Chapter III. Money Watered by Inflation

CHAPTER III MONEY WATERED BY INFLATION IN the good old medieval days rulers who wanted more money than they could squeeze out of their subj ects by taxing used often to solve the problem by debasing the coinage. This was most easily and effectively done by putting less preciou.s metal and more alloy into coins and then issuing them in payment with all the appearance of having the same value as before. By this process the monarch was able to make a given amount of gold or ~ilver go so much further in turning it into .pieces that their unsuspecting subjects would take in exch~nge for goods, until the fraud was discovered and prices adjusted themselves, more or less. Nowadays most commercial transactions, except the retail purchases on which we spend our pocket money, are carried out by means of various forms of paper money. the most important o~ which, in this country, is the cheque currency with which our banking system provides us. Before the war, we used to carry gold and silver coins for retail pur poses, but even tIlen all big payments ~ere made 52 CHAP. III] MULTIPLYING PAPER 53 by cheque. Si,nce the war, gold has practically vanished from circulation, and its place has been taken by Treasury notes, issued uuder the Currency and Bank Notes Act of 1914; and convertible on demand into gold at the Bank of England. This power, that a modern community has gained, of multiplying its currency by means of the printing press and of banking machinery, makes it easy for Gover11,1nentswhen they want money and are shy of taking it directly and openly out of the pockets of the citizens, to debase the currency, not by fraudulently tampering with it in the medieval manner, but by merely multiplying the amount of the paper instruments that will be taken by the public in exchange for goods. The buying power of the public is thus watered down by inflation, if this mixture of metaphors may be permitted. This is a very tempting and attractive method of financing any expensive enterprise, especially a war, because it does not, at first sight, call upon anyone for any such sacrifice as is involved when taxes are raised or when the citizens are called upon to limit their spending, save their money and lend it to the State.

By increasing the currency a Government does not take money out of anybody's pocket, but puts new money into the pockets of those to whom it has to make payments. It seems to be a delightfullyeasy and simple way of paying for things, just to manu facture new money for the purpose, and· this device is in fact the basis for all kinds of schemes by which wen...meaning. currency reformers often believe that 54 1vlQNEY WATERED BY INFLATION [CHAP. they can make mant1ud rich, by increasing the volume· of the n1edium by which payments are effected; whereas the only way by which we can be made re~lly better off is by increasing the supply of things that we need and improving the system by which they are distributed a-mong us. In fact the effect of an increase of currency, unless it is ~ccompanied by an increase in the output of goods, is just the same as that of the medieval debasement. It tends to produce a rise in the prices of all com modities of general use, and so throws the burden of paying for war, or providing whatever be the object that the Government is trying to secure, on the shoulders of the people least able to bear it namely, ill-paid workers and salary earners and people witb ~smallfixed incomes. It is a devious, unscientific; and round-the-corner dodge, and can only be excused on the ground that Governments make use of it without realizing what they are doing, and then continue it because, when once it is started,' it is very difficult to stop it, pr even to check its growth.

It is simply finance by inflation. The subject is difficult and technical, and to 'enter into all its intricacies would involve us all in much confusion and wearitless of J]lind, and would also fill out a portly volume. But if we keep to the broad outlines of the matter, it seems to me that the case against it is plain to the understanding and convincing to common sense. Professor Foxwell, in the course of a lecture on Inflation, lately gave an excellent III] DR. JOHNSON ON CURRENCY 55 illustration of the effect of the quantity of currency on prices from a remark of Dr. Johnson's. When told that in Skye twenty eggs might be bought for a penny, Johnson observed: {( Sir, I do not gather from this that eggs are plenty in your miserable island, but that pence are few." There it is in a nutshell. If currency is scarce, prices are low; If it is plentiful, prices are high. By inflation I mean an increase in the currency more rapid than in the volume of commodities and services that the com munity is producing. When this takes place, if at the same time whatis called the velocity of the circulation-that is, the pace at which money is turned over-remains the same, it is impossible to avoid the conclusion that a rise in prices must happen. Let us see the process at work in an imaginary example.

