Interest and Prices

CHAPTER 5

THE QUANTITY THEORY AND ITS OPPONENTS

IT is clear that the higher is the price of a commodity the greater is the amount of money required for the purpose of its sale and purchase. But the whole function of the available supply of money—so long at any rate as it retains the form of money—is to be exchanged, sooner or later, for commodities. It is now but a small step to recognising that the total volume of money instruments in existence in an economic system, or rather their volume taken in relation to the quantity of commodities exchanged, is the regulator of commodity prices. This doctrine is usually ascribed to the English philosopher Hume, but in origin it goes back very much earlier; it may even date back to ancient times.1 It marks a decided theoretical advance, by bringing into prominence the purely formal or conventional character of the value of money—or rather, of the function of money—in antithesis to the “mercantilist” conception, referred to above, of money as possessing a more or less unchangeable value of an intrinsic kind, which in the course of exchange is merely compared with the value of other commodities. (The Cost of Production Theory of Money belongs, of course, to a much more recent date.)

It cannot, I think, be denied that under given conditions the Quantity Theory is capable of being correct, and that in any case a significant degree of truth attaches to it. But it must not be imagined that the quantity of the available stock of money or of individual balances serves as a direct measure of commodity prices and determines their level. Rather is the phenomenon to be pictured somewhat as follows.

We saw above2 that the laws which govern the exchange of commodities have no significance in themselves in regard to the absolute level of money prices: it is of no consequence whatever to a purchaser that he has to pay more for one commodity provided that he can be certain of himself obtaining a correspondingly higher price for some other commodity. But this is on the supposition that the purchase and the sale which succeeds it both take place within the same indefinitely short interval of time. In practice this does not happen. Even if I have in stock the full equivalent of the goods that I purchase I am not always certain of being able to dispose of my goods at any moment to the best advantage. Still less so if my own products, by means of which I intend to regain the money that I spend, cannot be available until later—indeed they may involve the use of the very goods that I am purchasing. Buying, or spending money, on the one hand, and selling on the other hand, are usually concentrated over different parts of the month, quarter, or year. It follows that everyone, and particularly every business man, has to keep by him a certain sum of money—his till money—of which the average amount depends on the nature of his business, so as to defray such expenditure as is not covered by simultaneous receipts. (We are at present abstracting from the special arrangements by means of which, in a developed credit economy, this necessity can be curtailed and partly dispensed with.)

Now let us suppose that for some reason or other commodity prices rise while the stock of money remains unchanged, or that the stock of money is diminished while prices remain temporarily unchanged. The cash balances will gradually appear to be too small in relation to the new level of prices (though in the first case they have not on the average altered in absolute amount. It is true that in this case I can rely on a higher level of receipts in the future. But meanwhile I run the risk of being unable to meet my obligations punctually, and at best I may easily be forced by shortage of ready money to forgo some purchase that would otherwise have been profitable.) I therefore seek to enlarge my balance. This can only be done—neglecting for the present the possibility of borrowing, etc.—through a reduction in my demand for goods and services, or through an increase in the supply of my own commodity (forthcoming either earlier or at a lower price than would otherwise have been the case), or through both together. The same is true of all other owners and consumers of commodities. But in fact nobody will succeed in realising the object at which each is aiming—to increase his cash balance; for the sum of individual cash balances is limited by the amount of the available stock of money, or rather is identical with it. On the other hand, the universal reduction in demand and increase in supply of commodities will necessarily bring about a continuous fall in all prices. This can only cease when prices have fallen to the level at which the cash balances are regarded as adequate. (In the first case prices will now have fallen to their original level.)

