Interest and Prices

CHAPTER 10

INTERNATIONAL PRICE RELATIONSHIPS

IN order to subject our theory to the test of experience, it would be necessary to observe the simultaneous movements of rates of interest and prices in some closed economic system. But the only closed system to-day is the world as a whole, and for the world as a whole we have no reliable figures of commodity prices. The statistics that are so far available refer purely to single countries, or rather to single markets. We have then to ask whether such data are of any use whatever for our purpose. We have to ask, in other words, whether and how far a movement of prices in one country is an indication of a similar movement in other countries, and whether and how far the fluctuations of prices at the ports are related to the prices that rule in the interior.

It has long been recognised that the general level of prices in a single country cannot be altogether independent of the prices that rule in the countries with which it trades. The manner in which equilibrium between the various price levels is restored after it has been upset by some disturbance is explained by the familiar classical theory. If domestic prices rise, other things remaining equal, the import of foreign goods is encouraged, and the export of domestic goods is made more difficult. There consequently results a balance of payments in favour of foreign countries, and this has to be met in money. Money flows abroad and causes some rise in foreign prices, while at home the relative scarcity of precious metals brings prices down to their former level.

Fundamentally, this explanation must be correct. It is, however, clear that international equilibrium of prices is usually restored far more rapidly and far more directly. The increase in the supply of foreign goods and the diminution in the demand for exports must themselves exert, directly and indirectly, a pressure on domestic prices which is quite independent of any simultaneous movement of precious metals—and will be felt equally where the one country employs gold and the other silver as the standard of value, or where one or both of them have a paper standard. In these latter cases, however, there can be no question of a complete and definitive mutual regulation of prices. It is true that as a result of the unhindered rise in the rate of exchange (of the country in which there has been a relative rise in prices), the excess of imports will sooner or later disappear, and equilibrium will be restored. At the same time, the movement in the rate of exchange merely acknowledges the deviation between the two price levels, and supplies a measure of the alteration in the value in exchange of the one standard in terms of the other (for instance, gold in terms of silver); and this alteration must be regarded essentially as a consequence and not as a cause of the movement in relative prices,1 though this does not mean that the relationship between the two price levels, and so indirectly the relative values of the two precious metals, cannot be influenced by a change in the conditions of production of these precious metals.

Even if two countries employ the same metal as a standard of value, the general level of prices need by no means be the same. Considerable, and fairly permanent, deviations have to be reckoned with. Such deviations were more marked in former times—for example, in the first third of the nineteenth century, as Nassau Senior demonstrated by his well-known and thorough comparison of the costs of living of a worker in America, England, and India.2 The explanation given by Senior himself depends on the varying distances of these countries from the sources of the precious metal, and above all on the greater efficiency of labour in the more civilised countries. This explanation cannot be regarded as correct. The latter factor, as Mill points out,3 accounts for differences in real wages (which, as a matter of fact, were at that time abnormally low in England) but not differences in prices. If prices moved with money wages, real wages would be no higher in civilised countries than in uncivilised countries: what then would be the advantage to the worker of his greater efficiency?

Mill himself suggests as the most important cause of the differences in prices—the magnitude of which he considers in any case to be exaggerated4—the higher cost of transport of goods imported into England as compared with exported goods. But in any case, according to Mill, prices will tend to stand highest “in the countries for whose exports there is the greatest foreign demand, and which have themselves the least demand for foreign commodities”.

This view may be correct when it is a question purely of the direction of the deviation of prices and not of its magnitude. For no matter how eagerly the products of one country may be demanded by another country—the two countries may be separated by a political frontier or they may consist of two neighbouring ports—no appreciable difference of prices can persist when there is a free interchange of goods. In finding an answer to the above question, it is important to differentiate between these two factors (the direction of the deviation on the one hand and its magnitude on the other); for they take their origin in different, though partly interconnected, causes.

Let us suppose that there are two countries, A and B, which are absolutely identical so far as the conditions of production are concerned, or, what comes to the same thing, that in every branch of production A possesses a uniform advantage over B. Then, in accordance with Ricardo’s well-known law, no trade whatever can take place between these two countries, neither directly nor indirectly. If they are isolated from the rest of the world, the level of prices in either of them may exceed the level of prices in the other up to the point where the difference in prices amounts to the lowest possible, cost of transport (including tariffs) of any one commodity. The costs of transport (and tariffs) constitute a double-sided threshold up to which (but no higher) the difference in prices can rise on either side.

