Economics of the Free Society

CHAPTER IV MONEY AND CREDIT

“The sole fact that credit is today the normal and proper expression of value and of exchange has introduced an element of extreme instability into all contemporary economic systems. Modern economic systems appear to be balanced on a knife’s edge as it were; the tiniest excess or deficiency of national credit can tip the balance in one direction or the other. This system is minutely adjusted, so to speak, to reflect the smallest increment in weight which it can just support, and that is why it is so extremely sensitive.”

KARL LAMPRECHT

1. What Is Money?

We do not know when money first appeared in human history. Very probably, it was not invented in the same manner as the electric light bulb or the typewriter. What most likely happened is that one day, many thousands of years ago, people suddenly became conscious of the fact that money existed. Only one thing we can say with certainty: to be really money, money must have had to fulfill, thousands of years ago as today, the essential condition of being generally exchangeable and acceptable as a means of payment. We can understand, therefore, why the earliest form which money took was some particularly desirable commodity which could, if need be, serve for real satisfaction. Early money was constituted at times of bars of iron, at times of strips of cloth or of leather, and most often of cattle, proof of which we find in the fossil remains of language, in the Latin word “pecunia” and in the English “fee” which corresponds to the German “Vieh” (= cattle). Eventually, the precious metals, for many and obvious reasons, attained preeminence as money. Thence begins the history, open to our investigation, of money and currency.

We are already familiar with the economic revolution which followed the introduction of exchange based on money. Exchange was henceforth separated into two acts: the act of “selling” one’s own commodity against the receipt of a sum of money, and the act of “buying” another’s commodity by surrendering a sum of money. We can see that each of these two acts is an act of exchange: exchange of commodity against money, and exchange of money against commodity. In place of the original exchange of commodity against commodity, we now have the concatenation: commodity—money—commodity. Simultaneously, money made possible the participation of more than two persons in the act of exchange. The end result of the process of exchange in a money economy is, of course, an exchange of commodities against commodities, but in contrast to the economy of exchange in kind, this result is obtained in an indirect way by a detour passing through several individuals who make use of a general medium of exchange.

If we term a “good” every object or service to which we attach value, then money too is a “good.” Nevertheless, it is a good of a very special kind. We value an ordinary good because it is capable, in some way, of ultimately satisfying a want. In the act of satisfying a want, it renders up its economic soul, so to speak; it achieves the purpose of its existence. In a word, every other good but money serves for “real” satisfaction. From the raw material to the packaged product, chocolate goes through numerous stages and passes through many hands, but its final inglorious destiny is to be eaten. It is not so with money. If commodities providing real satisfaction are by essence and destination mortal, money is essentially immortal because it is not used for real satisfaction but for “circulatory” satisfaction. In other words, we do not derive satisfaction from money by eating it, but by spending it and by making it circulate, intact, from hand to hand. This does not mean that money, insofar as it is constituted of some material substance, may not also furnish real satisfaction. People can collect coins, melt them, or hang them on a watch chain. A man can paper his walls with bank notes, if he is willing to allow himself this extravagance. But money in these cases at once ceases to be money. It becomes a simple commodity, just one more addition to the strongly mixed company of chocolate bars, sugar buns, and phonograph records. It is essential to the concept of money that it circulate, and in a direction opposite to the (finite) circulation of ordinary goods. Whereas chocolate bars, phonograph records, etc. are always leaving the stream of goods in order to be consumed, it is the essential characteristic of money that it remain in circulation as money.

But if we employ—with this reservation—the comparison of money to a promissory note, we can see at once that it is possible to imagine a money which is incapable of furnishing any real satisfaction and which is thus without material value. But this lack will not negate the functions of money as a general medium of exchange provided that it retains the essential quality of “general acceptability” (F. von Wieser). The lack of a material content offering the possibility of real satisfaction does not exclude the possibility of a circulatory satisfaction, and if we value money according to what we can buy with the monetary unit, money without material value of its own possesses “value” just as well as money with material value. The value of money in the former case reflects the value of the goods which we can buy with the monetary unit; it does not flow from the value of the money material, but arises from the function of money which is to circulate and to be exchanged against commodities. Money in this context has a functional value and not a material value. The belief that it is the very essence of money to be incarnated in a piece of precious metal (metallism) is therewith refuted. The question of what will circulate as money is ultimately determined by the confidence of the people in the possibility of returning money to circulation. This confidence can be strengthened in two ways: either by endowing money with its own material value (coin), or by making it legal tender (nonredeemable paper money of fixed par value). As a general rule, it is necessary to educate the population to accept paper money which is nonredeemable and without material value. In the eastern provinces of Turkey, for example, it was still recently almost impossible to compel the peasants to accept the government’s (then stable) paper money. A Turkish official related to the author that while on an inspection trip, he had succeeded in getting a village wagoner to accept paper money rather than gold only by using his fists (admittedly, a somewhat crude illustration of the concept of fixed par value!). In our case, fisticuffs have been replaced by war which has so accustomed us to the use of paper money that we can scarcely recall a time when paper money was redeemable in gold. Indeed, we find it hard to imagine that our fathers could take their bank notes to the banks and obtain pieces of gold as naturally and as easily as postage stamps. Plainly, then, the connection of money with a precious material is not essential, though this does not exclude the fact that such connection may be very desirable. Normally, there is no need of making theatre tickets out of candy, unless it is feared that the management will sell more tickets than there are places, in which case we can console ourselves a little with the tickets made of candy.

In the case of inconvertible paper money, we see with special clarity the nature of money as a simple but indispensable auxiliary to economic activity, a kind of poker chip as it were. From the point of view of economics, money is a way-station, an item in the national ledger which disappears in the final accounting and which does not itself constitute an integral part of a nation’s wealth. A nation does not become richer or poorer because its supply of money increases or diminishes, but only when the supply of goods of which it disposes grows greater or smaller. If the supply of money in a country increases or diminishes while the supply goods remains the same, it follows that the supply of goods which can be purchased by the monetary unit will become smaller in the first case (inflation) and greater in the second (deflation). If the bank notes of a private individual are destroyed in a fire, his loss, which may be very great, does not necessarily represent a loss for the national economy, apart from the negligible value of the paper and the costs of printing. Indeed, the sum of which this unlucky individual is deprived actually benefits the rest of the population, for the purchasing power of all the other bank notes increases by the fraction corresponding to the amount of the burned bank notes. What has taken place is a sort of miniature deflation.

