Lecture II THE FUNCTION AND MECHANISM OF INTERNATIONAL FLOWS OF MONEY 1

At the end of my first lecture I pointed out that the three different types of national monetary systems which we have been considering differed mainly in the method by which they effected international redistributions of money. In the case of a homogeneous international currency such a redistribution is effected by actual transfers of the corresponding amounts of money from country to country. Under the “mixed” system represented by the traditional gold standard—better called “gold nucleus standard”—it is brought about partly by an actual transfer of money from country to country, but largely by a contraction of the credit superstructure in the one country and a corresponding expansion in the other. But although the mechanism and, as we shall see, some of the effects, of these two methods are different, the final result, the change in the relative value of the total quantities of money in the different countries, is brought about by a corresponding change in the quantity of money, the number of money units, in each country. Under the third system, however, the system of independent currencies, things are different. Here the adjustment is brought about, not by a change in the number of money units in each country, but by changes in their relative value. No money actually passes from country to country, and whatever redistribution of money between persons may be involved by the redistribution between countries has to be brought about by corresponding changes inside each country.

Before, however, we can assess the merits of the different systems it is necessary to consider generally the different reasons why it may become necessary that the relative values of the total quantities of money in different countries should alter. It is clear that changes in the demand for or supply of the goods and services produced in an area may change the value of the share of the world’s income which the inhabitants of that area may claim. But changes in the relative stock of money, although of course closely connected with these changes of the shares in the world’s income which different countries can claim, are not identical with them. It is only because people whose money receipts fall will in general tend to reduce their money holdings also and vice-versa, that changes in the size of the money stream in the different countries will as a rule be accompanied by changes in the same direction in the size of the money holdings. People who find their income increasing will generally at first take out part of the increased money income in the form of a permanent increase in their cash balances, while people whose incomes decrease will tend to postpone for a while a reduction of their expenditure to the full extent, preferring to reduce their cash balances.[1] To this extent changes in the cash balances serve, as it were, as cushions which soften the impact and delay the adaptation of the real incomes to the changed money incomes, so that in the interval money is actually taken as a substitute for goods.

But, given existing habits, it is clear that changes in the relative size of money incomes—and the same applies to the total volume of money transactions—of different countries make corresponding changes in the money stocks of these countries inevitable; changes which, although they need not be in the same proportion, must at any rate be in the same direction as the changes in incomes. If the share in the world’s production which the output of a country represents, rises or falls, the share of the total which the inhabitants of the country can claim will fully adapt itself to the new situation only after money balances have been adjusted.[2]

Changes in the demand for money on the part of a particular country may of course also occur independently of any change in the value of the resources its inhabitants can command. They may be due to the fact that some circumstances may have made its people want to hold a larger or smaller proportion of their resources in the most liquid form, i.e. in money. If so, then for a time they will offer to the rest of the world more commodities, receiving money in exchange. This enables them, at any later date, to buy more commodities than they can currently sell. In effect they decide to lend to the rest of the world that amount of money’s worth of commodities in order to be able to call it back whenever they want it.

2

The function which is performed by international movements of money will be seen more clearly if we proceed to consider such movement in the simplest case imaginable—a homogeneous international or “purely metallic” currency. Let us suppose that somebody who used to spend certain sums on products of country A now spends them on products of country B. The immediate effect of this is the same whether this person himself is domiciled in A or in B. In either case there will arise an excess of payments from A to B—an adverse balance of trade for A—, either because the total of such payments has risen or because the amount of payments in the opposite direction has fallen off. And if the initiator of this change persists in his new spending habits, this flow of money will continue for some time.

But now we must notice that because of this in A somebody’s money receipts have decreased and in B somebody’s money receipts have increased. We have long been familiar with the proposition that counteracting forces will in time bring the flow of money between the countries to a stop. But it is only quite recently that the exact circumstances determining the route by which this comes about have been satisfactorily established.[3] In both countries the change in the money receipts of the people first affected will be passed on and disseminated. But how long the outflow of money from A to B will continue depends on how long it takes before the successive changes in money incomes set up in each country will bring about new and opposite changes in the balance of payments.

This result can be brought about in two ways in each of the two countries. The reduction of money incomes in country A may lead to a decrease of purchases from B, or the consequent fall of the prices of some goods in A may lead to an increase of exports to B. And the increase of money incomes in country B may lead to an increase of purchases from A or to a rise in the prices of some commodities in B and a consequent decrease of exports to A. But how long it will take before in this way the flow of money from A to B will be offset will depend on the number of links in the chains which ultimately lead back to the other country, and on the extent to which at each of these points the change of incomes leads first to a change in the cash balances held, before it is passed on in full strength. In the interval money will continue to flow from A to B; and the total which so moves will correspond exactly to the amounts by which, in the course of the process just described, cash balances have been depleted in the one country and increased in the other.

