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The Regulation of the Currency

( Originally Published Early 1900's )

THE question whether government ought to make any provision whatever for regulating the currency, beyond protecting each individual against fraud or other wrong on the part of those with whom he deals, is an open one. The general principles involved in this question have already been so fully discussed that they need not be further considered at present. In whichever way we decide the question, the fact will remain that governments do sometimes undertake to issue currency, and to enact laws for its regulation. How strongly soever the student may be opposed to any such action on the part of the government, it is very essential that he should be able to trace the effects of the causes which may be brought into play by such action. Our discussion will not, however, be confined to government action, but will include the effect of such policies as may be adopted by the banks of the country.

To form a clear conception of the subject, certain principles laid down in the first few chapters of the preceding book are to be borne clearly in mind. It has been shown :

I. That a regular process of transfer of goods and services, which we have called the industrial circulation, is always going on, and is most necessary to human well-being.

II. That all such transfers of goods and services have to be balanced by a transfer of current money in the apposite direction, thus constituting a system of exchange.

III. That the money or credit passing in one direction must measure the value of the goods or services passing in the other direction. At the same time, the number of dollars of money or credit required for this measure depends upon the scale of prices, increasing or diminishing with that scale.

IV. Since the scale of prices cannot be fixed by any law, but is always a matter of individual bargaining, it follows that we cannot assign any definite quantity of money which shall be necessary or sufficient to effect all the exchanges of a country. If a certain volume of currency is required to transact the business of the country on a certain scale of prices, then if all prices are doubled, the volume of currency must also be doubled, or only half the exchanges can be effected. Consequently what is really wanted to keep business going at its normal rate is a fixed relation between the scale of prices and the volume of the currency.

V. If from any cause whatever the volume of the currency does not correspond to the scale of prices, that fact is made known to the public through an apparent excess or deficiency in the flow of the currency. A deficiency in the flow is shown by merchants not being able to sell their goods at the regular rate, and by the laborers of the community not being able to find employment at regular wages. All this will result in a diminution of wages and prices. An excess in the flow of the currency is shown by a brisk purchase of goods, and by such a demand for labor that laborers are able to command an increase of money wages.

VI. The apparent advantages and disadvantages thus arising are, however, in great part illusory, from the fact that what the laborer loses by lower wages he gains by getting his sustenance at lower prices, and vice versa.

VII. Nevertheless, owing to the difficulty of adjusting prices to variations in the flow of the currency, it is very essential to the public good that the general scale of prices should be kept as nearly uniform as possible from year to year. This requires that the flow of the currency shall always be accommodated to the industrial flow, increasing when the latter increases, and diminishing when it diminishes. At the same time it is a serious question whether the sum total of the industrial flow is subject to much variation from month to month when every-thing goes along at its normal rate. It is sometimes supposed by men in business that, at a certain period of each year, the " moving of the crops" causes a great increase in the industrial flow, requiring for its compensation a corresponding increase in the monetary flow. Quite likely this may be true; and if it is, we have an example of a case in which a. certain elasticity of the currency is required.

It follows from all this that if the regulation of the currency is to be regarded as something for either governments or banks to undertake, the main problem involved is that of adjusting the monetary to the industrial flow. There must be some way by which, when the industrial flow increases, an increased volume of currency shall be drawn into the circulation, to be retired again when the occasion for it has passed. To effect this adjustment is supposed to be one of the principal functions of banks. When more currency is wanted, it is supposed that merchants will apply to the banks for loans, thus increasing the volume of currency, and hence the monetary flow. When the occasion for the increase has passed away, the merchants pay off their Ioans, and thus the volume and flow of the currency are diminished.

Whether banks always do perform their functions so as to make this adjustment is a question which economists should investigate more fully than they have hitherto done. It should not be regarded by the student as a settled one, but as one which it should be his business seriously to examine. Our present object is to assist him by suggesting some ideas and discussing some theories which will come into play in the investigation.

