20: Problems of Credit Policy
Since the time of the currency school, western governments have sought to mediate between the demands of borrowers for low interest and the desire of lenders to profit by charging higher interest. They have primarily sided with the borrowers, and have set credit policies aimed to keep interest rates low, reasoning that "cheap money" would stimulate production (to make more production possible by virtue of a lower cost of capital) and keep consumer prices low (as any interest paid on a loan to a producer is invariably added to the price he must charge for his product).
This principle persists, in spite of the repeated failure of such a policy to have the intended results, and in spite of the damage that is often done to markets as a result. As such, the approach that will be taken in the present chapter is to examine the various "disguises" under which these principles have been applied.
(EN: In the next several sections, the author means to examine credit policy before the first world war)
Peel's Act
Passed in 1844, Peel's act and the principles on which it is based remain the standard for credit policy governance. The central idea of Peel's act was the basis of reserve banking: a requirement on banks to restrict their issue of money substitutes by requiring a certain percentage of cash to be maintained as a reserve. In effect, this capped the amount of fiduciary media a given bank could create - and on the level of all banks, tied the maximum amount of fiduciary media that could be issued to the supply of money.
It's noted that there was, and remains, widespread objection to Peel's Act - but the argument tends to be over the amount of reserve a bank should keep. Not one of the critics of reserve banking requirements suggest that a bank should be entirely unrestricted, and need no money to issue fiduciary media.
It's also noted that the argument in favor of restricting banks in the issue of fiduciary media make no such argument in favor of restricting consumer credit. Essentially, that an individual may obtain as much credit as others will extend him without being required to maintain a personal cash reserve.
And at the same time, the argument that is opposed to restricting banks in the issue makes no such argument opposed to restricting individuals in the same way. In effect, a personal check is a form of fiduciary media - a credit payment that, until the moment it is redeemed, represents an outstanding balance. And it is expected of the individual to maintain in his bank account the full amount to cover any checks he has written.
One of the foremost shortcomings of Peel's act was in its marrying the amount of fiduciary media that could be created to the supply of money. While well-intentioned, this prevents the banking system from mitigating fluctuations in the demand for money by issuing fiduciary media to be used in trade when the amount of money available is insufficient to meet the volume of demand.
It's also noted that there was a loophole in Peel's Act, in that it did not place the same restriction on writing checks based on unbacked deposits to a bank as it did on unbacked notes issued by a bank. And as such, deposits could be used in place of notes, as they both serve an identical purpose in exchange (particularly for large transactions), which circumvented the intention of the act entirely.
The author cites similar actions in Germany and the United States, based on the same principle, and ultimately suffering the same failure to have any practical effect on the ability of banks to issue fiduciary media in some form.
Discount Policy
The nature of the discount policy of central banks is obscure, and as a result is often misunderstood. Common misconceptions subscribe to the perverse notion that an act of law can maintain a low rate of interest to borrow and, at the same time, high purchasing power when spending.
In a competitive environment, each bank independently decides what a fair level of interest may be, but is ultimately constrained by the market rate of interest. To set a higher rate would be detrimental to demand, and to set a lower rate would be detrimental to profit.
As such, legislative interference in credit rates is entirely unnecessary. Were a mandatory rate too low, banks would choose not to extend credit; were it too high, consumers would choose not to obtain it.
It's also noted that, in international markets, the rate of credit determined by banks do not merely account for the supply and demand of the local economy, but of supply and demand anywhere. Were credit available at a lower rate in France than in Germany, German merchants would seek to borrow from French banks. And to serve customers in need of small amounts, German banks would obtain credit from French banks to aggregate the demand, and themselves capitalize on the difference in rates (though ultimately, lowering the domestic rate rather than pocketing the entire difference).
This is essentially the same as attempting to set the price of consumer goods: they will flow to the market at which there is greatest demand and the price of a good will seek the same point of equilibrium in all markets, excepting costs of transportation (as cost that is not associated with financial goods).
Trade restrictions an price discrimination have only limited power to interfere with this process, though there are at times legislative efforts to facilitate or inhibit the globalization of markets. Such restrictions are often sought by local producers, as it serves their interest to increase the price of foreign goods, whereas the consumers of goods would benefit from the lowest price regardless of the point of origin.