The reverse process will take place as the result of a fortuitous fall in prices, the stock of money remaining unchanged, or of a permanent increase in the available quantity of money. But in the latter case (as in the case of a diminution in the stock of money), the nature of the effects depends to some extent upon the route by which the additional supply of money reaches the economic system. Eventually, however, it must become distributed in the “channels of circulation”—at any rate this can be adopted as an assumption—and a rise in prices, if it has not already occurred, must now come about. It is not as though a man who accidentally possesses twice as many ten-mark pieces as usual would now proceed to bid double the price for every commodity But he will probably desire to complete some purchase that he would otherwise have postponed, or he will be more hesitant in disposing of some commodity that necessity would otherwise have compelled him to sell. In short, the result of the increase in the quantity of money is a rise in the demand for commodities, and a fall in their supply, with the consequence that all prices rise continuously—until cash balances stand once again in their normal relation to the level of prices.

Both the strength and the weakness of the Quantity Theory are now adequately revealed. It consists of more than a mere “truism”, i.e. a truth which is self-evident but barren; it consists of more than the rule that the sum of the quantities purchased, each multiplied by its respective price, must be equal to the amount of money paid for them. The Theory provides a real explanation of its subject matter, and in a manner that is logically incontestable; but only on assumptions that unfortunately have little relation to practice, and in some respects none whatever.

For it assumes an almost completely individualistic system of holding cash balances. In fact, over a wide field of economic activity, the individual balance has become scarcely anything more than an accounting magnitude, a legal conception, and is replaced in practice by a kind of collective holding of balances, arising out of the acceptance by banks of deposits.

It assumes that everybody maintains, or at least strives to maintain, his balance at an average level that is constant (relatively to the extent of his business or of his payments). Or, what really comes to the same thing, that the velocity of circulation of money is, as it were, a fixed, inflexible magnitude, fluctuating about a constant average level; whereas in practice it expands and contracts quite automatically and at the same time is capable, particularly as a result of economic progress, of almost any desired increase, while in theory its elasticity is unlimited.

It assumes, in the third place, that an almost constant proportion of all the business of exchange, even if not the whole of it, is transacted by means of money in the sense of coin or notes. In actual fact the border line between money in this sense and true instruments of credit (ordinary book credit, bills, cheques, etc.) is extremely vague; and over a wide range one can be substituted for the other—and on occasion is so substituted, as is demonstrated at every period of crisis.

Finally, the Quantity Theory assumes that the portion of the total stock of metal which is employed in actual circulation can be sharply differentiated from the portion which is kept in the form of hoards against future needs or which, in the form of ornaments and jewellery, is withdrawn from use as money. This too is, of course, an untrue assumption. Money is treasured up only with the object of being sooner or later returned into circulation, a process that may under certain conditions be hastened or delayed; and the same is to some extent true of jewellery made of precious metals. It is true that hoarding in the real sense cannot be significant except in undeveloped communities—in progressive countries it has usually assumed other forms—and that the cost of manufacture of metallic jewellery usually forms so large a proportion of the total value that melting down would not be an economic proposition (the possibility of melting down arises in practice only in the case of old-fashioned or worn-out objects).

To sum up: The Quantity Theory is theoretically valid so long as the assumption of ceteris paribus is firmly adhered to. But among the “things” that have to be supposed to remain “equal” are some of the flimsiest and most intangible factors in the whole of economics—in particular the velocity of circulation of money, to which in fact all the others can be more or less directly referred back. It is consequently impossible to decide a priori whether the Quantity Theory is in actual fact true—in other words, whether prices and the quantity of money move together in practice.

These difficulties have, of course, never been completely overlooked by supporters of the Quantity Theory. But they are open to the reproach that they have passed over the difficulties rather too lightly and have not subjected the details of the question to any comprehensive examination. They sometimes in fact express themselves as though the quantity of money, or of that part that at any moment finds itself in the hands of the public, must act as a direct and proximate price-determining force. That, of course, is putting the matter the wrong way round, and is open to a simple line of criticism.