If we all woke up one morning to find that some well-meaning fairy had doubled the alTIOunt of money in our pockets and in our banking accounts, and if at the same time no more stuff and services were being produced, we should all, probably, feel nice and rich until we found out that everybody else's money had also been doubled; then if at the same time there were no increase in the things that money is used to buy, the stress of competition would make the price of everythingshoot up like a rocket. If the price of everything,. including labour, services and capital, were exactly doubled, then we should all be exactly as we had been before, with regard to our power to buy; but in fact there would be a p.

56 MONEY WATERED BY INFLATloN [CHAP. painful process of adjustment in which those who were strongest in bargaining power would do best out of the scramble and the weakest would fare worst. Moreover, those who had made investments in house property, mortgages or securities, entitling them to so many pounds a year for a term of years or for all time, would find that the buying power of their so many pounds had been greatly lessened, but that they had no right to make their tenants or their debtors pay them more than was stipulated in the original contract. The result, then, of such an increase in the currency as we have imagined would be a great upsetting of the community's economic relations, with a rise in prices followed by a rise in wages for those who were strong enough to secure it, probably much friction and many strikes before this adjustment was secured, a good deal of injustice to unorganized workers and people like clerks and typists who are too respectable to strike, and a very unfair advantage to debtors, who would be· able to pay interest and repay capital to creditors in currency that had been debased to the extent of about half its value.

If inflation took place on this wholesale scale, we should all see at once what was happening, but of course it does not. It is usually done, even in times of acute crisis, so gradually that its effect is not observed until it is too late to remedy the evil by drastic measures, without raising a fresh crop of awkward problems. In normal times inflation is, as a rule, only practised on a very modest scale"

III] THE GUERNSEY MARKET 57 though it is said that there have been examples of economically backward States that worked the printing press so hard that at last their paper became so worthless that it did not even pay to print it. If inflation really has the excuse, like the unauthor ized baby, of being q only a very little one'/' its effect is hardly noticeable J and it appears to work a very comfortable miracle. There is the famous example, referred to in Jevons' s book on Money, Chapter XVI, of the G,uernsey market, which \-vas H built without apparent cost." The Governor of the island wanted to buildamarket l and,. not having the wherewithal l "issued under the seal of the island four thousand mar ket notes for one pound each, with which he paidthe artificers. When the market was finishep. and the rents came in, the notes were thereby cancelled." The whole trans .. action was completed, and the market had seem ingly been built out of nothing. In fact it had been built by means of temporary inflation, the effect of which would tend to raise the prices of all the goods that the community was consuming.

Jevons indeed considers that the infusion of those notes into the currency drove out so much gold. If that really happened, then there would be no inflation, because paper would have taken the place of gold in circulation and there would have been no increase in the total currency in the hands of the ,Guernsey folk. But Jevons does not state that gold was, in fact, actually driven out g and with all deference to his authority, the explanation S 58 MONEY WATERED BY INFLATION [CHAP. of the miracle given above seems to me more probable. In order to avoid misunderstanding, I think it is better to make it clear that by inflation I mean any increase in any form of currency, whether metallic, legal tender, or other-coins, bank notes, postal orders, or cheques-that is accepted in pay ment by the community. It is quite possible to have inflation by too great an inrush of gold, as several neutral countries have found in the course of the present war. But when it is a matter of too much gold, then equilibrium can be restored in ordinary times by the export of the gold, because it will be taken in payment elsewhere; but a country's paper money is not available as an article of export.

In normal times, such inflation as we are liable to is usually corrected by gold exports and the operation of other economic processes. If a coun try's currency system is sound, the inflation process should thus carry its own remedy with it. In our case, if we get in too much gold, or our banks create too much cheque currency, the consequent rise in prices tends to check our exports and increase our imports of goods. Thereby in the first place the volume of goods offered in our home markets in.. creases and so the relation between goods and cur rency is helped to return to the former level, and in. the second, as we are importing more goods and exporting less, there is a tendency for gold to be shipped to pay for some of the extra import~. So III] UNCHECKED IN WAR-TIME 59 that if we are suffering from too much gold, the cure begins to work ~ or if it is a case of too much banking credit, the export of gold calls attention to the diminished basis of this credit and so helps to cure it.

