Money

Preface

The Poliak Foundation for Economic Research welcomed the opportunity to publish, as its first volume, Professor Irving Fisher’s The Making of Index Numbers, because the first need of the science of economics appears to be accurate and generally accepted instruments of meas • urement. In this second volume, we venture upon a pre¬ liminary discussion of money, because money, which is our best measure of the strength of economic motives, should be made the core of economic theory, and because more of the world’s difficulties are due to monetary policies than to any other economic cause. In any event, this is a good time to study the subject. It seems likely that the era of monetary chaos through which we are passing will become the classic example of unsound public finance.

An understanding of the part that money plays in the world is prerequisite to a solution of the most critical problems of our day, national and international. Such an understanding requires a knowledge of those attributes of a money economy that make it essentially different from a barter economy. Failure to take this difference fully into account appears to be at the root of various popular fallacies. Even our textbooks insist, as a rule, that '‘all trade is, of course, barter,” and that “the young econo¬ mist must do exactly as Solomon and Hiram did — think in goods.” With attention fixed on goods rather than on money, however, the economist, young or old, is in danger of overlooking those aspects of modern production and distribution, particularly the unbalancing of supply and demand, that have most to do with the periodic ups and downs of business.

VI

PREFACE

Indeed, it is obvious facts and indisputable conclusions that are most frequently overlooked. For that reason, we have not hesitated to deal at length with various proposi¬ tions that we are well aware will be regarded by some read¬ ers as tiresome platitudes. That the world can consume, in the long run, no more than it produces; that stand¬ ards of living depend on sustained production; that pro¬ duction cannot be sustained at a high level without a medium of exchange; that gold is the most satisfactory basis for a medium of exchange; that central banks should be free from political pressure; that monetary reforms are impossible as long as governments meet their deficits by printing money; that sharp fluctuations in price-levels lead to disastrous results; that competition among con¬ sumers rather than governments should control prices and production: these are among the commonplaces of sound thinking that the war-wracked world of to-day disregards to its sorrow.

“The money fallacy,” said Simon Newcomb, many years ago, “is periodic, overwhelming us, not at regular intervals, but from time to time, owing to the influence of changing events. The Americans, more than any other people, have been its victims.” And now, as a natural aftermath of a world war, we are beset on every hand with proposals for reforming the entire economic order. Most of them blithely ignore what money does, and just as blithely assume that money does, or can be made to do, what it cannot possibly do. To offer another panacea for social ills is no part of our purpose. This is fair warning. The reader who is bold enough to venture beyond this preface into the discussion of a subject that has long been regarded as one of the dullest parts of ‘ ‘ the dismal science ’ ’ will do well to heed this warning. Otherwise, after read¬ ing all that the volume offers, he may cry impatiently:

PREFACE

Vll

“Well, if all this is true of a money economy, have you nothing more to offer by way of constructive proposals?” In subsequent studies, based in part upon this volume, the Poliak Foundation expects to have something to say in answer to that question. It hopes thereby to be of some help, at least, to the various economic agencies, happily increasing in number, that are now endeavoring, on the safe basis of fact and reason rather than on the hopeless basis of prejudice and passion, to hasten the day when money — with its purchasing power protected against excessive fluctuations — will do more to promote and less to hinder the work of the world.

The following pages, however, are only introductory — an indispensable groundwork, we believe, but nothing more. It goes without saying that a discussion of all as¬ pects of the topics we have touched upon — the rate of interest, the function of price, the circuit velocity of money, to go no further — would take us far beyond the confines of this volume. Here we have dealt only with some of the larger aspects of monetary phenomena, the significance of which appears to be overlooked at times in discussions of business problems and reform programs. Later on, we may discuss certain refinements and quali¬ fications.

For the present, we shall be content if the reader agrees with us that all proposals for changes in the established order, no matter from what source they arise, must be discussed in the light of the characteristics here outlined of an industrial society based upon the exchange of goods and services for money. This much is fundamental. In so far as our exposition is erroneous, it must be corrected; but in so far as it is sound, it must be accepted as the ad¬ mitted matter upon which constructive programs will have to be based. If all reformers proceeded from such

PREFACE

• • • viu

safe ground — if they were wise enough to distinguish what they know from what they do not know, and to insist on knowing how things really are, and why they are as they are, before launching a campaign for changing them — the world would be spared much strife and false accusation and bitterness and wasted effort.