But now let it be supposed that the conditions of production are the same except that in country A a certain commodity can be produced which it is impossible to produce in country B, or which can only be produced in country B at great cost. This commodity will, of course, be partly exported to B. If the price level in B were the same as in A, there would be no commodity which it would be profitable to export to A, and the imports into B would at first have to be paid for by means of money (precious metal). The result would be that the general level of prices would rise in A and fall in B until eventually it became profitable to export some commodity from B to A. When this point is reached, the general level of prices in A permanently exceeds that in B to the whole extent of the particular transport costs that are involved—except for that commodity in the production of which A has special advantages: this commodity is, of course, dearer in B than in A, but it is likely to play an insignificant part in the determination of the general level of prices.

We can now see what it is that determines the direction of the deviation of general price levels. It does not depend on the fact that one country is superior to other countries in all branches of production, but rather on the fact that its superiority is confined to a small number of branches of production, while the other countries either possess no advantages whatever or possess advantages only in respect of commodities of which the value is small compared with the necessary costs of transport. On the other hand, the magnitude of the deviation is determined by the general level of costs of transport. It therefore depends in particular on the distance between the two countries, on the height of the tariff walls, etc.

It can easily happen that the general level of prices is higher in a country which imports the standard of value, for instance gold, than in a country where it is produced; provided that gold does not constitute the sole or the main export of the latter country.

It can already be seen that the relative price levels of different countries cannot be related to their relative distances from the sources of the precious metal. This would only be the case if the conditions of production in all the countries were identical (or uniformly different), so that they all had to compete for the precious metal by means of the same products.

It is, however, broadly true that if two countries exhibit no particular distinguishing features and if their distances from the sources of the precious metal are fairly equal, then prices in these two countries will be at the same general level: they have to deliver up the same amount of goods in order to obtain a given quantity of gold.

On this point W. Lexis is responsible for a curious confusion.5 He tries to deprive Ricardo’s law of “comparative costs” of practical significance by maintaining that if a country is superior to another country in all branches of production, the immediate effect of removing tariff barriers would be devastating competition in the production of every kind of commodity. The reason why Lexis arrives at this conclusion is that he assumes that so long as the original tariffs are maintained “the general level of money prices would very probably be about the same” in both countries, and consequently also “the money price of the unit of labour”. But this would be an impossible situation. If the general (average) level of prices is the same in the two countries, the price of the unit of labour must (other things being equal) be correspondingly higher in the better situated country than in the less productive country. If Lexis means that the one country is inferior to the other only in his two branches of production (cloth and iron), then it has to be realised that, according to Ricardo’s theory, both these types of production would be completely abandoned after the introduction of Free Trade. On this count Lexis’ proof falls completely to the ground.

It can easily be seen that international or inter-local debt payments operate in the same way. Here doubtless is to be found the simplest explanation of the fact that prices and the cost of living are usually much lower in the more remote parts of the country than in the big towns and their environments. (This deviation was formerly even more significant than it is to-day.) The open country is always having to render payments to the towns for rents, legacies, taxes, etc. It follows that even if there were no exchange of commodities between the towns and the country, there would have to be a flow of goods from the country to the towns; and the level of prices in the country is depressed below the level in the towns by an amount equivalent to the costs of transport. Specifically urban products, which are of course somewhat cheaper in the towns than in the country, are not of great significance.

It is now clear—and it has frequently been pointed out—that the continual improvement in transport that has taken place throughout the greater part of the nineteenth century, and the disappearance of many tariff barriers, must have brought about a gradual equalisation of price levels in different countries and districts. This effect would have been more widespread and more deep-seated but for the revival of protectionist ideas at the present time.

This has to be borne in mind if correct conclusions are to be drawn from the price movements indicated by index numbers.6 These are almost exclusively concerned with wholesale prices in certain ports such as Hamburg and London. It is probable, and indeed certain, that at times when these index numbers are falling, the fall is partly due to this process of equalisation between prices in the interior and prices at the port; and it follows that the average level of European prices must have fallen much more slowly. On the other hand, in the fifties and sixties, when index numbers were on the whole rising, the rise in the interior, and therefore also the average rise, was probably more rapid. No material is available for a more precise investigation of this question.

In the next chapter we shall pay particular attention to prices in England. There are here two points that have to be specially borne in mind; in respect of the first half of the nineteenth century there are the changes in the conditions of transport during and after the war, and in respect of more recent times there is the great alteration in the constitution of England’s exports. At one time England’s exports consisted almost entirely of highly compact textiles and other manufactures, but ever since the removal of the export tax on coal at the beginning of the forties, England has been exporting an enormous quantity of precisely that commodity of which the weight and volume are greatest in relation to its value. England’s imports, on the other hand, now involve relatively low freights—in some cases the cost of transport is purely nominal—whereas formerly the situation was probably the opposite. There can be no other country which has experienced anything like the continuous and vigorous fall of prices that has taken place in England, except for the period 1850–1873.

