Interest and Prices

CHAPTER 11

ACTUAL PRICE MOVEMENTS IN THE LIGHT OF THE PRECEDING THEORY

ATTEMPTS have often been made to demonstrate a parallelism between changes in prices and changes in the rate of interest. It has already been mentioned that these attempts have never yet been successful. Some of them have been directed to ascribing both changes to a common cause. It has, for instance, been suggested that a “surplus of gold” leads both to a rise in prices and to a more or less permanent fall in the rate of interest (“cheap money”, in both senses of the term); and, on the other hand, that a scarcity of gold results in falling prices and a high discount rate. Others have regarded a low rate of interest as a stimulus to production and speculation, and have in this way tried to ascribe rising prices to a low rate of interest. But the facts have never conformed to the theories. It has always been observed that, broadly speaking, a low discount rate accompanies low and not high prices, while an abnormally high discount rate is scarcely ever found to prevail except when commodity prices are high. R. Giffen 1 has recently tried to rescue the theory by relating the rate of interest to the movement in prices of a somewhat later period of time. The results obtained by Giffen are somewhat better, but they cannot on the whole be regarded as convincing.

It was soon noticed that it would be more satisfactory to regard the movement of prices itself as the cause and the rate of interest as the effect. This point of view has its theoretical justification, for if other things remain equal, a continual, and therefore expected, rise of prices is calculated to raise the rate of interest on loans.

This, in fact, is the point of view that has recently been adopted by Irving Fisher. He points out2 that when prices are rising, entrepreneurs are in a position to pay a higher rate of interest on their loans (and that as a result of a rise in the demand for loans, they will gradually be compelled to pay a higher rate). For “business profits . . . are the difference between gross income and expense, and if both these rise, their difference will also rise”. This passage is based on a misconception. If this were the cause of the rise in business profits, profits could rise only in proportion to prices, i.e. at an annual rate not exceeding a small percentage of the net profit itself ; and entrepreneurs could not possibly be in a position to meet on the whole of their borrowed capital a rise in the rate of interest that corresponded to the rise in prices. (On Fisher’s assumption, they have really obtained no surplus profit at all, for their own costs of living have gone up in the same proportion.) The assumption which forms the logical basis for Fisher’s argument is that entrepreneurs incur their “expense” (wages, rents, etc.) when things are cheap, and dispose of their product after prices have gone up. But it is then necessary to suppose that the rise in prices originates from some quite independent cause, which has nothing to do with the behaviour of the entrepreneurs. According to my view, a rise in prices, at any rate an international rise in prices, is usually due to a rise in the entrepreneurs’ demand for labour and other productive services. Such a rise in prices is thus the consequence of a previous, no matter how far from uniform, rise in money wages and rents, and it merely serves to compensate the entrepreneurs for the rise in costs of production. It does not provide them with the means of paying a higher rate of interest—except in the case where the prevailing rate of interest is lower than the natural rate, i.e. than the profit which the entrepreneurs would obtain if prices did not alter.

The actual cause, however, of the change in prices remains in obscurity, and contradictions arise as soon as an attempt is made to elucidate it. It is impossible to conceive that a change in prices has no connection whatever with the situation in the money market (such a view, as we have several times had to point out, has no basis either in fact or in logic). But the explanation suggested by the Quantity Theory—that rising prices are due to an excess of money, falling prices to a scarcity—does not accord with actually observed movements of the rate of interest. If it were correct, we should expect that at a time of rising prices there would be a temporary reduction in the rate of interest, at a time of falling prices a temporary increase; and that when prices had become accommodated to the change in the stocks of precious metal, the rate of interest would once again return to its normal position. Observation teaches us, however, that when prices are rising there is a continual rise in rates of interest, and that when prices are falling there is a continual fall in rates of interest.

