The Theory of Money and Credit

We have already examined one of the objections that have been brought against the quantity theory: the objection that it only holds good ceteris paribus. No more tenable as an objection against the determinateness of our conclusions is reference to the possibility that an additional quantity of money may be hoarded. This argument has played a prominent role in the history of monetary theory; it was one of the sharpest weapons in the armory of the opponents of the quantity theory. Among the arguments of the opponents of the currency theory it immediately follows the proposition relating to the elasticity of cash-economizing methods of payment, to which it also bears a close relation as far as its content is concerned. We shall deal with it here separately; nevertheless all that we can say about it in the present place needs to be set in its proper light by the arguments contained in the third part of this book, which is devoted to the doctrine of fiduciary media.

For Fullarton, hoards are the regular deus ex machina. They absorb the superfluous quantity of money and prevent it from flowing into circulation until it is needed.43  Thus they constitute a sort of reservoir which accommodates the ebb and flow of money in the market to the variations in the demand for money. The sums of money collected in hoards lie there idle, waiting for the moment when commerce needs them for maintaining the stability of the objective exchange value of money; and all those sums of money, that might threaten this stability when the demand for money decreases, flow back out of circulation into these hoards to slumber quietly until they are called forth again. This tacitly assumes44  the fundamental correctness of the arguments of the quantity theory, but asserts that there is nevertheless a principle inherent in the economic system that always prevents the working out of the processes that the quantity theory describes.

But Fullarton and his followers unfortunately neglected to indicate the way in which variations in the demand for money set in motion the mechanism of the hoards. Obviously they supposed this to proceed without the will of the transacting parties entering into the matter at all. Such a view surpasses the naivest versions of the quantity theory in its purely mechanical conception of market transactions. Even the most superficial investigation into the problem of the demand for money could not have failed to demonstrate the untenability of the doctrine of hoards.

In the first place, it must be recognized that from the economic point of view there is no such thing as money lying idle. All money, whether in reserves or literally in circulation (that is, in process of changing hands at the very moment under consideration), is devoted in exactly the same way to the performance of a monetary function.45  In fact, since money that is surrendered in an exchange is immediately transferred from the ownership of the one party to that of the other, and no period of time can be discovered in which it is actually in movement, all money must be regarded as at rest in the cash reserve of some individual or other The stock of money of the community is the sum of the stocks of individuals; there is no such thing as errant money, no money which even for a moment does not form part of somebody’s stock. All money, that is to say, lies in some individual’s stock, ready for eventual use. It is a matter of indifference how soon the moment occurs when a demand for money next arises and the sum of money in question is paid out. In every household or family the members of which are at least moderately prosperous there is a minimum reserve whose level is constantly maintained by replenishment. (The fact has already been mentioned, that besides objective conditions, subjective factors influencing the individual economic agent help to determine the amount of the individual demand for money.) What is called storing money is a way of using wealth. The uncertainty of the future makes it seem advisable to hold a larger or smaller part of one’s possessions in a form that will facilitate a change from one way of using wealth to another, or transition from the ownership of one good to that of another, in order to preserve the opportunity of being able without difficulty to satisfy urgent demands that may possibly arise in the future for goods that will have to be obtained by way of exchange. So long as the market has not reached a stage of development in which all, or at least certain, economic goods can be sold (that is, turned into money) at any time under conditions that are not too unfavorable, this aim can be achieved only by holding a stock of money of a suitable size. The more active the life of the market becomes, the more can this stock be diminished. At the present day, the possession of certain sorts of securities which have a large market so that they can be realized without delay and without very considerable loss, at least in normal times, may make the holding of large cash reserves to a certain extent unnecessary.

The demand for money for storage purposes is not separable from the demand for money for other purposes. Hoarding money is nothing but the custom of holding a greater stock of it than is usual with other economic agents, at other times, or in other places. The hoarded sums of money do not lie idle, whether they are regarded from the social or from the individual point of view. They serve to satisfy a demand for money just as much as any other money does. Now the adherents of the banking principle seem to hold the opinion that the demand for storing purposes is elastic and conforms to variations in the demand for money for other purposes in such a way that the total demand for money, that is, that for storing purposes and that for other purposes taken together, adjusts itself to the existing stock of money without any variation in the objective exchange value of the monetary unit. This view is entirely mistaken. In fact, the conditions of demand for money, including the demand for storage purposes, is independent of the circumstances of the supply of money. The contrary supposition can be supported only by supporting a connection between the quantity of money and the rate of interest,46  that is, by asserting that the variations arising from changes in the ratio between the demand for money and the supply of it, influence to a different degree the prices of goods of the first order and those of goods of higher orders, so that the proportion between the prices of these two classes of goods is altered. The question of the tenability of this proposition, which is based on the view that the rate of interest is dependent on the greater or lesser quantity of money, will have to be brought up again in part three. There the opportunity will also arise for showing that the cash reserves of the banks that issue fudiciary media no more act as a buffer in this way than these mythical hoards do. There is no such thing as a “reserve store” of money out of which commerce can at any time supply its extra requirements or into which it can direct its surpluses.