The authors are grateful to all those who have read parts of the manuscript. Especially helpful have been the frequent criticisms by Hudson B. Hastings of the Poliak Foundation, and the suggestions offered, from time to time, by Irving Fisher, Wesley C. Mitchell, Gilbert H. Montague, Malcolm C. Rorty, John E. Rovensky, Martin J. Shugrue, Carl Snyder, O. M. W. Sprague, and Paul M. Warburg. Particular acknowledgment should be made of the indispensable services of Edith McDonald of the Poliak Foundation. Some of the chapters are in part re¬ printed, with the kind permission of the publishers, from papers that appeared during 1922 in the Atlantic Monthly , the American Economic Review, the Annalist , and The Saturday Evening Post.

As footnotes, “ like little dogs barking at the text,” annoy many readers, we have corralled all the little dogs in the Appendix, where they can be found easily enough by any one who wants them.

William Trufant Foster Waddill Catchings

Newton, Massachusetts January 1, 1923

Contents

I. Money a Central Interest of Life i

II. Money and Other Terms defined 15

III. Money as a Medium of Exchange 32

Chapter II N

At the outset, we shall do well to define the terms with which our discussion is mainly concerned. Many contro¬ versies are futile because neither side knows exactly what the other side is talking about. This seems particularly true of monetary questions. “No subject in political economy,” says Dean Johnson, “is to-day more fruitful of controversy and misunderstanding among economists, and none seems more cloudy and confused in the popular mind.” 1 Some of the controversies between “welfare economists” and “price economists” are perhaps cases in point. At times, disputants think they are in accord on principles, merely because their disagreement is hidden under ambiguous language. At other times, they think they disagree fundamentally concerning ideas, merely because they are confused concerning the meaning of words. Disputes which seem interminable are sometimes ended abruptly and happily upon the accidental discov¬ ery that the disputants agreed all the time as to the ques¬ tions really at issue. Careful definition of terms helps to make such discoveries prompt rather than belated, scien¬ tific rather than accidental.

Political economy, or economics, as we prefer to call this branch of social science, stands in special need of these precautions because it has only a meager, technical terminology that is peculiarly its own. Exactly what do we mean by consumption, demand, credit, money, wealth, price-levels, profits? These are familiar words of everyday speech: nobody hesitates to use any one of them for fear that he may not have a clear and accurate idea of its meani6 ing. Terms that are equally familiar to the engineering profession, such as the moment of inertia and the radius of gyration, most of us do not attempt to use at all. We know that we do not know what they mean. Various other professions have a similar advantage over econom¬ ics; their terminology makes it evident that hard study is prerequisite to any sensible discussion of their problems. Most people do not talk glibly about torts or spectrum analyses. About money, however, many people take it for granted that they know all they need to know, since their daily dealings are in terms of money. For this reason they are in special danger of concluding that whatever they do not agree with on this subject is wrong and what¬ ever they do not understand is nonsense. 2 Economics might fare better if it had a forbidding vocabulary of its own, freed from the confusion of everyday speech.

Since it has not, we shall devote this chapter to an expo¬ sition of the terms that are most commonly used in suc¬ ceeding chapters. For our present purposes, we do not ask any one to accept these definitions. All we ask is that those who- persist beyond these dull preliminaries will bear in mind that all these terms are used consistently throughout the volume in accordance with these defini¬ tions. General agreement in the use of economic terms would be a great convenience; but it is not a necessity. In order to arrive at sound conclusions, we need nothing but true premises and valid reasoning. Logically, therefore, it is of no importance how we define money or any other term. The essentials are that our definitions shall be clear and definite and that our use of terms shall be consistent throughout with our definitions. 3

Economics defined

Economics, as we shall use the term in connection with the money economy of to-day, is the science that deals with human interests from the standpoint of price. This definition covers not only the production and distribution of goods and services, but all other human interests, in so far as they are measured in terms of money. Although this may seem to be too broad a definition, the usual defi¬ nitions are much broader. They are too inclusive to mark off the field of economics as a science. It has been defined, too broadly for our purposes, as “the study of the mate¬ rial world and of the activities and mutual relations of man so far as all these are the objective conditions to the grati¬ fication and to the welfare of men.” This takes us far into the extensive domain of sociology. Too inclusive, also, is the definition of economics as the science that “deals with those activities of man which are devoted toward securing a living.” This is broad enough to cover large areas of the fields of chemistry and physics. Objectionable, in the same way, is the concept of economics as “ a body of prin¬ ciples which govern the practice of economy in its broadest sense.” The fundamental characteristic of every science is a close approximation to exact measurement. Each sci¬ ence is known by its point of view and its consequent units of measurement. Mechanics measures an engine in terms of horse power, and dietetics measures an egg in terms of calories; while economics measures both engines and eggs in terms of dollars. Without such a measure, there would be no science. For this reason, we consider money the central and unifying feature of the science of economics.

