Interest and Prices

CHAPTER 7

THE RATE OF INTEREST AS REGULATOR OF COMMODITY PRICES

A. The Classical Theory and the School of Tooke

THE above question, as to whether it is in the power of the banks to regulate at will the exchange value of money and commodity prices, was answered by Ricardo with a decisive affirmative. His answer was not, as Wagner asserts,1confined to the supposition of irredeemable paper money (as was current in England at the time at which Ricardo was writing). It applied equally well where the notes were redeemable in metal; though it must, it is true, be assumed that the banks of issue of the various countries pursue a uniform policy. There is a passage in Ricardo’s reply to Bosanquet which leaves no room for doubt on this point. “Let us suppose”, he says, “a case in which money could not be profitably exported—Let us suppose all the countries of Europe to carry on their circulation by means of the precious metals, and that each were at the same moment to establish a Bank on the same principles as the Bank of England—Could they, or could they not, each add to the metallic circulation a certain portion of money? and could or could they not permanently maintain that paper in circulation? If they could, the question is at an end; an addition might then be made to a circulation already sufficient, without occasioning the notes to return to the Bank in payment of bills due. If it is said they could not, then I appeal to experience, and ask for some explanation of the manner in which bank notes were originally called into existence, and how they are permanently kept in circulation. “2

According to Ricardo, such a new issue of notes must necessarily bring about a rise in prices. In principle this seems correct; though it is not to be expected that prices will rise in exact proportion to the increase in the note issue, for the notes may release or displace other instruments of credit and the velocity of circulation may decline.

It is to be observed in passing that Ricardo is here inconsistent with the view which he expresses elsewhere 3 on the question of the relatively stable value of the precious metals. If it is possible for the banks (to be accurate, for the banks of the world as a whole) to regulate the value of money through the issue of notes even though the notes are perfectly redeemable, then it is clear that a constant value of money is not ensured simply by the provision that the notes shall be redeemable. Yet this was Ricardo’s belief. A certain touch of logic must therefore be allowed to the later Currency School, no matter what view is taken of Peel’s Bank Act, for which they were responsible.

Quite a different line of approach is to be found in the writings of the school of Tooke (Tooke, Fullarton, Wilson, and also Mill, Nasse, and to some extent Wagner, etc.). It is here maintained that on the assumption that the banks issue notes purely by way of lending on adequate security—and not through advancing large sums to the government and the like—the banks are entirely dependent on the requirements of the business world for means of payment and have no means of affecting these requirements or of influencing prices.

For example, the eighth and ninth of Tooke’s propositions, already referred to, run as follows:

“That it is not in the power of Banks of Issue, including the Bank of England” (or any other Central Bank), “to make any direct addition to the amount of notes circulating in their respective districts, however disposed they may be to do so. In the competition of Banks of Issue to get out their notes, there may be an extension of the circulation of some one or more of them in a large district, but it can only be by displacing the notes of rival banks.

“That neither is it in the power of Banks of Issue directly to diminish the total amount of the circulation; particular banks may withhold loans and discounts, and may refuse any longer to issue their own notes; but their notes so withdrawn will be replaced by the notes of other banks, or by other expedients calculated to answer the same purpose.” 4

It is particularly the second of these propositions that sounds rather paradoxical. It is quite certain that it must be possible for all the banks of a country, provided that they are solvent, to diminish the quantity of notes in circulation, or indeed to withdraw them altogether. What “other expedients” could then take their place? Would it be some makeshift, such as direct exchange credit or private bills, circulating from hand to hand without being discounted and taking the place of means of payment? But how small would be the extent to which these makeshifts of a more primitive system could take the place of our instruments of organised credit! Or would it be precious metals flowing in from abroad? It is a fact that such a flow would finally set in—though only gradually at first—but it would occur only as a result of the fall in prices and the rise in the value of gold, which would take place in precise contradiction to the view expressed by Tooke. And even this makeshift ceases to be available as soon as we adopt an international point of view and assume that all banks pursue a uniform policy.

It is necessary then to admit that it lies within the power of the banks to diminish the quantity of means of exchange, for instance by raising the discount rate. It is scarcely logical to deny that, by means of the reverse operation, the banks can bring about an increase.