This part of the description is completely general. But we cannot say how many incomes will have to be changed, how many individual prices will have to be altered upwards or downwards in each of the two countries, in consequence of the initial changes. For this depends entirely on the concrete circumstances of each particular case. In some countries and under some conditions the route will be short because some of the first people whose incomes decrease cut down their expenditure on imported goods, or because the increase of incomes is soon spent on imported goods.[4] In other cases the route may be long and external payments will be made to balance only after extensive price changes have occurred, which induce further people to change the direction of their expenditure.

The important point in all this is that what incomes and what prices will have to be altered in consequence of the initial change will depend on whether and to what extent the value of a particular factor or service, directly or indirectly, depends on the particular change in demand which has occurred, and not on whether it is inside or outside the same “currency area”. We can see this more clearly if we picture the series of successive changes of money incomes, which will follow on the initial shift of demand, as single chains, neglecting for the moment the successive ramifications which will occur at every link. Such a chain may either very soon lead to the other country or first run through a great many links at home. But whether any particular individual in the country will be affected will depend whether he is a link in that particular chain, that is whether he has more or less immediately been serving the individuals whose income has first been affected, and not simply on whether he is in the same country or not. In fact this picture of the chain makes it clear that it is not impossible that most of the people who ultimately suffer a decrease of income in consequence of the initial transfer of demand from A to B may be in B and not in A. This is often overlooked because the whole process is presented as if the chain of effects came to an end as soon as payments between the two countries balance. In fact however each of the two chains—that started by the decrease of somebody’s income in A, and that started by the increase of another person’s income in B—may continue to run on for a long time after they have passed into the other country, and may have even a greater number of links in that country than in the one where they started. They will come to an end only when they meet, not only in the same country but in the same individual, so finally offsetting each other. This means that the number of reductions of individual incomes and prices (not their aggregate amount) which becomes necessary in consequence of a transfer of money from A to B may actually be greater in B than in A.

This picture is of course highly unrealistic because it leaves out of account the infinite ramifications to which each of these chains of effects will develop. But even so it should, I think, make it clear how superficial and misleading the kind of argument is which runs in terms of the prices and the incomes of the country, as if they would necessarily move in unison or even in the same direction. It will be prices and incomes of particular individuals and particular industries which will be affected and the effects will not be essentially different from those which will follow any shifts of demand between different industries or localities.

This whole question is of course the same as that which I discussed in my first lecture in connection with the problem of what constitutes one monetary system, namely the question of whether there exists a particularly close coherence between prices and incomes, and particularly wages, in any one country which tends to make them move as a whole relatively to the price structure outside. As I indicated then, I shall not be able to deal with it more completely until later on. But there are two points which, I think, will have become clear now and which are important for the understanding of the contrast between the working of the homogeneous international currency we are considering, and the mixed system to which I shall presently proceed.

In the first place it already appears very doubtful whether there is any sense in which the terms inflation and deflation can be appropriately applied to these interregional or international transfers of money. If, of course, we define inflation and deflation as changes in the quantity of money, or the price level, within a particular territory, then the term naturally applies. But it is by no means clear that the consequences which we can show will follow if the quantity of money in a closed system changes will also apply to such redistributions of money between areas. In particular there is no reason why the changes in the quantity of money within an area should bring about those merely temporary changes in relative prices which, in the case of a real inflation, lead to misdirections of production—misdirections because eventually the inherent mechanism of these inflations tends to reverse these changes in relative prices. Nor does there seem to exist any reason why, to use a more modern yet already obsolete terminology, saving and investment should be made to be equal within any particular area which is part of a larger economic system.[5] But all these questions can be really answered only when I come to discuss the two conflicting views about the main significance of inflation and deflation which underlie most of the current disputes about monetary policy.

The second point which I want particularly to stress here is that with a homogeneous international currency there is apparently no reason why an outflow of money from one area and an inflow into another should necessarily cause a rise in the rate of interest in the first area and a fall in the second. So far I have not mentioned the rate of interest, because there seems to be no general ground why we should expect that the causes which lead to the money flows between two countries should affect the rate of interest one way or the other. Whether they will have such an effect and in what direction will depend entirely on the concrete circumstances. If the initial change which reduces the money income of some people in one country leads to an immediate reduction of their expenditure on consumers’ goods, and if in addition they use for additional investments the surplus of their cash balances which they no longer regard worth keeping, it is not impossible that the effect may actually be a fall in the rate of interest.[6] And, conversely, in the country towards whose product an additional money stream is directed, this might very well lead to a rise in the rate of interest. It seems that we have been led to regard what happens to be the rule under the existing mixed systems as due to causes much more fundamental than those which actually operate. But this leads me to the most important difference between the cases of a “purely metallic” and that of a “mixed” currency. To the latter case, therefore, I now turn.

