Money, bank credit and prices

Preface

Writinc on the theory of money and prices in 1817, Ricardo declared, “Of those who give their attention to such subjects, none but the prejudiced are ignorant of its true principles.” + Nevertheless in 1877, Francis A. Walker lamented the vagueness of understanding of such matters which had “done much to obscure the truth during the seventy-five years of economical discussion since it became current.” ? And in 1911, Irving Fisher remarked, “It has seemed to me a scandal that academic economists have been led into disagreements over the fundamental propositions concerning money.” * The observations of Walker and Fisher are symptoms of more than a century of contentious discussion of money, bank credit, and prices which offers a most ironical commentary upon the optimism of Ricardo about the “‘true principles” of the subject.

Let it, therefore, be clear at the start that the present volume does not seek to add further controversy where a surfeit of controversy already exists. The dominating aim is to extend the positive and constructive analysis of the subject. The pursuit of this aim involves the following general lines of approach:

1. A restatement of the pure theory of the value of money in a form which lends itself to quantitative hypothesis, quantitative methods of investigation, and quantitative testing.

2. A breaking down of general concepts of movements and tendencies into standard time series—secular, seasonal cyclical, irregular—and a description of the shifting sequences and amplitudes of prices, credit, production, and other factors from phase to phase of the various types of movements.

3. A description of the bank mechanisms of adjustment through which prices and the means of payment act and interact upon each other and upon related factors in the business world.

1 Principles of Political Economy, ch. xxvii. 2 Money, p. v. & ® Purchasing Power of Money, p. viii.

vii vill PREFACE

4. An application of an institutional-genetic mode of treatment and point of view to the major concepts of monetary science.

5. A development of a technique of analysis useful not merely to “explain” price movements of the past, but also to predict, with due allowance for fortuitous events and the hazards of forecasting, the price movements of the future.

6. A critical evaluation of plans of price control and a development of standards of price control suited to achieve greater stability in the price level and the purchasing power of money.

In style of treatment and organization of material, the writer has had in mind to put the discussion in thoroughly teachable form at the college level of instruction. Although this purpose has required constant effort at clarity and precision, nevertheless it has not permitted a juvenile simplification of matters inherently complex and difficult. Having used the bulk of the materials of the book in class-room instruction for some years, the writer has reason to presume that the subject-matter can be made challenging and intelligible to the university student without sacrifice of the essentials and fundamentals of the problem.

In working toward this end, the treatment does not aim to reiterate the bare rudiments of the subject, as these are supposed to have been covered in the introductory course in economics.

For undergraduate courses the context will usually be sufficient ; for graduate courses, the use of footnote references and chapter readings will enable a more comprehensive exploration of the subject. For courses in money, most instructors will find a supplementary text unnecessary. For courses which combine money and banking, most instructors will find it desirable to use a supplementary text on the banking side of the material.

The setting of the problems of money, bank credit, and prices has shifted during the past two decades. Most of the American books on such problems were written against a background of greenbackism, bimetallism, and agitation for reform of the National Bank Act. The scene changes in essential respects with the great disturbances of the World War. The modern setting places emphasis upon such factors as the war legacy of inflation and deflation, central bank policy, the position of credit, interest rates, and prices in the business cycle, the use of statistics and

PREFACE ee index numbers, the gold exchange standard, the international connection of price movements, and the stability of the price level.

These modern issues are of fully as much interest and concern to the man of practical affairs as to the economist and student. It is hoped that the banker, the business man, the legislator, and the administrator may find in this treatment a wealth of significant material. Various popular monetary fallacies and heresies are analyzed ; some favorite assumptions in banking circles are questioned; some objectives of monetary reform are critically appraised. Any influence which this work may have on the shaping of public policy and of banking standards in this vitally important field must be reckoned among its most cherished values.

LIoneEL D. EpDIEe March 15, 1928 4 a | =~ — ti me - a

ne )> we. | . ny ol iv eR

CHAPTER

XVI XVII XVIII XIX xX

Contents

PREFACE

Tue Funcrions AND Quatities oF Monry

THE Gotp STANDARD: OriGIn, DEVELOPMENT, OuTLooK

Chapter I MONEY, CURRENCY, AND CREDIT

THE modern system of economic activity is aptly termed a money economy. Motivation runs largely in terms of the making of money; calculation of policy runs in terms of gain or loss in money income; wealth and welfare run in terms of money values. The disturbances to economic prosperity are interwoven with the fluctuations of prices and monetary profits; the distribution of property and income is deeply affected by changes in the purchasing power of money; the efficiency of the physical plant and equipment of industry is regulated by exigencies of finance. This phase of economic life is not the only phase, but surely none is more pervasive of all branches and none is more important.

