Chapter XIV: The Volume of Trade and the Volume of Money and Credit

IN the argument so far I have said nothing of the reverse relationship, the dependence of the volume of money and the volume of credit on trade. The two are indeed interdependent. Interdependence suggests circular theory, and is often a phrase to cover circular reasoning.¹ In the case of the relation under discussion, however, I have, I trust, already abundantly protected myself against the charge of circular reasoning by denying that either volume of money and credit on the one hand, or volume of trade on the other hand, is a true cause at all. Both are mere abstract names, designating highly heterogeneous individual occurrences, which, individually are cause or effect. In general, both volume of money and credit, on the one hand, and volume of trade on the other hand, are results of common causes, which are the veræ causæ of economic phenomena—values, psychological phenomena. The whole thing is to be explained immediately and primarily in terms of social relationships and mental processes,—in terms of social values.

To show that increasing trade tends to increase money and credit is not difficult. If one may venture a hypothetical illustration—and the sort of hypothetical illustrations, like the dodo-bone case, of which quantity theorists are fond make one hesitate to do so—let us assume a communistic community, isolated from other markets, with a developed system of production, including an extensive use of gold in the arts. Let the communistic régime gradually pass over to an individualistic régime. Assume that the inhabitants are acquainted with the use of gold as money, and that their government is willing to coin it freely. As individualism spreads, and trade grows, will not more and more gold be taken to the mints? I am not here concerned with the principles determining the apportionment of gold between the money employment and the arts. It is enough to show that expanding trade tends to increase the volume of money.

Assume that the money supply meets difficulties in its expansion. Is there not at once an incentive to extend credit? The seller finds his customers unwilling to buy for cash, in amounts as great as before. In order to sell as much as before (assuming that the use of credit is known, to avoid trouble with historical origins), he extends credit,—which, when practiced generally, lightens the strain on the money supply.

I have so far said nothing of the case where there are stocks of the money metal to be got from outside markets. But if a country is expanding its trade, does not money come in? The quantity theorists would, indeed, admit this, in general, though their reason is a bad one, namely: that expanding trade lowers prices, and lower prices make the market attractive to foreign buyers, who then send in money for the goods. I shall later discuss this aspect of the theory.¹ For the present, I merely interject the question as to the probability of an expansion of trade when prices are falling. Increasing stocks of particular goods may well mean lower prices for these goods and if they be articles of export the lower prices may well increase the export trade, and bring money in. But this increase in stocks of articles of export is very different from total trade within the country; and lower prices in articles of export are very different from a generally lower price-level.¹

Will expanding trade in a country increase credit? I come here to one of the striking features of Fisher’s doctrine—a feature in which I think he is fundamentally true to the quantity theory. He finds no way in which expanding trade can directly increase credit. Expanding trade can increase credit, (a) only by changing the habits of the people, so as to alter the ratio, M to M′, or (b) by reducing the price-level, and so bringing in money from abroad, whence, as M is now increased, M′ rises proportionately. “An increase in the volume of trade in any one country, say the United States, ultimately increases the money in circulation (M). In no other way could there be avoided a depression in the price-level in the United States as compared with foreign countries. [He should say, from the standpoint of his theory, that increasing trade will cause a fall in the price-level, and so bring in more money.] The increase in M brings about a proportionate increase in M′.² Besides this effect, the increase in trade undoubtedly has some effect in modifying the habits of the community with regard to the proportion of check and cash transactions, and so tends somewhat to increase M′ relatively to M; as a country grows more commercial the need for the use of checks is more strikingly felt.”³ In a footnote to this paragraph, he defines the issue still more sharply. “This is very far from asserting as Laughlin does that ‘The limit to the increase in legitimate credit operations is always expansible with the increase in the actual movement of goods’; see Principles of Money,¹ New York (Scribner), 1903, p. 82. We have seen, in Chapter IV, that deposit currency is proportional to the amount of money; a change in trade may indirectly, i. e., by changing the habits of the community, influence the proportion, but, except for transition periods, it cannot influence it directly.”²