The same is true of demands on the restriction of interest rates: it reflects a conflict between the demands of the consumer for lower interest, and the needs of the local "money market" to be protected from foreign sources of credit who can under price them. The author elaborates a bit on the notion of "money market" as the short-term credit industry, as opposed to long-term, which is subject to demonstrate the effects of conflicting demand more quickly than capital credit, which deals with long-term loans with interest rates fixed at their time of issue. However, the latter follows the former, given time.
Gold-Premium Policy
The gold premium policy is an attempt by government to devalue its currency against gold, thereby making gold more expensive in terms of currency than would be the natural consequence of the international market. This is generally done with the intent of making it difficult to obtain gold for export purposes.
The Bank of France attempted such a policy, privileged by its government to redeem its notes for Francs (at the time, the five-Franc coin was made of silver but allegedly represented gold). The bank opted not to redeem its notes for old, but for silver coin, and charge a fee to redeem coin for gold, whereas it insisted on paying for gold in equal value of coin.
The natural consequence of doing so was to cause the Franc to be devalued in international commerce. The value of French currency was deemed to be its actual exchange value for gold in foreign markets, inflating the cost of imported goods without effect on the rate at which physical gold was being exported.
It also had a detrimental effect on the bank's ability to issue fiduciary media, the premium charged for exchange of notes for cash being perceived as an additional premium on the interest rate of any loan (the paper being valued less in exchange than the gold it was meant to represent, with the knowledge that additional cost would be required to obtain the actual gold). In addition to devaluing its fiduciary media in exchange, this also causes borrowers to seek loans from other banks.
A desirable side effect of such a policy, which would be the movement of production into France, did not materialize due to concern by investors over the unpredictability of the fluctuations in the premium (no rate was published or committed) and the concern that invested capital might well be "repatriated" bu the French government.
As it became more clearly recognized that the gold premium policy did not, and could not, accomplish its intended effects, support for the notion evaporated.
While other countries attempted no such folly, it's noted that most central banks are obliged only to issue and redeem notes in exchange for legal tender (i.e., government-authorized currency). This enables the state to impose a similar policy in specifying the exchange value of currency for metal - which has similar effect in terms of its impact on international trade.
It's noted that gold coins in Britain (sovereigns) and Germany (marks) were degraded in terms of their weight and/or alloy. The effects were essentially the same, in that debased currency was valued appropriately in international commerce (for their gold content regardless of face value), such that it would take more currency, representing the same amount of gold, to purchase foreign goods.
The "Illegitimate" Demand for Money
Part of the rhetoric in support of the French policy suggested its intention was to discourage the "illegitimate" use of money as a method of speculation - in effect, for investors to obtain gold coin in order to hard it, predicting that an increase in the value of gold would render them a profit.
There is a legitimate distinction made between the demand for money for use in commercial exchange and a demand for money as derivative of the commodity value of the metal it contains. As such, it could be argued that hoarding coins as a means of investing in metal removes them from circulation and creates inflation.
However, the issuance of credit money, namely fiduciary media, should serve to defend against a shortage of money for use in commercial exchange, and prevent the value of money from exceeding the value of the metal it represents by averting shortage: a rise in demand for currency leads to an increased interest in borrowing, which in turn produces sufficient money substitutes to satisfy the needs of the market for money to conduct exchanges. This should serve to ensure that the exchange of a currency remains equal to the commodity value of its metallic content.
Other Methods for Strengthening the Stocks of Metal
Various schemes have been used by central banks toward gaining as large as possible a reserve of gold by effectively decreasing the amount of currency that the central bank must offer to obtain metal. Essentially, this amounts to the same as acting as a buyer of gold and bidding up the price to ensure the banks are able to obtain it.
The consequence of this is to offer more currency for gold than the gold is worth, which is essentially the same as debasing the currency - though in the instance of state-operated central banks, the value of the currency can be preserved by making up the difference in taxation.
On an international scale, the attempts of nations to manage the balance between currency and gold reserves is roughly the same as a bidding war among prospective buyers for metal. Such actions are to the penultimate benefit or detriment of companies seeking to import ot export goods, and to the ultimate benefit or detriment of the citizens who seek to purchase these goods and sell their labor in their respective domestic markets.