The student of money and prices is not, therefore, concerning himself with a mere isolated fragment of economic science. Rather, he is concerning himself with basic processes which permeate to the uttermost ends of that science and which interrelate themselves with all fields of economic activity. It is well at the outset to realize the intimacy of monetary problems with the length and breadth of modern economic life. It is well to bear in mind throughout the analysis that production, consumption, value, and distribution are saturated with the processes of money, credit, and prices, and that monetary economics is an integral part of the general science of political economy.

The present chapter will outline the structure of the modern monetary order and its origin and evolution.

The Structure of a Modern Monetary System.—On June 30, 1925, the monetary system of the United States contained the following elements:

Amount Per cent distribution Monetary stock of gold coin and bullion. $4,386,000,000 £273 Currency, not including gold.*........ ~ 3,835,000,000 10.9 Demand deposits, subject to check (esti- DOC inl einsa's 6 vies 2s 04+ « 27,189,000,000 76.8

100,0

The relative distribution of gold, currency, and credit varies ~ considerably from country to country. The United States has a high proportion of deposits subject to check, and in this respect closely resembles England. Most other countries rely relatively more upon note circulation than do these two, but they have in recent years moved in the direction of checks and deposits as a substitute for notes. With these qualifications, the monetary system of the United States may be taken as approximately representative of the systems of most of the advanced industrial countries.

(1) Gold coin and bullion.—A distinguished banker is reported to have testified before a congressional committee to the following effect, “There is only one thing which is money, and that is gold.” This strict limitation of the term money is permissible, although in common usage the word refers loosely to paper notes and often to bank loans and deposits. Economists themselves are far from agreement as to the limitation of scope of the word. Faced with this confusion of both popular and scientific usage, it is futile to lay down dogmatically a precise definition and to insist upon strict adherence to that definition. The best solution of the difficulty is to refer to gold as the standard money of the country, to other circulating general media as currency, and to bank deposits as credit. When necessary to refer to the aggregate of all these forms, we can employ some such phrase as the total media of exchange. This use of terms may appear somewhat clumsy, but it has the distinct advantage that ambiguity in the use of the word money is eliminated.

Gold is the standard money in the United States and in most other leading countries. All forms of currency and credit are convertible into gold, or, if not actually convertible, are maintained at par with gold by devices known as the gold exchange standard. Thus, by one device or another, the value of all other forms of media of exchange are maintained at a constant ratio with the value of the gold unit. It is the ultimate money of redemption or parity.

The character of the gold monetary unit is defined by statutory law. By an Act of Congress, the dollar is 25.8 grains of gold nine-tenths fine (23.22 grains of pure gold). Under such an arrangement a dollar is a weight unit. The test of a dollar is a test of weight. When we say that any article or service is worth j MONEY, CURRENCY, AND CREDIT 3 a dollar, we mean that it is worth 25.8 grains of gold nine-tenths fine. When we express the price of any article or service in terms of money, we are merely expressing the exchange ratio between such article or service and some multiple of this fixed weight unit of gold. Accordingly, this unit of weight serves as a unit of account for the whole price system. All reckoning and calculation from the smallest retail purchase to the largest corporate transaction runs in terms of this gold unit.

In order that gold or any other object should function as such a unit of account, it is necessary that it should be generally acceptable in exchange for any other article. The high degree of acceptability of gold is in part an outgrowth of custom and in part an outgrowth of law. Gold is universally desired as an object of adornment and as an object of industrial usefulness. When people endeavor to testify to the merit of an article by declaring that it is “as good as gold,” they are tacitly recognizing the fact that the desire for gold is so universal that one can always ex- . change it for the useful articles which one desires. The force of custom and habit in this respect is buttressed by the provision of law that gold shall be legal tender in settlement.of-debts. ead legal-tender provision requires the creditor to accept gold as settlement in full for any money obligation owing to him.

Although gold has become the preferred standard money of most countries, nevertheless it does not follow that other objects cannot serve the same purpose. Silver preceded gold in the favor of many countries and still retains its place as standard money in a few instances. But it is quite possible to depart from specie entirely in selecting a monetary standard. A paper standard is entirely conceivable. Indeed, most countries during the World War abandoned a gold standard and adopted paper standards. Such paper moneys were originally promises to pay gold to the — bearer on demand, but when gold convertibility was abandoned, “ these promises became ineffective. Of course, there was always the hope that some day the paper moneys would again become convertible into gold, but in extreme cases this hope became so dim as to be negligible. From these war-time experiences, it is neces~; sary to admit that it is possible to have a pure paper money without any reference to specie backing. The unit of account would be a paper certificate, perhaps simply stating, “This 1s_a_dollar. Tt custom and habit induced people to accept these paper counters