My own explanation of the causal sequence whereby expanding trade brings money into a country would be radically different from that given by Fisher in the first quotation. I should expect, first, that rising prices would encourage rising trade; I should then expect the rising volume of trade, with higher prices, to lead borrowers to need, and secure, larger loans from the banks, with, as loans and deposits rise in proportion to reserves, some slight increase in “money-rates,” just enough to draw to the country the extra gold which bankers felt desirable to add to their reserves. I should expect the causal sequence to be the exact reverse of that which Fisher indicates. With falling prices, or waning volume of trade—which would usually come together,³—I should expect loans to be reduced, deposits to be reduced, money-rates to fall, and gold then to leave the country again. I should expect this sort of thing to happen normally, and not infrequently, and I should expect gold to come in and go out many times in the course of a business cycle. This would seem to be the sort of explanation which our modern theory of elasticbank-credit would give in connection with this problem. I shall not here go into details with the theory of elastic bank-credit. The theory has been too well established in the debates between the “Currency School” and the “Banking School”¹ in regard to bank-notes to need elaboration and defence here, and the essential identity of deposits and elastic bank-notes from this angle is one of the commonplaces of the literature of banking. What I am here concerned with is the highly significant fact that Fisher’s “normal” theory finds no place for this highly important phenomenon. The quantity theory has no explanation of elasticity to give. On the basis of the quantity theory, and for all that the quantity theory can say, the Currency School was right! Fisher offers us, virtually, a “currency theory” of deposits. “Suppose, as has actually been the case in recent years, that the ratio of M′ to M increases in the United States. If the magnitudes in the equations of exchange in other countries with which the United States is connected by trade are constant, the ultimate effect on M is to make it less than what it would otherwise have been, by increasing the exports of gold from the United States or reducing the imports. In no other way can the price-level of the United States be prevented from rising above that of other nations in which we have assumed this level and the other magnitudes in the equation of exchange to be quiescent.” (P. 162.) If “bank-notes” be substituted for “M′”, in this quotation, we have here a perfect statement of the position of the “Currency School” in that great debate. Must this old issue be fought all over again? And yet, I defy any consistent quantity theorist to find any flaw in Fisher’s argument on this point. There is no place for a theory of elastic bank-credit within the confines of the quantity theory. Fisher’s recognition of this seems full and complete. He relegates all mention of elastic bank-credit to “transitions.” The footnote quoted above, in which Laughlin’s (somewhat extreme) doctrine based on the theory of elasticity is stated, denies categorically that there is any validity in it, except for transition periods. There is nowhere in the book any explanation of the theory of elasticity.¹ The references to it are few and grudging, and always in connection with the notion of transitions. The most important statement regarding elasticity (less than a page long) is on page 161, where again transitional influences are under discussion. What is a theory of money worth which can offer no explanation of so fundamental, important, and notorious a feature of modern money and banking?

There is a further, related, feature of banking for which the quantity theory can find no explanation. Among the items in a bank’s balance sheet, the quantity theorist seizes upon reserves on the assets side, and deposits on the liability side, and builds his theory on the supposed close relation between them. We have seen that this close relation does not, in fact, exist. The range of variation is enormous.¹ But there is one close relation in the balance sheet of the bank concerning which the quantity theory is silent, and that is the relation between deposits and loans. For individual banks and for banks in the aggregate, for long run periods and for short run periods, for reasons that are clear and inevitable, these two magnitudes (or for banks of issue on the Continent of Europe, notes and loans), vary closely together. The relationship between them is the only relationship which does stand out as clearly beyond dispute, among all the items in the banking balance sheet. No assumptions of a “static state” are needed for its demonstration! The relation varies, of course. As banks increase or reduce their capital, as their reserve-percentages rise or fall, as they increase or decrease their holdings of bonds, we find reasons which alter the proportion between deposits and loans. But, despite this, the variation, as shown by figures for the United States, is slight. Assume, for example, a statement showing “loans and discounts” of $1,000,000, deposits, $1,000,000, cash reserve, $200,000. Reserves are then 20% of deposits, and loans are 100% of deposits. If reserves be increased by $100,000 and loans and discounts reduced, to compensate, by $100,000, we have a 50% variation in the ratio of reserves to deposits, with only a 10% variation in the ratio of loans and discounts to deposits. Since cash reserve is much the smaller item, almost always, the same absolute variation in it will affect it, in percentage, vastly more than it will affect loans and discounts. It is strange that a theory should seize on this highly variable ratio of reserves to deposits, and ignore the much more constant ratio² of loans and discounts to deposits.

