Prices and Production

LECTURE 4

The notion common... to 90 per cent, of the writings of monetary cranks is that every batch of goods is entitled to he born with a monetary label of equivalent value round its neck, and to carry it round its neck until it dies.

D.H. Robertson Economica 23 (June 1928): 142

(1) If the considerations brought forward in the last lecture are at all correct, it would appear that the reasons commonly advanced as a proof that the quantity of the circulating medium should vary as production increases or decreases are entirely unfounded. It would appear rather that the fall of prices proportionate to the increase in productivity, which necessarily follows when, the amount of money remaining the same, production increases, is not only entirely harmless but is in fact the only means of avoiding misdirections of production. So far as an increase of production caused by a transition to more capitalistic methods of production is concerned, this result bears some resemblance to the theory underlying certain proposals for stabilizing the value of money so as to keep, not the prices of consumers’ goods, but incomes, or the prices of the factors of production constant, the prices of consumers’ goods being allowed to fall as costs fall and vice versa.71 Complete invariability of the effective money stream would, as we have seen, however, have the further effect that any transition to more capitalistic methods of production would also make a reduction of money income necessary, except in the case of complete vertical integration of production. This necessity, which in view of the notorious rigidity of wages is certainly very undesirable, could however only be avoided without causing misdirections of production, if it were possible to inject the required additional quantities of money in such a way into the economic system that the proportion between the demand for consumers’ goods and the demand for producers’ goods would not be affected. This is no doubt a task which cannot be solved in practice. But apart from the special difficulties which may arise from the existence of rigidities I believe that the conclusion stated above holds here not only for this case of the transition to more capitalistic methods of production but also for an increase of production caused by the absorption of unused resources. Furthermore, by another chain of reasoning—which is too long and complicated to reproduce here, and which I have sketched elsewhere72—it might be shown to apply in principle even to the particularly difficult case of an increase of production caused by the growth of population, the discovery of new natural resources, and the like. But however that may be, our result is in sufficient contrast to generally received opinions to require further elucidation.

(2) We can best observe how deeply the notion that it is the “natural” thing for the quantity of money to fluctuate with fluctuations in the volume of production is ingrained in the minds of many modern economists if we look at the use they make of it in their theoretical analysis. Professor Cassel, for instance, who is of course the outstanding representative of this point of view, discussing the treatment of price problems73 in a recent article, writes as follows: “The simplest assumption is, then, that a country has a paper currency so regulated as to keep the general level of prices constant.” And again—to quote another well-known authority—Professor Pigou is expressing the same opinion when he argues74 that if countries with paper currencies will regulate them with a view to keeping the general price level in some sense stable, there will be no impulses from the side of money which can properly be called “autonomous.” Both statements imply that changes in the quantity of the circulating medium which are only just sufficient to keep the general price level steady exert no active influence on the formation of prices, and that, accordingly, a money so regulated would remain “neutral” toward prices in the sense in which I have used the word. I see no foundation at all for this hypothesis, although by most it seems to be considered as an obvious platitude requiring no further justification. Everything that has been said in the earlier lectures seems to me to prove that changes in the volume of the circulation which are supposed to be justified by changes in the volume of production will have effects which are just as disturbing as those changes of the circulation which cause changes in the general price level. Prima facie, I suggest that we should expect rather that, to be neutral in this sense, the supply of money should be invariable. The question is, can this be true? Are there not many other reasons besides a change in the volume of production which experience suggests justify changes in the quantity of money in circulation if serious disturbances are to be avoided?

