Chapter IV: Money and Credit

“The sole fact that credit is today the normal and proper expression of value and of exchange has introduced an element of extreme instability into all contemporary economic systems. Modern economic systems appear to be balanced on a knife’s edge as it were; the tiniest excess or deficiency of national credit can tip the balance in one direction or the other. This system is minutely adjusted, so to speak, to reflect the smallest increment in weight which it can just support, and that is why it is so extremely sensitive.”

KARL LAMPRECHT

1. What Is Money?

We have already established that money is a device which is indispensable to an economic system founded on exchange and on an intensive division of labor. Consequently, any investigation of the modern economic process remains incomplete without a special chapter on money. It is, moreover, certain that we shall be unable to understand the operation of our economic system so long as we do not have a clear apprehension of the peculiar qualities of money. It is in the deepening of our knowledge of these qualities that economics has made its most notable advances in recent years.¹ We can go even further and say that the history of peoples and of civilizations cannot be fully understood if attention is not given to the important role which money has played in history, and in the development of the way of life of different epochs.²

We do not know when money first appeared in human history. Very probably, it was not invented in the same manner as the electric light bulb or the typewriter. What most likely happened is that one day, many thousands of years ago, people suddenly became conscious of the fact that money existed. Only one thing we can say with certainty: to be really money, money must have had to fulfill, thousands of years ago as today, the essential condition of being generally exchangeable and acceptable as a means of payment. We can understand, therefore, why the earliest form which money took was some particularly desirable commodity which could, if need be, serve for real satisfaction. Early money was constituted at times of bars of iron, at times of strips of cloth or of leather, and most often of cattle, proof of which we find in the fossil remains of language, in the Latin word “pecunia” and in the English “fee” which corresponds to the German “Vieh” (= cattle). Eventually, the precious metals, for many and obvious reasons, attained preeminence as money. Thence begins the history, open to our investigation, of money and currency.

We are already familiar with the economic revolution which followed the introduction of exchange based on money. Exchange was henceforth separated into two acts: the act of “selling” one’s own commodity against the receipt of a sum of money, and the act of “buying” another’s commodity by surrendering a sum of money. We can see that each of these two acts is an act of exchange: exchange of commodity against money, and exchange of money against commodity. In place of the original exchange of commodity against commodity, we now have the concatenation: commodity—money—commodity. Simultaneously, money made possible the participation of more than two persons in the act of exchange. The end result of the process of exchange in a money economy is, of course, an exchange of commodities against commodities, but in contrast to the economy of exchange in kind, this result is obtained in an indirect way by a detour passing through several individuals who make use of a general medium of exchange.

If we term a “good” every object or service to which we attach value, then money too is a “good.” Nevertheless, it is a good of a very special kind. We value an ordinary good because it is capable, in some way, of ultimately satisfying a want. In the act of satisfying a want, it renders up its economic soul, so to speak; it achieves the purpose of its existence. In a word, every other good but money serves for “real” satisfaction. From the raw material to the packaged product, chocolate goes through numerous stages and passes through many hands, but its final inglorious destiny is to be eaten. It is not so with money. If commodities providing real satisfaction are by essence and destination mortal, money is essentially immortal because it is not used for real satisfaction but for “circulatory” satisfaction. In other words, we do not derive satisfaction from money by eating it, but by spending it and by making it circulate, intact, from hand to hand. This does not mean that money, insofar as it is constituted of some material substance, may not also furnish real satisfaction. People can collect coins, melt them, or hang them on a watch chain. A man can paper his walls with bank notes, if he is willing to allow himself this extravagance. But money in these cases at once ceases to be money. It becomes a simple commodity, just one more addition to the strongly mixed company of chocolate bars, sugar buns, and phonograph records. It is essential to the concept of money that it circulate, and in a direction opposite to the (finite) circulation of ordinary goods. Whereas chocolate bars, phonograph records, etc. are always leaving the stream of goods in order to be consumed, it is the essential characteristic of money that it remain in circulation as money.

Money accomplishes its mission by enabling us to widthdraw from the huge store of the economy’s goods those which we desire. Ordinarily, we obtain this right by contributing, on our side, to this same store of goods. Money has thus been compared to an admission ticket providing access to the “social product,” that is, to the current stock of goods and services. Money may be compared, if we wish, to a “promissory note” on the social product. Such comparisons are permissible on the condition that we do not forget that money implies neither a qualitative nor a quantitative determination of a right to the commodities, nor any juridical claim on the store of commodities. The determination of the if, the what, and the how much is always subordinated to the market and to the formation of prices, in such a way that the “right” to something is narrowed to a simple possibility. From the purely juridical point of view, money should be defined only as “a final means of liquidating debts,” providing that it has been imbued by law with the quality of being “legal tender for all debts, public and private.” Such money confers on him who is obliged to pay (the debtor), vis-à-vis him who is entitled to receive payment (the creditor), the right to an acceptance which frees him from his debt.³

But if we employ—with this reservation—the comparison of money to a promissory note, we can see at once that it is possible to imagine a money which is incapable of furnishing any real satisfaction and which is thus without material value. But this lack will not negate the functions of money as a general medium of exchange provided that it retains the essential quality of “general acceptability” (F. von Wieser). The lack of a material content offering the possibility of real satisfaction does not exclude the possibility of a circulatory satisfaction, and if we value money according to what we can buy with the monetary unit, money without material value of its own possesses “value” just as well as money with material value. The value of money in the former case reflects the value of the goods which we can buy with the monetary unit; it does not flow from the value of the money material, but arises from the function of money which is to circulate and to be exchanged against commodities. Money in this context has a functional value and not a material value. The belief that it is the very essence of money to be incarnated in a piece of precious metal (metallism) is therewith refuted. The question of what will circulate as money is ultimately determined by the confidence of the people in the possibility of returning money to circulation. This confidence can be strengthened in two ways: either by endowing money with its own material value (coin), or by making it legal tender (nonredeemable paper money of fixed par value). As a general rule, it is necessary to educate the population to accept paper money which is nonredeemable and without material value. In the eastern provinces of Turkey, for example, it was still recently almost impossible to compel the peasants to accept the government’s (then stable) paper money. A Turkish official related to the author that while on an inspection trip, he had succeeded in getting a village wagoner to accept paper money rather than gold only by using his fists (admittedly, a somewhat crude illustration of the concept of fixed par value!). In our case, fisticuffs have been replaced by war which has so accustomed us to the use of paper money that we can scarcely recall a time when paper money was redeemable in gold. Indeed, we find it hard to imagine that our fathers could take their bank notes to the banks and obtain pieces of gold as naturally and as easily as postage stamps. Plainly, then, the connection of money with a precious material is not essential, though this does not exclude the fact that such connection may be very desirable. Normally, there is no need of making theatre tickets out of candy, unless it is feared that the management will sell more tickets than there are places, in which case we can console ourselves a little with the tickets made of candy.

In the case of inconvertible paper money, we see with special clarity the nature of money as a simple but indispensable auxiliary to economic activity, a kind of poker chip as it were. From the point of view of economics, money is a way-station, an item in the national ledger which disappears in the final accounting and which does not itself constitute an integral part of a nation’s wealth. A nation does not become richer or poorer because its supply of money increases or diminishes, but only when the supply of goods of which it disposes grows greater or smaller. If the supply of money in a country increases or diminishes while the supply goods remains the same, it follows that the supply of goods which can be purchased by the monetary unit will become smaller in the first case (inflation) and greater in the second (deflation). If the bank notes of a private individual are destroyed in a fire, his loss, which may be very great, does not necessarily represent a loss for the national economy, apart from the negligible value of the paper and the costs of printing. Indeed, the sum of which this unlucky individual is deprived actually benefits the rest of the population, for the purchasing power of all the other bank notes increases by the fraction corresponding to the amount of the burned bank notes. What has taken place is a sort of miniature deflation.

Pursuing this notion still farther, we see that however we use our money, our conduct will exercise an influence on the whole of the national economy. If we spend it, the way in which we spend it affects, in the fraction corresponding to the amount spent, the way in which goods are produced. If we do not spend it, we can either put it in a bank and thereby give to others the possibility of buying raw materials and machines, or we can pile it up in the cupboard at home. In the latter case, the purchasing power of the money becomes inactive to the profit of all the other members of the payment community who can now buy more cheaply. Whatever we do, we can never escape the responsibility which is imposed on us by the possession of money.

Money is one of those objects whose essence can be explained only in terms of their functions. Thus, the essence of money resides in its function of being a general medium of exchange. Of critical importance, in this connection, is how the broad masses of the citizens will react in a period, say, of hyper-inflation when once they become fully aware that money is no longer “functioning” as it should. Money is so indispensable to the modern economy that where the state-issued currency is rendered worthless, the country’s ongoing trade and business activities, even where they are at a low level, will of themselves bring into existence a substitute means of calculation. Such ersatz money may take the form of stable foreign monies as in the inflationary period following World War I when the dollar, the guilder, etc., supplanted the worthless local currencies in many countries. Or it may take the more unusual form of some scarce commodity such as the cigarettes which did yeoman service in those European countries which were devastated by World War II.