All these difficulties and complications at once disappear when it is changes, brought about by independent factors, in the natural rate of interest on capital that are regarded as the essential cause of such movements. These changes can be regarded as the cause, not only of the movement of prices, but indirectly of the analogous but somewhat later alteration in the money rate of interest. Abundance or scarcity of money, and in particular the quantity of cash held by the banks, is now imbued with a merely secondary importance. Such factors are to be regarded as consequences of changes in the demand for instruments of exchange brought about by changes in the level of prices. It still remains true, however, that they may take their origin in independent causes (the production of precious metals, issue of paper money, development of the credit system, etc.), and that they then have an independent significance in regard to movements of prices, in so far as they accelerate or retard the movement of the money rate of interest to the new position of the natural rate (they may even cause the money rate to move in the opposite direction to the natural rate).

No matter how plausible all this may appear, it is only the facts themselves that can provide final confirmation. Now, how is such confirmation possible if one of the significant factors is practically an unknown? No statistics of the natural rate of interest are available. A precise investigation would necessitate an ad hoc enquiry, and for the past this is as good as impossible. While the general trend of the natural rate over decades can be observed in the movement of the money rate itself, of the banks’ discount rates and the so-called open-market rate, and of the prices of debentures and Government securities, this can be done only by assuming that on the average the two rates of interest are equal to one another. What we are looking for is the extent of the divergence between them, and for this there are practically no data available.

It might be possible to obtain some information from the accounts of individual enterprises and from the annual reports and dividends of companies. But it has to be remembered that the thing that is commonly regarded as interest does not correspond to the use to which we are applying the term; for it usually covers not only interest on liquid capital, but consists far more largely of rents of every kind: rents of land, monopoly rents, the return on buildings and durable machinery. These rents are not affected by movements in the rate of interest in the narrow sense of the word, or if they are affected it is only very slowly as a result of the competition from additional capital goods of the same type. An excess of liquid real capital will have a tendency, as was shown above, to raise not only real wages, but also the real rewards of all factors of production. It raises for a time the rents obtained by fixed capital, and it permanently raises the rent of land, while the actual rate of interest will fall by a corresponding amount.

In recent times agricultural rents have remained unaltered, or have actually fallen. This is sometimes regarded as a consequence of the general tendency of rents on capital to fall. This explanation is fallacious. The phenomenon is in fact peculiar to western Europe, and can be explained as the result of increased agricultural competition from countries overseas and from Russia.

To deal with each of these difficulties individually would at present be impossible. We shall now try, nevertheless, to give in the light of our theory a short review of the history of prices of the nineteenth century, and particularly of its second half, so far as material is available.

In his article on “The Variation of Prices and the Value of the Currency since 1782”,3 Stanley Jevons worked out index numbers, based on Tooke’s tables,4 for forty groups of commodities. These index numbers are calculated both for various individual groups and for the aggregate of the forty groups. The results show that at the beginning of the seventeen-nineties there set in an enormous rise of prices, which culminated in 1809-1810, when prices had gone up since 1790 by 80 per cent, in terms of gold and by 90 per cent, in terms of the somewhat depreciated paper. There then ensued a downward movement of prices, beginning in 1809 in terms of gold prices, and in 1814 in terms of paper prices. This downward movement persisted with few interruptions until the middle of the century, by which time prices had fallen in the ratio of 5:2, i.e. by considerably more than half, as compared with the gold prices of 1810. The further movements of prices will be referred to below.

In order to discover the causes of these enormous variations in prices, it is essential to ascertain how far the phenomenon was matched in other countries and how far it was peculiar to England. Although no figures are available for a precise comparison, there can be no doubt that to some extent the position of England was peculiar. Ever since the development of her manufactures, and as a consequence of this development, the general level of prices has presumably stood higher in England than in other European countries, and a fortiori than in India. But this presumption can only refer to the direction of the deviation—to its algebraical sign, which was constantly positive for England. The magnitude of the difference depends, as was explained in the last chapter, on the general level of costs of transport. For several reasons, these were artificially raised during the war. Later on they were considerably diminished as a result both of the renewal of friendly relations and of the gradual development of sea and land transport. This would explain why the rise in prices before 1815 and the fall in prices after 1815 were more considerable in England than in most other countries.

