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Problems of Credit Policy

I. Prefatory Remark

1 The Conflict of Credit Policies

Since the time of the Currency School, the policy adopted by the governments of Europe and America with regard to the issue of fiduciary media has been guided, on the whole, by the idea that it is necessary to impose some sort of restriction upon the banks in order to prevent them from extending the issue of fiduciary media in such a way as to cause a rise of prices that eventually culminates in an economic crisis. But the course of this policy has been continually broken by contrary aims. Endeavors have been made by means of credit policy to keep the rate of interest low; "cheap money" (that is, low interest) and "reasonable" (that is, high) prices have been aimed at. Since the beginning of the twentieth century these endeavors have noticeably gained in strength; during the war and for some time after it they were the prevailing aims.

The strange vicissitudes of credit policy cannot be described except by passing in review the actual tasks that it has had to solve and will have to solve in the future. Although the problems themselves may always be the same, the form they assume changes. And, for the very reason that our task is to strip them of their disguises, we must first study them in their contemporary garb. In what follows, separate consideration will be given to such problems, first, as they exhibited themselves before the war, and then, as they have exhibited themselves in the period immediately after the war. [1]

II. Problems of Credit Policy Before the War[2]

2 Peel's Act

Peel's Bank Act, and the ideas on which it was based, still sets the standard by which credit policy is ultimately governed nowadays; even those countries that do not follow the example of the English bank legislation, or do not follow it so faithfully as others, have yet not been able to withstand its influence altogether. Here we are confronted with a strange phenomenon. While the economic literature of all countries was directing the most violent and passionate attacks against the system of having a fixed quota of the note issue not backed by metal; while people were untiring in calling Peel's Act the unfortunate legislative product of a mistaken theory; while the currency principle continued to be represented as a system of erroneous hypotheses that had long been confuted; yet one legislature after another took steps to limit the issue of uncovered banknotes. And, remarkably enough, this procedure on the part of governments evoked but little censure, if any at all, from those whose views on banking theory should logically have led them most severely to condemn it. To start from the banking principle, which denies the possibility of an overissue of banknotes and regards "elasticity" as their essential characteristic, is necessarily to arrive at the conclusion that any limitation of the circulation of notes, whether they are backed by money or not, must prove injurious, since it prevents the exercise of the chief function of the note issue, the contrivance of an adjustment between the stock of money and the demand for money without changing the objective exchange value of money. It might easily have appeared desirable to Tooke's followers that provision should be made for backing that part of the note circulation that was not backed by metal; but logically they should have condemned the prescription that a certain proportion was to be maintained between the stock of metal and the note circulation. There is an irreconcilable contradiction, however, between the theoretical arguments of these writers and the practical conclusions that they draw from them. Scarcely any writer that need be taken seriously ventures to put forward proposals that might fundamentally disturb the various systems for restricting the unbacked note issue; not a single one definitely demands their complete abolition. Nothing could show the inherent uncertainty and lack of independence of modern banking theory better than this inconsistency. That the note issue must somehow be restricted in order to guard against serious evils is still accepted today as the essence of government wisdom in matters of banking policy, and the science which claims to have produced proof to the contrary always ends up by deferring to this dogma, which nobody is nowadays able to prove and everybody thinks himself able to refute. The conversatism of the English hinders them from meddling with a law which stands as a monument to an intellectual contest which went on for many years and in which the best men of the time participated; and the example of the world's chief bank influences all the other banks. The conclusions of two generations of economists have not been able to shake the opinions which are supposed to be the result of practical banking experience.

Many serious errors are involved in the currency principle. The most serious lies in its failure to recognize the essential similarity of banknotes and bank deposits. [3] Its opponents have skillfully discovered these weak spots in the system and directed their sharpest attacks accordingly. [4] But the doctrine of the Currency School does not stand or fall by its views on the nature of checks and deposits. It is enough to correct it on this one point—to take its propositions concerning the issue of notes and apply them also to the opening of deposit accounts—to silence the censures of those who adhere to the banking principle. That its mistake on this point is of small significance in comparison with that made by the banking principle can hardly need further discussion. And in any case, it does not seem an inexcusable mistake to have made if we take into account the relatively backward development of even the English deposit system at the time when the foundations of the classical theory of banking were being laid, and if we further consider the ease with which the legal differences between payment by note and payment by check might give rise to error.

As far as Peel's Act was concerned, however, this very shortcoming of the theory that had created it turned out to be an advantage; it caused the incorporation in it of the safety valve without which it would not have been able to cope with the subsequent increase in the requirements of business. The fundamental mistake of Peel's system, which it shares with all other systems which proceed by restricting the note circulation, lies in its failure to foresee the extension of the quota of notes not backed by metal that went with the increase in the demand for money in the broader sense. As far as the past was concerned, the act sanctioned the creation of a certain amount of fiduciary media and the influence that this had on the determination of the objective exchange value of money; it did not do anything to counteract the effects of this issue of fiduciary media. But at the same time, in order to guard the capital market from shocks, it removed all future possibility of partly or wholly satisfying the increasing demand for money by the issuing of fiduciary media and so of mitigating or entirely preventing a rise in the objective exchange value of money. This amounts to the same thing as suppressing the creation of fiduciary media altogether and so renouncing all the attendant advantages for the stabilization of the objective exchange value of money. It is an heroic remedy with a vengeance, in essence hardly differing at all from the proposals of the downright opponents of all fiduciary media.