Money defined

By “money” economists usually mean anything that is (1) passed from hand to hand throughout a community in payment for commodities and services, and (2) regu¬ larly taken with the intention of offering it in payment to i8 others, and (3) customarily received without assay or other special test of quality or quantity, and (4) received without reference to or reliance upon the personal credit of the one who offers it. To cover all this, we shall use the term “currency.”

The term “money” we shall use throughout our discus¬ sion, in accordance with the everyday practice of business men, to cover not only all forms of currency, but bank credit as well. By “bank credit” we'mean deposits trans¬ ferable by check. It is important to bear in mind, in con¬ nection with all that follows, that the term “money” is always used as synonymous with “circulating purchas¬ ing power,” and always includes both currency and bank credit, as defined above.

Things that serve the Purposes of Money

From the standpoint of business, money interests us chiefly in so far as it aids in producing goods and moving them to consumers. Anything at all which performs that work has much the same major effects upon industry as though we called it money. And so, in connection with all the more important aspects of the world’s work, no mat¬ ter how we define “money,” we must take into account everything that serves the purposes of money. Otherwise, we shall be in constant danger of overlooking some of the factors that determine prices and production and, in gen¬ eral, the state of business activity. Liberty Bond coupons, for example, in so far as they serve as currency, must be dealt with as though they were money in circulation. We can safely ignore them only if, for the purpose at hand, the volume of coupons used to transfer goods is small enough to be negligible. The same is true of various other media of exchange, not included in our definition of money, which sometimes serve the purposes of money.

For this reason, we must take into account another kind of credit, namely, that allowed by dealers to their customers. This we shall call “book credit.” Book credit is the deferring of a payment of money. A man accepts book credit when he postpones the payment of a debt that is due to-day, and he extends book credit whenever he permits any one to postpone a payment that is due to-day. Although this kind of credit is less important than bank credit, it must, nevertheless, be taken into account in connection with any study of business fluctuations. For a while, it moves goods without the use of money. The failure to make allowance for book credit, as we shall see later on, leads frequently to fallacious reasoning concern¬ ing the relation between the money and the goods that change hands within any given period of time.

Money in Circulation defined

Money is in circulation, in our use of the term, as long as it is available for expenditure. The unused lending power of banks is not money in circulation, for it is not available for expenditure: it becomes money only through the joint act of a bank and a borrower. The lending power of banks is like gold in the mines; it is not money until somebody puts it where it can be used as money. All bank deposits are money in circulation, no matter what pro¬ portion of these deposits are checked out within any given period of time; just as all coins in people’s pockets are money in circulation, no matter how many of them are spent on any given day. In a certain sense, it is true, all money is idle except when it is actually being used in exchange; but in that sense only one dollar out of several thousand is active, and all the rest are idle, in any given minute. It is only a matter of convenience which concep¬ tion we employ. Either, if used consistently, leads us to the same conclusions as the other.

Money versus Wealth

In two opposite ways, money has been a source of con¬ fusion to economic thought. First, men attached to money a kind of importance which it did not possess. They regarded money as a kind of national wealth which, like any other kind of national wealth, increased in value as its quantity increased. Later, after the fallacy of this first position had been exposed by economists, money came to be regarded by many people as relatively insignificant. And then, mainly through the extensive development of bank credit, money achieved a far greater significance in the economic world than ever before. Thus, at first because its importance was overestimated, and later be¬ cause its importance was underestimated, money has proved to be an historic stumbling-block in the way of an understanding of economic processes and results.

It is important to keep in mind the distinction between money and other forms of wealth. From the standpoint of an individual, money is regarded as wealth, for it is a command over the objects of wealth. The more money an individual has, the better off he is, economically. It is not true, however, that the more money a nation has, the better off it is. The material wealth of a nation is its wheat, factories, railroads, mines, forests. From the com¬ munal standpoint, money is wealth only in so far as it is made of metal, which is wealth as such. This means that, for the individual, money is suspended purchasing power, a fact that we shall undertake to show is of the utmost importance to business. For the nation, however, money is suspended purchasing power only in so far as it is made of metal which will be accepted outside the country, on a barter basis, in exchange for goods.

