Interest and Prices

CHAPTER 8

THE NATURAL RATE OF INTEREST ON CAPITAL AND THE RATE OF INTEREST ON LOANS

THERE is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.

It is usually said that in modern communities capital (of the mobile kind) is lent in the form of money. But this is a metaphorical and inexact manner of speaking which can easily lead to error. Liquid capital, which is what we are considering, or in other words goods, are never lent—they are never given and taken by way of borrowing—they are simply bought or sold.

Even merchandise credit does not involve any lending of commodities, either from the legal or from the economic point of view. It represents a sale where payment is temporarily postponed, or, if you like, a cash transaction combined with a money loan. Otherwise it would be necessary to pay back the same or an identical parcel of goods, together with accrued interest; or there would have to be a guarantee that in exchange for the stipulated sum of money the same quantity of commodities would be obtainable at the time of payment as at the time of purchase; but this is never the case.

We shall now try, by means of a suitable illustration, to find a more precise basis for our proposition. Let us take an entrepreneur who possesses no capital of his own, or at least no liquid capital. He will require money for the purchase of raw materials and for the payment of wages and rents, and also for his own living expenses during the period of production. (There are other requirements, for instance taxation, but for the sake of simplicity these will be neglected.) All this money may be supposed to be devoted to the purchase of finished consumption goods, with which the workers and property owners, and also the entrepreneur, meet their own requirements ; in so far as it is used for the purchase of raw materials, the manufacturers of the raw materials pay it out in their turn on wages and rents (and keep some of it for themselves), and it is all once again exchanged for finished consumption goods. Now liquid capital must originate from somewhere. For the sake of simplicity it will be assumed that the present owners of the available consumption goods are capitalists; that is to say, that they have no immediate need either for the goods themselves or for such proceeds as they obtain for them in the form of other goods or of money. They are in a position, if necessary, to postpone payment up to a period of, let us say, one year.

It may be supposed in theory that the entrepreneur borrows these consumption goods from the capitalists in kind, and then pays them out in kind in the shape of wages and rents. At the end of the period of production he repays the loan out of his own product, either directly or after exchanging it for other commodities (relative prices being assumed to remain unaltered). If this procedure were adopted by all entrepreneurs who work with borrowed capital, competition would bring about a certain rate of interest that would have to be paid to the capitalists in the form of some commodity or other. The amount of this rate of interest would be determined by the “supply and demand” for capital. However, this phrase tells us very little. But it is possible to set for the rate of interest an upper limit which has a more palpable significance. This limiting value is the amount by which the total product (or its equivalent in other commodities) exceeds the sum of the wages, rents, etc., that have to be paid out. The magnitude of this excess depends on the productivity of the business on the one hand, and on the other hand on the level of wages and rents. This is a matter which will be discussed more fully in the next chapter. It is clear that the entrepreneur cannot pay more than this limiting amount. Moreover, he will be forced as a result of competition with other entrepreneurs to pay very nearly as much; for unavoidable risks cancel out in the course of a long succession of economic periods, and the entrepreneur’s own profit is confined to the amount which corresponds to the actual mental effort of the entrepreneur (and to the rents on such elements of monopoly as he may possess, like business secrets, special advantages of situation or of clientèle, unless these are regarded as additional sources of income).

But for reasons connected with the conception of subjective value, the probability that an entrepreneur will make a profit must always be somewhat greater than the probability that he will make a loss. For otherwise his “moral expectation” would be negative. In many cases, however, the entrepreneurs’ gambling spirit will prevent this rule from applying to their behaviour.

Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner. In such a case, there is no occasion for any alteration in the level of prices. In a developed credit system, the various transactions involve the use of an indefinitely small amount of money, and if cheques (or uncovered notes) are in general use, there is no need for metallic money at all. All that happens is that the banks extend to the entrepreneurs credits against which they draw cheques. These cheques (or notes) pass into the hands of workers and property owners in the form of wages and rents, and are then passed on in payment for the ordinary purposes of consumption into the hands of the capitalists, who for the sake of simplicity will be supposed at the same time to be traders. Finally, they are presented by the capitalists to the banks, where they are transformed into deposits. The difference between the rate of interest obtainable by direct lending to others and the rate paid by the banks to depositors, is compensated by the greater security and convenience offered by the banks. (Furthermore, creditors and debtors may gradually sever their temporary relations with their bank and enter into direct relations with one another1; but we are abstracting from this possibility.) At the end of the period of production, when the finished products become available, the trader-capitalists renew their stocks. They draw on their credits with their bank by means of cheques (or in the form of notes), and so buy the entrepreneurs’ produce. The entrepreneurs in their turn present these cheques at the bank and so liquidate their liability to the bank. If they desire to continue in production, as would normally be the case, they will soon draw out once more almost the same sum by way of a credit. And so the procedure will repeat itself.