An apparent confirmation of Tooke’s theory is provided by the famous unanimous assurance of the country bankers summoned before a Parliamentary Committee. Fullarton has set out their statements in the following words: “The amount of their issues is exclusively regulated by the extent of local dealings and expenditure in their respective districts, fluctuating with the fluctuations of production and price, and that they neither can increase their issues beyond the limits which the range of such dealings and expenditure prescribe, without the certainty of having their notes immediately returned to them, nor diminish them, but at an almost equal certainty of the vacancy being filled up from some other source.”5

But it must not be forgotten that it was here a question purely of provincial banks, of which the notes (as Ricardo had already pointed out) could circulate only in their own districts, but not in London, while the notes of the Bank of England were of course freely accepted everywhere. If provincial banks unduly enlarged their issue, then according to Ricardo a local rise in prices would result, and this would lead to increased imports of goods into the district and to diminished exports to London; so that the district’s balance of payments would rapidly become unfavourable. But on this matter Tooke’s treatment is certainly more accurate. Tooke would say that the cheaper terms of credit provided by the provincial banks would lead to a transfer of capital from the provinces to London. In either case the result is the same. A portion of the provincial banks’ notes would be returned to them for exchange into Bank of England notes, which would be employed in making payments in London; or, what comes to the same thing, the banks would be asked to supply bills or cheques on London.

Only if the provincial banks were acting in co-operation with the Central Bank, never if they were acting alone, would it be possible for them, having once displaced all Bank of England notes from their district, to expand their own circulation. This would be true even where paper money was irredeemable. In the same way a contraction of the Bank of England’s circulation would force the provincial banks to bring about a corresponding diminution in their own circulation. The provincial bankers’ statement was evidently based on the facts. But these facts have no relevance whatever to the question which lies before us. It is only within very narrow limits that a single bank can increase the extent of its lending, whether by means of notes or by means of cheques. If a bank provides credit on too liberal a scale it is in direct danger of its notes or cheques becoming concentrated in the hands of the other banks and being presented by them for redemption ; or, at best, it might have to pay a higher rate of interest on its current account with the other banks than the rate that it receives. In connection with the influence of “the banks” on the circulation of money and on prices, it is therefore essential to think of the aggregate of all the banks of a country, or, in the extreme case, of the world. In economics false conclusions are all too easily drawn by applying to a national, or to an international, economy knowledge which, before further examination is undertaken, is appropriate only to the private economy from which it is derived.

It is on the basis of these and similar facts that people like Fullarton and Tooke absolutely deny the possibility of banking policy being in any way responsible for such fluctuations in prices as occur in practice. J. S. Mill took up a middle position on monetary questions. His views were rather inconsistent6 and of no great significance for the further development of theory, either in his own country or abroad; but he comes to the same negative conclusion, making an exception of periods of speculation and crisis. In a “quiescent state of the market”, Mill regards Tooke’s theory as perfectly correct. Then “each person transacts his ordinary amount of business ... or increases it only in correspondence with the increase of his capital or connexion, or with the gradual growth of the demand for his commodity, occasioned by the public prosperity”. At such times, “producers and dealers do not need more than the usual accommodation”, and “as it is only by extending their loans that bankers increase their issues, none but a momentary augmentation of issues is in these circumstances possible”. “Even if we suppose, as we may do, that bankers create an artificial increase of the demand for loans, by offering them below7 the market rate of interest, the notes they issue will not”, Mill assures us, “remain in circulation; for when the borrower, having completed the transaction for which he availed himself of them, has paid them away, the creditor or dealer who receives them, having no demand for the immediate use of an extra quantity of notes, sends them into deposit. In this case, therefore,” concludes Mill, “there can be no addition, at the discretion of bankers, to the general circulating medium: any increase of their issues either comes back to them, or remains idle in the hands of the public, and no rise takes place in prices.” 8

It is a great pity that on a question of such far-reaching importance Mill relies for his exposition on one single example—worked out, moreover, very inadequately. It is quite impossible to state whether a given quantity of notes will remain in circulation for a longer or for a shorter period of time. It is equally easy to imagine the opposite of Mill’s example. It might be supposed that instead of being passed into the hands of a single trader and from him back into the Bank, notes are paid out in small quantities to a large number of separate individuals, and so disappear into circulation. But this, too, would prove nothing, for it is impossible to say whether a corresponding quantity of other notes might not be pushed out of circulation. Whether or not the result of such behaviour on the part of the Bank is to increase the circulation must ultimately depend on whether this procedure in itself is calculated to bring about a rise in prices. In other words, the real cause of the rise in prices is to be looked for, not in the expansion of the note issue as such, but in the provision by the Bank of easier credit, which is itself the cause of the expansion.

This becomes very clear if, instead of this rather complicated system, we imagine a system in which all payments are made by means of cheques.9 There is then no “circulation of money” at all. The cheques regularly return after a day or two to the Bank (or rather to one of the banks, and so to the bankers’ clearing house). To an expansion of the note issue in the case which we have been discussing there now corresponds an increase in banking turnover. It is clear that whether this occurs or not depends mainly on whether the lowering of the Bank’s discount rate is calculated in itself to bring about a rise in prices.