This may seem too simple to need emphasis, but, as a matter of fact, it is not at all easy to rid the mind of the idea that an increase of money is necessarily an increase of national wealth. If a man has ten dollars in his pocket, and his Government has not been playing fast and loose with its currency, he rests secure in the thought that those dollars mean for him a fairly definite quantity of potatoes, shoes, or tobacco, which is certainly real wealth to him. Except as noted, however, money is not wealth, and it is not even converted into wealth when it is spent for goods. It is merely used as a measure of command over wealth and a means of exchanging wealth; and the one who receives it uses it in the same way as a measure of his command over other people’s wealth. Various popular fallacies — those, for example, having to do with over¬ production, and with the favorable balance of trade — are due, as we shall endeavor to show later on, to the con¬ fusion of money and wealth.

After the World War, the illusion of wealth due to in¬ flated money continued. By borrowing during the War, England added about forty thousand millions of dollars to the wealth of the nation — as wealth is tabulated in official reports and usually thought of by the people; but it added no material wealth. On the contrary, the nation as a whole exchanged vast stores of real wealth — machines, ships, chemicals and so forth, used up in the War — for paper evidences of debt. This paper is noth¬ ing but a kind of claim of some people on a part of the future production of all the people. No laborer would consider a claim on that which does not yet exist, and which he, himself, must produce if he is ever to enjoy it, as present wealth. Yet national bookkeeping invites the people to make precisely that error. Monetary com¬ plexities obscure the fact that no system of bookkeeping can be devised, either for individuals or for nations, which can transform future money obligations into present real wealth.

Prices versus Price-Levels

Throughout our discussion, we must take special pains to keep in mind the distinction between individual prices and the general price-level. By individual prices, we mean the exchange value of any commodity — say a ton of coal or a barrel of flour — in terms of dollars. By the general price-level, we mean a composite of all prices; that is to say, the cost of coal, flour, and everything else at one time or place compared with the cost of the same things at another time or place. We shall try to make clear that the paramount interest of every community in the price-level is clear and simple: where the price-level happens to be is of minor importance; the major need is that it should stay where it is. The interest of the com¬ munity in individual prices — that is to say, in the rela¬ tion of prices to each other on a given price-level — is not so obvious. That is to be the subject of the eleventh chapter.

Currency in the United States

Currency in the United States consists of gold coin, silver dollars, paper money, and convenient amounts of so-called subsidiary money — half-dollars, quarters, dimes, nickels, and pennies. The increase in the volume of cur¬ rency since 1800, compared with the increase in popula¬ tion, is shown in Figure 2.

The volume of gold coin fluctuates in amount with the production of gold, and with the export and import of gold, for any one owning gold bullion may at any time obtain from the United States Government the corresponding amount of gold coin, and any one owning gold coin may obtain the corresponding amount of gold bullion.

The volume of silver dollars sometimes fluctuates with changes in the currency laws. In 1922 there were about 400 million silver dollars, in the Treasury or in circula¬ tion, and under the existing law this amount could not be more than about 600 million dollars. There is no reason to convert silver dollars into bullion, for as bullion the silver in a dollar is not worth a dollar. Paper money con¬ sists of gold and silver certificates, United States notes, United States Treasury notes, National Bank notes, Federal Reserve Bank notes, and Federal Reserve notes. Each gold certificate represents a corresponding amount of gold in the United States Treasury, and the certificates are exchangeable for gold, and gold is exchangeable for certificates. Likewise, silver certificates represent actual silver dollars in the United States Treasury and are exchangeable for these dollars; and silver dollars may be exchanged for silver certificates.

For many years, there have been $346,681,016 of United States notes, and under the law this amount re¬ mains unchanged. Against these notes there is a gold re¬ serve of approximately $150,000,000. When these notes are redeemed, they are reissued. United States Treasury notes were issued to pay for silver purchased under the Act of July 14, 1890. The amount of these notes has been reduced by the coinage of silver dollars, until to-day it is only approximately $1,500,000.

National Bank notes may be issued at any time, by any National Bank, in any amount not exceeding at any one time 125 per cent of the amount of the capital and sur¬ plus of the bank. When these notes are issued, the issuing bank must deposit, with the Treasurer of the United States, United States Government bonds at par, or at market price if this is lower, to the full amount of the notes issued, and in addition five per cent of the amount of the notes in gold to be used in redeeming such of these notes as are presented for redemption.

Federal Reserve Bank notes are issued by Federal Re¬ serve Banks under the same condition as National Bank notes, except that the amount is not limited by the cap¬ ital of the Federal Reserve Banks. Both National Bank notes and Federal Reserve Bank notes are obligations of the banks and of the United States.

The paper money of the United States, however, con¬ sists largely of Federal Reserve notes. There are approx¬ imately 2500 millions of these notes outstanding, while there are less than 100 millions of Federal Reserve Bank notes and not more than 760 millions of National Bank notes. Federal Reserve notes are obligations of the United States Government. The conditions under which they are used may be discussed to best advantage after a short analysis of the Federal Reserve Banking System.

