XIV. Inductive Verification (Monetary)

CHAPTER XIV INDUCTIVE VERIFICATION (MONETARY) § 1 No study··of the principles governing the rate of interest would be complete without. verification by facts. In this chapter those facts. will be £resented which bear on the problem discussed in Chapter V, the problem of apprecia tion and interest. The object will be to ascertain the extent to which i a reciation or _epreciation .of the monetary standard is foreseen by hOl::: rowers and lende~ and provided for in the rates of· interest upon which they agree. At the outset the question arises, How can a merchant .. be said to foresee the appreciation of money? Appreciation is a subtle concept. Few business men have any clear ideas about it. Economists disagree as to its de~nition, and statisticians as to its measurement. If we ask a merchant whether or not he takes account of appreciation, he will say tllat he never thinks of it, that he always ,~ regards a dollar as a dollar." In his mind, other things may 'change in terms of money, but money itself does not change. Yet it may be true that he does take account of a change in the purchasing power of money, under guise of a change in the prices of other things. In our daily life we seldom think of the earth as moving; nevertheless we take account of its rotation whenever we speak ·of "sunrise" or "sunset." During a period of paper-money inflation the ordinary man conceives the premium on gold as a rise of gold bullion, not a fall of the paper money; but he arrives at the same practical results. Appreciation of money, whether in reference to gold bullion, commodities, or labor, is' in effect taken account of in the practical man's forecast of s 257 258 THE RATE OF INTEREST [CHAP. XIV all the economic elements which concern him, - the prices of his product, the cost of his living, the wages of his worlc men, and so forth. Moreover, he takes account of the relative importance of these factors as affecting himself, and not of their relative importance in the elaborate aver ages of the statistician, - averages which may emphasize some particular commodity or labor whose fluctuations have no interest for him. His own aim is not to predict the index numbers of Sauerbeck or of the United States BureatlOf Labor, but to foresee those price changes which affect his own economic future. To foresee a rise or fall of a particular price is to that extent to foresee a change in the purchasing power of money. Such forecasts enable a man to make reasonably correct decisions, and in particu lar to contract a loan with intelligence. If gold appreciates in such a way or in such a sense that he expects for himself a shrinking margin of profit, he will be cautious about bor rowing unless interest falls; and this very unwillingness to borrow, lessening the demand in the" money market," will bring interest down. On tIle other hand, if inflation is going on, he will see rising prices and rising profits, and will be stimulated to borrow capital unless interest rises; moreover, this willingness to borrow will itself raise interest.

Foresight is clearer and more prevalent to-day than ever before. Multitudes of trade journals and investors' reviews have their chief reason for existence in supplying data on which to base prediction. Every chance for gain is eagerly watched for. An active and keen speculation is constantly going on which, so far as it does not consist of fictitious and gambling transactions, performs a well known and provident function for society. Is it reasonable to believe that foresight, which is the general rule, has an exception as applied to falling or rising prices? § 2 Appreciation and depreciation in this book are used in a purely relative sense. If gold appreciates relatively to SEC. 2] INDUCTIVE VERIFICATION (MONETARY) 259 silver, then necessarily silver depreciates relatively to gold. Any standard appreciates 1 per cent. relatively to another standard if a certain amount of it now commands 101 units in this other standard, when previously it conlmanded only 100 units.

General evidence that an expected appreciation or de preciation of money has an effect on the rate of interest in that money can be obtained from several sources. During the free-silver agitation of 1895-6, it was observed that municipalities could often sell gold bonds at better terms than "currency" or "coin" bonds. There was a· strong desire on the part of lenders to insert a gold clause in their contracts, and they were willing to yield something in their interest to secure it. The same tendency was strikingly shown in California 1 during the inflation period of the Civil War. For a time, gold contracts could not be enforced, and in consequence interest rates were excep tionally high. During a period of progressive paper inflation the rate of interest in contracts drawn on a paper basis is high. This was true during the Civil War, and also during the currency troubles in the thirties.' Raguet wrote.: 2 "In the six months before the suspension of '37, although the amount of the currency was greater than it had ever been before in the United States, yet the scarcity of money was so great that it commanded from 1 per cent. to 3 per cent.

per month." It would be unsafe to found much inference on these facts; their significance may be partly or wholly different. But they raise a presumption that anticipation of further depreciation of currency tends to increase the rate of interest. A definite test must be sought where two standards are simultaneously used. .An excellent case of this kind is 1 Bernard Moses, "Legal Tender Notes in California," Quarterly Journal 01 Economics, October, 1892, p. 15. 2 Currency and Banking (1839), p. 139; also Sumner, Hi8tory 01 Banking, New York (1896), p. 264.

260 THE RATE OF INTEREST [CHAP.XIV supplied by two kinds of United States bonds, one payable in coin and the other in currency. From the prices which these bonds have fetched in the market it is possible to calculate the interest realized to the investor. The cur rency bonds were known as currency sixes and matured in 1898 and 1899. The coin bonds selected for comparison were the fours of 1907. The following table gives the rates of interest realized in the two standards, together with the premium on gold. RATES OF INTEREST REALIZED FROM DATES MEN TIONED TO MATURITY 1 COIN CUR-PRICE OF GOLD COIN CURRENCY RENeY --- -Jan., 1870 6.4 5.4 119.9 Jan., 1879 3.7 4.5 July, 1870 5.8 5.1 112.2 Jan., 1880 3.8 4.0 Jan., 1871 6.0 5.3 110.8 Jan., 1881 3.3 3.4 July, 1871 5.8 5.0 113.2 Jan., 1882 3.0 3.5 Jan., 1872 5.3 4.9 109.5 Jan., 1883 2.9 3.3 July, 1872 5.6 5.0 113.9 Jan., 1884 2.6 2.9 Jan., 1873 5.7 5.1 111.9 May, 1885 2.7 2.7 July, 1873 5.4 5.0 115.3 Jan., 1886 2.6 2.6 Jan., 1874 5.0 5.0 110.3 Jan., 1887 2.3 2.6 July, 1874 5.1 4.9 110.7 Mar., 1888 2.3 2.9 Jan., 1875 5.0 4.7 112.6 Jan., 1889 2.2 2.6 July, 1875 5.1 4.4 117.0 May, 1890 2.1 2.6 Jan., 1876 4.7 4.4 112.9 July, 1891 2.4 3.0 July, 1876 4.5 4.2 112.3 Jan., 1892 2.6 3.1 Jan., 1877 4.5 4.4 107.0 Mar., 1893 2.8 3.1 July, 1877 4.4 4.3 105.4 Nov., 1894 2.7 3.5 Jan., 1878 5.0 4.6 102.8 Aug., 1895 2.8 3.6 July, 1878 3.9 4.4 100.7 Aug., 1896 3.2 4.3 I This table has been obtained by the aid of the usual brokers' bond tables. In the case of currency bonds, it was only necessary to deduct accrued interest (if any) from the quoted price and look in the table for the interest which corresponds to the price so found and the number of years to maturity. In the case of coin-bonds, _SEC. 3] INDUCTIVE VERIFICATION (MONETARY) 261 Several points in this table deserve notice. In 1870 the investor made 6.4 per cent. in gold but was willing to accept a return of only 5.4 percent. in currency. This fact becomesintelligible in the light of the theory which has been explained. It meant the hope of resunlption. Because paper was so depreciated there was a prospect .of a great rise in its value. It was not until 1878, when the prospect of a further rise disappeared, that the relative position of the two rates of interest was reversed. Mter resumption in 1879 the two remained very nearly equal for several years, until fears of inflation again produced a divergence. The quotations for 1894, 1895, and 1896 show a considerably higherrate of interestin the currencystandardthan in the coin standard, as well as a higher rate in both standards than in previous years. The difference is between -2.7 per cent. and 3.5 per cent. in 1894,and between 3.2 per cent.