One of the advantages of banks has been supposed to be that of economizing the use of gold and silver. If the latter were alone used as currency, we should have a capital equal to the whole volume of the currency lying idle and gaining no interest. If one has a twenty-dollar gold piece in his purse, he necessarily loses the interest upon it as long as he keeps it. The same is true of the man to whom lie transfers it.

The same is true of every piece of coined money issued from the mint. Thus in a certain sense the whole stock of coined gold and silver may be regarded as so much idle capital. The cur-rent theory is that in so far as this gold and silver is replaced by bank-notes, so far is interest gained on that portion of the capital of the country which is in use as money. Adam Smith compared the necessity of employing this dead capital to that of taking a certain portion of the land of the country for roads, and then likened the substitution of bank-notes for the gold and silver to the construction of a road through the air, which would permit the land previously occupied by roads to be cultivated, thus making an actual addition to the productive wealth of the country.

But this theory is at the best far from satisfactory. Who gains by this substitution ? Every holder of a circulating note loses interest on his investment in that note while it stays in his pocket, unless it bears interest, which bank-notes never do. Therefore the holder of a bank-note loses the interest as completely as if he had coin instead of the note. What is really saved by the substitution is the wear and tear of the gold and silver coin. In consequence of this wear and tear, all such coin is subject to a slight continuous loss, which the public must bear when the coin becomes too light for circulation. We may consider each man's share of that loss to be equal to the wear and tear of the coin while it is in his pocket.

Therefore whatever gains result from the substitution of bank-notes for coin must accrue to the benefit of the banks or other issuer of the notes. If they gained more than the regular interest on their invested capital, there would be an actual gain to the public by the issue of notes. It may be questioned, however, whether they do have any such extra gain. The general rule probably is that the expenses incident to the issue of the notes, and the management of the business, absorb all the profits.

Here a very important point is to be considered. We may readily believe that if all the circulating notes of the country were issued from a single central institution, a not inconsiderable profit could be made by that institution out of the business. For example, there are now circulating in the, United States about 600 million dollars in government and bank notes. If we subtract 25 per centum of this as a coin reserve to be held for their payment, there will remain 450 millions, on which the issuing authority could gain interest, Putting this interest at 3i per cent per annum, the amount gained would be 15 millions per annum. This would no doubt more than pay all the expenses of the issue, were it made by only a single institution. But when made by several hundred banks, each separately responsible for its own: share, the expense is so far increased that most of the banks find little or no advantage from the issue. The government gains an advantage from its issue of notes by having these notes form a part of the public debt on which no interest is paid.

Another consideration is that the continually increasing volume of credit used instead of coined money has resulted in the general volume of circulation for the world being several times larger than it would have been had bank credits not been used as money. Since, as: already pointed out, this whole volume of currency is necessary to the transaction of the world's business on the present scale of prices, it follows that our present scale is much higher than it would have been but for the employment of credit-currency.

The fact is that the world's business, or, as we have called it, the world's industrial circulation, has grown much more rap-idly than its stock of coin. The result of this is that the monetary and industrial flows could not have been balanced with-out a continuous fall of prices, but for the use of credit-currency. The use: of. this currency has resulted in the whole gold-supply not being necessary to the transaction of business. In consequence, a considerable portion of the gold-supply has been available for other purposes than that of money; watches, jewelry, and picture-frames, for example. We are. therefore to regard our ability to command these articles of luxury as being due in a great measure to the economy introduced by the credit system. The general benefits to the country rendered by the credit system are therefore that an increased business is trans-acted without an increased scale of prices, and that an important part of the world's supply of the precious metals has been available for use in manufactures and the arts.

Irredeemable Paper Money. The kind of circulating notes which we have hitherto considered have been those en-titling the holder to receive a certain amount of coin at the counter of a bank. They are in fact nothing but promissory notes, payable on demand, and deriving their value from the ability of the bank to pay them whenever presented. It has, however, been shown that the transaction of the business of the country requires a certain volume of currency to be continually in a state approximating to that of flow, being held first by one person and then by another. In other words, it is passing from hand to hand, and is received by one person only to be paid to another. Now, so far as the immediate results are concerned, it makes no difference to the payers and receivers whether the money thus flowing is coin, bank-notes, or credit. Hence a certain amount of money will always remain in circulation, and if it is credit-money, the payment of the credit in coin may never be demanded.