The Federal Reserve System

For the purposes of the Federal Reserve System the United States has been divided into twelve districts. In each district there is a Federal Reserve Bank, situated in a large city, and owned mainly by the so-called Member Banks. The Member Banks in each district include all the National Banks in the district and such of the State Banks as have chosen to join the system. Each Federal Reserve Bank is directed by a board of governors, partly elected by Member Banks of the respective districts, and partly appointed by the Federal Reserve Board. All Fed¬ eral Reserve Banks are largely under the control of the Federal Reserve Board which consists of eight members: the Secretary of the Treasury and the Comptroller of the Currency, ex ofliciis, and six other members appointed by the President of the United States.

The Federal Reserve Banks receive deposits from Mem¬ ber Banks, from the United States Government, from such Government agencies as the War Finance Corpora¬ tion, and under limited conditions from other banks, but not from individuals or corporations. The Federal Re¬ serve Banks lend their funds to some extent by purchas¬ ing United States Government securities and short-time obligations of States, municipalities, and banks; but they lend their funds principally by rediscounting for Member Banks certain commercial notes, drafts, and bills of ex¬ change. These commercial obligations are called “ short-time paper,” for they must be in connection with current transactions and have not over ninety days to run, except in the case of agricultural and live-stock paper which may run for six months. Such obligations are called “self-liquidating.” This means that the maker of the obliga¬ tion is engaged in a transaction where in due course of business it is expected that there will be received within the time-limit the money to pay the obligation.

Federal Reserve Notes

To return now to Federal Reserve notes, a subject of much importance in connection with most of the chapters that follow. Upon the security of short-time paper, a Fed¬ eral Reserve Bank may obtain, from the United States, Federal Reserve notes. Behind each of these Federal Re¬ serve notes there is not only the short-time obligation of some business in good credit which expects the money to pay the obligation within the specified time, but also the endorsement of a Member Bank, which carries a lien on its assets, and the obligation of the Federal Re¬ serve Bank. In addition, the Federal Reserve Bank must have, in gold reserves, forty per cent of the amount of all Federal Reserve notes for which it is responsible, or else suffer a penalty. In addition to these reserves against notes, a Federal Reserve Bank must maintain a thirty-five per cent reserve in gold against its deposits.

Federal Reserve notes, however, together with all other forms of currency, are used for only a small proportion of the nation’s business. The rest is effected by means of bank credit. We may now consider how bank credit is created and used.

Bank Credit

Bank credit is based in part but, as we shall note presently, only in part, on money entrusted to the bank by depositors. Originally a bank of deposit was a custo¬ dian of currency and the depositor paid the bank for safe¬ guarding it until he demanded it. In the course of time, experience showed that a bank could be so conducted as to pay all depositors on demand (not, of course, the actual coins and notes which were deposited but their equiva¬ lent) and yet make some use of a considerable portion of the money on deposit. This has been possible, however, only when banks have made such use of money on de¬ posit as never to interfere with the obligation to pay de¬ positors on demand.

In so far as a bank makes use of depositors’ money under such conditions that it can regain the money on de¬ mand, obviously the bank is prepared to repay its depos¬ itors upon their demand. But to make full use of their money, banks must part with most of it for definite peri¬ ods. Most borrowers from banks require money for ninety days, six months, or a year. Although the banks may lend depositors money for such fixed periods, the banks re¬ main under the obligation to pay depositors on demand.

Experience has shown that if a bank retains in its vaults a part, say fifteen per cent, of the money on de¬ posit with it; if it lends part on demand; if it lends part for ninety days and part for six months, almost invariably the bank is ready to pay those depositors who actually demand their money. If money on hand is reduced, money loaned on demand can be called in; and then, as payments are made to the bank when loans fall due, the bank can retain the money, and not lend it out again for fixed periods until the bank is assured that the require¬ ments of depositors again justify such disposition of their money.

Notwithstanding the fact that a bank need not keep all the depositors’ money in its vaults, but may lend it to others, the primary duty of a bank is to safeguard this money. Depositors are willing that banks should be more than mere custodians, but they insist that banks do not lose their money. Therefore it is necessary that banks not only pay those depositors who demand their money, but also safeguard the money of all depositors. Sound banking practice involves, therefore, two fundamentals, both of which are essential if depositors are to trust their money to banks. One is that banks always have at hand sufficient money to pay those depositors who demand payment. The other is that banks make only such use of depositors’ money as is consistent with safeguarding this money.