I suppose that, to most economists, the idea of a circulating medium which does not vary in amount will seem perfectly absurd. We have all been brought up upon the idea that an elastic currency is something highly to be desired, and it is considered a great achievement of modern monetary organization, particularly of the recent American Federal Reserve system, to have secured it. It does not seem open to doubt that the amount of money necessary to carry on the trade of a country fluctuates regularly with the seasons, and that central banks should respond to these changes in the “demand for money,” that not only can they do this without doing harm, but that they must do so if they are not to cause serious disturbances. It is also a fact which has been established by long experience, that in times of crisis central banks should give increased accommodation and extend thereby their circulation in order to prevent panics, and that they can do it to a great extent without effects which are injurious. How are we to reconcile all this with the conclusions of my earlier lectures?

(3) To begin with certain terminological elucidations. It should be fairly clear that the magnitude which in the course of my theoretical analysis I have called “quantity of money in circulation” and that commonly referred to under the same name in dealing with the practical problems mentioned before are not identical, but different in two respects. When, in the course of analysis, I speak of changes in the quantity of money, this is always meant to include that total of all kinds of media of exchange (including all so-called “substitutes” for money) used in either a closed economic system (i.e., in a country which has no communication with the outside world) or in the world as a whole. But when dealing with practical problems we speak of the quantity of money in circulation, we always mean the quantity of any particular kind or kinds of media of exchange used within one or several countries which form a part of a larger economic unit. Now, as we shall see, it follows from the definition of the quantity of money in circulation in open communities that the quantity of money thus defined will always be liable to fluctuations even if we suppose that the quantity included in the more comprehensive theoretical concept remains unchanged. It is probably this fact which makes it so difficult even theoretically to conceive the possibility or usefulness of an invariable circulation.

The fact that the monetary circulation of any one country, whatever we include under the heading money, will always show natural fluctuations in conforming with an increase or decrease of the volume of local production is probably the main reason why elasticity is generally considered a self-evident necessity for the amount of money in general. But the question we have to answer is just this. Do the reasons which make fluctuations of the circulation of any single country necessary apply when we are considering the quantity of money as a whole?75 The answer is simple. The increase or decrease of the quantity of money circulating within any one geographical area serves a function just as definite as the increase or decrease of the money incomes of particular individuals, namely the function of enabling the inhabitants to draw a larger or smaller share of the total product of the world. The relative magnitude of the total incomes of all individuals in an “open” community will always stand in a definite proportion to the share of the total product of the world which the people of that community command. And, if the money circulating within that nation regularly increases as a consequence of an increase of its product, this is only one of the steps in the process of adjustment which are necessary to enable that nation to procure a larger portion of the product of the world for itself. What appears to be an absolute increase of the amount of money in circulation consequent upon an increase of production, if viewed from the standpoint of a single country, proves to be nothing but a change in the relative local distribution of the money of all nations, which is a necessary condition of a change in the distribution of the product of the world as a whole. The same thing would happen, and would be just as necessary to restore equilibrium, if the product of this country were not absolutely increased but the products of all other countries were absolutely diminished. The fact that the increase of the product of any one country is regularly accompanied by an increase of the quantity of money circulating there, is therefore not only no proof that the same would be necessary for an isolated community, it rather shows by contrast how useless would be an increase of its monetary circulation either for such a community or for the world as a whole. While for any single country among others an increase of its possession of money is only a means of obtaining more goods, for the world as a whole the increase of the amount of money only means that somebody has to give up part of his additional product to the producers of the new money.

(4) The second source of the prevalent belief that, in order to prevent dislocation, the quantity of the circulating medium must adapt itself to the changing needs of trade arises from a confusion between the demand for particular kinds of currency and the demand for money in general.76 This occurs especially in connection with the so-called seasonal variations of the demand for currency which in fact arises because, at certain times of the year, a larger proportion of the total quantity of the circulating medium is required in cash than at other times. The regularly recurring increase of the “demand for money” at quarter days, for instance, which has played so great a role in discussions of central bank policy since attention was first drawn to it by the evidence of J. Horsley Palmer and J.W. Gilbart before the parliamentary committees of 1832 and 1841, is mainly a demand to exchange money held in the form of bank deposits into bank notes or coin.77 The same thing is true in regard to the “increased demand for money” in the last stages of a boom and during a crisis. When, toward the end of a boom period, wages and retail prices rise, notes and coin will be used in proportionately greater amounts, and entrepreneurs will be compelled to draw a larger proportion of their bank deposits in cash than they used to do before. And when, in a serious crisis, confidence is shaken, and people resort to hoarding, this again only means that they will want to keep a part of their liquid resources in cash which they used to hold in bank money, etc. All this does not necessarily imply a change in the total quantity of the circulating medium, if only we make this concept comprehensive enough to comprise everything which serves as money, even if it does so only temporarily.

