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Fiduciary Media and the Demand for Money

1 The Influence of Fiduciary Media on the Demand for Money in the Narrower Sense

The development of the clearing system, especially the extension of the clearinghouse proper, reduces the demand for money in the broader sense: part of the exchanges made with the help of money can be carried through without the actual physical circulation of money or money substitutes. Thus a tendency has arisen toward the reduction of the objective exchange value of money, which has counteracted the tendency for it to rise which was bound to result from the enormous increase in the demand for money in consequence of the progressive extension of the exchange economy. The development of fiduciary media has the same sort of effect; fiduciary media, which can, as money substitutes, take the place of money in commerce, reduce the demand for money in the narrower sense. This constitutes the great significance of fiduciary media, in this their effect on the exchange ratio between money and other economic goods is to be sought.

The development of fiduciary media, the most important institution for reducing the need for money in the narrower sense, equally with the establishment and development of clearinghouses, the most important institution for reducing the need for money in the broader sense, has not been merely left to the free play of economic forces. The demand for credit on the part of merchants and manufacturers and princes and states, and the endeavor to make a profit on the part of the bankers, were not the sole forces affecting its development. Intervention took place with the object of furthering and expediting the process. As the naive Midas-like trust in the usefulness of a large stock of precious metals disappeared and was replaced by sober consideration of the monetary problem, so the opinion gained strength that a reduction of the national demand for money in the narrower sense constituted an outstanding economic interest. Adam Smith suggested that the expulsion of gold and silver by paper, that is to say notes, would substitute for an expensive means of exchange a less expensive, which, however, would perform the same service. He compares gold and silver which is circulating in a country with a road over which all the corn has to be brought to market but on which nevertheless nothing grows. The issue of notes, he says, creates, as it were, a path through the air and makes it possible to turn a large part of the roads into fields and meadows and in this way considerably to increase the annual yield of land and labor. [1] Similar views are entertained by Ricardo. He also sees the most fundamental advantage of the use of notes in the diminution of the cost to the community of the apparatus of circulation. His ideal monetary system is one which would ensure to the community with the minimum cost the use of a money of invariable value. Starting from this point of view, he formulates his recommendations, which aim at expelling money composed of the precious metal from actual domestic circulation. [2]

The views on the nature of methods of payment which diminish the demand for money, which were developed by the Classical economists, were already known in the eighteenth century. Their acceptance in the writings of the Classical economists and the brilliant way in which they were expounded, ensured general recognition for them in the nineteenth and twentieth centuries also. The opposition which they occasionally called forth, has now sunk into silence. In all countries the aim of banking policy is to secure the greatest possible extension of money-economizing means of payment.

If metallic money is employed, then the advantages of a diminution of the demand for money due to the extension of such other means of payment are obvious. In fact, the development of the clearing system and of fiduciary media has at least kept pace with the potential increase of the demand for money brought about by the extension of the money economy, so that the tremendous increase in the exchange value of money, which otherwise would have occurred as a consequence of the extension of the use of money, has been completely avoided, together with its undesirable consequences. If it had not been for this the increase in the exchange value of money, and so also of the monetary metal, would have given an increased impetus to the production of the metal. Capital and labor would have been diverted from other branches of production to the production of the monetary metal. This would undoubtedly have meant increased returns to certain individual undertakings; but the welfare of the community would have suffered. The increase in the stock of precious metals which serve monetary purposes would not have improved the position of the individual members of the community, would not have increased the satisfaction of their wants; for the monetary function could also have been fulfilled by a smaller stock. And, on the other hand, a smaller quantity of economic goods would have been available for the direct satisfaction of human wants if a part of the capital and labor power that otherwise would have been used for their production had been diverted to mining precious metals. Even apart from the diversion of production, a decrease of prosperity would result from the fact that as a consequence of the rise in value of the precious metals caused by the use for monetary purposes the stock available for industrial employment would decrease, since certain quantities would be transferred from the latter employment to the former This all becomes particularly clear if we think of an economic community which does not itself produce the precious metals, but imports them. Here the amount of their cost is expressed by the quantity of commodities that must be surrendered to foreign countries in order to obtain the supplementary quantity of monetary metal in exchange. In a country that itself produces the precious metals, the matter is the same in principle; all that is different is the way of reckoning the loss of welfare through the sacrifice of the other branches of production and the preference for mining the precious metals; it is perhaps less perceptible, but it is just as comprehensible in theory. The measure of the additional harm done by the diversion of metal to monetary uses is always given by the quantity of metal that is withdrawn from other uses in favor of the monetary use.

