to the question of whether depreciation of the paper currency had occurred.5

The violent currency and price fluctuations which followed the termination of hostilities led Ricardo later to admit that gold and silver were more variable in their value even in short periods of time than had generally been recognized. He still insisted, however, that the variations in the value of gold were irrelevant to Edition: current; Page: [202] the bullionist case, and that in spite of these variations gold and silver still provided the most stable standard of value available.6 It was apparently Ricardo's position that since gold and silver were in general more stable in value than an inconvertible paper currency would be, in case of departure from a metallic standard the paper currency should ordinarily be so regulated as to give to it the value which a metallic currency would have had under like circumstances, even if this should occasionally result in a greater instability of the value of the currency than would have prevailed if the paper currency had not been so regulated.

Malthus, in the same spirit, maintained that even if gold had risen in its world value during the Restriction, as some critics of the Bullion Report had claimed, it would nevertheless be desirable to restore the paper currency to parity with gold.7 Although sufficiently loyal to the metallic standard, John Stuart Mill refused to go so far, though his refusal, given his denial that the circumstances which would justify this heresy had ever existed, was rather academic:

... Mr. Blake is of opinion, that instead of causing a variation, Edition: current; Page: [203] it [the Bank Restriction] prevented that which would necessarily have taken place, if the currency had continued on a level with its nominal standard. We ourselves, if we could believe the Bank Restriction to have had this effect, should be among the warmest of its defenders and supporters.8

V. Reform Without Departure from the Metallic Standard

The currency difficulties of the period, and especially the violent fluctuations after 1815 in the premium on gold, in commodity prices, and in business conditions, gave rise to a number of proposals for reform of the currency, with greater stability of its value as the objective. We will deal first with those proposals which involved a restoration and maintenance of a metallic standard of some sort, and then with those more radical proposals which involved the complete abandonment of a metallic standard and the substitution of a stabilized paper standard.

From at least 1809 on, proposals had been made that further depreciation of the currency should be checked, and at the same time a disastrous fall in prices avoided, by returning to the gold standard at then prevailing price of gold in terms of paper, instead of at the old par. The Bullion Committee held that devaluation would be a “breach of public faith and dereliction of a primary duty of Government,” 1 while Huskisson characterized it as “a stale and wretched expedient.” 2 Ricardo, writing in September, 1809, when, it should be noted, a marked depreciation had been prevailing for less than a year, not only termed devaluation “a shocking injustice,” but for some reason which he does not make clear, claimed that it would not remove the premium Edition: current; Page: [204] on gold over paper and would result in a further rise in commodity prices.3

Devaluation was not without its advocates in 1819, but they failed to receive a sympathetic hearing in influential circles. There was considerable impatience at the failure of the government to redeem the pledge which it had repeatedly given from 1814 on that resumption would be carried out at the old par as soon as practicable; and the decrease of the premium on bullion in 1819 to a point where the paper currency was almost at a par with gold, and the widespread feeling that the resumption of cash payments at anything less than the mint par would serve still further to increase the reputedly excessive profits of the Bank of England, also operated strongly to prevent devaluation from becoming a practical issue at the critical moment when policy was to be decided. Ricardo was therefore in accord with parliamentary sentiment in giving little or no consideration to the desirability of resumption of cash payments at a higher mint price for gold than the old par. In his testimony before the Parliamentary Committees of 1819 Ricardo still advocated resumption at par, with no reference to devaluation that I have been able to find.4 But in a speech in Parliament in 1820, Ricardo stated that if the premium on gold had not fallen to 5 per cent while the 1819 Committees were sitting, he would have favored an alteration of the standard in preference to a return to cash payments at the old standard,5 and he later made similar statements.6

By Silberling and Angell, this is taken as evidence of a revolution Edition: current; Page: [205] in Ricardo's views, corresponding to a change in his personal economic status from that of presumably a large holder of fixed-income securities to that of a landed proprietor. But Ricardo's will shows that he still had very large holdings of securities at his death, and the apparent change in his views can be explained in a much more creditable—and credible—way. When he attacked devaluation in 1809, the pronounced depreciation in the currency had prevailed only for a few months. By 1819 it had prevailed for some ten years, and many of the existing contracts had been entered into on the basis of such depreciation. What would be glaring injustice in the one situation might well be defended as the closest approach to justice available in the other situation.7

During the period of rising prices, the bullionists, Ricardo included, had always explained the mode of operation of a metallic standard as if, under given conditions in the world at large, it dictated to a country adhering to it a specific quantity of currency and a specific range of commodity prices. After 1815, however, Ricardo made it clear that he regarded the gold standard as not absolutely inflexible, but as permitting for short intervals of time some degree of latitude with respect to the quantity of currency and the level of prices which could be maintained under it. His charge that the Bank had so managed resumption as to bring about a greater contraction of the currency and a sharper fall in prices than was necessary would be unintelligible if he did not hold such views.8 In 1816 he proposed a remedy for the periodic Edition: current; Page: [206] scarcities in currency which occurred prior to the dates of payment by the government of the quarterly dividends on the public debt.9 He thought that the rigid rules for granting loans followed by the directors of the Bank made commercial discounts unsuitable as an instrument for the regulation of the volume of currency, and therefore recommended that the managers of the currency should engage in open-market operations when expansion or contraction of the currency was desirable.10

Walter Hall argued that if there were a return to the gold standard—which he vigorously opposed—the Bank of England should maintain generous specie reserves, so that it would not be necessary for it to make its note issue fluctuate in exact correspondence with specie movements. Whenever an unfavorable balance of payments occurred which was due to temporary factors, the Bank should permit gold to flow out without contracting its issues.11

John Rooke, although an advocate of more thoroughgoing currency stabilization than was possible on a fixed metallic basis,12 insisted that there were limited possibilities of price stabilization even on a fixed metallic basis:

A plain view of actual events would, therefore, seem to point out the justice and propriety of augmenting the circulating medium when prices have a tendency to fall, and of diminishing it when they have a tendency to rise. There is always a direct mode of acting at hand. A greater or less amount of bank paper may always be forced out of or into circulation, as occasion may require, and to a given extent, without causing the price of gold to vary. It evidently does not follow at all times, that an increase of bank paper will occasion a rise in the market rate of gold, since that depends upon the circumstance, whether the circulation of the paper money be carried to its greatest possible extent, which is seldom the case.13

Torrens also claimed that the gold standard permitted some scope for flexibility of the quantity of the currency, within the limits of the gold points. If a return were made to the gold standard, it would be desirable that the range between the gold Edition: current; Page: [207] points should not be too small. He therefore urged the retention of the laws against the melting and export of coin, as operating to raise the gold export point. For the same reason, he opposed Ricardo's plan of substituting ingots of bullion for gold coin. Coin was a “less eligible article of export” than bullion, and therefore would not reflect as closely as bullion the fluctuations in the foreign balance of payments.14

In 1812 Torrens had advocated raising the tariff as a means of making resumption of cash payments possible without resulting in a fall in the English price level. He conceded that this would involve a loss of the advantages of the “territorial division of employment,” but he maintained that the evil of a fall in prices was greater than the benefit from foreign trade.15 Another writer made a similar proposal in 1818:

A more rapid method however of increasing the price of commodities, may be found in the adoption of a paper currency; which, if aided by uniform duties on importation, will not entirely drive out of circulation the precious metals. By this means they may be kept at par with the paper, so long as the amount of paper issued does not exceed its due proportion to the rate of the import duties.16

In 1819 the Bank of England urged that if it were to be required to make gold payments, it should not be at a fixed rate, but at the market price of gold in paper, whatever that might be when its notes were being presented for payment in gold.17 Ricardo pointed out the obvious flaw in this proposal: The Bank, by regulating its issue of paper, could determine the price of gold in paper, and therefore would not be subject to any real Edition: current; Page: [208] limitation on its note issue.18 Only slightly less naive was George Booth's proposal.19 He advocated a paper standard currency. He vaguely suggested that a paper currency must de natura retain a constant general purchasing power, but gave no hint as to what he would do if the purchasing power of the paper currency should in fact fluctuate. But because of the liability to forgery of paper money of small denominations, he would retain gold and silver coinage. The standard would be the paper money, of which £1 would equal 20 silver shillings. The quantity of silver in a silver shilling would be made to vary with the market price of silver in paper money, so as to maintain parity of value between a paper pound and the quantity of silver in 20 silver shillings. The existing gold guineas were to be retained unaltered in their metallic content, but the number of shillings, paper or silver, which the guinea was to represent was to be varied according to the market price of gold in shillings. Booth failed to specify, however, any criterion for regulating the quantity of paper shillings in order to maintain stability of their purchasing power.

John Rooke, in 1824, made a somewhat similar proposal, which was not guilty, however, of the crucial omission in Booth's scheme of any plan for the regulation of the paper money issues.20 Rooke advocated a convertible paper currency so regulated in its amount as to have stable purchasing power. He proposed that, as the purchasing power of the paper currency increased, the amount of paper money should be increased, and vice versa. The market price of gold in paper should be permitted to fluctuate freely, but convertibility of the paper currency should be maintained by changing the value in shillings or the denominations of the gold coins whenever necessary. The paper money would thus have a constant purchasing power, but the gold coins would have a variable value both in shillings and in general purchasing power. Rooke preferred, as the criterion for stabilization of the purchasing power of the currency, the “annual price of farm labor” to the price of any other commodity or set of commodities, because it has few or no short-term fluctuations. But he conceded that “the prices of Edition: current; Page: [209] other things might be taken into account as well as labor, if doing so would give more exactness to the exchangeable value of the currency.” 21

Henry James, in 1818, advocated continuance of the Bank Restriction in order to avoid deflation.22 In 1820 he recommended stabilization of the purchasing power of the currency in terms of wheat and agricultural labor, but did not make any concrete suggestions as to the method of stabilization.23

Joplin was in general a strong adherent of a metallic standard currency, but he nevertheless recommended that gold payments should be stopped temporarily during periods of crop shortages, if otherwise the external drains of gold would result in sharp declines in prices.24

VI. Paper Standard Currencies

All of the proposals described above provided for the continuance in some degree of a metallic basis for the currency. But advocates were not lacking of a complete break with the metallic standard and the adoption of an inconvertible paper currency. All of the defenders of the suspension of cash payments had thereby demonstrated their preference for an inconvertible paper over a metallic standard at least during the continuance of a great Edition: current; Page: [210] war involving heavy foreign remittances. One anti-bullionist even appeared to find the superiority of the inconvertible paper currency over the metallic standard under wartime conditions to lie in the fact that the former was not set up or regulated in accordance with any deliberate plan.1 Many of the anti-bullionists claimed that England profited during the war from having a currency independent of international entanglements, and therefore free from the necessity of adjusting itself to all the wartime fluctuations in England's balance of payments.2 The suspension of cash payments, as one writer put it, gave England “the advantages of an insulated currency, under the circumstances of an expensive war.” 3 But while the war continued, most of the supporters of the Restriction defended inconvertibility only as an emergency measure, and looked forward to an eventual return to a metallic standard. The writers who then ventured to declare for an inconvertible paper currency as a permanent institution were few in number and do not appear to have attracted any following. Among them were: advocates of an “abstract currency” divorced from the precious metals, which in some unexplained way would always maintain a proper value and be issued in the correct volume;4 crude inflationists, for whom no amount of money could be excessive;5 and others who laid chief stress on the importance of having a currency which was not liable to flow abroad irrespective of internal needs.6 But when the war had Edition: current; Page: [211] ended, and especially when resumption of cash payments was accompanied by sharply falling prices, the advocates of an inconvertible paper currency became fairly numerous, although apparently never influential with the government. Of greater interest were the writers who, prior to 1830, advocated some form of stabilized paper standard.

An anonymous writer as early as 1797 had proposed a system of control of the inconvertible paper currency through the use of the interest rate, although he failed to make clear whether or not his proposal contemplated a variable interest rate as the regulator of the quantity of the currency, and he failed to formulate an intelligible criterion of the proper quantity of currency. He proposed that all bank notes should be suppressed and that national paper money, issued in exchange for government securities, should be substituted for bank notes. The Bank of England should be obliged to accept for deposit at interest whatever quantity of national paper money individuals should offer it, and the government should be obliged to accept from the Bank all the paper money above what the Bank found necessary for carrying on its business. The government should pay interest to or receive interest from the Bank according as to whether the government was indebted to the Bank or the Bank to the government.7

Although John Wheatley had been one of the most outspoken critics of the suspension of cash payments, his belief in the metallic standard diminished under the impact of the fall in prices accompanying the approach and the realization of resumption of cash payments.8 In his writings from 1816 on, he expressed preference at times for a currency so regulated as to maintain constancy in the price level, at other times for a currency constant in quantity. But stability of prices was apparently his ultimate objective, for he indicated that, where population was increasing Edition: current; Page: [212] and there was a corresponding growth of production, the quantity of money should be increased in the same proportion, so as to prevent prices from falling. This would seem to lead to a regulated paper currency, but in 1816 he still advocated a return to the gold standard, on such a basis as to restore the 1813 level of prices: “a currency of coin is neither liable to sudden excess, to defraud the creditor, nor sudden contraction, to defraud the debtor.... With a circulation of paper it is impossible to prevent a constant variation in the amount of our currency. In times of confidence the banks issue too much, in times of distrust they issue too little.” 9 In 1819 he still advocated resumption. The evil of deficiency of currency, which produces low prices, was greater than the evil of excess, which produces high prices, but under inconvertibility the currency system was liable to both deficiency and excess. All that was necessary to get a proper currency system was to abolish small notes, which were most liable to variation in their quantity, and to build up the stock of gold very gradually so as not to cause a sharp contraction of prices and so as not to involve other countries in difficulties.10 But in 1822 he argued that sterling should have been allowed to remain depreciated until the world price level had risen to equilibrium with the English price level. If under inconvertibility the amount of the paper currency had been kept constant, it would have been better that resumption of cash payments should never take place. He now advocated that there be increased issue of paper until the 1812–13 level of the price of corn had been restored, and that thereafter there should be only such changes in the quantity of currency as would be necessary to maintain prices and incomes at this level, with the metallic standard, presumably, definitely abandoned.11

Thomas Attwood may not have had any great zeal for a stabilized paper currency, and his real objective seemed to be whatever increase in currency and prices should prove necessary to bring about full employment, without limitations prescribed in advance.12 But he was deeply convinced that falling prices were Edition: current; Page: [213] a serious evil which could not be avoided except through an inconvertible paper currency, and his stabilization suggestions seem to have been made in the hope that they would make his plea for an inconvertible paper currency more palatable to public opinion. They are nevertheless of considerable interest. Attwood recommended an inconvertible paper currency issued by the government and its quantity regulated through open-market purchases and sales of its own securities by the government.13 As the criterion for the stabilization of the currency he wavered between the price of wheat,14 the general rise or fall in the prices of commodities,15 the rate of interest,16 and the wages of agricultural labor.17 He clearly was not prepared to commit himself definitely to any one criterion. Regulation of the amount of the currency should be entrusted to a legislative commission, and should be carried out not by “laws of maximum and minimum but by judicious legislative operations upon the issue of bank notes, or other national paper.” 18 He recognized that if wages of labor were used as the standard for stabilization, there would be timelags between changes in the quantity of currency and resultant changes in wages. He suggested, therefore, that, to supplement wages, the market rate of interest should be used as a more sensitive index of the effects of changes in the quantity of currency, the rate of interest to be used as a “temporary” and the wages of labor as a “permanent” guide in the regulation of issues.19

Attwood realized that it might not prove easy to reverse the trend of prices, and that more would be necessary than simple authorization to the banks to issue more paper:

It would be of no use to act upon the “rag makers,” without at the Edition: current; Page: [214] same time acting also upon the public mind; for unless the public are willing to borrow the “rags,” the “rag maker” cannot issue them. It is therefore necessary to act upon both parties; the one must be stimulated to borrow, and the other to lend. Both these dispositions are rather stagnant at present, and are becoming daily more so. Prudent and safe men are afraid to borrow money, because they cannot safely and beneficially employ it. Bankers are afraid to lend it, because they know that it cannot be safely employed, and because they remember the late panic, when they were compelled to pay everybody, whilst nobody could pay them.20

Although all of the prominent members of the classical school were adherents of a fixed metallic standard, I have not been able to find any serious attempt during this period to meet these claims that a better currency standard was available. There was then, as there has continued to be since, a marked tendency on the part of the exponents of the fixed gold standard to rely on dogmatic assertions of the injustice of any other system and of the impossibility of devising any system of currency which would have more stability of value than the precious metals.21 Attempts to stabilize the value of money beyond what metallic money would do of itself, they asserted, were impracticable, and were straining after unattainable perfection: “It does not seem the design or intention of the Author of the world, that ... stability [of the currency] should be perfect and invariable”;22 “to demand a standard abstractedly free from variation, is like seeking for better bread than is made of wheat.” 23 As has already been pointed out, James Mill, Ricardo, and their disciples, also tended to minimize both the extent and the evil consequences of changing price levels, and thus to foster the attitude that the metallic standard, variable though it was, met adequately the requirements of a good currency standard.

During this period the adherents of a fixed metallic standard did not expressly claim as an advantage of such a standard that Edition: current; Page: [215] it was an international rather than a purely national standard.24 The bullionists had laid great emphasis on the fall in the exchanges as evidence of the undesirable mode of operation of the inconvertible paper currency, but primarily or solely because exchange depreciation indicated internal depreciation in terms of bullion. I have found only one instance of even bare mention by a bullionist of instability of the exchanges as an evil in itself,25 and I have failed to discover what specific disadvantages, if any, the bullionists believed would result from a fluctuating exchange other than the fluctuations in the bullion value of the currency and in relative price levels as a whole at home and abroad which would be associated with it.

Few of the anti-bullionists conceded that fluctuating exchanges were an evil, and when they did they insisted that the advantages of a stable exchange could be acquired or retained only at an excessive cost, without as a rule indicating what they regarded as the disadvantages of a fluctuating exchange. As one paper-money advocate exclaimed, under a metallic standard: “The natural order of things will be reversed. Instead of a steady currency and fluctuating currency!!” 26 One anti-bullionist, Walter Hall, did, however, carry the discussion a little further. He was not prepared to concede that the disadvantages of a fluctuating exchange were very serious: “What may be the value of a steady exchange, I shall consider hereafter; but it seems to me it will cost too dear, if the price to be paid for it is a fluctuating currency.” 27 “After all, what is this mighty evil of an unfavorable exchange, that so much should be lost and hazarded for it.” 28 Clearly identifying Edition: current; Page: [216] a fluctuating with a falling exchange, he conceded that it results in a disadvantage to the consumer of imported goods in the form of higher prices, but he argued that this burden would be diffused equally over the whole community, and would be counterbalanced to the country as a whole by the advantage which resulted to the manufacturer and exporter, whereas the forced sales and the decline in prices which would result from the contraction of the currency for which falling exchanges were a substitute would fall heavily on the merchant and the manufacturer, and would cripple for a time the productive activities of the country.29 He had earlier argued that changes in taxes result in serious changes in the relations between particular prices and thus change “the relations of society,” 30 and had thus shown that he recognized that changes in relative prices as well as changes in price levels as a whole could have serious consequences, but his attempt to show that this did not apply to the changes in relative prices which would result from a depreciating exchange cannot be regarded as satisfactory. But superficial and inadequate as was his analysis of this vital phase of the problem, it was the only explicit recognition of it which I have found, not only in the literature of the bullionist controversy, but in such of the English nineteenth-century literature on the currency problem as I have examined.

It cannot be claimed for the literature of the bullionist controversy that it afforded a satisfactory answer to the issue, prominent now as then, as to the comparative merits of a metallic (and international) monetary standard, on the one hand, and a non-metallic (and national or “insulated”) standard, on the other. The defenders of the metallic standard contented themselves with an appeal to arbitrary dogmas and to moral issues, and with the claim that the limitations imposed by a metallic standard were a safeguard against the inflationary possibilities of an irresponsibly or incompetently managed paper standard currency. The exponents of a national paper standard made out a better case for what I am inclined to regard as theoretically a moderately inferior Edition: current; Page: [217] and under ordinary practical conditions a seriously inferior cause. They presented valid and novel arguments for the economic advantages of the freedom afforded by an independent monetary standard to escape a deflation (or inflation!) induced by external factors, to cope with a deflation resulting from internal factors and intensified by the prevalence of rigidity downwards in the prices of the factors of production, and, in general, to provide a country with the quantity of means of payment deemed best for it as against having that quantity dictated to it by external factors beyond its control. If the exponents of the paper standard, however, had intellectually somewhat the best of the argument, it was largely because of the failure of their opponents to set forth what seem to me to be the most important arguments for stability of the exchanges. The important issue lies between stable and unstable exchanges, and between a metallic standard and a paper standard only as and if the former in operation provides stable exchanges and the latter in operation fails to do so. First, fluctuating exchanges result in risks and uncertainties for foreign trade and foreign investment which are economically costly and for which the development of forward exchange markets and other facilities for hedging against exchange fluctuations provide only a strictly limited palliative. Second, although a paper standard currency managed without reference to the foreign exchanges could reduce the amplitude of short-term fluctuations in the general price level as compared to what they would ordinarily be under an international monetary standard, it would thereby tend to increase greatly the amplitude of short-term fluctuations relative to each other of sectional price levels—export commodities, import commodities, domestic commodities—as compared to what is conceivable under an international monetary standard. It was only under the stimulus of the recent great depression, however, that the analysis of these problems was carried much beyond the point at which it was left by the bullionists and their critics, and the present-day discussion seems to be tending to shift the issue from stable versus unstable exchanges to permanently stable versus shiftable exchanges. This is a much more significant issue, since almost no country for which foreign trade was of great importance has ever been willing for long to tolerate freely fluctuating exchanges, and stronger grounds can be presented for substituting a shiftable anchor for a permanently fixed one than for doing without an anchor at all.

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The student who turns from the literature of the Heroic Age of British monetary controversy in order to attempt a study of the original sources relating to the antecedents of our modern banking situation will find himself confronted with a jungle of blue books and Parliamentary discussions, pamphlets and tracts and leading articles: a jungle at first sight so impenetrable that he may well despair. For it is characteristic of the period of middle-class ascendancy after 1832 that it produced much heat and little light; many massive volumes of evidence and statistics, but no classic reports; much legislation but, for a long time at least, no final solution of the various problems to be faced.—T. E. Gregory, Select statutes, I, ix.

I. Introduction

The downward trend of the English price level, which persisted without any sustained reversal from 1815 to the 1850's, was for English industry and labor only partially compensated by the progress in manufacturing technique and the fall in the prices of imported raw materials. The occasional prosperous intervals were ordinarily terminated by sharp financial crises, and were followed by intervals of depression and unemployment. There was general agreement that these business fluctuations were inherent in the new structure of industry, but there was also a widespread conviction that they had been accentuated by chronic mismanagement—or misbehaviour—of the currency. It became apparent soon after resumption of cash payments that strict adherence to a fixed metallic standard was not sufficient to assure the smooth and beneficent working of the currency system. The Bank of England succeeded throughout the period in maintaining convertibility of its paper notes, but on several occasions only with great difficulty and after resort to emergency measures. In Edition: current; Page: [219] 1825, in 1836, and again in 1839, suspension of convertibility was avoided only by a narrow margin. In 1847, and 1857, and 1866, the Bank was again in serious difficulty. Each period of special strain gave rise to an extensive controversy, turning on the quality of the Bank's management of its affairs and on the principles which should be followed in the management of the currency.1 That the currency was operating badly no one disputed, although there were not a few who would have agreed with Cobden that “managing the currency [was] ... just as possible as the management of the tides, or the regulation of stars, or the winds,” 2 and that all that government could do, therefore, would be to place it on a wholly metallic basis, and then let “automatic” processes run their course.

During this period the English banking system underwent important structural changes. In the belief that it was mainly the small notes which were presented for redemption in gold during periods of financial stress, the renewal in 1822 of the right to issue notes under £5 was repealed by an act passed in 1826. To promote the establishment of financially stronger country banks, an act of the same year authorized the establishment in the provinces of note-issuing banks with an unlimited number of partners. An act passed in 1833 exempted the Bank of England, in so far as its discounts of short-term paper were concerned, from the legal maximum interest rate of 5 per cent under the usury laws, and thus gave it the power to use the discount rate as an instrument of credit control. This act also made the Bank's notes legal tender except by the Bank itself as long as the Bank maintained convertibility into gold, and definitely proclaimed—what had previously been questionable—the right to establish in the London area non-note-issuing banking establishments with more than six partners. The joint-stock banks grew rapidly in number and in importance, both in the provinces and in London. By the 1850's there were at least three joint-stock banks in London with deposits in excess of those of the Bank of England. The Bank of England had gradually given up most of its ordinary Edition: current; Page: [220] commercial discount business, and its “private deposits” came to consist largely of bankers' balances held with the Bank as the equivalent of cash reserves.

Finally, there was passed the Bank Charter Act of 1844, commonly referred to as Peel's Act, which was to remain the charter of English banking until the Great War. This act required the Bank formally to segregate the issue department from the banking department,3 and limited the issue department to a maximum issue of notes uncovered by bullion of £14,000,000, above which amount it could issue notes only in exchange for gold (or, within certain limits, silver). Country banks then issuing notes were permitted to continue such issue not to exceed the amount then in circulation, but the law made provision for the gradual absorption by the issue department of the Bank of England, as an addition to its uncovered issue, of the bulk of the note circulation of the country banks. Except as to note issue, the banking department of the Bank of England was left wholly free from statutory regulation, as were also the then existing private banks on all matters of consequence except the right to issue notes.

II. The “Currency School” -“Banking School” Controversy

The currency controversies of this period were carried on mainly by the members of two groups, with divergent views, who came to be known as the “currency school” and the “banking school,” respectively.1 The most prominent members of the currency school were Lord Overstone (Samuel Jones Loyd), G. W. Norman, R. Torrens, and William Ward. Thomas Tooke, John Fullarton, James Wilson, and J. W. Gilbart were the leaders of the banking school. There was not complete unanimity of doctrines within each group, and the currency school, under the impact of their opponents' criticisms, modified their doctrines Edition: current; Page: [221] fairly substantially in the course of the controversy. An attempt is nevertheless made in the next few pages to summarize the general position of the two schools, as a preliminary to a more detailed examination of such of the particular doctrines expounded in the course of the controversy as are of importance for the theory of international trade. The discussion between the two schools turned wholly, however, on short-run issues. On the question of what determined the quantity and the value of a metallic currency in the long run, both schools followed the “classical” or “Ricardian” doctrines.

The currency school maintained that under a “purely metallic currency” any loss of gold to foreign countries or any influx of gold from abroad would result immediately and automatically in a corresponding decrease or increase, respectively, in the amount of currency in circulation. The actual currency was a “mixed currency,” that is, convertible paper notes were a constituent element of the currency. A mixed currency would operate properly only if it operated precisely as would a metallic currency, i.e., only if any efflux or influx of gold resulted in a corresponding (absolute, not proportional) decrease or increase in the quantity of the currency—the “currency principle.” But a mixed currency would not operate in this manner automatically and immediately unless the issue of paper money were deliberately regulated so as to make the changes in its quantity conform to the changes in the quantity of gold held by the issuing agencies. In the absence of such regulation, paper money would at times be issued to excess, at other times unduly contracted; the maintenance of convertibility would not be definitely assured; the improper fluctuations in the currency would accentuate the tendency inherent in the economic structure toward recurrent booms and crises.

Since the ultimate objective of the currency school was that the value of the monetary unit, or the level of prices, should be the same under a “mixed currency” as it would be under a purely metallic currency, this could be accomplished by their rule of making the fluctuations in the amount of bank notes correspond to the fluctuations which would occur in the amounts of specie under a purely metallic currency only if the velocity of circulation of bank notes and of specie would under like circumstances be identical. This was apparently overlooked by the members of Edition: current; Page: [222] the currency school,2 although it may be that they took for granted that there would be such identity.3

The banking school denied almost all of these propositions. Generally waiving the question as to whether it was desirable that a mixed currency should operate precisely as would a purely metallic currency, they denied that a purely metallic currency would operate in the manner claimed by the currency school. They pointed out that under a purely metallic currency there existed in addition to specie, and under a mixed currency there existed in addition to specie and paper notes, a large quantity of bank deposits and bills of exchange which, they claimed, were also “currency” and in any case operated on prices in the same manner as did bank notes and specie. Under a purely metallic currency, moreover, some of the gold was not in circulation, but was in “hoards,” in modern times held mainly in the bullion reserves of the Bank of England and other banks. Changes in the amounts of these hoards could not possibly have any effect on prices.4 Even under a purely metallic currency, therefore, a gain or loss in the nation's stock of gold need not result in corresponding fluctuations of the currency, but might merely change the amount of gold in hoards, or might be offset by an inverse fluctuation in the amount of deposits. Without control of hoards and of deposits, limitation of the note issues could not suffice, therefore, to attain the objective of the currency school of enforcing correspondence between the fluctuations in the total circulation and the fluctuations in the total stock of gold. The banking school did not present an alternative program of statutory control of Edition: current; Page: [223] the currency. They held that statutory control of the deposits was not demanded by anyone, was impossible, and even if possible was undesirable. The amount of paper notes in circulation was adequately controlled by the ordinary processes of competitive banking, and if the requirement of convertibility was maintained, could not exceed the needs of business for any appreciable length of time—the “banking principle.” If unsound banking practices did occasionally lead to excess grant of credit, this brought its own corrective penalties. In any case it could not be prevented by legislative measures, and especially by mere limitation of note issue.

The bullionists, it will be remembered, had insisted that under an inconvertible paper money currency the issues should be so regulated as to conform to the aggregate circulation of specie and paper which could be maintained under a convertible currency, but usually maintained—or took it for granted, without argument—that if the requirement of convertibility were enforced there was no need of further regulation to insure against excess—or deficient—issue of paper money.5 The anti-bullionists, on the other hand, had ordinarily maintained that a paper currency could not be issued to excess whether convertible or not, if issued only by banks as loans on the security of good short-term commercial paper. The currency and the banking schools both rejected the anti-bullionist doctrine that an inconvertible paper money could not be issued to excess.6 The currency school went further; they claimed that even a convertible paper currency could be issued to excess, not permanently, but for sufficiently long periods to endanger the maintenance of convertibility and to generate financial crises. The “currency principle,” i.e., the doctrine that a mixed currency should be made to operate as would a “purely metallic” currency, did resemble, however, the bullionist doctrine that an inconvertible paper currency should be made to operate as would a convertible currency, and was obviously derived from it.