and 4.3 per cent. in 1896. Both the increaseand the wedg ing apart of the two rates are explainable as effects of the free-silver proposal and its incorporation (July, 1896) in the platform of the Democratic party. § 3 We see, therefore, that the facts agree with the theory previously laid down. But it is necessary further to inquire how close is this agreement. For this purpose the figures just given are of little value. They represent the rates of interest realized for the period~ between the dates named and the times at which the bonds matured; but as these since the quotations are given in currency, it is necessary to divide the quoted price by the price of gold in order to obtain their price in gold (i.e. It coin "),. and then proceed as above indicated. The quotations of prices of bonds and gold are the U opening" prices for the months named, and are taken from the Financial Review (Annual Summary of the Commercial and Financial Chronicle), 1895, The Commercial and Financial Chronicle, the (New York) Bankers' Maga %ine, and the Bankers' Almanac. After 1884, January quotations were not always available.

262 THE RATE OF INTEREST [CHAP. XIV periods are not the same for the two bonds, the two cor responding series of interest rates are not entirely com parable. Such a rate of interest is a sort of average of the rates of interest for the individual years of the periods in question.1 Thus, in the foregoingtable, the rate of interest in currency placed opposite January, 1870, is 5.4 per cent. This is the rate realized between 1870 and 1899. It is a sort of average of, say, the rate of interest for the period RATES OF INTEREST REALIZED FROM DATES MENTIONED TO JANUARY 1, 1879 (DATE OF RESUMPTION) 2 ApPRECIATION OF CURRENCY IN GOLD COIN CURRENCY " Expected" Actual i i a Jan., 1870 7.1 6.3 .8 2.1 July, 1870 6.2 5.7 .5 1.4 Jan., 1871 6.7 6.3 .4 1.3 July, 1871 6.4 5.7 .7 1.8 Jan., 1872 5.9 5.7 .2 1.3 July, 1872 6.2 5.7 .5 2.1 Jan., 1873 6.5 6.2 .3 2.0 July, 1873 6.2 6.0 .2 2.8 Jan., 1874 5.6 6.1 -.5 2.1 July, 1874 5.7 5.8 -.1 2.4 Jan., 1875 6.0 5.4 .6 3.1 July, 1875 6.1 4.2 1.9 4.9 Jan., 1876 5.4 4.1 1.3 4.3 July, 1876 5.2 2.4 2.8 4.9 Jan., 1877 5.5 4.0 1.5 3.5 July, 1877 5.7 3.1 2.6 3.6 Jan., 1878 8.2 6.0 2.2 2.8 July, 1878 4.8 2.6 2.2 1.4 1 For the nature of this average, see The Nature of Capital and Income, Appendix to Chap. XII, § 5.

2 Since the figures in this table represent the rates of interest which will render the "present value," at the date of purchase, of all the future benefits up to January, 1879, equal to the purchase price, they can be calculated by Horner's method as indicated in § 9 SEC. 3] INDUCTIVE VERIFICATION (MONETARY) 263 between 1870 and 1879 (which, as we shall see, was 6.3 per cent.) and that for the period between 1879 and 1899 (which was 4.5 percent.). For a true comparison between coin and currency rates, we must seek rates -relating to the same period in each case. This is the method in the fol lowing table. In it, the periods selected all terminate on January 1, 1879, the date of resumption of specie payments. The rates of interest in this table are the rates which would be realized by investors who should buy the bonds at the dates mentioned and sell them on January 1, 1879. of the Appendix to Chap. V. But the method which has been adopted is less laborious, as it enables us to use the bond tables. It can best be explained by an example. The opening price, January, 1870, of currency sixes was 109!, and in January, 1879, the price was 119t.

These prices require no correction for accrued interest. Our problem is, if a man spends $109! in 1870 and receives $119t in 1879 with $6 per annum (semiannually) in the meantime, what rate of interest does· he realize? Now it is clear that the answer is the same if all the benefits and sacrifices involved are doubled or halved or increased or decreased in any common ratio. Let us then divide them all by 1.19!. Then we would have $91.3 paid in 1870 for $100 due in 1879, and $5.02 per annum in the meantime. That is, the rate of interest realized is exactly as if the bond were a 5.02 per cent. bond maturing in 1879 and bought at 91.3 in 1870. This rate can readily be obtained from the bond tables by interpolating between the figures for a ,5 per cent. and a 5t per cent. bond purchased at 91.3 with 9 years to run. For a 5 per cent. bond we obtain 6.28 per cent. and for a 5! per cent'. bond, 6.81 per cent. Hence for a 5.02 per cent. bond the result is 6.30 per cent.

The third column gives what may be called the expected rate of appreciation 'of currency in terms of gold; that is, that rate of appre ciation which would have made the two interest rates equally profit able. It is therefore the difference between the two rates of interest. Finally, the last column gives the actual rate of appreciation be tween the dates mentioned and January 1, 1879. This is calculated from the quoted prices of gold. Thus the opening price of gold January, 1870, was 119.9, and January, 1879, 100. Hence currency appreciated in nine years in the ratio of 100 to 119.9, which is at the rate of 2.1 per cent. per annum. If the appreciation proceeded uni formly, this method would be strictly correct. As it is, a more elabo rate method would be required, in accordance with the principles explained in § 9 of the Appendix to Chap. V, to take account fully of the fluctuations of the annual appreciation. But for our present purposes, and for results worked out to but one decimal place, the simpler method here adopted is sufficiently correct.

264 THE RATE OF INTEREST [CHAP. XIV From this table we see that the rates of interest realized for the period, January, 1870 to January, 1879, were in coin, 7.1 per cent., and in currency, 6.3 per cent., the dif ference 1 between which is .8 per cent., the rate of apprecia tion which would equalize the investments in the two bonds This may be called the "expected appreciation." The actual rate of appreciation was 2.1 per cent. That is, the estimated appreciation was about two-fifths of the ap preciation as it really turned out. Those who held currency sixes therefore had the better investment during 1870 1879. In fact, it is well known that many speculators grew rich by exchanging gold bonds for currency bonds about this time. The table shows that there was the same underestimate of future appreciation in July, 1870, January, 1871, and July, 1871. From that time to July, 1874, the table shows that the outlook for resumption grew gloomy, due no dOllbt to the strong greenback senti ment. The inflation bill of 1874 actually produced a prospect of negative appreciation; i.e. depreciation. This bill was vetoed by President Grant, and in December of that year the bill for resumption was passed by the Senate. Accordingly, January, 1875, opened with a more hopeful estimate. The bill became a law on the 14th of January, and there was an immediate rise in the" expected appreciation" which from that time forward averaged 2 per cent. But during the same period the actual ap1 The formula used is therefore simply i =i +a. (i represents the rate of interest in coin, i the rate of interest in currency, a the expected rate of appreciation - that is, the rate of appreciation of the cur rency standard with respect to the coin standard). As shown in Ap pendix to Chap. V, § 3, this formula applies strictly only when the rates of interest and of appreciation are "reckoned continuously."