Where fiat or credit money is employed, these reasons in favor of the extension of clearing methods of payment and of the use of fiduciary media do not arise. The only thing in their favor is that they would avoid an increase in the value of money; although this consideration is decisive. Where they are employed, the principle of establishing the national monetary apparatus and maintaining it in working order with the minimum cost must be attained in another way. It must be an object of policy, for example, to manufacture the paper notes with the minimum cost of production. It is immediately obvious that nothing like the same quantitative significance can be attributed to this problem as to that of decreasing the monetary demand for precious metals. However great the care taken in producing the notes, their cost of production could never be anything near so great as that of the precious metals. If we take into further consideration the fact that the artistic production of the notes also constitutes a precautionary measure against counterfeiting, so that merely on this ground, economizing in this sphere is not worth considering, it follows that the problem of diminishing the cost of the circulatory apparatus when fiat or credit money is employed must be of an entirely different nature from what it is when commodity money is employed.

2 The Fluctuations in the Demand for Money

In order to be able to make an accurate estimate of the bearing of clearing methods of payment and of fiduciary media on the development of the demand for money, it is necessary to be clear about the nature of variations in the demand for money.

Fluctuations in the demand for money, insofar as the objective conditions of its development are concerned, are governed in all communities by the same law. An extension of the procedure of exchange mediated by money increases the demand for money; a decrease of indirect exchange, a return to exchange in natura, decreases it. But even apart from variations in the extent of indirect exchange which are insignificant nowadays, large variations in the demand for money occur which are determined by factors of general economic development. Increase of population, and progress in division of labor, together with the extension of exchange which goes hand in hand with it, increase the demand for money of individuals, and also therefore the demand for money of the community, which consists merely in the sum of the demands for money of individuals. Decrease of population and retrogression of the exchange economy, bring about a contraction in it. These are the determinants of the big changes in the demand for money. Within these large variations, it is possible to observe smaller periodical movements. Such are in the first place brought about by commercial and industrial fluctuations, by the alternation of boom and depression peculiar to modern economic life, by good and bad business. [3] The crest and the trough of the wave always cover a period of several years. But also within single years, quarters, months, and weeks, even within single days, there are considerable fluctuations in the level of the demand for money. The transactions involving the use of money are concentrated together at particular points of time; and even where this is not the case, the demand for money is differentiated by the practice on the part of buyers of settling their share of transactions on particular dates. On the daily markets it may perhaps seldom happen that the demand for money during the hours of the market is greater than before or after The periodical rise and fall of the demand for money can be seen much more clearly where transactions are concentrated in weekly, monthly and annual markets. A similar effect results from the custom of not paying wages and salaries daily, but weekly, monthly, or quarterly. Rents, interest, and repayment installments, are as a rule paid on particular days. The accounts of the tailor, the shoemaker, the butcher, the baker, the bookseller, the doctor, and so forth, are often settled not daily but periodically. The tendency in all these arrangements is enormously strengthened by the mercantile practice of establishing certain days as days of settlement, or paydays. The middle and last days of the month have gained a special significance in this connection, and among the last days of the month, particularly the last day of the quarters. But, above all, the payments that have to be made in a community during the year are concentrated in the autumn, the decisive circumstance being that agriculture, for natural reasons, has its chief business period in the autumn. All of these facts have been repeatedly and exhaustively illustrated by statistics; nowadays they are the common property of all discussions on the nature of banks and money. [4]

3 The Elasticity of the System of Reciprocal Cancellation

It is usual to ascribe to the payment system elasticity that is said to be attained by means of the credit system and the continual improvements in banking organization and technique, the capacity of adjusting the available stock of money to the level of the demand for money at any time without exerting any influence on the exchange ratio between money and other economic goods. Between the volume of fiduciary media and the bank transactions or private arrangements that can take the place of a transfer of money, on the one hand, and the quantity of money, on the other hand, there is said to be no fixed relationship which could make the former rigidly dependent upon the latter. Instead of there being a fixed quantitative relationship between money and its substitutes, that is to say, between the stock of money and the various exchange and payment transactions, it is said that the organization of banking institutions and the credit system has made commerce in the highest degree independent of the quantity of money available. The present-day organization of the money, clearing, and credit system is said to have the tendency to balance out variations in the quantity of money and render them ineffective, and so to make prices as far as possible independent of the stock of money. [5] By others, this adjusting capacity is ascribed only to fiduciary media, uncovered banknotes,[6] or unbacked deposits. [7]

Before the soundness of these assertions can be tested, they must be brought out of the obscurity that is due to a confusion between the effects of the clearing system and those of the issue of fiduciary media. The two must be considered separately.

The reduction in the demand for money in the broader sense that results from the practice of settling counterclaims by balancing them against each other is limited in the first place by the number and amount of the claims and counterclaims falling due on the same date. No greater number or amount of claims can be reciprocally canceled between two parties than exist between them at the given moment. If, instead of payment in money, claims on third persons are transferred which are canceled by the transferee and the debtor by means of claims held by the latter against the former, the sphere of the offsetting process can be extended. The clearinghouses which nowadays exist in all important commercial centers are able to avoid the technical and legal difficulties in the way of such transfers, and have thus performed a quite extraordinary service in the extension of the system of reciprocal cancellation. Nevertheless, the clearing system is still capable of further improvement. Very many payments that could be settled by way of cancellation are still made by the actual transfer of money.