There is here nothing calculated either to raise or to lower prices. It is true that as a result of changes in the conditions of production, due for instance to technical progress, first one and then another group of commodities will be obtainable with a smaller expenditure of labour and other factors of production, and that this must cause continual disturbances in relative values. But there is no apparent reason for any alteration in the general level of money prices. An increase in the supply of certain groups of commodities means an increase in the real demand for all other groups of commodities. Why then should it bring about a fall in the average level of prices, it being assumed that money is obtainable in any desired quantity on terms which correspond to the real advantages entailed in the use of credit?

Now let us suppose that the banks and other lenders of money lend at a different rate of interest, either lower or higher, from that which corresponds to the current value of the natural rate of interest on capital. The economic equilibrium of the system is ipso facto disturbed. If prices remain unchanged, entrepreneurs will in the first instance obtain a surplus profit (at the cost of the capitalists) over and above their real entrepreneur profit or wage. This will continue to accrue so long as the rate of interest remains in the same relative position. They will inevitably be induced to extend their businesses in order to exploit to the maximum extent the favourable turn of events. And the number of people becoming entrepreneurs will be abnormally increased. As a consequence, the demand for services, raw materials, and goods in general will be increased, and the prices of commodities must rise.

If the rate of interest rises, the opposite situation is created. So long as prices remain unaltered, entrepreneurs suffer a deficiency below their normal incomes, and there is a tendency for business to become confined to its more profitable elements. The demand for goods and services falls off, or at any rate lags behind the supply; and prices fall. The result in both cases is just those conditions as were depicted above.

But there we were proceeding on the assumption that the condition of the market was stationary. Retaining the formal part of our argument, we have now found our way to an important and necessary extension of its material basis. The natural rate2 is not fixed or unalterable in magnitude. The causes that determine it will be discussed somewhat more fully in the next chapter. In general, we may say, it depends on the efficiency of production, on the available amount of fixed and liquid capital, on the supply of labour and land, in short on all the thousand and one things which determine the current economic position of a community; and with them it constantly fluctuates.

An exact coincidence of the two rates of interest is therefore unlikely. For changes in the (average) natural rate may be presumed (on the basis of the Law of Large Numbers) to be continuous, while the money rate of interest is usually raised or lowered only in discontinuous jumps of one-half or one per cent., at any rate in so far as it is regulated by the large monetary institutions. But the money rate of interest can lie sometimes above and sometimes below the natural rate, and there is no reason for not expecting a sufficient degree of coincidence to prevent substantial fluctuations in prices. Our problem is, therefore, to show that in those periods when upward movements of prices have been observed, the contractual rate of interest—the money rate—was low relatively to the natural rate, and that at times of falling prices it was relatively high. It is only in this relative sense that the money rate of interest is of significance in regard to movements of prices. It can at once be seen that it is quite useless to try to demonstrate the existence of any direct relation between absolute movements of the rate of interest or of the discount rate and movements of prices.

In other words: If it were possible to ascertain and specify the current value of the natural rate, it would be seen that any deviation of the actual money rate from this natural rate is connected with rising or falling prices according as the deviation is downward or upward. But if the middle term of the comparison disappears—if the usual direct comparison is made between the level of prices and the rate of interest—a rise in prices is compatible, not only with a lower rate of interest, but equally with a constant or a higher rate, a fall in prices is as compatible with a constant or a lower money rate of interest as with a higher rate; for the natural rate may move further than the money rate.

It is mainly because this obvious possibility has been overlooked that discussions on the subject have been so barren. In the place of attempts to discover whether high prices are accompanied by high or by low rates of interest, it would have been well to elucidate the real meaning of a high or of a low rate of interest. It might then have been seen that it is an essentially relative conception, and that a further datum must be supplied, namely, the level of the natural rate, before it is possible to determine whether any particular rate of interest is to be regarded as high or as low.

Such investigations will provide the subject-matter of Chapter 11. We must now consider whether it is possible for credit institutions to maintain their rates of interest at any desired level, or whether they are obliged sooner or later, as a result of the operation on the money market of the forces of supply and demand, to come into line with the natural rate. The latter is the view generally held by economists. In principle they are perfectly right; but they usually omit to provide any clear account of the manner in which the two rates of interest are brought together. The money rate of interest depends in the first instance on the excess or scarcity of money. How then does it come about that it is eventually determined by the excess or scarcity of real capital?

“What is interest?” asks F. A. Walker,3 and proceeds to give the answer. “It is the compensation paid for the use, not of money, but of capital. Money is only one of many forms of capital; and in loans is usually only the agent of effecting a transfer of other forms of capital than itself. If I borrow money, the chances are that I at once, or shortly afterwards, purchase with it articles suitable for my business or my personal necessities. . . . These were what I really borrowed. These are what, in any philosophical view of the subject, I pay interest on; not upon the money. The money was but the means to this end....”

