The Theory of Money and Credit

Assuming uniformity of procedure, the credit-issuing banks are able to extend their issues indefinitely. It is within their power to stimulate the demand for capital by reducing the rate of interest on loans, and, except for the limits mentioned above, to go so far in this as the cost of granting the loans permits. In doing this they force their competitors in the loan market, that is all those who do not lend fiduciary media which they have created themselves, to make a corresponding reduction in the rate of interest also. Thus the rate of interest on loans may at first be reduced by the credit-issuing banks almost to zero. This, of course, is true only under the assumption that the fiduciary media enjoy the confidence of the public so that if any requests are made to the banks for liquidation of the promise of prompt cash redemption which constitutes the nature of fiduciary media, it is not because the holders have any doubts as to their soundness. Assuming this, the only possible reason for the withdrawal of deposits or the presentation of notes for redemption is the existence of a demand for money for making payments to persons who do not belong to the circle of customers of the individual banks. The banks need not necessarily meet such demands by paying out money; the fiduciary media of those banks among whose customers are those persons to whom the banks’ own customers wish to make payments are equally serviceable in this case. Thus there ceases to be any necessity for the banks to hold a redemption fund consisting of money; its place may be taken by a reserve fund consisting of the fiduciary media of other banks. If we imagine the whole credit system of the world concentrated in a single bank, it will follow that there is no longer any presentation of notes or withdrawal of deposits; in fact, the whole demand for money in the narrower sense may disappear. These suppositions are not at all arbitrary. It has already been shown that the circulation of fiduciary media is possible only on the assumption that the issuing bodies enjoy the full confidence of the public, since even the dawning of mistrust would immediately lead to a collapse of the house of cards that comprises the credit circulation. We know, furthermore, that all credit-issuing banks endeavor to extend their circulation of fiduciary media as much as possible, and that the only obstacles in their way nowadays are legal prescriptions and business customs concerning the covering of notes and deposits, not any resistance on the part of the public. If there were no artificial restriction of the credit system at all, and if the individual credit-issuing banks could agree to parallel procedure, then the complete cessation of the use of money would only be a question of time. It is, therefore, entirely justifiable to base our discussion on the above assumption.

Now, if this assumption holds good, and if we disregard the limit that has already been mentioned as applying to the case of metallic money, then there is no longer any limit, practically speaking, to the issue of fiduciary media; the rate of interest on loans and the level of the objective exchange value of money is then limited only by the banks’ running costs—a minimum, incidentally which is extraordinarily low. By making easier the conditions on which they will grant credit, the banks can extend their issue of fiduciary media almost indefinitely. Their doing so must be accompanied by a fall in the objective exchange value of money. The course taken by the depreciation that is a consequence of the issue of fiduciary media by the banks may diverge in some degree from that which it takes in the case of an increase of the stock of money in the narrower sense, or from that which it takes when the fiduciary media are issued otherwise than by banks; but the essence of the process remains the same. For it is a matter of indifference whether the diminution in the objective exchange value of money begins with the mine owners, with the government which issues fiat money credit money, or token coins, or with the undertakings that have the newly issued fiduciary media placed at their disposal by way of loans.

Painful consideration of the question whether fiduciary media really could be indefinitely augmented without awakening the mistrust of the public would be not only supererogatory, but otiose. For the problems of theory that we are dealing with, it is a question that has scarcely any significance. We are not conducting our investigation in order to show that the objective exchange value of money and the rate of interest on loans could be reduced almost to zero; but in order to disclose the consequences that arise from the divergence (which we have shown to be possible) between the money rate and the natural rate of interest. For this reason, it is also a matter of indifference to us, as we have just shown, that under a system of commodity money the fiduciary media cannot continue to be augmented after the objective exchange value of the money is reduced to the level determined by the industrial employment of the metal.