Pursuing this notion still farther, we see that however we use our money, our conduct will exercise an influence on the whole of the national economy. If we spend it, the way in which we spend it affects, in the fraction corresponding to the amount spent, the way in which goods are produced. If we do not spend it, we can either put it in a bank and thereby give to others the possibility of buying raw materials and machines, or we can pile it up in the cupboard at home. In the latter case, the purchasing power of the money becomes inactive to the profit of all the other members of the payment community who can now buy more cheaply. Whatever we do, we can never escape the responsibility which is imposed on us by the possession of money.

Money is one of those objects whose essence can be explained only in terms of their functions. Thus, the essence of money resides in its function of being a general medium of exchange. Of critical importance, in this connection, is how the broad masses of the citizens will react in a period, say, of hyper-inflation when once they become fully aware that money is no longer “functioning” as it should. Money is so indispensable to the modern economy that where the state-issued currency is rendered worthless, the country’s ongoing trade and business activities, even where they are at a low level, will of themselves bring into existence a substitute means of calculation. Such ersatz money may take the form of stable foreign monies as in the inflationary period following World War I when the dollar, the guilder, etc., supplanted the worthless local currencies in many countries. Or it may take the more unusual form of some scarce commodity such as the cigarettes which did yeoman service in those European countries which were devastated by World War II.

Only money makes possible the satisfaction of the complex pattern of consumer desires by causing the highly differentiated structure of production to shift continuously in response to such consumer desires. Only money makes possible rational economic calculation in that it provides a device for comparing production and consumption, profits and costs, and, as we have already seen, reduces all economic quantities to a common denominator. “Money alone is the absolute good: not merely because it satisfies a want in concreto but because it satisfies want as such, in abstracto” (Schopenhauer). It is, as Dostoievsky once expressed it, “coined freedom.” Finally, money has supplied the foundations for our modern credit system, without which the contemporary economy would be unthinkable. But it can furnish these manifold services only so long as it remains a general medium of exchange and meets the requirements of a “healthy” money.

When we consider somewhat more closely those services which money renders in virtue of its quality of being a general medium of exchange, our attention is drawn especially to the aforementioned attribute of money which enables us to compare all the objects of exchange with one another in such a way that we can express their value as a multiple of the common monetary unit. This is what is meant when we say that one of money’s functions is to be a general measure of value. However, we cannot regard this function of money as being equally important and equally necessary as its function of being a general medium of exchange. It is more accurate to say that because money in its concrete form is a general medium of exchange, the exchange value of marketable goods will inevitably be expressed in units of money. Money as a general medium of exchange consists of the concrete dollar notes or checks which I use to buy goods. Money as a measure of value, on the other hand, is the dollar as an abstract unit of account.

Closely connected with the exchange function of money is another of its functions, that of being a general means of payment. Every money payment need not involve an exchange transaction; payment of taxes, of penalties, of damages, gifts of money and many other examples show that money can also function as a means of unilateral value transfer. But this again is possible only because it is a general medium of exchange.

A further consequence of the exchange function of money is its ability to be an intermediary in capital transactions, i.e., its quality of making possible the emergence of debtor-creditor relationships and the transfer of the ownership of capital from person to person or group to group.

Finally, money’s function as a medium of exchange renders it an appropriate means of capital saving and capital movement. Or to express this idea somewhat differently, money becomes a vehicle of value through time and space (von Mises). Actually, money nowadays—except in periods of distress—no longer serves in any significant degree as a means of capital saving, since the average person is apt to put what is not mere working capital or simple cash reserves into investments which will yield a profit, or he turns over his savings to a bank to administer. It is as a vehicle of capital movement that money has retained a larger measure of significance.

In general, all monetary functions are exercised in a given country at a given time by one and the same monetary system. Indeed, its capacity for assuming all of its functions may be regarded as one of the criteria of a healthy money. It may happen, however, that the different functions are accomplished by different kinds of money. Such a process of division of functions was very well illustrated during the German inflation following World War I. The more worthless the mark became, the more of its functions it had to abandon. The first of its functions which the mark was to surrender was that of being a means of capital saving and capital movement; subsequently, it had to forego its function as go-between in capital transactions. Only an uncommon lack of economic insight could have induced anyone in the year 1923, at the height of the German inflation, to hoard mark bank notes or to buy mark securities. Next to go overboard was its function as a measure of value as more and more people turned to calculation in gold or used the “index” and the multiplier. The government itself was compelled in the end to collect its taxes in “gold marks.” Thus was the mark increasingly restricted to being merely a means of exchange and of payment. It was just about to lose even these last functions when the successful stabilization of the mark was accomplished in November 1923.

2. From Cattle to Bank Notes

The collection of coins we are contemplating tells us something else which is perhaps of even greater importance. Many of the silver coins will be seen to give off a suspicious reddish glint, indicating the presence of a strong alloy of copper. No great powers of imagination are needed to conjure up the coin debasements of past centuries (and the monetary depreciations which accompanied them); they are, in fact, the historical prototypes of the inflations of our own times. These experiences of the past make clear the importance of that other requirement of a sound money, stability of value, and the strenuous and repeated efforts required in the course of history to establish it. In this instance, too, the introduction of the gold standard in the nineteenth century was the factor most responsible for the establishment of money upon a solid base. Again, too, it is our own destructive age of wars and revolutions which is responsible for the sabotaging of this accomplishment. Once more, the maintenance of monetary stability has become an economic problem of the first magnitude.