(5) But at this point we must take account of a new difficulty which makes this concept of the total quantity of the circulating medium somewhat vague, and which makes the possibility of ever actually fixing its magnitude highly questionable. There can be no doubt that besides the regular types of the circulating medium, such as coin, bank notes and bank deposits, which are generally recognized to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, ceteris paribus, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

In particular, it is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economize money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required. The criterion by which we may distinguish these circulating credits from other forms of credit which do not act as substitutes for money is that they give to somebody the means of purchasing goods without at the same time diminishing the money-spending power of somebody else. This is most obviously the case when the creditor receives a bill of exchange which he may pass on in payment for other goods. It applies also to a number of other forms of commercial credit, as, for example, when book credit is simultaneously introduced in a number of successive stages of production in the place of cash payments, and so on. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided. But it is important not to overlook the fact that these forms of credits owe their existence largely to the expectation that it will be possible to exchange them at the banks against other forms of money when necessary, and that, accordingly, they might never come into existence if people did not expect that the banks would in the future extend credit against them. The existence of this kind of demand for more money, too, is therefore no proof that the quantity of the circulating medium must fluctuate with the variations in the volume of production. It is only a proof that once additional money has come into existence in some form or other, convertibility into other forms must be possible.

(6) Before proceeding to investigate whether there exist any genuine reasons which would make changes in the amount of the circulation necessary in order to keep money entirely neutral toward the economic process (i.e., to prevent it from exercising any active influence on the formation of prices), it is useful to ask whether, under the circumstances just described, it is at all conceivable that the quantity of the circulating medium can be kept invariable, and by what means a monetary authority could attain that end. I may say at once that, in spite of the qualifications that I shall introduce later, this question seems to me not merely a question of theoretical interest, but also a question the answer to which may prove very important in the shaping of a more rational monetary policy.

The credit system of a country has very often been compared to an inverted pyramid, a simile which serves very well for our purpose. The lowest part of the pyramid corresponds of course to the cash basis of the credit structure. The section immediately above corresponds to central bank credit in its various forms, the next part corresponds to the credits of commercial banks, and on these finally is built the total of business credits outside the banks. Now it is only in regard to the two lower parts, cash and central bank credit, that an immediate control can be exercised by the central monetary authority. So far as the third part, the credits of the commercial banks, are concerned, it is at least conceivable that a similar control could be exercised. But the uppermost section of the pyramid—private credits—can be controlled only indirectly through a change in the magnitude of their basis, i.e., in the magnitude of bank credit. The essential thing is that the proportion between the different parts of the pyramid is not constant but variable, in other words that the angle at the apex of the pyramid may change. It is a well-known fact that, during a boom, the amount of central bank credits erected upon a given cash basis increases, and likewise the amount of credits of the commercial banks based on a given amount of central bank credit, and even the amount of private credits based on a given amount of central bank credit. This is certainly true on the continent of Europe, where the possibility of rediscounting takes to a large extent the place of actual cash reserves. So that, even if central banks should succeed in keeping the basis of the credit structure unchanged during an upward swing of a cycle, there can be no doubt that the total quantity of the circulating medium would nonetheless increase. To prevent expansion, therefore, it would not be sufficient if central banks, contrary to their present practice, refrained from expanding their own credits. To compensate for the change in the proportion between the base furnished by the credit and the superstructure erected upon it, it would be necessary for them actually to contract credit proportionally. It is probably entirely utopian to expect anything of that kind from central banks so long as general opinion still believes that it is the duty of central banks to accommodate trade and to expand credit as the increasing demands of trade require. Unfortunately, we are very far from the more enlightened times when, as John Fullarton complained, “the words ‘demand’ and ‘legitimate demand’ could not even be mentioned in Parliament in connection with this subject unaccompanied by a sneer.”78 Nonetheless, I am strongly convinced that, if we want to prevent the periodic misdirections of production caused by additional credit, something very similar to the policy outlined above, absurd as it may seem to those accustomed to present-day practice, would be necessary. I do not delude myself that, in the near future, there will be any opportunity of experimenting with such a policy. But this is no excuse for not following the implications of our theoretical arguments right through to their practical consequences. On the contrary, it is highly important that we should become fully conscious of the enormous difficulties of the problem of the elimination of disturbing monetary influences, difficulties which monetary reformers are always so inclined to underrate. We are still very far from the point when either our theoretical knowledge or the education of the general public provides justification for revolutionary reform or hope of carrying such reforms to a successful conclusion.