But practically it applies to all cases with which we have to deal, as the interest periods are seldom over half a year. Even when the interest is payable only annually, and, in consequence, the correct formula is 1 + j = (1 + i) (1 + a), (see Appendix to Chap. V, § 2), the value of a calculated by this formula will seldom differ perceptibly from its value calculated by the simpler formula j =i +a, here employed.

SEC. 4] INDUCTIVE VERIFICATION (MONETARY) 265 preciation from the dates named to January, 1879, averaged 3.6. per cent., so that even after the government promised resumption, investors and speculators did not put implicit confidence in· that promise, the "expected appreciation" being only a little more than half the actual appreciation. This corresponds to the well-known fact that the resump tion act was looked upon as a political maneuver, likely to be repealed.1 § 4 Having compared the rates of interest in paper and coin, we may next compare them in gold and silver. The comparison, to be of value, must be between gold and silver contracts in the same market and with the same security. Such contracts are fortunately available in the London market of government securities. The loans of India 1 It should be observed that the method employed to determine the rate of interest realized is open to one danger. It correctly repre sents the rate of interest actually realized between two dates, but, unless the later of the two dates is maturity, it does not necessarily represent the rate of interest expected at the first date. The investor could not know in January, 1870, what the price of bonds would be in January, 1879, unless the bonds matured at that time. To accu rately compare, in 1870, the relative advantages of coin and currency bonds for the period 1870-1879, a forecast would have been necessary, not only of the relation of currency to gold, but also of the prices. of the two bonds in 1879. These prices, in turn, depend on a new fore cast made in 1879. It follows that a mistake in this forecast of 1879 and embodied in the prices of that year would affect the rate of in terest realized between 1870 and 1879 in the same manner as a mis take of the opposite kind in the forecast of 1870.

But in most cases the method given is sufficiently exact~ For, although in 1870 it would have been impossible to predict exactly the prices of the two bonds in 1879, yet it can usually be depended upon that any great change in price is apt to affect both alike, and thus eliminates itself for the most part in the comparison. The reason that the errors in predicting what the prices of the two bonds would be in 1879 are nearly equal is that the two bonds selected were ap proximately of the same term. The coin bonds matured in 1907, the currency bonds in 1898 and 1899. The eight or nine years be tween them would be almost immaterial in 1879. It is for this reason, that the coin bonds of 1907 were chosen in preference to those of 1881.

266 THE RATE OF INTEREST [CHAP. XIV have been made partly in gold and partly in silver, and both forms of securities are bought and sold in London. 1 The interest on the silver, or rather rupee, bonds is paid by draft on India. The sums actually received in English money depend on the state of the exchanges. The rate of interest in the silver standard is calculated in the same way as was shown 2 for coin bonds in § 3. The results are contained in the following table:RATES OF INTEREST REALIZED FROM DATES NAMED TO MATURITY OR IN PERPETUITY 3 DIFFER-EXCHANGE ON RUPEE GOLD INDIAENCE PENCE PER RUPEE 1865 4.3 4.1 .2 23.2 1868 4.3 4.0 .3 23.0 1870 4.3 4.0 .3 23.6 1871 4.1 3.8 .3 23.2 1872 3.9 3.7 .2 22.6 1873 3.9 3.7 .2 22.4 1874 3.9 3.8 .1 22.2 1 The silver bonds or "rupee paper" were issued to raise loans in India, but they have also been enfaced for payment in England, and in 1893-1894 some Rs. 25,000,000 were on the London books. - Bur dett's Official Intelligencer (1894), p. 75.

2 Thus in 1880 the average price paid in London for" rupee paper" of face value Rs. 1,000 yielding 4 per cent., or Rs. 40 per annum, was £79. In order to find the rate of interest realized by the investor, we must translate £79 into silver. The average rate of exchange in 1880 was 20d. per rupee. Hence £79 were equivalent to 948 rupees. That is, speaking in terms of silver (or, more exactly, in terms of exchange on India), the price of a4per cent. bond was 94.8, which, if the bond be treated as a perpetual annuity, yields the in vestor 4.3 per cent. In the same year, an India gold bond yielded 3.6 per cent. S This table is formed from averages of (usually ten) quotations distributed through each year, taken from the Economist, the In vestor's Monthly Manual, and the (London) Bankers' Magazine. The fourth column is founded on the table in the Report of the Indian Cur rency Committee (1893), p. 27, but is corrected to apply to calendar instead of official years.

SEC. 4] INDUCTIVE VERIFICATION (MONETARY) 267 RATES OF INTEREST REALIZED FROM DATES NAMED TO MATURITY OR IN· PERPETUITY -Continued RUPEE l DIFFER-EXCHANGE ON GOLD 2 ENCE INDIA PENCE PER RUPEE 1875 4.0 3.6 .4 21.9 1876 4.1 3.7 .4 20.5 1877 4.1 3.7 .4 20.9 1878 4.2 3.9 .3 20.2 1879 4.4 3.7 .7 19.7 1880 4.3 3.6 .7 20.0 1881 4.0 3.4 .6 19.9 1882 3.9 3.5 .4 19.5 1883 4.1 3.4 .7 19.5 1884 4.1 3.3 .8 19.5 1885 4.1 3.5 .6 18.5 1886 4.1 3.5 .6 17.5 1887 4.1 3.4 .7 17.2 1888 4.1 3.1 1.0 16.5 1889 4.1 3.0 1.1 16.5 1890, 1st half 4.0 3.0 1.0 17.6 i 1890, 2d half 3.9 3.1 .8 19.3 1891 3.8 3.1 .7 17.1 1892 3.9 3.1 .8 15.3 1893 3.9 3.0 I .9 15.0 1894 3.9 3.0 .9 13.5 1 The quotation from which the interest was computed for 1895 and succeeding years is for 3t per cent. rupee paper. All previous quotations are for 4 per cent. 'So The 4 per cent.'s were repayable on three months' notice; this notice was given in 1894, and the bonds redeemed or converted into 3t per cento's before the close of the year.

To obtain the rate of interest realized, the London quotations in pounds sterling are first converted into rupees at the current rates of exchange, and then the bonds are treated as perpetual annuities. The results differ from those given in the Inve8tor'8 Monthly Manual, because the rupee is there converted at a conventional value, not the ma.rket value. 2 From 1865 to 1880 inclusive the figures refer to 4 per cent. 's, repayable October, 1888, or later; those of 1881-1884 are for 3! per cent.'s maturing in 1931, and those for 1885-1906 are for 3 per cent.'s maturing in 1948.