This is also true to some extent of J. S. Mill, whose views, moreover, on this point seem to fail to be altogether clear or self-consistent (see Principles, Book III., cap. viii., § 2 ff.). Marx was, in my opinion, not entirely without justification when he wrote3 that Mill, “with his usual eclectic logic, understands how to hold at the same time the view of his father, James Mill, and the opposite view” (but the acidity is uncalled for, and furthermore unreasonable, inasmuch as Marx himself had in no way succeeded in overcoming the difficulties involved).

There are also many modern writers (for instance Charles Gide in his Principes d’économie politique) who adopt a very peculiar attitude towards the Quantity Theory. In some passages they write as though the theory is absolutely correct in principle and at the most is in need of simple modification, while elsewhere they would appear to hold that at the present stage of economic development it has lost almost all foundation and validity.

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Meanwhile it is far easier to criticise the Quantity Theory than to replace it by a better and more correct one. Up to the present every attempt in this direction has come to grief; or rather, scarcely a single serious attempt has been made, apart from the Cost of Production Theory, which to-day, except in orthodox Marxist circles, can no longer reckon on any direct supporters.

It is usual to speak of a Credit Theory of Money, which is supposed to originate from Thomas Tooke and provide a scientific antithesis to the Quantity Theory. But I find myself unable to say where such a theory is developed in Tooke’s writings. His monetary contributions—no matter how highly one may regard them in other respects—are on the theoretical side purely critical in general outlook and negative in concept. It is quite impossible, I think, to construct out of them a positive theory of money. He frequently mentions factors—and usually quite correctly—as being without influence on the value of money, but he never mentions the factors on which the value of money must ultimately depend.

Let us, for instance take the twelfth of the celebrated seventeen conclusions, in which Tooke formulated his objections to the Quantity Theory.4 It reads as follows:

“That the prices of commodities do not depend upon the quantity of money indicated by the amount of bank notes, nor upon the amount of the whole of the circulating medium; but that, on the contrary, the amount of the circulating medium is the consequence of prices.”

There can be no doubt that there is much truth in this, but clearly it provides no clue to the causes that determine the value of money; it simply leaves the question an open one.

And in fact almost all these conclusions of Tooke’s are of the same negative character. We shall later be considering the validity of some of them in more detail (particularly his criticism of the Quantity Theory). Only one of them, the thirteenth, attempts to provide a positive answer to the question at issue. It reads as follows:

“That it is the quantity of money, constituting the revenues of the different orders of the State, under the head of rents, profits, salaries, and wages, destined for current expenditure, that alone forms the limiting principle of the aggregate of money prices, ... As the cost of production is the limiting principle of supply, so the aggregate of money incomes devoted to expenditure for consumption is the determining and limiting principle of demand.”

Now this would indeed be a piece of positive elucidation if the method of elucidation itself were not unfortunately almost as obscure and in need of elucidation as the phenomenon under discussion. Incomes determine prices; but we might just as well say—so at least it would appear—that the former are determined by the latter. With the possible exception of interest on loans (debentures, government securities, etc.), there is no category of income that is not, to a greater or less degree, dependent on, or regulated by, the prices of goods and services. Indeed we can go further: since almost every adult is a producer in the wide sense of the word, in consequence either of his labour or of his ownership of land or capital, costs of production and money incomes are really only two different aspects of the very same thing, and the sum of each must be equal to the sum of the prices of all the goods (and services) produced and consumed. It might therefore appear that this method of elucidation is taking us quite hopelessly round a circle; or that, to quote Launhardt,5 it is no easier to decide “where in this endless, ring-shaped maze the beginning and the end are to be found than it is to decide which came first, the hen or the egg”.

For my part, I do not share this view. It is my belief that this observation of Tooke’s, or more precisely its first half, does really provide a starting-point from which a theory of the value of money and of prices can be developed. This I shall try to show later on. But Tooke himself never elaborated his suggestion, which makes an appearance in other sections of his works. As soon as he deals with changes that take place in the value of money in actual practice he ascribes them mainly—like many writers before and since—to changes in the conditions of production of the commodities themselves, to a greater or smaller yield of the harvests, etc. (apart from the more temporary influences of business speculation and the like). The unscientific and illogical character of such a method of exposition, as soon as it ceases to be regarded as a corollary of the (Cost of Production or of the) Quantity Theory of Money, has already been indicated.