That this close relation between deposits and loans should obtain follows naturally from the theory of elastic bank-credit. The two are built up together. When there are expanding business and rising prices, men borrow more from the banks; as they borrow, they receive deposit credits; the individual who receives the deposit credit may check against it, but it is redeposited by another man, and so, while the deposits of one bank need not grow out of its loans, still, for banks in general, deposits are large because loans are large. For a given bank, the relation holds closely, because the bank lends, in general, to active business men, who will have income as well as outgo, and whose income will, on the average, at least balance their outgo. Thus, through loans, deposits are linked with volume of trade and prices. Trade and deposits wax and wane together.¹ On the other hand, in the absence of rising prices and increasing trade, reserves may increase greatly without forcing an increase in deposits. Loans cannot increase without an increase in deposits. The linkage between deposits and trade is definite, causal, positive, statistically demonstrable. The linkage between reserves and deposits is, at most, negative—if reserves get too low, deposits and loans may be checked in their expansion. But this—to the extent that it is true, which we leave, for detailed analysis, for Part III—gives a very much looser relation indeed than the direct relation between loans and deposits.

The quantity theory has offered no explanation of this relation between loans and deposits. What explanation could a theory offer, which rests in the notion that volume of trade on the one hand, and volume of money and bank-credit on the other hand, are independent magnitudes?¹ I do not mean that quantity theorists are silent regarding the relation of loans and deposits. I mean that they do not attempt, in any discussion I have found, to apply the quantity theory to the explanation of that relation. What shall we say of a theory which, ignoring these easily proved, easily explained, and vital facts regarding bank-credit, offers as its sole explanation of volume of bank-credit a theory so untenable as that of a fixed ratio between volume of bank-credit and volume of money in circulation, with causation running from money to deposits?

Professor Fisher says little about bills of exchange. Here, surely, we have a credit instrument which grows directly out of trade, in general, and whose volume expands and contracts with trade. When banks discount bills of exchange, and issue notes; or grant deposit credits, against such discounted bills, the connection of bank-credit and volume of trade is obvious. The same thing holds largely, however, when promissory notes are discounted. Such notes are usually given by those who plan to use the credits granted in commercial or speculative transactions. The bill of exchange differs from the promissory note in practice, however, in that it itself is often a medium of exchange, without going into the bank’s portfolio. “The bill of exchange, therefore, before it gets to the bank usually² performs a series of monetary transfers, for the small dealer naturally prefers to pass on the bill, if possible, in making a payment, instead of handing it over to his bank, which would either deduct a certain percentage in the way of discount, or else accept the bill at its face value, crediting the customer with the amount on the date of maturity, while business men (other than bankers) are in the habit of taking bills of exchange as they would cash.”¹ This quotation describes conditions in Germany. The same authorities (p. 176) give figures showing a rapid development in the volume of bills of exchange, rising from about 13 billions of marks in 1872 to about 31 billions in 1907. These figures show that bills of exchange are a big factor in German business life,—a conclusion that is strengthened when they are compared with the figures for giro-transfers on pp. 188189 of the same article, or with the figures for note issue on p. 209.² In the United States, of course, the use of bills of exchange has become comparatively unimportant in domestic commerce,³ though there is a movement to revive them, since the new Federal Reserve system has come in. Their chief importance is in connection with foreign trade. Is it possible that Professor Fisher’s reason for wishing to minimize foreign trade⁴ is the unconscious desire to get rid of the annoying bills of exchange, which so obviously tend to make bank-credit and volume of trade interdependent, and which further spoil the quantity theory by serving as a flexible substitute for both money and deposits?

I regret the necessity for this elementary exposition of familiar things. But Fisher’s theory has no place for these familiar things—and Fisher has merely made very explicit the logic of the quantity theory!