B. Simplest Hypothesis. Variations of the Rate of Interest when the Market Situation Remains otherwise Unaltered

That such is the case is obvious in regard to current prices—given the assumption, which we are retaining throughout this chapter, that a fall in the rate of interest, or more generally an easing of credit, takes place without any other change in the market situation, so that it really increases the profitability of enterprise. In subsequent chapters we shall abandon this purely hypothetical assumption and consider the far more general case, in which an alteration in the rate of interest is accompanied by, or more frequently is caused by, economic changes in other quarters. Quite half the controversy which has arisen in this field can be ascribed to lack of attention to this important distinction.

In the example taken from Mill, it was a question, as is expressly stated, of “an artificial increase of the demand for loans”, such as would not occur under ordinary conditions. The borrower is intending to make some payment which otherwise he would have dispensed with or would have postponed. Either he desires to buy some commodity which otherwise he would not have bought at all, or would only have bought later; or he intends to make a payment in cash where otherwise he would have had to buy on credit; or finally he wishes temporarily to keep some or all of his own goods off the market, and he asks the Bank for money with which to meet his immediate or pending liabilities without having to sell his goods. In the first case (other things being equal), the demand for goods in general is raised; in the second case, the rise is concentrated into the field of cash purchases; in the third case, the supply of goods is lowered. Thus all three cases provide the basis for a rise of prices—of current prices.

This is precisely the proposition which is passionately contested by Tooke and his followers, with a display of instances which, on the face of them, are not unconvincing. A low rate of interest is by no means always accompanied by high, or by rising, prices. In fact the opposite is the general rule. “At the great trading centres”, remarks E. Nasse,10 “the rate of discount and the prices of the more important groups of commodities often fall almost simultaneously, and persist for a long time in deep depression, until” some outside cause “at last arouses entrepreneur activity”. . . .“It is impossible for a country’s credit institutions, acting by themselves, to bring about an upward movement of prices, no matter how willing they may be to supply capital at the lowest possible rate of interest. Some other stimulus must first be provided before real use can be made of the available purchasing capacity.”

We shall be giving a full account of the nature of this case and of its probable explanation. For the moment, we must say a word about the reasoning itself. The “other stimulus” of which Nasse speaks cannot possibly reside in anything else but the hope of higher profits. This may result from the expectation of an increased demand for particular groups of commodities, or from technical discoveries, lower wages, and the like, which hold out the promise of a higher return to producers. Now it must be a matter of indifference to the individual business man whether he derives his profit from higher gross receipts, from lower costs, in the narrow sense of the word, or from cheaper credit. It follows obviously that unless the fall in the rate of discount is neutralised by simultaneous changes elsewhere,11 it must, when it has persisted long enough to exert a depressing influence on long-term rates of interest, provide a stimulus to trade and production, and alter the relation between supply and demand of goods and productive services in such a way as necessarily to bring about a rise in all prices.

It is quite true that there are businesses to which a rise or fall in the rate of interest is of very little consequence, since an expansion or contraction of their activities is prevented by technical considerations. It is equally true that there are many other businesses in regard to which such an occurrence is the decisive factor. Some enterprises are in a state of complete preparation; for others the plans for expansion have long been ready, and their execution only awaits a favourable opportunity; in yet others business is bad, and it is being debated whether they shall be carried on or closed down. In all such cases an easing or tightening of credit may be the last drop which causes the vessel to overflow, so that the plans which have been worked out are brought into execution. It is impossible to conceive that to-day, when almost every enterprise works on borrowed capital of one shape or another, it should be a matter of complete indifference whether the need for credit is met at 3 per cent, or 4 per cent., or only at 6 or 8 per cent.

Easier credit sets up a tendency for production (and trade in general) to expand; but this does not in any way imply that production will in fact increase. There will in general be no such increase, or only a relatively small one, if the available means of production, labour and so on, are already almost fully occupied.12 (An individual business may indeed expand, but only at the expense of another, which must suffer a corresponding contraction.) But this is far from saying that there is any obstacle to a rise in prices; the excess of demand (brought about by easier credit) over supply of raw materials, labour, land, and the like, and directly and indirectly of consumption goods, is the decisive factor in forcing up prices.

Neglect of this important difference between tendency and fact is, if I am not mistaken, one of the chief reasons why the nature of the influence of credit on prices has up till now been so completely veiled in darkness. We shall soon be meeting with an even more important reason for this confusion.

It is usually unnecessary to concentrate attention on speculation, in the narrow sense of the word ; and that is the case here. Tooke points out 13 that real speculative purchases (excluding trading in futures, etc.) will scarcely take place unless the speculator can reckon on a rise in price of ten per cent., and that it is then of little importance whether he has to pay one per cent, more or less for his credit. This may be substantially correct, but such transactions belong to the class of exceptions. They are of importance in connection with times of speculation and crisis; but in dealing with an organic movement of prices, persisting over several years, it is not the exceptions which have to be taken into consideration but the ordinary regular and recurrent transactions, and the question that has to be asked is at what prices, taking into account the situation in the money and commodity markets, they can and will be effected.