In war-time, if the war is big and obtrusive enough, these nice and pretty checks and balances do not work to keep inflation down. Shipping gold is made expensive by high rates of freight and insur ance; and the people who usually handle the business of shipping gold, and do so, in peace time, whenever they can see a profit in it and sometimes merely to get the advertisement that gold shipments usually bring with them, are checked by patriotic motives and the desire to avoid ex porting a financial weapon which has to be kept for special uses. And so inflation can proceed merrily without setting to work the automatic mechanism that usually produces the antidote for the disease. How merrily inflation can work, when it is t9-11S given its head, the experience of the present war has well shown. All the warring countries have been calling in gold from circulation and replacing it with a much larger quantity of paper. Much of the gold that they have called in they have shipped to neutral countriesto pay for goods, and so all over the world there is this common experience of an increase in currency over and above the supply of goods, and a more or less universal rise in prices.

The thing has, gone to such a pitch that the Scancli60 MONEY WATERED BY INFLATION [CHAP. navian countries have in effect closed their ports against the entry of gold, and in America the danger of the inflation produced by the great mass of gold imported has long been a commonplace among econo'mic writers. The method of inflation differs in each country according to the arrangements of its currency system~ During the present war we in England are dqing it in three or perhaps four ways. The Governnlent has done it by printing paper currency, much greater in extent than the gold which it has replaced in circulation, and by minting a great quantity of silver. The Bank of England has done it by lending money to the Government, to Allies, to Colonial Governments, and to private individuals; and the other banks have done it by increasing their investments in Government securities and by making advances to customers in order to enable them to take up Government securities. In other words, most of the inflation ha? been due chiefly to the action of the Government in either directly increasing the currency itself by printing or coining it, or in borrowing money from the Bank of England and the other banks iristead of getting it out of the pockets of the public by taxing it or borrowing its savings. It is entirely natural that the Govern ment should have done this, because in peace time it does so habitually and as part of its regular scheme of finance. It borrows' from the Bank of England on Deficiency or Ways and Means advances to tide it over a time when taxes are coming in sluggishly"

ItI] CURRENCY MADE BY BANKS 61 , and on the other hand big payments have to be made, and for like reasons it sells Treasury bills, or temporary promises to pay, to the Bank of England or to other banks. These devices are, usually, on so small a scale, as compared with the vast sum of our monetary turnover, fha t the conse quent addition to our currency has no noticeable effect. But tlie huge, scale on which they have been used in this war has had bad results for all parties. As many people may be puzzled by the assertion that the Government increases the currency by borrowing from banks, it is better to explain the process briefly here, though in another book I have already shown how loans made by banks produce manufactured money by adding to the banks' deposits, which embody the right of their customers to draw the cheques which are the chief form of currency that we now use.1 When the Bank of England makes a loan to the Government or subscribes to any issue of Govern ment security, it increases its holding of Government securities as shown in its weekly return. When it makes advances to any less august borrower, it increases its holding of what it calls Other Securities.