. ae es

\ weight of gold or of some other commodity, but would simply be the purchasing power over goods in general possessed by a paper counter. A dollar would be not an amount of gold, but an amount of purchasing power evidenced by a paper certificate. It is not being argued that this kind of paper instrument would be a desirable form of money. It is merely being claimed that, whether good or bad, it would at least be real money. (2) Currency.—The currency in circulation in the United States includes gold coin, coin of silver, copper, nickel, or bronze, specie certificates, government notes, and bank notes. Gold coin has become relatively unimportant. The public, as a matter of convenience, prefer substitute forms of hand-to-hand currency. Gold for the most part is stored in the form of bullion and does not enter circulation at all. In the form of bullion, it is stored in: bank vaults as reserves or is shipped from one country to another in settlement of international balances. Gold certificates are practically warehouse receipts for gold deposited with the United States Treasury. They certify that a specified amount of gold has been so deposited and that the bearer can exchange the certificate for gold on demand. They are much more convenient than actual specie for circulation purposes. Government notes are illustrated by United States notes, popularly known as greenbacks. These notes are relics of the fiat paper notes issued during the Civil War. They are obligations of the government and are maintained at parity with gold. Bank notes are promises to pay a specified sum to the bearer on demand without interest. Federal Reserve notes are a combination government and bank note in that they are direct obligations of the United States Government, but are actually issued by and are also obligations of the Federal Reserve banks. Silver certificates are warehouse receipts for silver on deposit at the United States Treasury. Silver coin and coin of baser metals contain bullion of lesser value than the nominal amount stamped on the coin, but are maintained at parity with other forms of f cur- a rency by limitation of issue and 1 by free e exchangeability with 1 gold and with currency.

This heterogeneous system of notes and coins represents many technical differences in currency issue, but it embodies one basic principle—namely, that all forms of currency are freely exchangeable for gold and are maintained at parity with gold. Under all ordinary conditions, they are as acceptable in exchange for goods as gold itself would be. They perform the daily work of hand-to-hand currency, and everyone readily accepts them in settlement off debts. But it should be clearly recognized that nongold currency is not the standard money of the country. It may be backed by gold, convertible into gold, at parity with gold, and a promise to pay gold, but after all it is not the ultimate standard of value. Gold alone is that standard.

(3) Credit.—Credit is a promise to pay gold or legal-tender paper currency. The bulk of credit transactions cancel out by the process of clearance, so that actual gold or currency is greatly economized. It is commonly estimated that 90 per cent or more of all transactions are completed by means of credit, without the active intervention of money. However, back of this large volume of credit, reserves of gold and currency are necessary, either as a matter of law or custom, or of both. Since credit is a promise to pay money, banks must keep on hand a certain amount of the thing promised. The cash reserves of the banks support the superstructure of credit and insure that depositors can make good their claims to cash whenever they desire. However, as long as they are confident that cash is amply available, they are not anxious to secure it. Only when confidence is undermined does the public make a run on the banks for cash.

This relationship of credit to cash rests upon a difference in the degree of acceptability of the two media of exchange. The acceptability of credit-is-closely dependent upon the credit rating of the individual. Checks are not accepted among strangers. | Credit ins instruments in general acquire acceptability only among | \ that limited circle of business men who know something of the character and resources of the drawers and indorsers. The range of acceptability of currency is not so limited. Paper currency and coin are freely accepted in payment for merchandise in all parts of the country, from complete strangers as well as from the best-known citizens. Even in the worst panic, the general acceptability of such currency is not likely to be undermined. Some there will be who will require actual gold, but the bulk of _ the people will feel secure with any form of cash. Internationally, ‘\paper currency has limited acceptability. The only article which ‘enjoys full international acceptability is gold itself. For this reason, gold is used for the settlement of international balances.

Obviously it is possible to build up a hierarchy of the various forms of media, from most acceptable to least acceptable. Gold is the base, currency is the next layer, and credit is the great superstructure. It is important to visualize the relativity of the acceptability of money, currency, and credit.