3

If in the two countries concerned there are two separate banking systems, whether these banking systems are complete with a central bank or not, considerable transfers of money from the one country to the other will be effected by the actual transmission of only a part of the total, the further adjustment being brought about by an expansion or contraction of the credit structure according as circumstances demand. It is commonly believed that nothing fundamentally is changed but something is saved by substituting the extinction of money in one region and the creation of new money in the other for the actual transfer of money from individual to individual. This is however a view which can be held only on the most mechanistic form of the quantity theory and which completely disregards the fact that the incidence of the change will be very different in the two cases. Considering the methods available to the banking system to bring about an expansion or contraction, there is no reason to assume that they can take the money to be extinguished exactly from those persons where it would in the course of time be released if there were no banking system, or that they will place the additional money in the hands of those who would absorb the money if it came to the country by direct transfer from abroad. There are on the contrary strong grounds for believing that the burden of the change will fall entirely, or to an extent which is in no way justified by the underlying change in the real situation, on investment activity in both countries.

To see why and how this will happen it is necessary to consider in some detail the actual organisation of the banking systems and the nature of their traditional policies. We have seen that where bank deposits are used extensively this means that all those who hold their most liquid assets in this form, rely on their banks to provide them whenever needed with the kind of money which is acceptable outside the circle of the clients of the bank. The banks in turn, and largely because they have learnt to rely on the assistance of other (note issuing) banks, particularly the central bank, have come themselves to keep only very slender cash reserves, that is, reserves which they can use to meet any adverse clearing balance to other banks or to make payments abroad. These are indeed not meant to do more than to tide over any temporary and relatively small difference between payments and receipts. They are altogether insufficient to allow the banks ever to reduce these reserves by the full amount of any considerable reduction of their deposits. The very system of proportional reserves, which so far as deposits are concerned is to-day universally adopted and even in the case of bank notes applies practically everywhere outside Great Britain, means that the cash required for the conversion of an appreciable part of the deposits has to be raised by compelling people to repay loans.

We shall best see the significance of such a banking structure with respect to international money flows if we consider again the effects which are caused by an initial transfer of demand from country A to country B. The main point here is that, with a national banking system working on the proportional reserve principle, unless the adverse balance of payments corrects itself very rapidly, the central bank will not be in a position to let the outflow of money go on until it comes to its natural end. It cannot, without endangering its reserve position, freely convert all the bank deposits or banknotes which will be released by individuals into money which can be transferred into the other countries. If it wants to prevent an exhaustion or dangerous depletion of its reserves it has to speed up the process by which payments from A to B will be decreased or payments from B to A will be increased. And the only way in which it can do this quickly and effectively is generally and indiscriminately to bring pressure on those who have borrowed from it to repay their loans. In this way it will set up additional chains of successive reductions of outlay, first on the part of those to whom it would have lent and then on the part of all others to whom this money would gradually have passed. So that leaving aside for the moment the effects which a rise in interest rates will have on international movements of short term capital we can see that the forces which earlier or later will reduce payments abroad and, by reducing prices of home products, stimulate purchases from abroad will be intensified. And if sufficient pressure is exercised in this way, the period during which the outflow of money continues, and thereby the total amount of money that will actually leave the country before payments in and out will balance again, may be reduced to almost any extent.

The important point, however, is that in this case the people who will have to reduce their expenditure in order to produce that result will not necessarily be the same people who would ultimately have to do so under a homogeneous international currency system, and that the equilibrium so reached will of its nature be only temporary. In particular, since bank loans, to any significant extent, are only made for investment purposes, it will mean that the full force of the reduction of the money stream will have to fall on investment activity. This is shown clearly by the method by which this restriction is brought about. We have seen before that under a purely metallic currency an outflow of money need not actually bring about a rise in interest rates. It may, but this is not necessary and it is even conceivable that the opposite will happen. But with a banking structure organised on national lines, that is, under a national reserve system, it is inevitable that it will bring a rise in interest rates, irrespective of whether the underlying real change has affected either the profitability of investment or the rate of savings in such a way as to justify such a change. In other words, to use an expression which has given rise to much dispute in the recent past but which should be readily understood in this connection, the rise of the bank rate under such circumstances means that it has to be deliberately raised above the equilibrium or “natural” rate of interest.[7] The reason for this is not, or need not be, that the initiating change has affected the relation between the supply of investible funds and the demand for them, but that it tends to disturb the customary proportion between the different parts of the credit structure and that the only way to restore these proportions is to cancel loans made for investment purposes.