The result of this state of things is that when a government is in a difficulty, or is financially weak, it may issue a limited volume of its own notes with the reasonable assurance that they will pass for a certain time from hand to hand without the holders demanding payment. By the device of making them a legal tender a forced circulation is given them, quite irrespective of their money value, or of the power of the government to redeem them. If the volume issued becomes so great that the notes depreciate, then, in accordance with Gresham's law, they will displace all other good notes, or credit redeemable in coin, and thus may become the basis of the entire circulating medium of the country. Such notes are sometimes called paper money. Such money was the "greenbacks" of the United States issued during the civil war, the redemption of which in coin was not formally undertaken until 1879.

The possibility of a system of irredeemable paper money being a subject of public discussion, it is necessary that we should have a clear understanding of the laws which regulate its value and adaptability. On this subject two opposite opinions are current. One opinion is that such currency would perform all the functions of a circulating medium, if the government would only issue it, and call its units by the name of dollars. After the commercial panic of 1873 a political party was formed in many States of the Union, the object of which was to make the circulating notes issued by the government forever irredeemable in coin. The existing notes were promises to pay the bearer the amounts named on their faces ; but by common consent the government was postponing the redemption of this promise until a more convenient season. General B. F. Butler, one of the leaders of the new party, saw the absurdity of having a promise afloat which might never be per-formed, and therefore proposed that the notes, instead of bearing such a promise, should be declared money in themselves, and called certificates of value. Then a dollar note would be simply a piece of engraved paper issued by the government and bearing on its face a certificate that it was really one dollar and should be legal tender to that amount for all payments made under the laws of the United States. This view was the strictly logical consequence of the theory already discussed, that money derives its value from the fiat of the government. The reader may be supposed so well able to grapple with this theory that we shall leave him untrammelled in its discussion.

The opposing theory is that an irredeemable paper money has no value except that which it derives from the hope of being redeemed at some future time. Hence the more remote the process of redemption the less the value. This view might appear to be borne out by the facts of history. The general rule has been that such notes are issued only by governments in difficulties, and in such quantities that their redemption be-comes more and more doubtful. Thus the assignats of the French Revolution, the " Continental currency" issued by our own government during the Revolutionary War, and the circulating notes of the Southern Confederacy, all became value-less as it became certain that they would not be redeemed.

Although this view is nearer the truth than the other, it is not entirely sound. Under certain conditions an irredeemable paper currency may have the value and perform the functions of money, although it is certain that it will never be redeemed. What these conditions are may be learned from the principles already developed in treating of the volume and flow of the currency.

We have seen that it is absolutely necessary to the transaction of the business of the country that a certain volume of currency should be in circulation. It is impossible that the exchanges of the United States should be conducted without a volume of currency the value of which, measured by our present standard, would be about fifteen dollars for each inhabitant. Hence, whatever bills or tokens the people use in making their exchanges, it is certain that so long as the exchanges go on, the total volume of those bills or tokens will have a certain absolute value. It follows that the first essential condition of value of a paper currency is that it shall be generally accepted in trade as money. It must therefore either be a legal tender by law, or received so generally as a matter of custom that it will be refused only in exceptional cases. In times of great popular excitement the force of public opinion alone suffices to give a forced circulation to such money.

The money being universally accepted, the next condition on which its value depends is its total amount. If strictly limited to an amount not exceeding that required for the transaction of the current business of the community, it will not depreciate.

Here, however, a question will arise in the mind of the critical student. It has been shown in a preceding chapter that there is no definite volume of currency necessary to transact the business of the country, and that this business can be as well transacted with one volume as with another, always provided that the scale of prices is adjusted to the volume. The expression, " amount of currency required to transact the business of the country," therefore needs to be precisely defined.