There is no single, complete measure of a country’s volume of credit. However, as a basis for estimating the fluctuations of credit which are most closely connected with commodity prices, demand deposits of commercial banks are a fairly reliable indicator. Such deposits, under the Federal Reserve system, may be withdrawn immediately or at most on less than thirty days’ notice. In practice they are always subject to check and can be drawn out at any time by the depositor. Time deposits are not, for most purposes, a good measure of the volume of that form of credit which affects commodity prices. Relatively few checks are drawn against time accounts, and under the Federal Reserve law, notice of thirty days may be required before withdrawal. In many countries, data for demand and time deposits are not separated. The two are lumped together under some such heading as individual deposits. Various classes of loans, discounts, and investments may be taken as measures of credit, although these y reflect more the demand for credit than the supply of it. Book ' credits, charge accounts, and many other forms of credit escape ' the statistician. Clearly, the problem of measuring the volume of credit permits no simple, definite solution. The kind of measure employed depends largely upon the purpose of the investigator. In the present volume, the most common measure adopted will be demand deposits, since these are of primary importance where the purpose is analysis of commodity price fluctuations.

The Origin of Money.—There is a theory which has acquired the weight of an orthodox tradition that money was an invention

MONEY, CURRENCY, AND CREDIT r to overcome the inconvenience of barter. The well-known view of Adam Smith runs as follows: “In order to avoid the inconveniency of such situations, every prudent man in every period of society, after the first establishment of the division of labor, must naturally have endeavored to manage his affairs in such a manner as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry.”1 According to this view, the division of labor makes barter so clumsy and laborious a procedure that from sheer necessity men invent money as a means of facilitating trade between specialists.

This doctrine makes of the origin of money a highly rational and deliberate process. It overrates the conscious intent of primitive societies. It sets up a very speculative, imaginary, early state of industry. Studies of prehistoric man fail to throw much light on a pure barter economy; indeed, they leave us to conjure up such an economy by speculative inference. In the earliest forms of society of which we have any definite knowledge, there are certain articles which to some degree already serve in the capacity of a medium of exchange or unit for reckoning values. In the course of day-to-day exchange of goods, certain articles are so generally prized by all members of the community that people are willing to hold them in the confident expectation that at some later time they can be exchanged for articles of common necessity. Often the various mediating articles are graded according to some scale of uses, so that one article will facilitate exchange of one class of goods, another article will facilitate exchange of a higher class of goods, and so on. It is only gradually that one commodity is singled out for exclusive use as money. This slow evolution more resembles the growth of language than the rationalized process described by Adam Smith. Blind custom ‘and unconscious development are salient characteristics of the process.

Evolution of the Object Selected as Money.—A very - wide variety of commodities have at one time or another served in the capacity of money. The following classification of money commodities is suggestive:

1$mitH, ADAM, Wealth of Nations, Book I, Chapter iv.

(1) Consumable necessities, such as rice, salt, corn, fish, furs, tobacco, cattle, clothing.

(2) Capital goods, such as knives, nails, bullets, weapons, metals.

(3) Articles of ornament and display, such as shells, beads, gold, silver.

(4) Tokens, such as scraps of fur or paper, used as symbols or counters of purchasing power, but having no exchange value as commodities.

There is no fixed order or sequence of appearance among these commodities. Shells were among the earliest known forms of money, but they have reappeared from time to time in less remote periods. The Colonists in America in trade with the Indians and with each other reverted to commodities, such as furs and grains, which had been utilized by other communities many generations earlier. Gold, which is now the favorite money commodity, was in use many centuries B.c., and in general preceded the use of silver. Hence, it is futile to construct any chronological scheme whereby one age nicely follows after another. The scene shifts from country to country and period to period.

Nevertheless, there are certain landmarks along the way which deserve special consideration. The transition from the Old Stone Ages to the New Stone Ages marked the development of settled community life, the domestication of animals, the development of agriculture, and the more intensive specialization or division of labor. The institutions suitable to the new mode of life constituted a setting favorable to the increase of trade, the frequent exchange of certain articles in most common demand, and the gradual survival of one or more articles as the preferred medium of exchange and unit of account. The transition from the Stone Ages to the Bronze Age was characterized by the introduction of bronze and copper as money commodities. The growth of metallurgy facilitated the use of other metals, such as gold, silver, and iron. Thus, the evolving technology of production opened the way to new preferences and new customs in monetary usage.

In most Mediterranean countries, there was a common emphasis upon the ox as standard of value and to some extent as a medium of exchange. The ox unit seems to have achieved a more widespread vogue in this great basin of ancient civilization than any other monetary commodity. The word pecuniary (monetary) is derived from the Latin pecus (cattle). When coinage superseded cattle, the specie unit was an ox-worth of gold. The specie unit was that weight of gold, approximately equal to a modern five-dollar gold piece, which was at the ancient period considered of the same value as a cow or ox. The influence of the old money upon the new is an interesting feature of this monetary transition.