If we imagine the clearing system fully developed, so that all payments are first attempted to be settled by balancing, even those in everyday retail trade (which, for practical reasons, would not appear to be easy of accomplishment), then we are faced with a second limit to the extension of the clearing system, although this, unlike the first, is not surmountable. Even if the community were in a stable condition in which there were no variations in the relative incomes and wealth of individuals and in the sizes of their reserves, complete reciprocal cancellation of all the transfers of money that have to be made at a given moment would be possible, only if the money received by individuals was spent again immediately and nobody wanted to hold a sum of money in reserve against unforeseen and indefinite expenditure. But since these assumptions do not hold good, and in fact never could hold good, so long as money is in demand at all as a common medium of exchange, it follows that there is a rigid maximum limit to the transactions that can be settled through the clearing system. A community's demand for money in the broader sense, even with the fullest possible development of the system of reciprocal cancellation, cannot be forced below a minimum which will be determined according to circumstances.

Now the degree in which a clearing system is actually developed within the limits which the circumstances of the time allow for it, is in no way dependent upon the ratio between the demand for money and the stock of money. A relative decline in the one or the other can of itself exercise neither a direct nor an indirect influence on the development of the clearing system. Such development is invariably due to special causes. It is no more justifiable to assume that progressive extension of settlement on the clearing principle reduces the demand for money precisely in the degree in which the increasing development of commerce augments it, than to suppose that the growth of the clearing system can never outstrip the increase in the demand for money. The truth is rather that the two lines of development are completely independent of one another. There is a connection between them only insofar as deliberate attempts to counteract an increase in the exchange value of money by reducing the demand of money through a better development of the clearing system may be made with greater vigor during a period of rising prices; assuming, of course, that the aim of currency policy is to prevent an increase in the purchasing power of money. But this is no longer a case of an automatic adjustment of the forces acting upon the objective exchange value of money, but one of political experiments in influencing it, and the extent to which these measures are accompanied by success remains a matter of doubt.

Thus it is easy to see what little justification there is for ascribing to the clearing system the property, without affecting the objective exchange value of money, of correcting the disparities that may arise between the stock of money and the demand for it, and which could otherwise be eliminated only by suitable automatic variations in the exchange ratio between money and other economic goods. The development of the clearing system is independent of the other factors that determine the ratio between the supply of money and the demand for it. The effect on the demand for money of an expansion or contraction of the system of reciprocal cancellation thus constitutes an independent phenomenon which is just as likely to strengthen as to weaken the tendencies which for other reasons have an influence in the market on the exchange ratio between money and commodities. It seems self-evident that an increase in the number and size of payments cannot be the sole determinant of the demand for money. Part of the new payments will be settled by the clearing system; for this, too, ceteris paribus, will be extended in such a way as thenceforward to be responsible for the settlement of the same proportion of all payments as before. The rest of the payments could only be settled by clearing processes if there was an extension of the clearing system beyond the customary degree; but such an extension can never be called forth automatically by an increase in the demand for money.

4 The Elasticity of a Credit Circulation Based on Bills, Especially on Commodity Bills

The doctrine of the elasticity of fiduciary media, or more correctly expressed, of their automatic adjustment at any given time to the demand for money in the broader sense, stands in the very center of modern discussions of banking theory. We have to show that this doctrine does not correspond to the facts, or at least not in the form in which it is generally expounded and understood; and the proof of this will at the same time refute one of the most important arguments of the opponents of the quantity theory. [8]

Tooke, Fullarton, Wilson, and their earlier English and German disciples, teach that it does not lie in the power of the banks-of-issue to increase or diminish their note circulation. They say that the quantity of notes in circulation is settled by the demand within the community for media of payment. It the number and amount of the payments are increasing, then, they say, the media of payment must also increase in number and amount; if the number and amount of the payments are diminishing, then, they say, the number and amount of the media of payment must also diminish. Expansion and contraction of the quantity of notes in circulation are said to be never the cause, always only the effect, of fluctuations in business life. It therefore follows that the behavior of the banks is merely passive; they do not influence the circumstances which determine the amount of the total circulation, but are influenced by them. Every attempt to extend the issue of notes beyond the limits set by the general conditions of production and prices is immediately frustrated by the reflux of the surplus notes, because they are not needed for making payments. Conversely, it is said, the only result of any attempt at an arbitrary reduction of the note circulation of a bank is the immediate filling of the gap by a competing bank; or, if this is not possible, as for instance because the issue of notes is legally restricted, then commerce will create for itself other media or circulation, such as bills, which will take the place of the notes. [9]

It is in harmony with the views expounded by the Banking theorists on the essential similarity of deposits and notes to apply what they say on this point about notes to deposits also. It is in this sense that the doctrine of the elasticity of fiduciary media is generally understood today;[10] it is in this sense alone that it is possible to defend it even with only an appearance of justification. We may further suppose, as being generally admitted, that it is not because of lack of public confidence in the issuing bank that the fiduciary media are returned to it, whether in the form of notes presented for conversion into cash or as demands for the withdrawal of deposits. This assumption also agrees with the teachings of Tooke and his followers.