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The currency principle appears first to have been formulated during the 1820's. Joplin, in 1823, proposed a system of regulation of the issue of paper notes whose essence was the requirement of 100 per cent bullion reserves, so that “a paper circulation, by this system, would dilate and contract precisely in the same manner as a metallic currency.” 7 Henry Drummond, in 1826, similarly urged that the amount of paper money should be kept constant, so that all variations in the quantity of the currency should consist of corresponding variations in the quantity of specie.8

III. The “Palmer Rule

In 1827 the Bank of England adopted a rule—later commonly known as the “Palmer rule” or the “rule of 1832” because it was first publicly explained, in 1832, by the then governor of the Bank, J. Horsley Palmer—which aimed at making the fluctuations in the English currency conform with those which would occur under a purely metallic currency by keeping its security holdings, including discounted paper, constant. At the same time, although apparently wholly independently, Pennington, a confidential adviser of the Treasury on currency matters, had recommended the same rule in a memorandum to Huskisson, then Chancellor of the Exchequer. The problem as Pennington saw it was to make the paper currency operate as would a “purely metallic currency”: “The great objection to a paper currency arises from the extreme difficulty of subjecting its expansion and contraction to the same law as that which regulates the expansion and contraction of a currency purely metallic.” 1 He offered as a solution that the Bank of England should be given an exclusive monopoly of note issue (or direct control over the issues of the other banks) and should hold a fixed amount of securities. There could then be no variations in its outstanding note circulation without corresponding variations in its holdings of bullion:

Nothing more would be necessary than that the bank should constantly Edition: current; Page: [225] hold a fixed amount of the same unvarying species of securities. If its outstanding liabilities amounted, at any particular time, to £26,000,000, and if, against these, it held £18,000,000 of government securities and £8,000,000 of bullion, then, by confining itself to the £18,000,000 of securities, the action of the foreign exchange would necessarily turn upon the gold: at one time the bank might have six, at another time ten, and at another eight millions of treasure; and in all cases, its paper would contract and expand according to the increase or diminution of its bullion.2

The Palmer rule was essentially the same. When the exchanges were at par and the currency “full,” the Bank should try to have a bullion reserve of one-third of its combined note and deposit liabilities, so that its current assets should be one-third bullion and two-thirds securities. Thereafter all that would be required would be to maintain the securities at a constant amount. An influx of gold from abroad would thus act to increase the note circulation by a corresponding amount; an efflux of gold or a demand for coin for internal circulation would result in a corresponding decrease in note circulation. The internal circulation, specie plus paper, would thus remain constant unless acted upon by external gold movements.3

This rule had the fatal defect that it took no account of the necessity of also maintaining deposits constant if the maintenance of securities at a constant amount was to guarantee correspondence between the fluctuations in bullion and the fluctuations in note circulation. If the deposits were permitted to fluctuate, then as the bullion holdings fluctuated the note circulation might remain constant, or might fluctuate in the reverse direction. Under an inconvertible paper currency, a case could be made for the general policy of keeping the securities constant, if departure from this rule to offset variations in the velocity of circulation of notes and deposits were permitted, and if provision were made for adjustment of the amount of securities to the secular trend of production resulting from growth of population and capital. But under an international metallic standard, adherence to the rule of keeping the securities constant could lead to serious and lasting disequilibrium between the internal and the Edition: current; Page: [226] world price levels, and therefore to exhaustion or to indefinite accumulation of gold reserves.4

It is not easy to understand Pennington's original position in this connection. The objective of control stated by him seems to involve an unqualified acceptance of the currency principle. But the method of control which he advocated, like the Palmer rule, would have made the fluctuations in notes plus deposits correspond with the fluctuations in specie reserves, whereas the currency principle called for correspondence between the fluctuations in notes alone and the fluctuations in specie reserves. It especially seems to call for explanation that Pennington, who was an important factor in drawing attention to the importance of deposits as a means of payment, should have advocated a rule which would permit of withdrawal through the deposits of all the specie reserves without calling for any positive corrective action on the part of the Bank. When Pennington later, in 1840, published his memorandum, his views had apparently undergone some modification. He now made it appear that by a “purely metallic currency” he had meant one which consisted only of specie, and that by “paper circulation” he had meant notes and deposits.5 This would bring his rule of control into conformity with his objective. Against the currency principle proper he protested that it would make the fluctuations in the currency (= notes and deposits) exceed the fluctuations which would occur under a simple specie currency, with the result that “the public will be exposed to very great alternations of comparative ease and difficulty in the operations of the money market.” 6 What he now supported, apparently, was a provisional adherence to the Palmer rule, which would limit the fluctuations in notes and deposits to the fluctuations in specie reserves, with departure from it in the form of open-market sales of securities only when otherwise dangerous depletion of the specie reserves would occur.7

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As was to be expected, the affairs of the Bank went badly while the Palmer rule was in operation. From 1836 to 1839 in particular, while the rule was presumably being followed, the Bank was in serious difficulties much of the time. The Bank found at times that gold was being withdrawn for export through the deposits without any compensating reduction in the note circulation. It also found itself unable—or unwilling—to keep its securities constant, and it even increased its securities while a drain of gold was under way. Its difficulties were due in part to misguided violations of its own rule,8 but in part they were due also to the utter impracticability of the rule under a metallic reserve currency whenever greater contraction of the currency (notes and deposits) Edition: current; Page: [228] should be requisite than the rule of keeping the securities constant would permit.

Torrens and Overstone were critical of the Palmer rule, although they held that the departures from it had been such as to accentuate rather than moderate its shortcomings. They pointed out that if the currency principle were to be carried out, gold movements should not be permitted to operate on the deposits alone. When the Bank found that its gold reserves were being drawn out through its deposits, it should have reduced its note circulation by “forcible operation on its securities,” i.e., by deliberate contraction of its discounts or by sale of government securities in the open market. They held that maintenance of securities at a constant amount, instead of enforcing correspondence between the fluctuations in the amounts of bullion holdings and of note circulation, prevented the Bank from establishing such correspondence.9

According to Torrens and to Overstone, the error in the Palmer rule was that it aimed at keeping the whole of the Bank securities constant, including those upon which “the Bank lent its deposits,” and that it permitted gold flows to act on the whole of the liabilities, including the deposits. The Bank, on the contrary, should keep constant only those securities upon which it put out its notes, i.e., should keep constant the amount of its uncovered note circulation. Only then would variations in the Bank's note circulation necessarily correspond with the variations in its bullion holdings.10 To enforce this procedure on the Bank, and to make certain that the securities held as backing for the notes should be segregated from those held as backing for the deposits, the banking and issue departments of the Bank should be formally separated, and the latter should be confined to the exchange of notes for bullion and of bullion for notes, pound for pound, except for a fixed maximum of notes to be covered by securities.11 The currency Edition: current; Page: [229] school undoubtedly wanted the note issue powers of the country banks to be withdrawn, or at least drastically restricted, but they did not enlarge upon this phase of the question,12 as a precaution, perhaps, against providing further stimulus to the already vigorous opposition of the country bankers to the currency school proposals.

IV. The Bank Act of 1844

The Act of 1844 put into effect these proposals of the currency school. But any expectations which may have been held that the provisions of the act were sufficient to insure protection against currency disturbances were destined to meet with early disappointment. The Bank of England took too seriously the freedom from statutory regulation of its banking department under the act, and proceeded immediately to reduce its discount rate from 4 to 2½ per cent, the lowest rate in its history up to that time, and to expand its commercial discounts.1

Its reserves in the banking department soon began to fall. In 1847, the public, noting the decline in these reserves, and aware that under the Act of 1844 the Bank would be unable to meet the claims of its depositors with its own notes or with specie once the reserves of the banking department had been exhausted, took alarm, and proceeded to draw out their deposits. The Bank's attempts to check the drain by rationing, successive increases in the discount rate, sale of securities, and borrowing from the market, did not succeed. On October 22, 1847, the reserves in the banking department had fallen to £2,376,472, and a panic was in full sweep in the country. The Bank was still confident that it could continue to meet its payments, but the government, in order to allay the panic, stepped in, authorized the Bank to issue notes uncovered by gold in excess of the statutory maximum, and requested the Bank to discount freely, but at a high rate of interest. Edition: current; Page: [230] The panic ceased at once, gold began to flow back to the Bank, and no issue in excess of the statutory maximum was actually made. But it had been demonstrated that under the Act of 1844 gold could be withdrawn from the Bank by means of the deposits as well as by presentation of its notes for payment in specie, and that in a period of alarm knowledge that the power of the Bank to issue notes was legally restricted could operate to promote such withdrawal. In 1857 and 1866, suspension of the Bank Act was again invoked to prevent exhaustion of the reserves in the banking department. The Act of 1844 may have established an absolute guarantee of convertibility of the note issue, subject only to the condition that the amount of notes voluntarily remaining in the hands of the public did not fall below £14,000,000.2 It clearly failed to guarantee adequately good management of its credit operations on the part of the Bank of England.

The necessity of suspending the Bank Act three times within twenty-five years of its enactment was disappointing to its currency school advocates, but they denied that it justified the claims of the banking school that the currency school doctrines had been erroneous and that the act was injurious in its effects. Overstone even denied that the divergent fluctuations after 1844 in the note circulation of the Bank and in its bullion holdings disproved the contention of the currency school that the Act of 1844 would automatically enforce a correspondence between these fluctuations. He was able to show that when prior to the passage of the act he had supported the rule of forcing correspondence between the bullion holdings of the Bank and the note circulation in the hands of the public, instead of between the bullion holdings of the Bank and the notes outside the issue department, he had done so only because until 1844 information was not available as to the holdings of its own notes by the Bank as “till money.” Had such information been available, he would have included notes held by the Bank in the banking department in the “circulation” whose fluctuations should be made to correspond with the fluctuations of the bullion holdings of the Bank.3 The Act of 1844 did guarantee Edition: current; Page: [231] absolute correspondence between the variations in the amount of notes outstanding at the issue department and the amount of bullion held by the issue department.

The great fault of the currency school was the exaggerated importance which they encouraged the public to attribute to the automatic regulation of the issue department as contributing to a proper functioning of the Bank of England as a whole. In his speech introducing the Bank Act in the House of Commons, Sir Robert Peel had stated: “With respect to the banking business of the Bank, I propose that it should be governed on precisely the same principles as would regulate any other body dealing with Bank of England notes.” 4 In his opinion regulation of the operations of the issue department would suffice—or perhaps more accurately, would be likely to suffice—to assure sound management of the currency. In this respect Peel went further than his currency school supporters, and he later admitted that he had been overoptimistic.5 Torrens and Overstone had never committed themselves to the doctrine that regulation of the note issues was a remedy for all banking ills, although this was often charged against them, both by contemporary and by later critics of the currency school. They had recognized that careful management by the Bank of its discounts would be necessary if its banking department reserves were not to be exhausted through drawing down of deposits. In their discussion of the Palmer rule, they had pointed out that suitable management of its discounts was an essential element in the proper functioning of the Bank. But they had believed that the Act of 1844, by requiring segregation of part of the bullion reserve as cover for the notes, beyond achieving its primary objective of assuring convertibility of the note issue, would force the Bank to give close attention to the fluctuations in the unsegregated or marginal reserve held in the banking department, and therefore to act more promptly to check a threatening Edition: current; Page: [232] drain of gold.6 They now held that the difficulties of 1847 were due to mismanagement of the Bank, not to the Act of 1844, and that had it not been for the Act of 1844 the Bank would have carried its imprudence even further:

It was a case of banking mismanagement on the part of the Bank of England acting upon the community, at that moment peculiarly susceptible of alarm under vague and ignorant apprehensions of the effect of the new law ... Danger from undue exhaustion of the bullion is the evil against which the Act undertakes to protect the community; against an improper exhaustion of the banking reserve, and the consequent inconveniences, it is the duty of the Bank of England to take timely and effectual measures of precaution.7

But if the currency school were prepared to admit that proper functioning of the banking system required proper management by the Bank of England of its credit operations as a whole as well as of its note issues, why did they content themselves with proposals for the regulation of the note issue only? The answer lay partly in the fact that their primary objective was guarantee of convertibility of the note issue, and this the Act of 1844 substantially accomplished. As Overstone claimed: the Act of 1844 “has preserved the convertibility of the bank note; the purpose for which it was passed, and that which alone its authors promised that it should do.” 8 The currency school tended also to minimize or to deny the importance of bank credit in other forms than notes as a factor influencing prices, or, as in the case of Torrens, to claim that the fluctuations in the deposits were governed closely by the fluctuations in the note issues.9 They had a hankering also for a simple, automatic rule, and could find none Edition: current; Page: [233] suitable for governing the general credit operations of the Bank.10 They also had laissez-faire objections to extending legislative control of the banking system any further than seemed absolutely necessary.

The currency school held that their critics exaggerated the significance of suspension of the Bank Act. Overstone had prior to passage of the act conceded that, in case of an internal panic, suspension of the act would be desirable. In such a case, resort must be had to “that power, which all governments must necessarily possess, of exercising special interference in cases of unforeseen emergency and great state necessity.” But an explicit provision in the act authorizing its suspension in an emergency would be objectionable, for it would tend to convert into a routine and anticipated procedure what should be regarded as only an emergency measure.11 Later he argued that the suspensions which had occurred were of small consequence. During a panic an interval would elapse before a contraction of the note circulation would be offset by an inflow of gold from abroad: “To meet this temporary difficulty, which was purely technical and not depending upon any principle, an important provision of the Act was for a short time suspended.” 12

The banking school objected to the Bank Act of 1844, both that it was no remedy against overexpansion of bank credit and that overexpansion of convertible bank notes was impossible. But they never supported any proposals for legislative control of the volume of bank credit, partly because they thought it impracticable, partly because, like the currency school, they objected to such control on general laissez-faire grounds. In spite of the past record of the English banking system, which they interpreted as Edition: current; Page: [234] unfavorably as did the currency school, they apparently saw no alternative but reliance on the hope that the English bankers would in time learn to do better:

If the country banks have erred at all, it has not been in their conduct as banks of issue, but in their conduct as banks for discounts and loans; a matter altogether different and distinct, with which the legislature has no more to do than with rash speculations in corn or cotton, or improvident shipments to China or Australia.13

Were it possible, by any legislative proceeding, to restrain effectually the errors and extravagances of credit, that would be the true course to a really beneficial reform of our banking system. But these errors and extravagances are unfortunately rather beyond the pale of legislation, and can only be touched by it incidentally, or by a sort of interference which would be more vexatious and intolerable than even the evil which it sought to correct.14

The banking school were not willing to concede any merit whatsoever to the Act of 1844. They either denied that it would force the Bank to contract its issues more promptly in case of an external drain,15 or, if they granted this, they denied that this was an advantage.16 John Stuart Mill took an intermediate position. While in general hostile to the Act of 1844, he conceded that when an external drain took place, the act forced upon the Bank a prompter contraction of credit than it might carry out in the absence of the act. But he held that where the drain was due to a temporary factor and would soon cease of its own accord, such contraction was undesirable. The act, moreover, hindered the Bank from taking the steps which would give relief when a crisis had already occurred.17

V. The Possibility of Overissue of Convertible Bank Notes

The Bank Act of 1844, in setting a maximum limit for the note issues of the country banks and in providing for the eventual Edition: current; Page: [235] absorption of their circulation by the Bank of England, was carrying out the recommendations of the currency school. The bullionists, it will be remembered, had denied the possibility of a relative overissue of country bank notes if they were convertible upon demand into Bank of England notes or specie. But the boom of 1824–25 and the resultant crisis of 1826 opened the eyes of many to the expansion possibilities even under convertibility, and the currency school on this point did not adhere to the bullionist doctrine. They insisted that the country banks could expand their issues relatively to the Bank of England note circulation for a long enough period to create difficulties, without being adequately checked by the resultant adverse balance of payments with London. A fortiori, they held that the Bank of England and the country banks, acting together, could issue to excess even under convertibility.

Torrens on this question held views closer to those of the banking school than to those of his currency school associates. He claimed that when a relative overissue of country bank notes occurred, country notes would be presented to be exchanged for bills on London, which would in turn be exchanged for gold for export; the balance of payments both with London and with foreign countries would turn against the provinces, and the country banks would quickly find themselves compelled to contract their issues. Similarly, when the Bank of England directors “decreed a contraction of the currency, the provincial banks of issue, instead of resisting, obeyed and suffered.” 1

Norman replied that Torrens did not make sufficient allowance for “friction” when he claimed that the Bank of England had complete control over the country bank issues.2 Overstone argued that Torrens's conclusion rested on two assumptions, neither of which was valid: that the districts in which the two types of notes circulated were distinct and completely separated from each Edition: current; Page: [236] other,3 and that there was no delay before a contraction of Bank of England issues exercised its full effect on the reserves of the country banks. To Torrens's statement that when the Bank of England decrees contraction, the country banks of issue, instead of resisting, obey and suffer, he replied that “the country banks first resist, then suffer, and in the end submit.4

Torrens similarly claimed that nothing the Bank of England could do could increase the circulation by one pound beyond the amount decreed by the “necessary and natural law which governs the amount at which a convertible currency can be maintained.” If the Bank issued more notes it would displace an equal amount of bullion thereby driven abroad.5 Torrens and the remainder of the currency school thus meant different things by “excess” of note issue. Torrens by “excess” of note issue must have meant an amount of issue which was greater than was consistent with the retention of bullion in reserves or in circulation as coin at its existing and presumably appropriate volume and would therefore result in an immediate export of bullion. The currency school as a whole meant by excess of note issue an amount of issue such as to make the total circulation of notes and coin combined greater than could be permanently maintained consistently with maintenance of convertibility and of the gold standard. The latter explained the phenomena resulting from an excess note issue in terms of lags between the original excess issue and the consequent rise in prices, external drain of gold, and impairment of the Bank's bullion reserves. Torrens would here have no commerce with lags, and he gave no consideration to the possibility of a significant intervening period of excess aggregate circulation. It is not apparent, however, that Torrens ever realized the extent of the divergence of his views from those of the other prominent currency principle advocates, or the essential harmony between this phase of his analysis and that of the banking school writers whom he was vigorously attacking.

Against the possibility of overissue the banking school appealed to the alleged “law of reflux”, which amounted to nothing more than that the notes issued by a banking system on loan at interest Edition: current; Page: [237] to their customers would return to the banks in liquidation of these loans when they matured, and therefore any excess “would come back to the banks.”

New gold coin and new conventional notes are introduced into the market by being made the medium of payments. Bank-notes, on the contrary, are never issued but on loan, and an equal amount of notes must be returned into the bank whenever the loan becomes due. Bank-notes never, therefore, can clog the market by their redundance, nor afford a motive to anyone to pay them away at a reduced value in order to get rid of them. The banker has only to take care that they are lent at sufficient security, and the reflux and the issue will, in the long run, always balance each other.6

To Fullarton's “vaunted principle of reflux,” Torrens made an inadequate reply. If the Bank issued notes by discount of 60-day paper, there would be an interval of sixty days before an increase of notes would return to the Bank.7 But Fullarton had pointed out that there was no necessity “that the particular securities on which those notes were advanced should also furnish the channel for their return.” 8 As earlier loans matured during the 60-day interval, the Bank could contract its circulation by failing to replace them with new loans. What Fullarton certainly failed and Torrens apparently failed to see was that the “reflux” gave the Bank the power, but did not compel it, to contract its issues, and that by granting new loans as rapidly as old ones matured, the Bank could keep any quantity of notes out for any length of time, provided only that its bullion reserves were not exhausted, and that the Bank lent on terms attractive enough to find willing borrowers.9

The essential fallacy of the banking school doctrine had already Edition: current; Page: [238] been exposed during the bullionist controversy by Ricardo and others. It lay in its assumption that the “needs of business” for currency were a definite quantity independent of the state of business psychology and the activities of the banks. The banking school were right in insisting that the volume of bank credit was dependent on the willingness of businessmen to borrow, as well as on the willingness of banks to lend. But the willingness of businessmen to borrow depended on their anticipations of the trend of business, on the interest rate, and on their anticipations as to the willingness of the banks, in case of need, to renew loans upon their maturity. The banks, by lowering their interest rates, or consciously or unconsciously lowering their credit standards, could place more loans, and the increase of loans, by increasing prices and physical volume of sales, would in turn increase the willingness of businessmen to borrow. As Joplin had pointed out in 1826, bankers ordinarily do not see this, because they do not see that they themselves as a group had created the conditions which make an expansion of credit possible and appear to make it “necessary”:

Bankers, indeed, have the idea that their issues are always called forth by the natural wants of the country, and that it is high prices that cause a demand for their notes, and not their issues which create high prices and vice versa. The principle is absurd, but it is the natural inference to be deduced from their local experience. They find themselves contracted in their issues, by laws which they do not understand, and are consequently led to attribute the artificial movements of the currency to the hidden operations of nature, which they term the wants of the country.10

The banking school also argued, as against the possibility of overissue, that if any bank issued in excess of its usual amount it would find the balances running against it at the clearinghouse and would be forced to contract its issue. That the power to over-issue of a single bank, operating in competition with other banks, was closely limited, had long been known. It had been pointed out as far back as 1773 that if a single bank increases its note Edition: current; Page: [239] issue it at first causes a drain on the reserves of the other banks in its district, but that in time its balances to other banks become unfavorable and it is forced to contract its discounts in order to replenish its reserves.11 Lord King made the same point in 1804: “An excessive issue of notes by any particular banker is soon detected, if not by the public, at least by the interested vigilance of his rivals; an alarm is excited; and he is immediately called upon to exchange a very large portion of his notes in circulation for that currency in which they are payable.” 12

In the 1820's, in reply to the use of this argument to demonstrate the impossibility of overissue, a number of writers drew a distinction between what a single bank acting alone could do and what a large group of banks, or an entire banking system, could do, acting simultaneously.13 The Committee of 1826 on Joint-Stock Banks heard much evidence to the effect that the practice of the Scotch banks of making a periodic demand on each other for payment of their respective notes in cash, bills on London, or exchequer bills, was a complete safeguard against excess issue. The questions put to some of the witnesses indicate that the doctrine that banks acting together could issue to excess, though not accepted either by the questioners or the witnesses, was already current.14

In the same year, a number of writers denied the claims that were being made on behalf of the Scotch banks, that their regular procedure of presenting each other's notes for payment provided a guarantee against overissue, on the ground that if the Edition: current; Page: [240] banks all increased their issues simultaneously and in the same degree, they would not have adverse clearing balances against each other and therefore could overissue indefinitely.15 These writers overlooked or, in the case of Doubleday, denied, that, while simultaneous and equal expansion by the Scotch banks would not result in adverse clearing balances among themselves, it would result, at least after a time, in adverse balances with London. It is to their credit, however, that they perceived and expounded the important principle that there is less check to overexpansion by banks when they act in unison than when they act singly, and that it is an error to infer, from the limitations upon expansion to which a single bank acting alone is subject, that overexpansion for a time is impossible for an important group of banks, or a fortiori for a banking system as a whole, when acting in unison. After 1826, this principle was frequently stated,16 and it was adopted by the currency school as one of the elements in their reply to the banking school doctrine that overissue was impossible under convertibility. It became an important element in the then prevailing theory of business fluctuations that alternating waves of optimism and pessimism resulted in overtrading and speculation followed by collapse and contraction, and that the bankers, who as a group shared the optimistic or pessimistic Edition: current; Page: [241] views of their customers, fed the cycle by simultaneous expansion or contraction of their credits.17

Several writers, however, went further, and insisted that even a single bank could overissue for a time, and that credit expansion initiated by a single bank might spread to other banks. McCulloch, in 1831, started from the hypothetical case of ten banks in London, each with a note issue of £1,000,000. If one of them should increase its issue to £2,000,000, there would result a fall in the exchanges and a demand for gold. But the demand on the overissuing bank would be only in the same proportion to its issue as on the other banks. If to check the drain of gold general contraction takes place, then, when the reserves had been replenished the bank which had expanded its issue would find itself with a circulation of £1,818,000, and the other banks would have a circulation of only £909,000 each. The other banks “would certainly be tempted to endeavor to repair the injury done them by acting in the same way.” Even a single bank can expand, therefore, and, more important, may arouse the other banks to a defensive expansion.18 McCulloch failed to point out that a single bank which expanded its note issue while other banks remained passive or contracted would suffer a drastic impairment of its reserves. He now also insisted, for reasons which are not clear but which arose probably more from considerations of Scotch patriotism than of Scotch logic, that, while expansion by a single London bank was possible, this did not hold for Scotch banks.

Scrope denied that McCulloch's reasoning was sound either for London or for Scotch banks. He did not explicitly raise the issue of the effect on the reserves of the expanding bank, but he Edition: current; Page: [242] claimed that a bank could expand its issue relatively to other banks only by discounting at a lower rate, or on inferior security, than its competitors, and that to maintain its increased circulation it must continue to discount on more favorable terms. “But if, as is presumable, the other banks are going as far in both these ways as a sound practice will permit, ... the bank in question cannot go beyond them without risks, such as no stable or solvent establishment would hazard.” 19

Sir William Clay, in the hearings before the 1838 Committee on Joint-Stock Banks, received an affirmative reply to the following question put by him to a witness:

Is there not this circumstance with regard to a competition in the issue of money, that although it may be true that one bank, of many (issuing in competition in Dublin, we will say), if it issued more in a larger proportion than its rival banks, would have its notes returned upon it; and is it not true that would not operate as a check, if all, in the spirit of competition in a period of excitement, were also disposed to issue largely?

Longfield, citing this question and answer, objected that they took insufficient account of the part which even a single bank could play in bringing about an expansion of the circulation. If a single bank in a particular region expanded its discounts and permitted its cash reserve ratio to fall, there would result a gold drain from the banks of the region as a whole either to hand-to-hand circulation or for export, which all the banks in that region would feel in proportion to their circulation. If the other banks kept their discounts constant, they would find their reserves falling in greater proportion than their circulation (because since their circulation was several times larger than their reserves, the loss of a given amount of cash through presentation of notes for payment would represent a greater relative reduction in their reserves than in their circulation). To maintain their former reserve ratio, they must drastically contract their discounts. The expanding bank, if it had sufficient capital to withstand the drain on its own reserves, could by this procedure drive the other banks out of business. If the other banks in self-defense expanded their discounts, and allowed their reserve ratios to fall, there would Edition: current; Page: [243] result a general expansion of credit and circulation in the district. “Thus a bank may be driven in self-defense to take up the system of overtrading adopted by its competitors, and where there are several joint-stock banks of issue, the country will suffer under alternations of high and low prices, of confidence and panic, of great excitement and general depression of trade.” Competitive issue of bank notes might therefore operate as a stimulus to, instead of as a protection against, the periodic recurrence of general overexpansion and overcontraction of the circulation.20

VI. The Role of Deposits, Bills of Exchange, and “Credit” in the Currency System

It was, as we have seen, the position of the banking school that bank notes and bank deposits were both means of payment and parts of the circulating media, and that, since the proposals of the currency school dealt only with bank notes and left bank deposits free of control, they were bound to operate unsatisfactorily if put into practice. In a memorandum to Tooke in 1829, Pennington insisted that the deposits of London bankers performed exactly the same function as did the notes of country bankers: “the book credits of a London banker, and the notes of a country banker, are but two different forms of the same species of credit.” 1 This statement by Pennington is often credited with being the first statement of the identity between the economic functions of notes and deposits. It undoubtedly exerted a considerable influence not only on the members of the banking school, but also on the currency school, and especially on Torrens.2 But Edition: current; Page: [244] Pennington was merely repeating an old doctrine. At the very beginning of paper money in England, it was recognized that the transfer of bank notes and the transfer of book credits at the bank were alternative means of making payments.3 During the restriction on cash payments at the beginning of the nineteenth century the part played by the expansion of bank deposits in bringing about rising prices and the premium on bullion never became a subject of controversy, but a number of writers, both bullionist and anti-bullionist, in their analysis of the monetary process, assigned to bank deposits a role identical with that of bank notes. Boyd, in 1801, held that the “open accounts” of London bankers were, equally with country bank notes, an “addition to the powers of the circulating medium of the country.” Bank notes were the “active circulation” of the banks; book credits were the “passive circulation” because they circulated only as their owners issued orders upon the bank.4 Thornton in 1802 treated bank deposits as a substitute for paper money.5 James Mill, in 1807, accepted “the common cheque upon a banker” as in the same class with the bank note, both being “currency,” but neither being “real money.” 6 Lord Stanhope in 1811 presented a resolution in the House of Lords to authorize the Bank of England to establish branches throughout England, and to substitute for bank notes book credits with the Bank, to be legal tender and transferable without cost. Stanhope claimed for this proposal that it would avoid the disadvantage of paper money of its liability to forgery, and the disadvantage of metallic currency, of the influence on its quantity of the international balance of payments.7 He clearly regarded bank deposits as identical with bank notes in their monetary significance. Torrens, who was later Edition: current; Page: [245] radically to change his monetary views, in 1812 claimed that checks and bills of exchange were more important elements in the circulation than bank notes.8 Samuel Turner pointed out that “A country bank was a kind of clearing-house, where, without any actual interchange of notes or money, the greater part of all payments between man and man was effectuated by mere transfers in the books of their bankers.” 9 Senior stated that deposits subject to check were more important banking instruments for making payments than were bank notes.10 Other writers, while denying to bank deposits the dignity of constituting an independent element in the circulating medium, conceded that they were “economizing devices,” which rendered a smaller amount of bank notes sufficient to mediate a given volume of monetary transactions.11

There might be debate among economists today as to whether bank deposits are “money” or are “currency.” There would be general agreement, however, that they are, like bank notes, means of payment and therefore a part of the circulating medium. Many early writers, however, insisted that bills of exchange were also part of the circulating medium. Henry Thornton, in 1797, included as “means of payment,” not only coin and bank notes, but also bills of exchange “when used as such,” i.e., when they served as a means of final settlement of a transaction.12 An anonymous author wrote in 1802 that “Cash, or ready money, when considered as the medium of payment in a commercial country, comprehends every species of negotiable paper....” 13 Ravenstone stressed the importance of bills of exchange as a means of payment, and declared that “I do not know how this species of paper has entirely escaped the attention of those who have treated this subject.” 14 Burgess,15 Parnell,16 and subsequently many other Edition: current; Page: [246] writers, included bills of exchange as parts of the circulating medium.

Some writers included “credit” as a part of the circulating medium, but meant by “credit” bank credit, and regarded it not as an item additional to bank notes and bank deposits, but as the source from which the two latter items arose.17 But other writers, most notably J. S. Mill, included credit in a broader sense as an element of “purchasing power”:

The purchasing power of an individual at any moment is not measured by the money actually in his pocket, whether we mean by money the metals, or include bank notes. It consists, first, of the money in his possession; secondly, of the money at his banker's, and all other money due to him and payable on demand; thirdly, of whatever credit he happens to possess. To the full measure of this threefold amount he has the power of purchase. How much he will employ of this power, depends upon his necessities, or, in the present case, upon his expectations of profit. Whatever portion of it he does employ, constitutes his demand for commodities, and determines the extent to which he will act upon price.... Bank notes are to credit precisely what coin is to bullion; the same thing, merely rendered portable and minutely divisible. We cannot perceive that they add anything, either to the aggregate of purchasing power, or to the portion of that power in actual exercise.18

Modern writers on money as a rule include specie, government or bank notes, and bank deposits payable on demand by check, as constituting “money,” or the “circulating medium,” or the stock of “means of payment.” They exclude bills of exchange and promissory notes, and treat checks as merely the instruments whereby bank deposits are transferred or “circulate.” But during the early part of the nineteenth century bills of exchange for small amounts were still commonly used in some parts of England, and especially in Lancashire, as a means of payment between individuals, and sometimes passed through many hands in settlement of transactions before they matured and were canceled. To the extent that the receivers of these bills passed them on to others Edition: current; Page: [247] before their maturity in payment of debts or as payment for purchases, they functioned just as did bank notes and were properly to be included in the circulating medium. As one contemporary writer, Edwin Hill, pointed out, anticipating Francis Walker's dictum that “Money is that money does,” the correct test of whether something is “currency” or not is not what it is, but what it does; bills of exchange, to the extent that they settled transactions without involving the use of any other medium, acted as currency.19 But even when bills of exchange do not pass from hand to hand, they are still entitled to be ranked with checks as instrumentalities whereby bank deposits are transferred, provided, as was generally the case in England, these bills were made payable at the acceptor's bank and when they matured were passed through clearings and credited to and debited against bank accounts in the same manner as checks.

In including personal command over credit and individual claims on other individuals as part of the stock of “purchasing power,” J. S. Mill went too far. If valid individual claims to immediate payment are included as means of payment, then individual liabilities to immediate payment should be subtracted therefrom. Since these items are necessarily equal, they cancel each other, although they may in practice affect in different degree the willingness of the creditors and the unwillingness of the debtors to use their cash balances in other transactions. The case of command of credit in making purchases presents more difficulty. If all who can purchase on credit were simultaneously to do so, prices would rise even if demand deposits and notes in circulation remained unchanged in volume, for it is purchases which raise price levels, rather than payments for purchases. But the maintenance of the higher level of purchases requires, after some interval, an augmentation of the volume of payments, and this in turn requires Edition: current; Page: [248] either more means of payment of their greater “velocity” or rapidity of use. But the whole discussion as to what is and what is not “money” retains the appearance of significance only while velocity considerations are kept in the background. What mattered for the currency school-banking school controversy was the extent and the causes of the fluctuations in the volume of payments, i.e., of amount of money times its payment velocity, and therefore the wrongful inclusion as money of something which did not serve as a means of payment was of little consequence if its velocity coefficient was recognized to be zero. Moreover instruments which were not money at some particular moment could be so at some other moment. In this connection bills of exchange, time deposits, and overdraft privileges could be regarded as a sort of “potential money.” The quality which one writer attributed solely to bills of exchange, as the result of which “they can be either kept in the circulation, as media of payment, or withdrawn from the circulation, and held for a time as interest-bearing investments,20 was possessed also by time deposits, which could without much delay be transformed into demand deposits.