(7) As a matter of fact, the course of our argument so far understates rather than overstates the real difficulties. I think that I have shown that changes in the physical volume of production offer no sufficient reason for variations in the supply of money. Nonetheless there do seem to me to exist other causes whose operation may necessitate such changes if the “natural” price system or the equilibrium of the economic process is not to be disturbed. So far, I have been able to neglect these causes, since what I have said has been subject to an assumption, which I expressly introduced at the outset, the assumption, namely, that the proportion between the total flow of goods and the part which takes the form of an exchange against money, or the rate at which goods are exchanged against money, remains constant. But this assumption must now be removed.

Now it will be remembered that the proportion in question is not necessarily changed by changes in the physical volume of production while the amount of money in circulation remains the same, nor by a variation of the quantity of money in circulation, while the physical volume of production remains the same; it changes only if movements of goods which before have been effected without the use of money now require the transfer of money, or if movements of goods which before could only be effected by means of money payments can now be effected without the use of money. It will be remembered further that changes in that proportion are caused by certain changes of the business organization, as the amalgamation of two firms into one, or the division of one firm into two, by the extension of the money economy into spheres where before everybody had only consumed his own product, or where barter had predominated, and the like. The question to which we must now address our attention is this: will not such changes in the proportions of money transactions to the total flow of goods make a corresponding change in the quantity of the circulating medium necessary?

The answer to that question depends upon whether, without such a corresponding change in the quantity of money, the change in business organization, would cause shifts in the directions of demand and consequential shifts in the direction of production not justified by changes in the “real” factors. That the simple fact that a money payment is inserted at a point in the movement of goods from the original means of production to the final stage where none has been necessary before (or the reverse) is no “real” cause in the sense that it would justify a change in the structure of production, is a proposition which probably needs no further explanation. If, therefore, we can show that, without a corresponding change in the amount of the circulation, it has such an effect, this would provide sufficient reason, in these circumstances, to consider a change in the amount of money to be necessary.