The doctrine of the importance of hoards for stabilizing the objective exchange value of money has gradually lost its adherents with the passing of time. Nowadays its supporters are few. Even Diehl’s membership of this group is only apparent. He agrees, it is true, with the criticism directed by Fullarton against the currency theory. On the other hand, he concedes that Fullarton’s expressions inert and dormant are erroneously applied to reserves of money; since these reserves are not idle but merely serve a different purpose from that served by circulating money; he also agrees that sums of money in such reserves and sums used for purposes of payment are not sharply distinguishable, and that the same sums serve now one purpose and now the other. In spite of this, however, he supports Fullarton as against Ricardo. He says that, even if the sums taken out of the reserves must again be replaced out of the stocks of money present in the community; this need not occur immediately; a long period may elapse before it is necessary; and that in any case it follows that the mechanical connection which Ricardo assumes to exist between the quantity of money in circulation and the prices of commodities cannot be accepted, even with regard to hoards.47  Diehl does not show in greater detail why a long period may elapse before the sums supposed to be taken from the reserves are replaced. But he does admit the fundamental correctness of the criticism leveled at Fullarton’s arguments; it is possible to grant the sole reservation that he makes if we interpret it as meaning that time may and must elapse before changes in the quantity of money express themselves all over the market in a variation of the objective exchange value of money. For that the increase in individuals’ stocks of money which results from the inflow of the additional quantity of money must bring about a change in the subjective valuations of the individuals, and that this occurs immediately and begins immediately to have an effect in the market, can hardly be denied. On the other hand, an increase in an individual’s demand for money while his stock remains the same, or a decrease of his stock while his demand remains the same, must lead at once to changes in subjective valuations which must be expressed in the market, even if not all at once, in an increase of the objective exchange value of money. It may be admitted that every variation in the quantity of money will impel the individual to check his judgment as to the extent of his requirements for money and that this may result in a reduction of his demand in the case of a diminishing stock of money and an augmentation of it in the case of an increasing stock, but the assumption that such a limitation or extension must occur has no logical foundation, not to speak of the assumption that it must occur in such a degree as to keep the objective exchange value of money stable.

A weightier objection is the denial of the practical importance of the quantity theory, that is implied in the attribution to the present organization of the money, payment, and credit system of a tendency to cancel out variations in the quantity of money and prevent them from becoming effective. It is said that the fluctuating velocity of circulation of money, and the elasticity of methods of payment made possible by the credit system and the progressive improvement of banking organization and technique, that is, the facility with which methods of payment can be adjusted to expanded or contracted business, have made the movement of prices as far as is possible independent of variations in the quantity of money, especially since there exists no quantitative relation between money and its substitutes, that is, between the stock of money and the volume of transactions and payments. It is said that if in such circumstances we still wish to preserve the quantity theory we must not base it merely upon current money but “extend it to embrace all money whatever, including not only all the tangible money substitutes that are capable of circulation, but also every transaction of the banking system or agreement between two parties to a contract that replaces a payment of money.” It is admitted that this would make the theory quite useless in practice, but it would secure its theoretical universality. And it is not denied that this raises an almost insoluble problem—that of the conditions under which credit comes into being and of the manner in which it affects the determination of values and prices.48

The answer to this is contained in the third part of the present work, where the problem of the alleged elasticity of credit is discussed.49

• 43See Fullarton, On the Regulation of Currencies, 2d ed. (London, 1845), pp. 69 ff., 138 f.; Wagner, Die Geld-und Kredittheorie der Peelschen Bankakte (Vienna, 1862), pp. 97 ff.
• 44Elsewhere, explicitly as well. See Fullarton, op. cit., pp. 57 f.; Wagner, op. cit., p. 70.
• 45See also Knies, Geld und Kredit (Berlin, 1876), vol. 2, 1st half, pp. 284 ff.
• 46See Fullarton, op. cit., p. 71.
• 47See Diehl, Sozialwissenschaftliche Erläuterungen zu David Ricardos Grundsätzen der Volkswirtschaft und Besteuerung, 3d ed. (Leipzig, 1922), Part 2, p. 230.
• 48See Spiethoff, op. cit., pp. 263 ff.; Kemmerer, op. cit., pp. 67 ff.; Mill, op. cit., pp, 316 ff.
• 49See pp. 302 ff. below.