268 THE RATE OF INTEREST [CHAP. XIV RATES OF INTEREST REALIZED FROM DATES NAMED TO MATURITY OR IN PERPETUITY - Concluded DIFFER-EXCHANGE ON RUPEE GOLD INDIAENCE PENCE PER RUPEE 1895 3.4 2.8 .6 13.4 1896 3.3 3.1 .2 14.3 1897 3.5 3.1 .4 15.1 1898 3.7 3.2 .5 16.0 1899 3.6 3.2 .4 16.1 1900 3.7 3.4 .3 16.0 1901 3.7 3.5 .2 I 16.0 1902 3.6 3.5 .1 16.0 1903 3.5 3.5 .0 16.0 1904 3.6 3.7 -.1 16.1 1905 3.6 3.6 .0 16.1 1906 3.6 3.2 .4 16.0 From this table it will be seen that the rates realized to investors in bonds of the two standards differed but slightly until 1875, when the fall of Indian exchange began. The average difference previously to 1875 was .2 per cent., while the average difference from 1875 to 1892 inclusive was.7 per cent., or more than three times as much. Within this period, from 1884 exchange fell much more rapidly than before, and the difference in the two rates of interest rose accordingly, amounting in one year to 1.1 per cent.

Inasmuch as the two bonds were issued by the same gov ernment, possess the same degree of security, are quoted side by side in the same market, and are similar in all other respects except in the standard in which they are expressed, the results afford substantial proof that the fall of exchange (after it once began) was discounted in advance and af fected the rates of interest in those standards. Of course investors did not form perfectly definite estimates of the future fall, but the fear of a fall predominated in varying degrees over the hope of a rise.

SEC. 4] INDUCTIVE VERIFICATION (MONETARY) 269 The year 1890 was one of great disturbance in exchanges, the average for the first six months being 17.6 and for the last six months 19.3. The gold price of the silver bonds rose from an average for the first six months of 73.8' to 83.5 for the last six months, but the rise in their silver price was only from 100.6 to 103.7, showing that the increase of confidence in the "future of silver" was not great, and in fact only reduced the disparity in the interest from 1.0 to .8 per cent. This great rise in exchange and the slight revival in silver securities occurred simultaneously with the passage of the Sherman Act of July, 1890, by which the United States was to purchasefour and a half million ounces of silver per month. There can be little doubt that the disturbance was due in some measure to the operation or expected operation of that law. This is not the only case in which the relative prices of rupee paper and gold bonds were probably affected by political action. One of the smallest differences in the two rates occurs in 1878, which was the year of the Bland Act and the first international monetary conference.

Mter the closure of the Indian mints on June 26, 1893, exchange rose from 14.7 to 15.9, the gold price of rupee paper from 62 to 70, and consequently its 'rupee price from 101.2 to 105.7. From this point the exchange again dropped, much to the mystification of those who had pre dicted an established parity between gold and silver at the new legal rate of 16d. per rupee. There was much dis cussion as to the reasons for the failure of the legal rate to become operative. The reason seems to have been that the closure of the mints to silver attracted into the cir culation silver from other channels, especially old Native hoards. Within a few years, however, this source of supply was dried up so that the legal par was reached in 1898 and has been maintained ever since, subject only to the slight variations of exchange due to the cost of shipping specie. But until the par was proved actually stable by two or 270 THE RATE OF INTEREST [CHAP. XIV three years' experience, the public refused to have confi dence that gold and the rupee were once more to run parallel. Their lack of confidence was shown in the dif ference in the rates of interest in gold and rupee securi ties during the transition period, 1893-1898, and the two or three succeeding years. From 1893 to 1900 inclusive the two rates averaged .5 per cent. apart. From 1901 to 1906 inclusive, the average differencewas only .1 per cent.1 § 5 We shall next attempt to apply the theory of appreciation and interest to periods of rising and falling prices. We are met, however, by the difficulty that comparison can only be made between s'UCcessive periods. We can learn what the rate of interest has been during a price movement, but we cannot know what it would have been if that price movement had not taken place. Without this missing term of comparison, it is difficult to measure the influence of the rise or fall in price level. No two periods are so alike industrially that we can say they differ only in the state of the monetary standard. Other influences innumerable affect the "value of money." In spite of these difficulties, however, certain general conclusions can be established.

It must be borne in mind that we are studying the effects of rising, not high, prices, and of falling, not low, prices. Falling prices are as different from low prices as a waterfall is from sea level. Our study is not of price levels, but of the slopes between price levels.2 1 The preceding comparisons serve only to establish the influence of the divergence between the standards on the rates of interest, but afford no measure of that influence. ~n order to measure the extent to which the fall of silver was allowed for by investors, it would be necessary to examine the rates realized during specific periods, as in the case of coin and currency bonds considered in § 3. A some what unsatisfactory attempt to do this was made in "Appreciation and Interest," but is not reproduced here. The case is unlike that of the United States coin and currency bonds, since in the case now under discussion, the two kinds of bonds, rupee and gold, did not have approximately the same date of maturity.

2 De Haas appears to have fallen into the confusion between high SEC. 5 ] INDUCTIVE VERIFICATION (MONETARY) 271 It was once predicted by Mr. H. H. Gibbs,! formerly a director of the Bank of England, that the progressive scarcity of gold would raise the rate of interest. He reasoned that such scarcity would make a stringency in the money market, and that the banks, each struggling to attract reserves from the others, would raise their rates., This prophecy, however, was not fulfilled. The theory that appreciation raises interest has been frequently affirmed, and has even received the stamp of approval of Mr. Robert Giffen. But it is utterly at variance with facts. 2 When prices are rising or falling, money is depreciating or appreciating relativelyto commodities. Our theory would therefore require high or low interest according as prices are rising or falling, provided we assume that the rate of interest in the commodity standard does not vary. This assumption would be thoroughly justified only in case the two periods were alike in all respects except in the expansion or contraction of credit and currency.

In the following table for London the periods are selected to correspond with the main movements of prices. Thus, the period 1826-1829 was a period of falling prices, so that money appreciated in terms of commodities at the average rate of 4.2 per cent. per annum. This is indicated in the third column by the figure + 4.2. In the period 1836-1839 prices rose so that money fell at the rate of 2.3 per cent. per annum, indicated by - 2.3. The fourth and last column indicates the rate of interest which is virtually paid in com modities. It is the rate of commodity-interest equivalent to the nlarket rate of money-interest actually paid, and therefore is, in each case, the sum of the two. items of the two preceding columns. and rising prices, both in his crit!cism of Jevons and in his treatment of statistics. See" A Third Element in the Rate of Interest," Jour nal 01 the Royal Statistical Society, March, 1889.