If it is possible for the credit-issuing banks to reduce the rate of interest on loans below the rate determined at the time by the whole economic situation (Wicksell’s natürliche Kapitalzins or natural rate of interest), then the question arises of the particular consequences of a situation of this kind. Does the matter rest there, or is some force automatically set in motion which eliminates this divergence between the two rates of interest? It is a striking thing that this problem, which even at a first glance cannot fail to appear extremely interesting, and which moreover under more detailed examination proves to be one of the greatest importance for comprehension of many of the processes of modern economic life, has until now hardly been dealt with seriously at all.

We shall not say anything further here of the effects of an increased issue of fiduciary media on the determination of the objective exchange value of money; they have already been dealt with exhaustively. Our task now is merely to discover the general economic consequences of any conceivable divergence between the natural and money rates of interest, given uniform procedure on the part of the credit-issuing banks. We obviously need only consider the case in which the banks reduce the rate of interest below the natural rate. The opposite case, in which the rate of interest charged by the banks is raised above the natural rate, need not be considered; if the banks acted in this way, they would simply withdraw from the competition of the loan market, without occasioning any other noteworthy consequences.

The level of the natural rate of interest is limited by the productivity of that lengthening of the period of production which is just justifiable economically and of that additional lengthening of the period of production which is just not justifiable; for the interest on the unit of capital upon whose aid the lengthening depends must always amount to less than the marginal return of the justifiable lengthening and to more than the marginal return of the unjustifiable lengthening. The period of production which is thus defined must be of such a length that exactly the whole available subsistence fund is necessary on the one hand and sufficient on the other for paying the wages of the laborers throughout the duration of the productive process. For if it were shorter, all the workers could no longer be provided for throughout its whole course, and the consequence would be an urgent offer of the unemployment economic factors which could not fail to bring about a transformation of the existing arrangement.20  Now if the rate of interest on loans is artificially reduced below the natural rate as established by the free play of the forces operating in the market, then entrepreneurs are enabled and obliged to enter upon longer processes of production. It is true that longer roundabout processes of production may yield an absolutely greater return than shorter processes; but the return from them is relatively smaller, since although continual lengthening of the capitalistic process of production does lead to continually increasing returns, after a certain point is reached the increments themselves are of decreasing amount.21  Thus it is possible to enter upon a longer roundabout process of production only if this smaller additional productivity will still pay the entrepreneur. So long as the rate of interest on loans coincides with the natural rate, it will not pay him; to enter upon a longer period of production would involve a loss. On the other hand, a reduction of the rate of interest on loans must necessarily lead to a lengthening of the average period of production. It is true that fresh capital can be employed in production only if new roundabout processes are started. But every new roundabout process of production that is started must be more roundabout than those already started; new roundabout processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout processes of production, because they yield the greatest returns. It is only when all the short roundabout processes of production have been appropriated that capital is employed in the longer ones.

A lengthening of the period of production is only practicable, however, either when the means of subsistence have increased sufficiently to support the laborers and entrepreneurs during the longer period or when the wants of producers have decreased sufficiently to enable them to make the same means of subsistence do for the longer period. Now it is true that an increase of fiduciary media brings about a redistribution of wealth in the course of its effects on the objective exchange value of money which may well lead to increased saving and a reduction of the standard of living. A depreciation of money, when metallic money is employed, may also lead directly to an increase in the stock of goods in that it entails a diversion of some metal from monetary to industrial uses. So far as these factors enter into consideration, an increase of fiduciary media does cause a diminution of even the natural rate of interest, as we could show if it were necessary. But the case that we have to investigate is a different one. We are not concerned with a reduction in the natural rate of interest brought about by an increase in the issue of fiduciary media, but with a reduction below this rate in the money rate charged by the banks, inaugurated by the credit-issuing banks and necessarily followed by the rest of the loan market. The power of the banks to do such a thing has already been demonstrated.

The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the laborers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall.