Only money makes possible the satisfaction of the complex pattern of consumer desires by causing the highly differentiated structure of production to shift continuously in response to such consumer desires. Only money makes possible rational economic calculation in that it provides a device for comparing production and consumption, profits and costs, and, as we have already seen, reduces all economic quantities to a common denominator. “Money alone is the absolute good: not merely because it satisfies a want in concreto but because it satisfies want as such, in abstracto” (Schopenhauer). It is, as Dostoievsky once expressed it, “coined freedom.” Finally, money has supplied the foundations for our modern credit system, without which the contemporary economy would be unthinkable. But it can furnish these manifold services only so long as it remains a general medium of exchange and meets the requirements of a “healthy” money.

When we consider somewhat more closely those services which money renders in virtue of its quality of being a general medium of exchange, our attention is drawn especially to the aforementioned attribute of money which enables us to compare all the objects of exchange with one another in such a way that we can express their value as a multiple of the common monetary unit. This is what is meant when we say that one of money’s functions is to be a general measure of value. However, we cannot regard this function of money as being equally important and equally necessary as its function of being a general medium of exchange. It is more accurate to say that because money in its concrete form is a general medium of exchange, the exchange value of marketable goods will inevitably be expressed in units of money. Money as a general medium of exchange consists of the concrete dollar notes or checks which I use to buy goods. Money as a measure of value, on the other hand, is the dollar as an abstract unit of account.

Closely connected with the exchange function of money is another of its functions, that of being a general means of payment. Every money payment need not involve an exchange transaction; payment of taxes, of penalties, of damages, gifts of money and many other examples show that money can also function as a means of unilateral value transfer. But this again is possible only because it is a general medium of exchange.

A further consequence of the exchange function of money is its ability to be an intermediary in capital transactions, i.e., its quality of making possible the emergence of debtor-creditor relationships and the transfer of the ownership of capital from person to person or group to group.

Finally, money’s function as a medium of exchange renders it an appropriate means of capital saving and capital movement. Or to express this idea somewhat differently, money becomes a vehicle of value through time and space (von Mises). Actually, money nowadays—except in periods of distress—no longer serves in any significant degree as a means of capital saving, since the average person is apt to put what is not mere working capital or simple cash reserves into investments which will yield a profit, or he turns over his savings to a bank to administer. It is as a vehicle of capital movement that money has retained a larger measure of significance.

In general, all monetary functions are exercised in a given country at a given time by one and the same monetary system. Indeed, its capacity for assuming all of its functions may be regarded as one of the criteria of a healthy money. It may happen, however, that the different functions are accomplished by different kinds of money. Such a process of division of functions was very well illustrated during the German inflation following World War I. The more worthless the mark became, the more of its functions it had to abandon. The first of its functions which the mark was to surrender was that of being a means of capital saving and capital movement; subsequently, it had to forego its function as go-between in capital transactions. Only an uncommon lack of economic insight could have induced anyone in the year 1923, at the height of the German inflation, to hoard mark bank notes or to buy mark securities. Next to go overboard was its function as a measure of value as more and more people turned to calculation in gold or used the “index” and the multiplier. The government itself was compelled in the end to collect its taxes in “gold marks.” Thus was the mark increasingly restricted to being merely a means of exchange and of payment. It was just about to lose even these last functions when the successful stabilization of the mark was accomplished in November 1923.

2. From Cattle to Bank Notes

If we contemplate a collection of old coins, we can readily perceive some of those important features of a sound money about which we have been speaking. What first strikes us is the great variety of coins and of coin systems which appear to have existed in former times side by side within the frontiers of a single country. What a muddle of doubloons, continentals, florins, threepenny pieces, marks, ducats, and gold louis! We may rightly conclude that our ancestors’ patience must often have been tried with the continual counting and recounting made necessary by such a multiplicity of systems. Plainly, the elimination of such confusion by the establishment of a homogeneous monetary system must be numbered among the primary aims of monetary policy so soon as business activity has expanded beyond the rudimentary stage. Homogeneity of the monetary system is thus one of the principal requirements of a sound money: all monetary units within the same economic system should be exchangeable against one another at as stable and firm a ratio as possible. In spite of the antiquity which attaches to the discovery of the coin system, thousands of years of experimentation were required to develop the homogeneous monetary systems which, to our generation at any rate, seem so self-evident, and to put an end to the confusion in computation and, what was even more disagreeable, in prices. Actually, the homogeneity of national monetary systems is an accomplishment only of recent times. The close of the 19th and the beginning of the 20th centuries witnessed, moreover, the successful creation of international monetary homogeneity paralleling that existing on the national level, thanks to the gold standard which united all countries within the framework of one monetary system. The abandonment of the gold standard in our times means then, with regard to the postulate of monetary homogeneity, an unfortunate step backwards, for so far there has been discovered no other international monetary system. A special and thoroughly unhappy phase of the age-long struggle for national monetary homogeneity is represented in the attempts to combine the use of both gold and silver, in a fixed ratio, in one monetary system (bimetallism).⁴

The collection of coins we are contemplating tells us something else which is perhaps of even greater importance. Many of the silver coins will be seen to give off a suspicious reddish glint, indicating the presence of a strong alloy of copper. No great powers of imagination are needed to conjure up the coin debasements of past centuries (and the monetary depreciations which accompanied them); they are, in fact, the historical prototypes of the inflations of our own times. These experiences of the past make clear the importance of that other requirement of a sound money, stability of value, and the strenuous and repeated efforts required in the course of history to establish it. In this instance, too, the introduction of the gold standard in the nineteenth century was the factor most responsible for the establishment of money upon a solid base. Again, too, it is our own destructive age of wars and revolutions which is responsible for the sabotaging of this accomplishment. Once more, the maintenance of monetary stability has become an economic problem of the first magnitude.

There is one fact, however, which an examination of our coin collection does not reveal to us, but with which we have become intimately familiar as the result of our own painful experience. Though the people in whose pockets our collection of coins once jingled were plagued by a confusion of monetary systems and of coin debasements with a resulting lack of monetary homogeneity and stability, one thing was self-evident: their freedom to exchange their money against goods or against other kinds of money. Of course, there were instances in these earlier periods of where an unscrupulous ruler of the modern stamp such as King Philip the Fair of France would proclaim, as he did at the end of the thirteenth century during his struggle with the Papacy, an embargo on the export of money and letters of credit, thereby introducing what we term at the present time exchange control. But we have no record of Erasmus, Luther, or Goethe encountering any difficulties in exchanging their money on their respective journeys to Italy. Restrictions on freedom to exchange domestic money against foreign money are in fact an invention of our own time, and we have little reason to be proud of having made exchange control a normal procedure and therewith deprived money of that freedom which in the eyes of our forbears pertained to its very essence. Moreover, we find that in some countries even the freedom to exchange money against goods has been so restricted by rationing regulations that for the purchase of certain categories of goods money is worthless unless accompanied by a special permission to purchase. Out of such restrictions collectivist Russia has made a permanent system, a proof that in the collectivist economy money completely changes its role and in any case can no longer be equivalent to “coined freedom.”

If we keep in mind that the three most important postulates of a sound money are homogeneity, stability of value, and circulatory freedom, then we may regard the history of money as a history of the tribulations which it has endured: a history of debasements, of risky experiments, of repeated violations of these postulates. At the very least, valuable insights can be gained by reviewing the history of money from this angle. Another vantage point for the study of monetary evolution is found in the interesting fact that from earliest times to the present day, money has become progressively more abstract, more “aenemic.”

The cattle in which Homer counted out the value of Achilles’ shield was evidently a very concrete kind of money. Even in the age when men began to use specific weights of the precious metals as money, the purely material aspect of money was still of prime consideration. This primitive method of payment which consisted of weighing out amounts of the precious metals (“weight payment” according to G. F. Knapp) is memorialized in the fact that many contemporary words for money were originally nothing more than designations of weight, as in the obvious cases of the English “pound” and the Italian “lira,” but also in the cases of the German “mark” and the Yugosalv “dinar” (from the Latin “denarius”), among others. Nor did the evolution towards an even more complete dissociation of money from its purely material content end here. Those of us who have ever had to buy a railroad ticket at the last minute will appreciate the difficulties attendant upon the method of “payment by weight,” difficulties which disappeared after the tremendous forward step taken in antiquity—probably for the first time in Crete in the second millenary B.C., then later in Asia Minor—when unitary weights of the precious metals were introduced, embossed with an official stamp guaranteeing their weight and purity.

With the stamp of guarantee, there came into being a money which made it possible to make payments not by weighing, but simply by counting. The exchange value of this fully-valued money (currency) was still identical with its material value. But the next stage of development saw the issue of token money or subsidiary coin, that is, of under-valued monies whose material value represented only a fraction of their exchange value. This marks the further progress in the direction of monetary aenemia; and in fact in most civilized countries today, people know no other coins than these. These aenemic coins, however, are used only in transactions involving small sums; by far the greater part of payment transactions in all civilized countries is effected by means of money still more ephemeral in nature, viz., stamped pieces of paper.