But in the case both of the rise and of the fall there remains a residue, which must be ascribed to other causes. Jevons himself maintained that Tooke was too one-sided in explaining the causes of the rise in prices during the war (as being due to bad harvests, etc.), and that a principal cause was the effect on the money market of the suspension of cash payments by the Bank of England. Large issues of irredeemable paper money were made at that time also in other countries—in France, Austria, Russia, Sweden, and Denmark. But in these countries the paper money was usually issued either by the Government itself or through the banks in the form of advances to the Government. In England it was different: bank-notes were issued in excess of the sum corresponding to the Bank’s capital (advanced long before to the Government) purely by way of commercial credits covered by normal banking security. At the same time, the Bank pursued a very liberal discount policy. While bank rate continued, during the whole period of restriction, to be maintained in the normal way at the legal maximum of 5 per cent., it gradually became the case that loans were granted at this rate of interest without any restriction, so long as adequate security was forthcoming (whereas formerly, when the notes were redeemable, there were frequent occasions when the willingness of the Bank to lend became drastically curtailed). That this procedure was wrong in principle is conceded even by the followers of Tooke, though they maintain5 that an “over-issue of notes” would have been possible only if bank rate had accidentally stood lower than the rate in the open market, the “market rate”.6 I am unable to accept this argument. The so-called open-market rate (which usually refers to bills and securities of the very first quality, so that in respect of liquidity they can be regarded almost like actual cash) always stands under normal conditions below bank rate, whether this is high or low. The real question is whether bank rate (and consequently rates of interest in general) stood high or low in relation to the current level of the natural rate. It now appears extremely probable that bank rate was low in relation to the natural rate. In no sense was the war a period of depression for English industry. Quite the reverse: as Jevons emphasises, it was just in the period from 1782 to 1815 that “the very foundations of our home industries were being energetically laid”.7

This fact makes it all the more difficult to explain the rise in prices on the basis of Jevons’ treatment, which clings closely to the Quantity Theory. With our theory, on the other hand, it fits in extremely well. A rise in industrial productivity raises in the first instance the natural rate of interest, so that prices rise if the money rate is for the moment kept unaltered. It is only later, when the banks are driven by the contraction in their reserves to push up the money rate, that prices recede. This factor was completely absent during the period of restriction of payments.

There now ensued the inevitable consequence of a war—a relative depletion of liquid capital. It is thus extremely probable that the natural rate remained very high during the whole period, presumably far higher than the rate asked for by banks or bill-brokers; and prices rose in consequence. The one peculiarity lies in the fact that so great a rise in prices failed to bring about a more rapid and considerable fall (to use English terminology) in the rates of exchange and an efflux of gold. The explanation must be that there was, for the reasons already given, a simultaneous rise in prices in other countries; furthermore, we have seen that a rise in the costs of transport would in itself be responsible, other things remaining equal, for a relative rise of the English price level.

It is my opinion that essentially the same explanation holds good for the contrary movement of prices which characterised the long period of peace after 1815. While the development of industry continued unceasingly, it gave rise at the same time to a tremendous accumulation of capital, of which the influence on England would have been still more marked had it not been for the constant lending to other countries and subsequently for the inauguration of domestic railway building. There must have been a rapid fall in the natural rate of interest. The money rate followed only slowly and with hesitation. Bank rate remained at 5 per cent, until 1824, and then at 4 per cent, until 1836 (though the open-market rate was lower). According to our theory, a rapid fall in prices must have been the result. (In actual fact the collapse of prices was practically at an end by 1832. Prices then rose and fell in turn; after the crisis of 1847 there was another fall in prices, but it was of short duration.)

Jevons regards the fall in prices since 1815 as “less difficult to understand”8 than the previous rise. Among other factors, he ascribes it to the fact that the “production of almost all articles has been improved, extended, and cheapened during this period”. But he admits that this argument “tells two ways”; for there had been no check to the development of industry during the previous period.

According to my treatment, increased productivity cannot by itself be responsible for any general fall in prices. If entrepreneurs and capitalists appropriate the increase in output for the purposes of their own consumption, the money demand for consumption goods expands uniformly with their supply. If, on the other hand, entrepreneurs and capitalists diminish (or fail to increase) their own consumption, in order to accumulate capital, then it is true that with money wages and rents for the moment unaltered, an increased quantity of consumption goods is offered to workers and landlords, and prices have to fall. But ipso facto the natural rate of interest has fallen too, and when it comes to rest below the money rate, a further (progressive) fall of prices must be the usual consequence of the resulting pressure on money wages and rents.