In ,either case it increases, on the other side of its return, the amount of its deposits,which, as the appended specimen shows, are divided into Public and' Other, the former being the balances of the various departments of the British Government, 1 Meaning of Maney, pp. 64 et seq. 5* 62 MONE:ri WATERED BY INFLATION [CHAP. and the latter those of all other depositors, including the other banks : BANK OF ENGLAND BANKING DEPARTMENT July 1st, 1914 Capital Rest . Public Deposits • Other Million £ · I4t 31 · 17 · 54! 891 Million £ Government Securities. 1 I Other Securities. . 49! Reserve . 281 Anyone to whom the Bank of England makes an advance thereby gets a credit in its books, and so the amount of the deposi ts at the Bank is increased by the amount of the advance. If the Government is the borrower, the advance is added both to the Government Securities among the assets and to the Public Deposits among the liabilities; but as the Government does not borrow money in order to have the pleasure of contemplating a large balance at its bartker's, it sooner or later makes payments, out of this deposit, to contractors or other folk to whom it owes money, by means of cheques on the Bank of England, the contractors pay these cheques into their own banking accounts, and so the money originally lent by the Bank of .England to the Government is transferred from the Public to the Other Deposits, to the credit of the other banks to whom it has been distributed, and henceforward it figures as cash at the Bank of England in their III] CURRENCY MADE BY BANKS balance sheets. If the Bank of England makes an advance to any other borrower, he is credited with a corresponding deposit. He draws on it and transfers it to anyone to whom he has to make payments, but the deposit remains to the credit of someone as long as the advance is outstanding.

I-Iow far this proce,ss has been carried we see from the figures of the Bank of England's return pub lished at the end of last year, comparing with those at the end of June 1914 1 given on a previous page: Capital Rest . Public Deposits fi Other BANKING: DEPARTMENT December 27th, 1916 Million £ Million £ · 141 Government Securities. 57 31 Other Securities. .. 106! • 52 Reserve • 33 • 1261 Ig6i Ig61 Here we see an addition of more than 100 millions to both sides of the balance sheet, by increases in the securities on one hand and in the deposits on the other. These deposits are potential currency and more, for being U cash at the Bank of England," in the hands of the other banks they are regarded as just as good a reserve for them as gold or legal tender. Let us see the effect on the other banks of this increase in the currency which may be called, in a sense, part of the basis of their credit operations. I append an aggregate balance sheet 1 These dates are chosen to fit those· of the balance sheets Qfthe other panks, whiCh are only published half-yearly.

64 MONEY WATERED BY INFLATION [CHAP. of nineteen of the biggest English banks, showing their position first on June 30th, 19I4, the last date on which they were published before the war, and then on December 3Ist; 1916 z AGGREGATE BALANCE SHEEt' OF NINETEEN PRINCIPAL ENGLISH BANKS June 30th, 1914 Capital and Reserves • 69,864,000 Acceptances and Endorsements 37,646,000 Deposits (including undi vided profits, etc.):. 747,243,000 £854,753,000 f Cash in hand and at bank . 115,242,000 Investments . 114,583,000 Discounts and Advances (including money at call, etc.) • 571,451,000 Cover for Accept ance 5, P re mises, and Sundries 53,477,000 £854,753,000 December 31St, 1916 Capital and Reserves 72,497,000 Acceptances and Endorsements 57,498,000 Deposits (in cludingun divided profits, etc.) 1,095,574,000 Cash in hand and at bank • 251,875,000 Investments • 303,461,000 Discounts and Advances (including money at call, etc.) • 592,056,000 Cover for Accept ances, Pre mises, and Sundries 78,177,000 :i),225,5 69,000 .. t.

III] POTENTIAL CURRENCY 65 The most notable features in this very instructive comparison are the increases in the deposits on the Fabilities side and in the cash and investments among the assets, that has taken place during the period. It will be observed that the deposits, which are potential currency in the hands of the public, since they give the banks' customers the power to draw cheques against them,have risen by 348 millions, while the cash held by the banks has risen by 136 millions; their investments by 189 millions, and their loans and discounts by 21 millions. How much of the addition to the cash is due to the Bank of England's lending activities, as described above, how much to the issue of Treasury notes, of which 150 millions were out standing on December 31st last, and how much to gold paid in by customers, it is impossible to guess, but it is safe to assume that these three processes between them have done most of it. But a still larger movement is the increase in investments, the whole of which, it is safe to guess, has been due to the big subscriptions made by the banks to the two first War Loans, and to Exchequer bonds and Treasury bills, by means of which they increase on the one hand their investments and, on the other, the deposits of their customers, - by this process.

