XVI. Inductive Reputation of "Money Theory"

CHAPTER XVI INDUCTIVE REFUTATION OF "MONEY THEORY" § 1 IT would be impracticable, even if it were worth while, to array before the tribunal of facts all the rival theories of interest which have been presented. We must rest our case largely on the statement of principles which has already been made. It was shown, for instance, that the commOll theory, that interest varies inversely with the quantity of money, was superficial, since money is merely a means for obtaining capital. It was also shown that the theories commonly given in economic text-books, that the rate of interest depends on "quantity of capital," are only a little less superficial, since capital itself is merely a means to income. We cannot reach the ultimate regulator of interest until we reach income; and it is only because of the lack of an adequate theory of income that economists have been content with analyses so incomplete.

It is often true that up to a certain point facts may be adduced even in support of a false theory. It could doubt less be shown, for instance, that interest was often high when capital was scarce, and vice versa. The crucial test, however, comes when an income-stream of an ascending type occurs where capital is plentiful, or of a .. descending type where capital is scarce. If incomes are rising, though capital be plentiful, interest will be high, as in the United States recently; and if incomes are falling, though capital be scarce, interest will be low. As soon as economists think in terms of income, and give up thinking in terms of capital, which is merely an expression for contemplated income, there can be no difficulty in reaching a correct view of the problem, without the necessity of confuting all previous theories by special facts. 317 318 THE RATE OF INTEREST [CHAP. XVI The only theory for which its adherents will demand a test by facts is the theory, believed by many business men, that the rate of interest varies inversely with the quantity of money. This theory, in spite of having been refuted by economists for over a hundred years, is still dominant among many if not most business men. The business man prides himself on reasoning by facts, and it is only by mis reading facts, and not by any analysis of the problem, that he inclines to the money-theory of interest. It follows that only by facts can he be convinced of his error. As Moody's Magazine well says: 1_ "Slowly but surely the great financial, commercial, and business men of the world are reaching the conclusion . . . that an increased supply of gold means higher, rather than lower, interest rates.

Most converts, however, are converts from the force of facts, rather than from reason and logic." § 2 So far as the matter of appreciation in its relation to in terest goes, facts have already been adduced in sufficient numbers in Chapter XIV. At present we are to consider the theory that high rates of interest are associated with scarce money, and low rates with plentiful money. Since in general it is true that plentiful money means high prices, and scarce money low prices, if this theory were correct, we should expect to find that during those years when prices were high, rates of interest would be low, and vice versa. In the following table we see that there is no such inverse correlation between prices and interest as this theory calls for. The columns of the table relate respectively to dif ferent decades. Two rates of interest are given for each decade. The first, written opposite "high prices," is the average ratefor those years of the decade whoseprice-levels, as shown by an index-number, were above the average price level for the whole decade; the second is the average rate for the years whose prices were below the general average :1 August, 1906.

SEC. 2] REFUTATION OF It MONEY THEORY" 319 MARKET RATES OF INTEREST IN RELATION TO HIGH AND LOW PRICES 1 1824 1832 1842 1852 1862 1872 1882 to to to to to to to 1831 1841 1851 1861 1871 1881 1891 incl. incl. inc!' inc!' inc!' inc!' inc!. ------ -----London, High prices . 3.8 4.4 3.6 5.4 5.1 3.7 3.0 London, Low prices 3.2 3.2 2.6 3.0 2.6 2.5 2.5 -- -- -- -- ----New York, High prices . 9.1 7.4 7.0 5.3 New York, Low prices 9.1 6.7 5.1 5.1 -- -- ---- ---_.....Berlin, High prices . 4.6 3.7 3.3 Berlin, Low prices 3.4 3.2 2.7---- -------Paris, High prices . " 4.1 2.6 Paris, Low prices 2.4 2.6 ------ --.-- -.2 Calcutta, High prices . 6.2 5.4 Calcutta, Low prices 5.6 6.2 -- ---- ------.8 Tokyo, High prices . 12.3 10.1 Tokyo, Low prices 12.0 10.1 -- ---------•Shanghai, High prices . 6.0 Shanghai, Low prices 5.7 Of the 21 comparisons contained in this table, 17 show higher rates for high-price years than for low-price 1 This table is constructed from the data given in the Appendix to Ch. XIV. For New York, the rates for the first decade are aver aged from the column in the Appendix headed "60 days," and are not to be compared with those for the remaining decades, which are averaged from the column headed "Prime two-name 60 days." The index-numbers of prices which have been employed are those of Jevons (1824-1851), and Sauerbeck (1852-1891) for England, Soet beer and Heinz for Germany, the Aldrich Senate report for the United States and France, and the Japanese. report for India, Japan, and China. (See Appendix to Ch. XIV, § 3.) 2 For Calcutta the rate for the bank of Bengal is employed, no "market" rate being available. The first column is for 1873-1881 instead of 1872-1881, for the reason that no index-number for 1872 is available.