This kind of generality is too metaphorical to take us very far. Walker should have indicated the mechanism by which the same results are reached in real life as are suggested by “any philosophical view of the subject”. For in actual fact it is money which is lent, not the goods purchased by means of money. The rate of interest is a matter for negotiation with the owners of money and not with the owners of goods.

The most eminent of writers have contributed very peculiar views on this subject. W. S. Jevons remarks that under a system of credit the business man is not the real owner of the goods which he has bought on credit. “Though the merchant does not own the goods there must be someone to own them, to advance capital, or, as it is said, to discount the bills arising out of the transaction. Now this capital is limited, and the available amount is reduced during the period of permanent investment, from which a rise of prices proceeds. It is the exhaustion of this capital which limits credit; it is the limitation of credit which must sooner or later bring prices to a stand, or even cause them to recede to a rate much lower than they had reached. . . . While the elasticity of credit, then, may certainly give prices a more free flight, the inflation of credit must be checked by the well-defined (sic) boundary of available capital, which consists in the last resort of the reserve of notes, equivalent to gold, in the ... Bank of England.”4

It is almost impossible to obtain from these observations any kind of “well-defined” picture. At one moment Jevons seems by “capital” to mean the stock of goods, at another moment the gold or note reserve of the Bank of England. But on neither interpretation do his words carry any intelligible meaning. The stock of goods will certainly fall off when there is any undue conversion of liquid capital into fixed capital. But how can a scarcity of goods be regarded as a cause of a rise in the rate of interest or of a fall in prices? On the contrary, the smaller the available amount of commodities the smaller, other things being equal, is the demand for money. It follows that the rate of interest will fall rather than rise and that prices will go up still further. As for the stock of money, it is clearly impossible for this to alter at all as a result of a conversion of liquid capital into fixed capital.

Such mistakes on the part of distinguished writers provide a good indication of the difficulties of the subject. To avoid them, it is, I think, best for the moment to leave on one side variations in real capital, which only complicate the argument, and to concentrate on changes in the money or credit markets, assuming that the situation in the commodity market remains unaltered. It will then be possible later on to combine the two forces, and this in fact is the line of treatment which we shall pursue.

If an attempt had been made to search for the real cause, instead of being satisfied with such catch-phrases as “capital loaned in the form of money”, it would have been seen that the connecting link is supplied by the level of commodity prices. The only possible explanation lies in the influence which is exerted on prices by the difference between the two rates of interest. When the money rate of interest is relatively too low all prices rise. The demand for money loans is consequently increased, and as a result of a greater need for cash holdings, the supply is diminished. The consequence is that the rate of interest is soon restored to its normal level, so that it again coincides with the natural rate.

At the same time it is clear that in an elastic monetary system, where there is only a small reaction against an alteration in prices, a fairly constant difference between the two rates of interest could be maintained for a long time, and the effect on prices might be considerable.

The various practical obstacles which stand in the way of ideally perfect mobility of money are gradually being removed as a result of concentration in the hands of the banks of cash holdings and of the business of lending, and of the use of bills and notes, cheques and clearing methods. Money is continually becoming more fluid, and the supply of money is more and more inclined to accommodate itself to the level of demand. We have seen that in our ideal state every payment, and consequently every loan, is accomplished by means of cheques or giro facilities. It is then no longer possible to refer to the supply of money as an independent magnitude, differing from the demand for money. No matter what amount of money may be demanded from the banks, that is the amount which they are in a position to lend (so long as the security of the borrower is adequate). The banks have merely to enter a figure in the borrower’s account to represent a credit granted or a deposit created. When a cheque is then drawn and subsequently presented to the banks, they credit the account of the owner of the cheque with a deposit of the appropriate amount (or reduce his debit by that amount). The “supply of money” is thus furnished by the demand itself.5

The banks need not worry whether the dates on which their deposits become due correspond with the periods over which their loans have been granted. From our assumption that every withdrawal of a deposit must directly entail the deposit of an equal sum elsewhere or the repayment of an equal loan, it follows that the banks, or rather the aggregate of banks taken as a whole, can within limits to be stipulated in a moment lend any desired amount of money for any desired period of time at any desired rate of interest, no matter how low, without affecting their solvency, even though their deposits may be falling due all the time. It follows that if the rest of our theory is correct the banks can raise the general level of prices to any desired height.

In the next chapter we shall be discussing incidentally some of the ensuing consequences. They are the more interesting in that they run completely counter to the ordinary view. For instance, it can be seen that the credit institutions, by supporting long-term enterprises, can to some degree force the necessary real capital out of the public.