There is one fact, however, which an examination of our coin collection does not reveal to us, but with which we have become intimately familiar as the result of our own painful experience. Though the people in whose pockets our collection of coins once jingled were plagued by a confusion of monetary systems and of coin debasements with a resulting lack of monetary homogeneity and stability, one thing was self-evident: their freedom to exchange their money against goods or against other kinds of money. Of course, there were instances in these earlier periods of where an unscrupulous ruler of the modern stamp such as King Philip the Fair of France would proclaim, as he did at the end of the thirteenth century during his struggle with the Papacy, an embargo on the export of money and letters of credit, thereby introducing what we term at the present time exchange control. But we have no record of Erasmus, Luther, or Goethe encountering any difficulties in exchanging their money on their respective journeys to Italy. Restrictions on freedom to exchange domestic money against foreign money are in fact an invention of our own time, and we have little reason to be proud of having made exchange control a normal procedure and therewith deprived money of that freedom which in the eyes of our forbears pertained to its very essence. Moreover, we find that in some countries even the freedom to exchange money against goods has been so restricted by rationing regulations that for the purchase of certain categories of goods money is worthless unless accompanied by a special permission to purchase. Out of such restrictions collectivist Russia has made a permanent system, a proof that in the collectivist economy money completely changes its role and in any case can no longer be equivalent to “coined freedom.”

If we keep in mind that the three most important postulates of a sound money are homogeneity, stability of value, and circulatory freedom, then we may regard the history of money as a history of the tribulations which it has endured: a history of debasements, of risky experiments, of repeated violations of these postulates. At the very least, valuable insights can be gained by reviewing the history of money from this angle. Another vantage point for the study of monetary evolution is found in the interesting fact that from earliest times to the present day, money has become progressively more abstract, more “aenemic.”

The cattle in which Homer counted out the value of Achilles’ shield was evidently a very concrete kind of money. Even in the age when men began to use specific weights of the precious metals as money, the purely material aspect of money was still of prime consideration. This primitive method of payment which consisted of weighing out amounts of the precious metals (“weight payment” according to G. F. Knapp) is memorialized in the fact that many contemporary words for money were originally nothing more than designations of weight, as in the obvious cases of the English “pound” and the Italian “lira,” but also in the cases of the German “mark” and the Yugosalv “dinar” (from the Latin “denarius”), among others. Nor did the evolution towards an even more complete dissociation of money from its purely material content end here. Those of us who have ever had to buy a railroad ticket at the last minute will appreciate the difficulties attendant upon the method of “payment by weight,” difficulties which disappeared after the tremendous forward step taken in antiquity—probably for the first time in Crete in the second millenary B.C., then later in Asia Minor—when unitary weights of the precious metals were introduced, embossed with an official stamp guaranteeing their weight and purity.

With the stamp of guarantee, there came into being a money which made it possible to make payments not by weighing, but simply by counting. The exchange value of this fully-valued money (currency) was still identical with its material value. But the next stage of development saw the issue of token money or subsidiary coin, that is, of under-valued monies whose material value represented only a fraction of their exchange value. This marks the further progress in the direction of monetary aenemia; and in fact in most civilized countries today, people know no other coins than these. These aenemic coins, however, are used only in transactions involving small sums; by far the greater part of payment transactions in all civilized countries is effected by means of money still more ephemeral in nature, viz., stamped pieces of paper.

3. Money and the Banking System

But even paper money, abstract and ephemeral though it be, cannot be considered as the final stage of that “aenemia” which has characterized the development of money. Paper money is, after all, “cash”; it is a visible concrete currency. Now it is commonly known that most business transactions in the economically most developed countries are consummated not by the use of actual cash but by the transfer of bank deposits. The participants in such transactions maintain bank accounts against which they write checks. In disposing of their bank deposits in this way, they make use of a variety of money which is designated as credit money (bank money, check money, or demand deposits). In this, the dominant medium of exchange today, money has found its most abstract expression. Even the simple counter, as it were, has disappeared from the gaming tables of finance—people simply “keep track of the score.” If, under the general heading of “the banking system” we include both banks of issue and banks which handle demand deposits (commercial banks), it is evident that in the economically advanced countries the monetary system is intimately connected with the banking system. Thenceforth, money and credit constitute an inseparable entity.

We find, too, that the same sequence of credit expansion which is associated with the issuance of bank notes occurred in the case of demand deposits. Thus, to the extent to which demand deposits circulated as money, the banks felt themselves freed of the obligation of maintaining a 100 per cent cash reserve behind these deposits, despite the fact that they are debts of the bank subject to payment on demand (hence the name “demand deposit”). To provide the necessary minimum liquidity (the ability to meet expected demands for cash) it was deemed sufficient to maintain a supply of ready money equal to, let us say, 10 per cent of the total demand deposits oustanding. The banks could loan out the remaining 90 per cent and earn enough in the process to administer the deposits without charge or even to pay a small amount of interest on them. Hence-forth, the whole art of bank management consisted in effecting a daily compromise between the two opposed principles of liquidity and profitability, with the over-all goal being the maintenance of minimum liquidity and maximum profitability. Small errors of calculation could be corrected by recourse to the so-called “money market.” Thus, the whole system is truly “minutely adjusted to reflect the smallest increment in weight which it can just support.” We can now observe what an important bearing banking has on the entire monetary system. Prior to the development described above, only cash money circulated. Thenceforth, demand deposits circulated simultaneously with the greater part of the cash which gave rise to these same deposits. The circulation of demand deposits or check money was equivalent in short to the “creation” of an additional supply of money.

There is yet another angle from which we can observe how the modern banking system affects the supply of money. A businessman, for instance, may establish a demand deposit (checking account) not only by depositing hard cash in the bank, but by getting the bank to extend him a loan for this purpose. Thus, by adhering to a proportion of 1 : 10 between cash reserves and outstanding demand deposits, with 90 per cent of the actual currency paid in being loaned out, the bank can, by granting cerdits, create new checking accounts (demand deposits) to an amount nine times greater than that which has been paid into it. It is clear in this case that the bank, following the same procedure as a bank of issue, grants credits not out of preceding savings, but from additional resources obtained by the creation of credit. To what extent is a bank capable of creating credit? This depends upon the bank’s liquidity requirements, that is, upon the amount of the reserve which the bank must maintain to meet the demands for the conversion of check money into actual cash. This preoccupation with the maintenance of liquidity, which no bank can safely ignore, more or less effectively limits the bank’s power to create credit. The liquidity requirements of banks fluctuate with the degree of confidence placed in banks, with the amount of the payments made to those who are outside the circle of the bank’s regular clients (payrolls, small payments to retail merchants, farmers, etc.), and with the turnover of individual bank accounts. But more significantly, the fluctuations to which bank liquidity is subject—and pro tanto the fluctuations to which the total supply of credit is subject—coincide to a very large extent with the cyclical fluctuations of prosperity and depression. In a period of expansion the economy’s supply of credit increases, while the banks’ liquidity is proportionately lowered (credit expansion); in a period of depression the banks seek greater liquidity and are forced, in the process, to contract credit (deflation).