Nevertheless, something was overlooked in the calculations of the currency theorists. They did not realize that unbacked deposits were substantially the same as unbacked notes, and so they omitted to legislate for them in the same way as for the notes. So far as the development of fiduciary media depended on the issue of notes, Peel's Act completely restricted it; so far as it depended on the open ing of deposit accounts, it was not interfered with at all. This forced the technique of the English banking system in a direction in which it had already been urged in some degree by the circumstance that the right of note issue in London and its environs was an exclusive privilege of the Bank of England. The deposit system developed at the expense of the note system. From the point of view of the community this was a matter of indifference because notes and deposits both fulfill the same functions. Thus Peel's Act did not achieve its aim, or at least not in the degree and manner that its authors had intended; fiduciary media, suppressed as banknotes, developed in the form of deposits.

It is true that German writers on banking held that it was possible to discover a fundamental difference between notes and deposits. But they did not succeed in demonstrating their contention; in fact they did not really attempt to do so. Nowhere is the inherent weakness of German banking theory more obvious than in connection with this particular question of the note versus the check, which for years has been the central issue of all discussion. Anybody who, like them, had learned from the English Banking School that there is no fundamental difference between notes and checks, and was in the constant habit of stressing this,[5] should at least be prepared to supply a detailed proof in support of an assertion that the banknote system represents "an earlier and lower stage of development of the credit economy" than the deposit bank and the check, with the connected system of the account current, book credit, and clearinghouse. [6] Certainly reference to England and the United States cannot be accepted as proof of the correctness of this assertion, least of all in the mouth of a decided opponent of Peel's Act and of the restriction of the note issue in general; for it is undeniable that the great importance of the deposit system and the decreasing relative importance of the banknote in Anglo-Saxon countries are the result of that act. The consequence is that the German literature on banking theory is full of almost unbelievable contradictions. [7]

The repression of the banknote, as it has occurred in England and in the United States—in different ways and for different reasons, but as a result of the same fundamental ideas—and the corresponding growth in importance of the deposit, and the additional circumstance that the organization of the deposit banks has not attained that soundness that would have enabled it to retain the public confidence during dangerous crises, have led to serious disturbances. In England, as also in the United States, it has repeatedly happened in times of crisis that confidence has been destroyed in those banks that circulate fiduciary media in the form of deposits, while confidence in banknotes has been maintained. The measures by which the consequences which such a collapse of a part of the national business organization would infallibly have involved were avoided are well known. In England an attempt was made to fill the gap in the circulation which was due to the lack of large quantities of fiduciary media by the Bank of England being ready to increase the issue of its own notes. In the United States, where the law made this solution impossible, the clearinghouse certificates served the same purpose. [8] In both countries, attempts to give this device a legislative basis were made. But Lowe's bill was not passed, and even the Aldrich-Vreeland Act in the United States had only a partial success. [9]

None of the many systems of limiting the note circulation has proved ultimately capable of interposing an insurmountable obstacle in the way of further creation of fiduciary media. This is equally true of Peel's Act, which completely forbids the new issue of fiduciary media in the shape of notes, and of such bank-of-issue legislation in other states as does leave a certain scope for the augmentation of notes not backed by money. Between the English act of 1844 and, say, the German act of 1875, there seems to be a fundamental difference: while the one rigidly fixes, for all time, the quota of the note circulation not backed by metal, the other, inasmuch as it only requires that a certain proportion of the note circulation shall be backed by metal and puts a tax upon the rest, does make provision within certain limits for its future extension. But everything depends upon the scope that is thus provided for extending the issue of fiduciary media. If it had been wide enough to give free play to the development of the unbacked note circulation, then the German law —and the same is true, not only of other laws based on the same principle (for example, the Austrian), but also of those that attempt to limit the circulation of notes in other ways, as for example, the French—would have had fundamentally different results from the English. Since in fact it proved to be too narrow for this, the difference between the two laws is merely one of degree, not one of kind. All these laws have limited the issue of fiduciary media in the form of notes, but have set no limits to their issue in the form of deposits. Making the issue of notes more difficult was bound to promote an increased employment of deposits; in place of the note, the deposit account came into prominence. For the development of the credit system, this change was not altogether a matter of indifference. The note is technically superior to the deposit in medium and small transactions; in many cases for which it might have been used as a money substitute, checks or clearing transfers could not be used, and in such cases restriction of the issue of fiduciary media in the form of notes was bound to have the effect of restriction of the issue of fiduciary media in general. Under the law of the United States of America, the issue of fiduciary media in the shape of deposits is also restricted; but since this only applies to some of the banks, namely, the national banks, it is not enough to make a big difference between the deposit business of the United States and that of the other countries in which no similar regulations have been established.

The real obstacle in the way of an unlimited extension of the issue of fiduciary media is not constituted by legislative restriction of the note issue, which, after all, only affects a certain kind of fiduciary medium, but the lack of a centralized world bank or of uniform procedure on the part of all credit-issuing banks. So long as the banks do not come to an agreement among themselves concerning the extension of credit, the circulation of fiduciary media can indeed be increased slowly, but it cannot be increased in a sweeping fashion. Each individual bank can only make a small step forward and must then wait until the others have followed its example. Every bank is obliged to regulate its interest policy in accordance with that of the others.

3 The Nature of Discount Policy

The most obscure and incorrect concepts are current concerning the nature of the discount policy of the central banks-of-issue. Often the principal task of the banks is said to be the protection of their cash reserves, as if it would pay them to make sacrifices for such an aim as that. No less widespread, however, is the view that the banks' obligation to follow a discount policy that takes account of the circumstances of other banks is imposed upon them merely by a perverse legislation and that the ideal of cheap money—in a double sense, namely, a low purchasing power of money and a low rate of interest—could be realized by the abandonment of certain out-of-date legal provisions.