Check and Clearing Transactions as a Means of Reducing the Rate of Discount
Prior to the first world war, there as a relatively high amount of metal being used by German citizens in the conduct of their daily business. The explanation for it, in so many words, boils down to the believe that German citizens were fairly primitive in comparison to other nations of Europe and as such chose clung to the outdated use of metal rather than notes and certificates of credit for conducting their affairs. This also resulted in fairly high rates of interest and price inflation, as German banks were unable to convince citizens to utilize money substitutes in place of metal coin.
As such, the central bank of Germany was unable to accumulate a significant stock of metal, nor to exert as much control over the issuance of credit and resulting interest rate as other nations.
The reaction on the part of the Reichsbank was entirely misguided: it succeeded in getting citizens to conduct commerce in banknotes backed by metal rather than using metallic coin - but as a money certificate remains backed by metal in deposit, it does not have the same ability as fiduciary media to create money based on credit. AS such, the amount of money available in the form of banknotes was still married to the amount of metal held by the banks, which did nothing to alleviate the problem.
The amount of money and money substitutes in circulation can only be increased in a fractional-reserve banking system, in which some amount of money in circulation is effectively represented by goods that are not in present existence (but will be so in future). A full-reserve system may swap metal for paper, but does not increase the supply of money.
(EN: The author now shifts his attention from credit policy before the first world war to credit policy afterward.)
Gold-Exchange Standard
The current practice is to counteract increases in inflation by attempts to decrease (or prevent the increase in) the quantity of currency, on the reasoning that if there were less currency, the unitary value of currency would rise, thus counteracting inflation. And when that fails, as it historically, has, the next tactic is an attempt to re-establish a gold-standard currency as quickly as possible.
In the author's time, the nations of Europe sought to bolster their respective currencies by pegging them to an exchange for stable, commodity-backed currencies (namely, the American dollar). In effect, a dollar-standard was the equivalent of a gold standard - as it is, en effect, a valuation based on gold that backs the foreign currency to which the domestic currency is pegged.
Prior to the war, the gold-standard system had been thoroughly undermined: nations sought to accumulate gold in their state coffers by issuing currency and compelling citizens to conduct their transactions using only state-issued currency.
It's been said that the war transformed banks-of-issue in local markets to banks-of-issue for the world, but this process was already underway. One might argue that the ware facilitated or hastened the process already in course within the banking system, as central banks maintained the metal reserves of their markets and a clearinghouse for international exchange, mitigating fluctuations in the demand for gold among countries.
As such, the fluctuations in the price of gold are largely determined by a single government - that of the United states - by virtue fo its influence over the Federal Reserve Board, as the currencies of other nations are based upon dollars that represent a fixed amount of gold. The author cautions that this policy, which "involves considerable sacrifices" by the US in terms of its inability to float the value of its own currency. Might well be changed. (EN: Consider the "Nixon Shock" when the US withdrew from Bretton Woods and took itself off the gold standards some fifty years later.)
It's suggested that the United States gained economic predominance over other nations by virtue of remaining steadfast to the gold standard whereas other nations abandoned it. This is not due to any specific intentional action of the US, as the nations of Europe would have abdicated control over the world economy to any nation that maintained a gold standard.
In terms of the gold-exchange standard, there remain arguments in favor of substituting a credit-money standard, which would provide better affordance to control the rate of inflation by virtue of being able to increase the money supply to match the demand for money, as opposed to being compelled to maintain currency in proportions limited to the availability of a physical commodity. However, this would ceded to the wiles and whims of state the power to maintain the value of a currency. As this is undesirable, there remains one alternative only: to return to a gold standard of exchange, and even to the actual use of physical gold in commercial exchange.
Return to Gold Currency
The immediate effects of a return to a gold standard would have certain effects that "would scarcely be welcomed." It would lead to a rise in the price of gold by virtue of demand for it, which would in turn lead to a fall in the cost of other commodities when priced in terms of gold.
By nature of exchange, the relation of gold to other commodities would have no effect on the economic exchange value of goods (a certain quantity of bread would be worth a certain quantity of meat, gold being the medium through which the exchange is made), but the transition of state-backed currency to gold currency would be detrimental to those who presently maintain stock of state currencies (and advantageous to those who maintain stock of gold).
