Prices and Production

LECTURE 5

The Problems of a Really International Standard

1. Gold as the International Standard

I have now concluded the negative part of my argument, the case against independent national currencies. While I cannot hope in the space of these few lectures completely to have refuted the theoretical basis of monetary nationalism, I hope at least to have shown three things: that there is no rational basis for the separate regulation of the quantity of money in a national area which remains a part of a wider economic system; that the belief that by maintaining an independent national currency we can insulate a country against financial shocks originating abroad is largely illusory; and that a system of fluctuating exchanges would on the contrary introduce new and very serious disturbances of international stability. I do not want now further to add to this except that I might perhaps remind you that my argument throughout assumed that such a system would be run as intelligently as is humanly possible. I have refrained from supporting my case by pointing to the abuses to which such a system would almost certainly lend itself, to the practical impossibility of different countries agreeing on what degree of depreciation is justified, to the consequent danger of competitive depreciation, and the general return to mercantilist policies of restriction which now, as in earlier centuries, are the inevitable reaction to debasement in other countries.33

We must recognize, therefore, that independent regulation of the various national currencies cannot be regarded as in any sense a substitute for a rationally regulated world monetary system. Such a system may today seem an unattainable ideal. But this does not mean that the question of what we can do to get as near the ideal as may be practicable does not present a number of important problems. Of course some “international” systems would be far from ideal. I hope I have made it clear in particular that I do not regard the sort of international system which we have had in the past as by any means completely satisfactory. The monetary nationalists condemn it because it is international; I, on the other hand, ascribe its shortcomings to the fact that it is not international enough. But the question of how we can make it more satisfactory, that is, more genuinely international, I have not yet touched upon. It is a question which raises exceedingly difficult problems; I can survey them only rapidly in this final lecture.

The first, but by no means the most important or most interesting question which I must consider is the question of whether the international standard need be gold. On purely economic grounds it must be said that there are hardly any arguments which can be advanced for, and many serious objections which can be raised against, the use of gold as the international money. In a securely established world state with a government immune to the temptations of inflation it might be absurd to spend enormous effort in extracting gold out of the earth if cheap tokens would render the same service as gold with equal or greater efficiency. Yet in a world consisting of sovereign nation-states, there seem to me to exist compelling political reasons why gold (or the precious metals) alone and no kind of artificial international currency, issued by some international authority, could be used successfully as the international money. It is essential for the working of an international standard that each country’s holdings of the international money should represent for it a reserve of exchange medium which in all eventualities will remain universally acceptable in international transactions. And so long as there are separate sovereign states there will always loom large among these eventualities the danger of war, or of the breakdown of the international monetary arrangements for some other reason. And since people will always feel that against these emergencies they will have to hold some reserve of the one thing which by age-old custom civilized as well as uncivilized people are ready to accept—that is, since gold alone will serve one of the purposes for which stocks of money are held—and since to some extent gold will always be held for this purpose, there can be little doubt that it is the only sort of international standard which in the present world has any chance of surviving. But, to repeat, while an international standard is desirable on purely economic grounds, the choice of gold with all its undeniable defects is made necessary entirely by political considerations.

What should be done if the well-known defects of gold should make themselves too strongly felt, if violent changes in the condition of its production or the appearance of a large new demand for it should threaten sudden changes in its value, is of course a problem of major importance. But it is neither the most interesting nor the most important problem and I do not propose to discuss it here. The difficulties which I want to consider are rather those which were inherent in the international gold standard, even before 1914, and to a still greater degree during its short post-war existence. They are the problems which arise out of the fact that the so-called gold currencies are connected with gold only through the comparatively small national reserves which form the basis of a multiple superstructure of credit money which itself consists of many different layers of different degrees of liquidity or acceptability. It is, as we have seen, this fact which makes the effects of changes in the international flow of money different from merely interlocal shifts, to which is due the existence of separate national monetary systems which to some extent have a life of their own. The homogeneity of the circulating medium of different countries has been destroyed by the growth of separate banking systems organized on national lines. Can anything be done to restore it?