It is unnecessary to devote very much time to the refutation of such views as these. After all that has been said on the nature of money and fiduciary media, there can hardly be very much doubt as to the aim of the discount policy of the banks. Every credit-issuing bank is obliged to fix the rate of interest it charges for loans in a certain conformity with that of the other credit-issuing banks. The rate cannot be allowed to sink below this level, for if it did, the sums of money needed by the bank's rapidly extending clientele for making payments to customers of other banks would increase in such a fashion that the bank's solvency would be imperiled. It is by raising the rate of discount that the bank safeguards its own capacity to pay. This end is certainly not attained by protecting the redemption fund, the small insignificance of which for maintaining the value of the fiduciary media has already been demonstrated, but by avoiding the artificial extension of the circulation of fiduciary media that would result from asking less interest than the other banks, and so also avoiding an increase in the demands for the redemption of the fiduciary media. The banks would still have to have a discount policy even if there were no legislative regulation of the note cover.

In Germany there has been a controversy as to whether certain measures of the Reichsbank are dictated by regard to the circumstances of the domestic money market or to those of the international. In the form in which it is usually put, the question is meaningless. The mobility of capital goods, which nowadays is but little restricted by legislative provisions such as customs duties, or by other obstacles, has led to the formation of a homogeneous world capital market. In the loan markets of the countries that take part in international trade, the net rate of interest is no longer determined according to national, but according to international, considerations. Its level is settled, not by the natural rate of interest in the country, but by the natural rate of interest anywhere. Just as the exchange ratio between money and other economic goods is the same in all places, so also the ratio between the prices of goods of the first order and those of goods of higher orders is the same everywhere. The whole system of modern international trade would be completely changed if the mobility of capital goods were to be restricted. In Germany there are many who demand such a prohibition or at least a considerable restriction of the investment of capital abroad. It is not our task to demonstrate what a small prospect of success a policy like this would have, or to show that the time is now past for a nation to decide whether or not it will take part in international trade. So long and insofar, however, as a nation participates in international trade, its market is only a part of the world market; prices are determined not nationally but internationally. The fact that the rate of interest in Germany may rise, not because any change has occurred in its determinants within the Reich but because there have been changes, say, in the United States, should not seem any more remarkable than, say, a rise in the price of corn that is due to the state of foreign harvests.

It has not been easy to reconcile policy with the extension and combination of national markets into a world market. Stronger than the resistance encountered centuries ago by the development of the town economy into the national economy is that which the nineteenth and twentieth centuries have opposed to the further stage of development into a world economy. Nowadays there is nothing like the feeling of homogeneity which previously overcame regional interests; the pronounced emphasis upon national antagonisms which sets the keynote of modern policy would perhaps stand in the way of attempts at economic unification even if there were no interests to which these attempts might prove injurious. From the point of view of the producer, low prices seem to be the greatest of all evils, and in every state those producers who are unable to meet competition strive with all the means at their disposal to keep the cheap commodities of the world market out of the national market. But whether they succeed in this in each individual case or not depends to a large extent on the strength of the political influence of the opposing interests. For in the case of every individual commodity, the producers' interest in high prices is opposed by the interest of consumers in the opening of the market to the cheapening effect of foreign competition. The matter is only decided by the conflict of the two groups. The distribution of forces is otherwise when the problem of freedom of capital transactions is under discussion. We have already seen that creditor interests always get the worst of it when they clash with debtor interests. The interests of the capitalists are scarcely ever represented in monetary policy. Nobody ever objects to the importation of capital from abroad on the ground that it leads to a depression of the rate of interest in the home market and a reduction of the income of the capitalists; quite the reverse. The universally prevailing view is that it is in the interest of the community that the rate of interest should be as low as possible. In those European states with large capital resources, which so far as international dealings in capital are concerned need be considered only as creditors and not as debtors, this policy is expressed in the endeavor to put obstacles in the way of foreign investment. Undoubtedly, this is not the only point of view from which modern states judge the export of capital. Other considerations enter into the matter as well, some in favor of exportation, some against it. There is, for instance, the fact that it is frequently impossible to export commodities except by allowing the payment for them to be postponed, so that future goods are acquired in exchange for the present goods surrendered; and that for this reason alone it is consequently necessary to promote the export of capital or at least not to hinder it. [10] Nevertheless, it must be insisted that the policy adopted by these states with regard to the export of capital is guided by the endeavor, among others, to keep the domestic rate of interest low. On the other hand, the same motive leads these states which because they are poor in capital have to play the part of international borrowers to encourage its importation.

The attempt to depress the domestic rate of interest by influencing the international movement of capital is particularly pronounced in the so-called money market, that is, in the market for short-term capital investments. In the so-called capital market, that is, the market for long-term capital investments, there is less possibility of effecting anything by intervention; in any case, any steps that may be taken become effective much more quickly in the former than in the latter. Consequently there is a greater propensity toward exerting an influence on the rate of interest on loans in the money market than in the long-term capital market. But the most important cause of the persistence of demands for the exertion of influence upon the money market lies in the universally prevalent errors concerning the nature of fiduciary media and of bank credit. When a relatively small efflux of gold induces the powerful central bank-of-issue of a rich country to raise the discount rate there is a tendency to think that there must be some other way than this, by which the efflux of gold could be prevented without involving the community in what is regarded as the injurious effect of a rise in the rate of interest. It is not seen that what is happening is the automatic adjustment of the national to the world rate of interest owing to the way in which the country is involved in international trade. That the country cannot be cut off from participation in international capital dealings simply and solely by measures of banking and currency policy, is completely overlooked. This alone can explain how it can come about in large exporting countries that the very persons who demand measures for "cheapening" credit are those who benefit most from the export trade. If those manufacturers, for whom every increase in the rate of discount that can be traced to events abroad is an inducement to plead for a modification of the banking system in the direction of releasing the central bank-of-issue from its obligation to provide gold for export on demand, would realize that the increase in the rate of interest could be effectively stopped only by a suppression of the export of capital and complete exclusion of the country from international trade, then they would soon change their minds. And it seems that these implications have already won some degree of general recognition, even if the literary treatment of the problem may still leave something to be desired. In Germany and Austria it was only the groups that demanded the seclusion of the national market that also demanded the "isolation" of the currency.