In practice, the rate of interest is altered only in steps of one-half to one per cent., and only after lengthy intervals of time, during which the rate of interest (or at any rate the Bank rate of interest) remains completely unaltered. It would therefore appear that these changes are too small to exert more than a very diminutive influence on the structure of prices. Suppose that I am a business man and that, having sold my goods against bills drawn for three months, I can now discount these bills at 3 per cent, per annum instead of the 4 per cent, which formerly I had to pay. The result is that ipso facto I have received a higher cash price for my goods, and the transaction has put “into circulation” a greater sum of money. But it is easy to see that the rise amounts only to ¼ per cent, of the normal price. Moreover the contract may be as yet incomplete, so that it may be impossible for the seller to retain the whole of the extra profit for himself. He may be forced by competition to share part of it with the purchaser. Let us suppose that they participate equally in the advantage provided by the easier credit. Then the seller will have to reckon with a credit price which has fallen by ⅛ per cent., but as the result of the fall in the rate of discount, he receives a cash price which has risen by ⅛ per cent. Now suppose that the purchaser prefers to pay cash and raises the necessary sum himself by means of borrowing. Then if he intends to dispose of the commodity in three months’ time, the fall of 1 per cent, in the annual rate of interest means that at the most he can afford to raise the price which he offers by ¼ per cent.—always on the assumption that he cannot reckon on a rise in the price which he will himself obtain in the future. But here, too, the price will not actually rise to the maximum extent; it may only rise by, say, ⅛ per cent.

It is, however, frequently the case that quite a small fall in the rate of interest would immediately bring about a much greater rise in prices. The price which can be paid for goods obtained by means of credit is higher the longer is the period during which the credit is utilised. Take, for instance, the case where raw materials or labour will be employed for one, two, three or more years before the finished product emerges. Then a fall of 1 per cent, in the rate of interest will clearly be responsible in the extreme case for a rise in the current prices of these raw materials and services of 1, 2, 3, or more per cent. Where the investment is to all intents and purposes being undertaken “for eternity”, as in the case of such things as buildings, railways, and durable machinery, the possible rise in price is considerably greater. If railway companies could issue debentures at 3 per cent, instead of 4 per cent., they would be able, ceteris paribus, to pay almost 33⅓ per cent, more for all their requirements: 4 per cent, on 100 million marks comes to the same thing as 3 per cent, on 133⅓ million marks.

It is, of course, possible for the rise in the prices of particular goods and services to be even greater. It is probable that the prices of some of the factors of production will rise only slowly. This is likely to be the case with labour, because the market in ordinary day-labour is so large. The other factors—such as the land and property which have to be expropriated, and the iron and wood which are used as materials—can then be paid at a correspondingly higher rate.

It is commonly observed that at times of so-called expansion the commodities which are the first to show a substantial rise in price are precisely those raw materials which are employed for the purpose of further production. There is now no room for doubt as to the correctness of this observation nor as to its probable explanation. But it is a necessary condition that the easier terms of short-term lending shall have persisted sufficiently long to influence the long-term rate, the so-called bond rate of interest, so long as the upward movement is brought about by easier credit and not merely by other causes, such as technical progress. We have seen that a casual and temporary change in the discount rate would not in itself exert any marked influence on prices. To this extent it can be granted that Tooke was quite right in maintaining, in contradiction to Ricardo, that the banks’ discount policy is in itself of direct significance in respect only to such matters as international or interregional movements of capital and the postponement of payment of fluctuating liabilities, but that it is of smaller importance in respect to the structure of prices.

This, it may be noted, is in itself a reason for not expecting any precise correlation between movements in the discount rate and in commodity prices. The direct influence of the one on the other is at first trivial and may easily be masked by other factors or altogether annulled.14 But as soon as the long-term rate of interest moves in sympathy, and provided that conditions remain otherwise unaltered, prices suddenly rise and the whole world knows that “the upward phase” has started. We shall be referring later to some statistical data supplied by R. Giffen which seem to confirm this principle.

If we leave on one side these violent changes in the prices of such raw materials and services as are required for the purpose of long-term investment, and their reaction on the prices of other commodities, it would appear that a large change in the rate of interest could exert only an extremely trivial influence on prices.

It might even be supposed that prices would soon return of their own accord to their original level, or perhaps sink below it. In our first illustration the credit price which would have to be paid in three months’ time would be entirely unaffected by the fall in the discount rate, and in the second illustration it would actually be depressed. But it would be fallacious to draw any such deduction about the future level of prices. Prices accepted to-day for an immediate delivery of goods which will not be paid for until some point in the future, are not the prices of the future. They are current prices with an addition for interest, and have nothing in common with prices which will have to be paid in the future for goods or services supplied in the future, of which the level will be determined by the relation existing in the future between the conditions of supply and of demand. The one exception that I can think of is the case where the sellers’ services are also to be supplied in the future—in other words, where work is undertaken to order or where sales are made on a forward basis. This will be discussed more fully at a later stage in connection with a pertinent observation of Tooke’s on the alleged influence of the rate of interest on costs of production.