In his report to the Royal Commission on the Depression of Trade and Industry,6 Professor A. Marshall remarks that it is not possible, in the manner of Tooke and also of many recent writers, to put forward a diminution of the cost of production of commodities as an additional cause of a fall of prices, when its effects in increasing the supply of commodities relatively to gold have already been allowed for.

But it is to be noticed that according to Tooke’s view—which was expressed with ever-increasing precision as the years went by—an increase or decrease in the supply of commodities in relation to the available supply of money is not to be regarded as a cause of variations in prices; rather, the quantity of money in circulation depends, in accordance with the principle quoted above, on the level of prices (and the amount of business activity).

The inadequacy of Tooke’s method of explanation was further exposed by Jevons,7 as we shall see later, in so far as it relates to the great rise in prices in England at the beginning of the nineteenth century.

This gap in Tooke’s line of approach has not been bridged by his followers, among whom the chief German representatives are the distinguished scholars Adolf Wagner (in his earlier writings on banking) and E. Nasse. Wagner’s famous work, Die Geld- und Kredittheorie der Peelschen Bankakte, contains next to nothing that is positive about the causes that determine the value of money. He makes the assertion8 that a money system which changes into a pure credit system as a result of the general adoption of “giro” and cheque methods of transaction “can be regarded as perfect” and “offers the advantage of an unchangeable standard”. This assertion is made without any explanation and is not supported by the slightest investigation of the circumstances that are responsible for variations, or for the constancy, of the standard of value. Later in his life Wagner began to come round to the Quantity Theory, as seems to be indicated by his intercession for bimetallism. Nasse’s work will be referred to at a later stage.

Nor have the more recent opponents of the Quantity Theory succeeded in providing a real substitute. On the contrary, they fall only too easily into the still older way of thinking of the money substance as possessing an intrinsic value, or at any rate they incline towards this point of view. Thus R. Hildebrand, although, as we have seen, he had explained that money is “the very9 opposite of a commodity”, was eventually led to ascribe the origin of the value of money purely to the substance of which this “Nichtware” is composed. Bank notes, and irredeemable government paper money, constitute for him “only money tokens, not money, only means of payment, not means of exchange”. “Let us even suppose”, he goes on,10“that, as a result of the issue of inconvertible paper money, coins disappear almost entirely out of circulation, i.e. that in the country under discussion they become an ordinary commodity or that an agio comes into existence. . . . Even then the real seat of the purchasing power of money, the origin of its value, is still only to be found in the coins, although they no longer serve as a means of payment in this country and it is only in the imagination of the purchaser or seller that they continue to play the ròle of money. Even then the paper money is merely a money token, that is to say a representative means of payment playing the part of a deputy,—it is not money.”

It does not appear to me that such a conception has any foundation. It is not some vague ritual, but the palpable facts of exchange and of credit, of commodity markets and of the money market, which day by day determine individual commodity prices and consequently (in a country that has a paper standard) the average purchasing power of the nation’s paper money.11 On the other hand, it is the facts of the metal market and of foreign trade which determine the purchasing power of metallic money, or rather of the monetary metal. Let us now suppose that first of all paper is made irredeemable and that then free coinage is suspended. Every link between notes and the monetary metal is consequently broken (as is the case with silver in Austria and Russia), and the determination of the value of each takes place relatively independently—never quite independently, however, because the one can always be substituted to some extent for the other,—and the value of the one can lie either below or above the value of the other, as is borne out by experience. It may at first seem paradoxical that “worthless scraps of paper” can possess a value in themselves. The explanation is simple: these particular scraps of paper, furnished with a certain form of inscription, may not be manufactured or drawn up by anybody; it is essential to have some means of exchange (in spite of Hildebrand, it is impossible to deny such a title to paper money without flying too much in the face of common usage), and no other is available. Consequently the “scraps of paper” are accepted at the price at which they are obtainable.