Further explanation is unnecessary. Nevertheless, it may not be supererogatory to examine one by one the measures that are recommended by those who favor a low rate of interest and to show how incapable they would prove of leading to the expected result.

4 The Gold-Premium Policy[11]

Let us first review the systems which are supposed to be able to maintain the level of the rate of discount in the national money market by making it more difficult or more expensive to procure gold at a rate below that determined by the circumstances of the international market. The most important and most well known of these is the gold-premium policy, as it was carried out by the Bank of France.

In view of the circumstances that nowadays the silver five-franc piece is still legally current coin, the Bank of France is authorized to redeem its notes at its own choice either in gold or in these pieces. It sometimes used to make use of this authority for the purpose of increasing the difficulty of procuring gold for export purposes. As a rule it made no difficulty about surrendering gold in exchange for notes. And it exchanged five-franc pieces in the same way for gold coins, although it was not obliged to do so, and by so doing it endowed the latter with the property of being money substitutes. Naturally, these facilities were not requisitioned to a great extent for purposes of domestic business. Notes and five-franc pieces enjoyed unlimited public confidence so that their employability as money substitutes was not in the least in question. But if the bank was asked to surrender gold for export, it did not necessarily do so. It is true that it used to hand over gold unhesitatingly for the requirements of what was called "legitimate" trade, that is, when it was needed to pay for imported commodities, especially corn and cotton. But if gold was demanded for the purpose of speculating on the difference between home and foreign interest rates, it was not handed over as a matter of course. For this purpose, the bank did not issue Napoleons, the French gold coins, at all; and it issued ingots and foreign gold coins only at an additional charge, varying from four to eight percent of the 3,437 francs at which it was legally bound to purchase a kilogram of fine gold. It is impossible to state the exact amount of this "gold premium," because the rate has never been published officially. [12]

The purpose of the gold-premium policy was to postpone as long as ever possible the moment when the condition of the international money market would force the bank to raise the discount rate in order to prevent an efflux of gold. The lowness of the rate of discount is of extraordinary importance in French financial policy. In the interest of those classes of the community by which it is supported, the government of the Third Republic is obliged to avoid anything that might injure the high standing of the rentes which constitute the chief investment of those classes. Even a merely temporary high rate of discount is always dangerous to the rentes market, for it might induce some holders of rentes to dispose of their bonds in order to reinvest their capital more fruitfully, and the disturbance of the market that might result from this would have a disproportionately adverse effect on the quotation of the rentes. It is undeniable that the result aimed at was to a certain extent attained, even though the premium policy by no means possessed the significance that was erroneously ascribed to it.

It is above all mistaken to ascribe the lowness of the rate of discount in France to the procedure that has been described. If the rate of discount has been lower in France than in other countries, this is due to altogether different causes. France is of all the countries in the whole world that which is richest in capital; but its people are not greatly endowed with the spirit of initiative and enterprise. [13] Consequently its capital has to emigrate. Now in a country which exports capital, even disregarding the premium for risk-bearing that is contained in the gross rate of interest, the rate of interest on loans must be lower than in a country which imports capital. Capitalists, when comparing the yields of home and foreign investment, are led by a series of psychological factors to prefer the former to the latter when other circumstances are equal. This is enough to explain why long-term and short-term investments bear lower interest in France than in other countries, such as Germany. The cause is a general economic cause; it is a matter in which measures of banking or currency policy can have no influence. The ratio between the rate of interest in France and that abroad could not for long be forced away by the premium policy of the Bank of France from that determined by the general economic situation. The Bank of France was not above the laws that govern the course of economic affairs. In fixing the level of its discount rate, it was not exempt from the necessity for paying due attention to the level of the natural rate of interest. Like every other credit-issuing bank that has an influence on the domestic market, it had to endeavor to keep the rate of interest on domestic short-term investments at such a level that foreign investment did not appear so attractive to home capitalists as to endanger the bank's own solvency. Like the others, the Bank of France could effectively prevent an outflow of gold in one way only—by raising its discount rate. [14] Employing the premium policy could do no more than postpone for a short time a rise in the rate of discount that the state of the international money market had made necessary. The premium made it more expensive to export gold and so reduced the profitability of interest arbitrage transactions. When it was widely believed that the difference between the French and the foreign rates of interest was about to be altered in France's favor through a fall in the foreign rate, then arbitrage dealers would not export gold at all, since the small profit of the transaction would be too greatly reduced by the premium. In this way the Bank of France may sometimes have avoided raising the discount rate when it would otherwise have been necessary to do so for a short time. But whenever the difference between the rates of interest was significant enough to make short-term foreign investment still promise to be profitable in spite of the increased cost of procuring gold due to the premium, and whenever the result of arbitrage dealings was not jeopardized by the prospect of an imminent reduction of the foreign rate, then even the Bank of France could not avoid raising the rate of interest.