That differences in their velocity of circulation were the significant basis on which bank notes, deposits, and bills of exchange could be distinguished from each other with respect to their possession of the qualities of “currency” was by no means overlooked during this period. The existence of such differences was, indeed, the main ground on which the currency school refused to include deposits and bills of exchange, with their comparatively low velocity of circulation, on a parity with bank notes as parts of the circulating medium. This could be conceded to the currency school, however, without accepting their conclusion that deposits and bills of exchange should be treated as not constituting any part of the circulating medium, and should have led only to the assignment of greater weight to a given quantity of bank notes than to the same quantity of deposits. This was in effect done by several writers. Gilbart, for instance, although insisting that deposits were means of payment just like bank notes, argued that the extent to which they perform the functions of money must be measured, “not by the amount of the deposits, but by the amount of the transfers.” Because only deposits payable on Edition: current; Page: [249] demand could be transferred, he considered only such deposits as a part of the currency.21 Longfield, similarly, held that the greater velocity of circulation of bank notes was a significant, but the only significant, difference between deposits and notes, in so far as their influence on prices was concerned.22 J. W. Lubbock expounded the same doctrine for cash, checks, and bills, with the aid of an algebraic formula which has close resemblance to Irving Fisher's celebrated “equation of exchange.” 23

Although the members of the currency school all supported a system of currency regulation which would place the issue of bank notes under rigorous control but would leave deposits wholly Edition: current; Page: [250] free from interference, they did not agree on the grounds which justified this discriminatory treatment of deposits and notes.24

Torrens freely conceded that bank deposits and bank notes were coordinate means of payment and acted similarly on prices. He claimed, however, that payments in specie and notes bore a constant proportion to payments by check and that an expansion of deposits could therefore not take place without an increase of gold or notes,25 regulation of the volume of note issues thus automatically involved regulation of the volume of bank deposits.26 Sir William Clay conceded the similarity between bank deposits payable upon demand and bank notes,27 and even admitted that the latter were a subsidiary circulating medium, and one whose importance was bound to decrease.28 He nevertheless insisted that the issue of bank notes needed to be and could be closely controlled. As for deposits, however, he knew of no practicable means of controlling their volume, and in any case there was no desire for such control in any quarter.29

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Norman's main argument against the inclusion of deposits as a part of the currency was that the velocity of circulation of deposits was much less than that of bank notes or coin.30 He also claimed that the volume of deposits and bills of exchange was dependent on the volume of underlying credit, which in turn was regulated by the amount of bank notes and coin, and that in any case the influence on prices of these “economizing expedients” was only “trifling and transient.” 31 It was no more reasonable, moreover, to object to proposals for regulating note issues because the “economizing expedients” were left unregulated than it would be, in the absence of paper money, on similar grounds to object to the regulation of coin.32 Norman argued also that all that the currency school proposed was that the currency should be made to operate as if it were a purely metallic currency; but even under such a currency, i.e., even if bank notes did not exist, “the trade in money, like other trades, would be occasionally out of joint, although not probably so often or to so great an extent as now.” 33

Overstone's case for limiting regulation to note issues also consisted mainly of this argument that if a currency system which included bank notes could be made to operate as would a currency system in which bank notes did not exist, that was all that could be expected of it:

The utmost that can be expected from a paper-currency is that it shall be the medium of adjusting the various transactions of a country without greater inconvenience to the community than would arise under a metallic circulation.34

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Deposits, debts owing, indeed credit in any form, may be made the means of purchasing and paying, of adjusting transactions; and they may therefore, in one sense, be considered as forming a part of what has been called “auxiliary currency.” But the whole superstructure of “auxiliary currency” forms a subject, distinct from that of the management of the circulation. It may be raised equally upon a metallic or a paper circulation, and the fluctuations which it may undergo are subject to laws distinct from those which ought to regulate the substitution of paper for metallic money.35

The final outcome of the discussion was that the currency school agreed with the banking school that deposits and other forms of “auxiliary currency” or “economizing expedients,” as well as bank notes, could be a source of difficulty, but that the two groups appraised differently the relative importance of variations in the two types of means of payment as causes of currency and credit disturbances. The currency school were not prepared to support government regulation of the credit operations of the banking system, but believed that statutory limitation of the note issues would bring a substantial measure of improvement. The banking school refused to support statutory restrictions on either bank deposits or bank notes, and maintained that the strict limitation of the amount of uncovered note issue would either have no effect or would operate to accentuate rather than to moderate the fluctuations in business conditions.36

It is not sufficient, to refute the currency school argument, to show that note circulation and bank deposits have divergent fluctuations, Edition: current; Page: [253] or even that there are divergent fluctuations in the volumes of payments by means of bank notes and checks, respectively, if, as the currency school assumed to be the case, the relative use of notes and checks is at any one moment, given the circumstances and habits then prevailing, fairly definitely fixed, and if the regulation of the quantity of notes does not of itself operate to induce a change in these relations. But given their price and business-stabilizing objectives, the currency school should have proposed such a method of regulation of note issue as would have resulted at all times, if velocity is left out of account, in the desired aggregate volume of means of payment, or taking velocity into account, in the desired aggregate volume of payments. Since the different stages of a business cycle are marked by variations in the proportions between bank notes and deposits, mere limitation of the amount of uncovered note issue would not suffice, and no method of regulation of note issue would suffice which did not make provision for cyclical changes in the ratio between bank notes and deposits and in their relative velocities, as well as for any changes in these ratios which the regulation of one type of means of payment might itself tend to bring about. Since these provisions could not be reduced to a simple formula, regulation of note issue alone, though it might still operate on the whole to make a “mixed currency” conform more closely to a “purely metallic currency” than if left wholly unregulated, would fail to bring about the desired results with respect to prices and the volume of business activity. An additional difficulty, with respect to the timing of regulatory measures, would arise, if, as appears to have been the case, the fluctuations in deposits preceded, instead of being simultaneous with or following, the fluctuations in note issues, so that if attention was confined to note issue alone the danger signals would come too late.37

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During this period, however, the relative importance of bank notes in the English circulating medium, while steadily decreasing, was much greater than it is today. It is possible, moreover, to defend the currency school against these criticisms, even if deposits are acknowledged to be coordinate with notes as means of payment, if their objective of limiting the fluctuations in the volume of means of payment to such as would exist under a “purely metallic currency” is accepted as adequate, and if it is conceded that the variations in the proportions of deposits to specie and notes under a “mixed currency” would correspond, caeteris paribus, to the variations in the proportions of deposits to specie under a “purely metallic currency.”

VII. The Technique of Credit Control

The Record of the Bank of England.—In appraising the record of the Bank of England during this period, allowance must be made for the lack of an adequate statistical account of the operations of the Bank and also for the absence of any serious attempt on the part of the Bank publicly to defend its record. It nevertheless appears to me that the evidence available warrants the verdict that during the period from about 1800 to about 1860 the Bank of England almost continuously displayed an inexcusable degree of incompetence or unwillingness to fulfill the requirements which could reasonably be demanded of a central bank. During the restriction of cash payments, it not only permitted the paper pound to depreciate, prices to rise, and the exchanges to fluctuate, but it repeatedly denied that there was any relationship between these phenomena and its own activities. William Ward relates that when he became a director of the Bank in 1817, he “could trace nothing directly that could fairly be said to constitute a plan or system” of credit management. It was not until 1827 that the Bank, upon Ward's motion, rescinded a resolution which it had solemnly adopted in 1819, which appeared to deny any connection between the volume of its note issues and the level of the foreign exchanges.1 The Bank even after 1827 apparently continued to be without any reasoned policy as to its discount rate, for Ward, in 1840, could still write:

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I have often pressed on the Court the necessity of regarding the market rate of interest, but I generally found it an unwelcome subject. Low interest was said to encourage speculation; and on my enquiring the principle by which the rate should be governed, I was told in answer, to look to the practice of our forefathers.2

The growing authority of Horsley Palmer and G. W. Norman in the counsels of the Bank in the 1830's brought more enlightened pronouncements to the public, but does not appear to have improved the practice of the Bank. The adoption of the Palmer rule was a flagrant error, and the rule was repeatedly violated in such manner as to make things worse instead of better. The passage of the Act of 1844 by huge majorities was evidence of a general lack of confidence in the ability of the Bank properly to carry out its responsibilities to the public. When the Act of 1844 came into effect, the Bank at once proceeded to act as if the freedom from external control which the act left to the banking department had also rendered unnecessary any internal control. During this entire period, the management of the Bank showed an almost incomplete inability to profit not only from its own recent experience, and from the advice so freely offered to it by outsiders, much of it excellent, but even from “the practice of their forefathers” in the eighteenth century.3 The Bank then knew Edition: current; Page: [256] that there was a connection between their discount policy and their note issue, on the one hand, and the level of the foreign exchanges, on the other, and that a contraction of their discounts would operate to improve the exchanges and to check an external drain of gold. It recognized the difference between an internal drain due to impairment of confidence and an external drain due to a relative excess of note issue, and it was aware that different remedies were appropriate for the two cases: courageous extension of credit in the former and contraction of credit in the latter. Until the Bank was exempted in 1833 from some of the provisions of the Usury Acts, variations in the discount rate above 5 per cent were not available to it as an instrument of credit control, but it made use of informal rationing,4 of systematic borrowing from the market, and probably also of open-market operations, during the eighteenth century.

Variations in Discount Rate vs. Rationing.—From the beginning of the nineteenth century, writers had expressed regret that the Usury Laws prevented the Bank from substituting variations in the discount rate for rationing as an instrument of credit control.5 When in 1833 the Bank was exempted from the Usury Laws, in so far as its loans of three months' maturity or under were concerned, it was done with the approval of the Bank6 but apparently not at its request, and the Bank did not make systematic use of this new instrument until after 1844, and even then with a view too much to its own profit and not Edition: current; Page: [257] enough to its responsibilities as a central bank.7 The discovery by the Bank that the discount rate was an effective instrument of control seems to have surprised it,8 although dozens of writers had been scolding it for years for its failure to use it more extensively.

The arguments then used for the substitution of variations in the discount rate for rationing were that rationing was arbitrary and capricious in its mode of behavior, and that the fear to which it gave rise, that credit facilities in sufficient quantities would be unavailable on any terms in case of credit stringency, tended to promote panic. Formal rationing seems to have been practiced only at times of unusual credit strain. But even after the Bank had adopted variations in the discount rate as its chief instrument of control, it still upon occasion made use of rationing, in the form of shortening of the maturities of the paper which it would accept for discount, as a supplementary instrument of control.9

Open-Market Operations.—The present-day literature on banking commonly treats open-market operations, or the purchase and sale of securities by the Bank on its own initiative as a means of currency and credit control, as a recent development whether as idea or as practice.10 Given its legally and traditionally fixed rate of discount, there was for the Bank of England even during the eighteenth century no alternative to rationing of discounts except open-market selling operations and borrowing from the market when it wished for any reason to increase its bullion reserves. Since rationing meant refusal to its regular commercial customers of discount of what had hitherto been fully acceptable commercial paper, it was a drastic step which it could never readily have taken in the absence of emergency conditions. We Edition: current; Page: [258] know that during the Restriction period the Bank bought exchequer bills in the open market whenever it thought the circulation inadequate for the needs of the country but found no demand for additional discounts at the traditional rate.11 Ricardo regarded the volume of commercial discount business of the Bank as too small to serve as an adequate regulator of the volume of the currency, and he held that the conservative discount policy of the Bank made it necessary that it be in a position to use other means than increase in its commercial discounts to increase the amount of the currency, if this was to be maintained under a metallic standard at a sufficiently high level.12 He took it for granted that under a metallic standard open-market operations would be relied upon by the central bank whenever it desired to reinforce or to offset the effects of automatic gold movements.13 After the resumption of cash payments, open-market operations were without question the main instrument of credit control used by the Bank.14 It was reluctant to resort to the drastic step of formal Edition: current; Page: [259] rationing of discounts when it wished to contract its credit operations, and it had no means other that open-market operations of increasing the volume of outstanding bank credit when the demand for discounts at the traditional and legally the maximum permissible 5 per cent rate was insufficient either for credit control objectives or for its own income objectives. Under the Palmer rule, which called for the maintenance of the securities held by the Bank at a constant amount once the desired balance had been attained, the only scope for open-market operations would be to offset variations in the amount of commercial paper held by the Bank by counter-variations in the holdings of governments. The critics of the Palmer rule, when they insisted that “forcible operations upon the securities” would sometimes be necessary to check a drain of gold, or to make the note circulation expand to the same amount as did the gold reserves in case of an influx of gold, meant by such operations sales and purchases of government securities in the open market as well as contraction or expansion of commercial discounts. Norman, in fact testified in 1832 that, given the restrictions of the Usury Laws, open-market operations were the only practicable means of regulating the note issue,15 and Palmer, before the same committee, stated that if contraction was necessary the Bank would sell exchequer bills first, and would contract its discounts only as a last resort and only if the market rate of discount exceeded the legal maximum.16 It was common knowledge at the time that open-market operations were the main reliance of the Bank when it wished to act on the volume of its credits outstanding.17 Probably Edition: current; Page: [260] more important was the fact that prior to the passage of the Act of 1844 the Bank of England never lowered its commercial discount rate below 4 per cent, and after resumption of cash payments the market rate, except at crisis periods, was as a rule substantially lower than the Bank rate.18 The Bank, in consequence, lost most of its commercial discount business, and except at times of financial pressure what remained consisted largely of special accounts paying less than the nominal rate.19

There was little discussion, however, of the technique of open-market operations. One writer claimed that when the Bank wished to contract its note issue, the order of its operations was, first, to raise the discount rate, second, to sell government securities, and finally, if these did not suffice, resort to “putting on the Edition: current; Page: [261] screw” or rationing.20 It was pointed out that from the point of view of the Bank open-market operations suffered from the disadvantage that ordinarily it would be when securities were low in price that sales would be in order and when they were high that purchases would be made.21 During the crisis of 1847, the Bank, to escape the capital loss which would be involved in selling government stock, and to avoid arousing as much attention in the money market as would be involved in openly borrowing from the market, sold government securities for cash and at the same time bought an equal amount forward, thus in effect borrowing from the market.22 In 1875, and later, it appears to have resorted to analogous practices.

Internal and External Gold Drains.—The banking school regarded it as one of the defects of the Bank Act of 1844 that it failed to provide different treatment for an internal and an external drain on the Bank's gold, but in both cases aimed at forcing a corresponding contraction in the note circulation. They maintained that an internal drain due to mistrust called for an expansion instead of a contraction of credit.23 Palmer, in 1840, made a further distinction between external drains due to temporary causes which could be allowed to correct themselves and external drains due to a fundamental disequilibrium of price levels which could be corrected only by forcing down prices through contraction of credit:

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I think the Bank are always called upon to look for the cause of the drain as far as they can form an opinion upon it when it commences, and to act upon the best opinion they can form of the occurrences then passing. There are two causes that will act upon the bullion of the country; one I take to be the deranged state of prices between this and other countries; the other, distinct payments which are to be made to foreign countries without any derangement of the general prices; if of the latter character, ... that payment being made, and the commerce of the country not being deranged, I believe the bullion and currency would gradually resume their former state. If, as in the year 1825, a great derangement of prices existed, then it would only be by an adjustment of those prices, with reference to foreign countries, that the drain of bullion would be stopped.24

J. S. Mill drew similar distinctions between internal drains, external drains which were self-corrective in character, and external drains which could be checked only by a change in relative price levels, and criticized the Act of 1844 on the ground that it forced the Bank to apply identical treatment to all three types of drains.25 He claimed that a mechanical rule for the regulation of note issue was objectionable because it would prevent different treatment of the different types of drains,26 and he held that there would ordinarily be no difficulty for the Bank in determining the character of a drain, as the cause of a drain was generally notorious.27

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The distinction between external drains according to their causes is valid and important, but Mill exaggerated the ease with which they could be so distinguished in practice, especially in a period of scanty statistical data.28 A drain, moreover, which is distinctly of one type in its origin, may imperceptibly become a drain of another type, or may, by causing alarm, give rise to another type of drain as well.29

Mill was in error also when, following Tooke, he held that while prior to 1844, and also under a purely metallic currency, a drain would generally be met from the “hoards” of bankers and merchants, under the Act of 1844 it must necessarily come out of the circulation.30 A contemporary writer pointed out the ambiguous way in which Mill here used the term “circulation.” Mill's account of the manner in which the Act of 1844 must operate was correct only if by “circulation” he meant the “gross circulation” outside the issue department. But this gross circulation included the notes and bullion held by the banking department as well as whatever reserves of notes or bullion were held outside the Bank of England. These reserves outside the issue department, however, constituted “the identical hoards from which, as he so truly argues, when speaking of a [purely] metallic currency, nearly all drains must be taken.” Mill's criticism of the Act of 1844 would be valid therefore only if under it drains must come from the “active” or net circulation, which was not the case.31 The Bank, in other words, was still able, under the Act Edition: current; Page: [264] of 1844, to discriminate in its treatment between different kinds of drains, and to meet drains out of its reserves without contracting its “active” circulation when it thought it desirable, if it kept adequate reserves in its banking department. Mill, however, later admitted in effect that at least as far as external drains was concerned the Bank of England could still deal with them as it had had the power to do before 1844, if it retained in its banking department as large reserves as before 1844 had sufficed for the Bank as a whole.32

Adequate Reserves.—Gold reserves yield no income, and banks operating for profit tend to reduce them to the lowest level that seems consistent with safety. In countries with central banks, all other banks tend to rely upon the central bank to provide the bulk of the gold reserves for the system as a whole. The Bank of England was never legally charged with this responsibility, and its obligations to its shareholders, who during this period still held its stock primarily because they wanted dividends and not as a social duty or because prestige attached to being a “Bank proprietor,” necessarily loomed large in the minds of its directors. The other banks, on the other hand, behaved as if the Bank of England were a true central bank, with full responsibilities for looking after the gold reserves of the nation. When the Bank's charter was renewed in 1833, the government made a stiff financial bargain with the Bank, which reduced its earning power and made still more onerous for it the maintenance of any surplus reserves. The rapid growth of joint-stock banks in London further deprived the Bank of England of a large part of its commercial discount business, which had hitherto been the most remunerative form of employment of its funds. As a result of these circumstances, the English credit structure was marked, during the nineteenth century, by an extraordinarily low ratio of gold reserves to aggregate gross demand liabilities of the banking system. English banking statistics for this period are too meager to make possible an accurate determination of this ratio, but it seems that, disregarding the probably negligible amounts of coin and bullion held as reserves by the joint-stock and private banks, it fell at times to as low as 2 per cent and never between 1850 and 1890 exceeded 4 per cent.

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From the late 1820's33 on to the end of the century a continuous succession of writers called attention to the inadequacy of the gold reserves, but without any visible results. One writer pointed out that the interest of the public in an adequate gold reserve was so great as to render the cost of its maintenance a matter of very minor importance from the national point of view. He took it for granted that the terms of the 1833 Bank Charter made the maintenance of an adequate reserve a greater burden for the Bank than it could bear. He therefore recommended that the Bank should be required to establish, at the expense of the government, an additional reserve, not to be encroached upon without a warrant from the Treasury.34 Richard Page saw that the ambiguous status of the Bank was a source of danger: “The double interests and duties of the Bank—as the proper institution for regulating the currency, and conducting a profitable banking business—are incompatible. The two things may often consist, but times will occur when they cannot be preserved together.” 35 He warned that the economy of the use of the precious metals had already been pushed too far, and that means should be found to restore the reserves to a satisfactory level:

A banker is now encouraged to keep but a small amount of specie by him; all his transactions resolve themselves into and are based upon ready money, and yet he is relieved of all labor and anxiety in procuring specie. The charge and responsibility of that obligation are taken from his shoulders, and put upon the Bank of England. The customers for gold in the market are therefore reduced to a single body; who, if the gold comes, take it in, but confess that they do not conceive it a part of their duty to go out of their way to obtain it. This is an evil. If every banker was obliged to market for himself, we should soon find our condition amended.36

Every recent improvement in banking has gone upon the principle that we should retain gold as a standard, but bring it forward as seldom as possible, and scarcely ever touch it. The perfection of the Edition: current; Page: [266] theory would be a refinement of the thing into nothing, a spiritualizing away of the reality, until gold and no gold became one and the same. Such improvers would make it “small by degrees, and beautifully less,” until it had vanished altogether, and ceased to exist otherwise than argumentatively.37

The Bank Act of 1844 made the gold in the issue department of the Bank unavailable for external payments, except as the banking department had a disposable reserve of notes which it could exchange for issue department gold.38 The crises of 1847 and 1857, and the necessity of suspending the act in these years, could in large part be attributed to the inadequate reserves against emergencies held by the Bank. There was no lack of advice to the Bank that its reserves needed strengthening, but such advice was frequently accompanied by the recommendation that the additional expense should be borne by the government, or by the large joint-stock banks.39 One especially forceful statement was as follows:

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... we say with all the emphasis we can command, that the entire question of administering the monetary system of this country resolves itself into the magnitude of the bullion reserve of the Bank of England. The present system works badly, painfully, and dangerously, because it has at the bottom of it nothing more substantial than the five, six, or seven millions of reserve in the banking department. But let the reserve be raised to such a point that on the average of the year, or some more convenient period, it shall not be less than say fourteen millions, and the whole complexion of the case would be changed. A transmission of three or four millions of bullion goes a long way in these rapid days in adjusting even a large foreign balance; and even four millions taken out of fourteen is a very different measure, and leaves behind it a very different residue compared with four millions taken out of eight or nine. Moreover, it might be a by-law of the Bank Court that for any fall of half a million in the treasure below say twelve millions, the official rate should be raised a half per cent, or in some other proportion to be determined after due inquiry. It is pitiful and mean that a country like this, containing millions of people dependent on trade, cannot afford or manage to keep a bullion reserve so reasonably sufficient for the amount and uncertainties of the business carried on, that the arrival or departure of a few parcels of gold or silver produces commercial sunshine or storm.40

It has been said that Peel was aware that the metallic base of the currency was extraordinarily narrow, but did not think that either the Bank or the people would willingly bear the expense of broadening it.41 The contemporary literature throws little light on what the attitude of the Bank was toward this vital question. Testifying before the Parliamentary Committee of 1840, Palmer had in effect admitted that the Bank had not found the Rule of 1832 practicable. Asked to suggest a better procedure for the Edition: current; Page: [268] Bank, he replied: “I know of no other course which could be taken beyond holding a larger amount of bullion, but which I am not prepared to say the Bank could do, without means being devised to remunerate that establishment for the expenses and charges that would attend such a measure.” 42 G. W. Norman, on the other hand, denied that surplus gold reserves were desirable. If the Bank had surplus gold reserves, it would not need to contract its issues at the commencement of a drain. But “a foreign drain, however arising, would always diminish, pro tanto, a [purely] metallic currency,” and should therefore be made to operate likewise on a mixed currency. The lost gold could be recovered only by a proportional contraction of the issues, and this contraction would be less injurious if it came promptly than if it was delayed. Surplus reserves would make the regulation of the currency depend (in its timing?) “on the fancy or caprice of those who have to administer the currency; while I think that the contraction should be connected with a self-acting machinery, that it should be regulated simply by the state of the English currency, compared with that of the currencies of other countries as tested by the exchanges; in other words, that it should exactly conform to what would occur had we only metallic money.” 43

During this period discussion of the proper criterion of the adequacy of bullion reserves was generally in terms of the minimum absolute amounts of bullion which, in the light of past experience of external and internal drains, would afford full safety to the Bank. Treatment of the question in terms of the minimum safe ratio of bullion holdings to note circulation or to total demand liabilities of the Bank—or of the banking system—became common only toward the end of the century, and I have found only two contemporary discussions of the adequacy of reserves which were couched in terms of reserve ratios. One writer, while conceding that the Palmer rule did not call for Edition: current; Page: [269] maintenance of the bullion reserve ratio at one-third of the demand liabilities, claimed that the public had nevertheless so understood the rule, and insisted that it was a better rule than that of maintaining the security holdings constant.44 He proposed “that for the future the Bank of England govern her issues of notes (without reference at all to deposits) on the principle of holding one-third of gold against notes in circulation.” 45 Another writer, in the same year, recommended that instead of following the Palmer rule the Bank aim at maintaining a 50 per cent reserve against its note circulation. He apparently set the required reserve at so high a ratio because of his recognition that bullion could be drawn out of the Bank through its deposits as well as by presentation of notes and his belief that consideration should also be given to the existence of private bank note circulation dependent upon the Bank of England for its ultimate bullion reserve. He conceded that a 25 per cent reserve ratio would be adequate if the Bank followed the rule of withdrawing £4 in notes for each £1 loss in bullion. He called his proposal the “principle of proportion,” to distinguish it from “the principle hitherto assumed as the correct one, and which may be called the principle of diminution in equal amounts.” 46

The practice of extreme economy in the maintenance of bank reserves did have as an accidental by-product the beneficial effect that it guaranteed to the metallic standard world that as far as England was concerned there would be no hoarding of gold and that all gold reaching that country would quickly exercise an influence in the appropriate direction for international equilibrium on interest rates and the volume of bank credit. But it tended to intensify the growing tendency for instability of business conditions within England itself. Without willingness at times to maintain greater metallic reserves than were absolutely necessary to secure convertibility of the paper currency and without excess reserves which could be released during times of pressure as an alternative to credit contraction, there could be no “management” of a metallic standard currency in the interest of internal stabilization, and it is arguable that even the outside Edition: current; Page: [270] world had more to gain from greater internal stability in England than it would have had to lose by the occasional “sterilization” by the Bank of England of several million pounds of gold. While the English currency was undoubtedly even then a “managed” rather than a purely “automatic” one, the main objective of management appears to have been to achieve the maximum economy of reserves, i.e., the maximum banking profits, consistent with maintenance of convertibility. But the Bank of England was not set up as an eleemosynary institution, and during this period it probably could not have afforded to assume greater control responsibilities without financial guarantees from the government which could not be asked for without injury to its prestige and which would, moreover, probably not have been obtainable merely for the asking.

Foreign Securities as a Secondary Reserve.—In the hearings before the Committee of 1840, it was brought out that the Bank had given some consideration to the desirability of adopting the practice of holding foreign securities as a secondary reserve which would yield income while providing an emergency means of international payment. In reply to questions, Palmer and Norman agreed that foreign securities would serve equally with gold for this purpose, with the advantage over gold that they would earn interest while serving as a reserve. Palmer agreed also that the sale of foreign securities would be preferable to forced recourse to borrowing from foreign central banks as a means of checking an abnormal pressure on the gold reserves. Norman, however, thought that it would prove difficult in practice to find suitable foreign securities whose salability in the places with which the balances of payments were adverse could be relied upon, and Overstone was inclined to disapprove of the practice, on the ground that it would serve as an expedient to avoid resort to contraction of the note issue, which he regarded as the only sound method of dealing with an external drain of gold, and that it would tend to injure the credit of the Bank abroad.47

The discussion before the Committee of 1840 attracted some attention. James Ward claimed that the practice would prove highly profitable for the Bank of England—not only would foreign Edition: current; Page: [271] interest-bearing securities be substituted for bullion, but purchases of the securities would be made when the exchanges were favorable to England and sales when the exchanges were unfavorable, with an additional profit, therefore, on the turn of the exchanges. If the Banque de France should also adopt this practice, then “the joint operation would in fact be the same as if each country kept a banking account with the other to draw upon for the payment of any balances between them without the necessity of actually sending gold backwards and forwards for the purpose; and it must be evident that such an arrangement would very much diminish fluctuations in the rates of exchange.” 48

Robert Somers, writing in 1857, comments as follows on a suggestion made in a letter to the Times, recommending that mint certificates of deposit of bullion be used as a means of making international payments and thus of saving the cost of transport of the actual bullion:

The bullionists [i.e., the currency school] are so formal in adherence to their principle, that they would consider gold in the British mint a proper basis of money, though the right to it belonged to, and was doing service in, another country; but surely gold in another country, the right to which resides in this, must be a fully better security for British currency to rest upon. This is a distinction constantly overlooked under the Bank charter act. It is not the right of property in bullion, not the control over its movements and its possession, but the mere place where it may happen to be lodged, that forms the sole guide of the Bank in regulating the rate of discount. Though the whole stock of bullion in the Bank of England were in the power of a foreign capitalist, and could be removed any hour he chose, the Act would recognize it as a valid basis of paper money; but if British capitalists sent their gold temporarily to France or America, and held securities equivalent to such gold, these securities would pass for nothing.49

It is true that under the Act of 1844 the Bank could not have counted gold carmarked to its account abroad, or holdings by itself of foreign securities, to say nothing of private holdings of foreign securities, as part of its bullion reserve in the issue department. But there was nothing in the Act of 1844 to prevent the Edition: current; Page: [272] Bank from treating gold earmarked abroad or holdings by itself of foreign securities as part of its banking department reserves, or, in appraising its reserve position, from taking into account holdings by the British public of foreign securities and holdings by foreigners of British securities.