Such would certainly be the case if it could be assumed that the effect of a single but permanent change in the rate of interest was confined to the immediate impact, so that any further rise in prices would require a further fall in the rate of interest. But this assumption immediately leads to absurd conclusions.

On every consideration of probability things happen quite differently. It is to be supposed that the maintenance of a lower rate of interest has effects, ceteris paribus, which are not only permanent, but also cumulative. To understand the connection, attention must be devoted to the rather formal nature of money prices, and also to what may be termed the vis inertiae in the economic mechanism.

Though the determination of money prices often appears to be supported on very airy foundations, it is outside the power of any individual to fix them to suit his own desires. Every individual buyer or seller has to submit to their fluctuations; and any attempt to buy at a lower price or to sell at a higher price must necessarily prove disadvantageous unless his example is immediately followed by the other buyers or sellers of the commodity in question. But for the economic system as a whole, there is no tendency for any alteration in a structure of prices which has been once built up. For instance, once a rise in prices has been uniformly dispersed over all groups of commodities, equilibrium in respect to relative prices is once again restored; and relative prices are the only things that really matter so far as production and consumption are concerned.

The recipients of fixed money incomes will, it is true, respond to a rise in prices by diminishing their demand for goods of all kinds, and they will in this way be doing something to restrain the upward movement of prices. But if they are not in a position to hold back their own “wares” from the market, a new position of equilibrium will soon be attained, and they will be receiving a smaller share of the yearly production of commodities while the share of the rest of the community will be correspondingly increased. If, on the other hand, they can hold back their services, as, for instance, with civil servants who can obtain an increase in salaries as a result of a rise in the cost of living, there is then no exception to the general rule. And similarly in the case of a general fall of prices.

So a fall in the rate of interest, even though it is casual and temporary, will bring about a perfectly definite rise in prices, which, whether it is big or small, will persist as a permanent feature even after the rate of interest has returned to its former value. If the rate of interest remains at a low level for a considerable period of time, its influence on prices must necessarily be cumulative; that is to say, it goes on repeating itself over equal intervals of time in precisely the same manner. The producer has to pay more for raw materials, wages, rents, etc., but he receives correspondingly better prices for his own products. He finds himself in precisely the same situation as before the rise in prices took place, and he is therefore in a position to pay the same rate of interest as before for the credit which he requires. If, however, the credit institutions maintain the lower rates of interest, he will be in a position to offer rather more for raw materials, labour, and land, and competition will to some extent force him to do so. As a consequence, the demands of workers and landlords will be raised, and this will bring about a further rise in the price of consumption goods; and prices will continually rise higher and higher.

An improvement in the terms of credit enabled our business man to pay a higher cash price for the goods which he was going to sell in three months’ time, even though he was due to receive no more than the normal sale price. At the end of the period he will make the pleasant discovery that he can actually sell his goods at more than the normal price. He will now arrange a similar transaction for the next three months and he is likely to base his calculations on the current price. Even if the terms of credit have by now returned to normal he will still be able to pay the higher price. And if his bank continues to charge the lower rate of interest he will be in a position to bear still higher costs without involving himself in a loss (and he will in all probability be obliged to do so). In this kind of way an equal rise in prices will take place every three months.

Even more convincing is the case where the money is used for durable investment. Let us suppose that there is a general fall in the rate of interest from 4 to 3 per cent. We have seen that the value of all permanent capital goods, for instance of dwelling-houses, will go up by 33⅓ per cent. It would be possible to raise by anything up to this extent the prices paid for the materials and services required for house-building. This is based on the assumption that the net earnings of houses (in particular rents) remain unaltered in the future. But there will be a rise in wages, ground rents, etc., and this will bring about a rise in the money demand15 for all kinds of goods, including houses. Rents will rise, and while it is true that the owners of houses will spend proportionately more on such things as repairs, it is to be presumed that their net return will go up in proportion. This will bring about a further rise in the price of houses (though not the full equivalent of the original rise), and so indirectly a further rise in the prices of everything else. It must be admitted that this line of reasoning requires some modification. An abnormally large amount of investment will now probably be devoted to durable goods. There may result a relative overproduction of such things as houses and a relative underproduction of other commodities. However, this will merely mean a more rapid equalisation of relative prices. So long as other things remain equal, it is impossible that the average level of money prices should fall, or even that it should cease to rise.

We may go further. The upward movement of prices will in some measure “create its own draught”. When prices have been rising steadily for some time, entrepreneurs will begin to reckon on the basis not merely of the prices already attained, but of a further rise in prices. The effect on supply and demand is clearly the same as that of a corresponding easing of credit.