In the beginning, paper money still had a certain material aspect, in the sense that it was a receipt for a deposited amount of precious metal. This early paper money, moreover, had a 100 per cent coverage and could always be converted into precious metal. It was, therefore, originally a circulating claim against the “bank” which had assumed the safekeeping of a quantity of the precious metals and issued in exchange therefor a receipt (bank note). The banks soon noticed the influence of the “law of great numbers” on their increasing volume of business: their deposits and withdrawals largely offset each other. And they noted the even more important fact that the bank notes began to circulate as money, supported by the confidence that people had in the possibility of redeeming them. Consequently, it did not appear necessary to cover the notes to the extent of 100 per cent. Even where full convertibility of the paper notes was maintained, a given ratio of reserves to liabilities was sufficient to enable the bank to meet the demands for redemption which could be expected in the ordinary course of business, a ratio which was later legally fixed in most countries, in one form or another. This meant, of course, that the bank of issue could put into circulation many more notes than the equivalent of its reserve in precious metal and could thus issue more promises of payment than it would have been able to meet if they had all been presented at once. Such additional bank notes got into circulation when the bank of issue used them to accord commercial credits, primarily in the form of purchases of promissory notes from which the interest was deducted in advance (discounting). By using these additional bank notes to furnish credit, the bank had succeeded in a bit of legerdemain which to this day many people fail to understand: it had furnished credits which did not arise from previous savings but from the issuance of additional bank notes (creation of credit).⁵

The bank notes thus put into circulation were born of a credit operation and hence represented a combination of the monetary system and the credit system. So long as the notes remained redeemable (full gold standard, gold circulation standard),⁶ they preserved a certain indirect connection with the concrete matter of money. But this connection became increasingly attenuated when redeemability was restricted to certain categories of payments (such as payments to foreign countries) and when the domestic circulation of gold coins was prohibited (gold bullion standard).⁷ The divorcement of bank notes from a precious metal was made complete with the abolition of redeemability in any form (paper standard). Before World War I, the full gold standard prevailed in the economically developed countries; subsequently, it was the gold bullion or gold exchange standard which became the dominant type. And today we find the paper standard, under various forms, almost everywhere in operation.

3. Money and the Banking System

But even paper money, abstract and ephemeral though it be, cannot be considered as the final stage of that “aenemia” which has characterized the development of money. Paper money is, after all, “cash”; it is a visible concrete currency. Now it is commonly known that most business transactions in the economically most developed countries are consummated not by the use of actual cash but by the transfer of bank deposits. The participants in such transactions maintain bank accounts against which they write checks. In disposing of their bank deposits in this way, they make use of a variety of money which is designated as credit money (bank money, check money, or demand deposits). In this, the dominant medium of exchange today, money has found its most abstract expression. Even the simple counter, as it were, has disappeared from the gaming tables of finance—people simply “keep track of the score.” If, under the general heading of “the banking system” we include both banks of issue and banks which handle demand deposits (commercial banks), it is evident that in the economically advanced countries the monetary system is intimately connected with the banking system. Thenceforth, money and credit constitute an inseparable entity.

We find, too, that the same sequence of credit expansion which is associated with the issuance of bank notes occurred in the case of demand deposits. Thus, to the extent to which demand deposits circulated as money, the banks felt themselves freed of the obligation of maintaining a 100 per cent cash reserve behind these deposits, despite the fact that they are debts of the bank subject to payment on demand (hence the name “demand deposit”). To provide the necessary minimum liquidity (the ability to meet expected demands for cash) it was deemed sufficient to maintain a supply of ready money equal to, let us say, 10 per cent of the total demand deposits oustanding. The banks could loan out the remaining 90 per cent and earn enough in the process to administer the deposits without charge or even to pay a small amount of interest on them. Hence-forth, the whole art of bank management consisted in effecting a daily compromise between the two opposed principles of liquidity and profitability, with the over-all goal being the maintenance of minimum liquidity and maximum profitability. Small errors of calculation could be corrected by recourse to the so-called “money market.” Thus, the whole system is truly “minutely adjusted to reflect the smallest increment in weight which it can just support.” We can now observe what an important bearing banking has on the entire monetary system. Prior to the development described above, only cash money circulated. Thenceforth, demand deposits circulated simultaneously with the greater part of the cash which gave rise to these same deposits. The circulation of demand deposits or check money was equivalent in short to the “creation” of an additional supply of money.

There is yet another angle from which we can observe how the modern banking system affects the supply of money. A businessman, for instance, may establish a demand deposit (checking account) not only by depositing hard cash in the bank, but by getting the bank to extend him a loan for this purpose. Thus, by adhering to a proportion of 1 : 10 between cash reserves and outstanding demand deposits, with 90 per cent of the actual currency paid in being loaned out, the bank can, by granting cerdits, create new checking accounts (demand deposits) to an amount nine times greater than that which has been paid into it. It is clear in this case that the bank, following the same procedure as a bank of issue, grants credits not out of preceding savings, but from additional resources obtained by the creation of credit. To what extent is a bank capable of creating credit? This depends upon the bank’s liquidity requirements, that is, upon the amount of the reserve which the bank must maintain to meet the demands for the conversion of check money into actual cash. This preoccupation with the maintenance of liquidity, which no bank can safely ignore, more or less effectively limits the bank’s power to create credit. The liquidity requirements of banks fluctuate with the degree of confidence placed in banks, with the amount of the payments made to those who are outside the circle of the bank’s regular clients (payrolls, small payments to retail merchants, farmers, etc.), and with the turnover of individual bank accounts. But more significantly, the fluctuations to which bank liquidity is subject—and pro tanto the fluctuations to which the total supply of credit is subject—coincide to a very large extent with the cyclical fluctuations of prosperity and depression. In a period of expansion the economy’s supply of credit increases, while the banks’ liquidity is proportionately lowered (credit expansion); in a period of depression the banks seek greater liquidity and are forced, in the process, to contract credit (deflation).

It is of great importance that we thoroughly understand the above relationships, for without such understanding we cannot adequately comprehend the perils and the problems which currently beset our economic system. Hence, no effort should be spared in getting to the bottom of these relationships.⁸ One way of doing this is to imagine an economy where all payments are effected without the use of actual currency. Evidently, in such case, there would no longer be any limit to the power of the banks to create credit. The more widely extended is the system of transactions effected without cash, the greater becomes the power of the banks to “manufacture” credit. Yet again, we may compare a bank with the cloakroom of a theatre. In both cases we deposit something: in the bank, currency and in the cloakroom, our hats; in both cases in exchange for a receipt which authorizes us to reclaim what we have deposited. But while the cloakroom employees cannot count on the theatre-goer’s not presenting his receipt because he regards it as just as good as his headgear, the bank may safely assume that its clients will in fact consider their receipts (i.e., their right to claim their deposits) to be equally as good as their deposits. A bank is in consequence an institution which, finding it possible to hold less cash than it promises to pay and living on the difference, regularly promises more than it could actually pay should the worse come to the worst. Indeed, it is one of the essential features of a modern bank that alone it is unable to meet a simultaneous presentation for payment of all the debts owed by it (“run on the bank”).

When the whole banking system of a country is subject to a run, as in the United States in 1933, it is an event of very grave import. For then the whole ingenious system of immaterial money, founded on convention and on trust, suddenly crashes down and the desire of the public for solid cash erupts with elemental force. What then takes place is a sudden panic collapse of the credit edifice to some anterior stage of monetary evolution. In this headlong retrogression money may fall back past even the paper bank-note stage to full-value coins or, in more drastic cases, to unstamped pieces of the precious metals. In the ’30’s, a number of countries underwent such monetary crises and their effects are still being felt.

The so-called “creation of credit” by commercial banks is possible only because the circulation of short-term credit is equivalent to a circulation of money. To create credit, then, is to create money. This mysterious and seemingly sinister phenomenon may be better understood by once again comparing checks (or demand deposits) with bank notes and by recalling the historic discussion of the problems of bank note issuance. Two important facts emerge from such reflection: (1) bank notes can be printed ad hoc, as the occasion demands; (2) the commercial bank, with its power of creating credit, differs in this respect only in degree and not in kind from the note-issuing bank. No one, certainly, will gainsay the first point. For the truth of our second observation, we have only to recall that the transfer of a demand deposit from one person to another by means of a check, coupled with the confidence of the parties to such a transaction in the solvency of the bank, causes this deposit to circulate exactly as money.

Checking accounts may be regarded as money held on the bank’s books and awaiting withdrawal; checks and drafts drawn on these accounts are, therefore, simply means by which such book money is put into circulation. In the extent to which, in accordance with the law of great numbers, deposits and withdrawals offset each other, and to the extent, furthermore, that the circulation of demand deposits is confined to the banking system’s circle of customers, it is not required to maintain a 100 per cent reserve behind such deposits. On the contrary, a bank can, as we have seen, loan out a part of its deposited funds, even though such funds are callable by the bank’s depositors at any time. Bank notes and demand deposits are thus very similar to each other. Both have this in common, that they are circulating claims which the banks write against themselves and which they can create to an extent equal to some multiple of their cash reserves. The only difference between them is that the acceptability of demand deposits for purposes of general circulation is more limited than that of bank notes, but this is a difference of degree and not of kind.

Few will contest the fact that since bank notes are actual money and can be issued theoretically in unlimited amounts, there should be some kind of legal control over the note-issuing power. This is all the more necessary since in practically all countries bank notes are full legal tender even though they are no longer redeemable in specie. But it is interesting to recall that the power of banks to issue notes at will and thus to increase the supply of money was once just as controversial as is today the corresponding, if more limited power of the commercial banks to create credit.

To be sure, the issuance of bank notes has always been regarded as an undertaking fraught with risk to the community. The history of the note-issuing banks is a long and anguished one, dotted with ruined banks and—what is even more depressing—strewn with the memorials of wrecked monetary systems. “Never,” said the English economist Ricardo 150 years ago, “has a bank which had unlimited power to issue paper money not abused that power.” Thus the conviction grew that the issuing of bank notes should be subject to definite limitation. But where ought the limits to be placed? On this point there was a very heated argument one hundred years ago between two schools—the Currency School and the Banking School. Their differences, even after the lapse of a century, have lost none of their significance.