Silver as a Reserve Metal.—The Bank of England before 1844 bought and sold silver and always included its silver holdings at the market value in its returns of bullion held. In 1819 the Bank had opposed Baring's recommendation of a bimetallic standard on the ground that “silver bullion answered equally their purpose of checking an adverse state of exchange and a demand of their gold from abroad, as if it were converted into a current coin.” 50 The Bank in 1844 asked that it continue to be permitted to issue notes against silver and that it be permitted to count its silver holdings as part of its bullion reserves in the issue department. It claimed that foreign remittances could often be made more cheaply in silver than in gold, but that the variations in the market price of silver were too slight to compensate private concerns for holding it in stock, and were too slight also to compensate the Bank for holding it unless it could count it as part of its issue department reserve. The Act of 1844 gave the Bank the right to issue notes against silver not to exceed one-fourth of the gold held in the issue department, although the Bank had asked that this limit be set at not lower than one-third, and the Bank continued for a while to complain that the limit set by the act was too low.51

There is some evidence, however, that the attempt to operate a two-metal reserve under a monometallic standard had not been very successful. During the crisis of 1825, it apparently required the cooperation of the Banque de France to enable the Bank of England to exchange silver for gold.52 According to Baring, during the crisis of 1847 the Bank at one time had upward of £1,500,000 in silver, for which it was unable to get gold in exchange.53 In any case the Bank in 1850 ceased to issue against Edition: current; Page: [273] silver, except for a minor resumption of the practice in 1860–61, when, to help the Banque de France, it exchanged £2,000,000 of gold for silver on the basis of a repurchase agreement.54

Cooperation between Central Banks.—The Bank of England found itself forced, no doubt very reluctantly, to appeal to the aid of foreign money markets on a number of occasions. In 1836 the Bank of England, by arrangement with the Banque de France, drew bills of credit on Paris for over £400,000. This transaction was not publicly acknowledged until 1840. In 1838, while the Bank of England was under pressure, it arranged with the Governor of the Banque de France, who was in London at the time, for credit in Paris to be drawn upon if needed. In 1839, as the gold reserves of the Bank of England were approaching exhaustion, the Bank of England took advantage of this arrangement. As the Bank of England was not accustomed to draw on foreign countries, and the Banque de France made loans only on bills of exchange bearing French names or on French public securities, the transaction was carried out with the aid of intermediaries. Baring Brothers, on behalf of the Bank of England, drew bills on twelve Paris bankers to the extent of £2,000,000, which the Banque de France, in accordance with the arrangement, discounted for these bankers. At the same time similar credits established in Hamburg brought the Bank £900,000 additional gold.55 The necessity of resort to Paris for assistance, at a time, moreover, when relations with France were not too friendly, was regarded in England as rather humiliating, especially as it was reported that the followers of M. Thiers were boasting of the generosity of Frenchmen in coming to the assistance of the Bank of England when in difficulty while recommending that under no circumstances should such liberality be repeated in future.56

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In 1847 the financial crisis and the shortage of gold were common to both London and Paris. By arrangement with the Banque de France, the Emperor of Russia and the Imperial Russian Bank bought from the Banque de France and other sources, with gold taken from the Russian reserves, Russian and foreign securities to the amount of £6,600,000, thus relieving the strain in the Paris and London money markets.57 It does not appear, however, that the Bank of England was a direct party to this transaction, and it, in fact, indirectly gave assistance to the Banque de France in that year. The Banque de France, after giving consideration to proposals that it should engage in openmarket sales of rentes in order to check the drain of gold which it was undergoing, decided not to, on the ground that such operations would reduce the circulation, but would not increase the metallic reserve. Instead, it raised its discount rate and engaged a banker to borrow 25,000,000 francs in London, on rente collateral, and used the proceeds to withdraw gold from the Bank of England.58

Cooperation between central banks in the management of metallic currencies was during this period exceptional rather than an established policy. On the contrary, it appears that ordinarily the central banks either paid little attention during this period to what was going on in other money markets, or else engaged in competitive Edition: current; Page: [275] increases of their discount rates and in raids on each other's reserves at a time of actual or anticipated credit stringency.59

There were only scattered references in the literature of this period to the need for international cooperation in credit management. Poulett Scrope, in 1830, found fault with the suppression of small notes by the Act of 1826, on the ground that it operated to cause a rise in the value of gold throughout the world and produced distress in the other great commercial nations as well as in England. He remarked that this international aspect had apparently failed to attract any attention, although “There have been times when a far less injury would have been resented by a declaration of war. But this fact is one only of many, showing how, in the close relations by which commerce knits nations together, each is interested in the welfare and good government of the other, almost, if not quite as much, as in her own.” 60 Several writers pointed out that the growth of commerce and the increasing international mobility of capital was bringing about a greater interdependence of the world's money markets, with the result that single-handed regulation of its metallic currency by any country was becoming increasingly difficult. Because of this trend William Blacker predicted that “monetary panics will year after year become more frequent and more severe as long as a metallic basis is preserved, which, with the aid of steam, conveys the monetary convulsion from country to country with a rapidity which, for all practical effect, may be compared to a metallic wire passing through the lands of all nations conveying the electric shock almost simultaneously to the most remote quarters of the Edition: current; Page: [276] globe.” 61 Another writer stressed the importance of the comparative rate of expansion of credit in different countries as affecting the severity and the area of monetary pressure which would follow. If the expansion was widespread, there would be a general scramble for gold when the pressure came.62

VIII. The Relation Between Bank of England Operations and Specie Movements

The Bank of England did not itself engage directly in import or export transactions in bullion or specie. It was obligated, however, to give specie upon demand in exchange for its own notes, and as a part of its regular routine it also upon demand gave notes in exchange for specie, cashed its depositors' checks in specie, and bought gold bullion of standard fineness at the fixed price of £3.17.9 per ounce. In addition, the Bank operated its bullion department on ordinary commercial principles, buying and selling silver bullion and gold bullion of other than the standard fineness at the prevailing market prices. Periods of business expansion were also as a rule periods of expansion of Bank note circulation, of increased indebtedness to the Bank of private bankers and other clients, and of decline in the Bank's specie reserves. As long as the Bank of England would freely discount, a credit expansion could go on indefinitely, without a rise in the rate of interest or depletion of the cash reserves of private1 banks. A credit expansion, if peculiar to England, or relatively more marked there than abroad, would operate to stimulate imports and, through increased domestic absorption of supplies, to check exports, and would thus tend to create an unfavorable balance of payments. Even a credit expansion in which England was lagging behind the rest of the world might deplete specie reserves in England if it resulted in a substantial internal drain of gold to satisfy the demand for increased hand-to-hand specie circulation. Edition: current; Page: [277] The role of the Bank of England under such circumstances, whether she acted to protect her own specie reserves or to control the credit situation, was to check such credit expansion before it had reached a dangerous level. We are here concerned with the contemporary views as to the mechanism whereby the Bank of England could influence the flow of specie into and out of the country and thus into and out of her own coffers.

It was common doctrine that the market rate of interest influenced the flow of specie, a high rate operating to attract specie and a low rate to force it out, and that the Bank of England could regulate the flow of specie through its power over the market rate of interest. It was taken for granted that normally there were no idle funds outside the Bank of England, and that any reduction by the Bank of England of the volume of credit it had outstanding, whether accomplished through raising its discount rate, rationing, sales of securities in the open market, or borrowing from the market, would, other things being equal, force a rise in the market rate of interest.2 It was pointed out, however, that at times the market was sufficiently independent of the Bank to make the Bank's discount rate ineffective as a controlling factor unless supported by open-market sales and, in extreme cases, by borrowing from the market.3 On the other hand, there was recognition of the possibility that increases in the Bank rate might act as a deflationary factor not only directly through their influence on the volume of advances to the Bank's own customers, but also indirectly through their psychological influence on the market judgment as to business prospects and therefore on the willingness of private bankers to lend and of businessmen to borrow and on the velocity of circulation.4

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Most of the discussions of the role of the interest rate referred only to short-run disturbances, including periodic business fluctuations, or “cycles,” 5 and the changes in interest rates were related to specie movements mainly in terms of their influence on the international movement of short-term funds, and their influence on relative prices was commonly held to be too slow-working to be an important factor in restoring international equilibrium.6 Most emphasis was put on the international mobility of funds devoted to investment in securities, in response to relative changes in the market rates of interest in London and abroad,7 but many other ways in which a relative rise of the English interest rate could attract short-term funds from abroad or check their flow to abroad were noted.8

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Most of the writers of the period conceded the efficacy of the Bank discount rate, if employed skillfully and forcibly enough, as a regulator of specie movements through its influence on the international movement of short-term funds and, to a less extent, on the commodity trade balance. A skeptical note, however, was struck occasionally in the literature. It was pointed out that in so far as the movement of short-term funds was concerned what mattered was only the relative height of market rates of interest in London and abroad, and that rates were likely to rise and fall simultaneously in the important money markets. It was later claimed, moreover, that the foreign central banks, and especially the Banque de France, for a time during this period systematically followed the practice of meeting increases in the English discount rate by increases in their own rates in order to protect their reserves.9 A rise in the discount rate, moreover, might be interpreted as a signal of impending financial stress and thus instead of attracting funds to England might frighten them away.10 One writer, otherwise favorable to its use, regarded it as a defect of the discount rate as a regulator of specie flows that it operated to check exports, presumably by making it more costly or more difficult to finance them.11 Finally, the opponents of a metallic standard or of central bank control thereof tended either to deny in general terms the efficacy of the discount rate as Edition: current; Page: [280] a regulator of specie movements, or to deny any need of such control given the existence of a self-regulating mechanism, or to claim that the regulation, whether effective or not in protecting specie reserves, was costly to internal prosperity when it involved increase in the discount rate and contraction of credit, or to find still other objections to it.12

IX. Currency Reform Proposals

All that the currency school aimed at, as we have seen, was that the existing “mixed currency” should be made to operate precisely as they supposed a “purely metallic currency” would operate. By a “purely metallic currency,” it should be remembered, they meant one which would not include either government paper money or bank notes, but under which bank deposits transferable by check or bill of exchange would still exist. The chief characteristic of such a currency, they thought, was that every influx of gold from abroad or efflux of gold to foreign countries would immediately and automatically result in a corresponding increase or decrease, respectively, in the amount of money in Edition: current; Page: [281] circulation. The banking school pointed out that even under a “purely metallic currency” of this kind there would be “hoards” of gold of variable amounts, mainly in the form of bank reserves; that an influx of gold might go to augment the hoards instead of the specie and note circulation, while an efflux of gold might similarly come out of hoards instead of out of circulation; and that the influence of a variation in the metallic circulation on the level of prices might be offset or more than offset by an opposite variation in the amount of bank deposits. Many critics of the currency school, moreover, held that it was not desirable that a mixed currency should act precisely as would a purely metallic currency if that meant that it should undergo all the fluctuations in quantity and in value which would be experienced by a purely metallic currency. As one writer put it: “a mixed currency should not fluctuate as a metallic currency does. A metallic currency is undoubtedly the safest, possessing intrinsic value; but its liability to fluctuation in quantity arising from the state of the exchanges, and consequent drains, diminishes its claim to be considered the best type of a currency. Its liability to fluctuation is an evil to be counteracted and not adopted.” 1 The banking school, however, had no legislative solution to offer. Imperfectly as the currency operated, legislative interference would only make things worse. Reliance must be had on the good sense and the competence of those who had charge of the credit operations of the banking system.

There were numerous writers, however, who shared the dissatisfaction of the banking school with the existing currency system even if made to operate in accordance with the specifications of the currency school, but who rejected the banking school doctrine that nothing could be done by regulation to make the currency more stable in its value. The Attwoods had acquired a considerable following, who became known as the “Birmingham school,” at one time had an organization called the “National Edition: current; Page: [282] Anti-Gold Law League,” modelled after the Anti-Corn Law League, and engaged in vigorous and sustained propaganda for the total abandonment of a metallic basis for the currency. But the Attwood doctrines deteriorated in the hands of their disciples, who in the main were crude inflationists and advocates of a national inconvertible paper money, free not only from what they regarded as an arbitrary and dangerous bond with gold,2 but also from any other legislative restriction on its quantity. They had a naive reliance on the sufficiency of competition to keep prices from rising excessively, irrespective of the quantity of the currency in circulation.3 This group, and the many other crude inflationists who issued tracts during this period, we can reasonably ignore. A number of writers during this period, however, presented proposals providing either for the regulation of the quantity of the currency with a view to stabilization of its value, or for the adoption of practices which would lessen the evil consequences arising from fluctuating, and especially falling, price levels. There follows a brief account, with no pretensions to completeness, of the proposals for reforms of these types which were made during this period. It should be noted, however, that the government, and the more prominent economists of the time, such as J. S. Mill, McCulloch, Senior, Cairnes, and Torrens, either wholly ignored these writers or treated their proposals with derision or contempt.

Wheatley, in 1807, had made the following proposal for the voluntary use in long-term contracts of a tabular standard based on an index number of prices, as a protection against changes in the purchasing power of the monetary unit:

... in compositions of a permanent nature, some criterion should be assumed for the purpose of providing a graduated scale of the value of money, and ... an increase or diminution of income should be allowed in conformity to the result. The present impoverishment of the crown is a sufficient warning against permanent compacts for a definite sum; and no public composition will, I trust, be hereafter Edition: current; Page: [283] concluded, that does not contain within itself the power of revision as to the pecuniary compensation. In a late projected composition government very properly departed from the principle of a fixed income, and as a commutation for tithes, it was proposed to grant a stipendiary salary, according to the price of corn. The basis upon which the compensation was to be negotiated was perfectly just; but I have already shown the inefficiency of corn as an exclusive standard; and whenever it may be necessary for any object of extended policy to ascertain the relative value of money for a period of long duration, the principles, upon which Sir George Shuckburgh constructed his table of proportions, will be found the least objectionable.4

Joseph Lowe5 in 1822, and Scrope6 in 1833, made similar recommendations for the voluntary use of a tabular standard,7 although without reference to Wheatley. Some years later an anonymous writer recommended what was in effect a compulsory tabular standard of payments. According to his scheme, the currency would consist of £100 exchequer notes, made legal tender, and issued by the government in return for the obligation to pay to the government annually the value in pounds of a quarter of wheat at the average of the preceding ten years' prices. If wheat should be judged not to be a sufficient base, then the average prices of 50 or 100 commodities could be used instead. If prices rose because of overissue of this currency, it would be in the interest of holders of these notes to turn them in.8 The essence of the plan was the issue of inconvertible notes on loan Edition: current; Page: [284] at rates of interest varying in the same direction as the variations in commodity prices.9

John Gray, in 1842, advocated a currency system which would stabilize wages, and which would enable creditors to obtain at the maturity of their claims at least the same amount of command over goods as the amount of money which they had lent had had at the time the loan was contracted.10 To accomplish the latter purpose he would have a currency consisting of: bank notes freely issued by private banks but convertible upon demand into standard money; and of standard coins made to vary in weight inversely with variations in the market value of the metal of which they were composed. His proposal is a variant of the “compensated dollar” idea; the denominations of the coins are to be maintained unaltered, but their size is to be varied in such a manner as to keep their purchasing power over commodities constant.11 He apparently did not see that this might conflict with his other objective of keeping wages constant.

William Cross, in 1856, advocated a paper currency convertible into gold, but into amounts of gold varied periodically in conformity with a weighted “index list” or index number of commodities, so as to maintain constant purchasing power for the paper currency. He would retain the sovereign as a gold coin of Edition: current; Page: [285] fixed size but of variable value in paper currency.12 He believed that knowledge of liability to adjustment of the paper value of the gold coins (or of the gold value of the paper currency) would, through anticipations of businessmen, operate to reduce the need for such adjustments and to render potential changes “a preventative influence rather than a rectifying interference”:

On the other hand, during a general decline of prices, the observation of this circumstance would lead to anticipation of a reaction favorable to sellers at the next ensuing time for the adjustment of the standard, and thus tend to check the fall of prices and render any rectification unnecessary. For producers and holders of goods would refrain from pressing sales when they knew or believed that the value of their stocks would be increased ... as soon as the over-enhancement of money should be reduced ... by the legal rectification. In the same circumstances, capitalists would become more free in their accommodations, and merchants more liberal in their purchases, knowing money to be verging on the maximum, and commodities on the minimum value possible under the system of periodical adjustment.13

One writer advocated a paper currency convertible into gold at the variable market price of gold instead of at a fixed price. In order to stabilize the value of the paper currency in terms of commodities, he proposed that its issue should be controlled by an official body, with authority to increase it when the rate of interest rose above 5 per cent and to contract it when the rate of interest fell below 3½ per cent, but failed to reveal why he believed this would suffice to stabilize prices.14

Richard Page advocated a fixed issue of inconvertible paper money, with the limit fixed by Parliament and periodically adjusted to changes in the population and trade of the country.15 Edition: current; Page: [286] George Pell proposed a government legal tender paper currency, issued for a minimum period of one year on collateral securities, and with interest charged at the rate yielded by these securities at their fair appraised value at the time of issue of the currency. What the plan aimed at was “the prevention of fluctuations in the value, that is, in the purchasing power, of money at home,” and the author believed that the deviations between the rate of interest paid for the money and the rate of interest which could be earned by its investment would automatically so regulate the quantity of currency issued as to attain this objective. He assumed that the currency would maintain constant purchasing power if the rate charged for its issue were always kept equal with the average yield of capital. As the current rate of yield of capital rose it would be to the advantage of bankers to obtain larger quantities of currency from the government; as the current rate of yield of capital fell, it would be to their advantage to lessen the quantity already obtained by repayments to the government.16 He does not explain how these deviations between the yield of capital in the market and the rate charged by the government could occur if the government based its rate on the former, nor why stabilization of the purchasing power of the currency would be assured if the rate of interest at which currency was issued was always made equal to the current yield of capital.

Several writers proposed schemes designed to render the purchasing power of the currency stable in the short run, but not necessarily in the long run. Poulett Scrope insisted that there were important possibilities of short-run stabilization of the price level even under a fixed metallic standard through appropriate regulation of its note issues by the Bank of England. He anticipated so strikingly later views on this question that his exposition deserves quotation at some length:

When gold is, for commercial, financial, or political purposes, drawn away from this country in any quantity, it is chiefly from the treasure of the Bank that it is taken, and it is for the Bank Edition: current; Page: [287] exclusively to determine, whether the drain shall or shall not have any influence on our home prices. If the Bank choose to keep up its circulation of paper to the same point as before, no effect is felt in our markets. It may even reverse the natural effect of the drain, which is to lower prices, by increasing its issues as the gold flows out, and thereby raising our prices to an unnatural height. When the gold returns on this country by the spontaneous reaction of the exchanges, it is for the Bank to determine whether it shall have any effect upon our circulation or not. If they buy the gold as it comes in, and yet make no corresponding increase of their paper, the money of this country is in no degree enlarged; and should the Bank contract its issues while purchasing gold, our prices are actually depressed at a time when the influx would naturally have raised them....It is only when the Bank contracts its paper exactly as it parts with gold for a foreign drain, and expands it as the gold flows back again, that the effect of these local variations in the demand and supply of bullion are [sic] reduced to that which our metallic standard necessarily occasions, and which would happen all the same even though our circulation were purely metallic.

It is evident, then, that the power of the Bank over prices in the British markets is confined within no narrow limits through the obligation of paying its notes in gold; that by its conduct in extending and contracting its paper, and purchasing or selling bullion, the value of gold itself, first in this country and ultimately in others, is arbitrarily influenced to a very great extent; that the Bank has the power of determining the exchanges, and, consequently, whether gold shall flow into or out of this country; that, by accumulating gold at one time in its vaults, to the extent of fifteen or more millions, at another allowing them to be nearly emptied, before any attempt is made to restore the equilibrium, the Bank can influence the market for gold as well as that of every other commodity.17

Scrope no doubt saw that as long as convertibility was required the Bank could at best be able to prevent the price level from fluctuating in response to even short-term fluctuations in the balance of payments only within the limits of its available reserves of bullion or, when prevention of a rise in prices was its objective, within the limits of its financial ability to accumulate non-income-earning stocks of bullion, and that the Bank could not prevent the English price level from responding to a sustained trend in the world value of gold if convertibility of its paper into bullion at fixed rates were insisted upon. In any case, Scrope proposed Edition: current; Page: [288] as an ideal currency—“as perfect a system of currency as can be devised” —an inconvertible paper money to be preserved at par with bullion ordinarily, but to be left free to deviate from par for short periods during which temporary fluctuations of the price level would otherwise occur.18

William Blacker advocated an inconvertible paper money to be issued by a government commission in discount of commercial bills at such a rate of discount as would be found by experience to keep the exchange at par under ordinary circumstances, but to be left free to vary from par at times of temporary disturbances in the balance of payments. He argued that by varying the rate of discount the currency commissioners could make the currency operate as they pleased, but thought it was a debatable question whether or not the currency should be made to follow long-run changes in the value of gold and silver.19 J. W. Bosanquet similarly advocated a paper currency which would follow the long-run trends in the value of gold, but not its short-run fluctuations. To realize this objective, he would meet temporary external drains out of the reserves or by temporary issues of notes under £5 in exchange for specie in the hands of the public. If this did not suffice, he would have the managers of the currency temporarily suspend convertibility. If the exchange then continued unfavorable by as much as ½ of 1 per cent for two uninterrupted years with both Paris and Hamburg, he would have the rate of discount on advances raised, but not to more than 6 per cent. In case the exchanges remained favorable for a substantial period of time, he would have the rate of discount reduced. He believed that under such a system the English price level could be kept from responding to temporary fluctuations in the world value of gold and in the balance of payments without involving ordinarily an appreciable departure of the paper currency from parity with gold. He did not himself attach importance to the maintenance of convertibility of the paper currency, but he thought that public opinion was not prepared to consider a complete departure from the gold standard.20

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Supporters of an orthodox metallic standard frequently level against advocates of inconvertible paper currencies the criticism that their zeal for “management” or “stabilization” of currencies tends to be confined to periods when prices are falling, and that in general they show more concern lest prices fall than lest they rise. This criticism appears to have substantial justification for the period here studied.21 But when the gold discoveries of the middle of the century resulted in rising prices and augmented gold reserves, some at least of the disciples of the Attwoods taunted the advocates of the currency principle with the charge that their policy was fostering an inflation which only a regulated inconvertible paper currency could prevent.22

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Besides that the speculation is curious, it may frequently be of use in the conduct of public affairs. At least, it must be owned that nothing can be of more use than to improve by practice the method of reasoning on these subjects, which of all others are the most important, though they are commonly treated in the loosest and most careless manner.—David Hume, “Of interest,” Political discourses, 1752.

I. Introductory

In this chapter an account will be presented of the history and the present status of the theory of the mechanism of adjustment of international balances, in terms throughout of the simplifying assumption of an international simple specie currency, i.e., with the circulating medium consisting solely of standard metallic money. It was in terms of this assumption that the theory was first presented, and it has served ever since as a convenient device whereby to segregate for separate treatment different problems connected with the mechanism. It should be noted that in this chapter, as throughout the book, the term “balance of payments” is used in its original sense of an excess of immediate claims on abroad over obligations to abroad, or vice versa, which must be liquidated by specie. It should be noted also that by a “disturbance” to international equilibrium will be meant a change in one of the elements in a preexisting equilibrium such as to require a new equilibrium, and that this change, whether it takes the form of a series of crop failures, of international tributes or loans, of new import duties, or of a relative change in the demands of the two countries for each other's products, is presumed to continue indefinitely, and its cessation is treated as a new change in the reverse direction. A wide variety of disturbances can be used to Edition: current; Page: [291] illustrate the theory of the mechanism of international trade, and each has its own sequence of stages and to some extent its own set of special problems. A selection must be made, therefore, and the reader is asked not to attribute to me or to the writers cited generalization of the conclusions reached from the analysis of cases specifically dealt with beyond what the context clearly shows to be intended.

The “classical” theory of the mechanism of international trade, as developed from Hume to J. S. Mill, is still, in its general lines, the predominant theory. No strikingly different mechanism, moreover, has yet been convincingly suggested, although there has been gain in precision of analysis, and some correction of undoubted error. In recent years, it is true, a number of writers have pointed out what they regard as major errors in the classical theory, and have claimed that to eliminate these errors would require major reconstruction of the classical doctrines. But the current notions as to what the classical doctrines actually were are, with respect to this as to other matters, largely traditional rather than the product of examination of the original sources, and even when, as sometimes happens, the critics do use classical texts as the basis for the interpretation of the classical doctrines, they confine their references almost wholly to Ricardo and to J. S. Mill, and to the compressed, elliptical, and simplified expositions of their doctrines which are to be found in short chapters, labeled as on international trade, in their Principles. But if an adequate notion of the classical doctrines as to the mechanism of international trade is to be had, it is necessary to examine the writings of other classical economists, and for Ricardo and J. S. Mill to read in their Principles beyond the chapters distinctly labeled as dealing with international trade and also to explore what they had to say on this subject elsewhere. It is also necessary to bear in mind that there were important differences of doctrine within the ranks of the classical economists themselves, so that on some important points it is impossible to find any one doctrine which can properly be labeled as the classical doctrine. The following account will, I trust, demonstrate that some at least of the much-emphasized discoveries and “corrections” of recent years either are to be rejected as erroneous or were current doctrine in the classical period.

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II. The Mechanism According to Hume

In so far as the classical theory of the mechanism of international trade had one definite originator, it was David Hume.1 His main objective in presenting his theory of the mechanism was to show that the national supply of money would take care of itself, without need of, or possibility of benefit from, governmental intervention of the mercantilist type. He started out with the hypothesis that four-fifths of all the money in Great Britain was annihilated overnight, and proceeded to trace the consequences. Prices of British commodities and British wages would sink in proportion; British commodities would consequently overwhelm foreign competition in foreign markets, and the increase in exports would be paid for in money until the “level of money” in Great Britain was again equal to that in neighboring countries. Assuming next that the money in Great Britain were multiplied fivefold overnight, he held that prices and wages would rise so high in England that no foreign countries could buy British commodities, while foreign commodities, on the other hand, would become comparatively so cheap that they would be imported in great quantities. Money would consequently flow out of England until it was again at a level with that of other countries. The same causes which would bring about this approach to a common international level when disturbed “miraculously” would prevent any great inequality in level from occurring “in the common course of nature.” The same forces also would preserve an approximately equal level as between different provinces of the same country. An additional, though minor, factor, operating to correct “a wrong balance of trade,” was the fluctuations in the foreign exchanges within the limits of the specie points. If the trade balance was unfavorable, the exchanges would move against England, and this would become a new encouragement to export. The entire mechanism was kept in operation by the profit motive of individuals, “a moral attraction, arising from the interests and passions of men,” acting under the stimulus of differences in prices.

The mechanism, therefore, was according to Hume automatically Edition: current; Page: [293] self-equilibrating, was intranational as well as international, was bilateral, involving adjustments both at home and abroad, and consisted of such changes in the volume of exports and imports, resulting chiefly from changes in relative prices but also in minor degree from fluctuations in exchange rates, as would bring about or maintain an even balance of trade, so that no further specie need move to liquidate a balance.

III. An Omitted Factor? Relative Changes in Demand as an Equilibrating Force

In Hume's account, changes in price levels thus play the predominant role in bringing about the necessary adjustment of trade balances, and are assisted only by fluctuations in exchange rates, held to be a factor of minor importance. In recent years a number of writers, most notably Ohlin, have contended that such an account leaves out of the picture an important equilibrating factor. These writers insist that much, or even all, of the equilibrating activity commonly attributed to relative price changes is really exercised by the direct effects on trade balances of the relative shift, as between the two regions, in the amounts of means of payments or in money incomes; that when disturbances in international balances occur, the restoration of equilibrium will or can take place unaccompanied by relative price changes or accompanied by only minor changes in relative prices; and that such changes if they do occur will not be, or are not likely to be, or need not necessarily be—which of these is supposed to be the fact is not always made clear—of the type postulated in the later classical doctrine as expounded by J. S. Mill or Taussig. While none of these writers seems to have applied his doctrine to a currency disturbance such as postulated by Hume, where the need for at least temporary price changes of some kind would seem most obvious, it may be assumed, nevertheless, that they would hold Hume's analysis of the mechanism to be inadequate even when confined to such cases.

It will be conceded at once that, in the case, for instance, of the initiation of continuing unilateral remittances, the aggregate demand for commodities, in the sense of the amounts buyers are willing to purchase at the prevailing prices, will, in the absence of price changes, fall in the paying country and rise in the lending Edition: current; Page: [294] country,1 and that unless there is an extreme and unusual distortion of the relative demands for different classes of commodities from their previous proportions this shift in demands will of itself contribute to an adjustment of the balance of payments to the remittances. The problem is rather to explain why this fairly obvious proposition should not sooner have received general recognition and to determine to what extent its recognition constitutes, as some contend, a major revolution in the theory of the mechanism requiring wholesale rejection of what the older writers had to say. To the first question, even though I have sinned in this connection myself, I have no answer, except that it is difficult to judge, after something has been clearly pointed out to us, how obvious it would or should be to others not so circumstanced. While, however, the account of the mechanism given by Hume and by many later writers gives no indication of recognition that the direct influence on the trade balance of relative changes in demands in the two countries would be an equilibrating factor, such recognition was by no means wholly lacking on the part of the major writers of the nineteenth century.

That imports pay for exports, and that an increase in imports, by providing foreigners with increased means of payment, would operate to increase exports, was pointed out even during the mercantilist period. But the following account will disregard incidental recognition of the relationship between amount of income and extent of demand, which has always been common, even with laymen, and will deal only with cases where such recognition is to be found incorporated as an integral part of a more or less formal exposition by nineteenth-century writers of the mechanism of adjustment of international balances.2

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Wheatley, Ricardo.—Henry Thornton, in 1802, had applied the Hume type of explanation generally to any type of disturbance of the balance of payments, and specifically to the disturbance resulting from a crop failure which made necessary greatly increased imports of grain,3 and to a change in the English demand for foreign commodities as compared to the foreign demand for English commodities.4 Wheatley and Ricardo, on the other hand, denied that this explanation was applicable to such disturbances of a non-currency nature and offered different explanations of the mechanism of adjustment to such disturbances. While Wheatley's discussion was in part earlier, Ricardo's was less significant for the point at issue, and it will be convenient to dispose of it first. Ricardo denied that crop failures or the payment of subsidies would disturb the balance of payments at all and denied, therefore, that any mechanism of adjustment would be necessary.5 The only justification for this position which he offered was that if a crop failure should be permitted to disturb the balance of payments, since the disturbance would prove to be temporary and after it was over things would be as they had been before, any movement of specie—and presumably also any corresponding change in relative price levels—would have to be offset later by a return movement of equal size, a waste of effort which would not be indulged in:

The ultimate result then of all this exportation and importation of money, is that one country will have imported one commodity in exchange for another, and the coin and bullion will in both countries have regained their natural level. Is it to be contended that these results would not be foreseen, and the expense and trouble attending Edition: current; Page: [296] these needless operations effectually prevented, in a country where capital is abundant, where every possible economy in trade is practiced, and where competition is pushed to its utmost limits? Is it conceivable that money should be sent abroad for the purpose merely of rendering it dear in this country and cheap in another, and by such means to insure its return to us?6

This exaggerates the extent to which individual traders can foresee whether a drain of gold would be temporary or not, or would find it in their interest to check it even if they were convinced that it was temporary.7 Seasonal movements of specie are still permitted to occur, even though their seasonal character is generally known.

Wheatley defended his denial that crop failures or foreign subsidy payments would disturb the balance of payments by more adequate reasoning. He maintained that crop failures, or the payment of subsidies, would immediately alter the relative demands of the two regions for each other's products in such manner and degree that the commodity balance of trade would at once undergo the manner and degree of change necessary to maintain equilibrium in the balance of payments. This shift in relative demand would result from the alteration brought about by the crop failure or the subsidy in the relative ability of the two countries to buy each other's commodities:

If, then, it be correct in theory, that the exports and imports to and from independent states have a reciprocal action on each other, and that the extent of the one is necessarily limited by the extent of the other, it is obvious, that if no demand had subsisted in this country from 1793 to 1797 for corn and naval stores, the countries that furnished the supply would have possessed so much less means Edition: current; Page: [297] of expending our exports, as an inability to sell would of course have created an equal inability to buy. It is totally irregular, therefore, to infer, that our exports would have amounted to the same sum, had the import of the corn and naval stores been withheld, as those who provided the supply would have been utterly incapable of purchasing them.8

On similar grounds, Wheatley held that under an inconvertible paper currency the exchanges would not be affected by a crop failure or the payment of a subsidy, and could move against a country only if there had developed a relative redundancy of currency in that country.9 Wheatley carried his doctrine so much further than he clearly showed to be justified that even the bullionists rejected it, and in doing so overlooked the important element of validity underlying it.