2. The “Perverse Elasticity” of Our Credit Money

It is important here first to distinguish between the need for some “lender of last resort” and the organization of banking on the “national reserve” principle. That an extensive use of bank deposits as money would not be possible, that deposit banking of the modern type could not exist, unless somebody were in a position to provide the cash if the public should suddenly want to convert a considerable part of its holdings of bank deposits into more liquid forms of money, is probably beyond doubt. It is far less obvious why all the banking institutions in a particular area or country should be made to rely on a single national reserve. This is certainly not a system which anybody would have deliberately devised on rational grounds, and it grew up as an accidental by-product of a policy concerned with different problems.34 The rational choice would seem to lie between either a system of “free banking,” which not only gives all banks the right of note issue and at the same time makes it necessary for them to rely on their own reserves, but also leaves them free to choose their field of operation and their correspondents without regard to national boundaries,35 and on the other hand, an international central bank. I need not add that both of these ideals seem utterly impracticable in the world as we know it. But I am not certain whether the compromise we have chosen, that of national central banks which have no direct power over the bulk of the national circulation but which hold as the sole ultimate reserve a comparatively small amount of gold, is not one of the most unstable arrangements imaginable.

Let us recall for a moment the essential features of the so-called gold standard systems as they have existed in modern times. The most widely used medium of exchange, bank deposits, is not fixed in quantity. Additional deposits may at any time spontaneously spring up (be “created” by the banks), or part of the total may similarly disappear. But while they are predominantly used in actual payments, they are by no means the only forms in which balances can be held to meet such payments. In this function, deposits on current account are only one item—a very liquid one, although by no means the most liquid of all—in a long range of assets of varying degree of liquidity.36 Overdraft facilities, saving deposits and many types of very marketable securities on the one hand, and bank notes and coin on the other, will at different times and to different degrees compete with bank deposits in this function. And the amounts which will be held on current account to meet expected demands need not therefore fluctuate with the expected magnitude of these payments; they may also change with any change in the views about the ease with which it will be possible to convert these other assets into bank deposits. The supply of bank deposits on the other hand will depend on similar considerations. How much the banks will be willing to owe in this form in excess of the ready cash they hold will depend on their view as to how easy it will be to convert other assets into cash. It is when general confidence is high, so that comparatively small amounts of bank deposits will be needed for a given volume of payments, that the banks will be more ready to increase the amount of bank deposits. On the other hand, any increase of uncertainty about the future will lead to an increased demand for all the more liquid forms of assets, that is, in particular, for bank deposits and cash, and to a decrease in the supply of bank deposits.

Where there is a central bank, the responsibility for the provision of cash for the conversion of deposits is divided between the banks and the central bank, or one should probably better say shifted from the banks to the central bank, since it is now the recognized duty of the central banks to supply in an emergency—at a price—all the cash that may be needed to repay deposits. Yet while the ultimate responsibility to provide the cash when needed is thus placed on the central bank, until this demand actually arises, the latter has little power to prevent the expansion leading to an increased demand for cash.

But with an international standard a national central bank is itself not a free agent. Up to this point the cash about which I have been speaking is the money created by the central bank which within the country is generally acceptable and is the only means of payment outside the circle of the customers of a particular bank. The central bank, however, has not only to provide the required amounts of the medium generally accepted within the country; it has also to provide the even more liquid, internationally acceptable, money. This means that in a situation where there is a general tendency toward greater liquidity there will be at the same time a greater demand for central bank money and for the international money. But the only way in which the central bank can restrict the demand for and increase the supply of the international money is to curtail the supply of central bank money. In consequence, in this stage as in the preceding one, any increase in the demand for the more liquid type of money will lead to a much greater decrease in the supply of the somewhat less liquid kinds of money.

This differentiation between the different kinds of money into those which can be used only among the customers of a particular bank and those which can be used only within a particular country and finally those which can be used internationally—these artificial distinctions of liquidity (as I have previously called them)—have the effect, therefore, that any change in the relative demand for the different kinds of money will lead to a cumulative change in the total quantity of the circulating medium. Any demand on the banks for conversion of part of their deposits into cash will have the effect of compelling them to reduce their deposits by more than the amount paid out and to obtain more cash from the central bank, which in turn will be forced to take counter-measures and so to transmit the tendency toward contraction to the other banks. And the same applies, of course, mutatis mutandis to a decrease in the demand for the more liquid type of assets, which will bring about a considerable increase in the supply of money.