8 For Tokyo the first column is for 1873-1881 for the same reason. 4 For Shanghai the period is 1885-1893 instead of 1882-1891, for the reason that the available rates begin in 1885 and the index numbers end in 1893.

320 THE RATE OF INTEREST [CHAP. XVI years, one shows the opposite condition, and 3 show equal rates in the two cases. As the table covers 68 years for London, 40 for New York, 30 for Berlin, 20 for Paris, 19 each for Calcutta and Tokyo, and 9 for Shanghai, or 205 years in the aggregate, the result may be accepted with great confidence that high and low prices are usually as sociated with high and low interest respectively. There are two probable reasons for this connection. One is that a high price-level is often due to a temporary scare., ityof enjoyable commodities, as in a beleaguered city, in San Franciscoafter the earthquake and fire when bread was a dollar a loaf, or in the Klondike during the gold fever. In such cases the rate of interest is high for economic, not monetary, reasons, - because, in fact, of the relative scarcity of present real income. The second reason is that the years of high priees are usually the culminations of periods of rising prices, during which the rate of interest has been rising through the de preciation of money, in accordance with the principles ex plained in Chapters V and XIV. If the tables given in the Appendix are examined, it will be found that prices usually rise to a point, and then often break suddenly after a crisis.

The high-price years in this case evidently belong more often to the period of rising than to the period of falling prices. § 3 Whatever be the correct explanation, athe facts give no countenance to the theory that the rate of interest depends upon the supply of money. It may be said that the preceding table is not conclusive, owing to the fact that the correlation it shows is one of prices and interest, and not directly of quantity of rnoney and interest. But this objection can be readily met by constructing another table in which per capita circulation of money is stated in conjunction with the rates of interest :SEC. 3] REFUTATION OF If MONEY THEORY" 321 RATES OF INTEREST IN RELATION TO PER CAPITA CIRCULATION PER· CAPITA MONEY INTEREST RATE IN N. Y. IN CIRCULATION (Prime Two-Name IN U. S. JULY 1 60 Days) 1871 18.10 6.1 1872 18.19 8.0 1873 18.04 10.3 1874 18.13 6.0 1875 17.16 5.5 1876 16.12 5.2 1877 15.58 5.2 1878 15.32 4.8 1879 16.75 5.0 1880 19.41 5.2 1881 21.71 5.2 1882 22.37 5.7 1883 22.91 5.5 1884 22.65 5.2 1885 23.02 4.1 1886 21.82 4.7 1887 22.45 5.7 1888 22.88 4.9 1889 22.52 4.8 1890 22.82 6.0 1891 23.42 5.7 1892 24.56 4.3 1893 24.03 7.1 1894 24.52 3.4 1895 23.20 3.8 1896 21.41 5.8 1897 22.87 3.4 1898 25.16 3.8 1899 25.58 4.2 1900 26.94 4.4 1901 27.98 4.4 1902 28.43 4.9 1903 29.42 5.5 1904 30.77 4.2 1905 31.08 4.3 y 322 THE RATE OF INTEREST [CHAP. XVI An examination of this table will show that the per capita circulation goes up and down quite independently of the fluctuations of the rate of interest. If the money theory were true we should expect that when money shrank, in terest would rise, and reversely. The two should vary in versely. But as a matter of fact, out of the thirty-four pairs of consecutive years, we find that interest varied about as often directly as it did inversely with the per capita cir culation. To be exact, it varied inversely in 15! and directly in 18! cases.1 Thus it happened to move a little oftener in the manner opposed to the money theory than in the manner favorable to that theory.