(8) Let us examine what happens when a firm which represents two different stages of production, say spinning and weaving, is divided into two independent firms. The movement of the yarn from the spinning to the weaving factory, which before required no money, will now be effected by a purchase against money. The new weaving firm, which before, as part of the larger concern, had to keep money only for the payment of wages, etc., will now require additional money balances to buy the yarns. The new owner, whom we will assume to have bought the weaving mill from the old firm, will therefore need additional capital beyond what was needed to buy the existing plant and equipment and to replace the cash balances kept by the former owner for that mill, in order to effect these new payments. If no new money is added to the amount already circulating, he will either have to take this sum from other employments where it cannot be replaced, causing an absolute reduction of the demand for capital goods, and consequently a shrinkage of the structure of production; or he will have to use new savings for that purpose, which would thus cease to be available for lengthening the roundabout processes—that is to say, to use a phrase of Mr. Robertson’s, they would become “abortive.” The effects would be the same as if, other things remaining the same, the total amount of money in circulation had been reduced by a corresponding sum used before for productive purposes. The two cases are so far alike that the change in the proportion between the demand for consumers’ goods and the demand for producers’ goods, which in the second case as in the first is not determined by “real” causes, will not be permanent: the old proportion will tend to re-establish itself. But if, from the outset, the demand of the new entrepreneur for the additional cash balances had been satisfied by the creation of new money, this change in the total quantity of circulation would not have caused a change in the direction of the demand, and would only have helped to preserve the existing equilibrium.

It would be easy to show, if time permitted, that in the contrary case, the merger of two firms, and in a number of similar changes in business organization, money is set free and that this money, if not withdrawn from circulation, would have the same effects as if so much money were added to the circulation. But I think that what I have already said on this point will be sufficient to justify the conclusion that changes in the demand for money caused by changes in the proportion between the total flow of goods to that part of it which is effected by money, or, as we may tentatively call that proportion, of the coefficient of money transactions, should be justified by changes in the volume of money if money is to remain neutral toward the price system and the structure of production.

All this assumes a greater importance if we remember that this coefficient of money transactions may not only change in time, but that, at the same moment of time, it may be different in different parts of an economic system, for instance because goods change hands at shorter intervals in the lower stages of production than they do in the higher stages. If this is the case, any transfer of money from one part of the economic system to another or from one stage of production to another where the coefficient of money transactions is different will also make a corresponding change of the amount of money in circulation necessary. If, for instance, money is transferred from a lower to a higher stage of production where the interval between two successive stages is twice as long, and, accordingly, only half as much money is needed to hold the same quantity of goods in that stage, half the money so transferred would become free. In the opposite case an addition of new money of an equal amount would be necessary. In such a situation, therefore, the transition to more or less capitalistic methods of production may also require a change in the quantity of money, not because the physical magnitude of the goods-stream has changed, but because money has been transferred from a sphere where the coefficient of money transactions has been higher to one where it is lower, or vice versa.

(9) And this is not the only exception to which our original maxim of policy, that the quantity of money should remain invariable, may be deemed to be subject.

The case just discussed is, in fact, only a special aspect of a more general and very familiar phenomenon which, so far, has been entirely neglected in these lectures. I refer to changes in what is commonly called the velocity of circulation. Up to this point I have treated the quantity of money in circulation and the number of payments effected during a given period of time as equivalent concepts, a method of procedure which implied the assumption that the velocity of circulation is constant. That is to say, the whole of my argument applies directly only to the amount of payments made during a period of time. It applies indirectly to the amount of money if we assume the “velocity of circulation” to be constant. So long as we make that assumption, or so long as we are speaking only of the volume of payments made during a period of time, the case just discussed seems to me the only exception to the general rule that, in order that money should remain neutral toward prices, the amount of money or the amount of money payments should remain invariable. But the situation becomes different as soon as we take into account the possibility of changes in methods of payment which make it possible for a given amount of money to effect a larger or smaller number of payments during a period of time than before. Such a change in the “velocity of circulation” has rightly always been considered as equivalent to a change in the amount of money in circulation, and though, for reasons which it would go too far to explain here, I am not particularly enamored of the concept of an average velocity of circulation,79 it will serve as sufficient justification of the general statement that any change in the velocity of circulation would have to be compensated by a reciprocal change in the amount of money in circulation if money is to remain neutral toward prices.