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It remains true that if a country is in trading relations with the rest of the world, the movements of its price level must theoretically accord with the laws that have been developed above. The increase in imports, which is the concomitant of a rise in domestic prices and prevents any further rise, can be regarded as an increase in the country’s liquid capital. The result is a fall in the natural rate of interest, which, other things remaining equal, prevents any further rise or causes an actual fall in the domestic price level. This explanation was suggested above7 and could be illustrated in terms of the example employed towards the end of the last chapter.

Thus the main principle always remains the same, but it has to be admitted that its verification becomes considerably more difficult as soon as the relatively simple conditions of an isolated community are complicated by the intricate relationships involved in international trade. The difficulties are accentuated further when it is necessary to discuss the movements of prices in individual towns.

It is just on account of these very difficulties that it has seemed to me necessary to present a detailed statement of the essentials of our theory, and to try to make it convincing I will now attempt to test the theory somewhat more closely by the facts of reality.

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8 Cf. Professor Marshall’s Evidence before the Gold and Silver Commission, and especially his Memorandum (Appendix to Final Report, p. 47) [Official Papers, p. 170 ff.].

9 Three Lectures on the Cost of obtaining Money, p. 1.

10 Principles, book iii., chap, xix., § 2.

11 In Mill’s time (about the middle of the nineteenth century), English prices had, in the course of the previous twenty years, sunk considerably—probably more than in most other countries.

12 Schönberg’s Handbuch, 3rd ed., vol. ii., art. xxiv. (Handel), § 65, p. 903.

13 But the influence of tariffs can only be an indirect one, for foreign goods are, of course, valued in “bond” and their prices are reckoned duty-free.

