The Theory of Money and Credit

An increase in the stock of money in the broader sense caused by an issue of fiduciary media means a displacement of the social distribution of property in favor of the issuer. If the fiduciary media are issued by the banks, then this displacement is particularly favorable to the accumulation of capital, for in such a case the issuing body employs the additional wealth that it receives solely for productive purposes, whether directly by initiating and carrying through a process of production or indirectly by lending to producers. Thus, as a rule, the fall in the rate of interest in the loan market, which occurs as the most immediate consequence of the increase in the supply of present goods that is due to an issue of fiduciary media, must be in part permanent; that is, it will not be wiped out by the reaction that is afterward caused by the diminution of the property of other persons. There is a high degree of probability that extensive issues of fiduciary media by the banks represent a strong impulse toward the accumulation of capital and have consequently contributed to the fall in the rate of interest.

One thing must be clearly stated at this point: there is no direct arithmetical relationship between an increase or decrease in the issue of fiduciary media on the one hand and the reduction or increase in the rate of interest which this indirectly brings about through its effects on the social distribution of property on the other hand. This would follow merely from the circumstance that there is no direct relationship between the redistribution of property and the differences in the way in which the existing stock of goods in the community is employed. The redistribution of property causes individual economic agents to take different decisions from those they would otherwise have taken. They deal with the goods at their disposal in a different way; they allocate them differently between present (consumptive) employment and future (productive) employment. This may give rise to an alteration in the size of the national subsistence fund if the alterations in the uses to which the goods are put by the individual economic agents do not offset one another but leave a surplus in the one direction or the other This alteration in the size of the national subsistence fund is the most immediate cause of the variation which occurs in the rate of interest; and since, as has been shown, it is by no means unequivocally determined by the extent and direction of the fluctuation in the stock of money in the broader sense, but depends upon the whole social distributive structure, no direct relationship can be established between the variations in the stock of money in the broader sense and the variations in the rate of interest. In fact it is obvious that however great the increase in the stock of money in the broader sense might be, whether it occurred by way of an increase in fiduciary media or by way of an increase in the stock of money in the narrower sense, the rate of interest could never be reduced to zero. That could take place only if the displacements that occurred increased the national subsistence fund to such an extent that all possibilities of increasing production by engaging in more productive “roundabout” methods of production were exhausted. This would mean that in all branches of production the time that elapsed between the commencement of production and the enjoyment of the product was not taken into consideration, and production was carried so far that the prices of the products were only just sufficient to pay an equal return to the primary factors in each employment. In particular, as far as very durable goods are concerned, this would mean that their quantity and durability would be tremendously increased, until the prices of their services fell so low that they would only just provide for the amortization of the investments. It is impossible to conceive of the extent to which, for example, the supply of houses would have to be increased for their annual rental value to fall to a sum which would only just give a total return equal to their original cost by the time when their lengthened lives came to an end. Where the lifetime of a good can be almost indefinitely increased under conditions of decreasing cost, the result is that its services will become practically free goods. It seems hardly likely that a rigid proof could be given to show that the increase in the size of the national subsistence fund that may follow a redistribution of property could never go so far as this. But we have sufficient capacity for estimating the quantities involved without this unobtainable precise proof. As regards the displacements in the distribution of property that are evoked by an increase in the circulation of fiduciary media, it seems that we might go still further and safely assert that it can in no circumstances be very considerable. Although we cannot prove this in any way, whether deductively or inductively, it nevertheless appears a reasonable assertion to make. And we may content ourselves with that; for we do not intend to base any kind of further argument on such an undemonstrable proposition.

The question to which we now turn is the following: It is indisputable that the banks are able to reduce the rate of interest on the credit they grant down to any level above their working expenses (for example, the cost of manufacturing the notes, the salaries of their staffs, etc.). If they do this, the force of competition obliges other lenders to follow their example. Accordingly, it would be entirely within the power of the banks to reduce the rate of interest down to this limit, provided that in so doing they did not set other forces in motion which would automatically reestablish the rate of interest at the level determined by the circumstances of the capital market, that is, the market in which present goods and future goods are exchanged for one another The problem that is before us is usually referred to by the catch-phrase gratuitous nature of credit. It is the chief problem in the theory of banking.