To some extent, but only to some extent, the credit contraction will, as I have just said, by lowering prices induce additional payments from abroad and in this form offset the outflow of money. But to a considerable extent its effect will be that certain international transfers of money which would have taken the place of a transfer of goods and would in this sense have been a final payment for a temporary excess of imports will be intercepted, so that consequently actual transfers of goods will have to take place. The transfer of only a fraction of the amount of money which would have been transferred under a purely metallic system, and the substitution of a multiple credit contraction for the rest, as it were, deprives the individuals in the country concerned of the possibility of delaying the adaptation by temporarily paying for an excess of imports in cash.

That the rise of the rate of interest in the country that is losing gold, and the corresponding reduction in the bank rate in the country which is receiving gold, need have nothing to do with changes in the demand for or the supply of capital appears also from the fact that, if no further change intervenes, the new rates will have to be kept in force only for a comparatively short period, and that after a while a return to the old rates will be possible. The changes in the rates serve the temporary purpose of speeding up a process which is already under way. But the forces which would have brought the flow of gold to an end earlier or later in any case do not therefore cease to operate. The chain of successive reductions of income in country A set up by the initiating changes will continue to operate and ultimately reduce the payments out of the country still further. But since payments in and payments out have in the meantime already been made to balance by the action of the banks, this will actually reverse the flow and bring about a favourable balance of payments. The banks, wanting to replenish their reserves, may let this go on for a while, but once they have restored their reserves, they will be able to resume at least the greater part of their lending activity which they had to curtail.

This picture is admittedly incomplete because I have been deliberately neglecting the part played by short term capital movements. I shall discuss these in my fourth lecture. At present my task merely is to show how the existence of national banking systems, based on the collective holding of national cash reserves, alters the effects of international flows of money. It seems to me impossible to doubt that there is indeed a very considerable difference between the case where a country, whose inhabitants are induced to decrease their share in the world’s stock of money by ten per cent, does so by actually giving up this ten per cent in gold, and the case where, in order to preserve the accustomed reserve proportions, it pays out only one per cent in gold and contracts the credit super-structure in proportion to the reduction of reserves. It is as if all balances of international payments had to be squeezed through a narrow bottle neck as special pressure has to be brought on people, who would otherwise not have been affected by the change, to give up money which they would have invested productively.

Now the changes in productive activity which are made necessary in this way are not of a permanent nature. This means not only that in the first instance many plans will be upset, that equipment which has been created will cease to be useful and that people will be thrown out of employment. It also means that the revised plans which will be made are bound soon to be equally disappointed in the reverse direction and that the readjustment of production which has been enforced will prove to be a misdirection. In other words, it is a disturbance which possesses all the characteristics of a purely monetary disturbance, namely that it is self-reversing in the sense that it induces changes which will have to be reversed because they are not based on any corresponding change in the underlying real facts.

It might perhaps be argued that the contraction of credit in the one country and the expansion in the other brings about exactly the same effects that we should expect from a transfer of a corresponding amount of capital from the one country to the other, and that since the amount of money which would otherwise have to be transferred would represent so much capital, there can be no harm in the changes in the credit structure. But the point is exactly that not every movement of money is in this sense a transfer of capital. If a group of people want to hold more money because the value of their income rises, while another group of people reduce their money holdings because the value of their income falls, there is no reason why in consequence the funds available for investment in the first group should increase and those available in the second group should decrease. It is, on the other hand, quite possible that the demand for such funds in the first group will rise and in the second group will fall. In such a case, as we have seen, there would be more reason to expect that the rate of interest will rise in the country to which the money flows rather than in the country from which the money comes.

The case is of course different when the initiating cause is not a shift in demand from one kind of consumers’ goods to another kind of consumers’ goods, but when funds which have been invested in one type of producers’ goods in one country are transferred to investment in another type of producers’ goods in another country. Then indeed we have a true movement of capital and we should be entitled to expect it to affect interest rates in the usual manner. What I am insisting on is merely that this need not be the general rule and that the fact that it is generally the case is not the effect of an inherent necessity but due to purely institutional reasons.

