6th Lecture: Money and Inflation

One of the problems with which an economist must struggle is the fact that the terminology of business was developed prior to the development of economic theory, so that the language is not particularly appropriate for dealing with economic problems. One such case, which has resulted in real difficulty, is that of the money market.

At the end of the eighteenth century the British economists found the “money market” which was concerned with the lending of money to businesses. The terms “demand for money” and “supply of money” were already in use to signify the demand for, and supply of, loans. These terms were so firmly established that they could not be used for dealing with monetary problems, that is, for dealing with the demand for, and supply of, money as such. On the contrary economists had to point out that the rate of interest and the demand for loans on the market did not depend on the amount, or quantity, of money in existence. They had to point out that there was a demand for money, for cash money, independent of the demand for loans. As the stock market and the money market became more and more familiar to the people through newspaper reports, this was difficult for them to understand. Almost every newspaper used this business terminology to report on the state of the money market, i.e., the loan market.

Economists pointed out that there exists on the market a demand for money and a supply of money similar to the demand for, and supply of, any other article. It should be noted parenthetically, however, that this demand for, and supply of, money has nothing to do with the demand for, and supply of, loans. It is significant also that while the demand for most goods is a demand for consumption, the demand for money is not a demand for consumption; the demand for money does not consume or destroy the individual piece. The demand for money per se is a demand to hold money, a demand for “cash holding.”

Because future conditions are necessarily uncertain, people must keep a definite amount of cash on hand. Should things be certain, they could invest every bit of money for a definite time. Knowing exactly when they would need cash, they could plan to have their investments mature at that time. But because one cannot estimate exactly when money will be needed, one must keep a certain amount of cash on hand or in a checking account; one cannot lend or invest all one’s cash money.

Money in circulation is the sum of all cash holdings. Concerning the history of an individual money piece, there is no money piece that is not held by somebody, i.e., no cash that does not occur in somebody’s cash holding. It goes from one person’s cash holding to another person’s cash holding. In the case of any particular money piece, there is no instant between these two situations. There is no such thing as money that is not owned by someone and the disappearance of which in some way, for instance by fire, would not hurt the individual whose money it was.

False definitions, incorrect explanations and interpretations, of money fall into two classes, namely that money is either (1) something more than a commodity, or (2) something less than a commodity. But in reality money is neither more than, nor less than, a commodity; it is everything that a commodity is. Like any other commodity, the supply available influences its market value and like any other commodity, it is in demand because people consider it useful.

Because there is a demand for money for cash holdings, and because people are ready to part with goods to get money, the value of the object used for money is enhanced by this demand. The value of gold increased when it came into demand for monetary purposes. Similarly, the value of silver rose when it was demanded as money. When money conditions changed in the course of the nineteenth century and silver became less important for use as money, its value per unit, its purchasing power, tended to go down.

Inflation is an increase in the quantity of money without a corresponding increase in the demand for money, i.e., for cash holdings. I do not mean to say that inflation in itself does not influence the demand for money. The quantity of money and the demand for money are not absolutely independent magnitudes. The demand for money for cash holdings depends on the individual’s specific understanding of future conditions—his speculation and his ideas about the future.

At the start of an inflation, that is, at the beginning of an increase in the quantity of money without a corresponding increase in the demand for money, it causes a rise in prices. Then, if the people have learned something from theory or from history, they may anticipate still further price increases. In that case, they expect prices to rise and the purchasing power of each money piece to decline and they will tend to restrict their cash holdings, as compared with what they would have in the absence of such speculation as to the future purchasing power of money. This depends on the speculative reaction of the public. On the other hand, if people think prices will drop, there will be a tendency for them to increase their cash holdings in the expectation that the purchasing power of money will rise.

By and large, an inflationary change in the purchasing power of money is caused by the fact that a few people are quick enough to realize what is going on and to adjust their activities to the inflationary policy of the government. They do not always have great minds. Nor are they necessarily more intelligent than others. They just react more quickly than others. In Germany and Austria when there was inflation after the first World War, some “silly speculators” were pushed by accident into buying stocks on margin. It was not that they were clever, but the bankers were less clever. The banks held the common stocks, financed the sales, and sold the stocks to some speculators on margin. In a very short time, the speculators became extremely rich. And then very soon they lost what they had gained because they didn’t know what was going on.