It is a matter for wonder that so rapid a fall in English prices was not more effective in causing an influx of precious metal. The explanation may well be analogous to the one that we have suggested for the contrary phenomenon which was exhibited in the previous period. In the first place, there was a simultaneous, though less considerable, downward movement of prices in other countries; and secondly, the constant difference, positive in sign, between the English price level and that of other countries must necessarily have been diminished through improvements in transport. The cheapening of foreign produce at English ports exceeded the cheapening at foreign ports of the less bulky English produce. Finally, England’s foreign loans during this period exceeded the interest due to her on her old loans, and must, therefore, have contributed to the same result, by hindering or postponing the influx of sums that would otherwise have fallen due. It follows from the above that continual willingness to lend exerts a negative influence on a country’s price level, while the drawing of interest from abroad acts in a positive direction.

For the second half of the century, we have Sauerbeck’s tables for England and those of Soetbeer, continued by Heinz, and later those of Conrad, for Germany (Hamburg).9 They agree among themselves to a remarkable extent, though the downward movement of English prices in recent times is somewhat more pronounced, perhaps in accordance with the explanation that I have put forward above. The general effect is to reproduce, though on a somewhat smaller scale, the picture of England’s price movements in the two earlier periods.

An upward movement of prices started in the fifties, which, interrupted by the world crisis of 1857 and then by the crises of 1864-66, did not really culminate until 1873. Then began the gradual fall in prices, so often discussed, which has continued up to the present time; so that the general price level of to-day10 is lower than it was in the middle of the century.

The explanation seems to me completely analogous to that of the movement of prices in the years 1790-1815 and 1815-50. Though the period 1851-73 was not, as was the Napoleonic era, a time of uninterrupted warfare, it comprised, among other wars, the Crimean War, the extremely exhausting and expensive American Civil War, and the wars between Germany and Denmark, Germany and Austria, and finally Germany and France. On the other hand, this period was distinguished, not only by a general progressive movement in industry, but in particular by the freezing of enormous quantities of liquid capital as a result of the completion of the west European railway system. For both of these reasons, the natural rate of interest is generally admitted to have stood abnormally high. While the widely oscillating money rate of interest was on the average definitely higher during this period than either in the preceding or in the succeeding period, it seems very doubtful whether it rose as much as the natural rate, partly because the large increase in the production of gold and the issue of paper money in America, in Austria, and finally in France, were working in the opposite direction. It is remarkable and significant that in England, for instance, bank rate was on several occasions lower, or no higher, than the market rate, and was presumably exerting an overwhelming downward pressure on the market rate. The upward movement of prices is in no way inexplicable. On the contrary, it is to be expected that for Europe as a whole, and particularly for the more remote portions of our continent, the rise in prices was relatively even greater.

Since 1871 western Europe and the United States have enjoyed uninterrupted peace. It must be admitted that in Europe intentions have not always been so peaceful as actual relations—witness the frightful growth of armies and armaments. But no matter how many milliards have in this way been swallowed up, there can, of course, be no comparison in point of capital wastage with an actual war.11 Railway building, though it was continued on an enormous scale, took place mainly in countries outside Europe, or in its more remote regions. In short, there was a considerable lack of really profitable openings for the additions to liquid capital which arose out of the savings of almost all classes of the community. The increase in real capital served rather to raise real wages and the rewards of other factors of production. The natural rate of interest consequently fell everywhere, and this would, in my opinion, be even more noticeable if it were possible to distinguish the return to actual (liquid) capital from the rents of land and monopolies.