As applied to modern conditions, the quantity theory is obliged to assert—and Fisher does assert:

(a) that there is a causal dependence of bank-credit on money, and “normally” a fixed ratio between them;

(b) that velocity of circulation of money and credit instruments are independent of quantity of money and credit instruments;

(c) that, in general, money and volume of credit (taken together), velocities, and trade, are independent magnitudes, each governed by separate laws, though Fisher concedes some reaction of trade on velocities;

(d) in particular, that volume of money and credit has no influence on trade, and that trade has no direct influence on volume of credit.

All these doctrines are necessary if the contention that an increase of money will proportionately raise prices is to be maintained, or if it is to be maintained that a decrease in trade will proportionately raise prices. I have analyzed each of these contentions, and I find justification for none of them.

Not yet, however, have we reached the least tenable aspect of the quantity theory. There remains the contention that prices are passive, that a change, originating in prices, and involving a change in the average price, or the general price-level, cannot maintain itself—that P is a passive function of the other five magnitudes of the equation of exchange. To this central fortress of the quantity theory we shall devote the next chapter.

¹ The notion of interdependence need not involve circular reasoning, if the facts really justify it. The whole cosmos is, doubtless, interdependent. Often certain systems within the cosmos manifest enough independence of the rest of the universe to justify us, for some purposes, in thinking only of interrelations within the systems. The important thing is to make the circle in theory as big as the circle in fact. Cf. Social Value, p. 152, n.

¹ In chapter XVI.

¹Cf. our chapter, infra, on “The Quantity Theory and International Gold Movements.”

² Italics mine.

³Loc. cit., p. 165.

¹ The resemblance of the view here maintained to that of Professor Laughlin is at many points close. I am indebted to his Principles of Money for many suggestions.

²Loc. cit., p. 165, n. The doctrine is reiterated on p. 168.

³ This is strikingly true in the stock market—the place where more trade takes place than in any other market. See the figures in the preceding chapter with reference to stock transactions, and the chapter on “Bank Assets and Bank Reserves.”

¹ For a history of this debate, with bibliography, see Laughlin’s Principles of Money, ch. 7, on the “History and Literature of the Quantity Theory,” esp. pp. 260 and 263–264. Laughlin shows the connection of the currency principle and the quantity theory.

¹ It may be that in the brief discussion of elastic bank-notes on p. 173 (loc. cit.), Fisher means to given an explanation of the theory of elasticity from a quantity theory standpoint. The statement there is that money not only tends to flow away from places where prices are high, but also from times when money is high. “If the price-level is high in January as compared with the rest of the year, bank-notes will not tend to be issued in large quantities then. On the contrary, people will seek to avoid paying money at high prices and wait till prices are lower. When that time comes they may need more currency; bank-notes and deposits may then expand to meet the excessive demand for loans which may ensue. Thus currency expands when prices are low and contracts when prices are high, and such expansions and contractions tend to lower the high prices and to raise the low prices, thus working toward mutual equality.”

If this be the quantity theory account of elasticity—and it would seem to be about the only thing the quantity theory could say—it is about as far from giving an account of the real facts as any theory could be! Something of this sort is suggested, perhaps, by the behavior of Canadian banknotes, which do expand in the fall, when prices of wheat are lowest, and contract in January, when wheat prices are higher. This grows, however, out of the peculiarities of an agricultural country, and does not at all illustrate the general doctrine maintained. First, wheat prices in the fall are low because wheat is most abundant then. Wheat prices in January, under the influence of speculation, commonly differ from wheat prices in the fall by an amount about equal to the elevator charges, rattage, insurance, interest, and other carrying charges involved. Second, wheat prices are only one element in the general price-level. Low wheat does not prove that the level is necessarily low. A good wheat crop may mean increases in general prices, and often does. Third, and more important, the real reason for an expansion in Canadian notes at such a time is that the wheat has to be moved. The farmers do not want to carry it; the speculators are ready to carry it; and it must be sold. Expanding trade, at the season, is the cause of expanding bank-notes. The influence of the price of wheat is exactly the reverse of that which Fisher assigns. If the price of wheat is low in the crop-moving season, less notes will be issued than if the price is high. In other words, the greater the increase in PT, not P or T alone, the greater will be the expansion of bank-notes. Decrease either P or T, and less notes will be issued.

