The Theory of Money and Credit

The doctrine of the elasticity of fiduciary media, or more correctly expressed, of their automatic adjustment at any given time to the demand for money in the broader sense, stands in the very center of modern discussions of banking theory. We have to show that this doctrine does not correspond to the facts, or at least not in the form in which it is generally expounded and understood; and the proof of this will at the same time refute one of the most important arguments of the opponents of the quantity theory.8

Tooke, Fullarton, Wilson, and their earlier English and German disciples, teach that it does not lie in the power of the banks-of-issue to increase or diminish their note circulation. They say that the quantity of notes in circulation is settled by the demand within the community for media of payment. It the number and amount of the payments are increasing, then, they say, the media of payment must also increase in number and amount; if the number and amount of the payments are diminishing, then, they say, the number and amount of the media of payment must also diminish. Expansion and contraction of the quantity of notes in circulation are said to be never the cause, always only the effect, of fluctuations in business life. It therefore follows that the behavior of the banks is merely passive; they do not influence the circumstances which determine the amount of the total circulation, but are influenced by them. Every attempt to extend the issue of notes beyond the limits set by the general conditions of production and prices is immediately frustrated by the reflux of the surplus notes, because they are not needed for making payments. Conversely, it is said, the only result of any attempt at an arbitrary reduction of the note circulation of a bank is the immediate filling of the gap by a competing bank; or, if this is not possible, as for instance because the issue of notes is legally restricted, then commerce will create for itself other media or circulation, such as bills, which will take the place of the notes.9

It is in harmony with the views expounded by the Banking theorists on the essential similarity of deposits and notes to apply what they say on this point about notes to deposits also. It is in this sense that the doctrine of the elasticity of fiduciary media is generally understood today;10  it is in this sense alone that it is possible to defend it even with only an appearance of justification. We may further suppose, as being generally admitted, that it is not because of lack of public confidence in the issuing bank that the fiduciary media are returned to it, whether in the form of notes presented for conversion into cash or as demands for the withdrawal of deposits. This assumption also agrees with the teachings of Tooke and his followers.

The fundamental error of the Banking School lies in its failure to understand the nature of the issue of fiduciary media. When the bank discounts a bill or grants a loan in some other way, it exchanges a present good for a future good. Since the issuer creates the present good that it surrenders in the exchange—the fiduciary media—practically out of nothing, it would only be possible to speak of a natural limitation of the quantity of fiduciary media if the quantity of future goods that are exchanged in the loan market against present goods was limited to a fixed amount. But this is by no means the case. The quantity of future goods is indeed limited by external circumstances, but not that of the future goods that are offered on the market in the form of money. The issuers of the fiduciary media are able to induce an extension of the demand for them by reducing the interest demanded to a rate below the natural rate of interest, that is below that rate of interest that would be established by supply and demand if the real capital were lent in natura without the mediation of money,11  whereas on the other hand the demand for fiduciary media would be bound to cease entirely as soon as the rate asked by the bank was raised above the natural rate. The demand for money and money substitutes that is expressed on the loan market is in the last resort a demand for capital goods or, when consumption credit is involved, for consumption goods. He who tries to borrow “money” needs it solely for procuring other economic goods. Even if he only wishes to supplement his reserve, he has no other object in this than to secure the possibility of acquiring other goods in exchange at the given moment. The same is true if he needs the money for making payments that have fallen due; in this case it is the person receiving the payment who intends to purchase other economic goods with the money received.

That demand for money and money substitutes which determines the exchange ratio between money and other economic goods achieves expression only in the behavior of individuals when buying and selling other economic goods. Only when, say, money is being exchanged for bread is the position of the economic goods, money and commodity, in the value scales of the individual parties to the transaction worked out and used as a basis of action; and from this the precise arithmetical exchange ratio is determined. But when what is demanded is a money loan that is to be paid back in money again, then such considerations do not enter into the matter. Then only the difference in value between present goods and future goods is taken into account, and this alone has an influence on the determination of the exchange ratio, that is, on the determination of the level of the rate of interest.

For this reason the Banking principle is unable to prove that no more fiduciary media can be put into circulation than an amount determined by fixed circumstances not dependent on the will of the issuer. It has therefore directed its chief attention to the proof of the assertion that any superfluous quantity of fiduciary media will be driven out of circulation back to the issuing body. Unlike money, fiduciary media do not come on to the market as payments, but as loans, Fullarton teaches; they must therefore automatically flow back to the bank when the loan is repaid.12  This is true. But Fullarton overlooks the possibility that the debtor may procure the necessary quantity of fiduciary media for the repayment by taking up a new loan.