The fundamental error of the Banking School lies in its failure to understand the nature of the issue of fiduciary media. When the bank discounts a bill or grants a loan in some other way, it exchanges a present good for a future good. Since the issuer creates the present good that it surrenders in the exchange—the fiduciary media—practically out of nothing, it would only be possible to speak of a natural limitation of the quantity of fiduciary media if the quantity of future goods that are exchanged in the loan market against present goods was limited to a fixed amount. But this is by no means the case. The quantity of future goods is indeed limited by external circumstances, but not that of the future goods that are offered on the market in the form of money. The issuers of the fiduciary media are able to induce an extension of the demand for them by reducing the interest demanded to a rate below the natural rate of interest, that is below that rate of interest that would be established by supply and demand if the real capital were lent in natura without the mediation of money,[11] whereas on the other hand the demand for fiduciary media would be bound to cease entirely as soon as the rate asked by the bank was raised above the natural rate. The demand for money and money substitutes that is expressed on the loan market is in the last resort a demand for capital goods or, when consumption credit is involved, for consumption goods. He who tries to borrow "money" needs it solely for procuring other economic goods. Even if he only wishes to supplement his reserve, he has no other object in this than to secure the possibility of acquiring other goods in exchange at the given moment. The same is true if he needs the money for making payments that have fallen due; in this case it is the person receiving the payment who intends to purchase other economic goods with the money received.

That demand for money and money substitutes which determines the exchange ratio between money and other economic goods achieves expression only in the behavior of individuals when buying and selling other economic goods. Only when, say, money is being exchanged for bread is the position of the economic goods, money and commodity, in the value scales of the individual parties to the transaction worked out and used as a basis of action; and from this the precise arithmetical exchange ratio is determined. But when what is demanded is a money loan that is to be paid back in money again, then such considerations do not enter into the matter. Then only the difference in value between present goods and future goods is taken into account, and this alone has an influence on the determination of the exchange ratio, that is, on the determination of the level of the rate of interest.

For this reason the Banking principle is unable to prove that no more fiduciary media can be put into circulation than an amount determined by fixed circumstances not dependent on the will of the issuer. It has therefore directed its chief attention to the proof of the assertion that any superfluous quantity of fiduciary media will be driven out of circulation back to the issuing body. Unlike money, fiduciary media do not come on to the market as payments, but as loans, Fullarton teaches; they must therefore automatically flow back to the bank when the loan is repaid. [12] This is true. But Fullarton overlooks the possibility that the debtor may procure the necessary quantity of fiduciary media for the repayment by taking up a new loan.

Following up trains of thought that are already to be found in Fullarton and the other writers of his circle, and in support of certain institutions of the English and Continental banking system, which, it must be said, have quite a different significance in practice than that which is erroneously ascribed to them, the more recent literature of banking theory has laid stress upon the significance of the short-term commodity bill for the establishment of an elastic credit system. The system by which payments are made could, it is said, be made capable of the most perfect adjustment to the changing demands upon it, if it were brought into immediate causal connection with the demand for media of payment. According to Schumacher, that can only be done through banknotes, and has been done in Germany by basing the banknotes on the commodity bills, the quantity of which increases and decreases with the intensity of economic life. Through the channel of the discounting business, in place of interest-bearing commodity bills (which have only a limited capacity of circulation because their amounts are always different, their validity of restricted duration, and their soundness dependent on the credit of numerous private persons), banknotes are issued (which are put into circulation in large quantifies by a well-known semipublic institution and always refer to the same sums without limitation as to time, and therefore possess a much wider capacity of circulation, comparable to that of metallic money). Then on the redemption of the discounted bill an exchange in the contrary direction is said to take place: the banknotes, or instead of them metallic money, flow back to the bank, diminishing the quantity of media of payment in circulation. It is argued that if money is correctly defined as a draft on a consideration for services rendered, then a banknote based on an accepted commodity bill corresponds to this idea to the fullest extent, since it closely unites the service and the consideration for it and regularly disappears again out of circulation after it has negotiated the latter. It is claimed that through such an organic connection between the issue of banknotes and economic life, created by means of the commodity bill, the quantity of the means of payment in circulation is automatically adjusted to variations in the need for means for payment. And that the more completely this is attained, the more out of the question is it that the money itself will experience the variations in value affecting prices, and the more will the determination of prices be subject to the supply and demand on the commodity market. [13]