Indeed the effect may be even greater. The effect of easier credit is confined initially to those who work on borrowed money. But when prices have already gone up and are expected to go up further, almost every purchaser will be able to offer higher prices and every seller to demand them.

To put an immediate stop to any further rise in prices, it would not be sufficient for the banks to restore the rate of interest to its original level. This would have the same effect on the business world as would a somewhat lower rate of interest at a time when prices are not expected to alter. If, on the other hand, the banks continue to maintain the rate of interest at its lower level, two forces will be operating in the direction of higher prices, and the rise will be correspondingly more rapid.

But so long as business continues to be conducted on normal lines, it is not to be supposed that there will be any cumulative movement of prices in the manner of an avalanche.16 Through its influence on supply and demand, an expectation of a rise in prices in the future is by its very nature capable in itself of bringing about only a somewhat smaller rise than is actually expected. For a buyer could not obtain any profit if the whole of the expected rise were included in the actual price, and the seller will almost always prefer a smaller but more secure profit to a profit which is somewhat larger but less certain.

After credit ceases to remain easy prices will, for this reason, come sooner or later to a standstill. Let us suppose, for instance, that a further rise in prices of p per cent, over the next three months is generally expected, though without any real foundation. Then the rise which actually takes place can only amount to ap per cent., where a is less than unity, or, in other words, a proper fraction. Over the subsequent period of three months, it would be possible to reckon on a rise in prices of not more than ap per cent., and this expectation will bring about an actual rise of a2p per cent. And so it will continue. If, on the other hand, credit remains easy, prices will indeed rise without limit, but the rate of annual increase, so far from being indefinitely high, will at the most arrive at a certain finite limiting value.

The matter takes on an entirely different aspect in the case where the market is under the influence of speculation proper. Goods are now bought, not merely to be passed on to other producers and to be distributed to consumers by the normal methods, but to be hastily disposed of to other speculators. The time element, which normally plays a decisive part, now ceases to be of any great significance; and it becomes impossible to make even the roughest kind of estimate of the probable rise in prices. Insecure sentiment governs the market; as prices continue to soar and profits are easily earned, the movement may rapidly reach fever-point. There is almost no limit to the rise in prices in spite of the fad that credit becomes more and more expensive. But when prices ultimately come to rest, and the prospect of further profits disappears, the credit position is so strained and the rate of interest is so high as immediately to bring about a contrary movement, which proceeding in analogous fashion may rapidly drag down prices even below their normal level.

For the moment we leave such occurrences on one side. We are concerned with the organic development of a regular movement of prices.

I can think of but one exception to the rule that easier credit must lead to a rise in prices. This is the case where goods are produced to order, or the very similar case where goods are sold for delivery in the future (on a forward basis). The producer or seller then has to include in his estimate of costs the interest payments which he incurs over the intervening interval of time. A fall in the rate of interest will therefore bring about a, fall in the selling price. What would happen if production took place everywhere on the basis of previously arranged prices may well be left undecided. In the actual world this factor cannot be responsible for more than an insignificant counter-current against the general movement of prices; for the interval of time over which production takes place to order (or which elapses before the date arranged for delivery) usually amounts to only a small portion of the total period of production necessary for providing the goods and for their subsequent use. Suppose, for example, that a railway company has ordered a consignment of rails from an ironworks. The ironworks will be able, as a result of cheaper credit, to charge a somewhat lower price; but the easier credit, when it has persisted for a sufficiently long time, is likely itself to cause a far greater rise in the costs of manufacture and in the willingness of the railway company to purchase.

This is as much as can be said in favour of a peculiar statement made by Tooke (though it was not, so far as I know, repeated by his pupils). According to the fourteenth of Tooke’s theses or conclusions, to which we have already made several references, it is maintained:

“That a reduced rate of interest has no necessary tendency to raise the prices of commodities. On the contrary, it is a cause of diminished cost of production, and consequently of cheapness.”17

This involves a conflict with the well-accredited fact that a rise in the rate of interest has always shown itself to be the appropriate method of checking an unfavourable balance of payments and of instigating a flow of bullion from abroad. Tooke tries to meet this difficulty by remarking that such a rise in the banks’ discount rate is not “of such permanence as to affect the cost of production”; but, says Tooke, it causes a disturbance of credit and “extensive failures”, which usually lead to a slump in prices. Tooke would thus appear to maintain that the same procedure has precisely opposite consequences according as it is applied for a long or for a short period. This seems a doubtful possibility.

The opposite case of a favourable balance of payments leads to equally absurd consequences. A favourable balance would cause an inflow of bullion, and this clearly would, or at least could, bring about a lowering of the rate of interest. The result according to Tooke would be a still further fall in domestic prices (unless some fundamental distinction is admitted here too between the effects of an easing of credit which is temporary and of one that is permanent), so that the balance of payments would become more and more favourable and money would flow in on an ever-increasing scale.