Following up trains of thought that are already to be found in Fullarton and the other writers of his circle, and in support of certain institutions of the English and Continental banking system, which, it must be said, have quite a different significance in practice than that which is erroneously ascribed to them, the more recent literature of banking theory has laid stress upon the significance of the short-term commodity bill for the establishment of an elastic credit system. The system by which payments are made could, it is said, be made capable of the most perfect adjustment to the changing demands upon it, if it were brought into immediate causal connection with the demand for media of payment. According to Schumacher, that can only be done through banknotes, and has been done in Germany by basing the banknotes on the commodity bills, the quantity of which increases and decreases with the intensity of economic life. Through the channel of the discounting business, in place of interest-bearing commodity bills (which have only a limited capacity of circulation because their amounts are always different, their validity of restricted duration, and their soundness dependent on the credit of numerous private persons), banknotes are issued (which are put into circulation in large quantifies by a well-known semipublic institution and always refer to the same sums without limitation as to time, and therefore possess a much wider capacity of circulation, comparable to that of metallic money). Then on the redemption of the discounted bill an exchange in the contrary direction is said to take place: the banknotes, or instead of them metallic money, flow back to the bank, diminishing the quantity of media of payment in circulation. It is argued that if money is correctly defined as a draft on a consideration for services rendered, then a banknote based on an accepted commodity bill corresponds to this idea to the fullest extent, since it closely unites the service and the consideration for it and regularly disappears again out of circulation after it has negotiated the latter. It is claimed that through such an organic connection between the issue of banknotes and economic life, created by means of the commodity bill, the quantity of the means of payment in circulation is automatically adjusted to variations in the need for means for payment. And that the more completely this is attained, the more out of the question is it that the money itself will experience the variations in value affecting prices, and the more will the determination of prices be subject to the supply and demand on the commodity market.13

In the face of this, we must first of all ask how it is possible to justify the drawing of a fundamental distinction between banknotes and other money substitutes, between banknotes not covered by money and other fiduciary media. Deposits which can be drawn upon at any time by check, apart from certain minor technical and juristic details which make them unusable in retail trade and for certain other payments, are just as good a money substitute as the banknote. It is a matter of indifference from the economic point of view whether the bank discounts a bill by paying out currency in notes or by a credit on a giro account. From the point of view of banking technique there may be certain differences of importance to the bank official; but whether the bank issues credit in the business of discounting only or whether it also grants other short-term loans cannot be a very fundamental issue. A bill is only a form of promissory note with a special legal and commercial qualification. No economic difference can be found between a claim in the form of a bill and any other claim of equal goodness and identical time of maturity. And the commodity bill, again, differs only juristically from an open book debt that has come into being through a credit-purchase transaction. Thus it comes to the same thing in the end whether we talk of the elasticity of the note circulation based on commodity bills or of the elasticity of a circulation of fiduciary media resulting from the cession of short-term claims arising out of credit sales.

Now the number and extent of purchases and sales on credit are by no means independent of the credit policy followed by the banks, the issuers of fiduciary media. If the conditions under which credit is granted are made more difficult, their number must decrease; if the conditions are made easier, their number must increase. When there is a delay in the payment of the purchase price, only those can sell who do not need money immediately; but in this case bank credit would not be requisitioned at all. Those, however, who want money immediately can only make sales on credit if they have a prospect of immediately being able to turn into money the claims which the transaction yields them. Other granters of credit can only place just so many present goods at the disposal of the loan market as they possess; but it is otherwise with the banks, which are able to procure additional present goods by the issue of fiduciary media. They are in a position to satisfy all the requests for credit that are made to them. But the extent of these requests depends merely upon the price that they demand for granting the credit. If they demand less than the natural rate of interest—and they must do this if they wish to do any business at all with the new issue of fiduciary media; it must not be forgotten that they are offering an additional supply of credit to the market—then these requests will increase.

When the loans granted by the bank through the issue of fiduciary media fall due for repayment, then it is true that a corresponding sum of fiduciary media returns to the bank, and the quantity in circulation is diminished. But fresh loans are issued by the bank at the same time and new fiduciary media flow into circulation. Of course, those who hold the commodity-bill theory will object that a further issue of fiduciary media can take place only if new commodity bills come into existence and are presented for discounting. This is quite true. But whether new commodity bills come into existence depends upon the credit policy of the banks.