In the face of this, we must first of all ask how it is possible to justify the drawing of a fundamental distinction between banknotes and other money substitutes, between banknotes not covered by money and other fiduciary media. Deposits which can be drawn upon at any time by check, apart from certain minor technical and juristic details which make them unusable in retail trade and for certain other payments, are just as good a money substitute as the banknote. It is a matter of indifference from the economic point of view whether the bank discounts a bill by paying out currency in notes or by a credit on a giro account. From the point of view of banking technique there may be certain differences of importance to the bank official; but whether the bank issues credit in the business of discounting only or whether it also grants other short-term loans cannot be a very fundamental issue. A bill is only a form of promissory note with a special legal and commercial qualification. No economic difference can be found between a claim in the form of a bill and any other claim of equal goodness and identical time of maturity. And the commodity bill, again, differs only juristically from an open book debt that has come into being through a credit-purchase transaction. Thus it comes to the same thing in the end whether we talk of the elasticity of the note circulation based on commodity bills or of the elasticity of a circulation of fiduciary media resulting from the cession of short-term claims arising out of credit sales.

Now the number and extent of purchases and sales on credit are by no means independent of the credit policy followed by the banks, the issuers of fiduciary media. If the conditions under which credit is granted are made more difficult, their number must decrease; if the conditions are made easier, their number must increase. When there is a delay in the payment of the purchase price, only those can sell who do not need money immediately; but in this case bank credit would not be requisitioned at all. Those, however, who want money immediately can only make sales on credit if they have a prospect of immediately being able to turn into money the claims which the transaction yields them. Other granters of credit can only place just so many present goods at the disposal of the loan market as they possess; but it is otherwise with the banks, which are able to procure additional present goods by the issue of fiduciary media. They are in a position to satisfy all the requests for credit that are made to them. But the extent of these requests depends merely upon the price that they demand for granting the credit. If they demand less than the natural rate of interest—and they must do this if they wish to do any business at all with the new issue of fiduciary media; it must not be forgotten that they are offering an additional supply of credit to the market—then these requests will increase.

When the loans granted by the bank through the issue of fiduciary media fall due for repayment, then it is true that a corresponding sum of fiduciary media returns to the bank, and the quantity in circulation is diminished. But fresh loans are issued by the bank at the same time and new fiduciary media flow into circulation. Of course, those who hold the commodity-bill theory will object that a further issue of fiduciary media can take place only if new commodity bills come into existence and are presented for discounting. This is quite true. But whether new commodity bills come into existence depends upon the credit policy of the banks.

Let us just picture to ourselves the life history of a commodity bill, or, more correctly, of a chain of commodity bills. A cotton dealer has sold raw cotton to a spinner. He draws on the spinner and has the three-month bill discounted that the latter has accepted. After three months have passed, the bill will be presented by the bank to the spinner and redeemed by him. The spinner provides himself with the necessary sum of cash, having meanwhile spun the cotton and sold the yarn to a weaver, by negotiating a bill drawn on the weaver and accepted by him. Whether these two sale-and-purchase transactions come to pass depends now chiefly upon the level of the bank discount rate. The seller, in the one case the cotton dealer, in the second case the spinner, needs the money immediately; he can only make the sale with a delay in the payment of the purchase price if the sum due in three months less discount at least equals the sum under which he is not inclined to sell his commodity. It is unnecessary to give any further explanation of the significance attaching to the level of the bank discount rate in this calculation. Our example proves our point just as well even if we assume that the commodity that is sold reaches the consumers in the course of the three months during which the bill circulates and is paid for by them without direct requisitioning of credit. For the sums which the consumers use for this purpose have come to them as wages or profits out of transactions that were only made possible through the granting of credit on the part of the banks.

When we see that the quantity of the commodity bills presented for discount increases at certain times and decreases again at other times, we must not conclude that these fluctuations are to be explained by variations in the demands for money of individuals. The only admissible conclusion is that under the conditions made by the banks at the time there is no greater number of people seeking credit. If the banks-of-issue bring the rate of interest they charge in their creditor transactions near to the natural rate of interest, then the demands upon them decrease; if they reduce their rate of interest so that it falls lower than the natural rate of interest, then these demands increase. The cause of fluctuations in the demand for the credit of the banks-of-issue is to be sought nowhere else than in the credit policy they follow.