It has been asserted that it is possible for a central bank to use successive increases of the premium so as entirely to prevent the export of gold if it continually forces back the gold point or export limit as the fall in the rate of exchange requires. [15] This is undoubtedly correct. The procedure, as is well known, has been employed repeatedly; it is known as cessation of cash payments. The bank that adopts it deprives its fiduciary media of their character of money substitutes. If they continue to function as general media of exchange, it is in the role of credit money. Their value will have become subject to independent variation. In such a case, it is admittedly possible for the bank to follow a completely independent discount policy; it may now reduce to any desired extent the rate of interest it charges without running the risk of insolvency. But this brings to light the consequences that must follow a banking policy that endeavors by extending the issue of fiduciary media to depress the rate of interest on loans below the natural rate of interest. This point has already been discussed in detail; in the present connection there is a second point that is of importance. If the intervention of the bank leads to the artificial retention of the rate of interest on loans at a level below that of the rate given by international conditions, then the capitalists will be all the more anxious to invest their capital abroad as the gap between the domestic and foreign rates of interest increases. The demand for foreign common media of exchange will increase, because foreign capital goods will be desired more and home capital goods less. And there is no way in which the fall in the rate of exchange could automatically set forces in motion to reestablish between the bank money and gold, the world money, that exchange ratio which had previously existed when the notes and deposits of the bank were not credit money but still money substitutes. The mechanism of the monetary system tends to bring the exchange value of the two kinds of money to that "natural" level determined by the exchange ratio between each of them and the remaining goods. But in the present case it is the natural exchange ratio itself which has moved against the country that refuses to pay out gold. An "autonomous" interest policy must necessarily lead to progressive depredation.

There are many advocates of the gold-premium policy who make no attempt to deny that its employment in the way in which they intend must infallibly lead to a credit-money or fiat-money standard with a rapidly falling objective exchange value of the unit. In fact, they are inclined to regard this very fact as a special advantage; for they are, more or less, inflationists. [16]

Nevertheless, this was by no means the way in which the Bank of France carried out its premium policy. It observed a fixed limit, above which it never allowed the premium to rise in any circumstances whatever. Eight per mill is probably the highest premium that it has ever demanded. And this was certainly not an error on the part of the bank; it was founded on the nature of the case. In the eyes of the French government and of the administration of the bank controlled by it, the amount of depreciation consequent upon a gold premium of eight percent was not intolerable; but, in view of the unpredictable reactions throughout the whole community it was thought better to avoid further depreciation. Thus the French gold-premium policy was not able to prevent the export of gold altogether, but could only postpone it for a short time. Now this fact alone, and not only when the difference between the rates of interest was so inconsiderable and transient that the rate of discount did not need to be raised at all, meant a cheapening of the rate of interest on loans. But this was offset by the increase in the rate of interest during those periods when the rate of interest abroad was relatively low. Whenever the loan rate abroad sank so low that it might have seemed advantageous to capitalists to transfer capital to France for investment, they nevertheless refrained from doing so if a long continuance of the situation could not be reckoned with or if the difference between the rates was not very great, because they had reason to fear that a subsequent repatriation of the capital when the situation was reversed would be possible only at an increased cost. Thus the gold-premium policy did not merely constitute a hindrance to the efflux of gold from France; it also hindered an influx. It reduced the rate of interest on loans at certain times, but raised it at other times. It is true that it did not altogether exclude the country from international dealings in capital; it only made participation in them harder; but it did this in both directions. Its effect, the intensity of which should not be overestimated, was principally expressed in the fact that the rate of interest for short-term investments has been more stable in France than in other countries. It has never sunk so low as in England, for example; but neither has it ever risen so high. This is shown quite dearly by a comparison of movements in the London and Paris loan rates.

It has become more and more clearly recognized that the gold-premium policy could not have these effects ascribed to it. Those who once regarded it as the remedy for all ills are gradually becoming silent.

5 Systems Similar to the Gold-Premium Policy

The legal provisions which have permitted the Bank of France to follow the gold-premium policy were absent in those countries which until recently were on a pure gold standard. Where the gold coins have not been supplemented by any money substitutes, fiat money, or credit money, with unlimited legal tender by any payer including the central credit-issuing bank, the fiduciary media have had to be redeemed at their full face value in money without a premium being charged in addition. [17] But in actual fact these banks also were tending to adopt a policy different in degree but certainly not in kind from the described procedure of the Bank of France.

In most countries, the central bank-of-issue was only obliged to redeem its notes in legal tender gold coins of its own country, after the pattern of English banking law. It is in accordance with the spirit of the modern monetary system and with the ultimate aims of monetary policy that this obligation has been understood also to refer to the surrender of gold ingots to exporters at the legal ratio or at least at a price that made it more profitable to procure bullion than coins. Thus until 1889 the Bank of England voluntarily extended its obligation to redeem its notes by paying out on demand in ingots the value of the notes in full-weight gold coins. It did this by fixing its selling price for gold bullion once for all at 77s. 10½d. per ounce of standard gold. [18] For a time the Continental banks-of-issue followed this example. But they soon determined upon a different procedure, and eventually the Bank of England too relinquished its old policy and adopted the practice of the Continental banks.