When the whole banking system of a country is subject to a run, as in the United States in 1933, it is an event of very grave import. For then the whole ingenious system of immaterial money, founded on convention and on trust, suddenly crashes down and the desire of the public for solid cash erupts with elemental force. What then takes place is a sudden panic collapse of the credit edifice to some anterior stage of monetary evolution. In this headlong retrogression money may fall back past even the paper bank-note stage to full-value coins or, in more drastic cases, to unstamped pieces of the precious metals. In the ’30’s, a number of countries underwent such monetary crises and their effects are still being felt.

The so-called “creation of credit” by commercial banks is possible only because the circulation of short-term credit is equivalent to a circulation of money. To create credit, then, is to create money. This mysterious and seemingly sinister phenomenon may be better understood by once again comparing checks (or demand deposits) with bank notes and by recalling the historic discussion of the problems of bank note issuance. Two important facts emerge from such reflection: (1) bank notes can be printed ad hoc, as the occasion demands; (2) the commercial bank, with its power of creating credit, differs in this respect only in degree and not in kind from the note-issuing bank. No one, certainly, will gainsay the first point. For the truth of our second observation, we have only to recall that the transfer of a demand deposit from one person to another by means of a check, coupled with the confidence of the parties to such a transaction in the solvency of the bank, causes this deposit to circulate exactly as money.

Checking accounts may be regarded as money held on the bank’s books and awaiting withdrawal; checks and drafts drawn on these accounts are, therefore, simply means by which such book money is put into circulation. In the extent to which, in accordance with the law of great numbers, deposits and withdrawals offset each other, and to the extent, furthermore, that the circulation of demand deposits is confined to the banking system’s circle of customers, it is not required to maintain a 100 per cent reserve behind such deposits. On the contrary, a bank can, as we have seen, loan out a part of its deposited funds, even though such funds are callable by the bank’s depositors at any time. Bank notes and demand deposits are thus very similar to each other. Both have this in common, that they are circulating claims which the banks write against themselves and which they can create to an extent equal to some multiple of their cash reserves. The only difference between them is that the acceptability of demand deposits for purposes of general circulation is more limited than that of bank notes, but this is a difference of degree and not of kind.

Few will contest the fact that since bank notes are actual money and can be issued theoretically in unlimited amounts, there should be some kind of legal control over the note-issuing power. This is all the more necessary since in practically all countries bank notes are full legal tender even though they are no longer redeemable in specie. But it is interesting to recall that the power of banks to issue notes at will and thus to increase the supply of money was once just as controversial as is today the corresponding, if more limited power of the commercial banks to create credit.

To be sure, the issuance of bank notes has always been regarded as an undertaking fraught with risk to the community. The history of the note-issuing banks is a long and anguished one, dotted with ruined banks and—what is even more depressing—strewn with the memorials of wrecked monetary systems. “Never,” said the English economist Ricardo 150 years ago, “has a bank which had unlimited power to issue paper money not abused that power.” Thus the conviction grew that the issuing of bank notes should be subject to definite limitation. But where ought the limits to be placed? On this point there was a very heated argument one hundred years ago between two schools—the Currency School and the Banking School. Their differences, even after the lapse of a century, have lost none of their significance.

The opinion of the Banking School with respect to the phenomenon of credit creation may be summarized as follows: bank notes and demand deposits are similar inasmuch as both are phenomena pertaining to banking—hence the name “Banking School”—but neither exert any active influence on the monetary system. In the rigid view of this School, the monetary system will remain shipshape so long as bank notes enter circulation through banking operations alone, that is, through short-term credit transactions. In these circumstances, every legal barrier to the issuance of bank notes would be harmful while, conversely, unrestricted powers of issuance would be absolutely indispensable to maintaining elasticity of the supply of currency, and to adjusting this supply to the fluctuating needs of business. This adjustment would ensue automatically because demands for credit on the note-issuing banks would rise or fall as general economic activity rose or fell. Thus, the position of the note-issuing banks with respect to the increase or decrease of the volume of bank notes would be a completely passive one, since the volume of bank notes would depend on the money and credit needs of the business community and not on the volition of the note-issuing banks. A change in the volume of currency would be not the cause but only the effect of events occurring in the sphere of production, or of changes in the price level, or of cyclical changes, or of variations in the rates of foreign exchange, etc. Every attempt of the banks to alter the volume of currency above or below the requirements of business would fail; if too many notes were issued, the excess would flow back to the banks, while if not enough were issued, business would resort to other circulating instruments.

The Currency School, in contradistinction to the Banking School, considered bank notes to be a money phenomenon and not a credit phenomenon. It reasoned, therefore, that the issuance of bank notes should be just as jealously supervised as the issuance of any other kind of money. In opposition to the Banking School, it argued logically that the sum total of bank credits is not unaffected by the policy of the note-issuing bank which fixes the conditions of credit, particularly the rate of interest. The issuance of bank notes is to be considered like any other creation of money and there is nothing in the nature of the operation of the note-issuing bank which could prevent either an excessive creation of credit (credit inflation) or an insufficiency of credit (credit deflation). Hence, the issuance of bank notes requires strict legal supervision. But this much established, the Currency School forgot that demand deposits can be just as much a source of credit inflation or of credit deflation as bank notes. As a result, the adherents of this school suffered considerable disillusionment when the severe restrictions on the issuance of bank notes embodied in the famous English Bank Act of 1844 failed to solve the problems incident on credit creation; indeed, these restrictions on bank-note issues served to stimulate the growth of the demand deposit (check) system. The more rapid the increase in the last hundred years of the importance of demand deposits in business transactions, the clearer it has become that regulation of the note-issuing banks alone will not suffice to cope with the exceedingly difficult problems attendant on credit creation. Control of the note-issuing banks must be supplemented by regulation of the demand-deposit system.