By virtue of the power at their disposal of granting bank credit through the issue of fiduciary media the banks are able to increase indefinitely the total quantity of money and money substitutes in circulation. By issuing fiduciary media, they can increase the stock of money in the broader sense in such a way that an increase in the demand for money which otherwise would lead to an increase in the objective value of money would have its effects on the determination of the value of money nullified. They can, by limiting the granting of loans, so reduce the quantity of money in the broader sense in circulation as to avoid a diminution of the objective exchange value of money which would otherwise occur for some reason or other In certain circumstances, as has been said, this may occur. But in all the mechanism of the granting of bank credit and in the whole manner in which fiduciary media are created and return again to the place whence they were issued, there is nothing which must necessarily lead to such a result. It may quite as well happen, for instance, that the banks increase the issue of fiduciary media at the very moment when a reduction in the demand for money in the broader sense or an increase in the stock of money in the narrower sense is leading to a reduction of the objective exchange value of money; and their intervention will strengthen the existing tendency to a variation in the value of money. The circulation of fiduciary media is in fact not elastic in the sense that it automatically accommodates the demand for money to the stock of money without influencing the objective exchange value of money, as is erroneously asserted. It is only elastic in the sense that it allows of any sort of extension of the circulation, even completely unlimited extension, just as it allows of any sort of restriction. The quantity of fiduciary media in circulation has no natural limits. If for any reason it is desired that it should be limited, then it must be limited by some sort of deliberate human intervention—that is by banking policy.

Of course, all of this is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then—apart from an extension of its clientele—it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause. And just because it has employed a false principle for explaining the phenomenon that it has observed, it has also completely closed the way to understanding of a second tendency of the market, that emanates from the circulation of fiduciary media. It was possible for it to overlook the tact that so far as the banks proceed uniformly, there must be a continual augmentation of the circulation of fiduciary media, and consequently a fall of the objective exchange value of money.

5 The Significance of the Exclusive Employment of Bills as Cover for Fiduciary Media

The German Bank Act of March 14, 1875, required that the notes issued in excess of the gold cover should be covered by bills of exchange; but in practice this provision has been understood to refer only to commodity bills. The significance of this prescription differs from that popularly attributed to it. It does not make the note issue elastic; it does not even bring it, as is erroneously believed, into an organic connection with the conditions of demand for money; these are all illusions, which should long ago have been destroyed. Nei ther has it the significance for maintaining the possibility of conversion of the notes that is ascribed to it; this will have to be referred to in greater detail later.

The limitation of the note issue not covered by metal, that is of fiduciary media in the form of banknotes, is the fundamental principle of the German act, which is based upon Peel's Act. And among the numerous and multiform obstacles that have been set up with this aim, the strict provision concerning the investment of the assets backing the note issue takes a not altogether unimportant place. That these must consist not merely in claims, but in claims in the form of bills; that the bills must have at the most three months to run; that they should bear the names, preferably of three, but at least of two, parties known to be solvent—all these conditions limit the note issue. At the very beginning, a considerable part of the national credit is kept away from the banks. A similar effect results from the further limitation of the note cover merely to commodity bills, as was undoubtedly intended by the legislature even though express provision for it was omitted from the Bank Act, probably because of the impossibility of giving a legal definition of the concept of a commodity bill. That this limitation did in fact amount to a restriction of the issue of fiduciary media is best shown by the fact that when the Bank Act was passed the number of commodity bills was already limited, and that since then, in spite of a considerable increase in the demand for credit, their number has decreased to such an extent that the Reichsbank meets with difficulties when it attempts to select such bills only for purposes of investing without decreasing the amount of credit granted. [14]

6 The Periodical Rise and Fall in the Extent to Which Bank Credit Is Requisitioned

The requests made to the banks are requests, not for the transfer of money, but for the transfer of other economic goods. Would-be borrowers are in search of capital, not money. They are in search of capital in the form of money, because nothing other than power of disposal over money can offer them the possibility of being able to acquire in the market the real capital which is what they really want. Now the peculiar thing, which has been the source of one of the most difficult puzzles in economics for more than a hundred years, is that the would-be borrower's demand for capital is satisfied by the banks through the issue of money substitutes. It is clear that this can only provide a provisional satisfaction of the demands for capital. The banks cannot evoke capital out of nothing. If the fiduciary media satisfy the desire for capital, that is if they really procure disposition over capital goods for the borrowers, then we must first seek the source from which this supply of capital comes. It will not be particularly difficult to discover it. If the fiduciary media are perfect substitutes for money and do all that money could do, if they add to the social stock of money in the broader sense, then their issue must be accompanied by appropriate effects on the exchange ratio between money and other economic goods. The cost of creating capital for borrowers of loans granted in fiduciary media is borne by those who are injured by the consequent variation in the objective exchange value of money; but the profit of the whole transaction goes not only to the borrowers, but also to those who issue the fiduciary media, although these admittedly have sometimes to share their gains with other economic agents, as when they hold interest-bearing deposits, or the state shares in their profits.