The opinion of the Banking School with respect to the phenomenon of credit creation may be summarized as follows: bank notes and demand deposits are similar inasmuch as both are phenomena pertaining to banking—hence the name “Banking School”—but neither exert any active influence on the monetary system. In the rigid view of this School, the monetary system will remain shipshape so long as bank notes enter circulation through banking operations alone, that is, through short-term credit transactions. In these circumstances, every legal barrier to the issuance of bank notes would be harmful while, conversely, unrestricted powers of issuance would be absolutely indispensable to maintaining elasticity of the supply of currency, and to adjusting this supply to the fluctuating needs of business. This adjustment would ensue automatically because demands for credit on the note-issuing banks would rise or fall as general economic activity rose or fell. Thus, the position of the note-issuing banks with respect to the increase or decrease of the volume of bank notes would be a completely passive one, since the volume of bank notes would depend on the money and credit needs of the business community and not on the volition of the note-issuing banks. A change in the volume of currency would be not the cause but only the effect of events occurring in the sphere of production, or of changes in the price level, or of cyclical changes, or of variations in the rates of foreign exchange, etc. Every attempt of the banks to alter the volume of currency above or below the requirements of business would fail; if too many notes were issued, the excess would flow back to the banks, while if not enough were issued, business would resort to other circulating instruments.

The Currency School, in contradistinction to the Banking School, considered bank notes to be a money phenomenon and not a credit phenomenon. It reasoned, therefore, that the issuance of bank notes should be just as jealously supervised as the issuance of any other kind of money. In opposition to the Banking School, it argued logically that the sum total of bank credits is not unaffected by the policy of the note-issuing bank which fixes the conditions of credit, particularly the rate of interest. The issuance of bank notes is to be considered like any other creation of money and there is nothing in the nature of the operation of the note-issuing bank which could prevent either an excessive creation of credit (credit inflation) or an insufficiency of credit (credit deflation). Hence, the issuance of bank notes requires strict legal supervision. But this much established, the Currency School forgot that demand deposits can be just as much a source of credit inflation or of credit deflation as bank notes. As a result, the adherents of this school suffered considerable disillusionment when the severe restrictions on the issuance of bank notes embodied in the famous English Bank Act of 1844 failed to solve the problems incident on credit creation; indeed, these restrictions on bank-note issues served to stimulate the growth of the demand deposit (check) system. The more rapid the increase in the last hundred years of the importance of demand deposits in business transactions, the clearer it has become that regulation of the note-issuing banks alone will not suffice to cope with the exceedingly difficult problems attendant on credit creation. Control of the note-issuing banks must be supplemented by regulation of the demand-deposit system.

Though academic economists are now unanimously of the opinion that commercial banks can and do create credit, there is many a practical man of affairs who is inclined to view such “theories” with skepticism. There are still people in the banking world who hold that their own experience invalidates the creation of credit theory in toto. Such skepticism may be traced, in part, to exaggerated or incomplete descriptions of the process of credit creation. We must guard against overstating our case, for there are, of course, the limits to this process which were noted in an earlier part of this chapter. We also must take into account the optical illusion which causes the individual banker to view the aforementioned process in a radically different way than the economist who surveys the banking system as a whole. Thus the individual bank cannot continue indefinitely to make loans, for the cash reserve it must maintain clearly sets a limit to its loanable funds. If Bank A considers a reserve of 10 per cent adequate, then it can only loan out 90 per cent of its deposited cash. But the process of credit expansion is not therewith concluded because this 90 per cent will ordinarily become a primary deposit in Bank B which again loans out 90 per cent, etc. When the process is continued throughout the entire banking system it will be found that eventually nine times the original amount of cash deposited in the system will have been extended in loans (9/10 + 9/10 • 9/10 + 9/10 • 9/10 • 9/10 . . . . . . . 9/10ⁿ). We see that the “enigma of the banking system” (Philipps) consists in a given amount of cash becoming the basis for a towering edifice of credits and deposits, though this is clearly not the case with respect to the individual bank. Hence, by the very nature of the complicated process to which we have just alluded, it becomes impossible to distinguish between genuinely primary cash deposits and those derivative deposits that come into being through the creation of credit. Consequently, we can readily see why an individual banker will so vehemently deny the process of credit creation, a process that to us appears so self-evident. Such denial absolves the individual bank of the “guilt” (or at any rate of the responsibility) of creating additional credit. Now when we said that a bank must pay heed to its cash reserves, we said nothing more than that it must stay liquid. The degree of liquidity desired or required fixes the outer limits to a bank’s powers of credit creation, provided, of course, that actual currency is not completely displaced by demand deposits (check money) centralized in a single bank.

Two conclusions may be drawn from the foregoing analysis. First, that the global sum of a country’s demand deposits does not represent pure saving, but is in large part a consequence of the creation of bank credit. This is something which must never be lost sight of in considering any economic problem. The second conclusion is that money and credit constitute an entity, the complexities of which place a number of formidable difficulties in the path towards economic and monetary stability. A bank is no ordinary commercial enterprise. It is not just a cloakroom where we deposit our monetary property for safekeeping, or a kind of shop where one rents costumes for a masquerade, but an enterprise which exercises a profound influence on the circulation of money and thus on the entire economic process. Consequently, the thought never occurs even to the most intransigent European liberal to abandon the control of such an enterprise to itself. And so we repeat: he who does not understand the role of the banking system is incapable of understanding the operation of the modern economic system.

4. Inflation and Deflation

The foregoing description of credit creation and of the problems generated by this process has shown us how important it is that the economic system be assured of monetary stability. We also learned how difficult it is to prevent those monetary diseases (inflation and deflation) which destroy this stability. Let us begin by setting forth the nature of the problem as realistically as we can. Let us suppose that, in the year 1913, a dentist made a wager with his patient that the price of the gold filling he was about to insert would follow the general rise in prices which was then getting under way. The dentist, of course, would have lost his wager; a quick glance at his files on his previous gold purchases could have told him as much. For the simple and ingenious coupling mechanism of the gold standard, by defining the monetary unit as a fixed weight of gold, tied gold to money in such wise that the price of gold remained stable though all other prices fluctuated.

A contrasting and yet equally illuminating experience is one which was recounted to the author by a lady of his acquaintance. She showed him a magnificent belt of wrought silver which she acquired in India on a visit there with her husband towards the end of the last century. She explained proudly that she had got a wonderful bargain inasmuch as the native jeweler had demanded for his silver belt neither more or less than its weight in silver rupees. Had she not thereby gotten the exquisite handiwork for nothing? In truth, the lady’s satisfaction in her bargaining ability was premature for at the time of her visit the pure silver standard in India had been replaced by a blocked silver standard. When the Indian government discontinued the free coinage of silver, silver became scarcer in minted form than in unminted form; the bonds linking money to a precious metal, corresponding to those of the gold standard, had been broken, causing the mint value of the silver rupee to exceed considerably the value of silver itself. The rupee became a kind of metal bank note whose scarcity was determined not by the production of silver but by the decision of the issuing government. To underscore the moral of this story, we have only to visualize a transaction wherein a purchaser of visiting cards is required to pay a quantity of paper money equal to the weight of the cards.

And now a third illustration which takes us from the gold standard and the blocked silver standard to paper money. More than a quarter of a century ago, an astonishing and ingenious crime was committed which resulted in the institution of a most interesting civil suit. A band of international swindlers succeeded in convincing the well-known London firm of Waterlow & Sons, engravers of postage stamps and bank notes, that they were the representatives of the Central Bank of Portugal come to place an order for the printing of a large quantity of Portuguese bank notes. The order was duly filled and the bank notes delivered to the swindlers. When the fraud was finally discovered, the Bank of Portugal caused all of its extant notes (of whose genuineness there was, naturally, no question) to be withdrawn from circulation and replaced with a new issue. Since it proved impossible to catch the criminals, the Bank of Portugal sued Waterlow & Sons, demanding that the engraving firm make good the losses resulting from the issue of the fraudulent notes. The English courts presently discovered that the case involved issues of unusual subtelty and complexity, adjudication of which necessitated the admission of testimony by leading monetary theorists. The question before the courts was: how great were the actual losses incurred by the Bank of Portugal? If it had been postage stamps instead of bank notes in which the swindlers had trafficked, it is perfectly clear that the loss of the Portuguese government would have equaled the total value of the stamps. With respect to the bank notes, however, no such simple calculation could be made. Among the many questions which troubled the experts the following stand out as particularly relevant to our study: would the Bank of Portugal have issued the same amount of notes even if the swindlers had not done so? If not, was the increase in the supply of money resulting from the introduction of the fraudulent notes good or bad for Portugal? The answer to this question would depend on whether the circulation of the fraudulent notes disrupted the orderly processes of the Portuguese economy looking to the regulation of the volume of money; it would depend, in other words, on whether the additional notes served to avert an otherwise imminent deflation, or whether they resulted in an inflation. If the first supposition were true, then the swindlers would have unintentionally done a favor to Portugal. These and other considerations did, in fact, influence the highest English court to award the Bank of Portugal only a fraction of the damages it had claimed.^*

What lessons are contained in these three illustrations? They point to the truth of at least these three principles: (1) the value of money is determined by its relative scarcity; (2) monetary policy has no more important task than to regulate this scarcity in such wise that the value of money remains as stable as possible; (3) this task can be accomplished in different ways. Under a gold standard (or a silver standard with free coinage of fully-valued coins), the scarcity of money is automatically fixed by the scarcity of the standard metal. This, in turn, is affected primarily by the quantity of the metal which is produced in a given period. Such relationships are characteristic of so-called tied monetary standards under which money is linked securely to a precious metal with the regulation of the quantity of money being a function and a reflection of variations in the quantity of the precious metal. Under the “blocked” silver standard and, a fortiori, under the paper standard, the quantity of money is independent of the quantity of the precious metal and is regulated by the arbitrary decree of the government (free or manipulated standard). The determination of whether the control of the quantity of money should be submitted to the automatic forces of gold and silver production or to the conscious decree of the government is one of the cardinal problems confronting those entrusted with the making of monetary policy and upon the answer to which depends the choice of the particular monetary system in each case. A liberal—one [in Europe] who puts his trust in economic laws rather than in the whims of government—will generally opt for the tied or automatic standard. A collectivist—one who is willing to trust the caprice of the government over natural economic forces—will prefer the untied or manipulated standard. Since, however, the linking of money to a precious metal implies a much stricter control over the quantity of money than can be expected from arbitrary government regulation, we find that, paradoxically, it is the [European] liberal who, in money matters at least, demands a discipline far stricter than the collectivist.