All this is of course only the familiar phenomenon which Mr. R.G. Hawtrey has so well described as the “inherent instability of credit.” But there are two points about it which deserve special emphasis in this connection. One is that, in consequence of the particular organization of our credit structure, changes in liquidity preference as between different kinds of money are probably a much more potent cause of disturbances than the changes in the preference for holding money in general and holding goods in general which have played such a great role in recent refinements of theory. The other is that this source of disturbance is likely to be much more serious when there is only a single bank for a whole region or when all the banks of a country have to rely on a single central bank; since the effect of any change in liquidity preference will generally be confined to the group of people who directly or indirectly rely on the same reserve of more liquid assets.

It seems to follow from all this that the problem with which we are concerned is not so much a problem of currency reform in the narrower sense as a problem of banking reform in general. The seat of the trouble is what has been very appropriately been called the perverse elasticity of bank deposits37 as a medium of circulation, and the cause of this is that deposits, like other forms of “credit money,” are claims for another, more generally acceptable sort of money, that a proportional reserve of that other money must be held against them, and that their supply is therefore inversely affected by the demand for the more liquid type of money.

3. The Chicago Plan of Banking Reform

By far the most interesting suggestion on banking reform which has been advanced in recent years, not because in its present form its seems to be practicable or even theoretically right, but because it goes to the heart of the problem, is the so-called Chicago or 100 percent plan.38 This proposal amounts in effect to an extension of the principles of Peel’s Act of 1844 to bank deposits. The most practicable suggestion yet made for its execution is to give the banks a sufficient quantity of paper money to increase the reserves held against demand deposits to 100 percent and henceforth to require them to maintain permanently such a 100 percent reserve.

In this form, the plan is conceived as an instrument of monetary nationalism. But there is no reason why it should not equally be used to create a homogeneous international currency.39 A possible, although perhaps somewhat fantastic, solution would seem to be to reduce proportionately the gold equivalents of all the different national monetary units to such an extent that all the money in all countries could be covered 100 percent by gold, and from that date onwards to allow variations in the national circulations only in proportion to changes in the quantity of gold in the country.40 Such a plan would clearly require as an essential complement an international control of the production of gold, since the increase in the value of gold would otherwise bring about an enormous increase in the supply of gold. But this would only provide a safety valve probably necessary in any case to prevent the system from becoming all too rigid.

The undeniable attractiveness of this proposal lies exactly in the feature which makes it appear somewhat impracticable, in the fact that in effect it amounts, as is fully realized by at least one of its sponsors, to an abolition of deposit banking as we know it.41 It does provide, instead of the variety of media of circulation which today range according to their degree of acceptability from bank deposits to gold, one single kind of money. And it would do away effectively with that most pernicious feature of our present system: namely that a movement toward more liquid types of money causes an actual decrease in the total supply of money and vice versa. The most serious question which it raises, however, is whether by abolishing deposit banking as we know it we would effectively prevent the principle on which it rests from manifesting itself in other forms. It has been well remarked by the most critical among the originators of the scheme that banking is a pervasive phenomenon,42 and the question is whether, when we prevent it from appearing in its traditional form, we will not just drive it into other and less easily controllable forms. Historical precedent rather suggests that we must be wary in this respect. The Act of 1844 was designed to control what then seemed to be the only important substitute for gold as a widely used medium of exchange and yet failed completely in its intention because of the rapid growth of bank deposits. Is it not possible that if similar restrictions to those placed on bank notes were now placed on the expansion of bank deposits, new forms of money substitutes would rapidly spring up or existing ones would assume increasing importance? And can we even today draw a sharp line between what is money and what is not? Are there not already all sorts of “near-moneys”43 like saving deposits, overdraft facilities, bills of exchange, etc., which satisfy at any rate the demand for liquid reserves nearly as well as money?