14 P. 112 ff.

• 1See, for instance, his preface to the German edition of his Vorlesungen, II.: Geld und Kredit, 1922.
• 2Ibid., p. 198.
• 3Lectures, II.: On Money and Credit, 3rd Swedish ed., p. 197.
• 4In Wicksell’s opinion the money rate should be raised to ensure equilibrium on the capital market and prevent a rise of the price level; see Wicksell’s answer.
• 5See the following papers in the Ekonomisk Tidskrift: (i) Davidson, “On the Concept of the Value of Money”, 1906; (ii) Wicksell, “The Stabilisation of the Value of Money, a Means of Preventing Crises”, 1908; (iii) Davidson, “On the Stabilisation of the Value of Money”, 1909; (iv) Wicksell, “Money Rate of Interest and Commodity Prices”, 1909. Cf. also Brinley Thomas, “The Monetary Doctrines of Professor Davidson”, Economic Journal, March 1935.
• 6Loc. cit., 1908, p. 211.
• 7Loc. cit., pp. 65, 66.
• 8Wicksell always insisted that this reasoning did not mean more than an amplification of the old quantity theory. Moreover, he always regarded his own contribution as a doubtful hypothesis and never became as convinced of its tenability as did some of his pupils. He explicitly rejected the idea that his theory provided an explanation of the business cycle. He was critical of Mises’ idea that mistaken credit policy is the origin of the tendencies towards booms and depressions. A brief quotation will indicate his position: “Our conclusion is, therefore, that although the changes in the purchasing power of money, caused by credit policy, are under present conditions intimately bound up with the business cycle and without any doubt also influence the latter, above all by giving rise to crises, yet it does not seem essential to assume that there is, by the nature of things, any necessary connection between these two phenomena. The main cause of the business cycle, and a sufficient cause, seems to be the fact that technical and commercial progress cannot by its very nature give rise to a series which proceeds as evenly as the growth in our time of human needs—due above all to the organic increase in population—but is now accelerated now retarded. In the former case ... a mass of circulating capital is transformed into fixed capital, a process which, as I have said, accompanies every rising business cycle: it seems as a matter of fact to be the one really characteristic sign, or one in any case which it is impossible to conceive as being absent.”. . . “If the banks already at the beginning of a rising period sufficiently raised their interest rates, but on the other hand reduced them energetically when the depression was about to set in”, then the price level would probably remain stable, although raw materials for fixed capital would rise in price during periods of good trade and fall during times of bad trade. “Under such circumstances the chief crises-causing factor would probably have disappeared, and what remained would be only a quiet wave movement between periods of accelerated formation of fixed capital and periods when the new capital assumed . . . other forms.” . . . “Increase in commodity stocks is probably the most important form of real investment during so-called bad trade.”
• 9Wicksell always insisted that this reasoning did not mean more than an amplification of the old quantity theory. Moreover, he always regarded his own contribution as a doubtful hypothesis and never became as convinced of its tenability as did some of his pupils. He explicitly rejected the idea that his theory provided an explanation of the business cycle. He was critical of Mises’ idea that mistaken credit policy is the origin of the tendencies towards booms and depressions. A brief quotation will indicate his position: “Our conclusion is, therefore, that although the changes in the purchasing power of money, caused by credit policy, are under present conditions intimately bound up with the business cycle and without any doubt also influence the latter, above all by giving rise to crises, yet it does not seem essential to assume that there is, by the nature of things, any necessary connection between these two phenomena. The main cause of the business cycle, and a sufficient cause, seems to be the fact that technical and commercial progress cannot by its very nature give rise to a series which proceeds as evenly as the growth in our time of human needs—due above all to the organic increase in population—but is now accelerated now retarded. In the former case ... a mass of circulating capital is transformed into fixed capital, a process which, as I have said, accompanies every rising business cycle: it seems as a matter of fact to be the one really characteristic sign, or one in any case which it is impossible to conceive as being absent.”. . . “If the banks already at the beginning of a rising period sufficiently raised their interest rates, but on the other hand reduced them energetically when the depression was about to set in”, then the price level would probably remain stable, although raw materials for fixed capital would rise in price during periods of good trade and fall during times of bad trade. “Under such circumstances the chief crises-causing factor would probably have disappeared, and what remained would be only a quiet wave movement between periods of accelerated formation of fixed capital and periods when the new capital assumed . . . other forms.” . . . “Increase in commodity stocks is probably the most important form of real investment during so-called bad trade.”
• 10Wicksell always insisted that this reasoning did not mean more than an amplification of the old quantity theory. Moreover, he always regarded his own contribution as a doubtful hypothesis and never became as convinced of its tenability as did some of his pupils. He explicitly rejected the idea that his theory provided an explanation of the business cycle. He was critical of Mises’ idea that mistaken credit policy is the origin of the tendencies towards booms and depressions. A brief quotation will indicate his position: “Our conclusion is, therefore, that although the changes in the purchasing power of money, caused by credit policy, are under present conditions intimately bound up with the business cycle and without any doubt also influence the latter, above all by giving rise to crises, yet it does not seem essential to assume that there is, by the nature of things, any necessary connection between these two phenomena. The main cause of the business cycle, and a sufficient cause, seems to be the fact that technical and commercial progress cannot by its very nature give rise to a series which proceeds as evenly as the growth in our time of human needs—due above all to the organic increase in population—but is now accelerated now retarded. In the former case ... a mass of circulating capital is transformed into fixed capital, a process which, as I have said, accompanies every rising business cycle: it seems as a matter of fact to be the one really characteristic sign, or one in any case which it is impossible to conceive as being absent.”. . . “If the banks already at the beginning of a rising period sufficiently raised their interest rates, but on the other hand reduced them energetically when the depression was about to set in”, then the price level would probably remain stable, although raw materials for fixed capital would rise in price during periods of good trade and fall during times of bad trade. “Under such circumstances the chief crises-causing factor would probably have disappeared, and what remained would be only a quiet wave movement between periods of accelerated formation of fixed capital and periods when the new capital assumed . . . other forms.” . . . “Increase in commodity stocks is probably the most important form of real investment during so-called bad trade.”