It is a problem whose great theoretical and practical importance has often been overlooked. The chief responsibility for this belongs to the not altogether fortunate manner in which it has been formulated. At the present time, the problem of the gratuitous nature of bank credit does not appear to be a very practical issue, and since the inclination toward questions of pure theory is hardly prominent among the economists of our day it is a problem that has been much neglected. Yet, if the way in which the problem is stated is modified only a little the unjustifiability of neglecting it becomes obvious, even from the point of view of those who are only concerned with the needs of everyday life. A new issue of fiduciary media, as we have seen, indirectly gives rise to a variation in the rate of interest by causing displacements in the social distribution of income and property. But the new fiduciary media coming on to the loan market have also a direct effect on the rate of interest. They are an additional supply of present goods and consequently they tend to cause the rate of interest to fall. The connection between these two effects on the rate of interest is not obvious. Is there a force that brings both into harmony or not? It is probable in the highest degree that the increase in the supply of fiduciary media in the market in which present goods are exchanged for future goods at first exerts a stronger influence than the displacement of the social distribution which occurs as a consequence of it. Does the matter remain at that stage? Is the immediate reduction of interest which indubitably follows the increase of fiduciary media definitive or not?

Until now, the treatment that this problem has met with at the hands of economists has fallen a long way short of its importance. Its real nature has for the most part been misunderstood; and where the problem was incorrectly stated to start with, it was natural that the subsequent attempts at its solution should not have been successful. But even the few theories in which the essence of the problem has been correctly apprehended have fallen into error in their efforts to solve it.

To one group of writers, the problem appeared to offer little difficulty. From the circumstance that it is possible for the banks to reduce the rate of interest in their bank-credit business down to the limit set by their working costs, these writers thought it permissible to deduce that credit can be granted gratuitously or, more correctly, almost gratuitously. In drawing this conclusion, their doctrine implicitly denies the existence of interest. It regards interest as compensation for the temporary relinquishing of money in the broader sense—a view, indeed, of insurpassable naivety. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest hold an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy.14

No less untenable is the attitude of orthodox scientific opinion toward the problem. Orthodox scientific opinion, following in this the example set by the adherents of the banking principle, is content to question the problem’s existence. In fact, it cannot do otherwise. If the opinion is held that the quantity of fiduciary media in circulation can never exceed the demand—in the sense defined above—the conclusion necessarily follows that the banks have not the ability to grant credit gratuitously. Of course, they might not exact any reimbursement or compensation beyond the prime costs of the loans granted by them. But doing this would not fundamentally change the matter, except that the profits from the issue of fiduciary media that the banks would otherwise receive themselves would now go to the benefit of the borrowers. And since, according to this view, it does not lie in the power of the banks arbitrarily to increase the quantity of fiduciary media in circulation, the limitation of the issue of these would leave only small scope for the influence of their discount policy on the general rate of interest. It follows that only insignificant differences could arise between the rate of interest charged by credit-issuing banks and that determined by the general economic situation for other credit transactions.

We have already had an opportunity of finding out where the error in this argument lies. The quantity of fiduciary media flowing from the banks into circulation is admittedly limited by the number and extent of the requests for discounting that the banks receive. But the number and extent of these requests are not independent of the credit policy of the banks; by reducing the rate of interest charged on loans, it is possible for the banks indefinitely to increase the public demand for credit. And since the banks—as even the most orthodox disciples of Tooke and Fullarton cannot deny—can meet all these demands for credit, they can extend their issue of fiduciary media arbitrarily. For obvious reasons an individual bank is not in a position to do this so long as its competitors act otherwise; but there seems to be no reason why all the credit-issuing banks in an isolated community, or in the whole world, taken together could not do this by uniform procedure. If we imagine an isolated community in which there is only a single credit-issuing bank in business, and if we further assume (what indeed is obvious) that the fiduciary media issued by it enjoy general confidence and are freely employed in business as money substitutes, then the weakness of the assertions of the orthodox theory of banking is most clear In such a situation there are no other limits to the bank’s issue of fiduciary media than those which it sets itself.

But even the Currency School has not treated the problem in a satisfactory manner It would appear—exhaustive historical investigation might perhaps lead to another conclusion—that the Currency School was merely concerned to examine the consequences of an inflation of fiduciary media in the case of the coexistence of several independent groups of banks in the world, starting from the assumption that these groups of banks did not all follow a uniform and parallel credit policy. The case of a general increase of fiduciary media, which for the first half of the nineteenth century had scarcely any immediate practical importance, was not included within the scope of its investigations. Thus it did not even have occasion to consider the most important aspect of the problem. What is necessary for clearing up this important problem still remains to be done; for even Wicksell’s most noteworthy attempt cannot be said to have achieved its object. But at least it has the merit of having stated the problem clearly.

Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about.15  Up to this point Wicksell commands assent; but his further argument provokes contradiction.

According to Wicksell, at every time and under all possible economic conditions there is a level of the average money rate of interest at which the general level of commodity prices no longer has any tendency to move either upward or downward. He calls it the normal rate of interest; its level is determined by the prevailing natural rate of interest, although, for certain reasons which do not concern our present problem, the two rates need not coincide exactly. When, he says, from any cause whatever, the average rate of interest is below this normal rate, by any amount, however small, and remains at this level, a progressive and eventually enormous rise of prices must occur “which would naturally cause the banks sooner or later to raise their rates of interest.”16  Now, so far as the rise of prices is concerned, this may be provisionally conceded. But it still remains inconceivable why a general rise in commodity prices should induce the banks to raise their rates of interest. It is clear that there may be a motive for this in the regulations, whether legislative or established by mercantile custom, that limit the circulation of fiduciary media; or necessary consideration of the procedure of other banks might have the same sort of effect. But if we start with the assumption, as Wicksell does, that only fiduciary media are in circulation and that the quantity of them is not legislatively restricted, so that the banks are entirely free to extend their issues of them, then it is impossible to see why rising prices and an increasing demand for loans should induce them to raise the rate of interest they charge for loans. Even Wicksell can think of no other reason for this than that since the requirements of business for gold coins and banknotes becomes greater as the price level rises, the banks do not receive back the whole of the sums they have lent, part of them remaining in the hands of the public; and that the bank reserves are consequently depleted while the total liabilities of the banks increase; and that this must naturally induce them to raise their rate of interest.17  But in this argument Wicksell contradicts the assumption that he takes as the starting point of his investigation. Consideration of the level of its cash reserves and their relation to the liabilities arising from the issue of fiduciary media cannot concern the hypothetical bank that he describes. He seems suddenly to have forgotten his original assumption of a circulation consisting exclusively of fiduciary media, on which assumption, at first, he rightly laid great weight.

Wicksell incidentally makes cursory mention of a second limit to the circulation of fiduciary media. He thinks that the banks that charge a lower rate of interest than that which corresponds to the average level of the natural rate of interest encounter a limit which is set by the employment of the precious metals for industrial purposes. If the purchasing power of money is too low it discourages the production of gold but increases, ceteris paribus, the industrial consumption of gold, and the deficiency which would arise as soon as consumption began to exceed production has to be made up from the bank reserves.18  This is perfectly true when metallic money is employed; an increase of fiduciary media must be stopped before the reduction of the objective exchange value of money that it brings about absorbs the value arising from the monetary employment of the metal. As soon as the objective exchange value of money had sunk below the value of the metal in industrial uses, every further loss in value (which, of course, would also affect the purchasing power of the money substitutes in the same degree), would send all those who needed the metal for industrial purposes to the counters of the banks as their cheapest source of supply. The banks would not be able to extend their issue any further since it would be possible for their customers to make a profit simply by the exchange of fiduciary media for money; all fiduciary media issued beyond the given limit would return immediately to the banks.19

But demonstrating this does not bring us a step nearer to the solution of our problem. The mechanism, by which a further issue of fiduciary media is restricted as soon as the falling objective exchange value of the material from which the money is made has reached the level set by its industrial employment, is, of course, effective only in the case of commodity money; in the case of credit money, it is effective only when the embodied claim refers to commodity money. And it is never effective in the case of fiat money. Of greater importance is a second factor: this limit is a distant one, so that even when it is eventually effective it still leaves considerable scope for an increase in the issue of fiduciary media. But it by no means follows from this that it remains possible for the banks to reduce the rate of interest on loans as much as they like within these wide limits; as the following argument will attempt to prove.

• 14See, for instance, the most recent literature on the German banking reform; for example, the above-cited work by Schmidt (see p. 379 n. 3). An historical study would have to examine the extent to which Law, Cieszkowski, Proudhon, Macleod, and others, are to be regarded as inventors and adherents of this doctrine.
• 15See Wicksell, op. cit., pp. v ff.
• 16See ibid., pp. v ff., III; also “The Influence of the Rate of Interest on Prices,” Economic Journal 18 (1907): 213 ff.
• 17See Wicksell, “The Influence of the Rate of Interest,” p. 215.
• 18See Wicksell, Geldzins und Güterpreise, pp. 104 f.
• 19See Walras, Études d’économie politique appliquée (Lausanne, 1898), pp. 345 f.