The money rate of interest also fell, but whether it fell to a corresponding degree must be regarded as doubtful. For effect cannot precede cause, and furthermore there were monetary influences operating in the opposite direction. The production of gold was slackening (it has caught up again only in the last few years), cash payments were resumed in several countries (France, the United States), and finally silver was extensively demonetised. But the extent of the banks’ reserves, particularly in recent years, warns us against following the bimetallists in attaching undue importance to these influences. It has rather to be sup-posed that the banks, as a result either of discretion or of routine, have often been reluctant to allow their rates of interest to accommodate themselves immediately to the situation in the market, and have preferred to allow an ever increasing amount of their cash resources to lie idle, earning no interest.12

The fall in prices of recent decades is thus provided with an adequate explanation, which is free of the contradictory and arbitrary elements which run through most of the explanations hitherto put forward. It has furthermore to be noticed that the extent of this movement is perhaps somewhat exaggerated by the index numbers. In the first place, the equalisation of prices, to which we referred above, was presumably still in operation between various countries and districts. (We have, in fact, noticed that Sauerbeck’s index numbers for England, when brought to the same scale as Soetbeer’s for Germany, indicate a somewhat greater fall in prices.) Secondly, and most important, the constituents of the cost of living which take the form of personal services, house rents, etc., have fallen far less in price than actual commodities. In this connection it is to be observed that expenditure on travel and on urban fares, which to-day is indispensable to so many, was formerly far less important.

It is, of course, to be understood that these considerations can claim to indicate only very broad agreement between our theory and the facts. A detailed demonstration would be as interesting as it would be difficult. I do not yet feel myself to be in a position to undertake it. The theory must, therefore, be regarded for the moment as a mere hypothesis, the complete validity of which can be established only by further resort to the facts of experience.

If it turns out eventually to be correct the practical consequences are of enormous importance. Banks and credit institutions have hitherto exerted only an involuntary influence on prices, and consequently it has sometimes been in a favourable direction and sometimes in an unfavourable direction. Now, however, they will be able in full consciousness to pursue their objective, to the indisputable benefit of the world economy. It lies outside the terms of reference of a purely theoretical treatment to show how this might be brought about. My purpose is to lay down the theoretical principles which underlie these phenomena, and once they are correctly understood their application can be confidently left to the experience and insight of practical men. But the matter is one of great importance, and practical applications should be the goal of every theory. A few final remarks on this theme may not, therefore, be out of place.

_____________

13 Essays in Finance, Second Series, 1886, p. 70. Cf. the criticism of his views by Irving Fisher, Appreciation and Interest, 1896, p. 57, note.

14 Appreciation and Interest, p. 75.

15 Journal of the Royal Statistical Society, 1865; also Investigations in Currency and Finance, p. 119 ff. [second edition, p. 112].

16 History of Prices.

17 Wagner, Geld-und Kredittheorie der Peelschen Bankakte, p. 57.

18 Not to be confused with what we called above the “bond rate” (the rate of interest on long-term investment).

19 [Journal of the Royal Statistical Society, 1865, p. 303]; Investigations in Currency and Finance, p. 132 [second edition, p. 124].

20 Loc. cit., pp. [303], 131 [123] respectively.

21 A valuable compilation of these and other tables of prices, some of them previously unpublished, is to be found in the Appendix to Irving Fisher’s Appreciation and Interest.

22 [1898.]

23 See for instance Giffen’s well-known calculations (Essays in Finance, First Series, p. 1 ff.) on the cost of the Franco-Prussian War. The American War was even more costly.