In any case, the proposition that prices of commodities depend on their costs of production and rise and fall with them, has a meaning only in connection with relative prices.18 To apply this proposition to the general level of money prices involves a generalisation which is not only fallacious but of which it is in fact impossible to give any clear account. It can be concluded then that, with the one exception referred to above, Tooke’s proposition must be regarded as false, both in theory and in practice.

In other passages of the History of Prices Tooke repeats his statement, but in a somewhat modified version in the sense that it is given a particular application to those groups of commodities of which the production involves the use of large amounts of capital. So long as it is a question of relative prices, this application is perfectly correct, but it has no relation to the question under discussion.

We had arrived at the conclusion that, so long as the situation in the market remains unaltered, any permanent fall, no matter how small, in the rate of interest maintained by the credit institutions will cause the general level of prices to rise to an unlimited extent in a continuous and more or less uniform manner. And in the same way, a rise in the rate of interest, no matter how small, will, if maintained for sufficiently long, result in a continuous and unlimited fall in the prices of all goods and services.

These statements sound extremely bold, and indeed paradoxical. But it has to be remembered that the rate of interest referred to as the “previous” or the “normal” rate, away from which our deviations are imagined to originate, does not always remain the same and cannot be thought of as so much per cent. It merely means that rate which, having regard to the situation in the market, would be necessary for the maintenance of a constant level of prices. That there must always be such a rate was the implicit assumption underlying our whole argument. In the next chapter we shall consider whether it really exists, how it could be attained with the object of fulfilling its purpose, and similar questions about the causes determining the rate of interest.

It should now be clear that, in so far as our hypothetical conclusions are in accordance with reality, the movement and equilibrium of actual money prices represent a fundamentally different phenomenon, above all in a fully developed credit system, from those of relative prices. The latter might perhaps be compared with a mechanical system which satisfies the conditions of stable equilibrium, for instance a pendulum. Every movement away from the position of equilibrium sets forces into operation—on a scale that increases with the extent of the movement—which tend to restore the system to its original position, and actually succeed in doing so, though some oscillations may intervene.

The analogous picture for money prices should rather be some easily movable object, such as a cylinder, which rests on a horizontal plane in so-called neutral equilibrium. The plane is somewhat rough and a certain force is required to set the price-cylinder in motion and to keep it in motion. But so long as this force—the raising or lowering of the rate of interest—remains in operation, the cylinder continues to move in the same direction. Indeed it will, after a time, start “rolling”: the motion is an accelerated one up to a certain point, and it continues for a time even when the force has ceased to operate. Once the cylinder has come to rest, there is no tendency for it to be restored to its original position. It simply remains where it is so long as no opposite forces come into operation to push it back.

It is, of course, clear that such forces can never be entirely absent, no matter how developed the credit system may be, if a precious metal or some other material substance serves as a monetary basis. The simple quantity theory is no longer adequate to deal with the nature of these reactions and with the manner of their operation. It is this question which we shall shortly be considering.

 

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19 Geld- und Kredittheorie der Peelschen Bankakte, p. 47.

20 Ricardo, Reply to Mr. Bosanquet’s Observations, chap. v. (Works, McCulloch’s edition, p. 343). At the time of Ricardo the rate of interest on loans was still limited by English law to a maximum of 5 per cent. (The restriction was not definitely removed until 1837.) This explains why Ricardo and other economists were in the habit of referring to a restriction or expansion of the banks’ note issue rather than to a rise or fall in their rates of interest. The difference is not very significant; other means are available for restricting credit which are just as effective, and indeed even more sensitive, than actually raising the rate of interest.

21 Proposals for an Economical and Secure Currency (ibid., p. 391 ff.). Ricardo’s suggestion (Section II., pp. 400-402) that an ideal standard of value is an impossibility would to-day be regarded as old-fashioned and is no longer tenable in view of the possibility of employing index numbers.

22 An Inquiry into the Currency Principle, p. 122; History of Prices, vol. vi., Appendix xv., p. 636.

23 Fullarton, Regulation of Currencies, p. 85; quoted by J. S. Mill, Principles, book iii., chap, xxiv., § 1.

24 This has already been emphasised; see p. 51.

25 [The italics are Wicksell’s.]

26 Principles, book iii., chap, xxiv., § 2.

27 Cf. p. 70.

28 Nasse, “Ueber den Einnuss des Kredits auf den Tauschwert der edlen Metalle”, Zeitschrift für die ges. Staatawissensch., vol. xxi., 1865, p. 146.

29 Cf. p. 100, below.

30 Cf. p. 143, below.

31 History of Prices, vol. iii., p. 153.

32 Cf. below.

33 [“Qeldnachfrage (moneyed demand)” in original.]