Not everyone distrusts their government in this respect, as these quick ones must have. So long as those who are quick in anticipating inflation are in the minority and the slower ones are in the majority, so long as the housewife postpones purchases in the belief that prices will drop, telling herself that everybody, the government especially, says prices will go down, the inflation can continue. This mentality is the basis for inflation, the rock on which it is built. As more and more people discover there is something “fishy” about the government’s statements and then when one day everybody discovers it, the whole thing begins to break down. This change comes overnight. It comes when the housewife decides it is better to buy immediately rather than to wait until tomorrow, or until next year, because then prices will be still higher. In Germany after the first World War this was called Flucht in die Sachwerte—flight into true values.

This is a characteristic of every inflation that is not stopped in time. The first period may last many years; the government is then triumphant. The second period lasts for only a very short time. In Germany the first period lasted from August 1, 1914, until the end of September 1923; the second period lasted only three or four weeks. The second period in Germany was characterized by the fact that the workers were paid every morning in advance. Their wives would go with them to work; each man received his money, handed it immediately to the Mrs., and then she went to the nearest shop to buy something—anything—just to get rid of the money. To buy something was better than to keep the money which would lose value by tomorrow.

Such inflationary adventures have happened several times in the course of history. Most have been stopped by the governments before the second period. The three most important times when inflation has run its course are (1) the United States with the Continental currency in 1781, (2) France in 1796, and (3) Germany in 1923. There have been inflations in other smaller countries too, such as Hungary, but they were not so important.

The situation of the southern states with their Confederate currency in 1865, was another matter. It could be said it was different because the Confederate government itself broke down with the defeat of its forces.

In the twentieth century, Karl Helfferich [1872–1924], an excellent writer and a gifted economist but who lacked the qualities that make a man stand up for his opinions in public, invented a slogan: the money of the victorious nation will prove to be the best and will retain its value after a war. But this has not been the case in history. In the United States in 1781, the colonies were victorious; they had just defeated a great country, Great Britain, and yet the Continental currency degenerated. Also in 1796, France had been successful in military campaigns, and yet she suffered inflation. Helfferich was doubly wrong when it came to Germany—first, in thinking Germany would be victorious in World War I, and secondly, in believing that its money, as the money of a victorious nation, would necessarily be good. Helfferich failed to realize that whether a country is rich or poor doesn’t matter—when it comes to inflation what is important is its basis for putting additional money into circulation.

Every inflation that isn’t stopped in time consists of two periods—the catastrophic crack-up boom, which is very unwelcome, and the runaway inflation. It is an economic law that things happen in this way. The length of the first period depends on conditions which we may call psychological; it depends on the minds of the people, on their judgment, on their trust in their government. And it depends on their ideas, on the pseudo-economics with which they have been indoctrinated. So it is impossible to estimate how long the first period will last.

The Germans were definitely indoctrinated. They had confidence in their government. Even as late as October 19, 1918, they believed they would be victorious in the war and they thought their money was safe. They blamed the speculators for raising the cost of the U.S. dollar. The unsophisticated eighteenth-century farmers in the United States and in France had better judgment in these matters than did the sophisticated bankers in Germany. Let us not forget that the German banks broke down in this period because they were ignorant of the problems involved in the inflation.

This leads us to an explanation of why price controls cannot work. The government increases the amount of money. This is the inflation. Everybody has more cash in their cash holdings than before. The result is that the individual has a surplus of money which he hasn’t spent for daily consumption. In his eyes this is a surplus cash holding. If he doesn’t prefer to buy some luxury goods, he wants to invest a part. The small man invests it in savings banks or insurance policies. The big business enterprise appears with this amount directly or indirectly on the loan market. For a while the government succeeds in keeping prices down. Price control doesn’t remove the danger. But by making it easier for people to buy at low prices what they would have bought anyway, it increases the amount of money in their pockets, in their cash holdings, which is available for other purchases.