A statistical study of the rates of interest and the pro duction of the precious metals made by B. R. G. Levy leads to the same conclusion, that the rate of interest is not related to the quantity of money.2 § 4 The preceding facts must convince anyone open to con viction that the rate of interest is not inversely correlated to the quantity of money. But business men familiar with banking will not be satisfied until some place is found in our theory of interest for the common observation that if money in general does not, certainly bank reserves do vary inversely with the rate of interest. That this ob servation is correct is not questioned. It is the established policy of large banks, like the Bank of England, to protect their reserve by raising the rate of interest. From these facts the conclusion is drawn that the scarcity of bank reserves produces a high rate of interest. But the facts fit in with the present theory of interest quite as well as 1 When the rate remained the same in two consecutive years, it was counted as one half a variation both ways.

2 II Du taux actuel de l'interet et de ses rapports avec la production des metaux precieux e,t les autres phenomenes economique." B. R. G. Levy, Journal des Economistes, March, 1899, p. 334; April, 1899, p.28.

SEC. 4] REFUTATION OF "MONEY THEORY" 323 with the fallacious money theory of interest. A low bank reserve is merely a symptom of a general ebb tide in the income of the community. A bank of discount and deposit stands between those who have surplus income to deposit and those who wish to·eke out a lean income by borrowing. Those persons whose income is larger than they need to-day are the ones who swell the deposits .of a bank. When a farmer receives for his crops more money than he cares at once to turn into enjoyable income, he deposits some of it in a bank or trust company -with interest if possible, without it if necessary. On the other. hand, the same farmer, before his crop is sold, may wish to discount a ,note at the bank in order to pay off his help. Bank deposits grow, as compared with loans, when men's incomes are temporarily flush, that is, when their income-curves are descending; loans grow as compared with deposits when their incomes are temporarily scant, that is, when their income-curves are ascending. The banker must keep in equilibrium between the two classes of customers, those who discount and those who deposit. If the loans increase too much, the banker's reserve will be endangered; if the deposits accumulate, it will be idle. He regulates his reserve by adjusting the rate of discount, raising it if his reserve is low, or lowering it if it is high. To him, his action appears in the light of protecting and utilizing his reserve; but the banker is not the prime factor. Back of the reserve are the real causes, - the stat~ of the incomes of his customers. If ascending incomes are predominant, the reserve will need more "protection" than in the con trary case. A rise of the discount rate is therefore due, in the last analysis, to the predominance of ascending incomes, and a fall, to the predominance of incomes of the opposite type. The reserve is merely the football between the two sets of persons, those who· deposit and those who loan. The .business man regards· the ·rate of interest too much from the banker's point of view. A banker or broker is merely an intermediary. To regard him, or the gold that 324 THE RATE OF INTEREST [CHAP. XVI happens to be in his vaults, as primary influences on the rate of interest is as erroneous as to regard the operations of a grain broker as primary influences upon the price of wheat, or those of a real estate agent as primary influences upon the price of land. The banker enables the lenders and borrowers to find each other; they, and not he, in the end fix the rate of interest. 1 The theory of interest which does not look beyond the bank coffers is almost as crude as the theory which would ascribe the weather to the thermometer. In a Western town a servant was being instructed to prepare a bath at a partic ular temperature, and was shown the point recorded by the thermometer when the bath was at the right temperature.