34 In an article on “Der Bankzins als Regulator der Warenpreise”, Jahrbücher für Nationalōkonomie und Statistik, vol. 68, 1897, I may have expressed myself rather too hastily. At any rate I had as yet failed to take account of the considerations which follow above.

35 An Inquiry into the Currency Principle, p. 123; History of Prices, vol. vi., Appendix xv., p. 636. The italics are mine.

36 See p. 27.

• 1See, for instance, his preface to the German edition of his Vorlesungen, II.: Geld und Kredit, 1922.
• 2Ibid., p. 198.
• 3Lectures, II.: On Money and Credit, 3rd Swedish ed., p. 197.
• 4See 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.
• 5Loc. cit., 1908, p. 211.
• 6Loc. cit., pp. 65, 66.
• 7An 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.
• 8In 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.
• 9Preface.
• 10Lectures, 2nd Swedish ed., p. 202. See also Cassel, Theory of Social Economy, § 48.
• 11Ibid., p. 393.
• 12“The Monetary Problem of the Scandinavian Countries,” Ekonomisk Tidskrift, 1925; translated below, p. 199 ff.
• 13Loc. cit., 1909, p. 64.
• 14Pp. 201, 202, below.
• 15P. 210, below.
• 16In an article on “Der Bankzins als Regulator der Warenpreise”, Jahrbücher für Nationalōkonomie und Statistik, vol. 68, 1897, I may have expressed myself rather too hastily. At any rate I had as yet failed to take account of the considerations which follow above.
• 17An Inquiry into the Currency Principle, p. 123; History of Prices, vol. vi., Appendix xv., p. 636. The italics are mine.
• 18Only 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).
• 19Wicksell 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.”
• 20Wicksell 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.”
• 21Wicksell 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.”
• 22As 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.
• 23As 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.
• 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.
• 25I 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.
• 26As 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.
• 27Let 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.”
• 28In 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”.
• 29In 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.
• 30During 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.
• 31In 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.
• 32Briefly expressed, Wicksell’s doctrine—which on this point coincided on the whole with Cassel’s—amounted to this: if more money is lent to investors, and used by them for real investment, than is saved, then total purchasing power is increased, and prices rise. But if equilibrium is maintained between savings and investment, purchasing power is kept constant and prices cannot rise, at least not more than in proportion to any reduction in the available volume of commodities. Discussing the influence of war-time scarcity of commodities, Wicksell observed that in this kind of reasoning is reflected a “lack of a clear conception of the term purchasing power. It is only money purchasing power which here comes into question. It therefore stands to reason that a general rise in the market prices of both goods and services itself creates the purchasing power required for meeting the higher prices.” In addition is needed only “an increase in volume of the medium of exchange. If all payments were made on a cheque basis this increase would, of course, take place quite automatically.” The velocity of means of payments of every kind would increase, for most people are more conservative in regard to their habits of consumption than in regard to their habits of making payments. Besides, a new demand for credit would arise from people who wanted to increase their holdings of cash. It cannot be regarded as certain that credit restrictions will keep down such a demand for credit. “A rise in the rate of interest is certainly an almost infallible means of restricting the demand for credit on the part of all producers, but it can hardly have a similar effect on those who merely desire to strengthen their cash position in view of the increase in the volume of exchange.”
• 33Wicksell was, of course, quite right in pointing out that the fundamental concepts, not only of purchasing power or income, but also among others of savings and investment, had not been defined sufficiently clearly. When that has been done, it will, in my opinion, be possible to use the Wicksellian approach to the study of price movements with greater advantage. Although Wicksell’s tools were deficient, his scientific genius led him to an insight into the character and morphology of the movements of the price system which will, I think, always be regarded as a great scientific achievement, even when such concepts as his natural or normal rate of interest have long since been discarded. Nobody would have rejoiced more than Wicksell at the present questioning of the very fundamentals of monetary theory, his own contributions included, had he lived to witness it. His truly scientific and humble attitude towards monetary problems is well revealed in one of the concluding remarks, intended very seriously, in his last paper: ‘As to the period after the War, with its irrational and often puzzling price fluctuations, I am loth to confess that I would far sooner listen to somebody who could express an authoritative opinion on these matters than essay an explanation myself ”.
• 34But so long as business continues to be conducted on normal lines, it is not to be supposed that there will be any cumulative movement of prices in the manner of an avalanche. Through its influence on supply and demand, an expectation of a rise in prices in the future is by its very nature capable in itself of bringing about only a somewhat smaller rise than is actually expected. For a buyer could not obtain any profit if the whole of the expected rise were included in the actual price, and the seller will almost always prefer a smaller but more secure profit to a profit which is somewhat larger but less certain.
• 35“That a reduced rate of interest has no necessary tendency to raise the prices of commodities. On the contrary, it is a cause of diminished cost of production, and consequently of cheapness.”
• 36The 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.