It is also possible for the banks to maintain their rates of interest above the normal level for any length of time. They are thus able, within certain limits, to exert a continual downward pressure on prices.

We now have to investigate the limits which on one side or the other restrict the power of the banks.

It is, of course, clear that our discussion would have no application whatever to the case of an individual bank trying to pursue a discount policy different from that of the other banks. Such action is impossible. If a single bank were to maintain either too low or too high a rate of interest it would rapidly bring about either its own insolvency or the loss of all its borrowers, and the dividends of its shareholders would disappear. An individual bank must in some degree conform to the general movement.

The banks of a single country of which the money is based on a metallic (international) standard are in the same situation vis-à-vis foreign banks. If rates of interest are maintained at too low a level the precious metal flows away; and if rates are too high the domestic market becomes saturated with foreign metal, which must be accepted by the banks in the form of deposits on which interest has to be paid, for otherwise it would cause competition against them in their capacity as lenders.

The classical view is, of course, that these effects are brought about as a result of changes in the domestic price level, and consequently in the balance of trade and in the rate of exchange. According to Tooke, on the other hand, a fall in the domestic rate of interest causes an immediate outflow of the country’s money capital, attracted by more profitable opportunities for investment abroad, before it has had time to exert any influence on prices.6

Which explanation is correct can be regarded as a matter of indifference; for the final result is in both cases the same, nor does the one exclude the other. But the older view seems to have the advantage of greater generality. A country’s rate of interest can be low in relation to its natural rate without standing so much below the foreign rate of interest as to compensate for the costs and risks of a movement of capital. The effects of easier credit are then confined to its influence on domestic prices. This influence is cumulative, and the domestic price level must soon lie so much above the foreign price level that exports fall off, imports increase, the balance of trade begins to become unfavourable, and money begins to flow out of the country.

Still more so if the natural rate happens to be higher at home than abroad. If the money rate of interest were to remain the same at home as abroad, then, according to those who deny that the banks’ discount policy has any influence on prices, no influx of foreign capital could take place, in spite of the difference, possibly considerable, between the two natural rates. This seems unplausible. Actually domestic prices would constantly rise, and as a result the balance of payments and the rate of exchange would gradually deteriorate until the credit institutions would find it necessary to raise their rates of interest above those of foreign countries. An influx of foreign capital would ensue, possibly for a considerable period of time, though as a result of the difference in the two price levels, this influx would take the form, not of money, but of commodities. In other words, a portion of foreigners’ claims on goods would be utilised, directly or indirectly, for the purchase of domestic securities, debentures, and shares, and for the acquisition of bank deposits. Meanwhile foreign countries would become relatively poor in respect to real capital, and domestic wealth would increase, and the natural rate of interest on capital would rise abroad and fall at home; so that finally economic equilibrium would be restored.

Interest and dividends would now have to be paid to foreigners, and consequently, as we shall see later, the equilibrium level of domestic prices would be somewhat lower than that abroad.

Recent investigations of international movements of money seem to me on the whole to have confirmed the comparative validity of the older point of view.7

If, on the other hand, taking an international point of view, we suppose that the same movement is undertaken, consciously or unconsciously, by every bank in the world, or at any rate in the gold-standard countries, the matter assumes an entirely different appearance.

The question with which we are faced is whether the banks could continually maintain a rate of interest below the natural rate, and so drive up prices higher and higher. If we are looking at the matter purely with regard to the banks’ solvency, and are assuming that the credit system has been fully developed in every country, there is clearly no other limit than that which arises out of the absorption of the precious metal in industrial uses. A fall in the purchasing power of money discourages the production of gold and, other things being equal, it increases the consumption of gold in industry. As soon as consumption began to outstrip production the deficiency would have to be supplied out of the banks’ stocks, for no other source is allowed for.

But under actual conditions there is a considerable quantity of coin in circulation—or of notes, which under the banking laws of many countries comes to the same thing. The limit is now, of course, much narrower. A rise in prices exerts its influence, not only on the relation between the production and consumption of gold, but to a much more important extent on the demands of the monetary circulation. The quantity of coins and notes circulating in the hands of the public is usually much larger than the available reserves of the banks. It follows that quite a small rise in prices may bring about a very significant contraction of the banks’ reserves.

It, is, however, unlikely that, other things being equal, a rise in prices will cause a proportional increase in the quantity of gold and notes in circulation, particularly not of the former. Just as the richest of us does not need to carry with him more than fifty pfennig or one mark in nickel and about ten marks in silver, so there is a certain limit beyond which most payments are made, no longer in gold, but in notes, and a further limit above which they are normally effected by means of cheques. A general rise in prices will bring an increased proportion of the aggregate of payments above one or other of these dividing lines, so that in direct consequence the ratio of notes and cheques to gold coins is increased. (At the same time the constant development of banking technique is responsible for a displacement of coins and notes by cheques.)