In general, the phenomenon of elastic bank-credit is the phenomenon of an expanding bank-note or deposit issue accompanied by rising prices and volume of trade, and a decrease when trade and prices decrease. This is all commonplace, but I feel it best to refer to familiar sources to show how old and well recognized my statement of the case is. The following is from Mill’s Principles of Economics, Bk. III, ch. 24, par. 1: “Not only has this fixed idea of the currency as the prime agent in the fluctuations of price made them shut their eyes to the multitude of circumstances which, by influencing the expectations of supply, are the true causes of almost all speculations and of almost all fluctuations of price; but in order to bring about the chronological agreement required by their theory, between the variations of bank issues and those of prices, they have played such fantastic tricks with facts and dates as would be thought incredible, if an eminent practical authority had not taken the trouble of meeting them, on the ground of mere history, with an elaborate exposure. I refer, as all conversant with the subject must be aware, to Mr. Tooke’s History of Prices, The result of Mr. Tooke’s investigations was thus stated by himself, in his examination before the Commons Committee on the Bank Charter question in 1832; and the evidences of it stand recorded in his book: ‘In point of fact, and historically, as far as my researches have gone, in every signal instance of a rise or fall of prices, the rise or fall has preceded, and therefore could not be the effect of, an enlargement or contraction of the bank circulation.’”

I see nothing in Fisher’s discussion of credit to differentiate it from the position of the old Currency School. And the reason is a very simple one: Fisher has followed the quantity theory to its logical conclusions!

¹ See our chapter on the “Volume of Money and the Volume of Credit.”

² How close the relation between loans and deposits is may be seen from Professor Mitchell’s chart, Business Cycles, p. 344. The same chart exhibits the variations in the reserve percentage, which is very much greater.

The New York Clearing House banks, which we have seen (supra, “Volume of Money and Volume of Credit”) have a spread of from 24.89% to 37.59% in the yearly average of percentage of reserves to deposits—a spread of over 50%—show a variation in yearly average for the percentage of loans to deposits of only 24.3%—the range being from 83% to 104%. Ibid., pp. 325 and 331. For a partially different series of years, see the chart of J. P. Norton, Statistical Studies in the New York Money Market, facing p. 104.

¹ Neither deposits nor loans vary proportionately with trade. Very active trade may merely increase the activity of loans and deposits, causing both to be shifted more rapidly—larger outgo, larger income, loans more frequently contracted and paid off, larger amounts “deposited” on a given day, but balances, both of loans and deposits, at the end of the day not increased proportionately with the activity. This is strikingly illustrated in the business of the stockbroker.

¹Supra, p. 47.

² Italics mine.

¹ Miscellaneous Articles on German Banking,” in Report of Nat. Mon. Commission, p. 175. Art. by Max Wittner and Siegfried Wolff.

² The figures are not easily compared, as the figures for giro-transfers do not indicate the volume of giro-accounts, which is doubtless much smaller. I know no estimates for the turnover either of notes or of bills of exchange. To determine what proportion of business is done by each would, thus, not be easy. The volume of bills of exchange for the year is three times as great, for 1907, as the figures for note issue. The giro-system, as is well known, is relatively unimportant as compared with notes. But I do not undertake to assign figures showing proportions of business done.

³ Inland bills of exchanges in connection with the grain trade are still very important, especially at Chicago and Minneapolis. The writer has met frequent reference to cotton bills at St. Louis. Wool bills are frequent in Boston.

⁴Vide my criticism of his statistical fallacy in this connection, in the Annalist of Feb. 7, 1916. He rules out foreign trade from his “equation of exchange” by the device of assuming that imports and exports cancel one another. This, however, to the extent that it is true, makes the bill of exchange more, rather than less, important as a substitute for money and deposits. Fisher, loc. cit., pp. 306, and 374–375. See appendix to chapter XIII of the present book.