1 The Bimetallic Controversy, London (Wilson), 1886, pp. 19, 231 245-249, 373. 2 See" Appreciation and Interest," p. 57.

272 THE RATE OF INTEREST [CHAP. XIV LONDON RATES OF INTEREST IN RELATION TO RISING AND FALLING PRICESl VIRTUAL ApPRECIATION INTEREST IN BANK MARKET OF MONEY IN COMMODITIES COMMODITIES (Market) i a i 1826-1829 4.4 3.5 +4.2 7.7 1830-1835 4.0 3.2 0.0 3.2 1836-1839 4.7 4.2 -2.3 1.9 1840-1844 4.2 3.5 +5.9 9.4 1845-1847 3.7 4.2 -3.0 1.2 1848-1852 2.9 2.5 + 1.2 3.7 1853-1857 4.1 5.3 -2.4 2.9 1858-1864 4.4 4.2 -3.0 1.2 1865-1870 3.8 3.6 + 1.1 4.7 1871-1873 3.9 3.7 -6.2 - 2.5 1874-1879 3.2 2.7 +4.3 7.0 1880-1887 3.3 2.6 +3.8 6.4 1888-1890 3.8 2.9 -1.4 1.5 1891-1896 2.5 1.5 +3.4 4.9 1897-1900 3.2 2.6 -6.6 -4.0 1901-1906 3.6 3.1 -1.5 1.6 1 This table is constructed from the data given in the Appendix to this chapter. The third column is based on index numbers (Jevons' for 1826-1852, and Sauerbeck's for the remaining years). The index numbers for two dates, as 1826 and 1829, being given, their inverse ratio gives the relat~ve value of money (in commodities) at those two dates. From these it is easy to calculate the average annual change in its value. The method is the same as that employed for finding the rate of interest by which $1, by compounding, will amount to a given sum in a given time. Theoretically, since the loans here included run usually perhaps thirty to ninety days, the quotations of rates of interest averaged should begin at the first of the two dates, and cease, say, sixty days before the second. But the index numbers are not always for definite points of time, nor can the interest quotations be subjected to such minute corrections with out an immense expenditure of labor. Hence, the method adopted has been to average the rates for all the years of a period; e.g. for the four years, 1826-1829. The It appreciation" is reckoned between those dates. If the index numbers represent the price levels at the middle of 1826 and 1829, then the average interest rates ought in theory to include only the last six months of 1826, and the first four months of 1829. But it seems better to include too much at both ends than to omit the averages for 1826 and 1829 altogether, for the reason that an average is the more valuable the greater the number of terms included.

SEC. 6] INDUCTIVE VERIFICATION (MONETARY) 273 If this table be examined, it will be found that if, in comparing one period with the next, the rate of interest falls, the" appreciation" usually rises, or if the rate rises, the "appreciation" falls. The comparison of each period with the one following may be designated as a "se quence." In twelve out of fifteen sequences for bank rates and· in eleven out of fifteen for market rates, interest is high or low according to the degree in which prices are rising or falling. Attention is called particularly to the period 1853-1857, during which prices rose very fast simul taneously with, and presumably because of, the great gold production. The market rate of interest averaged 5.3 .. per cent., which was far higher, not only than in any sub sequent, but also than in any previous period. § 6 The following table for Berlin displays the same connec tion between price movements and interest:BERLIN RATES OF INTEREST IN RELATION TO RISING AND FALLING PRICES 1 • ApPRECIA-VIRTUAL VIRTUAL TION OF INTEREST IN INTEREST IN BANK MARKET MONEY IN COMMODITIES COMMODITIES COMMODITIES (Bank) (Market) i i a i i 1851-1852 4.0 - -1.5 2.5 1853-1857 4.7 - -3.3 1.4 1858-1864 4.3 3.7* -2.2 2.1 1.5 1865~1870 4.7 4.0 0.0 - 4.0 1871-1873 4.5 4.1 -4.1 - 0.0 1874-1879 4~3 3.2 +3.1 - 6.3 1880-1883 4.3 3.4 -0.1 - 3.3 1884-1888 3.6 2.5 +2.9 - 5.4 1889-1891 4.0 3.1 -1.4 - 1.8 1892-1895 3.4 2.2 +5.2 - 7.4 1896-1899 4.2 3.6 -6.8 - - 3.2 1900-1902 4.2 3.2 5.4 - 8.6 1903-1905 3.9 3.0 -1.4 - 1.6 1 This table is constructed from the data in the Appendix. The average in the second columnmarked (*)is for the years 1861-1864, T 274 THE RATE OF INTEREST [CHAP. XIV In the foregoing table the relation between appreciation and interest is observed in seven out of twelve sequences for bank rates (two being neutral) and in eight out of ten, for market rates.

For France, index numbers covering a wide range of articles are not available. Using those given in the" Ald rich Report" for sixteen articles, we have:PARIS RATES OF INTEREST IN RELATION TO RISING AND FALLING PRICES 1 ApPRECIATION BANK MARKET OF MONEY IN COMMODITIES 1861-1864 5.1 - 8.1 1865-1870 3.2 + 3.6 1871-1873 5.3 4.6* - 4.5 1874-1879 3.1 2.6 + 4.3 1880-1886 3.2 2.8 + 2.3 1887-1890 3.1 2.6 - 5.1 1891-1895 2.6 2.0 Here the same connection is observed in five out of six sequences for bank rates and three out of four for market rates. 2 It will be noted that the course of prices and interest has been very much the same in England, Germany, and France. For New York we have the following table:not 1858-1864. The" appreciation" to 1891 is calculated from the figures of Soetbeer and Heinz, as given in the "Aldrich Report" of 1893 of the U. S. Senate on Wholesale Prices. The figures for the later years are taken from The London Economist and from A. Soet beer's tables in the Journal of the Royal Statistical Society, Vol.

LXVII, Part I, pp. 85, 89. 1 This table is constructed from the data in the Appendix. The average in the second column marked (*) is for the years 1872-1873, not 1871-1873. 2 Assuming that prices fell, 1891-1895.

SEC. 6] IN_DUCTIVE VERIFICATION (MONETARY) 275 NEW YORK RATES OF INTEREST IN RELATION T·O RISING AND FALLING PRICESl ApPRECIA-VIRTUAL VIRTUAL PRIME TION OF INTEREST IN INTEREST IN CALL 60 Two MONEY IN COMMODITIES COMMOnDAYS NAME COMMOD- (60 Days) ITIES 60 DAYS ITIES (Prime) i i a i i 1849-1857 6.2 9.2 - - 3.8 5.4 1858-1860 5.0 7.4 - +6.4 13.8 1861~1865 5.9 8.4 6.8 -20.2 -11.8 -13.4 1866-1874 5.4 8.4 7.5 + 4.7 13.1 12.2 1875-1879 - - 5.1 + 7.9 - 13.0 1880-1884 - - 5.4 +0.6 - 6.0 1885-1891 - - 5.1 - 0.2 - 4.9 1892-1897 - - 4.6 + 5.6 - 10.2 1898-1906 - - 4.6 - 3.5 - 1.1 We find here the same association of appreciation and interest in all of the three sequences 'for call loans, in two of the three cases for 60-day paper (the third being neutral), and in three of the six cases for "prime" paper (one being neutral). Perhaps the most remarkable feature of this table is the extremely low rate for 1875-1879. The extraordinary change in interest rates beginning in 1875has been observed before; but its connection with the resumption act (as it seemsto the writer) has been misconstrued.2 1 This table is constructed from the data in the Appendix. The rates of appreciation are calculated from Falkner's figures for prices and wages in the It Aldrich Report."

2 Thus William Brough, referring to that act, says: liThe mere announcement of our intention to put our money on a sound metal lic basis had brought capital to us in such abundance that the resump tion was not only made easy, but the normal rate of interest was reduced. . .. This remarkable reduction . . . is explainable only on the ground of a large reflux of foreign capital." (Natural Law 01 Money, New York, 1894, p. 124.) If this explanation were correct, we would expect a still lower rate of interest after resumption had been accomplished; but the facts are the opposite.