24 Cf. W. Scharling. Preussiche Jahrb., 1895, conclusion.

• 1See, for instance, his preface to the German edition of his Vorlesungen, II.: Geld und Kredit, 1922.
• 2Lectures, II.: On Money and Credit, 3rd Swedish ed., p. 197.
• 3See 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.
• 4Ibid., p. 198.
• 5Loc. cit., 1908, p. 211.
• 6In 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.
• 7Loc. cit., pp. 65, 66.
• 8An analysis of these questions is to be found in my Swedish book, Monetary Policy, Public Works, Subsidies and Tariffs as Remedies for Unemployment, 1934. A revised English version will appear in 1936 under the title The Theory of Expansion.
• 9Preface.
• 10Lectures, 2nd Swedish ed., p. 202. See also Cassel, Theory of Social Economy, § 48.
• 11Ibid., p. 393.
• 12Loc. cit., 1909, p. 64.
• 13Wicksell 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.”
• 14Wicksell 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.”
• 15As 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.
• 16Wicksell 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.”
• 17As 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.
• 18As 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.
• 19In 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.
• 20I have come to regard this side of the Wicksellian theory as more important than his other attempt to combine price theory and monetary theory—by his identification of the rate of interest which would maintain the price level constant with the rate as determined in the theory of pricing and distribution, the latter being termed alternatively natural rate, i.e. the marginal productivity of capital, and normal rate, i.e. the rate which equalises supply and demand of savings. The general theory of pricing and distribution is, after all, static in character and its concepts are not likely to lend themselves to the more dynamic analysis of, say, problems of inflation. Rather than build monetary theory on this static analysis, it would seem more natural to pursue the monetary analysis of the actual determinants of the various rates of interest in a dynamic world and then, in the light of such analysis, to revise the theory of distribution. Work along this line seems to me to be the natural consequence of the first-mentioned innovation of Wicksell’s. It would bring monetary theory into harmony with price theory by making the latter more dynamic and would probably give up not only concepts like the natural rate of interest but the whole idea of a monetary equilibrium and thus also the concept of a normal rate of interest defined in equilibrium terms.
• 21Let me return now to the third modification, introduced by Wicksell in the first Swedish edition of his Vorlesungen (1906). It concerns the influence of gold production on prices: “I had formerly, in close accordance with the opinion of the classical school, imagined that this influence is mainly exercised chiefly through the intervention of the rate of interest; gold production in excess of needs ought in the first place to cause an increase in the gold stocks of banks and thereby a reduction of their interest rates, which in its turn should cause a rise in prices. . . . After further reflection I have, however, come to the conclusion that the main emphasis ought rather to be placed on the demand for commodities from the gold-producing countries; if this demand is not offset by an equally large supply of goods from other countries—in other words, by a need for new gold—it must necessarily lead to a rise in prices, and this immediately; thus the money rate of interest is perhaps not at all affected or possibly affected even in the opposite direction.” “The increasing gold stocks would then serve as a sort of ‘hook’ behind the price movement, preventing it from receding again . . . i.e. not as the first cause of the rise in prices but as a foundation which has been inserted after the beginning of the price movement. ... I mention this only in passing as a conceivable hypothesis. ... A similar treatment seems to be called for by the rapid reduction of the value of money which is as a rule the consequence of successive issues of paper currency.” “In this case, too, the rise in prices is, strictly speaking, the primary factor, the increase in the quantity of means of payment the secondary factor, and it is at least conceivable that under such conditions no real surplus of paper currency and consequent fall in the rate of interest emerges.” Two years later, however, in a discussion with Davidson, Wicksell seems to have returned to his old position; he made an attempt to deal with the case of gold production as a mere special instance of a discrepancy between the normal rate and the money rate of interest. “In so far as the new gold does not exercise a depressing influence on the interest rates of the banks, it will instead increase business profits, by enabling business men to sell in a market with higher prices after having bought in one with lower prices; in this way the discrepancy between the two factors, the money rate and the natural rate, will remain about the same.”
• 22In the second Swedish edition of the Lectures (1915), Wicksell introduced a modification of more far-reaching character, although he did not himself regard it as important. In the Preface he writes: “I have not found myself called upon to modify my general standpoint, if one does not count as such a certain concession to my critics concerning the mutual effect on one another of the money rate and the natural rate of interest”. This concession reads as follows: “It has been objected that a reduction of the money rate ought to have a depressing effect on the real (natural) rate; thus, the stimulus to a further rise in prices would disappear. This possibility cannot in general be denied. A reduction of the real rate requires, other things being equal, new real capital, i.e. increased savings.” Wicksell admits that the tendency towards an increase in savings may be much stronger than the opposite tendency, so that the rise in prices which has begun may stop. However, he regards this reaction between savings and the real rate of interest as a “secondary factor”.
• 23In my opinion, the bearing of this objection is much wider than Wicksell supposed. The analysis of Lindahl and of Myrdal has demonstrated that the existence of “credit and of money rates of interest are included as elements in the construction by which the natural rate is determined”. “It is impossible to conceive of relative barter terms whose development is independent of the absolute monetary units in which credit contracts are concluded.” In other words, Wicksell’s concept of a natural rate of interest proves to be of little use in dynamic analysis.
• 24In 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.