It is, indeed, not surprising that the liberal should attach such importance to the maintenance of effective and positive control over the quantity of money and that he should desire in this case at least, that nothing should be left to chance. It was an English liberal of the early nineteenth century and one of the leading adherents of the Currency School, Lord Overstone, who drew the clear and emphatic distinction between money and goods. There is no sense, he observed, in applying to the manufacture of money the principle of cheap and abundant production which, with regard to the manufacture of goods, the liberal expects to find operating in a competitive economy. What is essential in the case of money, on the contrary, is strict control of its quantity. While the liberal holds private initiative and free competition to be desirable in the realm of goods production, he knows that judicious regulation of the quantity of money cannot be expected to emanate from those sources. What is needed instead is a carefully thought-out system of monetary control instituted and supervised by government. If in the production of goods the most important pedal is the accelerator, in the production of money it is the brake. To insure that this brake works automatically and independently of the whims of government and the pressure of parties and groups seeking “easy money” has been one of the main functions of the gold standard. That the liberal should prefer the automatic brake of gold to the whims of government in its role of trustee of a managed currency is understandable.

This distrust of the manipulated monetary standard is not alone a consequence of the liberal philosophy. Almost the whole course of monetary history vindicates this distrust. For as money has become increasingly etherealized—attaining the pinnacle of incorporeality and insubstantiality in the form of credit money—the danger of arbitrariness and caprice in the regulation of the quantity of money has become correspondingly greater. It is, of course, true that even the standard metals have been at times subject to considerable fluctuations in value. But these have been negligible compared with the monetary fluctuations which have occurred since manipulated standards have been adopted, and the laws of nature and of economics exchanged for the unpredictable caprices of politicians and governments. It was the paper standard which first taught us the meaning of the word “inflation.” Indeed, it would be difficult to cite a single paper standard which has not sooner or later succumbed to depreciation because the government concerned was unable or perhaps even unwilling to keep the quantity of money within limits.

It should by now be clear that the quantity of money in circulation decisively affects the purchasing power of money, an increase in the supply of money lowering its purchasing power (inflation), a decrease raising it (deflation). In the long run, the first mentioned danger of an inflationary increase in the money supply has always been decidedly greater than that of a deflationary reduction in the supply of money. The temptation to engage in inflation is omnipresent for its immediate consequences are usually very popular. Recent history knows no case of the murder of a statesman responsible for inflation. On the other hand, there have been at least several instances in which statesmen thought to be responsible for deflation have been done in (e.g., in Czechoslovakia and Japan). This one example may suffice to show that arbitrariness in the matter of issuing money tends more in the direction of the “too much” than in the direction of the “too little.” And indeed every money of which we have record has at some time in its history been prey to the disease of inflation which, if it has not proved fatal, has left the permanent scar of depreciation. If we lay side by side a modern bank note and the gold coin which is its equivalent, we could lay heavy odds on the certainty that in a hundred years’ time the bank note—even the “hardest” and most respectable—will have suffered the ignominy of depreciation while the piece of gold will still enjoy the same valuation and the same esteem as the gold pieces of King Croesus of Lydia enjoyed 2,500 years ago. The most finely-spun theories on the stupidity of the gold standard, all the clever satires on mankind’s frenetic digging for the yellow metal, and all the ingenious schemes for creating a gold-less money will never change the truly remarkable fact that for thousands of years men have continued to regard gold as the commodity of highest and surest worth and as the most secure anchor of wealth. One may protest this as often as one likes—the fact remains. It is this stubborn fact that continues to make the gold standard the best and most eminently useful of all monetary systems.

Our researches thus far have perhaps yielded sufficient proof of the theory that the value or the purchasing power of money is determined primarily by the proportion of the quantity of money to the volume of goods (quantity or scarcity theory of money). Hence, those abrupt changes in the purchasing power of money which are the characteristic symptoms of the monetary diseases of inflation and deflation will be found to have originated in a marked increase or decrease in the quantity of money (including credit money). The most important prerequisite of an orderly monetary system is therefore the regulation of the quantity of money in such wise that the monetary system is immunized against the ever-present contagion of inflation.

These considerations need to be emphasized at a time like the present marked as it is by a rash of risky monetary schemes aimed at banishing the dominant bogey of our time—deflation.⁹ In the long run, we repeat, it is inflation, and nowadays especially the insidious inflation of credit money, which constitutes the greatest and most imminent danger. Indeed, the effectiveness (or lack of it) in keeping money scarce may well serve as a criterion by which we may judge and understand, in its minutest operations, the performance of any monetary system whatsoever. The linking of money to a precious metal, the establishment of reserve requirements by central banks, the strenuous efforts to control the operations of the note-issuing banks—all these measures serve the same ultimate aim of keeping money scarce. And now for decades the world has been wrestling with the ever more acute problem of finding the most efficacious methods of braking the credit-creating powers of the modern banking system. In the long run, moreover, it is the greater or smaller degree of scarcity of money in an economy which determines the exchange relationships between domestic and foreign money (the exchange rate).¹⁰

Our generation, which recalls the despair caused by the inflations in the post World War I era and which was required to undergo the self-same catastrophes following World War II, needs no instruction concerning the fact that the worst disease with which a monetary system can be afflicted is that kind of inflation which is caused by a deficit of the government budget. The German inflation of the years 1920-23 will always remain as a horrible example of what happens when a government attempts to cover its budget deficits by resorting to the deceitful and irresponsible expedient of the printing press. What in Germany began as “deficit financing’’ ended in a series of catastrophic price rises which caused the shameless enrichment of some at the cost of the hopeless impoverishment of others, and in a serious undermining of the whole economic and social structure. But the inflationary creation of money caused by the budget deficits of government need not necessarily lead to the economic and social disorders attendant on an open inflation of the kind that followed World War I. Beginning in 1933, National Socialist Germany demonstrated that a determined government can change an open into a repressed inflation by placing the country in the economic strait jacket of a command economy. Rationing, the imposition of stringent controls on wages, consumption, capital investment, rates of interest, and similar measures aimed at restricting the free use of the increasing amount of purchasing power may succeed in containing for an indefinite period the mounting inflationary pressure on prices, wages, exchange rates, stock prices, etc.

Since Hitler has shown how far and how long a government can neutralize an inflation by means of the command economy, we may well ask ourselves whether from now on there will be any government which will not follow the same road when it disposes of a functioning coercive apparatus. The greater the inflationary pressure the stronger will be the counterpressure of the command economy needed to repress it. By the same token, the command economy must resort to ever more comprehensive and ruthless controls if it is to effectively contain the mounting forces of inflation. This leads logically to the question of whether such a command economy is possible without totalitarian slavery (of which the Third Reich was such a repellent example).

The experience of Germany demands that we consider a little more closely this peculiar phenomenon of repressed inflation. As we have seen, it consists, fundamentally, in the fact that a government first promotes inflation but then seeks to interdict its influence on prices and rates of exchange by imposing the now familiar wartime devices of rationing and fixed prices, together with the requisite enforcement measures. As inflationary pressures force up prices, costs, and exchange rates, the ever more comprehensive and elaborate apparatus of the command economy seeks to repress this upward movement with the countermeasures of the police state. The repressed inflation can be conceived of, then, as the deliberate maintenance of a system of coercive and fictitious values in which, economically speaking, there is neither rhyme nor reason. Such a system is an inevitable feature of a collectivist economic regime and is to be encountered wherever socialism has gained control of influence (Soviet Union, National Socialist Germany, Austria, Great Britain, Sweden, and some other European countries). Where this repressed inflation leads was shown with tragic incisiveness in the complete disintegration of the German economy, a process which was arrested only by the comprehensive economic and monetary reform which restored a free price system in which actual rather than fictitious supply-demand relationships were reflected (Summer, 1948). The prolongation of a policy of repressed inflation means that all economic values become increasingly fictitious, and this in a twofold sense: (1) stated values correspond less and less to actual scarcity relationships and (2) fewer and fewer transactions are completed on the basis of such values. The distortion of all value relationships which accompany the division of the economy into “official” and “black” markets, and the struggle between the directives of the market and those of the administrative authorities finally lead to chaos, to a situation in which any kind of order, whether of the collectivist or the market economy type, is lacking.