276 THE RATE OF INTEREST § 7 [CHAP. XIV The preceding statistics apply to gold standard countries. The following table gives the rates of interest and appre ciation for silver standard countries-India, Japan, and China:RATES OF INTEREST IN RELATION TO RISING AND FALLING PRICES IN CALCUTTA, TOKYO, AND SHANGHAI 1 BANK MARKET ApPRECIATION IN COMMODITIES Calcutta, 1873-1875 5.3 +2.6 1876-1878 6.8 -11.0 1879-1885 5.9 +3.8 1886-1889 6.0 -2.6 1890-1893 4.3 -4.7 Tokyo, 1873-1877 14.0 12.0 -0.2 1878-1881 16.3 12.2 -13.3 1882-1886 12.8 10.3 + 10.4 1887-1893 9.3 9.4 -2.8 1894-1899 9.7 11.2 -5.8 1900-1902 11.0 12.4 0.0 Shanghai, 1874-1881 9.1 -1.4 1882-1888 7.5 5.8* + 1.3 1889.:..1893 7.0 5.8 -0.9 Here we find the theory confirmed in three out of four cases for India, three out of five for bank rates in Japan, and three out of five for market rates; one out of two for bank rates in China, while the one case for market rates is neutra1.2 1 This table is constructed from the data given in the Appendix.

The entry marked (*) is for 1885-1888, not 1882-1888. 2 See also "Price Movements and Interest in India," by the writer, in Yale Review, May, 1897, p. 80.

SEC~ 8] INDUCTIVE VERIFICATION (MONETARY) 277 Summarizing the· cases for the seven countries examined we find 64 favorable and 22 unfavorable· to the theory, dis tributed as follows: ENG" GER-FRANCE UNITED INDIA JAPAN CHINA TOTAL'LAND MANY STATES -------------Favorable 23 15 8 8 3 6 1 64 Unfavorable 7 5 2 2 1 4 1 22 The favorable cases are about three times as numerous as the unfavorable cases. This is a large preponderance, especially when we consider that there are so many causes affecting the rate of interest besides the mere appreciation or depreciation of the monetary standard. We therefore conclude with great confidence that, "other things being equal," the rate of interestis relativelyhigh when prices are rising and relativelylow when·prices are falling. § 8 The question now arises whether, on the average, the rate of interest fully adjusts itself to price-movements. This question cannot be answered with perfect certainty in any individual case, for the reason that we have no means of knowing what the rate in commodities would have been had it been possible to have contracts drawn in "com modities" or in a monetary standard which was stationary with respect to commodities. We have, however, computed the it virtual" interest in commodities by adding'to the rate of interest in. money the rate of appreciation of money in commodities. Thus in London for 1826-1829 the rate of interest in money was 3.5 per cent., but money was appre ciating relatively to commodities 4.2 per cent., so that the , II virtual interest," or interest actually paid, translated in terms of commodities (the forty commodities averaged by Jevons),was7.7 per cent. It will be seenfrom the tables that the virtual rate of interest reckoned in commodities 278 THE RATE OF INTEREST [CHAP. XIV usually varies inversely with the rate reckoned in money.

For 1853-1857, money interest was 5.3 per cent., and for 1874-1879, 2.7 per cent.; but commodity-interest for 1853 1857 was 2.9 per cent. and for 1874-1879, 7 per cent. There are two possible explanations for this inverse relation. One is that when prices are rising the cause may not be monetary but may lie in a progressive scarcity of commodities pro duced and exchanged; and,reversely, when prices are falling, the cause may lie in progressive abundance. From the theory of interest maintained throughout this book it follows that a progressive scarcity of commodities, implying as it does a progressive descending income curve, tends to make the rate of interest low; and reversely, progressive ab~dance, implying an ascending income curve, tends to make interest high. When, therefore, general price-move ments represent changes in the income-stream of enjoyable services, the rate of "commodity interest" would naturally be high when prices were falling and low when prices were rising, whatever might be true of "money-interest."

The second possible reason that commodity-interest and money-interest vary inversely during price-movements is that these Inovements are often imperfectly foreseen. The high or low rate in commodities is then an abnormal phenomenon. It is, as it were, a trick played by money on those who put too much faith in its stability. Thus, during 1898-1905 the increase of prices in the United States is known to have been due largely to the in crease of gold production. There is no evidence that commodities were getting scarce and incomes decreasing, but rather the reverse. There seems, therefore, no reason which would justify the low commodity-rate of interest of 1.8 per cent. which we found to have been virtually paid during that period. This low rate must, in all probability, have been due to inadvertence. The inrushing streams of gold caught merchants napping. They should have stemmed the tide by putting up interest, not only to 4.6 per cent., as they did, but two or three per cent. higher.

SEC. 8] INDUCTIVE VERIFICATION (MONETARY) 279 Doubtless both of the causes playa part in the explanation of particular cases. Sometimes commodity-interest is low during rising prices because it is foreseen that the real in come-stream is then drying up, sometimes because it is not foreseen that monetary inflation is taking place, and some times for both reasons; and reversely, commodity-interest is high during falling prices, sometimes because of a foreseen increase of the income-stream, sometimes because of unfore seencontractioIl of the currency,and sometimesboth. It is impossible to decide what part these two factors-- foreseenchanges in real income and unforeseen changes.in theirmonetarymeasure-may play in each individual case. We are too ignorant of the actual conditions behind the scenes. Nevertheless there is internal evidence to show that in general the latter factor - unforeseen monetary change-is the more important. This evidence consists in the fact that commodity-interest fluctuates so widely, in some cases even becoming negative. The following table shows that the mean variability or It standard deviation"

from the mean, which is the best measure of the fluctuations of any variable, is far greater for the calculated or " virtual" rate of .interest than for the actual money rate of interest:VARIABILITY (Standard Deviation) No. PERIODS MARKET VIRTUAL INTEREST INTEREST London. 16 .88 3.42 Berlin 11 .56 2.93 New York 7 1.06 8.43 The virtual interest in commodities is from four to eight times as variable as the market interest in money. All these facts suggest - indeed, practically demon strate -that money-interest was not adequately adjusted to the changes in purchasing power of money. It is, of course, not to' be assumed that commodity-interest ought 280 THE RATE OF INTEREST [CHAP. XIV to be absolutely invariable; but it is practically certain that its variations could not be three and a half times the variations in money-interest, unless the price-movements were inadequately predicted. If any doubts were possible on this point they must disappear when we find that for 1871-1873 commodity-interest in London was minus 2.5 per cent. This shows that money lenders would have been better off had they simply bought commodities in 1871 and held them until 1873. As it was, they actually lost some thing, measured in commodities, as a consequence of lending money. Such losses are especially apt to appear in short periods. Thus if we take the period 1824-1825, we find that the market rate was 3.7 per cent., the rate of appreciation was minus 14.5 per cent., and the virtual rate of interest in commodities, minus 10.8 per cent. !