Though academic economists are now unanimously of the opinion that commercial banks can and do create credit, there is many a practical man of affairs who is inclined to view such “theories” with skepticism. There are still people in the banking world who hold that their own experience invalidates the creation of credit theory in toto. Such skepticism may be traced, in part, to exaggerated or incomplete descriptions of the process of credit creation. We must guard against overstating our case, for there are, of course, the limits to this process which were noted in an earlier part of this chapter. We also must take into account the optical illusion which causes the individual banker to view the aforementioned process in a radically different way than the economist who surveys the banking system as a whole. Thus the individual bank cannot continue indefinitely to make loans, for the cash reserve it must maintain clearly sets a limit to its loanable funds. If Bank A considers a reserve of 10 per cent adequate, then it can only loan out 90 per cent of its deposited cash. But the process of credit expansion is not therewith concluded because this 90 per cent will ordinarily become a primary deposit in Bank B which again loans out 90 per cent, etc. When the process is continued throughout the entire banking system it will be found that eventually nine times the original amount of cash deposited in the system will have been extended in loans (9/10 + 9/10 • 9/10 + 9/10 • 9/10 • 9/10 . . . . . . . 9/10n). We see that the “enigma of the banking system” (Philipps) consists in a given amount of cash becoming the basis for a towering edifice of credits and deposits, though this is clearly not the case with respect to the individual bank. Hence, by the very nature of the complicated process to which we have just alluded, it becomes impossible to distinguish between genuinely primary cash deposits and those derivative deposits that come into being through the creation of credit. Consequently, we can readily see why an individual banker will so vehemently deny the process of credit creation, a process that to us appears so self-evident. Such denial absolves the individual bank of the “guilt” (or at any rate of the responsibility) of creating additional credit. Now when we said that a bank must pay heed to its cash reserves, we said nothing more than that it must stay liquid. The degree of liquidity desired or required fixes the outer limits to a bank’s powers of credit creation, provided, of course, that actual currency is not completely displaced by demand deposits (check money) centralized in a single bank.

Two conclusions may be drawn from the foregoing analysis. First, that the global sum of a country’s demand deposits does not represent pure saving, but is in large part a consequence of the creation of bank credit. This is something which must never be lost sight of in considering any economic problem. The second conclusion is that money and credit constitute an entity, the complexities of which place a number of formidable difficulties in the path towards economic and monetary stability. A bank is no ordinary commercial enterprise. It is not just a cloakroom where we deposit our monetary property for safekeeping, or a kind of shop where one rents costumes for a masquerade, but an enterprise which exercises a profound influence on the circulation of money and thus on the entire economic process. Consequently, the thought never occurs even to the most intransigent European liberal to abandon the control of such an enterprise to itself. And so we repeat: he who does not understand the role of the banking system is incapable of understanding the operation of the modern economic system.

4. Inflation and Deflation

The foregoing description of credit creation and of the problems generated by this process has shown us how important it is that the economic system be assured of monetary stability. We also learned how difficult it is to prevent those monetary diseases (inflation and deflation) which destroy this stability. Let us begin by setting forth the nature of the problem as realistically as we can. Let us suppose that, in the year 1913, a dentist made a wager with his patient that the price of the gold filling he was about to insert would follow the general rise in prices which was then getting under way. The dentist, of course, would have lost his wager; a quick glance at his files on his previous gold purchases could have told him as much. For the simple and ingenious coupling mechanism of the gold standard, by defining the monetary unit as a fixed weight of gold, tied gold to money in such wise that the price of gold remained stable though all other prices fluctuated.

A contrasting and yet equally illuminating experience is one which was recounted to the author by a lady of his acquaintance. She showed him a magnificent belt of wrought silver which she acquired in India on a visit there with her husband towards the end of the last century. She explained proudly that she had got a wonderful bargain inasmuch as the native jeweler had demanded for his silver belt neither more or less than its weight in silver rupees. Had she not thereby gotten the exquisite handiwork for nothing? In truth, the lady’s satisfaction in her bargaining ability was premature for at the time of her visit the pure silver standard in India had been replaced by a blocked silver standard. When the Indian government discontinued the free coinage of silver, silver became scarcer in minted form than in unminted form; the bonds linking money to a precious metal, corresponding to those of the gold standard, had been broken, causing the mint value of the silver rupee to exceed considerably the value of silver itself. The rupee became a kind of metal bank note whose scarcity was determined not by the production of silver but by the decision of the issuing government. To underscore the moral of this story, we have only to visualize a transaction wherein a purchaser of visiting cards is required to pay a quantity of paper money equal to the weight of the cards.

And now a third illustration which takes us from the gold standard and the blocked silver standard to paper money. More than a quarter of a century ago, an astonishing and ingenious crime was committed which resulted in the institution of a most interesting civil suit. A band of international swindlers succeeded in convincing the well-known London firm of Waterlow & Sons, engravers of postage stamps and bank notes, that they were the representatives of the Central Bank of Portugal come to place an order for the printing of a large quantity of Portuguese bank notes. The order was duly filled and the bank notes delivered to the swindlers. When the fraud was finally discovered, the Bank of Portugal caused all of its extant notes (of whose genuineness there was, naturally, no question) to be withdrawn from circulation and replaced with a new issue. Since it proved impossible to catch the criminals, the Bank of Portugal sued Waterlow & Sons, demanding that the engraving firm make good the losses resulting from the issue of the fraudulent notes. The English courts presently discovered that the case involved issues of unusual subtelty and complexity, adjudication of which necessitated the admission of testimony by leading monetary theorists. The question before the courts was: how great were the actual losses incurred by the Bank of Portugal? If it had been postage stamps instead of bank notes in which the swindlers had trafficked, it is perfectly clear that the loss of the Portuguese government would have equaled the total value of the stamps. With respect to the bank notes, however, no such simple calculation could be made. Among the many questions which troubled the experts the following stand out as particularly relevant to our study: would the Bank of Portugal have issued the same amount of notes even if the swindlers had not done so? If not, was the increase in the supply of money resulting from the introduction of the fraudulent notes good or bad for Portugal? The answer to this question would depend on whether the circulation of the fraudulent notes disrupted the orderly processes of the Portuguese economy looking to the regulation of the volume of money; it would depend, in other words, on whether the additional notes served to avert an otherwise imminent deflation, or whether they resulted in an inflation. If the first supposition were true, then the swindlers would have unintentionally done a favor to Portugal. These and other considerations did, in fact, influence the highest English court to award the Bank of Portugal only a fraction of the damages it had claimed.1