The entrepreneurs who approach banks for loans are suffering from shortage of capital; it is never shortage of money in the proper sense of the word that drives them to present their bills for discounting. In some circumstances this shortage of capital may be only temporary; in other circumstances it may be permanent. In the case of the many undertakings which constantly draw upon short-term bank credit, year in, year out, the shortage of capital is a permanent one.

For the problem with which we are concerned, the circumstances causing the shortage of capital on the part of entrepreneurs do not matter. We may even provisionally disregard, as of minor importance, the question whether the shortage is one of investment capital or working capital. Sometimes the view is propounded that it is unjustified to procure investment capital partly by way of bank credit although this is less undesirable as a way of procuring work ing capital. Such arguments as these have played an important part in recent discussions of banking policy. The banks have been adversely criticized on the ground of their having used a considerable part of the credit issued by them for granting loans to industrial enterprises in search not of fixed but of working capital and of having thus endangered their liquidity. Legislation has been demanded to limit to liquid investments only the assets backing the liabilities arising from the issue of fiduciary media. Provisions of this sort are designed to deal with fiduciary media in the form of deposits in the same way as the note issue has been dealt with under the influence of the doctrines of the Currency School. We have already commented on their significance and have shown, as further discussion will remind us, that the only practical value of these, as of all similar restrictions, lies in the obstacles they oppose to unlimited expansion of credit.

The cash reserve which is maintained by every business enterprise also is a part of its working capital. If an enterprise feels for any reason obliged to increase its reserve this must be regarded as an increase of its capital. If it requisitions credit for this purpose, its action cannot be regarded as any different from a demand for credit that arises from any other cause—say, on account of an extension of plant or the like.

But attention must now be drawn to a phenomenon which, even if it adds nothing new to what has been said already, may serve to set some important processes of the money-and-capital market in a clearer light. It has been repeatedly mentioned already that commercial practice concentrates all kinds of settlements on particular days of the year so that there is bound to be a bigger demand for money on these days than on others. The concentration of days of settlement at the end of the week, the fortnight, the month, and the quarter, is a factor which considerably increases the demand for money, and so of course the demand for capital, on the part of undertakings. Even though an entrepreneur could reckon safely on sufficient receipts on a given day to meet the obligations falling due on that or the following day, still it would only be in the rarest cases that he could use the former directly for paying the latter. The technique of payment is not so far developed that it would always be possible to fulfill obligations punctually without having secured some days beforehand free disposal over the necessary means. A person who has to redeem a bill that falls due at his bank on September 30 will usually have to take steps, before that date, for covering it; sums which do not reach him until the very day of maturity of the bill will mostly prove useless for this purpose. In any case it is completely impracticable to use the receipts on any given day for making payments that fall due on the same day at distant places. On the days of settlement there must therefore necessarily be an increased demand for money on the part of the individual undertaking, and this will disappear again just as quickly as it arose. Of course, this demand for money too is a demand for capital. Hypercritical theorists, following Mercantile usage, are accustomed to draw a subtle distinction between the demand for money and the demand for capital; they contrast the demand for short-term credit, as a demand for money, with the demand for long-term credit, as a demand for capital. There is little reason for retaining this terminology, which has been responsible for much confusion. What is here called the demand for money is nothing but a real demand for capital; this must never be forgotten. If the undertaking takes up a short-term loan to supplement its cash reserve, then the case is one of a genuine credit transaction, of an exchange of future goods for present goods.

The increased demand of the entrepreneur for money and consequently for capital which occurs on these days of settlement, expresses itself in an increase of the requests for loans that are made to credit-issuing banks. In those countries where notes and not deposits are the chief kind of fiduciary media, this is perceptible in an increase in the quantity of bills handed in at the banks-of-issue for discounting and, if these bills are actually discounted, in the quantity of notes in circulation. [15] Now this regular rise and fall of the level of the note circulation round about the days of settlement can in no way be explained by an increase in the total quantity of bills in existence in the community. No new bills, particularly no new short-term bills, are drawn and handed in to the banks to be discounted. It is bills that have the normal period to run, that are negotiated shortly before maturity. Until then they are retained in the portfolios either of nonbankers or of banks whose issue of fiduciary media is limited, whether because they have a small clientele or because of legal obstacles. It is not until the demand for money increases that the bills reach the large banks-of-issue. It is clear how little justification there is for the assertion that the amount of the note issue of central European banks-of-issue is organically connected with the quantity of bills drawn in the community. Only some of the bills are discounted at the banks by the issue of fiduciary media; the others complete their term without calling bank credit into use. But the proportion between the two amounts depends entirely on the credit policy that the credit-issuing banks follow.