(10) Even now our difficulties are not at an end. For, in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy. No doubt the statement as it stands only provides another, and probably clearer, formulation of the old distinction between the demand for additional money as money which is justifiable, and the demand for additional money as capital which is not justifiable. But the difficulty of translating it into the language of practice still remains. The “natural” or equilibrium rate of interest which would exclude all demands for capital which exceed the real supply capital, is incapable of ascertainment, and, even if it were not, it would not be possible, in times of optimism, to prevent the growth of circulatory credit outside the banks.

Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by over-caution. Under existing conditions, to go beyond this is out of the question. In any case, it could be attempted only by a central monetary authority for the whole world: action on the part of a single country would be doomed to disaster. It is probably an illusion to suppose that we shall ever be able entirely to eliminate industrial fluctuations by means of monetary policy. The most we may hope for is that the growing information of the public may make it easier for central banks both to follow a cautious policy during the upward swing of the cycle, and so to mitigate the following depression, and to resist the well-meaning but dangerous proposals to fight depression by “a little inflation.”

(11) Anybody who is skeptical of the value of theoretical analysis if it does not result in practical suggestions for economic policy will probably be deeply disappointed by the small return of so prolonged an argument. I do not, however, think that effort spent in clearing up the conditions under which money would remain neutral toward the economic process is useless because these conditions will never be given in the real world. And I would claim for these investigations at least two things. The first is that, as I have said in my first lecture, monetary theory is still so very far from a state of perfection that even some of the most fundamental problems in this field are yet unsolved, that some of the accepted doctrines are of very doubtful validity. This applies in particular to the widespread illusion that we have simply to stabilize the value of money in order to eliminate all monetary influences on production and that, therefore, if the value of money is assumed to be stable, in theoretical analysis, we may treat money as nonexistent. I hope to have shown that, under the existing conditions, money will always exert a determining influence on the course of economic events and that, therefore, no analysis of actual economic phenomena is complete if the role played by money is neglected. This means that we have definitely to give up the opinion which is still widely prevalent, that, in the words of John Stuart Mill, “there cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money” which “like many other kinds of machinery only exerts a distinct and independent influence of its own when it gets out of order.”80 It means also that the task of monetary theory is a much wider one than is commonly assumed; that its task is nothing less than to cover a second time the whole field which is treated by pure theory under the assumption of barter, and to investigate what changes in the conclusions of pure theory are made necessary by the introduction of indirect exchange. The first step toward a solution of this problem is to release monetary theory from the bonds which a too narrow conception of its task has created.

The second conclusion to be drawn from the results of our considerations follows from the first: so long as we do not see more clearly about the most fundamental problems of monetary theory and so long as no agreement is reached on the essential theoretical questions, we are also not yet in a position drastically to reconstruct our monetary system, in particular to replace the semiautomatic gold standard by a more or less arbitrarily managed currency. Indeed, I am afraid that, in the present state of knowledge, the risks connected with such an attempt are much greater than the harm which is possibly done by the gold standard. I am not even convinced that a good deal of the harm which is just now generally ascribed to the gold standard will not by a future and better informed generation of economists be recognized as a result of the different attempts of recent years to make the mechanism of the gold standard inoperative. And there is still another and perhaps no less important reason why it seems dangerous to me to overstress at the present moment the urgency of a change in our monetary system; it is the danger of diverting public attention from other and more pressing causes of our difficulties. I must say a last word on that point because it will help to prevent a misunderstanding which I am particularly anxious to avoid. Though I believe that recurring business depressions can only be explained by the operation of our monetary institutions, I do not believe that it is possible to explain in this way every stagnation of business. This applies in particular to the kind of prolonged depression through which some European countries are passing today. It would be easy to demonstrate by the same type of analysis which I have used in the last two lectures that certain kinds of state action, by causing a shift in demand from producers’ goods to consumers’ goods, may cause a continued shrinking of the capitalist structure of production, and therefore prolonged stagnation. This may be true of increased public expenditure in general or of particular forms of taxation or particular forms of public expenditure. In such cases, of course, no tampering with the monetary system can help. Only a radical revision of public policy can provide the remedy.