In New York during the inflation period, 1861-1865, commodity-interest sank to the ridiculously low figure of minus 13.4 per cent. This shows in a striking way how thoroughly the greenback inflation upset all business cal culations, and how little the investing public realized in advance the serious rise in prices of those fateful years. That foresight was actually misguided at this time is amply confirmed if we examine the predictions as to the termi nation of the war and the reduction of the gold premium, which were recorded from month to month in the "Notes on the Money Market" in the (New York) Bankers' Maga zine. In all probability such errors of prediction are common in periods of paper money inflation. Our tables in § 7 show it for the Japanese inflation of 1878-1881. § 9 vVe can now understand why a high rate of interest need not retard trade nor a low rate stimulate it. These facts have puzzled many writers. For instance, Robert Baxter wrote: 1_ ' 1 J oumal 0/ the Royal Statistical Society, June, 1876.

SEC. 9] INDUCTIVE VERIFICATION (MONETARY) 281 "Public inquiry has been of late strongly directed to the reasons for the very low rate of interest upon loanable capital in the year 1875, the more especially as ten years ago the very high rates then prevailing c~eated equal surprise." And Jevons wrote: 1_ It The effect of such and many more changes effected during the last twenty years or so is seen in a general increase in wealth and of mercantile industry and profits. Thus only can be explained the extraordinary high rate at which the interest of money has in the last ten years often stood. During 1854-1857 the rate of interest was only for a few months below 5 per cent., but for many months above. it. For more than half a year it stood at 6 and 7 per cent., and in the end of 1857 it remained for nearly two months at 10 per cent. Again, in 1861, interest rose to 6 a:nd 8 per cent., and all this, to the surprise of the elder generation,without the general stoppage of trade, the breach of credit, and the flood oj bankruptcy, whichhas hithertoattendedsuchratesoj interest. It is certainly not to increasing scarcity of capital we should attribute such rates, but rather to a greatly extended field for its profitable employment."

But were these rates high? If we turn to our table for London rates, we find that the average market rate for 1853-1857 does appear to be the highest in the table; but, unmasking it of the money element, we find it is equiva lent to a commodity-interest of 2.9 per cent. This is a very low rate. Merchants with increasing prices and money profits would find it easy to repay loans on such a basis. Professor Bonamy Price,2 writing at a time of very low interest rates, says:"Everyone remembers the agitations associated with 7 per cent., the trepidation of merchants, the apprehension of losses in busi ness. .. .• If only a moderate rate could be reckoned on as steady, how happy would everyone have been! • •• Yet what are the facts and feelings to-day? Is every merchant, every manufac turer rejoicing in the pleasant terms on which he obtains the ac commodation so necessary for his business? .•• Alas! no such sounds meet. our ears... •• Conlmercial depression is the uni versal cry, depression probably unprecedented in duration in the annals of tra~e, except under the disturbing action of a prolonged 1 Investigations 'in. Currency., p. 95. (The italics are the present writer's.) :3 "One per cent," Contemporary Revtew, April, 1877. (The italics are the present writer's.) 282 THE RATE OF INTEREST [CHAP. XIV war. . .. In the export figures, the writer still fails to see any signs of the long-looked-for revival of trade. Both quantities and values continue to shrink in all save a few cases. . .. What, then, is the cause? The explanation will certainly not be found in gold nor in any form of currency whatever • • • nor has anyone said anything so ridiculous. . .. That cause is one and only one: overspending."

If we turn back to the London table we find, however, that for 1874-1879 the commodity-rate of interest, so far from being low, was 7 per cent.! It would be astonishing if trade did not shrink under such a burden. All these writers mistook high or low nominal interest for high or low real interest. Tooke apparently did the same. In his History of Prices, Vol. II, p. 349, he names as the last of six reasons for the fall of prices for 1814-1837, "a reduction in the general rate of interest." This is probably not only an inversion of cause and effect, but also, when the veil of money is thrown off, a misstatement of fact. The commodity-interest for 1826-1829 was 7.7 per cent. Tooke, Price, and Jevons all overlooked the fact that interest, unlike prices, is not an instantaneous but essentially a time phenomenon. § 10 When long periods of price-movements are taken, the influence of appreciation on interest is more certain. The following table shows this for England. It consists of four periods, of 10, 12, 22, and 11 years respectively:LONDON MARKET RATES OF INTEREST IN RELATION TO RISING AND FALLING PRICES MARKET ApPRECIATION VIRTUAL OF MONEY IN INTEREST IN INTEREST COMMODITIES COMMODITIES i a i 1826-1835 3.4 + 1.2 4.6 1853-1864 4.6 -0.9 3.7 1874-1895 2.4 +2.4 4.8 1896-1906 2.9 -2.9 0.0 SEC. 10] INDUCTIVE VERIFICATION (MONETARY) 283 In averages covering so many years we may be sure that accidental causes are almost wholly eliminated. We find that during the period of falling prices, 1826-1835, the aver age rate of interest was only 3.4; that· during the following period of risingprices,1853-1864, it washigher (4.6 percent.) ; that during the next period, 1874-1895,when prices were again falling, the rate was again low (2.4 per cent.); and finally that in 1896-1906, with prices rising, interest again recovered. In every case interest is high when prices are rising and lowwhen they are falling. For these long periods, therefore, we find the facts in agreement with the theory in every case. It is also a noteworthy fact that the com modity-interest in this table of long periods is far less variable than for short periods. The variability, as shown by the" standard deviation" of the four figures in the above table is, for London, .82 for the market rate, and 1.94 for the virtual rate. The adjustment of (money) interest to long price-movementsis more perfectthan to short price-movements.

The following table gives the long time averages for New York.The war period is omitted:NEW YORK RATES OF INTEREST IN RELATION TO RISING AND FALLING PRICES INTEREST PRIME ApPRECIATION OF VIRTUAL INTERESTTwo NAME MONEY IN IN COMMODITIES60 DAYS COMMODITIES i al 1 1 1849--1857 8.2 1 - 3.8 4.4 1875-1896 5.1 +2.6 7.7 1897-1906 4.5 - 3.4 1.1 We find that the money rate in the second period, when money was appreciating, was, as our theory requires, 1 The average of Elliott's figures (which are not for H prime" paper) is 9.2, but 1.0 has been deducted from this average in order that it may be properly compared with the average of Robbins's figures for 1875 1891. This correction is based on the fact that 1.0 was the average excess of Elliott's figures over Robbins's during the fifteen years. 1860-1874. See Appendix to Chap. XIV, § 1.

284 THE RATE OF INTEREST [CHAP. XIV lower than that in the first, when money was depreciating, but that the rate in the third period, when money was again depreciating, was, unfavorably to our theory, lower than that in the second when money was appreciating. Here we also see that the variability of the virtual interest in terms of commodities is less than for short periods, and more nearly like the variability for the market rate of interest in terms of money. The variability, as measured by the H standard deviation," of the rates of interest for the three periods in the above table are for market rate of interest in terms of money, 1.6; for virtual interest in terins of commodities, 2.3. § 11 Three general facts have now been established: (1) Ris ing and falling prices and wages are directly correlated with high and low rates of interest; (2) The adjustment of interest to price-movements is inadequate; (3) This adjustment ..' is more nearly adequate for long than for short periods.