Longfield, Torrens, Joplin.—In 1840, Longfield, discussing the effect of increased imports of grain owing to a harvest failure in England, pointed out that this would result in a relative shift in the amounts of money available for expenditure in England and in the grain-exporting countries, and that this shift would contribute, even in the absence of price changes, to a rectification of the trade balance. Longfield denied, however, that this contribution would be sufficient to make price changes unnecessary:

A certain equilibrium exists between our average exports and imports. This is disturbed by the importation of corn. England suddenly demands a large quantity, perhaps six millions worth of corn. She may be ready to pay for them by her manufactures, but will those who sell it be willing to take those manufactures in exchange? Will the Prussian or Russian landowner, whose wealth has been suddenly increased, be content to expend his increased wealth in the purchase of an increased amount of English manufactures? We say that the contrary will take place, and that his habits will remain unchanged, and his increase of wealth will be spent in nearly the same manner as his former income, that is to say, not one fiftieth part in the purchase of English goods. His countrymen will, in the first instance, have the advantage of his increased expenditure. It will not be felt in England until after a long time, and passing through many channels.... Thus the English have six millions less than usual to expend in the purchase of the commodities which they Edition: current; Page: [298] are accustomed to consume, while the inhabitants of the corn exporting countries have six millions more.... The commodities, therefore, which the Russians and Prussians consume, will rise in price, while those which the English use will undergo a reduction. But a very great proportion, much more than nineteen-twentieths of the commodities consumed in any country, are the productions of that country. English manufactures will therefore fall, while Russian and Prussian goods will rise in price. The evil, after some time, works its own cure.10

Torrens, in 1841–42, in the course of an attempt to demonstrate that retaliation against foreign tariffs would be beneficial to England even if such retaliation did not lead foreign countries to reduce their tariffs, placed main emphasis on the role of relative price changes in adjusting the international balances to tariff changes, but in his well-known Cuban illustration the restoration of equilibrium was made to result directly from the relative shift in the amounts of means of payment, as well as indirectly from the relative shift in prices resulting from this shift in means of payment. He assumed, first, that all the demands for commodities in terms of money in each country had unit elasticity, and that Cuba was exporting to England 1,500,000 units of sugar, at a price of 30 shillings per unit, in return for 1,500,000 units of English cloth, at a price also of 30 s. per unit. Cuba then imposes a duty of 100 per cent on cloth, with the result that the price of cloth rises to 60 s. in Cuba, and the Cuban consumption falls by 50 per cent, to 750,000 units. Sugar continues for a time to flow to England at the original price and in the original quantity. There results an unfavorable balance of payments for England, and specie moves from England to Cuba. The price of sugar rises, and the price of cloth falls. The Cuban consumption of cloth increases to more than 750,000 units, apparently because of both the fall in the price of cloth and the increase in the amount of money available for the purchase of cloth in Cuba. Conversely, the rise in the price of sugar and the decrease in the quantity of money in England result in a decline in the English consumption of sugar to less than 1,500,000 units. Specie continues to flow from England to Cuba, the amount of money to fall in England and rise in Cuba, the price of cloth to fall and the price of sugar Edition: current; Page: [299] to rise, until the exports of cloth to Cuba had expanded and the exports of sugar to England contracted sufficiently to restore equilibrium in the balance of payments between the two countries. Under this final equilibrium, Cuba would be importing annually 1,500,000 units of cloth, at a price before duty of 20 s., and after duty of 40 s. per unit, and would be exporting 750,000 units of sugar at a price of 40 s. per unit.11 These results, it is to be noted, could not have resulted from the changes in prices alone, given the postulated elasticities of demand. They imply changes in money incomes in each country, and consequent changes in each country, the same in direction as the changes in money incomes, in the quantities which would be demanded of both commodities if the prices had remained unaltered.

Joplin, in his many tracts, repeatedly expounded the mechanism of adjustment of international balances in terms only of relative price changes, but in one passage, by exception, he stressed the direct influence on the course of trade of the relative change in demand for each other's commodities resulting from the transfer of money from one of the countries to the other, with the change in relative prices mentioned only as a by-product of, rather than as an essential factor in, the equilibrating process:

Now, when the balance of payments is against one and in favor of another nation, it arises from the inhabitants of the former having a greater demand for the productions of the latter, than the inhabitants of the latter have for the productions of the former. But after a transmission of the balance in money, an alteration must necessarily be experienced in the state of this demand. The inhabitants of the country from whence the money was sent would be unable, from their reduced monetary incomes, to purchase so large a quantity of the products of the money-importing country as before; while they, the inhabitants of the importing country, would be enabled, by the increase in their monetary incomes, to purchase more of the commodities of the nation from which the money had been received. Thus the trade would again be brought to a balance in money, and be thereby rendered an exchange of commodity for commodity: the nation receiving the money gaining by the improved terms on which the barter would be thereafter conducted.12

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J. S. Mill, Cairnes.—John Stuart Mill, in the exposition of the mechanism which he gives in his Principles, appears to attribute to relative changes in prices sole responsibility for bringing about a trade balance such as would restore equilibrium in a disturbed balance of payments.13 At one point, in fact, he appears explicitly to say so. Discussing a case where “there is at the ordinary prices a permanent demand in England for more French goods than the English goods required in France at the ordinary prices will pay for,” he states that “the imports require to be permanently diminished, or the exports to be increased; which can only be accomplished through prices.14 At another point, however, he expressly includes, as a factor operating to restore equilibrium, the relative shift in the amount of monetary income in the two countries resulting from the transfer of specie. He is tracing the consequences of a cheapening of the cost of production of a staple article of English production:

The first effect is that the article falls in price, and a demand arises for it abroad. This new exportation disturbs the balance, turns the exchanges, money flows into the country ... and continues to flow until prices rise. This higher range of prices will somewhat check the demand in foreign countries for the new article of export; and will diminish the demand which existed abroad for the other things which England was in the habit of exporting. The exports will thus be diminished; while at the same time the English public, having more money, will have a greater power of purchasing foreign commodities. If they make use of this increased power of purchase, there will be an increase of imports: and by this, and the check to exportation, the equilibrium of imports and exports will be restored.15

The ordinary interpretation of Mill's theory as explaining the adjustment of international balances solely in terms of relative Edition: current; Page: [301] price changes probably should be accepted, and this passage therefore regarded as indicating only an accidental perception by Mill at one moment of the presence in the mechanism of an additional factor rather than as a statement of an integral element in his theory. But it may be an error to do so. The exposition in the Principles is a restatement, in some respects less detailed, of an earlier exposition by Mill,16 in which the relative change in monetary income in the two countries resulting from a movement of specie is expressly incorporated in the exposition of the mechanism as, together with the elasticities of demand in terms of money prices, determining the extent of the response to price changes of the volume of purchases of each other's commodities by the two countries. Even here the emphasis is mainly on relative price changes, but this can in part be explained by the fact that Mill treats a rise in the prices of a country's own products as necessarily involving also a rise in its money incomes,17 as well as by the fact that he is here primarily concerned with the effects of disturbances on the “gains” from trade, rather than with the mechanism qua mechanism.18

Cairnes, in his better known expositions of the mechanism of international trade,19 makes no reference to the relative shift in means of payment, or in demands for commodities in terms of money, as a factor contributing to the adjustment of international balances. But in an earlier essay he emphasized the role it plays, and showed that he was aware that he was adding something not in the usual version:

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... it is not true that the motives to importation and exportation depend upon prices alone; and, should the fall in prices be very sudden and violent, I conceive its effect on the whole would be rather unfavorable than otherwise on the exportation of commodities. ... if any circumstance should occur to render industry less profitable, or to diminish the general wealth of the country, the means at the disposal of the community for the purchase of foreign commodities would be curtailed. Without supposing any alteration in prices, therefore, the demand for such commodities would decline and consequently the amount of our imports would fall off. And conversely, if the opposite conditions should occur, if the wealth of the country were to increase, we should each on an average have more to spend; a portion of this increased wealth, without necessarily supposing any fall in prices abroad, would go in extra demand for foreign commodities; and our imports would consequently increase ... and what takes place here will of course take place equally in foreign countries. It follows, therefore, that the relation between our exports and imports, and, by consequence, the influx and efflux of gold, depends not only on the state of prices here and abroad, but also on the means of purchase which are at the command, respectively, of home and foreign consumers.

[In the cases of crop failures, military remittances abroad, etc.] The transference of so much gold from this country to foreign countries—though it need not interfere to any great extent with the proceedings of commerce at home—yet alters the disposable wealth comparatively of this and other countries; their means of expenditure is proportionally altered, and consequently their demand for each other's goods. There is thus, in the circumstances attending a transmission of gold from this country, a provision made for its return, quite independently of the state of prices, or of the circulation....20

Bastable, Nicholson.—Bastable in 1889 defended, against Mill, Ricardo's doctrine that an international loan would not result in a transmission of specie or in relative changes in prices, by invoking the direct effect of the relative change in “purchasing power” or money incomes in the two countries on their trade balances:

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Suppose that A owes B £1,000,000 annually. This debt is a claim in the hands of B, which increases her purchasing power, being added to the amount of that power otherwise derived.... [It is also doubtful whether in case of interest payments or repayments of previous loans] Mill is correct in asserting that the quantity of money will be increased in the creditor and reduced in the debtor country. The sum of money incomes will no doubt be higher in the former; but that increased amount may be expended in purchasing imported articles obtained by means of the obligations held against the debtor nation.... Nor does it follow that the scale of prices will be higher in the creditor than in the debtor country. The inhabitants of the former, having larger money incomes, will purchase more at the same price, and thus bring about the necessary excess of imports over exports.21

A few years later Nicholson presented a similar criticism of Mill's reasoning, worked out in some detail, and accompanied by a denial, based on crudely fallacious reasoning, that price changes and specie movements played any part in the mechanism.22

A number of the most important nineteenth-century writers on the theory of international trade thus recognized that relative shifts in the amounts of means of payment, or of incomes, exercised, independently of relative price changes, an equilibrating role in the mechanism of adjustment of international balances to disturbances.23 But there were important divergences of doctrine between these writers. It was common doctrine for all of them that a change in relative money incomes resulting, say, from loans would contribute to the adjustment of the balance of payments to the loans through its influence on the relative demands of the two countries for each other's commodities. But one group (i.e., Edition: current; Page: [304] Ricardo, Longfield, J. S. Mill, Cairnes) either explained this shift in relative incomes as resulting from a prior transfer of money or conceded that a transfer of money would result from it, whereas another group (Wheatley, Bastable, and Nicholson, and, at one point, Cairnes) denied that any transfer of money need take place. One group (Longfield, Joplin, Cairnes, J. S. Mill) left an important place in the mechanism for relative price changes, whereas another group (Wheatley, Ricardo, Bastable, Nicholson) denied, or questioned, the necessity of relative price changes for the restoration of equilibrium.

In the later literature there continue to be presented explanations of the mechanism of adjustment which do and others which do not assign an equilibrating role to the relative shift in demands, and some writers who at one time take pains to point out its significance at other times permit it to drop out of their exposition and revert to an explanation in terms solely of relative price changes. Mainly owing to Ohlin, however, there has been a growing awareness of the issue, and an increasing readiness to give weight to this factor.

Taussig, Wicksell.—In an article published in 1917, and dealing primarily with the mechanism of adjustment under a paper standard currency, Taussig argued that in the case of an international loan under a metallic standard that part of the proceeds not used immediately by the borrowers in purchase of foreign goods would enter the borrowing country in the form of goods only after a remittance of specie from lender to borrower had raised prices in the borrowing country and lowered them in the lending country.24 In a reply to this article, Wicksell claimed that the increased demand for commodities in the borrowing country, and the decreased demand for commodities in the lending country, would “in the main” be sufficient to call forth the changes in the trade balance necessary to restore equilibrium in the balance of payments. He held that it would not make any difference if the increased power of purchase in the borrowing country were directed toward its own products rather than imported products:

... this of course would diminish the imports, but if the value of imports surpasses the value of exports by precisely the amount borrowed Edition: current; Page: [305] during the same time, there would be no occasion for sending or receiving gold.

Gold would move to the borrowing country, but only because, and after, it had acquired additional commodities, and not before the transfer of the loan in the form of goods.25

Taussing, in his brief rejoinder, confined his discussion in the main to other points and did not adequately meet the fundamental issue raised by Wicksell as to the role played by changes in demand in the equilibrating process. To Wicksell's denial of the necessity of specie movements at an early stage of the process of adjustment, he made an effective reply: “I find it difficult to conceive how ‘increased demand for commodities’ will cause a rise in the price of commodities, unless more money is offered for them; and no more money can be offered for them unless the supply of money is larger.” 26 This may seem to imply an acceptance by Taussig of Wicksell's doctrine at least to the extent of recognition that changes in demand do play an equilibrating part aside from price changes, for if there is an increase in demand it operates to increase the amount taken at the same prices as well as to increase the prices, but I cannot find a clear statement to this effect either here or in his later writings. Taussig also pointed out that Wicksell's denial of the possibility that relative price changes could be an important equilibrating factor, since, transportation costs aside, commodities tend to have uniform prices everywhere, overlooked the existence of “domestic” commodities not entering into international trade, whose price movements could diverge from the movements of the prices of international commodities and thus contribute to the establishment of a new international equilibrium.27

“Canada's Balance.”—In 1924, reviewing this discussion between Wicksell and Taussig, I conceded, as had Taussig in his original article, that to the extent that the new spendable funds Edition: current; Page: [306] in the borrowing country resulting from the loan were used in the purchase of foreign commodities which otherwise would not have been imported there would be a contribution to adjustment independent of relative price changes. I also accepted the argument, which I attributed to Wicksell,28 that the use of the proceeds of the loans to purchase home-produced commodities which otherwise would have been exported would similarly contribute to adjustment. I concluded, however, that there was no a priori reason to expect that these two factors would suffice to bring about adjustment, on the grounds that: (1) the theoretical expectation would be that in the absence of price changes the same percentage of the additional, as of the original, spendable funds would be used in the purchase of “domestic” or non-international commodities; and (2) unless in the absence of price changes none of the borrowed funds would be used in the purchase of “domestic” commodities, there could not be adjustment of the balance of payments without relative price changes.29 As will appear later, this last proposition was an error, resulting from my failure, at this point,30 to bear in mind that a diversion of productive factors from production of exportable commodities for export to production of domestic commodities for domestic consumption would, by restricting the volume of exports, contribute as much to the adjustment of the balance of payments as would an Edition: current; Page: [307] equivalent increase of imports or of domestic consumption of products hitherto exported.

Keynes, Ohlin.—The discussion of the transfer aspect of the German reparations problem gave rise to intensified discussion of this issue, but the contributions of Ohlin and Keynes can alone be dealt with here. Ohlin, in an article published in 1928, laid strong emphasis on the role which a relative shift in demand for commodities, in terms of money, upward in the receiving countries, downward in Germany, would play in adjusting the German balance of payments to the reparations payments, thus making relative price changes adverse to Germany a subsidiary and probably unnecessary part of the mechanism, and easing the task of transfer of the reparations in the form of goods.31 In this article, it appears to me, he took a position with respect to the lack of significance of relative price changes in the international mechanism more extreme than the treatment in his later book (which still seems extreme to me). He argued that when international unilateral remittances occurred a change in price favorable to the paying country was as likely to take place as one unfavorable to that country, and that in the absence of knowledge of the particular circumstances it must be presumed that no relative change in prices will occur.32 He further claimed that even if a relative price change unfavorable to the paying country did occur, it would only be at the beginning of the payments, and would not persist long enough to be significant.33

In 1929, Keynes, in a pessimistic article on the possibility of transfer of the German reparations, which stressed the difficulties which Germany would encounter even if she succeeded in providing for the payments in her government budget, did not take into account, as a factor facilitating economic transfer of the payments, the shift in the demands for commodities which would result from an initial transfer of means of payment from Germany to the receiving countries. Ohlin replied, invoking this shift as a Edition: current; Page: [308] factor which would lessen the seriousness of the transfer problem, and there resulted a further exchange of views between the two writers, in which neither succeeded in converting the other.34 Ohlin did not state his views as clearly as he has since presented them, and on one essential point he made an unnecessary concession to Keynes.

Keynes reasoned throughout, on the conventional lines, as if the only factor tending to adjust the German trade balance to its reparations obligations could be an increase in German exports relative to imports resulting from a fall in German prices relative to outside prices. Taking an extreme case to emphasize his point, namely, where the foreign (simple “Marshallian”) elasticity of demand for products of Germany was assumed to be less than unity, and abstracting from the possibility of a reduction in the value of German imports, he concluded that “in this case, the more she exports, the smaller will be the aggregate proceeds. Again the transfer problem will be a hopeless business” —i.e., the reparations in this case could not be transferred even if relative price changes did occur. Keynes therefore concluded that the elasticities of demand of the two countries might be such as to make transfer in kind wholly impossible, and that for such transfer to take place in any case, “the expenditure of the German people must be reduced, not only by the amount of the reparation-taxes which they must pay out of their earnings, but also by a reduction in their gold-rate of earnings below what they would otherwise be,” that is, German money wages, etc., must fall even aside from taxation thereof.35 This Ohlin denied.

At a later stage of the controversy, Keynes explained that he had attributed little (no?) importance to changes in demand conditions, because he had assumed that Germany was not in a position to export large quantities of gold, and because if Germany did ship gold her products would have to share the benefits of the resultant increase in demands outside Germany with the products of the rest of the world, so that the gain to her export trade Edition: current; Page: [309] would be negligible.36 To this it could be replied that the ratio of gold shipments to aggregate reparations payments over the entire period would not have to be large, since a given transfer of gold will continue to keep up the level of foreign demand in terms of money for German goods by some fraction (or multiple) of itself per unit period as long as the gold stays abroad; it will operate not only to raise the foreign demand for German goods but to decrease the German demand for foreign goods; and if in the first instance all, or most, of the receiving country's increase in demand is directed to the products of third countries, these countries will acquire the specie surrendered by Germany, and their demands for foreign commodities, including those of Germany, will rise. But Keynes, apparently to the last, failed to understand Ohlin's argument that the initial transfer of specie, or its equivalent, would result in a relative shift in an equilibrating direction of the demands in terms of money prices of the two countries for each other's products, regardless of their elasticities. He still argued that if the world's demand for German goods had an elasticity of less than unity, “there is no quantity of German-produced goods, however great in volume, which has a sufficient selling-value on the world market, so that the only expedient open to Germany would be to cut down her imports.” 37 But elasticity of demand of less than unity for German exports would set a definite limit on the value of such exports only if no increase in the foreign demand for German commodities in terms of money Edition: current; Page: [310] resulted directly from the transfer abroad by Germany of specie.38

The failure of the two writers to make themselves clear to each other, and especially the failure of Ohlin to convert Keynes, was probably due in part to an ambiguous and otherwise unsatisfactory use by both writers of the treacherous term “purchasing power.” Ohlin's argument that a relative shift in demand for each other's products would occur rested on the doctrine that the payment of reparations would commence with a transfer of “purchasing power” from Germany to the receiving countries and that the resultant relative change in the amounts of “purchasing power” in the respective areas would bring about this relative shift in demands for commodities. In reply, Keynes presents a hypothetical case, where Germany, having succeeded by some means in developing a net export surplus of £25,000,000, meets her reparations obligations to the extent of £25,000,000 out of the proceeds of this export surplus. Exploiting to the full the ambiguities of the term “buying power,” he then claims that “the increased ‘buying power,’ due to the fact of Germany paying something ... will have been already used up in buying the exports, the sale of which has made the reparation payments possible,” whereas “Professor Ohlin has to maintain that the ‘increased buying power’ is more than £25,000,000, and—if his repercussion is to be important—appreciably more.” 40 Ohlin, instead of pointing out that the increase of “buying power” in France which could be counted on to bring about real transfer of Edition: current; Page: [311] reparations would precede rather than follow the real transfer, and would not be “used up” by the French import surplus of a particular year, merely replied: “Surely it is easier to sell many goods to a man who has got increased buying power, even though after buying them he has no longer greater buying power than he used to have!” 40 a reply which conceded too much to Keynes, and left his argument intact instead of refuting it.

For Keynes, the real transfer of £25,000,000 of reparations was due to a fortuitous development of an export surplus by Germany, payment for which Germany was willing to accept in credits against her reparations liabilities. Suppose, however, that Germany's first step in her attempt to meet her reparations obligations was the payment of £25,000,000 in gold to France, and that in France this increase in gold had its normal effects on the total volume of means of payments. Suppose also that thereafter at each reparations payment date, Germany credited France anew with £25,000,000 in German funds at German banks. Frenchmen would now have both increased willingness to buy German goods at the same prices and increased power to pay for them in French currency, and there would therefore tend to be recurrent French import surpluses with respect to Germany. These import surpluses could be liquidated internationally by drafts against the reparations credits in favor of France periodically set up by the German government in German banks. As long as Germany continued, in the narrow financial sense, to meet her reparations obligations, the increase in the French willingness to buy and power to pay, as compared to the pre-reparations situation, would never be “used up,” but would be everlasting. But the question of the place of willingness to buy and power to pay for foreign commodities in the mechanism of transfer of unilateral payments will be dealt with in a more fundamental manner later, after a needed digression on the role of price changes in the mechanism.

IV. Prices in the Mechanism: the Concept of “Price Levels

An adequate exposition of the role of price changes in the mechanism of international trade as it affects a particular country Edition: current; Page: [312] would explain both what would be the necessary relationship under equilibrium between prices in that country and prices abroad, and in what manner if any fluctuations of prices would contribute to, or would be associated with, the restoration of equilibrium when it had been disturbed. In tracing the development of doctrine on these questions, it is once more convenient to begin with Hume. For our present purposes it is convenient to accept as the predominant criterion of equilibrium in international trade under an international metallic standard a situation in which there is an even balance of payments, i.e., no flow, and no tendency to flow, of bullion or specie from country to country.1

Hume held that when the balance of payments of England with the outside world was even, the “level of money” in England and in neighboring countries would also be equal, subject to minor qualifications. The mechanism of international trade operated to bring money to a common level in all countries, just as “all water, wherever it communicates, remains always at a level.” Hume meant by “level of money” the proportion between money and commodities:

It must carefully be remarked, that throughout this discourse, whenever I speak of the level of money, I mean always its proportional level to the commodities, labor, industry, and skill, which is in the several states. And I assert that where these advantages are double, triple, quadruple, to what they are in the neighboring states, the money infallibly will also be double, triple, quadruple.2

Modern usage makes it tempting to translate “level of money” by average value or purchasing power of money as against commodities in general, with some statistical average of prices as its reciprocal. But this would be an anachronism as far as Hume, or even as the classical school as a whole, was concerned. Hume wrote before the first attempt in England, that of Evelyn in 1798, to measure changes in price levels by means of statistical averages.3 Even after 1798, the leading economists until the time of Edition: current; Page: [313] Jevons either revealed no acquaintance with the notion of representing, by means of statistical averages, either a level of prices, or changes in such level, or found it inacceptable for various reasons, good and bad.4 While a number of crude index numbers were constructed during the first half of the nineteenth century, none of the classical economists, with the single exception of Wheatley, would have anything to do with them.5

Hume's use of the term “level” troubled some of the classical economists. Wheatley claimed that Hume was inconsistent in arguing both that money everywhere maintained its level and that one country might retain a greater relative quantity than another, “which is incompatible with the nature of a level.” 6 Ricardo, in his published writings, seems to have avoided the use of the term “level” for the general state of prices, although he used it in this sense freely in his private correspondence.7 He refused to acknowledge that there was any satisfactory way of comparing the value of money, or of bullion, in different countries:

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When we speak of the high or low value of gold, silver, or any other commodity in different countries, we should always mention some medium in which we are estimating them, or no idea can be attached to the proposition. Thus, when gold is said to be dearer in England than in Spain, if no commodity is mentioned, what notion does the assertion convey? If corn, olives, oil, wine, and wool, be at a cheaper price in Spain than in England, estimated in those commodities, gold is dearer in Spain. If, again, hardware, sugar, cloth, &c., be at a lower price in England than in Spain, then, estimated in those commodities, gold is dearer in England. Thus gold appears dearer or cheaper in Spain, as the fancy of the observer may fix on the medium by which he estimates its value.8

Malthus denied that money necessarily maintained a uniform level in different countries, if by uniformity of level was to be understood necessary equality of the prices of some specified commodity or of the “mass of commodities.” 9

What then were the views of the classical writers with respect to the relationship of prices and of the value of gold in different countries? The following seems to be a correct interpretation of their general position: (1) When they speak of the value of money or of the level of prices without explicit qualification, they mean the array of prices, of both commodities and services, in all its particularity and without conscious implication of any kind of statistical average; (2) when they postulate a tendency for the uniformity of the value of money, or of prices, in different countries, they have reference only to particular identical commodities taken one at a time, and only to transportable commodities, and they claim such a tendency for uniformity only subject to allowance for transportation costs both for the commodities and for the specie; (3) where the monetary units are not the same, or where different standards are in use, they postulate uniformity in the prices of identical commodities only after conversion into a common currency unit at the prevailing rate of exchange, and they postulate uniform ratios between the prices of different transportable commodities in the currencies of the respective countries.10

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Most of these propositions are implied in the following passage from Hume:

The only circumstance that can obstruct the exactness of these proportions, is the expense of transporting the commodities from one place to another; and this expense is sometimes unequal. Thus the corn, cattle, cheese, butter, of Derbyshire, cannot draw the money of London, so much as the manufactures of London draw the money of Derbyshire. But this objection is only a seeming one; for so far as the transport of commodities is expensive, so far is the communication between the places obstructed and imperfect.11

In spite of the obscurity of his exposition, it seems clear that Ricardo would have subscribed to these propositions, and that where occasional statements in his writings appear to conflict with them the inconsistency is only apparent. Thus Ricardo says at one point that “the value of money is never the same in any two countries” and that “the prices of the commodities which are common to most countries are also subject to considerable difference” 12 but the context shows that he had in mind the differences in different countries in the purchasing power of gold over particular commodities which were due to the cost of transporting gold, to bounties and tariffs, to the cost of transporting goods, and to the existence of non-transportable “home commodities” which, according to him, would be higher in price in countries where the effectiveness of labor in export industries and therefore also the wages of labor were comparatively high, and he included as an element in the value of money its purchasing power in terms of labor, which he assumed to be a non-transportable commodity.13 In a letter to Malthus, Ricardo conceded that the situation suggested by Blake, where gold moved from France to England although the value of gold in terms of commodities was constant in France and rising in England, was possible though improbable, and explained the possibility of such divergent trends of the value of gold by reference to the transportation costs of commodities and the existence of non-transportable commodities.14

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Wheatley held that in the absence of tariff barriers “corn and manufactures ... would always be brought, or have a constant tendency to be brought to the same proportion and price in all countries, with the exception of the charge of transit between them. A difference to the extent of this charge might always exist; but if trade were open, the difference in the price of corn and manufactures, in any two countries, could never exceed the expense of bringing in the one and taking out the other.” 15

The classical school and its important followers all held the same views on this point: after allowance for transportation costs, the market prices of identical transportable commodities must everywhere be equal or tend to be equal when expressed in or converted to a common currency.16 When, therefore, critics of the classical theory have taken it to task on the ground that it explained the adjustment of international balances by the influence on the course of trade of divergent market prices in different markets of identical transportable commodities,17 or Edition: current; Page: [317] when followers of the classical theory have attempted to defend it although themselves giving it such an interpretation,18 they have misinterpreted the classical doctrine.

When costs connected with transportation, including tariff duties as such, are taken into account, prices in two markets for identical commodities can vary independently of each other within the limits of the transportation costs in either direction between these markets, except as a connection of both markets with a third market may impose narrower limits. Assuming only two markets, A and B, a cost of transportation from A to B of m, and from B to A of n, and a technological possibility of the production of the commodity in either A or B, and it is possible, (1) when Pa is the price in A, for the price in B to be anywhere from Pa+m to Pan, and (2) when Pb is the price in B, for the price in A to be anywhere from Pb+n to Pbm. If the commodity is regularly moving from one market to the other, the price in the buying market must obviously be higher than the price in the selling market by exactly the cost of transportation, but the possibility of reversal of direction of movement, or of cessation or initiation of movement because of substitution in one country of domestic production for import or of import for domestic production, makes the double-transportation-cost range of possible relative variation in price potentially of practical significance.19

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It may be objected that some difference, slight though it may be, must exist between the market prices of identical commodities in different regions, even in the absence of transportation costs, if there is to be any inducement to move the commodities from one region to the other. This is not true, however, with respect either to intranational or to international trade. When there is no intermediary between buyer and seller, the selling price and the buying price, f.o.b., are the same price whether the buyer is here or abroad. The only difference in price necessary to induce export from A to B of a particular commodity, transportation costs being assumed to be zero, is an excess in the actual or potential supply price at which B can procure the commodity from any source other than A in the quantities required by B over the price at which it can be procured from A.

Such changes in relative sales prices of identical commodities in different markets as may occur within the limits of the transportation costs and may result in the complete cessation or initiation of movement, or in a reversal of the direction of movement, of the particular commodities affected, can ordinarily be a minor, but only a minor, factor in bringing about adjustments of the course of trade to disturbances of moderate duration such as international loans. It is relative changes in the supply prices of identical commodities as between different potential sources of supply, and, above all, relative changes in the actual sales prices of different commodities which, through their influence on the direction and extent of trade, exercise a significant role in the mechanism of adjustment of international balances.

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V. The “Terms-of-Trade” Concept

In the classical theory, the discussion of the role of variations in prices in the mechanism of adjustment of international balances relates not to relative variations in prices of identical commodities in different markets, but to relative variations in prices of different commodities in the same markets, and primarily to relative variations in prices as between export and import commodities. It concerns itself, therefore, with the effect of disturbances on what are now called the “terms of trade.” Changes in the terms of trade were discussed, however, with reference to two essentially distinct though related problems; first, their role in the mechanism of adjustment and, second, their significance as measures of gain or loss from foreign trade. It is only the former of these problems that concerns us in this chapter.1

The most familiar concept of the terms of trade measures these terms by the ratio of export prices to import prices, what Taussig has called the “net barter terms of trade,” and I prefer to designate as the “commodity terms of trade.” The classical economists, however, had also another concept of terms of trade, for which they tacitly accepted the commodity terms of trade as an accurate measure, so that they used the two concepts as quantitatively identical although logically distinct. This second concept, which I would designate as the “double factoral terms of trade,” is the ratio between the quantities of the productive factors in the two countries necessary to produce quantities of product of equal value in foreign trade.

From Hume on, there was general agreement that some or all types of disturbances in international balances would result in changes in the terms of trade, and that these changes would contribute to the restoration of equilibrium. As has been shown, Hume held that a relative change in the quantity of money in one country as compared to other countries would result in a rise in the prices of its products relative to the prices of foreign products, until, as the result of the influence of this relative change in prices on the course of trade and on the flow of specie, the “level of money” had again been equalized internationally. Edition: current; Page: [320] This was almost universally accepted doctrine during the next century. Thornton and Malthus claimed, with Wheatley and Ricardo dissenting, that a similar change in relative prices would occur and would operate to restore equilibrium in the balance of payments when it had been disturbed by a crop failure or the remittance of a subsidy, and this also came to receive wide acceptance, under the erroneous designation of the “Ricardian theory.” Ricardo conceded, however, that there were some types of disturbance in an existing international equilibrium other than those originating in the currency which would affect the terms of trade, and he specified an original change in the relative demand of two countries for each other's products and a tariff change as disturbances of this sort.2 There is ground for distinguishing in this connection between different types of disturbances, and Ricardo's distinctions have some measure of validity. In the account which follows of later treatments of the question, only the historically most important controversies are referred to.

Irish Absenteeism.—The economic consequences for Ireland of the absenteeism of Irish landlords was a burning issue in the eighteenth and nineteenth centuries and gave rise to extensive discussion. The Irish complaints against absenteeism often rested on mercantilist arguments to the effect that the remittance of the rents abroad represented an equivalent loss of specie to Ireland. The English classical economists, notably McCulloch, tended to be satisfied that when they had demonstrated that the remittances were ultimately transferred in the form of goods rather than in specie they had also demonstrated that absenteeism was not economically injurious to Ireland. An early instance of this argument follows:

When it is considered that, if in the natural order of things, undisturbed by such a measure as the restriction on specie, the remittances to absentees, by causing a balance of pecuniary intercourse Edition: current; Page: [321] against Ireland, would force an export from thence wherewith to pay it, and restore the level, it may be fairly concluded that the absentees, by bringing over their money to England, force the manufacture or produce to follow them, which, but for their coming, they would necessarily have caused to be used at home, the only difference is, that the produce or manufactures which their incomes naturally promote, would come to be consumed or used in England, in the stead of being consumed or used in Ireland; and thus the encouragement to the productive industry of Ireland may be said to operate in both cases ... 3

Longfield4 introduced into the controversy the question of the effect of absenteeism on the Irish terms of trade, apparently for the first time in print.5 He insisted that it was important to examine whether the increase in Irish exports resulting from absenteeism took place “in consequence of a diminished demand [for Irish products] at home, or an increased demand abroad,” and claimed that the former was the case, because Irish landlords living abroad would not have the same demand for Irish commodities and services as would the same landlords if living in Ireland. In order to induce acceptance of the rents in goods instead of money, therefore, the Irish tenants would have to offer more Edition: current; Page: [322] goods to liquidate their indebtedness to absentee landlords than would be necessary if the landlords lived in Ireland, i.e., there would have to be a fall in the prices of Irish export products relative to the prices of imports.6

Tariff Changes.—Torrens's discussion of the effect of a tariff on the terms of trade has already been referred to.7 In his basic illustration, Torrens assumed unit elasticities of demand for sugar and cloth in both countries, production of sugar only in Cuba and of cloth only in England, and production under conditions of constant costs for both countries, and he concluded that both the commodity and the factoral terms of trade would move in favor of Cuba, the tariff-levying country. His argument was on the whole received unsympathetically by most of the economists of his time, because it seemed to them to undermine the case for free trade.8 But their criticisms, in so far as they were deserving of consideration at all, bore only on the conformity of the assumptions to real conditions. Of these criticisms, the most important was the argument by Merivale that if sugar could be produced in England as well as in Cuba, or if a third country which could produce sugar were brought into the hypothesis, the English elasticity of demand for Cuban sugar would be greatly increased, and the shift in the terms of trade in favor of Cuba would in consequence be much lessened in degree.9 The only favorable comments on Torrens's argument were by an anonymous writer in the Dublin University magazine,10 who may perhaps have been Longfield, and by J. S. Mill, who made the publication of Torrens's The budget the occasion for the publication of his own Essays on some unsettled questions, which had been written some fifteen years before, and of which the first essay presented a similar argument as to the effect of import duties on the terms of trade.