But it is very doubtful whether this limit has ever actually been reached, particularly during recent years. For gold has been accumulating in the shape of banking reserves and the uncovered note issue frequently falls short of the legal limit. The operation of this limiting factor can least of all be maintained by those who deny the existence of any connection between the magnitude of available stocks of gold and the level of prices. For if the banks were in practice prevented out of regard for their reserves from lowering their discount rates, what answer would be available in reply to the bimetallists, who find in this factor the very cause of falling prices?8 It is irrelevant to point out that the rate of discount has stood at a lower level in recent times than in the period before 1873. We have already indicated that it is never a question of the absolute level of the rate of interest, but of the level of the lending rate relatively to the uncontrolled rate9 (the natural capital rate).

Once it is admitted that at the present time the banks’ reserves are unnecessarily large and could be diminished without endangering their solvency, it must also be admitted that the banks could lower their rates of interest still further if they desired to do so; at the most it could only be the unnecessary stringency of legal restrictions which prevents them.

It is difficult to understand the view expressed by W. Scharling that “gold does not accumulate in the banks because it can find no use as a commodity, but because great stocks of capital which can find no profitable use are represented by the gold lying in the banks, and require this gold to represent them”.10 It must be left undecided whether unused real capital, that is to say, stocks of commodities awaiting sale, are greater to-day in relation to the volume of production and consumption than was formerly the case. Even if it were so and if it were desired to regard the gold lying unused in the banks as “representative” of stocks of commodities, which it could be instrumental in purchasing and disposing of when trade improved—this manner of speaking is purely metaphorical—there would still be no reason why the banks should not at once offer the gold by way of loans. If they are unwilling to do so, that is to say, if they cannot bring themselves to lower their rates of interest, they must have their reasons, some of which we shall set out in a moment. Here lies the direct cause, and in no other “scarcity of gold”, for falling prices.

As a matter of fact, Scharling himself, at the end of his very noteworthy discussion, admits that at the present time the banks’ stocks of gold are from every point of view unnecessarily large.

We turn now to the opposite question. Is there anything to prevent the banks from maintaining the rate of interest above the natural rate? It is clearly no longer a question of the banks’ solvency—provided that in other respects the banks are solvent in the ordinary sense of the word, their assets exceeding their liabilities. It is now a question purely of the banks’ economic interests.11 Our theory tells us that such behaviour will result in a continual fall in prices and a continual rise in the purchasing power of gold. The production of gold will become more profitable, and, other things being equal, its output will increase, though possibly not by very much; while the consumption of gold will be curtailed, and, more important, larger and larger quantities of gold and notes will flow out of circulation into the banks as a result of the change in prices. It is true that any simultaneous increase in population and in economic welfare and any development of the monetary system (at the expense of the natural system of economy) will exert a somewhat moderating influence. On the other hand, the development of the monetary system carries with it a continual expansion in the use of credit and of banking facilities, and consequently the tendency for money to pass out of circulation is accentuated.

We have already seen that the banks have to accept these sums on deposit and pay interest on them even though they do not really want to; and they have to pay a rate which falls only a little short of their own discount rate, for otherwise they would suffer from competition with private lenders. (There is an exception in the case of central banks, for reasons which need not here be discussed. In any case, most of the gold which accumulates in the central banks does not reach them by way of deposits, but as a result of exchange against notes, part of which then remain in the tills of the other banks.) The banks may dispose of these deposits in interest-earning securities and stocks, but this does not curtail the superfluity of money, for the money which is thereby released has in its turn to find a use. Ultimately the banks have no alternative but to lower their discount rates, so as to stimulate the diminishing demand for money. This checks or overcomes the upward movement of prices, and a point is soon reached where the circulation is once again sufficient to absorb the excess of gold and notes.

It is thus confidently to be expected that the Bank rate, or more generally the money rate of interest, will always coincide eventually with the natural capital rate, or rather that it is always tending to coincide with an ever-changing natural rate. But whether this result is achieved with sufficient rapidity to prevent a continual rise in prices at times when the capital rate is rising (so that the money rate is left below the natural rate), or to obviate a gradual fall in prices at times when the capital rate is falling (and consequently the money rate is left higher than the natural rate), seems a priori very doubtful. This question involves a survey of various complications which unfortunately requires a far more intimate insight into the secrets of banking technique than is at my disposal, particularly as the matter is partly associated with forces tending in contrary directions.