The Bank of England and the German Reichsbank, apart from the Bank of France the two most important credit-issuing banks in the world, were in the habit of issuing for export purposes worn gold coins only of inferior value. Sovereigns, as issued by the Bank of England for export, were usually from two to three percent worse than newly minted sovereigns. The weight of the twenty-mark pieces received by a person who withdrew gold coins from the German Reichsbank for purposes of exportation was, according to the calculations of experts, 7.943 grams on an average as against a standard average of 7.965 grams; that is, something over a quarter of one percent less than their mint value. [19] The Bank of England sometimes refused altogether to issue gold ingots, and sometimes would only issue them at a price in excess of the 77s. 10½d. which alone was usual until 1889. It sometimes raised the selling price of ingots to as much as 77s. 11d. [20]

As regards the range and the effect of these measures, nothing need be added to what has already been said about the French gold-premium policy. The difference—as has been said—is only quantitative, not qualitative. [21]

The other "little devices" which have also been employed for making the export of gold more difficult have their effect in precisely the same fashion. As, for example, when the German Reichsbank sometimes prohibited the issue of gold for export purposes except in Berlin by invoking the letter of section 18 of the Bank Act, which had the effect of making the export of gold more costly by burdening the gold exporters with the risk and cost of transporting the gold from Berlin to the place of export.

6 The Nonsatisfaction of the So-called Illegitimate Demand for Money

In the returns of the Bank of France it has been repeatedly asserted that the gold-premium policy was directed only against those who wished to withdraw gold from the bank for speculative purposes. The bank, it was said, never put difficulties in the way of procuring gold for satisfying the legitimate demands of French trade. [22] No explanation was given of the idea of "legitimate" demand and its contrary "illegitimate" demand.

The idea on which this distinction is obviously based is that trade in commodities and dealings in capital are two perfectly distinct and independent branches of economic activity and that it would be possible to restrict the one without affecting the other; that refusal to surrender gold for arbitrage dealing could not increase the expense of procuring commodities from abroad so long as no difficulty was made about placing at the disposal of the importer the sums needed by him to pay for his purchases.

On closer examination this argument can hardly be accepted as valid. Even if we completely ignore the fact that dealings in capital only constitute one form of the general process of exchange of goods and consider nothing beyond the technical problem of the withdrawal of gold, it is clear that the bank cannot achieve its aim by discriminatory treatment of different requests for gold. If exportation of gold did not seem profitable because of the difference between the rates of interest, imported raw materials would actually be paid for, partly or wholly, by the commodities exported. The importer would not try to obtain gold from the bank; he would go into the market and buy bills originating in the French export business. If gold were delivered to him by the bank without a premium while the rate of exchange rose roughly by the amount of and on account of the premium that was charged to arbitrage dealers, this might well mean a favoring of the import business, and might possibly in some circumstances benefit the consumer as well, although that depends entirely upon the state of competition among importers. But all the same, the rate of exchange would experience the variation that the bank wished to avoid. The upper gold point would be fixed too high by an amount equal to the amount of the premium.

Finally, it must be pointed out that the distinction between a legitimate and an illegitimate demand for gold for export cannot be applied in practice. The demand for gold with which to pay for imported goods may be called legitimate, the demand for gold with which to buy foreign bills as a temporary investment with a view to exploiting a difference in interest rates may be called illegitimate. But there are many remaining intermediate cases, which cannot be placed in either one or the other category. Would it have been possible, say, for the Bank of France to put obstacles in the way of the withdrawal of deposits held by foreign states, municipalities, and companies, perhaps as the balances of loans? Or for the Austro-Hungarian Bank, which has repeatedly been accused of refusing to issue bills to persons who intend to carry out arbitrage dealings, to increase the difficulty of speculative repurchase of home securities from abroad? [23]

7 Other Measures for Strengthening the Stock of Metal Held by the Central Banks-of-Issue

The endeavors of the central banks-of-issue to build up as large gold reserves as possible have led to the employment of devices which have just the opposite appearance to that of the premium policy and the systems similar to it. By raising the price they paid for gold imports the banks used to try to diminish the cost to the importer of importing gold and so to reduce the lower gold point.

Among these devices was the practice of granting interest-free or low-interest-bearing advances to importers of gold, a practice which was not unknown in England, France, and Germany. [24] There was also the practice of buying gold not only at the chief office, but also at branches situated near the national boundary. [25] Perhaps the most interesting of these devices was that of buying certain kinds of gold coin at a price in excess of their bullion value. If the bank issued to a gold exporter, instead of ingots or coins of the country, coins of the country to which he intended to send the gold, it could get a higher price for them than that corresponding to their gold content. For the exporter would save the expense of melting and recoinage and avoid the loss in which he would be involved by the fact that the domestic coins would be worn down to some extent. So the bank would be able to agree to pay a higher price than that corresponding to their metal content for the current gold coins of the states into which a future export of gold was probable. [26]

All of these measures can best be described as weapons against the premium policies and related devices employed by foreign banks. If the central bank in a country A endeavored to raise the upper gold point for export from A to country B, then the bank in B took steps to lower it. If only used coins were issued for export purposes in A, this procedure was rendered nugatory when a price in excess of the gold content was paid in B for coins of country A. It is very probable that the devices and counterdevices were largely compensatory, so that the extension of the gap between the gold points, which otherwise would necessarily have resulted from the intervention of the banks, did not in fact occur.