I am afraid all this must be admitted, and it considerably detracts from the alluring simplicity of the 100 percent banking scheme. It appears that for this reason it has now also been abandoned by at least one of its original sponsors.44 The problem is evidently a much wider one, and I agree with Mr. H.C. Simons that it “cannot be dealt with merely by legislation directed at what we call banks.”45 Yet in one respect, at least the 100 percent proposal seems to me to point in the right direction. Even if, as is probably the case, it is impossible to draw a sharp line between what is to be treated as money and what is not, and if consequently any attempt to fix rigidly the quantity of what is more or less arbitrarily segregated as “money” would create serious difficulties, it yet remains true that, within the field of instruments which are undoubtedly generally used as money, there are unnecessary and purely institutional distinctions of liquidity which are the sources of serious disturbances and which should as far as possible be eliminated. If this cannot be done for the time being by a general return to the common use of the same international medium in the great majority of transactions, it should at least be possible to approach this goal by reducing the distinctions of liquidity between the different kinds of money actually used, and offsetting as far as possible the effects of changes in the demand for liquid assets on the total quantity of the circulating medium.

4. Exchange Rates and Gold Reserves

This brings me to the more practical question of what can be done to diminish the instability of the credit structure if the general framework of the present monetary system is to be maintained. The aim, as we have just seen, must be to increase the certainty that one form of money will always be readily exchangeable against other forms of money at a known rate, and that such changes should not lead to changes in the total quantity of money. Insofar as the relations between different national currencies are concerned, this leads of course to a demand for reforms in exactly the opposite direction from those advocated by monetary nationalists. Instead of flexible parities or a widening of the “gold points,” absolute fixity of the exchange rates should be secured by a system of international par clearance. If all the central banks undertook to buy and sell foreign exchange freely at the same fixed rates, and in this way prevented even fluctuations within the “gold points,” the remaining differences in denomination of the national currencies would really be no more significant than the fact that the same quantity of cloth can be stated in yards and in meters. With an international gold settlement fund on the lines of that operated by the Federal Reserve System, which would make it possible to dispense with the greater part of the actual gold movements which used to take place in the past, invariable rates of exchange could be maintained without placing any excessive burden on the central banks.46 The main aim here would of course be rather to remove one of the main causes of international movements of short-term funds than to prevent such movements or to offset their effects by means which will only increase the inducement to such movements.47

But invariability of the exchange rates is only one precondition of a successful policy directed to minimize monetary disturbances. It eliminates one of the institutional differentiations of liquidity which are likely to give rise to sudden changes in favor of holding one sort of money instead of another. But there remains the further distinction between the different sorts of money which constitute the national monetary systems; and, so long as the general framework of our present banking systems is retained, the dangers to stability which arise here can hardly be combated otherwise than by a deliberate policy of the national central banks.

The most important change which seems to be necessary here is that the gold reserves of all the central banks should be made large enough to relieve them of the necessity of bringing about a change in the total national circulation in proportion to the changes in their reserves; that is, that any change in the relative amounts of money in different countries should be brought about by the actual transfer of corresponding amounts from country to country without any “secondary” contractions and expansions of the credit superstructure of the countries concerned. This would be the case only if individual central banks held gold reserves large enough to be used freely without resort to any special measures for their “protection.”

Now the present abundance of gold offers an exceptional opportunity for such a reform. But to achieve the desired result not only the absolute supply of gold but also its distribution is of importance. In this respect it must appear unfortunate that those countries which command already abundant gold reserves and would therefore be in a position to work the gold standard on these lines, should use that position to keep the price artificially high. The policy on the part of those countries which are already in a strong gold position, if it aims at the restoration of an international gold standard, should have been, while maintaining constant rates of exchange with all countries in a similar position, to reduce the price of gold in order to direct the stream of gold to those countries which are not yet in a position to resume gold payments. Only when the price of gold has fallen sufficiently to enable those countries to acquire sufficient reserves should a general and simultaneous return to a free gold standard be attempted.

It may seem at first that even if one could start with an appropriate distribution of gold between countries which at first would put each country in a position where it could allow its stock of gold to vary by the absolute amounts by which its circulation would have to increase or decrease, some countries would soon again find their gold stocks so depleted that they would be compelled to take traditional measures for their protection. And it cannot be denied that, so long as the stock of gold of any country is anything less than 100 percent of its total circulation, it is at least conceivable that it may be reduced to a point where in order to protect the remainder, the monetary authorities might have to have recourse to a policy of credit contraction. But a short reflection will show that this is extraordinarily unlikely to happen if a country starts out with a fairly large stock of gold and if its monetary authorities adhere to the main principle not only with regard to decreases but equally with regard to increases in the total circulation.