When they subscribe to War Loans or buy Treasury bills from\ the Government, the banks pay for the securities so taken bya dra~t on their balance at the Bank of England, and so, for the time being, hold ~9 much les§ cC\sh at ~he BC\nk of England 66 MONEY WATERED BY INFLATION [CHAP. and so much more investments) but as the Govern ment uses its increased balances to pay debts, by drawing cheques on them, and the contractors who get the cheques pay them into their banks, the banks get back their balances at the Bank· of Eng land and also have their deposits increased, by the cheques on the Bank of England, which their cus tomers pay in ~ and so when the transaction is all complete the banks find themselves with their deposits increased by the amount· that they have subscribed to the new loan, or whatever the security may be. In other words, they and the Government between them, by this credit operation, have in creased the amount of currency in the hands of the public, and if at the same time there has been no corresponding increase in the volume of goods, in flation is thereby produced. The figures given above are complicated by the addition, during the period, of two small banks by amalgamation; but if banking figures of the whole of the United I{ing dom could be compared, the total increase in deposits, that is in potential currency, would be over 400 millions.

A similar process is set to work when a bank makes an advance to a customer to enable him to take up War Loan, or any other security, or for any other purpose. As I have shown elsewhere,1 as lqng as the. loan is outstanding there is almost ~~ertain to be a deposit in some bank or other against it. The banks had not, up to the date of 1 Meanin~ 01 Money, lOVe cit, III] BORROWING FOR WAR LOAN the balance sheet shown above, done· mucb. of this business since the war. In fact, owing to the extent to which industry is no\v on a cash. basis and owing to the decrease in Stock Exchange specula lation, the increase in loans and discounts of the banks was quite small. But during the first quarter of this year they must have made very large advances to customers, since everyone was urged to anticipate future savings, borrow from his bank and subscribe to vVar Loan, and we know that the public responded very practically to this appeal.

This was quite as it should be, since it was only by anticipating savings that the huge amount required could be got i but, as was pointed out at the time by Professor Pigou, in a letter to the Times of January 19th, 191], unless the money so subscribed was saved and paid back to the banks, so cancelling the increased credits, as fast as it was spent by the Government, this, system of subscribing out of bank advances could only lead to inflation. The banks are, among other things, manufacturers of currency, 'and as long as their manufacture does not outstrip the pace at which goods are being pro duced, the general level of prices will remain fairly level. Or if new currency that they create is used by producers to set to work and make more goods, then by creatingit they are helping the production of goods and so maintaining the equilibrium between goods and currency. It is when they manufacture currency that is handed straight over to a great consumer like a Government in war-time, that 68 MONEY WATEI\ED BY INFLATION [CHAP.

inflati0l?-can almost be seen getting to work. A new buyer c~mes into the markets, with a great mass of currency to draw on, competing with all other Quyersand probably, from what we know of Govern ment depa~tments, with itself,1'and up go prices. It is a subtle, insidious, but' very effective way of getting ;money out of us, not by taking it from us, but by vvatering down the value of all the money that 'rve possess. As the prices of goods rise our buying power over them declines, and so we have to put up with less of them:~ This is right and reasonable if they are wanted for the nation's needs, but the inflation process does the job in the worst nossible way by throwing the burden of going without on those who are least able to bear it. 'Inflation, however, does not only hit the poorest members of the community. It is bad finance for the Government that indulges in it to any extent that suffices to cause any serious rise in prices and depreciation in the currency. In the first place, the Government drives prices up against itself and so makes the warA or whatever else be the object of its spending, more costly. In the second, the Govern ment, being not only an inflater but a borrower, since it is by the borrowing process that much of tpe inflation is done~ borrows at a time when the currency Is depreciated by its own action and engages to pay interest and pay the debt back in 1 A report of the Committee of Public Accounts quoted in the Economist of August 26th, 1916, p. 357, shows that the Admiralty and the War Office were buying against one another.