For instance, it is in the interests of the banks of issue to have as large a note issue as possible, in so far as they can issue notes against a purely banking12 cover. They can content themselves for a time with a somewhat low rate of interest inasmuch as the rise in prices, and the consequent increase in the demand for instruments of exchange, will soon enable them to raise their rate. If notes constituted the sole means of exchange, the extent of the note issue would be a matter of indifference; for the value of money would then vary in inverse ratio to the size of the note issue. But this is no longer true if the banks can with their notes displace, in whole or in part, such other instruments as bills, cheques, and cash.

Precisely in the opposite direction lie the interests of those banks which do not issue notes and at the same time possess much capital of their own. A high rate of interest increases their profits, and the consequent fall in prices does them no harm—indeed, the higher the purchasing power of gold the greater is the value of their own property. Finally we have those banks which neither issue notes nor possess much capital. To them the level of prices and the magnitude of the rate of interest are both matters of almost complete indifference (their profits originating principally out of the difference between the rates for borrowing and for lending). Here, however, we have to deal with a new, and very subtle, consideration. If the banks maintain a discount rate, and consequently a deposit rate, which is too low in relation to the natural rate, many capitalists will withdraw their deposits in order themselves to become entrepreneurs in such guises as those of shareholders and sleeping partners. This will not imperil the banks’ solvency, or at any rate not nearly so much as would at first sight appear. In a pure cheque economy, the withdrawal of deposits must always (for the banks taken as a whole) bring about either the making of fresh deposits or the repayment of loans. In the case which we are considering, it is the latter effect which must be realised. As a result of the assumption by a large number of capitalists of the rôle of entrepreneur, there is a necessary decline, ceteris paribus, in the activity of those businesses which work on borrowed capital. Their owners find no further use for part of the credit which they have been employing, and repay it to the banks. There is consequently a contraction in banking activity, or at any rate it fails to expand in the same measure as prices rise, i.e. as the value of money declines. The opposite would be the case—banking activity would expand relatively to the level of prices—if the banks maintained too high rates on loans and deposits. It follows that it is in the interests of the banks to maintain their rates of interest at a high rather than at a low level. But there is always the danger of stifling the spirit of enterprise, a consideration which tells in the opposite direction.

I am unable, as I have said, to assess the importance in actual banking practice of these various factors.

I content myself with a reference to one feature which is universally admitted to be of predominant importance in determining banking policy—the influence of habit and of routine. A bank manager occupies a position of high responsibility, and a great deal depends on his actions. If he is conscientious it will not occur to him to indulge in unnecessarily dangerous ventures and experiments. He is a servant of routine, and it is only when circumstances are completely altered that he will deviate from the tradition which, adopted by his bank, has been tested by experience.13 As regards bank-rate policy, there is a far stronger reason for the maintenance of fixed rules of conduct. For neither an individual bank nor the banks of an individual country can on their own initiative embark on any change without keeping in accord with the procedure adopted by other banks. The open market may perhaps seem to present a somewhat more lively picture, but it is practically certain that the lending rate of interest never follows directly on movements of the natural rate, and usually follows them only very slowly and with considerable hesitation. During the period of transition, the deviation between the two rates has full play, resulting in that phenomenon, often referred to above, which on a superficial view appears to contradict our theory but in reality is in complete accordance with it: prices rise when the rate of interest (the capital rate and consequently the money rate) is high and rising, and in the contrary case they fall.

This brings us to a consideration which has for a long time been emphasised by various writers. When the rate of interest (both the capital and the money rate) is high, there is an obvious tendency for money to circulate somewhat more rapidly, for “hoards” of coin and bullion to be drawn out of their hiding-places, and for the employment of all credit instruments to become more profitable—in short, there is a tendency for prices to rise (though only once and for all, not progressively). A low rate of interest has in all respects the opposite tendency: certain kinds of credit instrument can no longer be used at all, because such payments as the stamp duty on bills and the tax on notes would absorb too substantial a part of the interest: other things being equal, prices stand at a lower level.

In its essence this is merely a special case of our general proposition. For it is only so long as these various factors maintain the money rate of interest either above or below the appropriate level of the natural rate that prices will continue moving in the one direction or the other. Eventually the normal relation between the two rates must be’ attained, and any further rise or fall in prices is then impossible.

The phenomenon of lending provides our principle with a comprehensive basis; for the only possible limit to the demand for loans, and with their assistance for goods and services, and therefore the only possible limit to a rise in prices, is to be found where the expected gain corresponds to no more than the payment which has to be made for the “use” of the money.

The fundamental ideas of the last two chapters can now be summarised as follows:

At any moment and in every economic situation there is a certain level of the average rate of interest which is such that the general level of prices has no tendency to move either upwards or downwards. This we call the normal rate of interest. Its magnitude is determined by the current level of the natural capital rate, and rises and falls with it.

If, for any reason whatever, the average rate of interest is set and maintained below this normal level, no matter how small the gap, prices will rise and will go on rising; or if they were already in process of falling, they will fall more slowly and eventually begin to rise.