The recommendation to abandon even gold-exchange currencies and using physical gold in commerce has but one consequence that is negative to the desires of the state: it disables the state's ability to attempt to control he rate of inflation. Governments desire to exert control of inflation by means of currency for three reasons: it can more conveniently do so by merely managing currency rather than passing additional laws to regulate commerce and banking; the state can use accumulated metal as a "war chest" to facilitate spending without the need for direct taxation (though by devaluing its currency, it depreciates the purchasing power of its subjects); and last, to use currency as a means of controlling the economic behavior of its subjects.
While the author seems to favor a return to gold currency, he dismisses the notion that doing so would discourage states from warfare by depriving them of the economic means to engage in war. A state that wishes to undertake any enterprise will extract from its subjects the means to do so by whatever method it finds convenient and expedient. The advantage of market manipulation is that it enables the state to do so indirectly and covertly, well in advance, to avoid provoking protest from its subjects.
It's also noted that the use of gold currency does not preclude the use of notes or fiduciary media - these are money substitutes, which should be no less acceptable in a system of gold money as they are in a system in which currency is otherwise created.
The Freedom of Banks
The events of the authors time reopened questions of economics that had long been regarded as closed. For example, the freedom of banks to issue banknotes, once taken for granted, became restricted when the irresponsible behavior of a few banks led to legislation of all, with the net effect of limiting note issue to a few privileged institutions.
And yet, "state regulation of banks-of-issue has been incomparably more unfavorable than the experience of uncontrolled private enterprise." It was not until state control of banking that nations have experienced the complete collapse of banking systems, rather than the collapse of individual banks, as all banks are tied by law to the same policies, as a matter of regulation, for better or for worse.
A few uncharacteristically bold assertions: State control of banking industry aggregates power over economy to the state and, once such power is gained, governments "put it to the worst conceivable use," subjugating markets, and all citizens who participate in commercial exchange, to the political and ideological objectives of the state. And in regard to the recent crises, it has been the action of governments that have caused widespread damage that the intention of sate control so was to prevent, ha d markets been left to "uncontrolled private enterprise."
That governments, in the late nineteenth and early twentieth centuries, gained such control and were able to undermine the world economy at the stroke of a pen, is ultimately to be blamed on the citizens, who by acceptance of government-backed currencies, gave their governments "the moral right" as well as the practical ability to do so.
The arguments in favor of the centralization, monopolization, and control of the banking industry by the state, including its ability to compel all participants in a market to accept a specific currency, are no more sound than if the same arguments were made in favor of giving the same degree of control to any private enterprise. Protected from competition by force of law, control becomes power, and power becomes its own end.
Any money substitute, whether a note or fiduciary medium, carries with it some element of risk; and the defense against that risk remains in the right of any individual to refuse to accept it in voluntary exchange.
(EN: more of the same follows, but what I find interesting here is the author's insistence on a gold standard. The principles he espouses, particularly the notion of voluntary acceptance in free trade, would lead to the conclusion that anything could be used as currency, so long as it has exchange value to the parties involved. This goes back to the origins of currency, when money represented a specific commodity. And while there are various reasons that precious metals might tend to be preferred, the basic argument that exchange should be voluntary leads to the conclusion that no specific item, gold included, necessarily "must" become the standard of exchange.)
Fisher's Proposal for a Commodity Standard
It is a naturally consequence of the nature and trade that economic activity is cyclical. At while it has been the attention, or at least the premise, of government to mitigate the chaos of cycles of boom and bust in an economy, it is no more subject to the arbitrary nature of legislation than any naturally occurring event.
An act of law cannot make crops grow except in their own season, and it cannot therefore bring agricultural products to market sooner or later, and it cannot therefore mitigate the economic activity that rises when the products are brought to market and falls when there are no products to be had. The notion that the state can use control of currency to mitigate the effect of downturns in the economic cycle is as foolish as the notion that act of law can conjure grain in a year of drought.
It's also noted that fiduciary media are issued in the expectation of future payment, facilitated by the future production and sale of goods. And it is therefore beyond the control of state, or even of any independent bank, to create an issue of fiduciary media when it is not demanded - fiduciary media can only be issued when there is demand for it, derived from the future expectation of a potential borrower to produce.
(EN: My sense is that this view does not consider the credit extended to customers, who are driven by their desire to purchase goods for consumption rather than production. This is the basis of the present crisis of credit, though it would have been averted had consumers been mindful that credit for their present consumption would need to be repaid by their own future production.)