If we assume the different countries start with a gold reserve amounting to only a third of the total monetary circulation,48 this would probably provide a margin amply sufficient for any reduction of the country’s share in the world’s stock of money which is likely to become necessary. That a country’s share in the world’s income, and therefore its relative demand for money, should fall off by more than this would at any rate be an exceptional case requiring exceptional treatment.49 If history seems to suggest that such considerable losses of gold are not at all infrequent, this is due to the operation of a different cause which should be absent if the principle suggested were really applied. If under the traditional gold standard any one country expanded credit out of step with the rest of the world, this did usually bring about an outflow of gold only after a considerable time lag. This in itself would mean that, before equilibrium would be restored by the direct operations of the gold flows, an amount of gold approximately equal to the credit created in excess would have to flow out of the country. If, however, as has often been the case, the country should be tardy in decreasing its circulation by the amount of gold it has lost, that is, if it should try to “offset” the losses of gold by new creations of credit, there would be no limits to the amount of gold which may leave the country except the size of the reserves. Or, in other words, if the principle of changing the total circulation by the full amount of gold imported or exported were strictly applied, gold movements would be much smaller than has been the case in the past, and the size of the gold movements experienced in the past create therefore no presumption that they would be equally large in the future.

5. Credit Policy of the Central Banks

These considerations will already have made it clear that the principle of central banking policy here proposed by no means implies that the central banks should be relieved from all necessity of shaping their credit policy according to the state of their reserves. Quite the contrary. It only means that they should not be compelled to adhere to the mechanical rule of changing their notes and deposits in proportion to the change in their reserves. Instead of this they would have to undertake the much more difficult task of influencing the total volume of money in their countries in such a way that this total would change by the same absolute amounts as their reserves. And since the central bank has no direct power over the greater part of the circulating medium of the country, it would have to try to control its volume indirectly. This means that it would have to use its power to change the volume of its notes and deposits so as to make the superstructure of credit built on those move in conformity with its reserves. But as the amount of ordinary bank deposits and other forms of common means of exchange based on a given volume of central bank money will be different at different times, this means that the central bank, in order to make the total amount of money move with its reserves, would frequently have to change the amount of central bank money independently of changes in its reserves and occasionally even in a direction opposite to that in which its reserves may change.

It should perhaps always have been evident that, with a banking system which has grown to rely on the assistance of a central bank for the supply of cash when needed, no sort of control of the circulating medium can be achieved unless the central bank has power and uses this power to control the volume of bank deposits in ordinary times. And the policy to make this control effective will have to be very different from the policy of a bank which is concerned merely with its own liquidity. It will have to act persistently against the trend of the movement of credit in the country, to contract the credit basis when the superstructure tends to expand, and to expand the former when the latter tends to contract.

It is today almost commonplace that, with a developed banking structure, the policy of the central bank can in no way be automatic. It would indeed require the greatest art and discernment for a central bank to succeed in making the credit money provided by the private banks behave as a purely metallic circulation would behave under similar circumstances. But while it may appear very doubtful whether this ideal will ever be fully achieved, there can be no doubt that we are still so far from it that very considerable changes from traditional policy would be required before we shall be able to say that even what is possible has been achieved.

In any case it should be obvious that the existence of a central bank which does nothing to counteract the expansions of banking credit made possible by its existence only adds another link in the chain through which the cumulative expansions and contractions of credit operate. So long as central banks are regarded, and regard themselves, only as “lenders of last resort” which have to provide the cash which becomes necessary in consequence of a previous credit expansion with which, until this point arrives, they are not concerned, so long as central banks wait until “the market is in the bank” before they feel bound to check expansion, we cannot hope that wide fluctuations in the volume of credit will be avoided. Certainly Mr. Hawtrey was right with his now-celebrated statement that “so long as the credit is regulated with reference to reserve proportions, the trade cycle is bound to recur.”50 But I am afraid only one (and that not the more important of the essential corollaries of this proposition) is usually derived from this statement. What is usually emphasized is the fact that concern with reserve proportions will ultimately compel central banks to stop a process of credit expansion and actually to bring about a process of credit contraction. What seems to me much more important is that sole regard to their own reserve proportions will not lead central banks to counteract the increase of bank deposits, even if it means an increase of the credit circulation of the country relatively to the gold reserve, and although it is an increase largely made possible by the certain expectation—on the part of the other banks—that the central bank will in the end supply the cash needed.