We see, then, that a repressed inflation is worse than an open one because, in the end, money loses not only its function as a medium of exchange and as a measure of value (as happens in the last stages of an open inflation), but also its even more important function as a stimulus to the production and distribution of maximum quantities of goods. Repressed inflation is a road which ends inevitably in chaos and paralysis. The more values are raised by inflation, the more will the authorities feel compelled to use their machinery of compulsion. But the more fictitious the system of compulsory values, the greater will be the economic chaos and the public discontent and the more threadbare either the authority of the government or its claim to be democratic. If the repressed inflation is not stopped in time it will, drawing strength from its own momentum, lead to the dissolution of economic activity and perhaps even of the state itself. This modern economic disease is one of the most serious of all; it is doubly pernicious since it tends to be recognized only when it is in an advanced stage.¹¹

Today in 1962, inflation, in the particularly pernicious form of repressed inflation it took in the immediate postwar period, has been overcome in a majority of the developed industrial countries of the free world, if not in a large number of underdeveloped countries and in the Communist states of whose economic systems it constitutes an integral part. This does not mean, of course, that inflation may be considered as banished. Instead of the clearly distinguishable forms it has hitherto assumed, inflation has taken on a creeping character, the analysis of which is not an easy task. Two particularly noticeable types of this “creeping inflation” are the so-called “wage inflation” and the so-called “imported inflation.”¹²

By wage inflation is meant the inflationary impulses originating in the labor market, and which take the form of wage increases which—in those labor markets dominated by powerful labor unions—are so rapid and of such large amount that the ratio between goods and money is upset. The result is on the one hand an inflationary overpressure of demand and, on the other, an increase in costs which may bring an increase in prices in its train, though in both cases inflation is possible only to the extent that the monetary and fiscal authorities permit the creation of a corresponding addition to the supply of money. Were such additions to the supply of money not permitted, the wage and/or price increases would have the effect of making some portion of domestic output unsaleable and thus cause unemployment. But when the government and the central bank of a country believe themselves obliged to maintain full employment despite wage increases, the choice they then face of accepting some unemployment or some inflation will often be decided in favor of inflation. The decision may also be, as has been the case for some time in the United States, to effect a compromise between these two alternatives. In such case, unemployment and economic stagnation are joined to continuous, if mild price increases. In the United States, labor union power of a degree unknown in Europe has caused a wage inflation of such a severe and chronic type that the government and the central bank (the Federal Reserve System) have been obliged—in the interest of avoiding unfavorable effects on the balance of payments—to go further in the direction of tight money than they would otherwise dare to go, given the risks implicit in such policies of unemployment and economic stagnation.

We may speak of imported inflation where a country such as West Germany achieves a continuous surplus in its balance of payments (i.e., an excess of payments from abroad over payments to abroad, irrespective of the transactions giving rise to such payments). Since the surplus takes the form of a net receipt of foreign monies or gold which the central bank (the Deutsche Bundesbank) is obliged to convert into domestic currency, its end effect is to expand the domestic money supply. Because the increase in the quantity of money is not offset by an increase in the quantity of goods—the surplus itself being due to the exportation of a portion of domestic output without any corresponding importation of goods—such “monetization of the balance of payments surplus” becomes the agent in an inflationary increase of prices, wages, investments, consumer demand, and in the emergence of an acute shortage of labor (over-employment) . The inflation in such case is not the “fault” of the domestic monetary authorities, but is brought in from outside, is “imported.” The origin of the balance of payments surpluses which cause such imported inflation lies, paradoxically, in the fact that in the affected country (Germany in our example) efforts to control creeping inflation by means of stricter monetary and fiscal discipline are more successful than elsewhere. In the specific case of West Germany, moreover, part of the reason for the surplus was the fact that the competitiveness of the German economy was continually increased as the result of advances in production and distribution techniques and the reestablishment of contact with foreign markets in the years following war and occupation. The result was that Germany was a country which, until the revaluation of the Deutschemark in March 1961, remained “cheap” in relation to other countries. The only effective remedy for this particularly virulent form of inflation was the surgical operation of changing the rate of exchange: the international purchasing power of the Deutschemark was increased in order that its internal purchasing power be prevented from falling.¹³

5. The Purchasing Power of Money and Its Measurement

Implicit in the preceding section are a number of exceptionally complex problems which we must seek to make explicit, at least. Even the concept of the purchasing power of money—called also the “value of money”—is a problematical one. In contrast to ordinary goods, money, the good in terms of which the prices of the “ordinary” goods are expressed, has itself no price, at least within the area in which it circulates as money. Outside of this area, it cannot logically be used as money, so that the price at which it sells on currency markets in terms of the monetary units of other payment areas (exchange rate) represents not the price of money considered as money but of money considered as merchandise. As an indicator of the “value” of money, the exchange rate is consequently of no use to us, no more than the fact that for one dollar we can obtain one hundred cents. For help in this problem, we must turn to another concept, viz., that the purchasing power of money is a function of the height of the price level; or in other words that it is a reflection of the average rate at which goods and money exchange for one another. If prices rise, the purchasing power of money falls; if prices fall, the purchasing power of money rises. However, every rise in an individual price is not equivalent to a fall in the purchasing power of money. A genuine fall in the purchasing power of money will take place only if there is an average rise in prices all along the line, a rise in the “general price level.” Otherwise, we have to do simply with a rise in the prices of some goods, not with a depreciation of money. The purchasing power of money can be measured, therefore, only by the average “bundle” of goods and services that can be bought for a monetary unit.

But such a definition does not advance us much, as the following illustration will show. As it happens, our forbears in antiquity have left us the interesting piece of information that the construction of the Propylaea on the Acropolis in Athens cost a little more than 2,000 gold talents. Was this dear or cheap? Naturally, the talent is not negotiable on the exchanges of our day, but on the basis of its gold content we can establish that a sum of 2,000 talents would be equivalent to about 4,000,000 gold dollars. But was the purchasing power of the 2,000 talents equal to that of 4,000,000 gold dollars? We must admit that we are completely in the dark about this. It is possible that in ancient Athens, bread and eggs were much cheaper than they are today in New York or London; on the other hand, some things were probably more expensive than they are today, some, indeed, infinitely more expensive—things which all the gold in antiquity could not buy for the simple reason that they did not exist. Such were the radio, the telephone, electricity, and other goods upon which we moderns place such great value. Since the composition of demand has completely changed, we lack the means of comparing the purchasing power of money of those times with that of our own. Moreover, comparisons of purchasing power cannot be made unless we know the relative importance of each item in that average or typical “bundle” of goods of which we have spoken, and this relative importance of the different items varies in the course of the years. Hence, historical comparisons of purchasing power are always matters of conjecture, more or less. Furthermore, since the relative importance of each commodity varies not only from century to century but also from country to country, comparisons of the value of money are exceedingly difficult to make not only in time but also in space. True, we hear talk of expensive countries and cheap countries, and there is no denying that with an equal sum of money a traveler may be better off in one country than in another. But it is only with serious qualifications that we can accept the flat assertion that four German marks have the same purchasing power as one United States dollar.^* Many who have spent longer periods of time in the one and in the other country, and whose scales of preferences differ, may rightly question the validity of such parities, proving once again how questionable are all such calculations of average purchasing power.

The extremely problematical character of such average estimates may be seen in an analogous kind of measurement. Every skier knows that meteorological data describing the snow as being of a depth of so and so many inches will often be unreliable; violent winds or a hot sun may have left his favorite slopes bare of snow. The practice of announcing the average fall of snow is not, for all that, devoid of utility. But if we would really like to establish what the average fall is, we should eventually have to measure the depth of the snow in all locations and to reduce to an average these numerous particular data. But even then we would have omitted to consider a fact of especial interest to skiers, namely, that though some slopes may be superbly covered, there will be others completely denuded of snow. Measurement of the snowfall in all places is patently impossible, but another possibility remains. We can content ourselves with measuring the fall of snow in fifty places, and with these partial measurements estimate the average fall, taking into account the area covered at a given height by the snowfall. In other words, we use a practicable number of particular measurements and then “weigh” the results according to their importance. This is exactly the way in which we attempt to estimate the average level of prices (and the variations from it) : we ascertain this level by means of so-called index numbers. We are now aware, however, that there is a certain arbitrariness which enters into all such calculations.¹⁴ This arbitrariness, we may add, is limited in its effects, being of less importance the greater is the change in the value of money. For example, during the German inflation, the crudest index numbers still served their purpose. Vice versa, a change in the value of money can be unambiguously determined only when the change is one of large degree.

If the concept of the purchasing power of money is problematical, the supposed connection between the purchasing power of money and the quantity of money, of which we have already made mention, is equally so. It does not detract from the fundamental truth of the quantity theory of money to add that there are features of this theory which are, to say the least, highly problematical.¹⁵ As it is hardly possible to give here even a brief description of the more doubtful aspects of the quantity theory, we shall content ourselves with two important observations. We should note, in the first place, that the quantity of money is not the sole determinant of its purchasing power. It is clear that if the quantity of money remains the same while the quantity of goods offered for sale varies, the purchasing power of money will vary correspondingly. Secondly, it is clear that it is not simply the quantity of money which determines purchasing power but only that fraction of it which is actually spent in a given period. If the rate at which money is expended (velocity of circulation) increases, the effects on the purchasing power of money will be the same as those caused by an increase in the quantity of money, velocity remaining unchanged.¹⁶ Thirdly, particular attention should be directed to the fact that the connection between the quantity of money and its purchasing power is less and less problematical the greater is the change in purchasing power. The greater the degree of monetary depreciation, the simpler becomes the analysis of its causes. In the macroscopic proportions of the great German inflation (192023), even the crudest form of the quantity theory which attributed the depreciation of the mark only to the gigantic increase in the money supply fitted the facts immeasurably better than those explanations which sought to ascribe the blame to other factors, in particular to Germany’s then “passive” (unfavorable) balance of payments.