What lessons are contained in these three illustrations? They point to the truth of at least these three principles: (1) the value of money is determined by its relative scarcity; (2) monetary policy has no more important task than to regulate this scarcity in such wise that the value of money remains as stable as possible; (3) this task can be accomplished in different ways. Under a gold standard (or a silver standard with free coinage of fully-valued coins), the scarcity of money is automatically fixed by the scarcity of the standard metal. This, in turn, is affected primarily by the quantity of the metal which is produced in a given period. Such relationships are characteristic of so-called tied monetary standards under which money is linked securely to a precious metal with the regulation of the quantity of money being a function and a reflection of variations in the quantity of the precious metal. Under the “blocked” silver standard and, a fortiori, under the paper standard, the quantity of money is independent of the quantity of the precious metal and is regulated by the arbitrary decree of the government (free or manipulated standard). The determination of whether the control of the quantity of money should be submitted to the automatic forces of gold and silver production or to the conscious decree of the government is one of the cardinal problems confronting those entrusted with the making of monetary policy and upon the answer to which depends the choice of the particular monetary system in each case. A liberal—one [in Europe] who puts his trust in economic laws rather than in the whims of government—will generally opt for the tied or automatic standard. A collectivist—one who is willing to trust the caprice of the government over natural economic forces—will prefer the untied or manipulated standard. Since, however, the linking of money to a precious metal implies a much stricter control over the quantity of money than can be expected from arbitrary government regulation, we find that, paradoxically, it is the [European] liberal who, in money matters at least, demands a discipline far stricter than the collectivist.

It is, indeed, not surprising that the liberal should attach such importance to the maintenance of effective and positive control over the quantity of money and that he should desire in this case at least, that nothing should be left to chance. It was an English liberal of the early nineteenth century and one of the leading adherents of the Currency School, Lord Overstone, who drew the clear and emphatic distinction between money and goods. There is no sense, he observed, in applying to the manufacture of money the principle of cheap and abundant production which, with regard to the manufacture of goods, the liberal expects to find operating in a competitive economy. What is essential in the case of money, on the contrary, is strict control of its quantity. While the liberal holds private initiative and free competition to be desirable in the realm of goods production, he knows that judicious regulation of the quantity of money cannot be expected to emanate from those sources. What is needed instead is a carefully thought-out system of monetary control instituted and supervised by government. If in the production of goods the most important pedal is the accelerator, in the production of money it is the brake. To insure that this brake works automatically and independently of the whims of government and the pressure of parties and groups seeking “easy money” has been one of the main functions of the gold standard. That the liberal should prefer the automatic brake of gold to the whims of government in its role of trustee of a managed currency is understandable.

This distrust of the manipulated monetary standard is not alone a consequence of the liberal philosophy. Almost the whole course of monetary history vindicates this distrust. For as money has become increasingly etherealized—attaining the pinnacle of incorporeality and insubstantiality in the form of credit money—the danger of arbitrariness and caprice in the regulation of the quantity of money has become correspondingly greater. It is, of course, true that even the standard metals have been at times subject to considerable fluctuations in value. But these have been negligible compared with the monetary fluctuations which have occurred since manipulated standards have been adopted, and the laws of nature and of economics exchanged for the unpredictable caprices of politicians and governments. It was the paper standard which first taught us the meaning of the word “inflation.” Indeed, it would be difficult to cite a single paper standard which has not sooner or later succumbed to depreciation because the government concerned was unable or perhaps even unwilling to keep the quantity of money within limits.

It should by now be clear that the quantity of money in circulation decisively affects the purchasing power of money, an increase in the supply of money lowering its purchasing power (inflation), a decrease raising it (deflation). In the long run, the first mentioned danger of an inflationary increase in the money supply has always been decidedly greater than that of a deflationary reduction in the supply of money. The temptation to engage in inflation is omnipresent for its immediate consequences are usually very popular. Recent history knows no case of the murder of a statesman responsible for inflation. On the other hand, there have been at least several instances in which statesmen thought to be responsible for deflation have been done in (e.g., in Czechoslovakia and Japan). This one example may suffice to show that arbitrariness in the matter of issuing money tends more in the direction of the “too much” than in the direction of the “too little.” And indeed every money of which we have record has at some time in its history been prey to the disease of inflation which, if it has not proved fatal, has left the permanent scar of depreciation. If we lay side by side a modern bank note and the gold coin which is its equivalent, we could lay heavy odds on the certainty that in a hundred years’ time the bank note—even the “hardest” and most respectable—will have suffered the ignominy of depreciation while the piece of gold will still enjoy the same valuation and the same esteem as the gold pieces of King Croesus of Lydia enjoyed 2,500 years ago. The most finely-spun theories on the stupidity of the gold standard, all the clever satires on mankind’s frenetic digging for the yellow metal, and all the ingenious schemes for creating a gold-less money will never change the truly remarkable fact that for thousands of years men have continued to regard gold as the commodity of highest and surest worth and as the most secure anchor of wealth. One may protest this as often as one likes—the fact remains. It is this stubborn fact that continues to make the gold standard the best and most eminently useful of all monetary systems.