If, on the other hand, the rate of interest is maintained no matter how little above the current level of the natural rate, prices will fall continuously and without limit.

In the interests of accuracy, we have purposely avoided the statement that for the maintenance of stable prices it is necessary that the money and natural rates should be equal. In practice they are both rather vague conceptions, if it is a general mean level that is under discussion, and their exact determination, even from the theoretical point of view, involves great difficulties. On the basis of one definition it would be correct to speak of an absolute equality between the two rates; according to another it would be a question of the constancy of the excess of the natural rate over the money rate, corresponding to the unavoidable risks of enterprise and the like. The essential point is that the maintenance of a constant level of prices depends, other things remaining equal, on the maintenance of a certain rate of interest on loans, and that a permanent discrepancy between the actual rate and this rate exerts a progressive and cumulative influence on prices.

In two later chapters we shall subject our theory to the test of experience, in the shape of actual movements of prices. Some further theoretical discussion is, however, desirable. We shall begin by examining more closely the causes which determine the natural rate of interest, and we shall deal more systematically with the probable influence on prices of a deviation of the money rate of interest from the natural rate. Here we shall base our treatment on certain quantitative relations, and we shall have to resort to highly simplified assumptions which differ widely from the conditions of reality.

Many will doubt the usefulness of such an investigation, but it provides, in my opinion, a convenient opportunity for gathering together all the threads of the argument. Experience suggests that in any discussion of the complicated conditions of reality there is constant danger of overlooking or losing sight of what may perhaps be the most important elements in the problem.

But those of my readers who have no love for the methods of abstraction may omit the following chapter. It does not contain any positive extension of the propositions which have already been set out, and it is not absolutely necessary for an understanding of the argument of the later portions of the book. It is written for those who, like myself, regard as the prime requisite of a scientific theory that it shall be capable of being set out in a form that is self-contained and free of inconsistency, even if at first the assumptions have to be of a purely imaginary character.

 

_____________

14 See p. 74 ff.

15 [From now on, “natural rate” will be used to denote “natural rate of interest on capital”.]

16 Money in its relations to Trade and Industry, p. 80.

17 “A Serious Fall in the Value of Gold”, Investigations in Currency and Finance, pp. 31, 32 [second edition, pp. 27, 28]. The italics are mine. A similar treatment is to be found in Nasse, loc. cit., p. 149 ff., and also in Scharling, Preussiche Jahrb., 1895 (see p. 115, below).

18 Cf. Emil Struck, “Skizze dea englischen Geldmarktes”, Separat-abdruck of the Jahrbuch für Gesetzgebung, Jahrg. X., p. 45 ff.

19 Cf. History of Prices, vol. iv., pp. 197-202. But here Tooke himself admits that a low rate of interest tends to stimulate enterprise and so indirectly to raise prices, in peculiar contradiction to his view, referred to above, that low rates of interest must lead to lower prices.

20 Cf. Carl Heiligenstadt, “Beiträgo zur Lehre von den auswärtigen Wechselkursen”, Jahrbüicher fur Nationalökonomie, vols. 59-61, 1892-3.

21 Cf. O. Arendt, Die vertragsmässige Doppelwährung, vol. i., p. 166 ff.

22 [“Verkehrszins” in original.]

23 Preussiche Jahrb., 1895. See also Nationalökonomisk Tidskrift (Copenhagen), 1895.

24 It will become clear that this factor playa a part also in setting a lower limit to the rate of interest.

25 [“bankmässige” in original.]

26 Gilbart maintains (Practical Treatise on Banking, i., section iv.) that the director of a bank must always follow certain general “principles”; but he goes much further in emphasising that these principles must always he followed than in defending them against objection. In the light of what is said above, this attitude can easily be understood.