It is not difficult to discover the origin of Hildebrand’s view. The essential similarity between paper money and redeemable notes is often denied, but it is recognised, quite rightly I think, by Hildebrand, who consequently refuses to ascribe the value of the one to a different factor from the value of the other. But even redeemable notes do not derive their value from that of coins. Their redeemability guarantees their value in terms of the metal of coinage, but the value in terms of commodities equally of the notes and of the metal is determined by the general situation in the money market; and this in its turn is influenced just as much by the presence of notes—and indeed of any other instruments of exchange and credit—as by the presence of coins.

Strictly speaking, we can assert that all money—including metallic money—is credit money. For the force which is directly responsible for the generation of value always lies in the belief of the receiver of an instrument of exchange that he will be able to obtain for it a certain quantity of commodities. However, notes and paper usually enjoy a purely local credit, while the precious metals—or at any rate gold—are accepted on a more or less international scale. But it is all a question of degree. This is shown by the behaviour of silver in recent times; since the suspension of free coinage, the value of silver has fallen far below the value of notes based on silver.

Among the most zealous opponents of the Quantity Theory at the present time is Professor G. Luzzatti,12 an Italian. His views on the causes responsible for the value of money are so fantastic and confused that they almost lie outside the scope of serious criticism. According to this writer, it is the amount of the community’s wealth, and particularly the relation between the whole and its individual parts, which determine the level of prices. The quantity of money exerts an influence only in so far as the money itself forms a part of the wealth.13

As a result of an increase of the community’s wealth, and particularly of a more equal distribution (which increases the purchasing power of the working classes), all prices would tend to rise; in the opposite case they would fall; and so on.14 Luzzatti supplies no logical deduction of these propositions, which are not, it seems to me, very well confirmed by the experience of recent decades—except perhaps by that of Italy. Luzzatti’s reasoning becomes eventually so loose that it is impossible to tell whether by the value of money he means its value in exchange with commodities, or its subjective value, varying from individual to individual.15

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So it is no good; the Quantity Theory cannot just be thrown overboard. The above instances illustrate the danger of running into even less perfect, and quite untenable, conceptions or semi-mystical speculations. Relatively, at any rate, the Quantity Theory is the most competent of all the methods of interpretation that have so far been advanced of the oscillations of the general price level; indeed, it is the only one which attempts in some degree to provide a rational explanation. It must be put up with, in the hope that a more intimate analysis of the underlying facts might remove the blemishes from which it undoubtedly suffers.

Above all, it is important to have a clear picture of the phenomenon of velocity of circulation of money and of the causes which are responsible for variations in this factor.

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16 Cf. the often quoted fragment from the Roman lawyer Paulus (L.I, Dig. xviii. 1), Origo emendi vendendique etc.; contained in it are the words: “eaque materia” (money) “forma publiea percussa usum dominiumque non tarn ex substantia praebet quam ex quantitate”.

For an account of Hume’s immediate forerunners, see Marx, op. cit., p. 99, note; also p. 82, notes.

17 P. 23.

18 Op. cit., p. 100, note; cf. ibid., p. 82.

19 An Inquiry into the Currency Principle, 1844, pp. 121-4. Cf. History of Prices, vol. vi., Appendix xv., pp. 635-7.

20 Das Wesen des Geldes, p. 42.

21 Third Report, 1886, Appendix C, p. 421; Marshall, Official Papers,p. 5.

22 Investigations in Currency and Finance, p. 131 [second edition, p. 123].

23 Die Geld- und Kredittheorie der Peelschen Bankakte, p. 127.

24 [In the original “wahre” is presumably a misprint for “gerade”; cf. p. 34.]