The inflations of the two World Wars in this country were comparatively mild because a great part of those workers who had earned additional money tended to increase their cash holdings during the war. The small worker really did increase his cash holdings in anticipation of a post-war move and because some goods were not obtainable during the war—radios, refrigerators, automobiles, and so forth. This is a characteristic of the first period of inflation. Remember the housewife who says, “let us keep the money; next year prices will be lower.” But as soon as people discover that things may be otherwise, the catastrophe may occur. These explanations of the simple man make the situation critical and dangerous.

Today [1951] there is still powerful resistance to inflation. There is still a lot of talk about the necessity of restricting inflation. It is true that 90 percent of this talk is just nonsense consisting, for instance, of plans to conceal the inevitable effects of the inflation by price control. But nevertheless, as long as there is such a resistance and as long as the government and Congress are forced to concede that there is danger in inflation, the danger is not yet great. The breakdown occurs when government officials no longer care what happens and fear that they may not be in control later.

During the last World War in most of the countries the economists were prevented from saying what was happening in their own country because of censorship. Or they were prevented from talking because they were in the army. But in the first World War, not all the countries were involved. In Sweden, which was neutral, there was an economist, Professor Gustav Cassel [1866–1945]. As a neutral, he had the privilege of visiting Germany one week, England the next, and in between of stopping in the Netherlands and Belgium. He wrote about what he saw. Cassel told the Germans, “You are inflating your currency and your profits are not real profits but illusionary profits.” He told them they must take the additional money out of the system (1) by taxes and (2) by loans. But the Germans did not have the courage to tax those who had received the extra part of the money. They tried an excess profit tax, which removed only a small part. They tried loans in this way—in order to buy 100 Marks of such a loan, the citizen had to pay only 17 Marks and the remaining 83 Marks to pay for the loan were provided by the government’s printing new banknotes. Thus, every new issue of bonds meant an increase in the amount of money. This shows how even the best advice is useless in the hands of people who have such ideas.

Now I want to deal with the second problem. In the second part of the eighteenth century, Great Britain was on the gold standard. This was evident to everybody because there were gold coins in use every day in daily business transactions. Also in use were notes of the Bank of England and, at that time already, the beginning of checkbook money. The banknotes were used as money substitutes and were redeemable immediately, without any delay or excuse. This was the gold standard as it existed in England in the eighteenth century, and as it was adopted in the course of the nineteenth century by the more important continental countries of Europe—France, Germany, the Netherlands, Belgium, and the Scandinavian countries.

Adam Smith had suggested that if all travel could be done by air, the land then used for roads could be put to more productive use such as farming. In this same vein, economists began to ask whether or not it was really necessary that mankind devote a part of its toil and trouble to the production of precious metals in order to have a good currency. If one could construct a currency with less expense, it would be advantageous. In 1819, Ricardo reasoned that one could do away with gold coins and have only banknotes which should be redeemable, not in coins, but in ingots, bullion. This gold bullion could be used for international transactions. This would save the money involved in making gold coins in smaller denominations. For more than 60 years Ricardo’s suggestion remained a “dead letter.”

In the 1870s, countries, that were having a hard time financially and yet wanted to get on the gold standard in the cheapest way, discovered this solution of Ricardo’s. It was called the “gold-exchange standard.” Toward the end of the nineteenth century and the beginning of the twentieth, many countries adopted this type of gold-exchange standard. It differed only in degree from the classical gold standard. On behalf of the American public, Professor Jeremiah Jenks [1856–1929] of New York University studied this gold-exchange standard in the Far East—the Malayas, the British West Indies, and so on. He was enthusiastic, as was his assistant, Professor Edwin Walter Kemmerer [1875–1945]. People didn’t see anything questionable in this theory. I can’t say that I was enthusiastic myself, but I couldn’t see any reason why it shouldn’t be adopted. One German economist said that by concentrating all the gold in the hands of the government, it would make things easier in time of war. What it does is to make it easy for the government to manipulate the currency, which always means to manipulate it downward, thus preparing the way for inflation. When a country has a gold-exchange standard and no gold in daily circulation, no one realizes what it means when the government declares that banknotes are no longer redeemable.