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VI. The Prices of “Domestic” Commodities

While the distinction between “domestic” commodities and those entering into international trade dates at least from Ricardo,1 and subsequent writers made clear that international uniformity in the prices of identical commodities after allowance for transportation costs was a necessary condition under equilibrium only for “international” commodities,2 Taussig was the first to lay emphasis on the significance for the mechanism of adjustment of international balances to disturbances of changes in the level of domestic commodity prices as compared to the prices of international commodities. In 1917, Taussig argued that some of the proceeds of an international loan would ordinarily be directed in the first instance to the purchase of domestic commodities, instead of import commodities. But in order that the loan should be transferred wholly in the form of goods, it was necessary that there should develop an excess of imports over exports equal to the amount of the borrowings, and this could not occur if part of the proceeds of the borrowings continued to be directed to purchases of domestic goods. The increased purchases of domestic goods would raise their prices, however, relative to other commodities, and the rise in prices of domestic commodities as compared to international commodities, as well as the rise in export prices as compared to import prices, would operate to decrease exports, increase imports, sufficiently to effect a transfer of the loan in the form of goods.3

In my Canada's balance, I conceded that the increase in means Edition: current; Page: [324] of payment in the borrowing country would, even in the absence of price changes, result in both a decrease in exports and an increase in imports. I claimed, however, that in the absence of price changes and of special circumstances it was to be expected that the borrowings abroad would not disturb the proportions in which the total purchasing power in the borrowing country, including that derived from the loan, would be used in buying domestic and foreign commodities; and I claimed further that without a change in these proportions the direct effect of the transfer of means of payment would not suffice fully to adjust the balance. I held, therefore, that there would have to occur relative price changes of the type postulated by Taussig, namely, for the borrowing country, a rise of export prices relative to import prices and of domestic commodity prices relative to both export and import prices.4

To my statement that, in the absence of price changes, it was theoretically to be expected that increase in the amounts available for expenditure by the borrowing country would not result in a change in the proportions in which these expenditures were distributed among the different classes of commodities, it has been objected that “there are ample grounds to dispute this view,” 5 and that “there is every reason to believe, on the contrary, that borrowings abroad would disturb the proportions.” 6 But this statement was not intended to be a denial of the obvious fact that there were an infinite number of proportions in which the increased funds could conceivably be divided among the three classes of commodities, nor even as an assertion that in the absence of price changes the probability that the proportions in which the expenditures were divided among the three classes of commodities would not be disturbed was greater than the probability that these proportions would be disturbed, i.e., was greater than all the other probabilities combined. The probability that the Edition: current; Page: [325] proportions would be disturbed is obviously infinitely greater than the probability that they would not be. If an indifferent marks-man aims at a distant target, the probability that he will hit the bull's-eye is, on the basis of experience, small. But it is nevertheless much greater than the probability that he will hit any other single spot in the universe, and if a forecast of his shot must be made, the probable error will be minimized if, in the absence of a known bias in his marksmanship or in the conditions governing his shooting, it is forecast that he will hit the bull's-eye.7 The assumption that, in the absence of price changes and of known evidence to the contrary, the amounts available for expenditure in each country would after their increase or decrease be distributed among the different classes of commodities in the same proportions as before still seems to me more reasonable than any other specific assumption. It represents what Edgeworth in another connection described as “a neutral condition between two conditions of which neither is known to prevail.” 8 But this assumption was not sufficient to justify such definite conclusions as I drew from it, and in occupying themselves with the assumption instead of with the partly erroneous inferences I based upon it my critics have directed their ammunition at the wrong target.

The existence of domestic commodities affects the mechanism of adjustment only as it affects the manner in which the amounts available for expenditure are apportioned as between native9 and foreign products. The assumption of the existence of domestic commodities is not essential to any valid theory of the general mechanism of adjustment of international balances to disturbances; and certainly no quantitative proposition as to their importance relative to international commodities need be incorporated in an abstract explanation of the mechanism. But if “domestic” commodities do exist, certain important consequences ensue, and it becomes necessary to take specific account of them in the analysis. For a commodity to be a “domestic” commodity, be it noted, it is not necessary that its prices be wholly independent Edition: current; Page: [326] of the prices of similar commodities abroad, or of the prices of competitive or of complementary international commodities at home. If this were the case, there could obviously be no “domestic” commodities in a world in which all prices are parts of an interrelated system. It suffices to make a commodity a “domestic” commodity if it ordinarily does not cross national frontiers and if its price is not tied directly to the prices of similar commodities abroad in such manner that there is always a differential between them approximating closely to the cost of transportation between the two markets.10

That in the United States, for instance, there is an extensive and important range of commodities (including services) available for purchase whose prices are capable of varying within substantial limits while the prices of identical or similar products or services in other countries remain unaltered, seems to me so obvious that it would not require restatement had it not been disputed. One writer11 has claimed, however, not only that the existence of a substantial range of domestic commodities is a vital assumption of the ordinary theory of the mechanism but that such an assumption is contrary to the facts. But the evidence he offers in support of his argument consists only of an irrelevant demonstration that the prices in different markets of identical commodities actually moving in international trade in constant directions are bound together in a close relationship.

VII. The Mechanism of Transfer of Unilateral Payments in Some Recent Literature

Recent discussion of the problem of the effect of international unilateral payments on the terms of trade has made it clear that the older writers (including myself) had not sufficiently explored Edition: current; Page: [327] the problem and had failed to realize its full complexity. There follows an account of some recent attempts at a more definitive solution of the problem.1

Wilson.—Wilson examines the effects on relative prices, and especially on the commodity terms of trade, of trade, of a continued import of capital, with the aid of an elaborate series of arithmetical illustrations of an ingenious type.2 He concludes that relative price changes will ordinarily be necessary for restoration of equilibrium, but that the type of change will depend on the particular circumstances of each case, and may be unfavorable the paying country. He believes that he demonstrates that the changes in export and import prices, relative to each other, make no direct contribution to bringing about a transfer of the loan in the form of goods instead of in money, but that the role of these changes is solely to determine for each country to what extent the transfer shall take place through a change in exports or a change in imports, and to bring the two countries to a uniform decision, and that it is the relative changes in prices between domestic and international commodities which, together with the shift in demands resulting from the transfer of means of payment from lender to borrower, brings about the transfer of the loan in the form of goods.3 Wilson's account marks a distinct advance over previous attempts, because it takes more of the variables simultaneously into account and deals with some of them with a greater measure of precision of analysis than had previously been achieved. While he carries the problem forward toward a solution, there are, however, some defects in his mode of analysis which seriously detract from the significance of the concrete results which he obtains.

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Wilson's mode of analysis and the nature of the results which he obtains can for present purposes be made sufficiently clear by reference to two of his arithmetical examples, I and IV,4 which are here presented in somewhat modified form to simplify the exposition. It is assumed in both examples that production is under conditions of constant cost; that in the absence of price changes the transfer of the payments will not change the proportions in which either country would desire to distribute its expenditures as between the classes of commodities available to it; and that the amount to be paid is 9 monetary units. In Wilson's example I there are no domestic commodities in either country, while in his example IV there are domestic commodities in each country. Purchases are measured in monetary units uniform for both countries. The paying country's export commodity is represented by P, and its domestic commodity by Dp; the receiving country's export commodity is represented by R, and its domestic commodity by Dr.

Wilson'S Example I: No Price Changes Necessary
Paying country Receiving country
Commodity Purchases before payment Purchases after payment if no price changes occurred Purchases before payment Purchases after payment if no price changes occurred
P............ 60 54 30 36
Dp............ .. .. .. ..
Dr............ .. .. .. ..
R............ 30 27 15 18
Total............ 90 81 45 54

Granted Wilson's assumptions, his example I is an adequate demonstration of the possibility that payments can be transferred without resulting in any movement of the terms of trade. Under the conditions given, the receiving country is willing in the absence of price changes to increase its purchases of each of the commodities to an extent just sufficient to offset the decreases in Edition: current; Page: [329] purchases by the paying country, and therefore no price changes are necessary for the restoration of equilibrium. This example suggests a general principle already formulated by a previous writer in this connection that “If the borrower wants what the lender does without, no change in prices is necessary.” 5 It is to be noted, however, that in example I one of the countries spends a substantially larger amount on foreign than on native commodities. It will be found upon experimentation that, given the assumption that in the absence of price changes the international loan or tribute will not cause either country to desire a change in the proportions in which it had hitherto distributed its expenditures between native and imported commodities, the transfer of the loan or tribute will necessarily result in a movement of the terms of trade unfavorable to the paying country unless before reparations the unweighted average ratio of expenditures on native to expenditures on foreign commodities for the two countries combined is unity or less, an improbable situation when there are domestic commodities.

In example I there were assumed to be no domestic commodities. To show that his conclusion—that the transfer of payments will not necessarily involve a movement of the terms of trade against the paying country and may even involve a movement of the terms of trade in its favor—is not dependent on the assumption that there are no domestic commodities, Wilson presents his example IV, in which domestic commodities are introduced for both countries but otherwise the same assumptions are followed as for example I.

Comparing separately for each commodity the amounts which in the absence of price changes the two countries combined would be willing to purchase after the payments with the amounts they purchased before the payments, Wilson concludes that while the price of the receiving country's domestic commodity would rise, and the price of the paying country's domestic commodity would fall, the aggregate demand for the receiving country's export commodity will at unaltered prices have fallen more (from 60 to 58) relatively than the aggregate demand for the paying country's export commodity (from 50 to 49) and therefore the price of the former will probably have to fall relatively to the price of the Edition: current; Page: [330] latter to restore equilibrium. For the relations of the price levels of the internationally-traded commodities, he reaches the general conclusion that: “No matter what be the original proportions of total demand, that class of goods will be higher relatively in price to the other, for which the borrowing country has the greater relative demand as compared with the lending country.”6

No significance can be attached, for constant cost conditions, to the results derived by Wilson from his example IV, since it fails to take into consideration the necessary relationship between the prices in each country of domestic and export commodities resulting from their competition for the use of the same factors of production. If in either country the prices of domestic commodities rose or fell relative to export commodities, factors of production would be diverted from the low-price to the high-price industry until the earning power of the factors in the two industries was equalized, and under constant costs this would mean that in neither country could there be relative changes

Wilson'S Example IV: Terms of Trade Move Against Receiving Country
Paying country Receiving country
Commodity Purchases before payment Purchases after payment if no price changes occur Purchases before payment Purchases after payment if no price changes occur
P............ 20 18 30 31
Dp............ 40 36 .. ..
Dr............ .. .. 210 217
R............ 30 27 30 31
Total............ 90 81 270 279

between the prices of domestic and export commodities. What the direction of relative change of the prices of the products of the respective countries will be as the result of international payments will depend on what effect the payments have on the relative aggregate demands of the two countries for all the products, and therefore for the factors of production, of the respective Edition: current; Page: [331] countries. In Wilson's example IV, the payment results, in the absence of price changes, in an increase in the aggregate demand for the products of the receiving country (275 after the payment as compared to 270 before the payment) and in a decrease in the aggregate demand for the products of the paying country (85 after the payment as compared to 90 before the payment). The prices of the factors, and consequently the commodity terms of trade, must therefore move against the paying country if equilibrium is to be restored.

To an objection to his analysis made by some unspecified person7 to the effect that the flow of gold from lending to borrowing country, by raising money prices and incomes generally in the borrowing country, and lowering them generally in the lending country, will make the prices of the productive services and therefore also of their products, in domestic and export industries alike, rise in the borrowing country and fall in the lending country, Wilson replies that: “mere changes in money costs of production are not sufficient in themselves to cause a change in prices. If prices are to be affected by changes in costs of production, it can only come about through a change in the relative demand and supply of those goods whose money costs of production are affected,” and that the relative changes in price which such changes in cost would tend to produce would tend to be checked by diversion of expenditures to or from other classes of goods not so affected.8 This reply bears only on the degree of relative price changes needed, whereas the issue is whether any price changes are needed, and if so, in what directions. It, moreover, misses the character of the valid objection to which his analysis is open, which is not the common but fallacious argument that relative changes in the amounts available for expenditure in the two countries must necessarily result in changes in the same direction in the prices of the productive services and therefore also in the money costs of production of the two countries,9 but that changes in the relative aggregate demands for the commodities of the respective countries will do so. If, as is possible, but, as will later Edition: current; Page: [332] be shown, improbable, a transfer of funds on loan from country A to country B results in an increase in the aggregate demand of the two countries for A's products and a decrease in their aggregate demand for B's products, it will be the prices of A's, and not of B's, factors of production which will rise.

Yntema.—Yntema applies to the problem a powerful mathematical technique, and analyzes it on the basis of a wide range of assumptions.10 For cases such as those contemplated by the older writers, he reaches conclusions substantially in accord with theirs, especially with reference to the relative movement of the prices of the domestic commodities of the two countries and of their double factoral terms of trade.11 But Yntema's analysis rests throughout on certain assumptions which seriously limit the significance of his results. He assumes that when a relative change in the amount of money in two countries occurs as a result of loans or tributes or other disturbances in the international balances, there will occur in the country whose stock of money has increased a rise not only in all of that country's demand schedules (in the simple Marshallian sense), but also in the prices of the factors of production and in the supply schedules of that country's products, and that there will similarly occur in the country whose stock of money has decreased a fall not only in all of that country's demand schedules, but also in the prices of its factors of production and in the supply schedules of that country's products, though these rises or falls need not be uniform in degree within each country. But a rise in all the demand schedules of a country does not necessarily lead to or require a rise in its supply schedules or in the prices of its factors of production. What will be the effect of an international transfer of income on the direction of the relative movement of the prices of the factors in the two countries is itself the question relating to the equilibrating process awaiting solution, but in Yntema's analysis it is unfortunately decided by arbitrary assumption. Yntema's conclusion that under constant cost the terms of trade must necessarily shift in favor of the receiving country results from his assumption that the prices of the factors and the money costs of production will necessarily Edition: current; Page: [333] rise in the receiving country. As had been argued above, this is not a valid assumption.

Ohlin.—In his important treatise,12 Ohlin gives an elaborate account of the mechanism, whose most important contribution is the convincing demonstation that not price changes only but also relative shifts in demands resulting from the transfer of means of payment, are operative in restoring a disturbed equilibrium in the balance of payments. On the question immediately at issue, i.e., the specific mode of operation of relative changes in sectional price levels in the mechanism of adjustment, he is extremely critical in tone in his treatment of the older writers, although as long as he adheres to the traditional assumptions he follows the traditional reasoning and conclusions only too closely. Ohlin claims that the older writers exaggerated the importance of relative price changes in the equilibrating process both because they overlooked the direct influence on purchases of the shift in means of payment and because the ordinarily high elasticity of foreign demand for a particular country's exportable products makes a small change in price exert a large influence on the volume of trade. Subject to the qualification that I believe I have shown that recognition of its validity was not nearly as rare among the classical expositors of the theory of international trade as he appears to take for granted, I concede his first point. But on the second point, at least a partial defense can be made of the position of the older writers. When two factors are necessarily associated in a complex economic process, there is rarely a satisfactory criterion for measuring their relative importance, even if all the quantitative data that could be desired were available. Ohlin appears to regard the relative degree of price change as between different classes of commodities as an appropriate measure of the importance of such price changes in the equilibrating process. A more appropriate criterion, if it could be applied, would be the proportion of (1) the equilibrating change in the trade balance which results from relative price changes to (2) the total change in the trade balance necessary to restore equilibrium. Since foreign demands for a particular country's products ordinarily have a high degree of elasticity, small price changes in the right direction can exert great equilibrating influence. But the emphasis Edition: current; Page: [334] which Ohlin gives to the question of the degree of change seems to me a novel one, as far as discussion of mechanism is concerned, and I cannot recall a single instance in the older literature where a definite position was taken as to the extent of the price changes necessary to restore a disturbed equilibrium.

Taking the case of international loans,13 Ohlin assumes, as a first approximation, that “all goods produced in a country require for their manufacturing ‘identical units of productive power’ consisting of a fixed combination of productive factors.” The lending country B must make initial remittances to the borrowing country A. The assumptions as to the effects on demands are not clearly stated, but seem to be as follows: the aggregate demands in terms of money prices of the two countries combined (1) for the export goods of A and (2) for the export goods of B, are each assumed to remain unaltered;14 (3) the demand in A for A “domestic” goods increases; (4) the demand in B for B “domestic” goods decreases. This “implies” a shift in demand from B factors to A factors, which “raises the [relative] scarcity of the A unit, which means that every commodity produced in A becomes dearer than before compared with every commodity produced in B. The terms of exchage between A's export goods and B's change in favor of A.” 15 So far, therefore, there is no correction of the older doctrines with respect to the kind of price changes necessary to restore equilibrium. But Ohlin attributes these results to the assumption that all industries use identical “units of productive power,” and remarks that it is because they have expressed costs in such units that “men like Bastable, Keynes, Pigou, and Taussig have stopped at the preliminary conclusion in §5 and have found a variation in the terms of trade certain in all cases, at least where the direction of demand is not of a very special sort.” 16

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These results, however, arise not from the assumption of the use in each country of identical “units of productive power,” but from Ohlin's assumption that the transfer of funds does not of itself lead to any alteration in the aggregate monetary demand for the export commodities of the respective countries. Even with both these assumptions, they are not necessary results, if it be granted that, without price changes, the increase in funds in A may lead to a decrease in the demand for A “domestic” goods, or that the decrease in the funds in B may lead to an increase in the demand for B “domestic” goods, or both, consequences by no means inconceivable, as, for instance, if A's and B's domestic goods are both predominantly low-grade necessaries of the sort heavily consumed only when there is economic pressure.17 But Ohlin would probably regard—and not without justification—such movements of demand as “of a very special sort” and therefore not calling for consideration.

Abandoning the assumption of identical “units of productive power” and substituting the assumption that different industries use different factors, and use the same factors in different proportions, Ohlin shows that by introducing additional assumptions of non-competing factoral groups, the existence of idle resources, the tendency of the prices of the products to rise more rapidly than the prices of the factors in an expanding industry, and so forth, instances are possible where the commodity terms of trade turn against rather than in favor of the borrowing country.18

It is to be noted that some of these assumptions are of a non-equilibrium nature, i.e., can be valid only temporarily. But granted that Ohlin has shown the possibility that the terms of trade, when such assumptions are made, will turn against the borrowing country, what about the probabilities? Every one of these added factors is as likely, a priori, to accentuate the movement of the terms of trade in favor of the borrowing country as to operate to move them against the borrowing country. Take only one example, sufficiently representative of the others: Ohlin argues that the factors used relatively largely in expanding industries are Edition: current; Page: [336] likely to rise in price, while those used relatively largely in declining industries are likely to fall in price; in the borrowing country, the domestic commodity industries will be expanding, because of the increased demand for their products, while the export commodity industries will be declining, presumably because of decreased demand in the lending country for their products; the prices of the factors used largely in the domestic commodity industries therefore will rise, while those used largely in the export commodity industries will fall. In the lending country, reverse trends will be operating. The export commodities of the borrowing country therefore will decline in price relative to the prices of the export commodities of the lending country; i.e., the terms of trade will move against the borrowing country. But the export commodity industries of the borrowing country are not, a priori, more likely to decline than to expand. The foreign demand for their products, it is true, will tend to fall, but Ohlin overlooks that the home demand for their products will tend to rise, and that there is no obvious reason why the latter tendency should be expected to be less marked than the former and to be insufficient to offset the former.

The “orthodox” conclusions as to the kind of price change which would tend to result from international borrowing thus emerge from Ohlin's critical scrutiny almost unscathed. When he adheres to the usual assumptions, Ohlin reaches the same conclusions. When he departs from them, he succeeds in showing that different results are possible. But he does not succeed in showing that they are probable, or even that they are not improbable.

Pigou.—In a recent article Pigou has attacked the problem in terms of marginal utility functions, and has reached the conclusion that, under constant costs, there is a strong presumption, but not a necessity, that the commodity terms of trade (which he calls the “real ratio of international interchange”) will turn against the paying country as the result of reparations.19 Pigou's results, it will later be shown, can in part at least be reached by an alternative procedure which is simpler and has the additional virtue that it does not involve resort to utility analysis. But Pigou's analysis can be made to serve the useful function of bringing into clear view the utility implications of this alternative procedure, and thus warrants detailed examination and elaboration.

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Pigou assumes a paying country, Germany, and the rest of the world, which he calls “England,” but since the existence of neutral countries, neither paying nor receiving reparations, gives rise to complications which this procedure disregards, I will proceed, for the time being, as if there are only two countries, Germany, the paying country, and England, the receiving country. Pigou makes the following additional assumptions: only one commodity produced in each area; “constant returns” (i.e., constant technological costs); dependence of the utility of any commodity on the quantity of that commodity alone; and linear utility functions throughout.

Pigou writes lf0619_figure_004.jpg for the commodity terms of trade before reparations, and lf0619_figure_005.jpg for the terms of trade after reparations, where: X, Y, represent the annual pre-reparations physical quantities of English exports and imports, respectively; X + P–P being negative—represents the annual quantity of English exports (or German imports) after reparations payments have been initiated; R represents the annual reparations payments measured by their value in English goods; and Y + Q represents the annual quantity of English imports (or German exports) after reparations payments have commenced. He further writes nX, nY, for the “representative” Englishman's pre-reparations exports and imports, respectively, and mX, mY, for the “representative” German's pre-reparations imports and exports, respectively. He then writes:

φ(nY) for the marginal utility of (nY) German goods to the representative Englishman;

ƒ(nX) for the marginal disutility to him of surrendering (nX) English goods;

F(mX) for the marginal utility of (mX) English goods to the representative German;

ψ(mY) for the marginal disutility to him of surrendering (mY) German goods.

Then, in accordance with Jevon's analysis,

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In order that the new terms of trade should be equal to the old, it would therefore be necessary that


which, for linear functions, implies20 that


It can similarly be shown that reparations will cause the terms of trade to turn in favor of Germany if lf0619_figure_015.jpg and to turn against Germany if.


VIII. A Graphical Examination of Pigou's Analysis1

The examination of Pigou's algebraic analysis, and especially of its economic implications, can be facilitated by the use of Edition: current; Page: [339] graphical illustrations. In chart III the left-hand diagram relates to the representative Englishman and the right-hand diagram to the representative German. Commodity units of the respective commodities are so chosen, for each country separately, as to be equal in price prior to reparations. For the English and the German “representative” consumer, respectively, the quantity purchased before reparations of his own country's commodity is


measured on the df or d1f1 axis, to the left from the oa or o1a1 axis, and the quantity purchased before reparations of the imported commodity is measured on the same axis but to the right from the oa or o1a1, axis. For the representative consumer in each country the marginal utilities of the different commodities are measured vertically from the bc, or b1c1, axis. The curve of marginal utility to the representative English consumer is, therefore, ab for the native commodity and ac for the imported commodity, and a1b1 and a1c1 are similarly the curves of marginal utility to a representative German of the German and the English Edition: current; Page: [340] commodities, respectively. Since the utility functions are assumed to be linear, ab, ac, a1b1 and a1c1, are all drawn as straight lines.

In chart III there is substituted, for the two “marginal disutility of surrendering” functions which Pigou uses (i.e., ƒ(nX) and ψ(mY)), the corresponding marginal utility curves, ab and a1b1. The substitution does not call for a change in the numerical value of the slope, and by placing the ab and a1b1 curves on the left side of oa, o1a1 axes, i.e., by making their inclinations positive, change of signs is also avoided. Since ⊘ = the slope of ac, ƒ′ = the slope of ab, ψ′ = the slope of a1b1 and F' = the slope of a1c1, Pigou has demonstrated that the terms of trade of Germany will not change, will move against Germany, or will move in favour of Germany according as


Unless, however, some presumptions can be established as to the relative slopes of the various utility curves, no progress has been made toward determining the probable effects of reparations payments on the terms of trade. To establish such presumptions Pigou resorts to two additional sets of presumptions, first, that before reparations each country spends more on native than on imported goods, and second, that the utility functions within each country are “similar.”

The presumption that each country before reparations spends more on its own products than on foreign products is equivalent to making de > ef and d1e1 > e1 f1 in chart III. Pigou adopts it, presumably, on the ground that such is almost invariably the actual situation. The general prevalence of this situation results, however, chiefly from restrictions on foreign trade, from the existence—by no means universal—of greater international than internal costs of transportation from producer to consumer, and, above all, from the fact that included in the native commodities of each country are “domestic” commodities, or commodities which because of regional differences of taste or non-transport-ability cannot find a market outside their country of production. But Pigou presumably abstracts from trade restrictions and transportation costs, and he explicitly excludes “domestic” commodities by his assumption that “there is only one sort of good made in the reparation paying country and only one sort made in the rest Edition: current; Page: [341] of the world.” In the absence of these factors, there would be no a priori presumption that there was any difference in either area in the amounts spent for native and for imported commodities if the two areas were equal in size, size being measured in terms of the pre-reparations value of output or of consumption. If the two areas were unequal in size, the most reasonable assumption would appear to be that, at the pre-reparations equilibrium, prices of the commodities would be such as to induce each country to spend more on the larger country's than on the smaller country's product. To justify acceptance of a general presumption that each country spends more on its own than on imported products it is necessary to recognize the existence of trade restriction, transportation costs, and above all, “domestic” commodities. It will be shown, moreover, that while an excess in each country before reparations of expenditures on native over expenditures on imported commodities, of itself, whatever its cause, tends to make lf0619_figure_019.jpg , i.e., to contribute toward a situation in which reparations will make the terms of trade turn against the paying country, to the extent that such excess is due to higher international than internal transportation costs or to import duties this tendency unfavourable to the paying country will, given linear utility functions, be more than offset by the counter-tendency of the transportation costs and import duties to cause deviations from “similarity” of the utility functions within each country in directions favorable to the paying country.

By “similarity” of the utility functions within each country, Pigou must mean that, numerically, φ′ = E(ƒ′) and F′ = G(ψ′), where E is the pre-reparations ratio of the expenditures of a representative Englishman on English goods to his expenditures on German goods, and G is the pre-reparations ratio of the expenditures of a representative German on German goods to his expenditures on English goods. When the commodity units within each country are so chosen as to be equal in price before reparations, this is equivalent to the assumption that within each country first units of the different commodities have equal utilites, i.e., that in chart III the lines ab,ac start from the oa axis at some common point a, and the lines a1b1, a1c1 start from the o1a1 axis at some common point a1.

For the two-country case, the assumptions of linearity and of Edition: current; Page: [342] “similarity” within each country of the utility functions turn out to involve as a corollary the familiar assumption in other discussions of this problem that, in the absence of relative price changes, changes in the amounts available for expenditure in the respective countries resulting from reparations payments will not affect in either country the proportions in which these expenditures are apportioned between native and foreign commodities. Before reparations the representative Englishman bought ed units of English commodities and ef units of German commodities. Since the commodity units in chart III have been so chosen as to make the pre-reparations prices of the two commodities equal, their marginal utilities must have been equal to a representative English purchaser of both, i.e., kd = lf. Therefore, d, e, f, must be points on a horizontal straight line. Suppose that in the absence of relative price changes the representative Englishman, after reparations, buys hg units of English commodities and hj units of German commodities. If no changes have occured in their relative prices, the two commodities must still have equal marginal utilities to him, i.e., g, h, j, must be points on a horizontal straight line. From the geometry of triangles it follows that lf0619_figure_020.jpg i.e., that in the absence of relative price changes, changes in the amount of his aggregate expenditures will not affect the proportions in which the representative Englishman distributes them as between English and German commodities. Similarly, lf0619_figure_021.jpg i.e., in the absence of relative price changes, changes in the amount of his aggregate expenditures will not affect the proportions in which the representative German distributes them as between German and English commodities.

That for the two-country case the assumptions of linearity and of similarity within each country of the utility functions plus the assumption of an excess before reparations for the representative consumer of each country of his purchases of native over his purchases of foreign commodities suffice to establish Pigou's conclusion that reparations will necessarily cause the terms of trade to turn against the paying country, i.e., that lf0619_figure_022.jpg can also readily be demonstrated from chart III. Suppose that in chart III, ed > ef and e1d1 > e1f1. Then, since: numerically, φ′: ƒ′:: ed: ef; Edition: current; Page: [343] numerically, ψ′: F′:: e1f1: e1d1; and


The assumption of “similarity” of the utility functions is a reasonable one, not because “similarity” is in fact probable, but because in the absence of specific information the “dissimilarity” which is likely to exist is, a priori, as likely to be in the one direction as in the other. Given the proportions in which expenditures in each country before reparations are divided between native and imported commodities, dissimilarities existing within either or both countries will tend to make reparations turn the terms of trade against or in favor of the paying country according as they take the form of lower or of higher ratios of the utility of initial units of native to the utility of initial units of imported commodities, the units of the commodities being so chosen, for each country separately, as to be equal in their pre-reparations prices.

Chart IV illustrates the bearing of “similarity” of utility functions on the problem. The proportions in which expenditures in each country are divided before reparations between native and imported commodities are made the same as in chart III, i.e., ed > ef and e1d1 > e1f1. Reparations payments, nevertheless, would leave the terms of trade unaltered, i.e., lf0619_figure_025.jpg This results from the assumptions in the chart that, when for each country such commodity units are chosen as will make their pre-reparations prices equal, to the representative Englishman the utility of a first unit of the English commodity is sufficiently greater than the utility of the first unit of the German commodity (i.e., oa > oA) and to the representative German the utility of a first unit of the German commodity is sufficiently greater than the utility of the first unit of the English commodity (i.e., o1a1 > o1A1) to make


It can be seen from chart IV that, other things equal, the greater before reparations the average ratios of excess of the consumption of native over the consumption of imported commodities in the two countries, the greater must be the average ratio of excess in the two countries of the initial utility of the imported commodity over the initial utility of the native commodity if the terms of trade are not to be turned against the Edition: current; Page: [344] paying country by reparations payments. Although the pre-reparations ratios of consumption of native to consumption of imported commodities assumed in chart IV are much lower than would ordinarily be found in practice, the ratio of excess of the initial utility of native over the initial utility of imported commodities had to be substantial for each country (or on the average for the two countries combined) if reparations payments were not to turn the terms of trade against the paying country. If with uniform commodity units in both countries the ratio between the


prices of the two commodities was identical in both countries—as would be the rule for internationally traded commodities in the absence of trade barriers or transportation costs—it would be difficult, if not impossible, to find plausible grounds for holding that such substantial “dissimilarities” of utility functions were likely to prevail in practice.

IX. Some Elaborations on the Basis of Pigou's Analysis

Duties on imports, however, whether levied by the paying or the receiving country, and a fortiori when levied by both, do tend to result in higher initial utilities in each country for native than for imported commodities, and although they also tend to result Edition: current; Page: [345] in an excess of expenditures on native over expenditures on foreign commodities, they operate to make reparations turn the terms of trade in favor of, instead of against, the paying country. Import duties, regardless of which country levies them, operate to make the imported commodity relatively dearer than the native commodity in each country, as compared to what the situation would be in the absence of the duties. If in each country the units of the two commodities are so chosen as to be equal in price before the imposition of the duty, then, with the units used for the English commodity in England and the German commodity in Germany left unaltered, after the imposition of the duty the size of the unit used for the German commodity in England and the size of the unit used for the English commodity in Germany will both have to be decreased if the units used for the two commodities within each country are to be kept equal to each other in price. In terms of the graphical illustrations here used, it will follow that the initial utility of the imported commodity will be lower in each country after the duty than before, the initial utility of the native commodity remaining unaltered. A situation with respect to “dissimilarities” of the utility functions within each country corresponding in kind to that illustrated in chart IV will thus tend to result.