Let us just picture to ourselves the life history of a commodity bill, or, more correctly, of a chain of commodity bills. A cotton dealer has sold raw cotton to a spinner. He draws on the spinner and has the three-month bill discounted that the latter has accepted. After three months have passed, the bill will be presented by the bank to the spinner and redeemed by him. The spinner provides himself with the necessary sum of cash, having meanwhile spun the cotton and sold the yarn to a weaver, by negotiating a bill drawn on the weaver and accepted by him. Whether these two sale-and-purchase transactions come to pass depends now chiefly upon the level of the bank discount rate. The seller, in the one case the cotton dealer, in the second case the spinner, needs the money immediately; he can only make the sale with a delay in the payment of the purchase price if the sum due in three months less discount at least equals the sum under which he is not inclined to sell his commodity. It is unnecessary to give any further explanation of the significance attaching to the level of the bank discount rate in this calculation. Our example proves our point just as well even if we assume that the commodity that is sold reaches the consumers in the course of the three months during which the bill circulates and is paid for by them without direct requisitioning of credit. For the sums which the consumers use for this purpose have come to them as wages or profits out of transactions that were only made possible through the granting of credit on the part of the banks.

When we see that the quantity of the commodity bills presented for discount increases at certain times and decreases again at other times, we must not conclude that these fluctuations are to be explained by variations in the demands for money of individuals. The only admissible conclusion is that under the conditions made by the banks at the time there is no greater number of people seeking credit. If the banks-of-issue bring the rate of interest they charge in their creditor transactions near to the natural rate of interest, then the demands upon them decrease; if they reduce their rate of interest so that it falls lower than the natural rate of interest, then these demands increase. The cause of fluctuations in the demand for the credit of the banks-of-issue is to be sought nowhere else than in the credit policy they follow.

By virtue of the power at their disposal of granting bank credit through the issue of fiduciary media the banks are able to increase indefinitely the total quantity of money and money substitutes in circulation. By issuing fiduciary media, they can increase the stock of money in the broader sense in such a way that an increase in the demand for money which otherwise would lead to an increase in the objective value of money would have its effects on the determination of the value of money nullified. They can, by limiting the granting of loans, so reduce the quantity of money in the broader sense in circulation as to avoid a diminution of the objective exchange value of money which would otherwise occur for some reason or other In certain circumstances, as has been said, this may occur. But in all the mechanism of the granting of bank credit and in the whole manner in which fiduciary media are created and return again to the place whence they were issued, there is nothing which must necessarily lead to such a result. It may quite as well happen, for instance, that the banks increase the issue of fiduciary media at the very moment when a reduction in the demand for money in the broader sense or an increase in the stock of money in the narrower sense is leading to a reduction of the objective exchange value of money; and their intervention will strengthen the existing tendency to a variation in the value of money. The circulation of fiduciary media is in fact not elastic in the sense that it automatically accommodates the demand for money to the stock of money without influencing the objective exchange value of money, as is erroneously asserted. It is only elastic in the sense that it allows of any sort of extension of the circulation, even completely unlimited extension, just as it allows of any sort of restriction. The quantity of fiduciary media in circulation has no natural limits. If for any reason it is desired that it should be limited, then it must be limited by some sort of deliberate human intervention—that is by banking policy.

Of course, all of this is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then—apart from an extension of its clientele—it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause. And just because it has employed a false principle for explaining the phenomenon that it has observed, it has also completely closed the way to understanding of a second tendency of the market, that emanates from the circulation of fiduciary media. It was possible for it to overlook the tact that so far as the banks proceed uniformly, there must be a continual augmentation of the circulation of fiduciary media, and consequently a fall of the objective exchange value of money.

• 8See pp. 150 ff.
• 9See Tooke, An Inquiry into the Currency Principle (London, 1844), pp. 60 ff.; 122 f.; Fullarton, On the Regulation of Currencies, 2d ed. (London, 1845), pp, 82 ff.; Wilson, Capital, Currency and Banking (London, 1847), pp. 67 ff.; Mill, Principles of Political Economy (London, 1867), pp. 395 ff.; Wagner, Geld-und Kredittheorie der Peelschen Bankakte (Vienna, 1862), pp. 135 ff. On Mill’s lack of consistency in this question, see Wicksell, Geldzins und Güterpreise (Jena, 1898), pp. 78 f.
• 10See Laughlin, The Principles of Money (London, 1903), p. 412.
• 11See Wicksell, op. cit., p. v.
• 12See Fullarton, op. cit., p. 64.
• 13See Schumacher, op. cit., pp. 122 f.