Our researches thus far have perhaps yielded sufficient proof of the theory that the value or the purchasing power of money is determined primarily by the proportion of the quantity of money to the volume of goods (quantity or scarcity theory of money). Hence, those abrupt changes in the purchasing power of money which are the characteristic symptoms of the monetary diseases of inflation and deflation will be found to have originated in a marked increase or decrease in the quantity of money (including credit money). The most important prerequisite of an orderly monetary system is therefore the regulation of the quantity of money in such wise that the monetary system is immunized against the ever-present contagion of inflation.

Our generation, which recalls the despair caused by the inflations in the post World War I era and which was required to undergo the self-same catastrophes following World War II, needs no instruction concerning the fact that the worst disease with which a monetary system can be afflicted is that kind of inflation which is caused by a deficit of the government budget. The German inflation of the years 1920-23 will always remain as a horrible example of what happens when a government attempts to cover its budget deficits by resorting to the deceitful and irresponsible expedient of the printing press. What in Germany began as “deficit financing’’ ended in a series of catastrophic price rises which caused the shameless enrichment of some at the cost of the hopeless impoverishment of others, and in a serious undermining of the whole economic and social structure. But the inflationary creation of money caused by the budget deficits of government need not necessarily lead to the economic and social disorders attendant on an open inflation of the kind that followed World War I. Beginning in 1933, National Socialist Germany demonstrated that a determined government can change an open into a repressed inflation by placing the country in the economic strait jacket of a command economy. Rationing, the imposition of stringent controls on wages, consumption, capital investment, rates of interest, and similar measures aimed at restricting the free use of the increasing amount of purchasing power may succeed in containing for an indefinite period the mounting inflationary pressure on prices, wages, exchange rates, stock prices, etc.

Since Hitler has shown how far and how long a government can neutralize an inflation by means of the command economy, we may well ask ourselves whether from now on there will be any government which will not follow the same road when it disposes of a functioning coercive apparatus. The greater the inflationary pressure the stronger will be the counterpressure of the command economy needed to repress it. By the same token, the command economy must resort to ever more comprehensive and ruthless controls if it is to effectively contain the mounting forces of inflation. This leads logically to the question of whether such a command economy is possible without totalitarian slavery (of which the Third Reich was such a repellent example).

The experience of Germany demands that we consider a little more closely this peculiar phenomenon of repressed inflation. As we have seen, it consists, fundamentally, in the fact that a government first promotes inflation but then seeks to interdict its influence on prices and rates of exchange by imposing the now familiar wartime devices of rationing and fixed prices, together with the requisite enforcement measures. As inflationary pressures force up prices, costs, and exchange rates, the ever more comprehensive and elaborate apparatus of the command economy seeks to repress this upward movement with the countermeasures of the police state. The repressed inflation can be conceived of, then, as the deliberate maintenance of a system of coercive and fictitious values in which, economically speaking, there is neither rhyme nor reason. Such a system is an inevitable feature of a collectivist economic regime and is to be encountered wherever socialism has gained control of influence (Soviet Union, National Socialist Germany, Austria, Great Britain, Sweden, and some other European countries). Where this repressed inflation leads was shown with tragic incisiveness in the complete disintegration of the German economy, a process which was arrested only by the comprehensive economic and monetary reform which restored a free price system in which actual rather than fictitious supply-demand relationships were reflected (Summer, 1948). The prolongation of a policy of repressed inflation means that all economic values become increasingly fictitious, and this in a twofold sense: (1) stated values correspond less and less to actual scarcity relationships and (2) fewer and fewer transactions are completed on the basis of such values. The distortion of all value relationships which accompany the division of the economy into “official” and “black” markets, and the struggle between the directives of the market and those of the administrative authorities finally lead to chaos, to a situation in which any kind of order, whether of the collectivist or the market economy type, is lacking.

By wage inflation is meant the inflationary impulses originating in the labor market, and which take the form of wage increases which—in those labor markets dominated by powerful labor unions—are so rapid and of such large amount that the ratio between goods and money is upset. The result is on the one hand an inflationary overpressure of demand and, on the other, an increase in costs which may bring an increase in prices in its train, though in both cases inflation is possible only to the extent that the monetary and fiscal authorities permit the creation of a corresponding addition to the supply of money. Were such additions to the supply of money not permitted, the wage and/or price increases would have the effect of making some portion of domestic output unsaleable and thus cause unemployment. But when the government and the central bank of a country believe themselves obliged to maintain full employment despite wage increases, the choice they then face of accepting some unemployment or some inflation will often be decided in favor of inflation. The decision may also be, as has been the case for some time in the United States, to effect a compromise between these two alternatives. In such case, unemployment and economic stagnation are joined to continuous, if mild price increases. In the United States, labor union power of a degree unknown in Europe has caused a wage inflation of such a severe and chronic type that the government and the central bank (the Federal Reserve System) have been obliged—in the interest of avoiding unfavorable effects on the balance of payments—to go further in the direction of tight money than they would otherwise dare to go, given the risks implicit in such policies of unemployment and economic stagnation.

5. The Purchasing Power of Money and Its Measurement

Implicit in the preceding section are a number of exceptionally complex problems which we must seek to make explicit, at least. Even the concept of the purchasing power of money—called also the “value of money”—is a problematical one. In contrast to ordinary goods, money, the good in terms of which the prices of the “ordinary” goods are expressed, has itself no price, at least within the area in which it circulates as money. Outside of this area, it cannot logically be used as money, so that the price at which it sells on currency markets in terms of the monetary units of other payment areas (exchange rate) represents not the price of money considered as money but of money considered as merchandise. As an indicator of the “value” of money, the exchange rate is consequently of no use to us, no more than the fact that for one dollar we can obtain one hundred cents. For help in this problem, we must turn to another concept, viz., that the purchasing power of money is a function of the height of the price level; or in other words that it is a reflection of the average rate at which goods and money exchange for one another. If prices rise, the purchasing power of money falls; if prices fall, the purchasing power of money rises. However, every rise in an individual price is not equivalent to a fall in the purchasing power of money. A genuine fall in the purchasing power of money will take place only if there is an average rise in prices all along the line, a rise in the “general price level.” Otherwise, we have to do simply with a rise in the prices of some goods, not with a depreciation of money. The purchasing power of money can be measured, therefore, only by the average “bundle” of goods and services that can be bought for a monetary unit.