III] IS INFLATION INEVITABLE? 69 years hereafter, when we may fairly hope that prices ,vill have gone back from their present level. Consequently it borrows millions of depreciated pounds with a fair prospect of having to payback its debtors later on with pounds that will be much more valuable. Unlike the quality of mercy which blesseth him that gives and him that takes, the system of financing by il1flation curses both the inflater and the inflatee. 1I But," it is argued, 1I you cannot possibly get away from inflation in time of war. It is inevitable. The rise in prices makes a larger amount of cur rency necessary." But could there be a general rise in prices without an increase in the volume of currency? There could, of course, if there had been a decrease in the production of goods. But if the production of goods had remained fairly constant, as it probably did if ,ve include war material as goods, and if there hq.d been no increase in the volume of currency, then, I think, though certain prices must have risen, others must have fallen.

The price of carriage by sea could not help rising, owing to the demands on the merchant fleets of the world by the .warring Governments, the shutting up of Germany's ships in neutral harbours, and the destruction of Allied and neutral tonnage by German submarines. This would have meant that everything that came by sea would be dearer, so that food prices must have risen. At the same time} the more generous diet required by the fighter and the war worker would have had a like effect 70 MONEY WATERED BY INFLATION .[CHAP. War materials would also have inevitably been dearer. But if there had been no increase in the currency, t!1e greater volume of it required for pur chases of food and war material would surely have lessened the amount available for buying other things and their prices would have fallen, and the decreased demand for them might have set free labour employed in producing them and so helped to increase the production of food and war material and checked the rise in their prices. Without inflation private extravagance would have been much less general. If, for example, the higher prices paid by the Government for the petrol which it was using in such huge amounts had diminished, by their full extent, the supply of money that other people could pay for it and for other things, we might have heard less about race meetings thronged with private cars in the third year of the war. But as long as the Government and the banks kept ladling out fresh supplies of currency, competition between the State and the citizen for the· goods and services available became ever keener, to the detriment of both parties. As more money went into buying potatoes, owing to the rise in their price, less, if it had not been for inflation, might have gone into buying flowers, and so ground and labour used for growing flowers" would much more rapidly have been used for growing potatoes, and the rise in the price of potatoes would have been checked. As more money was needed for ocean carried food, less would have been in buyers' pockets"

III] GOODS AND SERVICES if there had been no inflation, for ocean-carried furs and feathers and wine and silk dresses, and so more ship space would have been set free for food, and the rise in its price would have been checked. In other words, if all the money required by the Government for the war had been taken out of the pockets of the public in taxes and loans paid for out of savings, instead of much of it being manufactured by the Government and the banks between them, then the public's buying power would have been reduced by the full amount spent on the war; and the reduction of consumption, by which alone war's needs can be met, would have been brought about with much less friction and economic disturbance. For, as has been said over and over again in the course of the War Savings campaign, the Govern ment makes war with goods and services. Those tha tit needs for war can only be handed over to it if somebody goes without. It cannot by any possibility, or by any financial sleight of hand, get more than the country can produce, either by its own labour and energy or by selling goods abroad in exchange for war goods made abroad, pl,us the amount that it can get abroad by borrowing and selling securities. As a warring country's power to borrow and sell securities abroad is obviously limited,it is clearthat after a certainpoint the war demand for goods and services can only be met by the reduction, enforced or voluntary, of the buying power of the civilian population. Inflation helps to effect this in an insidious, roundabout, and 72 MONEY WATERED BY INFLATION [CHAP. III inequitable manner, laying much· of the war burden on the wrong shoulders. It is not the sole cause of all the rise in pri~es, but by encouraging extrava gance it helps to raise the prices of goods that need not necessarily ri~~ at all, and it increases the rise in prices in which a rise is inevitable.

As has been said! inflation does not H cut much ice" in normal times. But it is like one of those diseases I that demoralize the patient into enjoying them, and war's experience shows us that we shall have to be careful to get cured of it as quickly as we can without starting some other ailment, and then keep i:t out of' our system.