• 11As Wicksell worked on monetary problems for almost three decades after the publication of the Geldzins, it may be worth while to say something here about the changes which his views underwent. These were not, as a matter of fact, considerable. Although he was always ready to question his own reasoning, his lively discussions with other Swedish economists do not seem to have left many traces on his theory. Take, for instance, his discussion with Professor Davidson. In 1906 Davidson, whom Wicksell held in the highest esteem, suggested that during periods of rapid technical progress and increasing productive efficiency a greater stability of business would be ensured if commodity prices fell in proportion to the increase in output than if they remained stable. Davidson asserted that if the money rate of interest and business profits (Wicksell’s natural rate) stood in a normal relation to one another before the increase in efficiency, then they would continue to do so if prices fell in proportion to the latter. There would be no need for a change in the money rate of interest. If it were reduced to prevent a fall in the price-level, it would be too low in relation to profits, and a process of an inflationary character would start. To this Wicksell replied: “In the case which Davidson has chosen it may appear that the increase in profits due to increased productivity and the reduction in profits due to the fall in prices, caused on his assumption by the former, would offset one another. But surely this would only happen if the price movement could be anticipated beforehand and estimated, or if it were so even and had lasted for so long that it had come to be generally regarded as something constant? In general, however, the individual business man will make his calculations for the future, and so fix his demand for labour, raw materials, and credit on the basis of current prices.” Hence, prices would rise if the money rate were not immediately raised, and when some time later the increase in productivity had led to a greater supply of finished goods, so that prices would fall, business men would make losses and the situation would be disturbed.
• 12As Wicksell worked on monetary problems for almost three decades after the publication of the Geldzins, it may be worth while to say something here about the changes which his views underwent. These were not, as a matter of fact, considerable. Although he was always ready to question his own reasoning, his lively discussions with other Swedish economists do not seem to have left many traces on his theory. Take, for instance, his discussion with Professor Davidson. In 1906 Davidson, whom Wicksell held in the highest esteem, suggested that during periods of rapid technical progress and increasing productive efficiency a greater stability of business would be ensured if commodity prices fell in proportion to the increase in output than if they remained stable. Davidson asserted that if the money rate of interest and business profits (Wicksell’s natural rate) stood in a normal relation to one another before the increase in efficiency, then they would continue to do so if prices fell in proportion to the latter. There would be no need for a change in the money rate of interest. If it were reduced to prevent a fall in the price-level, it would be too low in relation to profits, and a process of an inflationary character would start. To this Wicksell replied: “In the case which Davidson has chosen it may appear that the increase in profits due to increased productivity and the reduction in profits due to the fall in prices, caused on his assumption by the former, would offset one another. But surely this would only happen if the price movement could be anticipated beforehand and estimated, or if it were so even and had lasted for so long that it had come to be generally regarded as something constant? In general, however, the individual business man will make his calculations for the future, and so fix his demand for labour, raw materials, and credit on the basis of current prices.” Hence, prices would rise if the money rate were not immediately raised, and when some time later the increase in productivity had led to a greater supply of finished goods, so that prices would fall, business men would make losses and the situation would be disturbed.
• 13As Wicksell worked on monetary problems for almost three decades after the publication of the Geldzins, it may be worth while to say something here about the changes which his views underwent. These were not, as a matter of fact, considerable. Although he was always ready to question his own reasoning, his lively discussions with other Swedish economists do not seem to have left many traces on his theory. Take, for instance, his discussion with Professor Davidson. In 1906 Davidson, whom Wicksell held in the highest esteem, suggested that during periods of rapid technical progress and increasing productive efficiency a greater stability of business would be ensured if commodity prices fell in proportion to the increase in output than if they remained stable. Davidson asserted that if the money rate of interest and business profits (Wicksell’s natural rate) stood in a normal relation to one another before the increase in efficiency, then they would continue to do so if prices fell in proportion to the latter. There would be no need for a change in the money rate of interest. If it were reduced to prevent a fall in the price-level, it would be too low in relation to profits, and a process of an inflationary character would start. To this Wicksell replied: “In the case which Davidson has chosen it may appear that the increase in profits due to increased productivity and the reduction in profits due to the fall in prices, caused on his assumption by the former, would offset one another. But surely this would only happen if the price movement could be anticipated beforehand and estimated, or if it were so even and had lasted for so long that it had come to be generally regarded as something constant? In general, however, the individual business man will make his calculations for the future, and so fix his demand for labour, raw materials, and credit on the basis of current prices.” Hence, prices would rise if the money rate were not immediately raised, and when some time later the increase in productivity had led to a greater supply of finished goods, so that prices would fall, business men would make losses and the situation would be disturbed.
• 14In his rejoinder Wicksell admitted that this case required more attention than he had so far given to it. Davidson’s reasoning depended, however, on “the tacit assumption that the supply of real capital has been increased in the same proportion as productivity. Davidson is obviously of the opinion that money wages remain unaltered; thus if commodity prices have fallen, real wages would have been subject to an increase, but how can they be raised without an increased supply of real capital?” Making reference to Böhm-Bawerk’s theory of capital, Wicksell asserted that this is impossible, and continued: “If the quantity of real capital is increased the real rate of interest will fall even if prices remain unaltered and thus money wages rise. . . . Naturally, however, my assumption is that ‘other things remain equal’; i.e. that real capital and real wages are not subject to any change. . . . An increase in productivity when the supply of real capital is unaltered must necessarily mean a rise in the real rate of interest, and equilibrium on the market can never exist unless the money rate is made to coincide with the latter, i.e. unless it is in this case raised.” Although it was possible that prices might temporarily fall, a tendency for a cumulative rise in prices would set in unless the money rate was raised.