25 Theorie des Geldes, p. 64.

26 It cannot be denied that the adoption of a legally enforced rate, the acceptance of notes in payment of taxes, etc., assist in maintaining the value of a paper currency; for the supply and demand of paper means of payment is not then determined entirely by the condition of the market. But there is no reason, I think, for regarding them as the sole, or indeed as the predominant, influence.

27 Prezzi ideali e prezzi effettivi, Milan, Ulrico Hoepli, 1892.

28 Ibid., p. 3: “Non è la moneta che fa i prezzi alle cose; ma è la valuta. ma è il complessivo valor d’uso sociale, ma è specialmente il rapporto fra il tutto e le singole parti che li prefinisce a una certa misura”. And p. 5: “il corpo di questi beni (the commodities employed as money) per la sua abbondanza o per la sua scarsezza, non ha alcun effetto sul valore del denaro raffigurato da essi, se non in quanto l’abbondanza determini un accrescimento del valor d’uso sociale e la scarsezza una qualche diminuzione”.

29 Ibid., p. 7 ff.

30 Cf. Ibid., p. 36 ff.

• 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.
• 4Loc. cit., 1908, p. 211.
• 5Loc. cit., pp. 65, 66.
• 6An 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.
• 7Ibid., p. 198.
• 8Statsökonomisk Tidskrift, Oslo, 1917.
• 9Preface.
• 10In 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.
• 11Lectures, 2nd Swedish ed., p. 202. See also Cassel, Theory of Social Economy, § 48.
• 12Ibid., p. 393.
• 13Loc. cit., 1909, p. 64.
• 14“The Monetary Problem of the Scandinavian Countries,” Ekonomisk Tidskrift, 1925; translated below, p. 199 ff.
• 15Only recently has a change in this respect come about as a result of Lindahl’s The Means of Monetary Policy (in Swedish), 1930, and of Myrdal’s “Der Gleichgewichtsbegriff als Instrument der geldtheoretischen Analyse”, Beiträge zur Geldtheorie, edited by F. A. v. Hayek, 1933, (published in Swedish in the Ekonomisk Tidskrift, volume of 1931 but printed in 1932).
• 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.”
• 17Wicksell 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.”
• 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.
• 19As 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.
• 20In 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.
• 21I 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.
• 22Wicksell 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.”
• 23Wicksell’s opinion of the character of the business cycle is perhaps most clearly presented in his paper “The Riddle of Crises”. Here he pointed out that there are two entirely different methods of explaining the comparatively regular ups and downs of business. One is to assume that some extraneous forces work intermittently and so cause oscillations. The other makes use of the hypothesis that the present economic system will, by its very nature, react in an oscillatory manner to any irregular forces which tend to make it move. It might be imagined to be like a rocking-horse. Wicksell undoubtedly inclined towards the latter view, while maintaining that intelligent credit policy—at least under most conditions—could prevent the rocking tendency from growing violent.
• 24Let 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.”
• 25As 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.
• 26In 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”.
• 27In 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.
• 28In 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.
• 29During his last years Wicksell came more and more to doubt the solidity of what had been regarded as the cornerstone of his monetary theory:—the idea that if the money rate coincided with a normal rate of interest, which brought about equality between savings and investment, the commodity price level would remain constant. To what extent his earlier discussion with Davidson influenced him we cannot say. To judge from his last paper, it was discussions with business men on the causes of war inflation, especially the influence of a reduction in the supply of commodities, which caused the alteration in his views.
• 30The chief reason why Wicksell changed his views so little was undoubtedly that the criticism which his theory met did not go down to fundamentals. During his last years Wicksell was again questioning the whole structure of monetary theory; this was not, however, due to the criticism which he had received but to his own doubts about the reliability of the explanation of war-time inflation which he, like all other Swedish economists, had presented and defended.