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^*See C. H. Kisch, The Portuguese Bank Note Case (London, 1932).

^*The official rate of exchange as of 1962 was 4 Deutschemarks to 1 dollar.

NOTES

1(p. 79) The Recent Evolution of Monetary Theory

This evolution is marked by a growing tendency to end the isolation of the theory of money from the main body of economic thought. Increasingly, monetary theory has been merged into the theories of credit, of capital, of wages, of interest, of foreign trade, and especially of cyclical theory. There is also increasing recognition of the fact that money is indissolubly linked to all economic phenomena, so that it is no longer sufficient in rigorous analysis to “abstract” from money in order to apprehend more precisely the “real” nature of economic processes. Representative contributions to this—for beginners, rather rarefied—area of inquiry are: J. M. Keynes, A Treatise on Money (London, 1930); J. M. Keynes, The General Theory of Employment, Interest, and Money (London, 1936); F. A. von Hayek (ed.), Beiträge zur Geldtheorie (Vienna, 1933); F. A. von Hayek, Prices and Production (2nd ed.; London, 1935); L. v. Mises, The Theory of Money and Credit (New Haven, 1953); D. H. Robertson, Banking Policy and the Price Level (3rd ed.; London, 1932); R. G. Hawtrey, Currency and Credit (3rd ed.; London, 1931); D. H. Robertson, Essays in Monetary Theory (London, 1940); Ch. Rist, Histoire des doctrines relatives au crédit et à la monnaie (Paris, 1938); G. N. Halm, Monetary Theory (2nd ed.; Philadelphia, 1946); G. N. Halm, Economics of Money and Banking (Homewood, 111., 1956); L. Baudin, La monnaie et la formation des prix (2nd ed.; Paris, 1947). The following works are suitable as introductions to the theory of money: D. H. Robertson, Money (6th ed.; London, 1948); F. Lutz, Das Grundproblem der Geldverfassung (Stuttgart, 1936); Luigi Federici, La moneta e l’oro (2nd ed.; Milan, 1943); Otto Veit, Der Wert unseres Geldes (Frankfurt am Main, 1958).

2 (p. 79) The Influence of Money on History

The theory which considers that changes in monetary systems have exerted an active influence on world history may be designated as the monetary interpretation of history. This theory is by no means to be summarily rejected. Cf. J. M. Keynes, A Treatise on Money, op. cit., Chapter 30; M. Herzfeld, “Die Geschichte als Funktion der Geldbewegung,” Archiv für Sozialwissenschaft, Vol. 56, 1926, pp. 654 ff.

3 (p. 81) The Legal Character of Money

Money acquires a strictly legal character when the state confers upon its possessor certain legal rights. Most notable of these are:

1. The right to convert money into other kinds of money. A money endowed with this right is known as “provisional” money (for example, the bank notes which circulated in the gold-standard countries before World War I as contrasted with inconvertible definitive money).

2. The right of the possessor to have his money accepted in payment of debts. Money endowed with this right (legal tender) must be accepted by creditors in settlement of all debts. This right is found in the following three forms:

(a) in the form of an unqualified right of the debtor to have his money accepted in payment of “all debts, public and private” (full legal tender, currency);

(b) in the form of a right to acceptance by creditors up to a certain maximum sum (limited legal tender, subsidiary coin such as silver coins and “minor coins” [nickels and pennies]);

(c) in the form of a right to acceptance only by the state treasury, for example, the gold certificates issued by the United States Treasury and now held only by Federal Reserve banks, or the Rentenmark in Germany after the stabilization of the mark in 1923.

The endowment of the different kinds of money with one of these rights or with a combination of several of these rights represents the principal means of which the state disposes for the regulation and stabilization of the monetary system. But it is an exaggeration to say that this legal character of money constitutes its origin and essence as was maintained by G. F. Knapp in his celebrated State Theory of Money (London, 1924). This view is refuted by the simple fact that in every age, including our own, we find monies which manage to function successfully without the sanction of the authorities (optional money or trade money; for example, the dollar notes used in Germany during the great inflation, or the silver Maria Theresa thalers struck in Vienna and used for decades in Abyssinia). The best criticism of Knapp’s theory is found in H. S. Ellis, German Monetary Theory, 1905-1933 (Cambridge [Mass.], 1934). See also A. Nussbaum, Money in the Law (2nd ed.; Brooklyn, N. Y., 1950).

4 (p. 87) Bimetallism

When both gold and silver are standard money, the maintenance of the homogeneity of the monetary standard and of monetary stability becomes a knotty problem since, as we know from the experience of the last hundred years, the value relationships of the two metals to one another are subject to wide fluctuation. Two cases must be distinguished: (a) The parallel standard. This type of standard exists where gold and silver coins of full value circulate simultaneously without a legal ratio being fixed between them. In this case, the homogeneity of the monetary system is destroyed; there are now two monetary standards within one country between which emerges an exchange relationship (intra-monetary exchange rate) which fluctuates with market conditions exactly as the exchange rate between the currencies of different countries. Even the establishment of an official ratio between the two metals will not eliminate the inconveniences of this system, unless there is a real effort to enforce the ratio. The parallel standard was in general use throughout the world until the beginning of the nineteenth century. Eventually, the growth of business activity led to proposals for a reform of this split standard, (b) The double standard (alternative standard). In this case, gold and silver are made standard metals with an exchange ratio between them legally fixed and maintained, at 1: 151/2, for example. If there is a change in this value relationship in the metals market, money minted from the metal which has become dearer disappears from circulation (Gresham’s law: “bad money drives out good”). Under the double standard, coins minted from the metal which has become cheaper will become the dominant medium of exchange. This is so because the public stands to profit by bringing to the mint the lower-priced metal (which was silver at the close of the nineteenth century) and exchanging it for silver coin, since the nominal value of the “under-valued” silver coins is the same as that of the “over-valued” gold coins. If the price of silver should drop sharply, the standard is automatically established on silver as silver alone will be brought to the mint. This result may be forestalled by abolishing the free coinage of silver and by restricting its use to the minting of subsidiary coin. Gold will then be reestablished as the standard money. This, in fact, marks the last stage in the nineteenth-century evolution of monetary standards.

5 (p. 90) The Function of the Note-issuing Bank

The problem of the early note-issuing bank—and later of the deposit bank-lay in the fact that it was at once a bank and an institution for issuing money, and that in it were combined the manufacture of both credit and currency. The history of more than a hundred years of banking shows that the dangerous situations thus produced were the prime concern of those entrusted with the making of banking policy. Out of this historical experience have crystallized the following principles:

1. A central bank of issue should be a state enterprise, or at least be placed under rigorous state control (principle of government monopoly).

2. Limitations should be placed upon the issuance of bank notes by the several methods available for this purpose (fixing of reserve requirements, establishing maximum quantities in which bank notes may be issued, taxing of bank notes, etc.).

3. The issuing of bank notes should be closely regulated and the nature of the credit operations involved strictly defined.

The practical result of the application of this last principle has been to limit the granting of credit by banks of issue to short-term working credits for business and industry, and to a particular species of these operations (discounting operations). A study of these limitations, which have been the subject of considerable debate, would take us deep into the domain of credit theory. Cf. L. von Mises, The Theory of Money and Credit, op. cit.; Argentarius, Die Notenbank, (1922); F. Somary, Bankpolitik (3rd ed., 1934); R. G. Hawtrey, The Art of Central Banking (London, 1932); J. M. Keynes, op. cit.; Victor Morgan, The Theory and Practice of Central Banking, 1797-1913 (Cambridge, 1943); Otto Veit, Der Wert unseres Geldes, op. cit.

6 (p. 90) The Gold Standard

Under the gold standard as it existed in most countries prior to 1914, a variety of arrangements caused money and gold to be so closely coupled that the material value and the nominal value of money were identical and all types of money were freely convertible into gold. This coupling mechanism was such that at all times money could be converted into gold, and gold into money at an unchanging and practically identical price. It was the maintenance of this kind of convertibility which was the objective of the prescriptions concerning free coinage of gold, the obligation of the monetary authorities to buy and sell gold at a fixed price, and the freedom to export and import gold. Under such a system, the prices of all goods can change while the price of gold remains the same; gold becomes the “pole star of the monetary universe.” The inestimable advantage of the gold standard is that it stabilizes the value of money and protects it from the caprices of governments. Despite the hopeful promises of monetary reformers, not even an approximate equivalent for it has as yet been discovered. Therewith is connected a further advantage of the gold standard, viz., that it united all the countries employing it into an essentially homogeneous monetary system supplied with a de facto world money. Cf. W. Röpke, International Order and Economic Integration (Dordrecht, Holland, 1959).