The purchasing power of any commodity, gold included, is derived from its availability as compared to the availability of other goods. Historically, the economic activity precipitating from the discovery and mining of a new source of gold (a "gold rush") demonstrated an increase in the price of other goods when set in terms of gold - more gold in circulation makes a quantity gold less valuable. Likewise, an increase in the production of other goods (such as a bumper crop of wheat), makes a given quantity of wheat less valuable when priced in terms of another commodity (such as gold). During the years immediately preceding the first World War, the exchange value of gold fell, meaning that the price of other consumer goods in terms of gold rose. This resulted from the increased production of gold and the decreased availability of other goods for which it could be traded.
As such, it is predicted that there would be an economic wave should countries decide to return to the gold standard: the value of gold would increase in the first nations to adopt the standard (as gold is in greater demand for use in commercial exchange), causing a decrease in the price of goods. In terms of its relations with other nations, it would export cheap goods in exchange for gold. The disparity would continue until the other nations also adopted the gold standard, at which point equilibrium would be restored.
Irving Fisher's notion for overcoming this problem and mitigating disparity would be for the establishment of a "commodity" standard - which would more accurately reflect the exchange of purchasing power by denominating transactions in any given commodity, rather than focusing all transactions on a single commodity. (Fischer's intent was not for a supplementary or temporary system, but for one that could be perpetuated along with, or instead of, a metals standard.)
(EN: To concretize it a bit better, Fisher's system would have a debtor agree to repay an amount in a given quantity of any commodity - one might buy a pair of shoes in exchange for future payment of "ten loaves of bread" or "five oranges" or whatnot. But more to the point ,what was being promised is not the commodity, but purchasing power equivalent to that commodity. If, when payment comes due, the other party is owed ten oranges, they could agree to settle the debt for an amount of salt that is equal in exchange value to ten oranges instead.)
The author finds this notion "ambitious and yet simple," though he does pause to note that this does not imply his acceptance of Fisher's monetary theory in general, which he regards to be "inadequate" in several critical areas.
Fischer's scheme seeks to naturalize the effects of a change in value of any specific commodity (e.g., gold) by enabling the participants in an exchange to name any commodity they desire to use as a basis for a credit transaction, and then to substitute any commodity they desire to use as a basis of settling the debt.
But there are considerable complications in doing so - specifically, in that both parties would necessarily need to refer to an index of exchange that prices any good against any other good (to know the value of bread when priced in oranges, and the value of an orange priced in salt), which may be burdensome to the consumer (EN: Not to mention that it is confounded by issues of quality: one orange may be considered to be worth more than another orange to a discerning consumer. There are a limited number of commodities that are sufficiently uniform to be used as money.)
Also, the difficulty would be compounded because it introduces two points of negotiation rather than one (how many loaves of bread are worth a single orange when the purchase is made, how much salt is worth a single orange when the debt is settled).
Additional problems exist, in the calculation of interest over time (how do you pay back the loan of "one cow" at six percent interest?) as well as the changes in the value of consumer goods over time. Granted, the latter is a problem regardless of what goods are in question, but in setting a single commodity as a means of exchange(a loan of salt must be repaid in salt), the participants are better able to understand and predict the potential for fluctuation, as well as accepting the risk of change in future prices.
(EN: While I don't necessarily agree with the author's insistence that gold or other metal must be the commodity upon which money must be based, I would agree that there are many commodities that are unsuitable as money, and that any system that proposes to make the medium of exchange arbitrary between the incursion of debt and its payment is inherently flawed.)
Questions of Future Currency Policy
In spite of the problems inherent in the various suggestions for a basis of currency, it is clearly evident that many economic theorists are attempting to define a system of exchange in which government is unnecessary, reflecting a fundamental principle of free markets: that any economic exchange is a voluntary arrangement between two parties - a buyer and seller - and any legislative involvement is a violation of the fundamental rights of one or both parties to define the terms of the exchange between them. And moreover, that politics is entirely unnecessary and can only be harmful to matters of commerce.
And moreover, given the sorry condition of economic affairs in the author's time, the world over, as a result of state meddling in commerce, it seems the most rational path for states to abdicate control over commerce and allow markets to redefine a standard of money that is based on voluntary acceptance.
The author returned to the manuscript in a later edition, after the Great Depression of the early twentieth century, as a result of further economic interference on the part of government. His remarks, which go on for a few pages, might more succinctly stated as follows: "I told you so, you damned idiots."