On the question of how far central banks are in practice likely to succeed in this difficult task, different opinions are clearly possible. The optimist will be convinced that they will be able to do much more than merely offset the dangers which their existence creates. The pessimist will be skeptical whether on balance they will not do more harm than good. The difficulty of the task, the impossibility of prescribing any fixed rule, and the extent to which the action of the central banks will always be exposed to the pressure of public opinion and political influence certainly justify grave doubts. And though the alternative solution is today probably outside of the realm of practical politics, it is sufficiently important to deserve at least a passing consideration before we leave this subject.

As I have pointed out before, the “national reserve principle” is not insolubly bound up with the centralization of the note issue. While we must probably take it for granted that the issue of notes will remain reserved to one or a few privileged institutions, these institutions need not necessarily be the keepers of the national reserve. There is no reason why the banks of issue should not be entirely confined to the functions of the issue department of the Bank of England, that is, to the conversion of gold into notes and notes into gold, while the duty of holding appropriate reserves is left to individual banks. There could still be in the background—for the case of a run on the banks—the power of a temporary “suspension” of the limitations of the note issue and of the issue of an emergency currency at a penalizing rate of interest.

The advantage of such a plan would be that one tier in the pyramid of credit would be eliminated and the cumulative effects of changes in liquidity preference accordingly reduced. The disadvantage would be that the remaining competing institutions would inevitably have to act on the proportional reserve principle and that nobody would be in a position, by a deliberate policy, to offset the tendency to cumulative changes. This might not be so serious if there were numerous small banks whose spheres of operation freely overlapped over the whole world. But it can hardly be recommended where we have to deal with the existing banking systems, which consist of a few large institutions covering the same field of a single nation. It is probably one of the ideals which might be practical in a liberal world federation but which is impracticable where national frontiers also mean boundaries to the normal activities of banking institutions. The practical problem remains that of the appropriate policy of national central banks.

6. Conclusions

It is unfortunately impossible to say here more about the principles which a rational central banking policy would have to follow without going into some of the most controversial problems of the theory of the trade cycle which clearly fall outside the scope of these lectures. I must therefore confine myself to pointing out that what I have said so far is altogether independent of the particular views on this subject for which I have been accused, I think unjustly, of being a deflationist. Whether we think that the ideal would be a more or less constant volume of the monetary circulation, or whether we think that this volume should gradually increase at a fairly constant rate as productivity increases, the problem of how to prevent the credit structure in any country from running away in either direction remains the same.

Here my aim has merely been to show that whatever our views about the desirable behavior of the total quantity of money, they can never legitimately be applied to the situation of a single country which is part of an international economic system, and that any attempt to do so is likely in the long run and for the world as a whole to be an additional source of instability. This means of course that a really rational monetary policy could be carried out only by an international monetary authority, or at any rate by the closest cooperation of the national authorities and with the common aim of making the circulation of each country behave as nearly as possible as if it were part of an intelligently regulated international system.

But I think it also means that so long as an effective international monetary authority remains a utopian dream, any mechanical principle (such as the gold standard) which at least secures some conformity of monetary changes in the national area to what would happen under a truly international monetary system is far preferable to numerous independent and independently regulated national currencies. If it does not provide a really rational regulation of the quantity of money, it at any rate tends to make it behave on roughly foreseeable lines, which is of the greatest importance. And since there is no means, short of complete autarchy, of protecting a country against the folly or perversity of the monetary policy of other countries, the only hope of avoiding serious disturbances is to submit to some common rules, even if they are by no means ideal, in order to induce other countries to follow a similarly reasonable policy. That there is much scope for an improvement of the rules of the game which were supposed to exist in the past, nobody will deny. The most important step in this direction is that the rationale of an international standard and the true sources of the instability of our present system should be properly appreciated. It was for this reason that I felt that my most urgent task was to restate the broader theoretical considerations which bear on the practical problem before us. I hope that by confining myself largely to these theoretical problems I have not too much disappointed the expectations to which the title of these lectures may have given rise. But, as I said at the beginning of these lectures, I do believe that in the long run human affairs are guided by intellectual forces. It is this belief which for me gives abstract considerations of this sort their importance, however slight may be their bearing on what is practicable in the immediate future.