• 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.
• 5In 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.
• 6I 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.
• 7Let 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.”
• 8In 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”.
• 9In 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.
• 10Wicksell always insisted that this reasoning did not mean more than an amplification of the old quantity theory. Moreover, he always regarded his own contribution as a doubtful hypothesis and never became as convinced of its tenability as did some of his pupils. He explicitly rejected the idea that his theory provided an explanation of the business cycle. He was critical of Mises’ idea that mistaken credit policy is the origin of the tendencies towards booms and depressions. A brief quotation will indicate his position: “Our conclusion is, therefore, that although the changes in the purchasing power of money, caused by credit policy, are under present conditions intimately bound up with the business cycle and without any doubt also influence the latter, above all by giving rise to crises, yet it does not seem essential to assume that there is, by the nature of things, any necessary connection between these two phenomena. The main cause of the business cycle, and a sufficient cause, seems to be the fact that technical and commercial progress cannot by its very nature give rise to a series which proceeds as evenly as the growth in our time of human needs—due above all to the organic increase in population—but is now accelerated now retarded. In the former case ... a mass of circulating capital is transformed into fixed capital, a process which, as I have said, accompanies every rising business cycle: it seems as a matter of fact to be the one really characteristic sign, or one in any case which it is impossible to conceive as being absent.”. . . “If the banks already at the beginning of a rising period sufficiently raised their interest rates, but on the other hand reduced them energetically when the depression was about to set in”, then the price level would probably remain stable, although raw materials for fixed capital would rise in price during periods of good trade and fall during times of bad trade. “Under such circumstances the chief crises-causing factor would probably have disappeared, and what remained would be only a quiet wave movement between periods of accelerated formation of fixed capital and periods when the new capital assumed . . . other forms.” . . . “Increase in commodity stocks is probably the most important form of real investment during so-called bad trade.”
• 11During 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.
• 12Briefly 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.”
• 13Wicksell 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 ”.
• 14Wicksell always insisted that this reasoning did not mean more than an amplification of the old quantity theory. Moreover, he always regarded his own contribution as a doubtful hypothesis and never became as convinced of its tenability as did some of his pupils. He explicitly rejected the idea that his theory provided an explanation of the business cycle. He was critical of Mises’ idea that mistaken credit policy is the origin of the tendencies towards booms and depressions. A brief quotation will indicate his position: “Our conclusion is, therefore, that although the changes in the purchasing power of money, caused by credit policy, are under present conditions intimately bound up with the business cycle and without any doubt also influence the latter, above all by giving rise to crises, yet it does not seem essential to assume that there is, by the nature of things, any necessary connection between these two phenomena. The main cause of the business cycle, and a sufficient cause, seems to be the fact that technical and commercial progress cannot by its very nature give rise to a series which proceeds as evenly as the growth in our time of human needs—due above all to the organic increase in population—but is now accelerated now retarded. In the former case ... a mass of circulating capital is transformed into fixed capital, a process which, as I have said, accompanies every rising business cycle: it seems as a matter of fact to be the one really characteristic sign, or one in any case which it is impossible to conceive as being absent.”. . . “If the banks already at the beginning of a rising period sufficiently raised their interest rates, but on the other hand reduced them energetically when the depression was about to set in”, then the price level would probably remain stable, although raw materials for fixed capital would rise in price during periods of good trade and fall during times of bad trade. “Under such circumstances the chief crises-causing factor would probably have disappeared, and what remained would be only a quiet wave movement between periods of accelerated formation of fixed capital and periods when the new capital assumed . . . other forms.” . . . “Increase in commodity stocks is probably the most important form of real investment during so-called bad trade.”
• 15Wicksell 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.”
• 16As 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.
• 17As Wicksell worked on monetary problems for almost three decades after the publication of the Geldzins, it may be worth while to say something here about the changes which his views underwent. These were not, as a matter of fact, considerable. Although he was always ready to question his own reasoning, his lively discussions with other Swedish economists do not seem to have left many traces on his theory. Take, for instance, his discussion with Professor Davidson. In 1906 Davidson, whom Wicksell held in the highest esteem, suggested that during periods of rapid technical progress and increasing productive efficiency a greater stability of business would be ensured if commodity prices fell in proportion to the increase in output than if they remained stable. Davidson asserted that if the money rate of interest and business profits (Wicksell’s natural rate) stood in a normal relation to one another before the increase in efficiency, then they would continue to do so if prices fell in proportion to the latter. There would be no need for a change in the money rate of interest. If it were reduced to prevent a fall in the price-level, it would be too low in relation to profits, and a process of an inflationary character would start. To this Wicksell replied: “In the case which Davidson has chosen it may appear that the increase in profits due to increased productivity and the reduction in profits due to the fall in prices, caused on his assumption by the former, would offset one another. But surely this would only happen if the price movement could be anticipated beforehand and estimated, or if it were so even and had lasted for so long that it had come to be generally regarded as something constant? In general, however, the individual business man will make his calculations for the future, and so fix his demand for labour, raw materials, and credit on the basis of current prices.” Hence, prices would rise if the money rate were not immediately raised, and when some time later the increase in productivity had led to a greater supply of finished goods, so that prices would fall, business men would make losses and the situation would be disturbed.
• 18Loc. cit., pp. 65, 66.
• 19An 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.
• 20Preface.
• 21Lectures, 2nd Swedish ed., p. 202. See also Cassel, Theory of Social Economy, § 48.
• 22Ibid., p. 393.
• 23Ibid., p. 198.
• 24“The Monetary Problem of the Scandinavian Countries,” Ekonomisk Tidskrift, 1925; translated below, p. 199 ff.
• 25Pp. 201, 202, below.
• 26P. 210, below.