But such a definition does not advance us much, as the following illustration will show. As it happens, our forbears in antiquity have left us the interesting piece of information that the construction of the Propylaea on the Acropolis in Athens cost a little more than 2,000 gold talents. Was this dear or cheap? Naturally, the talent is not negotiable on the exchanges of our day, but on the basis of its gold content we can establish that a sum of 2,000 talents would be equivalent to about 4,000,000 gold dollars. But was the purchasing power of the 2,000 talents equal to that of 4,000,000 gold dollars? We must admit that we are completely in the dark about this. It is possible that in ancient Athens, bread and eggs were much cheaper than they are today in New York or London; on the other hand, some things were probably more expensive than they are today, some, indeed, infinitely more expensive—things which all the gold in antiquity could not buy for the simple reason that they did not exist. Such were the radio, the telephone, electricity, and other goods upon which we moderns place such great value. Since the composition of demand has completely changed, we lack the means of comparing the purchasing power of money of those times with that of our own. Moreover, comparisons of purchasing power cannot be made unless we know the relative importance of each item in that average or typical “bundle” of goods of which we have spoken, and this relative importance of the different items varies in the course of the years. Hence, historical comparisons of purchasing power are always matters of conjecture, more or less. Furthermore, since the relative importance of each commodity varies not only from century to century but also from country to country, comparisons of the value of money are exceedingly difficult to make not only in time but also in space. True, we hear talk of expensive countries and cheap countries, and there is no denying that with an equal sum of money a traveler may be better off in one country than in another. But it is only with serious qualifications that we can accept the flat assertion that four German marks have the same purchasing power as one United States dollar.2 Many who have spent longer periods of time in the one and in the other country, and whose scales of preferences differ, may rightly question the validity of such parities, proving once again how questionable are all such calculations of average purchasing power.

 

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3See C. H. Kisch, The Portuguese Bank Note Case (London, 1932).

4The official rate of exchange as of 1962 was 4 Deutschemarks to 1 dollar.

• 1*See C. H. Kisch, The Portuguese Bank Note Case (London, 1932).
• 2*The official rate of exchange as of 1962 was 4 Deutschemarks to 1 dollar.
• 3And now a third illustration which takes us from the gold standard and the blocked silver standard to paper money. More than a quarter of a century ago, an astonishing and ingenious crime was committed which resulted in the institution of a most interesting civil suit. A band of international swindlers succeeded in convincing the well-known London firm of Waterlow & Sons, engravers of postage stamps and bank notes, that they were the representatives of the Central Bank of Portugal come to place an order for the printing of a large quantity of Portuguese bank notes. The order was duly filled and the bank notes delivered to the swindlers. When the fraud was finally discovered, the Bank of Portugal caused all of its extant notes (of whose genuineness there was, naturally, no question) to be withdrawn from circulation and replaced with a new issue. Since it proved impossible to catch the criminals, the Bank of Portugal sued Waterlow & Sons, demanding that the engraving firm make good the losses resulting from the issue of the fraudulent notes. The English courts presently discovered that the case involved issues of unusual subtelty and complexity, adjudication of which necessitated the admission of testimony by leading monetary theorists. The question before the courts was: how great were the actual losses incurred by the Bank of Portugal? If it had been postage stamps instead of bank notes in which the swindlers had trafficked, it is perfectly clear that the loss of the Portuguese government would have equaled the total value of the stamps. With respect to the bank notes, however, no such simple calculation could be made. Among the many questions which troubled the experts the following stand out as particularly relevant to our study: would the Bank of Portugal have issued the same amount of notes even if the swindlers had not done so? If not, was the increase in the supply of money resulting from the introduction of the fraudulent notes good or bad for Portugal? The answer to this question would depend on whether the circulation of the fraudulent notes disrupted the orderly processes of the Portuguese economy looking to the regulation of the volume of money; it would depend, in other words, on whether the additional notes served to avert an otherwise imminent deflation, or whether they resulted in an inflation. If the first supposition were true, then the swindlers would have unintentionally done a favor to Portugal. These and other considerations did, in fact, influence the highest English court to award the Bank of Portugal only a fraction of the damages it had claimed.*
• 4But such a definition does not advance us much, as the following illustration will show. As it happens, our forbears in antiquity have left us the interesting piece of information that the construction of the Propylaea on the Acropolis in Athens cost a little more than 2,000 gold talents. Was this dear or cheap? Naturally, the talent is not negotiable on the exchanges of our day, but on the basis of its gold content we can establish that a sum of 2,000 talents would be equivalent to about 4,000,000 gold dollars. But was the purchasing power of the 2,000 talents equal to that of 4,000,000 gold dollars? We must admit that we are completely in the dark about this. It is possible that in ancient Athens, bread and eggs were much cheaper than they are today in New York or London; on the other hand, some things were probably more expensive than they are today, some, indeed, infinitely more expensive—things which all the gold in antiquity could not buy for the simple reason that they did not exist. Such were the radio, the telephone, electricity, and other goods upon which we moderns place such great value. Since the composition of demand has completely changed, we lack the means of comparing the purchasing power of money of those times with that of our own. Moreover, comparisons of purchasing power cannot be made unless we know the relative importance of each item in that average or typical “bundle” of goods of which we have spoken, and this relative importance of the different items varies in the course of the years. Hence, historical comparisons of purchasing power are always matters of conjecture, more or less. Furthermore, since the relative importance of each commodity varies not only from century to century but also from country to country, comparisons of the value of money are exceedingly difficult to make not only in time but also in space. True, we hear talk of expensive countries and cheap countries, and there is no denying that with an equal sum of money a traveler may be better off in one country than in another. But it is only with serious qualifications that we can accept the flat assertion that four German marks have the same purchasing power as one United States dollar.* Many who have spent longer periods of time in the one and in the other country, and whose scales of preferences differ, may rightly question the validity of such parities, proving once again how questionable are all such calculations of average purchasing power.