This reasoning is illustrated, for the case of an English import duty, in chart V. It is there assumed that initially there are no trade restrictions in either England or Germany, that there are no “domestic” commodities, and that in each country the representative consumer spends as much on imported as on native commodities. It is also assumed that in each country the utility functions are linear and originally “similar,” so that when commodity units are so chosen as to be equal in their original prices, the utilities of initial units are also equal. Then lf0619_figure_028.jpg so that Germany could make reparations payments to England without affecting the terms of trade.

Suppose, however, that before the obligation to pay reparations comes into effect, England imposes a revenue import duty of 50 per cent ad valorem on the German commodity. Let us assume that as a result the price of the German commodity to the English consumer rises by one-third relative to the price of the English commodity, i.e., one unit of the English commodity now has the Edition: current; Page: [346] same price in England as three-fourths of a unit of the German commodity, duty-paid. If, while the unit used for the English commodity in England is left unchanged, a new unit three-fourths as large as the old one is now used for the imported commodity so as to make units of the two commodities equal in value at the new relative prices, there will be a new utility function, a'c', for the imported commodity, with oa' 75 per cent of oa, and oc' 33 ⅓ per cent greater than oc.

If the levy of a 50 per cent duty on the German commodity


causes its price in England duty-paid to rise by one-third relative to the price of the English commodity in England, then in Germany, with units unchanged, the price of the English commodity must rise one-eighth relative to the price of the German commodity, i.e., one unit of the German commodity now has the same price in Germany as eight-ninths of a unit of the English commodity.1 If the unit used for the German commodity in Germany is Edition: current; Page: [347] left unchanged, but a new unit eight-ninths as large as the original one is now used for the English commodity in Germany so as to make the units of the two commodities equal in value at their new relative prices, there will be a new utility function, a'1c'1, for the English commodity in Germany, with o1a'1 eight-ninths of o1a1, and o1c′1 nine-eighths of o1c1. Since ⊘' and F' are now both smaller numerically and therefore greater algebraically than they were before the imposition of the duty, while ƒ′ and ψ′ are unaltered, therefore lf0619_figure_030.jpg in the new situation, and, even in the case illustrated by chart V, where the imposition of the duty causes the representative consumer in each country to spend more on native than on imported commodities,2 the levy of the duty creates a situation in which reparations payments would make the terms of trade turn in favor of Germany.

It can be similarly shown that export taxes levied by either or both countries and an excess of international over internal transportation costs for the commodities of either or both countries, even when they result in an excess in each country of expenditures on native over expenditures on foreign commodities, by tending to make native commodities relatively cheap in each country and thus tending to make the initial utility of native commodities greater in each country than the initial utility of imported commodities of equal price, tend likewise, given linear functions, to create a situation in which reparations payments will turn the terms of trade in favor of the paying country. Export Edition: current; Page: [348] or import subsidies, granted by either or by both countries, and an excess of internal over international transportation costs for the commodities of either or both countries, tend, on the other hand, by making native commodities dear in each country relative to imported commodities, to create a situation in which reparations will turn the terms of trade in favor of the receiving country in spite of an excess in each country of expenditures on foreign over expenditures on native commodities.

The existence of “domestic” commodities also operates to create a presumption that reparations payments will turn the terms of trade against the paying country, but in this case by increasing the proportion of expenditures in each country on native commodities without affecting the relative utilities of initial units of native and imported commodities. To adapt Pigou's analysis to the existence of domestic commodities, the utility functions for a representative consumer of the products of his own country must be interpreted as representing the marginal utility curve of a composite commodity made up of one or more units of each of the different native commodities, with the units so chosen as to be equal in pre-reparations price, and with the number of units of each commodity entering into the composite commodity made proportional to their respective importance in domestic consumption. If the assumptions of constant costs and of similarity and linearity of utility functions for “representative” consumers are adhered to, and if the possibility that reparations payments may change the identity of the “representative” consumer is disregarded, the weighting of the different native commodities in making up the composite native commodity presents no difficulty, since under these assumptions relative variations in the prices or the volume of consumption of the constitutent items of the composite native commodity cannot result merely from a change in the total expenditures of the representative consumer. The introduction in either country of domestic commodities will operate with respect to that country to reduce the slope of the curve of marginal utility to a representative individual of the composite native commodity, i.e., the existence of domestic commodities will operate to reduce the relevant ƒ′ and/or ψ′. Since lf0619_figure_031.jpg and lf0619_figure_032.jpg it follows, therefore, that where there are only two countries, the existence of “domestic” commodities in Edition: current; Page: [349] either country will tend to make lf0619_figure_033.jpg and therefore will tend to make reparations payments turn the terms of trade against the paying country.

If either of the countries is incompletely specialized, i.e., if it imports a portion of its consumption of some commodity, say cloth, which it also produces at home, a special case arises where the ratio of lf0619_figure_034.jpg to lf0619_figure_035.jpg does not suffice to determine the effect of reparations on the terms of trade even on the assumptions of linearity and “similarity” within each country of the various utility functions. Regardless of the ratio of lf0619_figure_036.jpg to lf0619_figure_037.jpg the incompletely specialized country, whether it be the paying or the receiving country, can check any tendency for the terms of trade to move against it by cutting down on its exports and shifting the productive resources thus freed to the production of cloth. Under constant costs the prices of other foreign commodities could not rise relative to cloth as long as cloth was still being produced abroad, and the prices of other native commodities could not fall relative to cloth as long as more cloth could be produced at home. Before the terms of trade could turn against the country which before reparations had been incompletely specialized, it would be necessary therefore that she should be producing nothing except (“domestic” commodities and) cloth and that the other country should have completely abandoned the production of cloth.3

If the assumption of linearity of the utility functions is abandoned the solution of the problem becomes much more difficult. But in the two-country case, the departures from linearity are as likely a priori to be in directions strengthening the presumption that reparations payments will cause the terms of trade to turn against the paying country as to weaken it, and Pigou has shown in effect that if lf0619_figure_038.jpg is much greater numerically than lf0619_figure_039.jpg it will take substantial deviations from linearity in directions working favorably for the terms of trade of the paying country to keep reparations payments from turning the terms of trade against her.4

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The use of the concept of a “representative” German or Englishman in utility analysis raises familiar difficulties. Its use in this particular problem involves a tacit evasion of the difficulty arising if the payment of reparations results in a redistribution of the available spending power within either or within both communities of such a nature that the individual who could reasonably be taken as “representative” before the payments began was no longer “representative” after they had begun. Any redistribution in spending power in Germany resulting from the making of reparations payments would operate to make the terms of trade move unfavourably or favorably to Germany according as the reduction in spending power fell relatively more heavily or less heavily on individuals for whom, as compared to other Germans, the lf0619_figure_040.jpg ratio, or the ratio of the slope of their utility curve for German goods to the slope of their utility curve for English goods, was large or small numerically. Similarly, any redistribution in spending power in England resulting from the receipt of reparations payments would operate to make the terms of trade move favourably or unfavourably to Germany according as the increase in spending power accrued more heavily or less heavily to individuals for whom, as compared to other Englishmen, the lf0619_figure_041.jpg ratio, or the ratio of the slope of their utility curve for German goods to the slope of their utility curve for English goods, was small or large numerically. In the absence of special information, it is hard to see any basis for any presumption that the changes in distribution of spending power in either country would be in one direction rather than the other.

I have so far assumed that there are only two countries. If in addition to the countries directly participating in the reparations payments there are other countries connected with them through trade relations, additional complications arise which Pigou, who does not differentiate “England” from “non-Germany,” but takes his “representative Englishman,” with his significant ratio lf0619_figure_042.jpg as representative of all non-Germany, fails to mention. If there are three or more countries, there is no longer only one significant set of commodity terms of trade, but there are at least four distinct sets, namely, the terms of trade: (1) between Germany and the rest of the world, including England; (2) between England Edition: current; Page: [351] and the rest of the world, including Germany; (3) between Germany and England, and (4) between the neutral area and the rest of the world.

Since the reparations payments go only to Englishmen proper, the change in the relative distribution of spending power as between Englishmen and other non-Germans as the result of reparations will, even with the assumptions of linearity and of “similarity” of the utility functions within the entire non-German area, prevent Pigou's lf0619_figure_043.jpg ratio, although adequately representative of the utility functions of all non-Germany before reparations, from being representative after reparations, and will render inadequate Pigou's criterion for the effect of reparations payments on the terms of trade of Germany, unless before reparations the ratios corresponding to Pigou's lf0619_figure_044.jpg ratio were identical for both the representative Englishman and the representative neutral. If before reparations the ratio for the representative Englishman corresponding to Pigou's lf0619_figure_045.jpg for all non-Germany was smaller algebraically than the similar ratio for the representative neutral, then the terms of trade would turn against Germany as the result of reparations not only when before reparations Pigou's condition of lf0619_figure_046.jpg was met, but also if lf0619_figure_047.jpg and even, within limits, if lf0619_figure_048.jpg On the other hand, if before reparations the ratio for the representative Englishman corresponding to Pigou's lf0619_figure_049.jpg was greater algebraically than the similar ratio for the representative neutral, the terms of trade would turn in favor of Germany as the result of reparations not only when before reparations lf0619_figure_050.jpg , but also if lf0619_figure_051.jpg , and even, within limits, if lf0619_figure_052.jpg . But since, a priori, the probability that the ratio corresponding to Pigou's lf0619_figure_053.jpg will be greater algebraically for the representative Englishman than for the representative neutral is no greater than the probability that it will be smaller, and, because of the existence of “domestic” commodities, Pigou's lf0619_figure_054.jpg is likely to be much Edition: current; Page: [352] smaller algebraically than lf0619_figure_055.jpg the presumption that the terms of trade will turn against the paying country survives the introduction of third countries into the problem. If England and the third country produce the same commodity (or commodities), there is no basis for trade between these two countries, and the terms of trade between Germany and the outside world as a whole must be identical with those between Germany and England. The third country, therefore, will share with England any improvement or impairment in the terms of trade with Germany which may result for England as the result of her receipt of reparations from Germany.

If the third country produces the same commodity (or commodities) as Germany, similar conclusions would be reached as in the preceding case, except that the fortunes of the neutral country would now be pooled with those of the paying country instead of with those of the receiving country. If either England or Germany produces “domestic” commodities as well, this would operate, in the manner already explained, to make reparations payments result in the terms of trade turning against Germany, but whether or not the neutral country produced “domestic” commodities would not affect the direction of change in the terms of trade of Germany with the outside world as the result of reparations.

If the third country, however, produces distinctive exportable commodities of its own, the method of approach needs to be modified somewhat. To take first the terms of trade of Germany with the outside world, “non-German” data are to be used wherever in the case of only two countries English data would be used, and the problem will then correspond to the case where England and the neutral country produce identical commodities, except that given the pre-reparations ratio of lf0619_figure_056.jpg representative of all non-Germany, the greater numerically the slope of the representative Englishman's utility curve for the neutral country's commodity as compared to the slope of his curve for the German commodity, the more favorable will be the situation for Germany with respect to the terms of trade. Similarly, for the terms of trade of England with the rest of the world, “non-English” data are to be used wherever in the case of only two countries German Edition: current; Page: [353] data would be used, and the problem will then correspond to the case where Germany and the neutral country produce identical commodities, except that, given the pre-reparations ratio lf0619_figure_057.jpg representative of all non-England, the greater numerically the slope of the representative German's utility curve for the neutral country's commodity as compared to the slope of his curve for the English commodity, the less favorable will be the situation for England with respect to the terms of trade. To take next the terms of trade of England with Germany, they will remain unchanged, move in favor of England, or move in favor of Germany, given Pigou's assumptions, according as lf0619_figure_058.jpg =, <, or > lf0619_figure_059.jpg where Φ′ and ƒ′ relate to the slopes of the utility curves of the representative Englishman for English and German commodities, respectively, and ψ′ and F′ relate to the slopes of the utility curves of the representative German for English and German commodities, respectively, i.e., regardless of the slopes of their respective utility curves for neutral country commodities or of the slopes of the utility curves of the representative neutral for the commodities of England and Germany.

To take, finally, the terms of trade of the neutral country with the rest of the world, the payment of reparations by Germany to England will leave them unchanged, will move them in favour of the neutral country, or will move them against the neutral country, caeteris paribus, according as the slope of the utility curve for the neutral country's commodity is numerically equal, smaller, or greater for the representative Englishman than for the representative German, and, caeteris paribus, according as the pre-reparations volume of imports of neutral commodities is equal, greater, or smaller for England as a whole than for Germany as a whole, in proportion to their total expenditures.

X. An Alternative Solution

That it is possible to attack the problem without resort to utility analysis is demonstrated in chart VI in terms of a two-country case, based on the assumptions that in each country before reparations more is spent on native than on imported commodities, that Edition: current; Page: [354] the proportions in which expenditures are distributed between native and imported commodities remain unaltered in both countries, in the absence of relative price changes, as the amount available for expenditures changes, that production is carried on under constant cost conditions, and that there are no trade barriers or transportation costs. The “amount available for expenditure,” it is to be noted, is measured not in money but in units of the native commodity, or their equivalent in value, which can be bought with the money available at the prevailing prices.

Through any point,e, on a vertical line mn draw a horizontal line df, such that the distance df, represents the aggregate number of units of commodities which England can purchase with her national income before reparations at the prevailing prices, when the physical units of the commodities are so chosen that the English


and the German commodity are equal in price, and such that de, and ef, represent the amounts of German commodities, respectively, which the English would consume before reparations at the prevailing prices. Through any point on mn below e draw another line gj such that, in the absence of price changes, gj—df would represent the amount of reparations received Edition: current; Page: [355] by England, and gh and hj would represent the amounts of English and of German commodities, respectively, which the English would consume after reparations. Draw lines connecting g with d and j with f, and project them until they intercept mn. If a change in the amount England has available for expenditure does not, in the absence of price changes, and within the range of observation, change the proportions in which England would divide her expenditures between English and German commodities, i.e., if gh:hj::de:ef, then the projections of gd and jf will intercept mn at some common point a, above e.

Through any point e1 on another vertical line m1n1 draw a horizontal line d1f1 such that the distance d1f1 represents the aggregate number of units of commodities which Germany can purchase before reparations at the prevailing prices when the physical units of the commodities are the same as in the other part of the diagram, and such that d1e1 and e1f1 represent the amounts of German and English commodities, respectively, which the Germans would buy before reparations at the prevailing prices. Through any point on m1n1 above e1 draw another line g1j1 such that, in the absence of price changes, d1f1g1j1 would represent the amount of reparations paid by Germany, and g1h1, h1j1, would represent the amount of German and of English commodities, respectively, which the Germans would buy after reparations. Draw lines connecting d1 with g1 and f1 with j1 and project them until they intercept m1n1. If a change in the amount Germany has available for expenditure does not in the absence of price changes change the proportions in which Germany divides her expenditure between German and English commodities, i.e., if, then g1h1:h1j1::d1e1:e1f1 and d1g1 when extended upward will intercept f1j1 at some common point a1 above h1.

Suppose now that de > ef, and that d1e1 > e1f1, i.e., that before reparations each country spent more money on its own than on the other country's commodities. To show that on these assumptions reparations must turn the terms of trade against Germany, it is necessary to show that, in the absence of relative price changes, the two countries combined would, after reparations, want to buy more of England's commodities and less of Germany's commodities than before reparations, i.e., that, in the absence of relative price changes: (1) the amount by which England would want to increase her consumption of English commodities Edition: current; Page: [356]was greater than the amount by which Germany would want to decrease her consumption of English commodities, or that gk > l1f1 (2) that the amount by which Germany would want to decrease her consumption of German commodities was greater than the amount by which England would want to increase her consumption of German commodities, or that d1k1 > lj.

By assumption,


By assumption,


Since reparations results in an increase in England's spendable funds equal to the decrease in Germany's spendable funds,


Reparations payments will, therefore, in the absence of relative price changes, result in this case in a shortage, relative to demand, of English commodities, and a surplus, relative to demand, of German commodities, and the establishment of a new equilibrium, adjusted to the reparations payments, will require a relative rise in the prices of English commodities, i.e., a movement of the commodity terms of trade against Germany.

If in either or in both countries the proportion in which expenditures between native and imported commodities, in the absence of relative price changes, varies with variations in the aggregate amount of spendable funds, such variations will operate favorably or unfavorably for Germany's terms of trade according as, in the case of Germany, the proportion spent on German goods increases or decreases with a decrease in the amount of spendable funds and as, in the case of England, the proportion spent on German goods increases or decreases with an increase in the amount of spendable funds. Deviation in the proportions of the expenditures in a direction favorable to Germany in either or in both countries will not suffice, however, to turn the terms of trade in favor of Germany, given an excess before reparations in the Edition: current; Page: [357] expenditures of each country (or in both combined) on native commodities over their expenditures on imported commodities, unless such deviations are sufficiently marked to make reparations payments result in the aggregate for both countries, in the absence of relative changes in prices, in a relative increase in the demand for German commodities over the demand for English commodities.1

A concrete case may be cited to illustrate the type of situation in which the terms of trade might turn in favor of the paying country as the result of reparations. First, suppose that the paying country, Germany, produces two kinds of commodities, one a “domestic” commodity, primarily a necessary, and the other a luxury, which is exported but is not consumed heavily at home, and imports from England what is essentially a luxury commodity. As the spendable funds of Germany are cut down by reparations payments, there would probably occur, in the absence of relative price changes, a proportionately greater reduction in the German purchases of the luxury import than of the necessary “domestic” commodity. Suppose, in turn, that England also produces two kinds of commodities, one a “domestic” commodity, primarily a necessary, and the other a luxury, which is exported but is not consumed heavily at home, and imports from Germany what is a luxury commodity. As the spendable funds of England are increased by the reparations receipts, there would probably occur, in the absence of relative price changes, a proportionately greater increase in the English purchases of the imported luxury than of the necessary “domestic” commodity. These deviations from proportionality, both working in favor of Germany, could conceivably be sufficiently marked to make the terms of trade turn in favor of Germany as the result of reparations, even if before reparations each country spent much more on native than on foreign commodities. This would be certain to be the situation if the English demand for native commodities was such that, with prices unchanged, the English purchases of native commodities would fall absolutely when the English incomes increased, and if the German demand for native commodities was such that, with Edition: current; Page: [358] prices unchanged, the German purchases of native commodities would rise absolutely when the German incomes decreased, demand phenomena which are no doubt highly improbable, but are not inconceivable.2

Demand and supply curves in terms of money prices of the ordinary Marshallian type cannot legitimately be used in the solution of the reparations transfer problem, since they abstract from the interrelationships between demands, supplies, and incomes.3 Nor can the problem be solved through the use of Marshallian reciprocal-demand curves without additional information, since the problem turns on what happens as the result of reparations payments to the position and shape of the reciprocal-demand curves, and this depends on the utility functions in both countries, and cannot be determined without reference, direct or indirect, to these functions.4

It has so far been assumed that in every industry production is carried on under conditions of constant costs. By virtue of this assumption, it has been possible to carry out the analysis without explicit reference to costs without impairing the validity of the conclusions reached. Under constant technological costs money costs can change only as the prices of the factors of production change, and, assuming no change in the supplies of the factors, their prices can change only as the aggregate demands for them from all the industries using them change. It was therefore necessary to take account only of the apportionment by the two countries of their expenditures as between their own products and foreign Edition: current; Page: [359] products, and their mode of apportionment of their expenditures as between their “domestic” and their export commodities had no bearing on the problem. Under constant costs, moreover, the double factoral terms of trade would be affected by reparations payments in precisely the same way, both as to direction and as to degree, as the commodity terms of trade. But if some, or all, industries operate under varying costs as their output is varied, it is possible in each country for the prices of domestic and of export commodities, respectively, to move in different degrees and even in different directions as the result of a change in the volume of expenditures, so that the movement of the prices of the “domestic” commodities of the two countries may differ in direction or in degree from the movement of their export commodity prices, and the factoral terms of trade may move differently, in degree, and when the commodity terms of trade move against the receiving country, even in direction, from the commodity terms of trade. This will hold even if there is effective mobility of the factors within each country, i.e., if the marginal value productivity and the rate of remuneration of each factor are equal in all industries in which it is employed, provided different industries use the factors in different and variable combinations. But if prices at which any factor is available are for any reason not uniform in all industries, or if there are factors which are specialized for certain industries, then the range of possible relative variation of the prices of “domestic” and of export commodities in each country will be still greater.

The task of tracing the effect of international payments on the terms of trade when production is carried on under conditions of varying cost as output is varied appears to be one of discouraging complexity. Even after resort to the utmost simplification of which the problem admits there remain more variables to be dealt with than either arithmetical illustrations or ordinary graphic methods can effectively handle. Though general solutions may be obtainable by algebraic methods, it seems evident that they are not easily obtainable, and in any case they are not within my power. There seems no good a priori reason to suppose, however, that any of these additional factors has an inherent tendency to operate more in favor of the paying than of the receiving country, as far as the terms of trade are concerned.

I venture the prediction, therefore, that when the problem is Edition: current; Page: [360] solved for more complex cases involving varying costs as output is increased, the following conclusions derived from analysis of the simpler cases dealt with above will be found not to require substantial modification: (1) that a unilateral transfer of means of payment may shift the commodity terms of trade in either direction, but is much more likely to shift them against than in favor of the paying country; (2) that the double factoral terms of trade will ordinarily shift in the same direction as the commodity terms of trade, but under increasing costs in all industries, when the commodity terms of trade shift in favor of the paying country, the double factoral terms of trade will nevertheless shift in favor of the receiving country, or will shift in less degree than the commodity terms of trade in favor of the paying country; and (3) that the tendency of the terms of trade to move against the paying country will be more marked, caeteris paribus, the greater the excess in each country, prior to the transfer, of consumption of native products to consumption of imported products, to the extent that such excess is not due to trade barriers or to higher international than internal transportation costs.

XI. Types of Disturbance in International Equilibrium

In the examination of the probable effects on the terms of trade of a lasting disturbance of a preexistent international equilibrium, there is one basis of distinction between types of disturbances which calls for special emphasis. Disturbances are to be distinguished according as they originate in a relative change in the amounts, measured in units of constant purchasing power over native goods, available for expenditure in the two areas, or as they originate in a relative change in the demands of the two countries for each other's products in terms of their own products resulting from changes in taste or in conditions of production, or from changes in tariffs, subsidies, internal taxes, or transportation costs.1 The analysis presented above of the effects on the terms of trade of reparations payments is applicable without serious modification to all lasting disturbances of the first class, i.e., involving an initial relative shift in the amounts available for expenditure, whether this shift is due to loans, tribute, or subsidy, Edition: current; Page: [361] but is not applicable to disturbances of the second class, where, however, analysis in terms of reciprocal demand curves is appropriate in most cases.

Whereas in the first class of disturbance a relative change in the amounts available for expenditure in the two countries is the source of the disturbance and a relative change in the demands of the two countries for each other's products is the result of the disturbance, in the second class of disturbance a relative change in the demands is the original cause of the disturbance and a relative change in the amounts available for expenditure is part of the process of adjustment to the disturbance. The case of a new revenue import duty, levied by one of the countries, may be taken as sufficiently illustrative of the effects of disturbances of the second class on the terms of trade. Let us suppose only two countries, only two commodities, no tariffs, no transportation costs, and an even balance of payments between them. One of the countries, England, now imposes a duty on imports of the German commodity. Before the duty the two commodities exchanged for each other at the same rate in both countries. After the duty the German commodity will rise in price to the English consumer relative to the English commodity. Let us assume that this relative rise is at first equal to the amount of the duty. The English will therefore buy smaller physical quantities than before of the German commodity and larger physical quantities than before of the English commodity. Suppose that the reduction in the volume of their sales to England will tend to cause Germans to reduce their total expenditures to the same amount, and that part of this reduction will be applied to German commodities. The willingness to buy German goods at the prevailing price (in England plus duty) will therefore decline in both countries; the willingness to buy English goods will increase in England, and decrease in Germany; with the increase in the former (corresponding to the total decrease in English purchases of German goods and therefore, by assumption, to the total decrease in German purchases of German and English goods combined) exceeding the decrease in the latter country.

Two consequences will follow: (1) Germany will have an adverse balance of payments with England, and specie will move from Germany to England; (2) the price of the German commodity Edition: current; Page: [362] will fall in both countries relative to the English, so that in England it will, without duty, be lower than it was before the duty was imposed, and, including duty, will exceed the pre-duty price by less than the amount of the duty. In other words, the commodity terms of trade will have moved against Germany, with an international transfer of specie as part of the process whereby this comes about. The effect of the duty on the terms of


trade is illustrated in chart VII, an application in a slightly modified2 form of Marshall's foreign trade curves.

The quantity of the English commodity is measured from o on the ox axis, and the relative price of the English commodity, in terms of number of units of the German commodity for one unit of the English commodity, is measured from o on the oy axis. The curve ae represents the quantities of the English commodity which before the duty England would be willing to export at the indicated rates of exchange of the English for the German commodity, and the curve bg represents the quantities of the English commodity which Germany would be willing to import at the indicated rates of exchange of the English for the German commodity. Equilibrium will be established at the terms of trade Edition: current; Page: [363] of mn or ot units of the German commodity for one unit of the English commodity.

If now England should levy a duty of 40 per cent ad valorem on imports of the German commodity, payable by the importer and used by the government to remit other taxes, the English export supply curve adjusted to the duty will be a1e1, with a1e1 uniformly 40 per cent higher than ae with reference to the ox axis. The new equilibrium rate of exchange of English commodities for German will in the English market (i.e., after payment of duty) be m1k, or ol, units of German goods for one unit of English goods. The new terms of trade, or the rate at which Germany will be able to exchange its commodity for the English commodity, will be m1n1, or o1t1, units of the German commodity for one unit of the English commodity, which will also correspond to the relative prices of the two commodities within Germany. The terms of trade will thus be turned against Germany by the English import duty.

It can similarly be shown that an English protective duty, a German export bounty, higher German or English internal taxes on German than on English goods, a shift in taste in either country in favor of English goods, or a relative reduction in the cost of producing the German commodity, will in like manner turn the terms of trade against Germany, whereas a German revenue or protective duty, an English export bounty, lower German or English internal taxes on German than on English goods, a shift in taste in either country in favor of German goods, or a relative reduction in the cost of producing the English commodity, will turn the terms of trade in favor of Germany.

An endless variety of further distinctions between types of disturbances can of course be drawn. Tributes and loans, for instance, are to be distinguished from each other by the fact that, since the former are as a rule involuntary and the latter voluntary, the problem of adjustment in the “paying” country is likely to be more serious in the former than in the latter case. Loans, moreover, call almost immediately for interest payments and eventually for amortization payments in the opposite direction from the loans, whereas this is not true of tributes. Loans are to be distinguished according to whether they are made out of income or out of capital, and according to whether the proceeds are used in the borrowing country for immediate Edition: current; Page: [364] consumption or for investment, since the nature of the source and of the mode of use of the loan will affect the manner in which adjustment is made to the change in the amount of funds available for expenditure, and will affect also the relative availability of the different classes of commodities toward which the expenditures are directed. In actual experience the initial disturbances may come in various combinations, or may originate at home or abroad, or simultaneously in both, and, depending on the nature of the original disturbance and perhaps on other circumstances, what at one time operates as the source of the disturbance and gives rise to the need for adjustment may at other times be the equilibrating factor, with corresponding changes in the time-sequence of phenomena. Thus price changes, capital movements, changes in demand, for example, may at one time be disturbing factors, at other times equilibrating ones, and except when there are drastic disturbances whose origin is fairly obviously to be associated with contemporary events external to the mechanism of international trade itself, it will ordinarily be fruitless to try to distinguish equilibrating from adjusting factors. Some writers have attempted to generalize, however, as to the “disturbing” or “equalizing” character of specific elements in international balances. Thus Keynes, for instance, has maintained that historically the international movement of long-term capital has adjusted itself to the trade balance rather than the trade balance to capital movements,3 whereas Taussig4 has supported the opposite, and traditional, view. There is no apparent a priori reason why the dependence should not be as much in one direction as the other, and the question of historical fact can be settled only, if at all, by comprehensive historical investigation. It is possible, however, to set forth theoretically the types of circumstances which would tend to make the one or the other the more probable direction, and to find striking historical illustrations in support of such analysis. It seems clear to me, for instance, that in the case of Canada before the war the fluctuations in the trade balance were much more the effect than the cause of the fluctuations in the long-term borrowings abroad, whereas in the case of New Zealand the fluctuations in her balance of indebtedness Edition: current; Page: [365] since the war seem to be clearly the result rather than the cause of the fluctuations in her trade balance. In New Zealand a marked degree of dependence of the national income on the state of the crops and the world-market prices of a few export commodities, with sharp year-to-year fluctuations in the crops and in prices, makes it necessary to choose between highly unstable expenditures on consumption or domestic investment, on the one hand, and substantial fluctuations in the net external indebtedness of the country, on the other, and the choice seems to be predominantly in favor of the latter. Examination of such data as are readily available strongly confirms, however, the orthodox doctrine that, at times when “fear” movements of capital are not important, short-term capital movements are much more likely than long-term capital movements to be “equilibrating,” and that major long-term capital movements have, as Taussig maintains, mainly been “disturbing” rather than “equilibrating” in nature.

The foregoing discussion, it should be repeated, has dealt solely with the long-run effects of a lasting variation in one of the elements of an original equilibrium on the terms of trade. It should be noted also that changes in the terms of trade have been treated as purely objective phenomena, without reference to the differences in hedonic significance which may be attached to them according to the types of disturbance from which they result.

XII. Specie Movements and Velocity of Money

The classical economists were agreed that (abstracting from the process of distribution of newly-mined bullion) there were no specie movements under equilibrium conditions, and that specie moved only to restore and not to disturb equilibrium, or, as Ricardo put it, gold was “exported to find its level, not to destroy it.” 1 But on the range of circumstances which could disturb equilibrium in the balance of payments so as to require corrective specie movements they were, as we have seen, not in agreement. Wheatley, as much later Bastable and Nicholson, held that the balance of payments would adjust itself immediately, and without need of specie movements, to disturbances of a non-currency nature, through an immediate and presumably exactly equilibrating relative shift in the demand of the two regions for each Edition: current; Page: [366] other's commodities. Granted that a relative shift in demand as between the two countries may, without the aid of relative price changes, restore an equilibrium disturbed, say, by an international tribute, it is an error to suppose that the shift in demand can ordinarily occur, under the assumption, be it remembered, of a simple specie currency, without involving a prior or a supporting transfer of specie from the paying to the receiving country. The new equilibrium requires that more purchases measured in money be made per unit of time in the receiving country and less in the paying country; as has been shown above, it is by its effect on the relative monetary volume of purchases in the two countries that the relative shift in demands exercises its equilibrating influence. Unless as and because one country becomes obligated to make payments to the other velocity falls in the paying country and rises in the receiving country, these necessary relative changes in purchases and in demands will not occur except after and because of a relative change in the amount of specie in the two countries, and such changes in velocity are at least not certain to occur, nor to be in the right directions if they do occur. Acceptance of the doctrine that a relative shift in demand schedules may suffice, without changes in relative prices, to restore equilibrium in a disturbed international balance does not involve as a corollary that specie movements are unnecessary for restoration of equilibrium, as Wheatley, Bastable, Nicholson, and others seem to have supposed. The error arises from acceptance of a too simple version of the quantity theory of money, in which price levels and quantities of money must move together and in the same direction regardless of what variations may occur in other terms of the monetary equation. In its most extreme application this erroneous doctrine has led to the conclusion that if unilateral payments should perchance result in a relative shift in price levels in favor of the paying country, the movement of specie will be from the receiving to the paying country!2

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It has been generally overlooked, however, that the velocity of money, or the ratio of the amount of purchases per unit of time to amount of money, has an important bearing on the extent of the specie movement which will be necessary to restore a disturbed equilibrium. It is not purchases, or transactions, in general which are significant for the mechanism of adjustment, but only purchases of certain kinds. If, for instance, a particular house has changed ownership as between dealers through purchase and sale three times in one year, and not at all in the next year, neither the transactions in one year nor their absence in the next year have any direct significance for the international mechanism. What matters is only the volume of expenditures which for the unit period operate to remove the purchased commodities from the market. Such purchases we will call final purchases, to distinguish them from transactions which do not consist of purchase and sale of commodities and services or which, if they do involve such purchase and sale, result merely in transfer of ownership from one person to another who will in turn before the unit period of time is over sell or be ready to sell the commodity or service, whether in the same form or not does not matter, to a third person. It is the relative change as between the two countries in the volume of final purchases, so defined, which plays a direct and equilibrating role in the mechanism of adjustment of international balances to disturbances.