To the consternation of the housekeeper, when the servant had prepared the bath the next day its temperature was found to be far too cold. The servant explained that she had used the "conjure stick," referring to the thermometer, but that it didn't seem to heat the water at all! ~lany persons have a similar superstition that money is a sort of tl conjure stick" potent to regulate the rate of interest, whereas in fact it is only a thermometer to faithfully record tlievariations of that rate. When there is "plenty of money in Wall Street," interest is low, and vice versa; but the causes which have influenced interest are the causes which have put the money on loan in Wall Street. § 5 The money-theory comes nearest to scoring a point when applied to'panics, for during a time of panic it is true that money loans are sought to be used as solvents of debts. This fact has often puzzled economists who, while dis believing the money-theory of interest in general, have felt that in this case at least it was true. 2 It is clear, howl Cf. George Clare, "A Money Market Primer," London (Effingham Wilson), 1905, pp. 134-135.

2 See Mill. Principles of Political Economy, Book 3, Chap. XXIII, 14.

SEC. 5] REFUTATION OF II MONEY THEORY" 325 ever, that even a panic loan, from PeW to pay PaulJs a /1 case of an.£ffQrtto maintain the even flow of one's inCQIllit , stream. The alternative, if one does not borrow, is to sell some of one'sgoods,necessitatingthe sacrificeof the income which they are designed to bring. The choice between the loan and the sale is between the' necessity of repaying the loan when due, and the necessity of losing the income from the goods, - a choice between two bits of income differen~t in amount, or kind, or distribution in time. The loan sub... stitutes one of these bits of income for the other, and is therefore in this respect exactly similar to any other loan. If one's solvency is in question, the same exchange occurs in a somewhat different form; the loan is then undertaken in preference to the deformation of the income-stream which insolvency involves. It is true, however, that money, as money, is more vitally related to panic loans than to any other. In or dinary loans, money enters merely as a convenientmedium for securing something else - capital, and through that capita~, income; in a panic loan, however, the money enters as a necessary medium for the legal discharge of a debt.' Again, in an ordinary loan, the borrower is free to adjust the amount borrowed according to the rate of interest; in a panic loan, on the other hand, there is no such elastic choice. The borrower must borrow that fixed amount necessary to discharge his debt, even if. the rate of interest is exorbitant. If physical money is not sufficient to allow debtors to discharge their debts, the rate of interest will be high and there can be no escape from it as in ordinary times. In this case it maybe truly said that scarcity of money has made interest high. Money of any kind brought into the market will relieve the stringency and lower the rate of interest. The United States has accomplished this by prepaying interest on bonds, and the clearing house has accomplishedit by issuing clearing-housecertificates. It is therefore important, in order not to have violent changes in the rate of interest, that the currency should be elastic.

326 THE RATE OF INTEREST [CHAP. XVI A panic is always the result of unforeseen conditions; and among those unforeseen conditions, and partly as a con sequence of other unforeseen conditions, is scarcityof money on loan. Under ordinary and normal conditions, money on loan is so automatically adjusted as to make it a mere trans mitter through the medium of which borrowers and lenders act UpOIl the rate of interest, just as a smooth-running gear transmits power from one wheel to another, without ex erting any independent force itself. But when the gear gets out of order it may stick and offer a resistance of its own to the wheels with which it is in contact. It is therefore not asserted that money plays no role in determining the rate of interest. But its role is a minor one, and very different from that often assigned to it. Its role normally is to efface itself and merely facilitate the frictionless working of economic machinery. Under the abnormal conditions of a panic, the dearth of it may create friction and enhance interest at that particular point.

Finally, as we have seen in previous chapters, a change in the monetary standard will affect the number by which the rate of interest is expressed, increasing it if the monetary standard is depreciating, and decreasing it if the standard is appreciating. With these reservations, we may say that the rate of interest is not affected by the quantity of money.