Gold was employed as a form of money as early as about 3000 B.c. At first it passed current in the form of bars, rings, or chunks, usually stamped with some insignia of the ruler, and measured by weight or by size. Coinage made its first appearance in about the seventh century B.c. in Lydia. The device spread gradually westward in Europe and came into usage mainly as a result of borrowing a foreign institution. The technique of coinage passed through many important steps of evolution. Private coinage was displaced by government monopoly; the arts of casting, stamping, milling, and designing so as to avoid counterfeiting, made progress; new devices for debasement and for recovery from debasement were resorted to.

Token money appears in both recent and distant times. The modern forms of token money are chiefly subsidiary coin and fiat notes. The subsidiary coins are a semi-token medium, since they contain bullion of some value as a commodity, but their face value exceeds their value as bullion. Fiat notes have come into existence chiefly as a result of major wars. They are promises to pay specie, but as promises they are worthless because specie payments are suspended. Nevertheless, they pass current, serve as the unit of prices, and perform all the work of money. In primitive societies there appeared occasionally prototypes of such token instruments. The instances were comparatively rare, but they are sufficient to show the possibility of a commodity, worthless in itself, serving as a symbol or counter of purchasing power.

Some Factors in the Evolution of Money.—The evolution of money has been shaped by so many different influences that it is difficult to single out the few primary influences of greatest importance. Nevertheless, some outline of the variety of forces at work is helpful in building up an adequate picture of the diversity and complexity of the process.

In a great many of the early societies, money appears to have been used to make gifts before it was used to any significant degree to facilitate trade. Intertribal gifts and offerings as a symbol of peace, interfamily presents and dowries, tributes and ransoms paid by defeated tribes to their conquerors, donations to priests or other religious officials—all of these required the use of articles held in the highest esteem by the recipients. Moreover, money seems quite commonly to have developed in external relations and foreign trade before it developed in internal relations or domestic trade. The possibility of traffic with the foreigner hinged upon the ability to offer a medium of exchange which appealed vividly to his imagination.

War and religion were powerful influences in the development of money commodities. The exaction of indemnities from the vanquished, the hiring of soldiers, the collection of taxes, the financing of invasion of neighboring territories, alike were facilitated by the use of a money medium. Chiefs, princes, and kings encouraged and enforced the adoption of various commodities for such purposes. The general acceptability of a money commodity was often due to its significance for religious sacrifice. The wide vogue of oxen as a money commodity among Mediterranean peoples was in large measure an outgrowth of the great importance attached to the animal for purposes of religious sacrifice. People sought favor with the gods by offering the best which they had. When gold and silver became available, the temples were filled with vessels and ornaments of these precious metals.

To these factors must be added the strategies of law and government. Rulers collected dues in terms of the commodities most esteemed and prized for their use. They engaged without scruple in plunder and pillage among their neighbors. They coerced the foreigner to use money for the purpose of paying tribute as well as for the purpose of carrying on trade. When the foreigner resisted the innovation of a money commodity, his “‘sales resistance’ was forcibly broken down. Unknown lands and seas were explored in the hope of discovering new monetary treasure. Meantime there grew up a framework of law to protect the property rights of those who acquired wealth and treasure. The development of police power, freedom of contract, rights of private property, and security of ownership insured a set of rules

MONEY, CURRENCY, AND CREDIT II and regulations under which the making of money incomes flourished. In its more sinister aspect, this process was marked by exploitation of the weaker classes, by avarice, cupidity, and

_acquisitiveness. To no small degree, the money institution was forced upon the reluctant masses by the early pastmasters in the art of acquisition.

The predilection for shells, beads, and baubles, and the ultimate adoption of silver and gold as the money medium, suggest the great weight attached to ornament, extravagance, and blandishment in the evolution of money. Although these articles ministered in a minimum to the basic necessities of bodily comfort, they nevertheless captivated the imagination of savage and modern alike. How else could one display his importance in society? The purchase price of a bride, the wedding dowry, the gift to a queen or a temple, the glitter of rare and precious jewelry— these commanded the highest prestige in the community. Conspicuous waste, ostensible extravagance, glaring riches depended upon the blatant show of these scarce articles of beauty.

Permeating all of these influences upon monetary evolution was the process of cultural diffusion. From one or more centers where money originated, the cultural trait spread to the outside world. Independent invention or discovery of the money mechanism was extremely rare. Borrowing of the mechanism, voluntarily or involuntarily, was the most frequent source of its adoption. Local adaptations took the form of substituting commodities of peculiar local importance for those used elsewhere, but the lineage of the new monetary practice as an institution was traceable to preéxisting institutions of similar type in neighboring regions. Travel, conquest, exploration, migration, and mixture of races and nationalities facilitated this. diffusion of the money culture trait.