7(p. 90) The Gold Bullion Standard

The gold bullion standard, as distinguished from the pure gold standard (gold circulation system), is a system under which the free coinage of gold is abolished and gold coins cease to be legal tender. The coupling mechanism is restricted to the maintenance of a stable ratio between money and a central fund of gold. From this fund, gold is sold as before at a fixed price, but only for a limited number of specific purposes, and not in the form of gold coin. Nevertheless, the state treasury must continue to buy gold at a fixed price as it is offered. A variant of the bullion system is the gold exchange standard in which the central fund may consist of foreign exchange instead of, or in addition to gold. This, however, is an extremely questionable substitute which, as experiences with this system up to 1931 demonstrated, can easily lead to international inflation. The gold bullion standard may be properly describe as a “gold” standard since, as a result of its retention of the coupling mechanism, it assures a fixed price for gold, avoids arbitrary fixing of the money supply, and automatically stabilizes rates of exchange. Compared with the true gold standard, it offers the advantage of economizing gold, but it is an advantage which is secured at the cost of certain serious inconveniences. Above all, the automatism of the system is seriously weakened, bringing us one step closer to a paper standard. Cf. F. Machlup, Die Goldkernwährung, (1924); W. A. Brown, Jr., The International Gold Standard Reinterpreted, 1914-1934 (New York, 1940); X. Zolotas, L’étalonor en théorie et en pratique (Paris, 1933); T. E. Gregory, Gold, Unemployment, and Capitalism (London, 1933); W. Röpke, International Order and Economic Integration, op. cit.; Luigi Federici, La moneta e l’oro, op. cit.

8 (p. 92) The Origin of Credit Money

The most important sources of further information on this subject are: L. A. Hahn, Volkswirtchaftliche Theorie des Bankkredits (3rd ed., 1930); L. A. Hahn, Geld und Kredit (Frankfurt am Main, 1960); F. A. von Hayek, Geldtheorie und Konjunkturtheorie (Vienna, 1929); J. M. Keynes, A Treatise on Money, op. cit.; Hans Neisser, Der Tauschwert des Geldes (1928); C. A. Philipps, Bank Credit (New York, 1920); W. F. Crick, “The Genesis of Bank Deposits,” Economica, June 1927; Hans Gestrich, Kredit und Sparen (2nd ed.; Godesberg, 1948). On the problems connected with the manufacture of credit see F. Lutz, Das Grundproblem der Geldverfassung, op. cit.

9 (p. 102) Projects for Reform of Monetary Standards

It is undoubtedly correct that a reform of our economic system may be effected, to a large extent, by a reform of the monetary system. But we must proceed with great prudence in order to prevent such an undertaking from ending in disaster. It is unfortunate that the most imprudent of such reform projects are the ones which have the most enthusiastic backing; they attract by their radicalism and by the almost religious zeal which informs their promises to save the world economically and socially by revolutionizing its monetary system. All these theories of “monetary redemption,” of which Silvio Gesell’s theory of stamp money is perhaps the best known, tend with monotonous regularity to end in inflation. Cf. F. Haber, “Geld (Geldreformer)”, Handwörterbuch der Staatswissenschaften, (4th ed.), Vol. IV; H.T.N. Gaitskell, “Four Monetary Heretics” in What Everybody Wants to Know about Money (Cole ed.; London, 1933); L. Federici, op. cit., Chapter III.

10(p. 103) The Theory of Exchange Rates

To explain adequately the theory of exchange rates would require a book, a fact which gives some idea of the complex interrelationships involved. It should never be forgotten that one of the most important determinants of foreign estimate of the value of money is the domestic purchasing power of that money as compared with the domestic purchasing power of foreign money (theory of purchasing power parities). Here too, the more macroscopic the relationships involved, that is, the greater the changes in the purchasing power ratios, the more will this factor outweigh others in the final determination of the exchange rate. During the German inflation even the crudest form of the purchasing power parity theory was infinitely more correct than the attempts to explain the fall in the exchange rate of the mark by the “balance of payments deficit.” In other words: the principal cause of the fall of the mark exchange rate was an excessive use of the Reichsbank printing press, resulting in a rapid depreciation of the mark within Germany. In comparison with this principal cause, other factors were reduced to insignificance. Under the microscopic conditions of normal times, the interrelationships in question are far more complicated. Cf. G. Haberler, The Theory of International Trade (London, 1936); B. Whale, International Trade (2nd ed.; London, 1934; a small book which makes an excellent introduction to the subject); F. Machlup, “The Theory of Foreign Exchanges,” Economica, November 1934; H. v. Stackleberg, “Die Theorie des Wechselkurses bei vollständiger Konkurrenz,” Jahrbücher für Nationalökonomie u. Statistik, Vol. 161.

11 (p. 105) Currency Diseases and Their Cure

From the extensive literature on this subject may be mentioned: C. Bresciani-Turroni, The Economics of Inflation: a Study of Currency Depreciation in Postwar Germany (New York, 1940); Frank D. Graham, Exchange, Prices, and Production in Hyper-Inflation: Germany, 1920-1923 (Princeton, 1930); E. L. Hargreaves, Restoring Currency Standards (London, 1926); E. W. Kemmerer, Modern Currency Reforms (London, 1928); J. Rueff, L’ordre social (Paris, 1947). On “repressed inflation”: W. Röpke, “Offene und zurückgestaute Inflation,” Kyklos, Vol. I, no. 1, 1947; W. Röpke, “Repressed Inflation,” Kyklos, Vol. I, no. 3, 1947; F. A. Lutz, “The German Currency Reform and the Revival of the German Economy,” Economica, May 1949.

12 (p. 105) The “Creeping Inflation” of Today

For more extensive treatment of this phenomenon, see my book A Humane Economy (Chicago, 1960), Chapter IV. Excellent treatments of the subject are G. Haberler, Inflation, Its Causes and Cures (Washington, D.C., 1960); Henry Hazlitt, What You Should Know About Inflation (New York, 1960).

13(p. 106) Imported Inflation

The phenomenon was described first in my essay of 1956, “Das Dilemma der importierten Inflation” (reprinted in my book Gegen die Brandung [2nd ed.; Zurich, 1959]) in which this terminology was also suggested. See also the special section on inflation in my previously mentioned book A Humane Economy, pp. 199 ff.

14 (p. 109) The Measurement of Purchasing Power

An index number is constructed by selecting the prices of fifty or more representative commodities and multiplying these prices by a coefficient which corresponds to their economic importance (weighted index number). The amounts thus obtained are added together. The average of prices for the year which is selected as a “base”, say 1913, is equated with 100; subsequent changes in prices are then expressed as a percentage of the base average (100). For comment on the problematical aspects of such calculations see G. Haberler, Der Sinn der Indexzahlen (1927).

15 (p. 109) The Quantity Theory of Money

Our observations on the theory of exchange rates apply equally to the quantity theory of money. Considered in detail, it has many problematical aspects, but its basic truth is indisputable; and it is the more apt, the greater is the fluctuation in the value of money. For extended discussion of this theory see the bibliography listed under Note 1.

16 (p. 109) The Velocity of Circulation of Money

This concept is based on the fact that within a certain period of time the same piece of money may be used over and over again to purchase different goods. Here again, we may observe the essential difference between money and goods: a loaf of bread can be eaten only once, but a piece of money can be repeatedly used as a medium of exchange so long as it remains in circulation. The faster money is passed from hand to hand or, what amounts to the same thing, the briefer are its rest periods in our pockets, the more it can buy within a given period of time. This speed of circulation of money (or its reciprocal, the average rest period) is affected by various factors, such as the average intervals between income payments, the mode of payment, the degree of differentiation in the economy, the proportion of durable goods to total production, bookkeeping customs, and other factors. Velocity of circulation is an especially sensitive barometer of the public’s confidence in the stability of money. Hence, in times of inflation there will be sudden and marked changes in this velocity. The effects on the value of money of an increase in the quantity of money will be aggravated by a rise in the velocity of circulation or, vice versa, a fall in velocity may offset the effects of an increase in quantity. It was particularly easy to follow the working of this monetary law during the great German inflation which followed World War I. It was observed that in the first phase of this inflation, the depreciation of money was less than proportional to the increase in the quantity of money. The reason was to be found in the fact that the public, in the expectation of a future appreciation of the mark, was less disposed to spend money; for this and other reasons (tax evasion and general political uneasiness), the public increased its cash holdings; it “hoarded” money. At the peak of the inflation, however, the depreciation of money was much more than proportional to the increase in the quantity of money. The reason for this was the tremendously accelerated rate of bank-note circulation which followed the complete collapse of public confidence in the mark, the general flight into “real values,” and the shortening of all payment intervals necessitated by the galloping currency inflation. The velocity of circulation increased enormously and thereby multiplied many times over the inflationary effects of the increased supply of money. It is interesting, also, to note that while the value of the paper marks in circulation reached an astronomical figure, the gold value of the money supply based on the dollar rate of exchange continued to fall, finally amounting to only a few millions, a clear indication that the depreciation of money was proceeding at a faster rate than the increase in its quantity. On the difficult problems connected with the velocity of circulation of money see M. W. Holtrop, De Omloopssnelheid van het geld, (Amsterdam, 1928); F. A. Lutz, “Velocity Analysis and the Theory of the Creation of Deposits,” Economica, May 1939; H. S. Ellis, “Some Fundamentals in the Theory of Velocity,” Quarterly Journal of Economics, May 1938; L. Federici, op. cit., Chapter V.