This is one of the ways in which the equilibrium of the loan market is reestablished after it has been disturbed by the intervention of the banks. The increased productive activity that sets in when the banks start the policy of granting loans at less than the natural rate of interest at first causes the prices of production goods to rise while the prices of consumption goods, although they rise also, do so only in a moderate degree, namely, only insofar as they are raised by the rise in wages. Thus the tendency toward a fall in the rate of interest on loans that originates in the policy of the banks is at first strengthened. But soon a countermovement sets in: the prices of consumption goods rise, those of production goods fall. That is, the rate of interest on loans rises again, it again approaches the natural rate.

This countermovement is now strengthened by the fact that the increase of the stock of money in the broader sense that is involved in the increase in the quantity of fiduciary media reduces the objective exchange value of money. Now, as has been shown, so long as this depreciation of money is going on, the rate of interest on loans must rise above the level that would be demanded and paid if the objective exchange value of money remained unaltered.22

At first the banks may try to oppose these two tendencies that counteract their interest policy by continually reducing the rate of interest charged for loans and forcing fresh quantities of fiduciary media into circulation. But the more they thus increase the stock of money in the broader sense, the more quickly does the value of money fall, and the stronger is its countereffect on the rate of interest. However much the banks may endeavor to extend their credit circulation, they cannot stop the rise in the rate of interest. Even if they were prepared to go on increasing the quantity of fiduciary media until further increase was no longer possible (whether because the money in use was metallic money and the limit had been reached below which the purchasing power of the money-and-credit unit could not sink without the banks being forced to suspend cash redemption, or whether because the reduction of the interest charged on loans had reached the limit set by the running costs of the banks), they would still be unable to secure the intended result. For such an avalanche of fiduciary media, when its cessation cannot be foreseen, must lead to a fall in the objective exchange value of the money-and-credit unit to the paniclike course of which there can be no bounds.23  Then the rate of interest on loans must also rise in a similar degree and fashion.

Thus the banks will ultimately be forced to cease their endeavors to underbid the natural rate of interest. That ratio between the prices of goods of the first order and of goods of higher orders which is determined by the state of the capital market and has been disturbed merely by the intervention of the banks will be approximately reestablished, and the only remaining trace of the disturbance will be a general increase in the objective exchange value of money due to factors emanating from the monetary side. A precise reestablishment of the old price ratios between production goods and consumption goods is not possible, on the one hand because the intervention of the banks has brought about a redistribution of property, and on the other hand because the automatic recovery of the loan market involves certain of the phenomena of a crisis, which are signs of the loss of some of the capital invested in the excessively lengthened roundabout processes of production. It is not practicable to transfer all the production goods from those uses that have proved unprofitable to other avenues of employment; a part of them cannot be withdrawn and must therefore either be left entirely unused or at least be used less economically. In either case there is a loss of value. Let us, for example, suppose that an artificial extension of bank credit is responsible for the establishment of an enterprise which only yields a net profit of four percent. So long as the rate of interest on loans was four and one-half percent, the establishment of such a business could not be thought of; we may suppose that it has been made possible by a fall to a rate of three and one-half percent which has followed an extension of the issue of fiduciary media. Now let us assume the reaction to begin, in the way described above. The rate of interest on loans rises to four and one-half percent again. It will no longer be profitable to conduct this enterprise. Whatever may now occur, whether the business is stopped entirely or whether it is carried on after the entrepreneur has decided to make do with the smaller profits, in either case—not merely from the individual point of view, but also from that of the community—there has been a loss of value. Economic goods which could have satisfied more important wants have been employed for the satisfaction of less important; only insofar as the mistake that has been made can be rectified by diversion into another channel can loss be prevented.

• 20See Böhm-Bawerk, op. cit., pp. 611 ff.
• 21Ibid., pp. 151 ff.
• 22The fact that the two movements occur in opposite directions, so that they cancel one another, had been emphasized by Mill (Principles, pp. 391 ff.) in order to show that the increase in the rate of interest caused by inflation would be counteracted by the circumstance that the additional quantity of notes, if issued by the banks (and the additional quantity of gold so far as it was used productively), have a reducing effect on the bank rate of interest.
• 23See p. 229.