8 The Promotion of Check and Clearing Transactions as a Means of Reducing the Rate of Discount

In Germany, where before the war relatively very much gold was in circulation, there was a constantly growing endeavor to withdraw it from circulation by an extension of check and clearing transactions and to divert it into the vaults of the Reichsbank. The aim of this propaganda is set forth in a circular of the elders of the Kaufmannschaft of Berlin, s.d. May 2, 1907, to the following effect: "The causes to which the high rate of interest in Germany are to be traced are rooted to a large extent in the circumstance that the German people make greater use than those in other countries of cash media of circulation (gold and silver) for payments arising in and out of the course of business, but have not yet sufficiently accustomed themselves to the procedure which might replace the use of gold and silver, and also of banknotes and Treasury notes, as media of circulation, namely, the use of checks and the clearing system. If a considerable proportion of payments could be settled by means of transfers from one account to another or by checks, then this would save large sums of currency, in gold and silver as well as in banknotes and this saved currency would then accumulate in the reserves of the banks-of-issue, especially of the central bank-of-issue, the Reichsbank. The more this happened, the smaller would be the demand for currency that had to be satisfied by the Reichsbank, and the stronger would be the cash reserve of the Reichsbank, which circumstances would contribute considerably toward a reduction of the rate of interest at the Reichsbank and in the whole country." [27]

In this is a very clear demonstration of the weakness of the theoretical views that underlie modern banking policy. The level of the rate of interest is said to depend on the demand for currency. A strengthening of the cash reserve of the central bank-of-issue is credited with the effect of reducing the rate of interest in the whole country, and of reducing it appreciably. And this is not just the opinion of some private person or other, but that of the highly respected corporation of the Berlin Kaufmannschaft, and also, as everybody knows, that of the leaders of German economic policy in general. On this one point, all parties seem to be agreed, however much their views on the nature of economic phenomena may otherwise diverge. But even if this fundamental error is for a moment disregarded it is impossible to overlook the weakness of the doctrines expounded, and, above all, their contradictoriness. The proportion of cover for the Reichsbank notes provided for in the banking legislation of the seventies is treated as sacrosanct. The possibility of changing these provisions by substituting, say, a cover of one-quarter or one-fifth for that of one-third is never contemplated. The letter of the law has to be preserved while the assumptions on which it was based are being altered. When money substitutes in the form of deposits are augmented without provision being made for a monetary cover, the quantity of fiduciary media is increased. This is further demonstrative of the fact that even that part of the argument of the banking principle which was theoretically correct was unable to exert any influence on practical politics. Tooke and Fullarton repeatedly point out that there is no fundamental difference between notes and deposits (which they speak of as checks). Their modern successors do not dare to draw the logical conclusion from this incontrovertible fact; they stand for the differential treatment of fiduciary media according to whether they are notes or deposits. [28]

If part of the gold in circulation in Germany and part of the banknotes had been replaced by fiduciary media in the shape of deposits, this might have led to a diminution of the rate of interest only insofar as the gold that had become superfluous was employed for obtaining capital goods from abroad. The replacement of notes without a metal backing by deposits without a metal backing is of no consequence in this connection. Only so far as notes covered by metal were replaced by deposits not covered by metal would there be any increase of the circulation of fiduciary media at the expense of that of money certificates, by which gold would be released for export to other countries. But the same result could have been attained by a diminution of the ratio between cover and banknotes; nevertheless this simpler device was generally held to be impracticable, in spite of the fact that it was precisely as safe or precisely as dangerous as the other. If the gold dispensed with in this way had been exported, then the stock of other economic goods at the disposal of the German nation would have increased correspondingly. This might have led to a fall, if only a trifling one, in the rate of interest, assuming that the quantity of gold expelled from Germany was absorbed abroad with a general fall in the objective exchange value of money. But the German champions of an extension of the checks and clearing system did not think of that when making proposals of this sort. They recommended the extension of the circulation of fiduciary media in the form of deposits because they believed that this would reduce the number and extent of those applications that made demands upon the credit that the Reichsbank granted in the form of notes; and they hoped that this would lead to a reduction in the rate of interest on loans. There is a serious error in all this. The level of the rate of interest on loans depends not on the amount of the national stock of money in the wider sense, nor, of course, on the amount of fiduciary media in circulation. It was not the legal regulations concerning cover that forced the Reichsbank to aim at a discount policy that would prevent any tension from arising between the natural rate of interest and the discount rate, but its inevitable concern for its own solvency.

In all those countries whose credit system is organized on the so-called single-reserve basis so that the stock of money needed for the redemption on demand of money substitutes is administered by a central bank on which in times of emergency all the credit-issuing banks must ultimately fall back, it is the directors of this bank who are the first to notice the outward flow of gold; and it is they who must be the first to take steps to stop it, since its first effects are directed against the institution for which they are responsible. Therefore, the raising of the discount rate by the central bank usually precedes the increased severity of lending terms in the open market and in the dealings between the private banks and their clients. And so superficial critics jump to the conclusion post hoc ergo propter hoc. Nothing could be more mistaken. Even quite apart from the proceedings of the central bank-of-issue, the private banks and others who issue money have to adjust their interest policy to the rate of interest ruling in the world market. Sums could be withdrawn from them for the purposes of interest arbitrage, just as from the central bank. In fact, so long as the mobility of capital is not restricted it remains impossible for the credit-issuing banks of any single country to follow an independent credit policy.

[1] [Some of the problems that have arisen since are referred to on pp. 14-22. H.E.B.]

[2] [See editor's Introduction, p. 13, above. H.E.B.]

[3] See Torrens, The Principles and Practical Operation of Sir Robert Peel's Act of 1844 Explained and Defended, 2d ed. (London, 1857), pp. 8 ff.

[4] See Tooke, An Inquiry into the Currency Principle (London, 1844), pp. 23 ff.

[5] See Wagner, "Banknote," in Rentzsch, Handwörterbuch der Volkswirtschaftslehre (Leipzig, 1866), p. 91.

[6] See Wagner, "Kredit," ibid., p. 201.

[7] See Schumacher's criticism of this contradiction, Weltwirtschaftliche Studien (Leipzig, 1911), pp. 62 ff.