Under the assumption of a simple specie currency, the significant velocity concept for the analysis of the mechanism of international trade is accordingly the ratio of final purchases per unit of time to the amount of specie in the country, which we will call the “final purchases velocity of money.” This concept Edition: current; Page: [368] is to be distinguished not only from the familiar velocity concept, or the “transactions velocity of money,” but also from the “income” or “circuit” velocity of money concept. This latter is for our purposes a more serviceable concept than the “transactions velocity,” since it disregards many kinds of transactions which are of no direct significance for the international mechanism. It is nevertheless not a wholly satisfactory concept for the present purpose. For any limited period of time “income” is not only difficult of measurement but almost incapable of definition. It does not matter, moreover, for the mechanism of international adjustment whether what is spent comes from current net income or from disposable capital funds, borrowings, internal or external, or “negative income” or business losses eventually to be defrayed by the creditors. Nor does it matter whether the expenditures are for consumption or for maintenance or expansion of investment, except indirectly as this may affect the productive resources of the country or the apportionment of expenditures as between different classes of commodities. What matters for present purposes is primarily the ratio to the volume of money of the expenditures per unit of time which, for that unit of time, make an equivalent reduction in the willingness to spend of the purchasers.3 The final purchases velocity of money will of course necessarily be much smaller than the transactions velocity. It may be smaller or larger than the income velocity. It will tend to be smaller than the income velocity in so far as the latter covers income not spent or invested at home but hoarded or lent abroad. It will tend to be larger than the income velocity in so far as the latter fails to take account of maintenance and replacement expenditures, disinvestment expenditures, or expenditures of the proceeds of external or internal borrowings.

Since the relative change in the amount of final purchases in the two areas is an important equilibrating factor in the process of adjustment to a disturbance in their international balances, then, assuming no change to occur in either country in the final purchases velocity of money, the greater is the weighted average final purchases velocity of money in the two countries combined, the smaller will be the amount of money necessary to be transferred to restore a disturbed equilibrium, other things remaining Edition: current; Page: [369] the same. If, as the result of a transfer of specie to meet the first instalments of new and periodic obligations of one country to the other, a sudden change occurs in the amount of money in each country, and the volume of final purchases in each country does not immediately respond proportionately to the change in the amount of money, the amount of transfer of money to the receiving country will for a time have to be greater than the amount of such transfer ultimately necessary, and after the velocities in the two countries have recovered their normal levels, but before the periodic payments have terminated, a partial return of money to the paying country will occur. If, on the other hand, change in the amount of money tends to be accompanied with change in its velocity in a corresponding direction, a smaller initial transfer of money will suffice for the time being, but as the velocities recede to their normal levels more money will have to be transferred from the paying to the receiving country to maintain their relative volumes of final purchases at the new equilibrium level. In all cases, the amount of specie transfer necessary for adjustment to a disturbance will depend on the velocities of money in the two areas as well as on the manner in which the demands for different classes of commodities behave as the amounts of money are varied. Except under very unusual conditions, however, adjustment of the balance of payments to new and continuing unilateral remittances will require some initial transfer of specie from the paying to the receiving country.

The final purchases velocities in the two countries not only help to determine the amount of specie transfer necessary for adjustment, but they also help to determine what effects the remittances shall have on the absolute price levels in the two countries combined. If in the receiving country money has a higher velocity than in the paying country, the transfer of means of payment will result in a higher level of prices for the two countries combined, and vice versa. It is even conceivable, though not of course probable, that reparations payments may result in higher (or in lower) prices in both of the countries. Failure to take into account the possibility of different velocities in the two countries has led some writers to deny this even as a theoretical possibility.4

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The role of specie movements and of the velocity of money in the mechanism of adjustment to disturbances is illustrated in table V, in which it is assumed that before reparations the unweighted average ratio of expenditures on native to expenditures on foreign commodities for the two countries combined is unity, and that, in the absence of price changes, reparations payments will not disturb the proportions in which expenditures are distributed between native and foreign commodities in either country. Under these conditions reparations payments, as we have seen, would not disturb the terms of trade. The pre-reparations equilibrium is disturbed by the imposition on one of the countries of the obligation to pay reparations to the other for an indefinite period of time at the rate of 600 monetary units per month.

In case A, the final purchase velocity of money per month, both before and after5 the beginning of the reparations payments is unity in both countries, and prior to the transfer the final purchases per month are 3000 in the receiving country and 1500 in the paying country. There must therefore have been, in the initial equilibrium situation, 3000 monetary units in the former, and 1500 in the latter, country. A transfer of 600 monetary units from the paying to the receiving country takes place when the payments begin, and the resultant shifts in demands bring about an adjustment of the balance of payments of the two countries to the tribute without necessitating any change in prices. In case B the velocity of money per month both before and after the beginning of the tribute payments is 2 in the receiving country and 1 in the paying country, and prior to the transfer there are 1500 units of money in each of the countries. To restore equilibrium; a transfer of only 450 units of money is necessary. But since the Edition: current; Page: [372] transfer of money is from a low-velocity to a high-velocity country, it results in an increase in the world level of prices and of money incomes. As in case A, however, equilibrium is restored without any change in the terms of trade. In case C the velocity of money is ½ in the receiving country and 1 in the paying country, and prior to the transfer there are 6000 units of money in the receiving country and 1500 in the paying country. To restore equilibrium a transfer of 720 units of money is necessary. But since the transfer of money is from a high-velocity to a low-velocity country, it results in a decrease in the world level of prices and of money incomes. As in the previous cases, however, equilibrium is restored without any change in the terms of trade. Whatever other cases were chosen, the same conclusion would be indicated that the effect of a transfer of payments on relative prices is independent of the velocities, provided that such changes in money incomes as are offset by corresponding changes in prices are assumed not to affect the apportionment of expenditures among different classes of commodities.6


Solving for x, Ir and Ip


Allocation of Ir and Ip to the different classes of commodities in the proportions in which it is assumed each country would distribute its expenditures in the absence of relative price changes yields the remainder of the data necessary to determine whether relative changes in prices are necessary for the new equilibrium, and, if so, in what direction.

In the older literature, analysis of this sort of the role of velocity of money in the mechanism of adjustment of international Edition: current; Page: [373] balances is to be found, if at all, only by implication. In the more recent literature, also, discussion of this phase of the mechanism is scanty. Ohlin's treatment of velocity is imbedded in his exposition of the mechanism as a whole, but there seems to me to be agreement between our accounts in so far as they cover the same ground. D. H. Robertson, in a short essay,7 which nevertheless contains in germ much of what has here been more elaborately expounded with reference to the transfer mechanism, also treats the velocity factor, in so far as he carries his analysis, in the same manner in which it is here treated. But concerned presumably more with establishing certain possibilities than with surveying the range of probabilities, he applies his analysis only to assumptions so extreme as to lead him to highly improbable conclusions. In an analysis of the effects of reparations payments by Germany to America on specie movements, terms of trade, and aggregate income in the two countries, he introduces an annual velocity of money factor, assumed to be unity and invariable in each country, and which represents the ratio of annual income, or annual expenditure, to the stock of money. From an arithmetical illustration he concludes that the payment by Germany of reparations need involve no transfer of money, no alteration in the terms of trade, and no change in “gross monetary income” in either country. Substituting “final purchases” for “gross monetary income,” and taking only the data which he presents for America, his illustration is as follows:


Before Reparations Payments

Final purchases of £1,600 buy 900 American goods + 100 German goods and pay £600 taxes.

Gold stock £1,600. V = 1.

Price of American goods = £1.

During Reparations Payments at the rate of £600 per year

Final purchases of £1,600 buy 900 American goods + 700 German goods.

Gold stock £1,600. V = 1.

Price of American goods = £1.

How extreme the assumptions are on which all of these results Edition: current; Page: [374] depend is not made apparent only because they are not brought clearly into the open in either the illustration or the accompanying text. The illustration assumes that the government of America uses the proceeds of the reparations payments to remit taxation, but it presumably continues to render the same services to the community, for otherwise £600 of spending power would be unaccounted for. As far as final purchases or “gross money incomes” are concerned, the apparent absence of an increase when reparations are received is due solely to the fact that real income in the form of government services for which previously £600 was paid by individuals in taxes is now met by the reparations income of the government and therefore does not appear in the accounts of private monetary income. As far as money stocks are concerned, the absence of any increase in the receiving country can be explained only if the periodic receipt of the reparations payments and their use by the government in hiring personnel and buying materials with which to carry out its functions requires no use of the country's stock of money, whereas collection of taxes equal in amount to the reparations plus use of the tax receipts in the identical fashion in which the proceeds of the reparations are used would involve the use of £600 throughout the year. As far as the commodity terms of trade are concerned, the absence of any change is to be explained by the assumption that although in the receiving country no prices have changed and spending power has increased by £600, no increase will occur in that country in the amount of its own goods or governmental services demanded by its people.

XIII. Commodity Flows and Relative Price Levels

Graham and Feis hold that the explanation of the mechanism of adjustment of international balances to capital borrowings offered by the classical economists and their modern followers omits reference to a factor operating to bring about relative shifts in price levels in the direction opposite to that posited in this explanation. Graham claims that since the effect of a loan is to shift goods from the lending to the borrowing country, the volume of goods relative to the volume of gold will be increased in the borrowing country and decreased in the lending country, and therefore the prices will tend to fall in the former and rise in Edition: current; Page: [375] the latter. On the assumption that the first phase of the mechanism is a transfer of gold from the lending country to the borrowing country unaccompanied by a transfer of goods, and that the transfer of goods is a later phase, Graham, calling the former the “short-range” effect of capital movements and the latter the “long-range” effect, concludes that “the short and long range effects of borrowings will run in opposite directions.” 1 He had earlier applied the same reasoning to the problem of the adjustment of international balances to capital imports under an inconvertible paper currency, on the assumption that the quantity of money in each country is held constant.2 Feis accepts Graham's argument:

The effects of the goods movements upon price levels would, therefore, tend to be in the opposite direction to those produced by changes in the volume of purchasing power in each of the countries concerned, as Professor Graham has pointed out. Apparently, two conflicting tendencies are present in each country during the process of adjustment. These tendencies may or may not be simultaneous and equal in strength.3

This reasoning seems erroneous to me. The conclusion of these writers results from a mechanical application of the lf0619_figure_074.jpg formula of price determination to the international trade mechanism, on the implicit assumptions that the price level is result and not cause, and that the changes in M and the changes in T are unrelated and independent factors in the mechanism,4 and Edition: current; Page: [376] Feis, at least, explicitly attributes the same assumptions to the classical school.5 But in the classical theory, as in the preceding exposition, the establishment of international equilibrium is regarded as primarily a problem of international adjustment of prices, and the direction and extent of flow of specie, and therefore also the relative amounts of money in the two countries, instead of being treated as independent factors, are held to be determined by the relative requirements for money of the two countries given their equilibrium price levels and their respective physical volumes of transactions requiring mediation through money. The bearing of the commodity flows in the mechanism, therefore, is not their influence on the relative price levels, but is, instead, their influence on the quantity of specie flow necessary to support the price relations required for equilibrium.

Let us suppose that when the lending first begins the lending country ships sufficient commodities on consignment to the borrowing country to bring its export surplus to equality with its volume of lending per unit period, but that, in consequence of the influx of goods, prices as a whole fall in the borrowing country to a level lower than is consistent with the maintenance of its import surplus at the required amount. A new or intensified flow of specie must thereupon occur from lending to borrowing country, so as to bring prices (and demands) in the borrowing country to a level adequately high to result in a continuing import surplus equal to the borrowings.6

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“Capital” movements, it is true, if they consist of funds which in the absence of such movement would have been invested at home, and if they result in an increase in the amount of investment in the borrowing country as compared to what would have been the situation in the absence of the borrowings, will eventually result in a relative increase in the output of the marketable commodities of the borrowing country as compared to those of the lending country and, therefore, will to this extent tend to result in a relative fall in the price level of the borrowing country. But Graham's and Feis's argument rests on the supposed effect on relative price levels of the relative changes in the output of commodities in the two countries.

XIV. Exchange Rates

Hume conceded that the fall in the exchange value of a country's currency when for any reason there was adverse pressure on its balance of payments tended to exercise an equilibrating influence by providing an extra incentive to commodity export and a deterrent to commodity import. He held, however, that this could be but a minor factor in the process of adjustment, and although he gave no reasons it may be presumed that he saw that under a metallic standard the maximum possible range of variation of the exchanges, i.e., between the specie export and import points, was so limited as to make it extremely unlikely that such variation could exert an appreciable direct influence on the course of trade.1 Since his time the maximum range of variation has become still narrower under normal conditions because of reduction in the cost of transporting specie, and scarcely anyone today would dispute that under an international metallic standard exchange variations are a negligible factor as far as their direct Edition: current; Page: [378] influence on commodity trade is concerned.2 It has sometimes been suggested, however, that this narrowing of the range between the gold points has not been an unalloyed benefit, since by its facilitation of specie shipments it has contributed to the instability of national credit structures. Proposals have been made, starting with Torrens in 1819,3 artificially to widen the margin between the specie points, by seigniorage charges, premiums on gold for export, different buying and selling prices for gold at the Central Bank, generous tolerance for underweight in the internal specie circulation, differential buying or selling prices for the gold of the particular degrees of fineness most in supply or demand abroad, and other similar devices, and such practices have, for this or other reasons, been followed. To the extent that such practices exist, the range of possible exchange fluctuations under a metallic standard, and therefore the possible influence of exchange variations on the course of trade, can of course be somewhat increased. In effect this is an attempt to retain the advantages of an international metallic standard while escaping in part one of its incidents, namely, the direct dependence of the national stock of money, or of the specie reserves upon which it rests, on the state of the foriegn exchanges. But the same advantages of partial freedom of the quantity of the exchanges can be more safely, and especially for an important financial center whose effectiveness depends largely on its ability to attract foreign short-term funds, more cheaply obtained, by the maintenance of excess specie reserves, than by artificial widening of the range between the gold points. Even with such widening, moreover, unless it were carried to much greater lengths than has ever been customary, the direct influence of exchange rate fluctuations on the course Edition: current; Page: [379] of commodity trade would still be negligible. But even small variations in the exchanges can exert an appreciable influence on the movement of short-term capital funds, and through them on the mechanism of adjustment. This phase of the machanism is discussed in the next chapter, in connection with the discussion of the relation of banking processes to the mechanism.

In their discussion of the foreign exchanges, the writers on the theory of international trade with apparently almost complete unanimity expound a particular error of minor practical importance but revealing lack of due precision in exposition or thought. They hold that when the balance of payments is even, the exchanges will be at their mint par.4 The correct statement is that when the balance of payments is even the exchanges will be somewhere within the export and import points. The mint par has significance for the exchanges only as a base point from which to determine the specie export and import points. Equilibrium between the amount of foreign bills demanded and offered is as likely to be reached at any one as at any other rate within the limits of the specie points. Except for the approximately fixed limits to the range of possible fluctuation of the exchanges under an international metallic standard, there is no basis for differentiating the theory of the foreign exchanges between two currencies having a common metallic standard, on the one hand, and between two currencies on different standard, on the other hand.

XV. A Criticism of the Purchasing-power Parity Theory1

Owing more, probably, to good fortune than to superior insight, the classical economics escaped almost almost completely the fatal Edition: current; Page: [380] error of formulating their theory of the international relationships of prices in terms of simple quantitative relationships between average price levels. But since 1916, Professor Gustav Cassel has expounded, and obtained wide acceptance of, a simple formula purporting to express the relationship to each other of national statistical price levels, which he called the purchasing-power parity theory. Some writers have found in this formula nothing but a restatement of the English classical theory, but it differs substantially from any version of the classical theory known to me.

The following citation embodies an early formulation of his theory by Cassel, and the one which first gained for it wide attention:

Given a normal freedom of trade between two countries, A and B, a rate of exchange will establish itself between them and this rate will, smaller fluctuations apart, remain unaltered as long as no alterations in the purchasing power of either currency is made and no special hindrances are imposed upon the trade. But as soon as an inflation takes place in the money of A, and the purchasing power of this money is, therefore, diminished; the value of the A-money in B must necessarily be reduced in the same proportion.... Hence the following rule: when two currencies have been inflated, the new normal rate of exchange will be equal to the old rate multiplied by the quotient between the degrees of inflation of both countries. There will, of course, always be fluctuations from this new normal rate, and in a period of transition these fluctuations are apt to be rather wide. But the rate calculated in the way indicated must be regarded as the new parity between the currencies. This parity may be called the purchasing power parity, as it is determined by the quotients of the purchasing powers of the different currencies.2

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Cassel has expounded the theory primarily in terms of paper currencies and with special bearing on the effects of currency inflation on exchange rates. But if true for paper currencies, there is no apparent reason why it should not apply equally to gold standard currencies. Since under an international gold standard the possible range of variation of the exchanges is narrowly limited by the gold points, it should follow that under such a standard the possibility of substantial divergence of movement of price levels, in direction or in degree, in different countries is correspondingly limited. It would seem further that if substantial relative changes in the purchasing power of two currencies must generally result in corresponding inverse changes in the rates at which these currencies exchange for each other, then under equilibrium conditions metallic standard currencies must have equal purchasing power in terms of units of identical gold content,3 unless adequate reason can be found for holding that all the factors other than relative price levels capable of exerting an enduring influence on the exchanges were already present in the year arbitrarily chosen as the base year, had already exercised all of their possible influence on the exchange rates, and would never disappear or weaken. It is easy to conceive, however, of changes in cost or demand conditions or both, in one or the other countries, or both, which so change the relative demands of the two countries for each other's products in terms of their own as to bring about an enduring and substantial relative change in their levels of prices, including the prices of domestic commodities and services, even under the gold standard. The existence of non-transportable goods and services in one country which have no exact prototype in the other, moreover, makes it difficult to see not only how there could be any necessity under the gold standard that the price levels be identical in the two countries, but how the two price levels could be compared at all with any approach to precision.

Cassel nevertheless accepts readily the corollaries of his doctrine:

Even when both countries under consideration possess a gold standard, Edition: current; Page: [382] the rate of exchange between them must correspond to the purchasing power parity of their currencies. The purchasing power of each currency has to be regulated so as to correspond to that of gold; and when this is the case, the purchasing power parity will stand in the neighborhood of the gold parity of the two currencies. Only when the purchasing power of a currency is regulated in this way will it be possible to keep the exchanges of this currency in their parities with other gold currencies. If this fundamental condition is not fulfilled, no gold reserve whatever will suffice to guarantee the par exchange of the currency. Under stable currency conditions and when no radical alterations in the conditions of international trade take place, no great or lasting deviation from purchasing power parity is possible.4

Some writers have held that the purchasing-power parity theory is invalid if applied to general price levels, but that it could be made acceptable, and in fact reduced to the status of a truism, if it were confined to the price levels of commodities directly entering into international trade, and if abstraction were made, as does Cassel, from relative changes in transportation costs or tariff rates. The following quotation from Heckscher is representative of this point of view:

The conception that the exchanges represent relative price levels, or, what is the same thing, that the monetary unit of a country has the same purchasing power both within the country and outside it, is correct only upon the never existing assumption that all goods and services can be transferred from one country to another without cost. In this case, the agreement between the prices of different countries is even greater than that which is covered by the conception of an identical purchasing power of the monetary unit; for not only average price levels but also the price of each particular commodity or service will then be the same in both countries, if computed on the basis of the exchanges.5

Cassel, however, rejects this view, and insists that the doctrine will not hold if applied to international commodities alone, since if the prices of all B's export commodities were doubled, all other prices in B and all prices in A remaining unchanged, the exchange value of B's currency would fall by much less than Edition: current; Page: [383] half. Before the exchange could fall to this level, other commodities hitherto produced only for home consumption could be profitably exported by B, and its imports of A's commodities would have fallen, and thus a further drop in its exchanges would be prevented.6

Cassel is right in maintaining that the doctrine need not hold if applied to the price levels of a variable range of international commodities. But it need not hold even if applied to a fixed assortment of international commodities. Suppose that there are only two countries, that no new commodities enter into international trade, that no commodities already in international trade change the direction of their flow or disappear from trade, and that there are no tariffs or freight costs, so that all international commodities command idential prices in all markets, in terms of the standard currency when this is uniform and exchange is at par, or in terms of the currency of either of the countries converted from the other, when necessary, at the prevailing rate of exchange. Even in this case, the doctrine that the exchange rates will vary in exact inverse proportion with the relative variations in the index number of prices of international commodities in the two countries would not only not be atruism, but would not necessarily or ordinarily be true if, as would be most appropriate, weighted index numbers were used and the basis for the weighting were, not the relative importance of the commodities in international trade (which, with only two countries, would mean identical weights for both countries) but their relative importance in the consumption or the total trade, external and internal, of the respective countries. In fact, it would be possible for the exchange rate under these conditions to change even if no change Edition: current; Page: [384] occurred in any price, provided there were changes in the weights in the two countries, or even if no change occurred in any weight, provided there were any changes in prices, notwithstanding the necessity under the conditions assumed that any price changes should be identical in both countries.

The only necessary relationships between prices in different countries which the classical theory postulated, or which can be formulated in general terms, are the international uniformity of particular prices of commodities actually moving in international trade when converted into other currencies at the prevailing rates of exchange, after allowance for transportation costs and tariff duties, and the necessity of such a relationship between the arrays of prices in different countries as is consistent with the maintenance of international and internal equilibrium.

The one type of case which would meet the requirement of exact inversely proportional changes in price levels and in exchange rates would be a monetary change in one country, such as a revaluation of the currency, which would operate to change all prices and money incomes in that country in equal degree, while every other element in the situation, in both countries, remained absolutely constant.7 Cassel, however, argues for at least the practical validity of his theory, as applied to actual history, on the ground that it is substantially confirmed by the facts, since under the gold standard there do not occur even over long periods wide divergences in the trends of the indices of different countries, and under fluctuating paper currencies the divergences between the actual trends of the indices and the purchasing-power parities calculated in accordance with his formula are not great and tend to disappear. He claims that the disturbances such as capital flows or tariff changes which operate to prevent purchasing-power parity from establishing itself are rarely powerful enough, as compared to the influence of the comparative purchasing power of the respective currencies, to result in a wide divergence from purchasing-power parity and are moreover likely to be temporary in character. His defense of the theory is essentially empirical rather than analytical.

It is no doubt true that the comparative purchasing power of two paper currencies in terms of all the things which are purchasable in their respective countries is at least ordinarily the most Edition: current; Page: [385] important single factor in determining the exchange rate between the two currencies and must ordinarily be powerful enough to keep divergences of the exchange rate and purchasing power parity from reaching such lengths as, say, a rate only 50 per cent or as much as 200 per cent of the rate called for by the purchasing-power parity formula. It is also true that the exchange rate, which means approximately the comparative mint prices of gold, is ordinarily the most important single factor in determining the price levels of countries on an international gold standard. But the divergences between actual exchange rates and those required by the purchasing-power parity formula are in fact frequently substantial, and the “disturbances” from which such divergences result need not by any means be temporary in character, so that a longer period would lessen the divergence, but may in fact be progressive in character through time. Nor can these divergences be satisfactorily explained by defects in the available index numbers. On the contrary, the indices ordinarily used are unweighted wholesale price indices, and these are notoriously heavily loaded with the staple commodities of international commerce, whose prices are most likely to have uniform trends in different countries. Examination of such few indices as are constructed on a broad enough basis to give some representation to domestic commodities and services indicates, what is to be expected, that the more comprehensive the index the wider tends to be the divergence of the actual exchange rate from the purchasing-power parity rate. Use of weighted indices also ordinarily results in a widening of the indicated deviation of the exchanges from the purchasing-power parity rate.

Cassel's theory purports to be not merely a statement of relations between quantities, but also an explanation of the order of causation, with exchange rates being determined by relative price levels, rather than vice versa. Under an international metallic standard in the long run, for any one country, and especially if it is a small country, its price level will be determined for it largely by factors external to it and impinging upon it through specie movements.8 Under paper standards not substantially pegged to gold, whether de jure or de facto, it is impossible to formulate the issue intelligently without reference to the principles Edition: current; Page: [386] on which the quantity of money in each country is regulated, and if, as is, however, rarely the case, there is no clear governing principle, and the play of circumstances, such as the state of the national budget, pressure from business, or more or less arbitrary or traditional discount policies, are allowed to be the determining factors, there will be mutual influence of prices on exchange rates and of exchange rates on prices, with no satisfactory way of apportioning to each set of influences its share of responsibility for the actually resultant situation.

Cassel has defended his failure to give attention to the factors which even in the long run can operate to create divergence between the actual exchange rate and the purchasing-power parity rate on the ground that his theory threw the emphasis on what was during the war and post-war period of extreme inflation overwhelmingly the most important factor in determining exchange rates, namely, currency inflation. Under such circumstances, the proper procedure for the economist apparently is to forget about the minor factors:

The art of economic theory to a great extent consists in the ability to judge which of a number of different factors cooperating in a certain movement ought to be regarded as the most important and essential one. Obviously in such cases we must choose a factor of permanent character, a factor which must always be at work. Other factors which are only of a temporary character and may be expected to disappear, or at any rate can be theoretically assumed to be absent, must for that reason alone be put in a subordinate position.9

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No objection can be made to this, if it is to be understood to mean merely that minor factors should be treated as minor factors. But if it is presented as justification for the omission of mention of minor factors, and even for express denial that they are operative, on the ground that their recognition weakens the persuasive power of one's argument, then this amounts merely to saying that bad theory may make good propaganda, and is a debatable proposition at that.10

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... many writers have perplexed themselves and their readers by founding theorics on exceptional circumstances. Others have been led astray by statistics—the characteristic form of modern research....—G. Arbuthnot, “Sir Robert Peel's Act of 1844 ... vindicated,” 1857, p. vii.

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 Edition: current; Page: [389] 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, Edition: current; Page: [390] 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.3 4

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 Edition: current; Page: [391] 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 Edition: current; Page: [392] 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, Edition: current; Page: [393] 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 Edition: current; Page: [394] 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.

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

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Central bank operations
Central bank objective Gold outflow (Primary contraction) Gold inflow (Primary expansion)
(1) Fixed reserve ratio Secondary contraction Secondary expansion
(2) Minimum reserves Secondary expansion while excess reserves persist; secondary contraction when reserves are below minimum Secondary expansion to check accumulation of excess reserves
(3) Minimum intervention Secondary contraction when reserves approach safety minimum Secondary expansion when needed to protect foreign central banks
(4) Stabilization Secondary expansion if undesired deflation under way or “reflation” desired; secondary contraction if undesired inflation under way or deflation desired Secondary contraction if undesired inflation under way or deflation desired; secondary expansion if undesired deflation under way or “reflation” desired

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 Edition: current; Page: [396] 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 Edition: current; Page: [397] 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 Edition: current; Page: [398] 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 Edition: current; Page: [399] 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 Edition: current; Page: [400] 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 Edition: current; Page: [401] 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. Edition: current; Page: [402] 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 Edition: current; Page: [403] 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

III. Short-Term Loans in the International Mechanism

International short-term lending takes many forms; interbank credits, transfers of deposits, purchase of foreign bills of exchange, purchase of foreign treasury bills, commercial credits, purchase of long-term securities in a foreign market with the expectation of their early resale abroad, etc. Whatever form it takes, the international movement of short-term funds derives its importance for the mechanism of adjustment of international balances from the fact that these funds are highly mobile and in the absence of financial or political disturbance respond quickly, especially as between well-developed money markets, to even moderate relative fluctuations in interest rates. Since outward drains of gold ordinarily tend to result in rising rates of interest or at least to occur under circumstances which cause a rising rate of interest to be associated with them, and since inflows of gold are ordinarily similarly associated with falling rates of interest, the short-term funds and the specie are likely to move in opposite directions. Such movements of short-term funds in a reverse direction from the actual or incipient movement of specie are helpful to the international mechanism of adjustment in two main ways.

To take first the less important type of case, the balance of immediate obligations of any country is likely to be undergoing constant fluctuation and to be repeatedly shifting from a debit to a credit status. The most marked instances of such fluctuations in the balance of immediate obligations are to be found in countries whose export and import trade have marked and divergent seasonal patterns. If such countries did not resort to international Edition: current; Page: [404] short-term credit operations, specie would repeatedly have to be exported in substantial quantities to liquidate a debit balance, only to return soon thereafter upon the development of a credit balance. If such countries have well-developed money markets, such credit operations will take place through the initiative of individual banks or traders, in response to the seasonal relative shifts in interest rates at home and abroad. These operations will be further stimulated, moreover, by seasonal fluctuations in exchange rates resulting from the seasonal fluctuations in the trade balance. This goes counter to the doctrine sometimes expounded that the cost of shipping gold, or the deviation of the exchanges from the mint par, acts as a deterrent to the movement of short-term funds in response to small differentials in interest rates.1 This doctrine overlooks the fact that the movements of short-term funds and of gold are frequently, and perhaps in the majority of cases, in opposite directions rather than in the same direction, and that when the former is the case the turn of the exchanges which is to be anticipated is a stimulus rather than a deterrent to short-term movements of funds. An individual in a country whose currency is above par in the exchange market who lends in terms of the foreign currency to a country whose currency is below par stands to profit not only from whatever interest differential he can obtain but also from the gain on the turn of the exchanges which may be expected to occur, and for which he can wait before recalling his funds.2 When the movement of short-term funds is in the opposite direction from the actual or incipient movement of gold, it operates to reduce the extent of the gold movement to a corresponding degree.

Secondly, a major disturbance of international equilibrium requiring for its complete adjustment a more or less enduring contraction of means of payment and deflation of prices in some country may come so suddenly, or may have been so long neglected by the banking authorities of that country, that if short-term Edition: current; Page: [405] loans could not be made abroad a large amount of gold would have to be exported at once and bank credit contracted suddenly and sharply, with the danger that a major crisis would result. By resort to borrowing on short-term abroad, the necessary drain of gold can be spread over a longer period and even reduced in its total amount, and bank credit can be more gently and gradually contracted, thus avoiding or moderating the internal crisis.

This cushioning effect of short-term loans is especially important for long-term capital-exporting countries, where the flotation of foreign issues is likely to be irregularly spaced. Suppose, for instance, that country A floats the first of a series of great long-term loans in country B, whose balance of payments had previously been in approximate equilibrium. Even if the flotation of the loan were followed immediately by a substantial transfer of specie from B to A, and by supporting secondary expansion of means of payment in A and secondary contraction of means of payment in B, it would still ordinarily take some time before the demands for and the prices of commodities in the two countries would shift sufficiently to effect a transfer of the remainder of the loan in the form of commodities. In the meantime there would have been a heavy and unnecessarily large specie movement, an excessive credit expansion in the borrowing country, and an even more disturbing credit deflation in the lending country. But if the short-term money markets of the two countries are flexible and responsive to differentials in money rates, there will be a rise in short-term interest rates in B and a fall in A which will induce A to lend B on short term some of the funds it has borrowed from B on long term. The adverse balance of immediate