Bank legislation has taken particular account of the extraordinary increase in the demand for money round about quarter-day. Article two of the German Bank (Amendment) Act of June 1, 1909, extends the usual tax-free quota of notes of 550 million marks to 750 million marks for the tax accounts based on information concerning the last days of March, June, September, and December in each year, thus sanctioning a procedure that the banks had been in the habit of following for decades. On every day of settlement, the entrepreneur's demand for credit increases, and therefore the natural rate of interest also. But the credit-issuing banks have endeavored to counteract the increase in interest on loans either by not raising the rate of discount at all, or by not raising it to an extent corresponding to the increase in the natural rate of interest. Of course, the consequence of this has necessarily been to swell their circulation of fiduciary media. State banking policy has in general put no obstacles in the way of this practice of the banks, which undoubtedly helps to stabilize the objective exchange value of money. The German Bank Act of 1909 was the first which took steps to give it direct support.

7 The Influence of Fiduciary Media on Fluctuations in the Objective Exchange Value of Money

Thus there is no such thing as an automatic adjustment of the quantity of fiduciary media in circulation to fluctuations in the de mand for money without an effect on the objective exchange value of money. Consequently all those arguments are ill founded which seek to deny practical significance to the quantity theory by reference to the alleged elasticity of the circulation of money. The increase and decrease of the stock of fiduciary media in a free banking system have no greater natural connection, direct or indirect, with the rise and fall of the demand for money in the broader sense, than the increase and decrease of the stock of money have with the rise and fall of the demand for money in the narrower sense. Such a connection exists only insofar as the credit banks deliberately try to bring it about. Apart from this, the only connection that can be established between the two sets of variations, which are in themselves independent of each other, is like that of the policy which, say, in a period of increasing demand for money in the broader sense aims at an increase of fiduciary media in order to counteract the rise in the objective exchange value of money which might otherwise be expected. Since it is impossible to measure fluctuations in the objective exchange value of money, even only approximately, we are not able to judge whether the increase of fiduciary media that has occurred during the last century in nearly all the countries of the world has together with the increase in the quantity of money kept pace with the increase in the demand for money in the broader sense, or fallen behind it, or outstripped it. All that we can be sure of is that at least a part of the increase in the demand for money in the broader sense has been robbed of its influence on the purchasing power of money by the increase in the quantity of money and fiduciary media in circulation.

[1] See Smith, The Wealth of Nations, Cannan's ed. (London, 1930), vol. 2, pp. 28, 78.

[2] See Ricardo, "The High Price of Bullion a Proof of the Depredation of Bank Notes," in Works, ed. McCulloch, 2d ed. (London, 1852), pp. 263 ff.; "Proposals for an Economical and Secure Currency" in ibid., pp. 397 ff.; see pp. 291 above and 427 below.

[3] On the question of the dependence of economic fluctuations on credit policy, see pp. 405 f. below.

[4] See Jevons, Investigations in Currency and Finance, pp. 8, 151 ff.; Palgrave, Bank Rate and the Money Market in England, France, Germany, Holland and Belgium 1844-1900 (London, 1903), pp. 106 ff.; 138; J. Laughlin, The Principles of Money (London, 1903), pp. 409 ff.

[5] See Spiethoff, "Die Quantitätstheorie insbesondere in ihrer Verwertbarkeit als Haussetheorie," Festgaben für Adolf Wagner (Leipzig, 1905), pp. 263 f.

[6] See Helfferich, Studien über Geld-und Bankwesen (Berlin, 1900), pp. 151 f.; Schumacher, Weltwirtschaftliche Studien (Leipzig, 1911), pp. 5 ff.

[7] See White, An Elastic Currency (New York, 1893), p. 4.

[8] See pp. 150 ff. above.

[9] See Tooke, An Inquiry into the Currency Principle (London, 1844), pp. 60 ff.; 122 f.; Fullarton, On the Regulation of Currencies, 2d ed. (London, 1845), pp, 82 ff.; Wilson, Capital, Currency and Banking (London, 1847), pp. 67 ff.; Mill, Principles of Political Economy (London, 1867), pp. 395 ff.; Wagner, Geld-und Kredittheorie der Peelschen Bankakte (Vienna, 1862), pp. 135 ff. On Mill's lack of consistency in this question, see Wicksell, Geldzins und Güterpreise (Jena, 1898), pp. 78 f.

[10] See Laughlin, The Principles of Money (London, 1903), p. 412.

[11] See Wicksell, op. cit., p. v.

[12] See Fullarton, op. cit., p. 64.

[13] See Schumacher, op. cit., pp. 122 f.

[14] See Prion, Das deutsche Wechseldiskontgeschäft (Leipzig, 1907), pp. 120 ff., 291 ff.

[15] Part of the rediscounting done at the Reichsbank by the private banks shortly before the critical days of settlement is done not so much because the banks are short of capital but because they desire to pass on nearly matured bills to be called in by the Reichsbank, which is able to perform this task more cheaply than they are, thanks to its extensive network of branches. See ibid., pp. 138 ff.

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