[8] See Cannon, Clearinghouses: Their History, Methods and Administration (New York, 1900), pp. 79 ff.

[9] The Federal Reserve Act has since provided the United States with a basis for issuing notes in order to allay a panic.

[10] See Sartorious von Waltershausen, Das volkswirtschaftliche System der Kapitalanlage im Auslande (Berlin, 1907), pp. 126 ff.

[11] [See p. 13 above. H.E.B.]

[12] See Rosendorff, "Die Goldprämienpolitik der Banque de France und ihre deutschen Lobredner," Jahrbücher für Nationalökonomie und Statistik 21 (1901): 632 ff.; Dunbar, Chapters on the Theory and History of Banking, 2d ed. (New York, 1907), pp. 147 ff.

[13] See Kaufmann, Das französische Bankwesen (Tübingen, 1911), pp. 35 ff.

[14] On this, see Rosendorff, op. cit., pp. 640 ff., and passages cited in the essay "Die neue Richtung in der Goldpolitik der Bank von Frankreich," Bank-Archiv. 7 (1907): (72) ff., taken from the statements of account of the Bank of France, in which the raising of the discount rate is spoken of as the "seul moyen connu de défendre l'encaisse."

[15] See Landesberger, Währungssystem und Relation (Vienna, 1891), p. 104.

[16] Ibid., p. 105, and Über die Goldprämienpolitik der Zettelbanken (Vienna, 1892), p. 28.

[17] Even at the time when the thaler was still unlimited legal tender and so occupied position analogous to that of the French five-franc piece, the German Reichsbank never followed a gold-premium policy on the French pattern, although it was often advised to do so. This is probably to be ascribed not so much to the circumstance that the number of thalers was relatively small as to the influence of Bamberger's ideas throughout the Reich. An open break with the principles of the banking and currency reform of the period after 1870-71 was, in view of the prevailing opinion, out of the question.

[18] See Koch, Der Londoner Goldverkehr (Stuttgart, 1905), p. 708.

[19] Ibid., pp. 81 f.

[20] See Clare, A Money Market Primer and Key to the Exchanges, 2d ed. (London, 1893), p. 22.

[21] Rosendorff ("Die Goldprämienpolitik der Banque de France," p. 636) would appear to be mistaken in thinking it possible to detect a difference of principle between the procedure of the Bank of England and the Reichsbank in paying out gold and the gold-premium policy of the Bank of France. He bases his view on the argument that, whereas the latter refuses altogether to pay out French gold coins and is thus theoretically able to raise the amount of the premium indefinitely, the Bank of England and the Reichsbank, which in contrast to the Bank of France always redeem their notes at their full value in current gold coin and have never attempted to refuse to pay out gold, are able to raise the selling price of bullion only by the amount of the cost of minting and an allowance for wear and tear. Rosendorff, in arguing from the statement that the Bank of France is "theoretically" able to raise the amount of the gold-premium indefinitely, flatly contradicts what he says in the rest of his book. In fact it does not do it, quite apart from the consideration that the law forbids it also. But if it did it, then it would completely alter the character of the French monetary system. It could not be expected that the French government and the Chambers would sanction the transaction to a credit-money standard which would be involved in such a procedure.

[22] Thus, in the Compte rendu for 1898 (pp. 12 f.): "Si nous nous efforçons de conserver de grandes disponibilités métalliques et de les ménager le mieux possible, nous ne devons pas non plus perdre de vue les intérêts du commerce et lui refuser les moyens de payement qu'il réclame pour les besoins les plus légitimes, c'est-à-dire pour l'approvisionnement du marché français."

[23] See my article Das Problem gesetzlicher Aufnahme der Barzahlungen in Osterreich-Ungarn, p. 1017. If the Austro-Hungarian Bank were to follow the example of the Bank of France in this or some other way it would achieve an exactly opposite result to that achieved by the French institution. Like that of the Bank of France, its action would restrict not merely the efflux but also the influx of gold. In France, the creditor nation, this means something very different from what it means in Austria, the debtor nation. In France, restriction of the importation of capital (which would only exceptionally occur) is unobjectionable; in Austria, the country that is dependent on constant importation of capital from abroad, it would have quite a different effect. The fact that there was a possibility of difficulties in subsequently repatriating the capital would mean that a greater gap than otherwise would have to occur between the Viennese and the foreign rates of interest before capital would be sent to Austria, and this would mean that the rate of interest in Austria would always be higher. The fact, on the other hand, that the export of Austrian short-term capital would also not be profitable except when there was a greater gap than otherwise between the home and foreign rates would not counteract the above disadvantage, because the question of capital exportation from Austria-Hungary to western countries very seldom arises.

[24] See Koch, op. cit., p. 79; Die Reichsbank 1876-1900 (Berlin, 190l), p. 146.

[25] See Obst, Banken und Bankpolitik (Leipzig, 1909), pp. 90 f.; Hertz, "Die Diskont und Devisenpolitik der österreichisch-ungarischen Bank," Zeitschrift für Volkswirtschaft, Sozialpolitik und Verwaltung 12 (1903): 496.

[26] See Koch, op. cit., pp. 79 ff.; Hertz, op. cit., p. 521; Spitzmüller, "Valutareform und Währungsgesetzgebung," in Oesterreichischen Staatswörterbuch, 2d ed., vol. 2, p. 300.

[27] See also Proebst, Die Grundlagen unseres Depositen-und Scheckwesens (Jena, 1908), pp. 1 ff.

[28] It is only in very recent years that views on this point in dominant circles have begun slowly to change.

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