These facts are capable of a common explanation ex pressing the manner in which the adjustment referred to takes place. Suppose an upward rp.ovement of prices be gins. Business profits (measured in money) will rise; for profits are the difference between gross income and expense, and if both these rise, their difference will also rise. Bor rowers can now afford to pay higher "money-interest." If, however, only a few persons at first see this, the interest will not be fully adjusted, l and borrowers will realize an 1 It seems scarcely necessary to add as an independent cause of maladjustment the accumulation (or in the opposite case, depletion) of bank reserves, for this is but another symptom of maladjustment due to imperfect foresight. An increase of gold supply, as in 1852 1853 (see Tooke and Newmarch, History 01 Prices, Vol. V, p. 345), may first find its way into the loan market instead of into circulation.

But if foresight were perfect, this would not happen, or if it did hap pen, borrowers would immediately take it out (or increase the liabili ties against it) to avail themselves of the double advantage of low interest and high prospective profits from the rise of prices about to follow.

~JiJO. 12] INDUCTIVE VERIFICATION (MONETARY) 285 extra margin of profit after deducting interest charges. This raises an expectation of a similarprofit in the future and this expectation, acting on the demand for loans, ·will raise the rate of interest. If the rise is still inadequate, the process is repeated, and thus by continual trial and error . the rate approaches the true adjustment. When a fall of prices begins, the reverse effects appear. Money profits fall. Borrowers cannot afford to pay the old rates of interest. If, through miscalculation, they still attempt to do this, it will cut into their real profits. Dis couraged thus for the future, they will then bid lower rates. Since at the beginning of an upward price-movementthe rate of interestis too low, and at the beginningof a down ward movement it is too ,high, we can understand not only that the averages for the whole periods are imperfectly adjusted, but that the delay in the adjustment leaves a relatively low interest at the beginning of an ascent of prices, and a relatively' high interest at the beginning of a descent. And this is what we find to be true. That the adjustment is more perfect for long periods· than for short seems to be because, in short periods, the years of non-ad justment at the beginning occupy a larger relative part of the whole period.

§ 12 What has been said bears directly on the theory of " credit cycles." In the view here presented, periods of speculation and depression are the result of inequality of foresight. If all persons underestimated a rise of price in the same degree, the non-adjustment of interest would merely pro duce a transfer of wealth from lender to borrower. It would not influence the volllme of loans (except so far as the diver sion of income from one person to another would itself have indirect effects, such as bankruptcy). Under such circumstances the rate of interest would he below the nor mal, but as no one would know it, no borrower would 286 THE RATE OF INTEREST [CHAP.XIV borrow more and no lender lend less because of it. In the actual world however, foresight is very unequally distrib uted. Only a few persons have the faculty of always II coming out where they look." Now it is precisely these persons who largely make up the borrowing class. Just because of their superior foresight, there is delegated to them the management of capital; they become "captains of industry." It therefore happens that when prices are rising, borrowers are more apt to see it than lenders.

Hence, while the borrower is willing to pay a higher interest than before for the same loan, lenders are willing to loan for the same interest as before. This disparity has as its effect that the rate of interest will not rise as high as if both sides saw the conditions equally well. It will also cause an increase of loans and investments. 1 This con stitutes part of the stimulus to business which takes place in times of rising prices. When prices fall, on the other hand, borrowers see that they cannot employ It money" productively except on easier terms, but lenders do not see why the terms should be made easier. In consequence, "enterprisers" borrow less, trade languishes, and, though interest falls in conse quence of decrease in demand, it does not fall enough to keep the demand from decreasing.2 We see, therefore, that while imperfection of foresight transfers wealth from creditor to debtor or the reverse, inequnlity of foresight produces overinvestment during rising prices and relative stagnation during falling prices.

1 That this and the corresponding statement in the next paragraph are borne out by facts appears to be confirIUed, so far a5 bank loans and discounts are concerned, by Sumner, History of Banking in the United States (New York, 1896), and Juglar, Crises Commerciales (Paris, 1889). 2 President Andrews, in An Honest Dollar, p. 3, writes: "Interest is low . . . not because money is abundant as before, but because it is not, its scarcity having induced fall of prices, and so paralysis in industry." But, it should be added, the cause of the fall of interest is primarily the ezpectationof small profits.

SEC. 13] INDUCTIVE VERIFICATION (MONETARY) 287 In the former case society is trapped into devoting too much investment of productive energies for future return, while in the contrary case, underinvestment is the rule. It does not seem possible to decide the question which of the two evils is the greater. l § 13 The facts which have been shown in this chapter are im portant in two respects. They prove, first, that men do actually, even if unaware of so doing, contrive to offset the effects of changes in the monetary standard by adjusting the rate of interest; and, secondly, that this adjustment is far from adequate. In consequence of the inadequacy of the interest-adjustment, a large amount of wealth is continually and unintentionally transferred from the cred itor-to the debtor-class, and vice versa. The bimetal lists were partially right in their claim that the creditor class were gainers during the period of falling prices in the two decades 1875-1895. The situation has been the exact opposite during the decade 1896-1906. We must not make the mistake, however, of assulning that the en richment of the debtor..class during the last decade atones for the impoverishment of that class during the previous two decades; for the personnel of social classes changes 1 For arguments on both sides, see Professor Marshall's evidence, Report on Depression 01 Trade (1886), p. 422. See also his Principles of Economics, Vol. I (3d ed., 1895), p. 674: "When we come to dis cuss· the causes of alternating periods of inflation and depression of commercial activity, we shall find that they are intimately con nected with those variations in the real rate of interest which are caused by changes in the purchasing power of money. For when prices are likely to rise, people rush to borrow money and buy goods, and thus help prices to rise; business is inflated, and is managed recklessly and wastefully·; those working on borrowed capital pay back less real value than they borrowed, and enrich themselves at the expense of the community.. When afterwards credit is shaken and prices begin to fall, everyone wants to get rid of commodities and get hold of money which is rapidly rising in value; this makes prices fall all the faster, and the further fall makes credit shrink even more, and thus for a long time prices fall because prices have fallen."

288 THE RATE OF INTEREST [CHAP. XIV rapidly. Nor must we make the mistake of assuming that the debtor-class consists of the poor. The typical debtor to-day is the stockholder, and the typical creditor, the bondholder. What is actually going on to-day in conse quence of a steadily cheapening dollar is a vast transfer of advantage from bondholders to stockholders. It is this transfer which has produced many of our latest million aires. Their millions have been silently abstracted from the pockets of the unsuspecting "safe" investors in bonds, depositors in savings banks, and the salaried classes. The fault, however, is not of those who thus profit, but of the monetary conditions which permit the ceaseless ebb and flow of price-levels. The problem of a stable monetary standard is of vital importance. We are apt to forget its importanc~ during a period of "prosperity," and we are apt also to forget that much of what is called prosperity is delusive. It is delusive for two reasons: First, it is often not general prosperity, but prosperity of the debtor or stockholding or entrepreneur classes, who are always much in evidence, at the expense of the creditor, bond holding, salaried classes, who bear their losses silently behind the scenes; secondly, so-called prosperity is often another name for reckless wastefulness, for which there must be a day of reckoning in the form of a commercial crisis.1 1 See The Gold Supply and Prosperity, edited by Byron W. Holt (The Moody Corporation), New York, 1907.