We start, then, with the proposition that whatever be the volume of irredeemable currency, it will fulfil all the functions of a circulating medium on a certain scale of prices corresponding to its volume. If the volume is less than fifteen dollars for each inhabitant, this scale of prices will be below prices in gold. If gold coin were not receivable as money, it would then be at a positive discount as compared with the paper money which we suppose to be so receivable. But being receivable, we should, in the case supposed, have a mixed currency of paper and gold. If we continually add to the volume of the paper currency, it will at length amount to fifteen dollars for each in-habitant, and will then suffice to transact all the business of the country on the gold scale of prices. If we add still further to the volume, gold will entirely disappear from circulation, and will be at a premium, in accordance with Gresham's law. With every further addition there will be a further depreciation: doubling the volume will simply double all prices as measured by currency. To speak more accurately, the standard of measure, or the dollar, will be reduced to one half its value. The theorem just enunciated may therefore be expressed with greater precision, as follows: So long as the total volume of irredeemable currencies of all kinds does not exceed that necessary to transact the business of the country on a coin scale of prices, so long the currencies will not depreciate.

It follows, therefore, that could a strictly limited volume of irredeemable paper currency be issued, it would perform all the functions of money. Unfortunately, as human nature is constituted, the experiment of such an issue would be a very dangerous one. The experiment can at present have no object but that of making money more plentiful, and the more plentiful we make it the higher prices will be, and the greater the volume of currency that will be required to transact the business of the country. Hence the same reason which will prompt one issue will lead to another, and so on until the whole fabric collapses in ruin.

The regulation of the currency through the action of banks is seen at its best in the working of the Bank of England. The criterion by which the governors of this institution judge of the state of the currency is simply the demand for gold from their vaults. The bank has a variable volume of credit outstanding, payable to its creditors on demand, either in bank-notes or in coin. Since the bank-notes are themselves payable in coin, this whole mass of credit is thus payable.

The object which the governors keep before them is to allow the mass of credit to be as large as is consistent with entire security against such a withdrawal of coin as might endanger their ability to make good all their obligations on demand. The instrumentality through which they regulate the volume of their credits is the rate of interest. When the demand for coin by their creditors exceeds the deposits of coin, they know that it is being withdrawn for export. They conclude, there-fore, that there is a larger volume of credit in circulation than is necessary for the transaction of the home business on the existing scale of prices. They therefore raise the rate of interest on loans. The result of this is that their customers are discouraged from borrowing, and thus a moral force is brought into play which tends to diminish the volume of credit currency. This checks the ability of the public to pay, and so lessens the demand for goods. The system may therefore be considered as acting much like the governor of a steam-engine, which closes the throttle-valve as soon as the engine begins to go too fast, and opens it again when the speed is reduced to the proper limit.

In the United States the banks were long prevented from performing this function in the same manner through the existence among us of an idea which has come down to us from the dark ages, that the rate of interest should be limited by law. The national banks are prohibited from charging a higher rate than the laws of the State in which they are located. This limiting rate varies from six to ten per cent. Owing to the great fall in the rate of interest since 1875, this restriction has practically ceased to do any mischief, since the market rate would seldom exceed that fixed by law. Under the system of the Bank of England, and of all banks unrestricted by usury laws, the credit is allowed to the person who will pay the highest rate of interest, regard being had, of course, to the security which he offers. In the case of banks restricted by such laws, if, at the maximum rate allowed by law, the demand for credit exceeds that which the banks can supply, loans become a matter of favor, and the banks give the preference to those who have been its best customers. The result is that the unfavored part of the community cannot get money at any price whatever.

The effect of the method of regulation which we have described is to keep the general scale of prices somewhere near the average gold prices of the world at large. It is one of the unsettled questions of political economy whether this system of regulation is really of any benefit to the public. It may be held that banks really foster injurious changes in the general scale of prices at the moment when those changes are most severely felt, namely, in times of commercial panic and depression. These are the times when the flow of the currency least suffices to transact the business of the country, but they are also the times when banks are compelled to be most careful in making loans. What is wanted is some source of currency which shall be available only when a commercial panic is threatened. Plans for this can be discussed with advantage when the public are more enlightened on general principles.

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