4

There are one or two further points which I must shortly mention before I can conclude this subject. One is the rather obvious point that the disturbing effects of the organisation of the world’s monetary system on the national reserve principle are of course considerably increased when the rate of multiple expansion or contraction, which will be caused by a given increase or decrease of gold, is different in different countries. If this is the case, and it has of course always been the case under the gold standard as we knew it, it means that every flow of gold from one country to another will mean either an inflation or a deflation from the world point of view, accordingly as the rate of secondary expansion is greater or smaller in the country receiving gold than in the country losing gold.

The second point is one on which I am particularly anxious not to be misunderstood. The defects of the mixed system which I have pointed out are not defects of a particular kind of policy, or of special rules of central bank practice. They are defects inherent in the system of the collective holding of proportional cash reserves for national areas, whatever the policy adopted by the central bank or the banking system. What I have said provides in particular no justification for the common infringements of the “rules of the game of the gold standard”, except, perhaps for a certain reluctance to change the discount rate too frequently or too rapidly when gold movements set in. But all the attempts to substitute other measures for changes in the discount rate as a means to “protect reserves” do not help, because it is the necessity of “protecting” reserves rather than letting them go (i.e. using the conversion into gold as the proper method of reducing internal circulation) not the methods by which it has to be done, which is the evil. The only real cure would be if the reserves kept were large enough to allow them to vary by the full amount by which the total circulation of the country might possibly change; that is, if the principle of Peel’s Act of 1844 could be applied to all forms of money, including in particular bank deposits. I shall come back to this point in my last lecture. What I want to stress, however, is that in the years before the breakdown of the international gold standard the attempts to make the supply of money of individual countries independent of international gold movements had already gone so far that not only had an outflow or inflow of gold often no effect on the internal circulation but that sometimes the latter moved actually in the opposite direction. To “offset” gold movements, as was apparently done by the Bank of England,[8] by replacing the gold lost by the central bank by securities bought from the market, is of course not to correct the defects of the mixed system, but to make the international standard altogether ineffective.

One should probably say much more on this subject. But I am afraid I must conclude here. I hope that what I have said to-day has at least made one point clear which I made yesterday; namely that many objections which are raised against the gold standard as we knew it, are not really objections against the gold standard, or against any international standard as such, but objections against the mixed system which has been in general vogue. It should be clear too that the main defect of this system was that it was not sufficiently international. Whether and how these defects can be remedied I can consider only at the end of this course. But before I can do this I shall yet have to consider the more completely nationalist systems which have been proposed.

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[1] For a full description of this mechanism cf. R. G. Hawtrey, Currency and Credit, chapter IV, 3rd ed., 1928, pp. 41–63.

[2] Perhaps, instead of speaking of the world’s output, I should have spoken about the share in the command over the world’s resources, since of course it is not only the current consumable product but equally the command over resources which will yield a product only in the future which is distributed by this monetary mechanism.

[3] Cf. particularly F. W. Paish, Banking Policy and the Balance of International Payments (Economica, N. S., vol. III, no. 12, Nov. 1996); K. F. Maier, Goldwanderungen, Jena 1936, and P. B. Whale, The Working of the Pre-War Gold Standard (Economica, vol. IV, no. 13, February 1937).

[4] Cf. on this particularly the article by F. W. Paish just quoted.

[5] Cf. J. M. Keynes, A Treatise on Money, 1930, vol. I, chapter 4.

[6] Although it is even conceivable that a fall in incomes might bring about a temporary rise in investments, because the people who are now poorer feel that they can no longer afford the luxury of the larger cash balances they used to keep before, and proceed to invest part of them, this is neither a very probable effect nor likely to be quantitatively significant. Much more important, however, may be the effect of the fall of incomes on the demand for investment. Particularly if the greater part of the existing capital equipment is of a very durable character a fall in incomes may for some time almost completely suspend the need for investment and in this way reduce the rate of interest in the country quite considerably. Another case where the same cause which would lead to a flow of money from one country to another would at the same time cause a fall in the rate of interest in the first would be if in one of several countries where population used to increase at the same rate, this rate were considerably decreased.

[7] This has been rightly pointed out, but has hardly been sufficiently explained, in an interesting article by J. C. Gilbert on the Present Position of the Theory of International Trade, The Review of Economic Studies, vol. III, no. 1, October 1935, particularly pp. 23–6—To say that money rates of interest in a particular country may be made to deviate from the equilibrium rate by monetary factors peculiar to that country is of course not to say that the equilibrium rate in that country is independent of international conditions.

[8] Cf. Minutes of Evidence taken before the Committee on Finance and Industry, London, 1931, vol. I, Q. 353. Sir Ernest Harvey: “You will find if you look at a succession of Bank Returns that the amount of gold we have lost has been almost entirely replaced by an increase in the Bank’s securities.”