When the first World War broke out all the countries went on the gold-exchange standard. There was still a little gold in circulation, but not very much. Even the countries on the gold standard had gradually approached the gold-exchange standard more and more. Soon in place of the gold-exchange standard fiat money standards came in all countries. After the war, all countries were eager to return as quickly as possible to the gold standard. But most only returned to the gold-exchange standard by making the domestic currency redeemable in foreign exchange, and giving that to the people instead of gold. But in 1929, with the crisis, people began to advocate something else.

The gold-exchange standard with a flexible parity was known as the flexible standard. When the banks had issued banknotes they really redeemed the money; a discrepancy of one-tenth in the parity at which the notes were redeemed was considered disgraceful. (Incidentally, in the 1870s, French banking was centered in Paris and the gold was in Paris, which was in the hands of the Communists. Yet even then a deviation from parity of 5 percent in the currency was considered terrible. Today [1951] a currency is considered stable if it deviates no more than 20 percent.) The redemption of their notes by the central banks was controlled by the public, because the central banks were obliged to publish a statement every week telling the public the whole situation.

Step by step, governments acquired the opportunity to replace the gold-exchange standard with the flexible standard, which meant parity was no longer determined by law but perhaps by a bureaucrat. Bank transactions were transferred from the bank to a new agency. In Britain, this was the Exchange Equalization Account. First of all, parity was no longer fixed in the same way as before; it was surrounded by secrecy. From time to time the newspapers printed a statement that the currency was weaker, which meant that the bureaucrats had changed the parity a little bit. From time to time it was changed to a greater extent depending on the country and so forth. Devaluation could occur even in a country ostensibly governed by democratic methods. In Switzerland in 1936, even though assurances had been given that the Swiss franc would not be devalued, it was accomplished in half an hour by a meeting of Parliament. They really had no choice—the preceding policies, such as subsidies to agriculture, the watch industry, the hotels, and so on—had put them on the spot. And even in such a democracy, the change was accomplished by administrative action.

The flexible standard was defended by Keynes and his followers as a great thing, but it disappeared when something even “greater” was substituted. Great Britain’s return to the gold standard at US$4.86 in April 1925, had led to higher import prices, declining exports and unemployment. In 1931 [September 21], Britain abandoned the gold standard and the value of the pound sterling was left to fluctuate. It declined.

Money is like any other commodity. As there is no custom line between Manhattan and Brooklyn, prices increase between the two boroughs only by the amount of transportation charges. If there were a custom barrier, conditions would be different. So it is with money. If Brooklyn had a separate coin system from Manhattan, the exchange ratio between these two moneys would be established at such a height that it would make no difference whether the commodity was bought in one place or the other, with one money or the other. Should a difference appear, immediately there would arise an opportunity to make an advantageous deal. This advantage would continue until the difference disappeared.

We speak in the same way of Great Britain’s devaluation in 1931 when it went off gold, and her devaluation of two years ago [September 18, 1949] when the rate was changed from $4.03 to $2.80. But these are two absolutely different things—they have nothing in common. In 1931, when the British abandoned the gold standard, the amount of foreign money or gold that the owner of a British banknote had been able to obtain was reduced. It was intended by this means to keep the British currency stable with reference to foreign currency. The British government assumed a monopoly in the trade of gold and foreign exchange and the right also to expropriate foreign exchange. In revaluing, what they had had in mind was changing the rate at which British holders of foreign money would be indemnified on the one hand, and on the other hand the rate at which the importer would get his foreign exchange from the British government.

Two years ago in Great Britain, the $4.03 parity was a historical fact like any other historical fact. It was a parity de facto—it was the legal norm for the expropriation of Britishers who owed foreign money, and the price they had to pay for foreign money. But in fact the pound on the world market was worth only $3.00, more or less. In a treaty with the United States the British government promised that on a certain date they would again begin to redeem their currency against gold, dollars, and so on. But the British government no longer had clever bank-economist advisers. They had not considered what it would mean if it should be possible to redeem the money in London in the relation of three to four; anybody in the world would be able to buy a pound for $3.00 outside the United Kingdom and then sell the same pound to Great Britain at $4.00. After four or six weeks they discovered that this was completely unrealistic.