Problems In Money And Banking

( Originally Published 1918 )

The Macmillan Company issued in 1917 a third and carefully revised edition of a standard work called "Outlines of Economics," written by Richard T. Ely, Professor of Political Economy in the University of Wisconsin; Thomas S. Adams, Professor of Political Economy in the Sheffield School of Yale University; Max O. Lorenz, Associate Statistician, Interstate Commerce Commission; and Allyn A. Young, Professor of Economics and Finance in Cornell University. It is used as a text-book in many of the more advanced educational institutions of this country.

In Volume 11 of that work is a chapter on "Problems in Money and Banking" by Professor Young, which is highly informative, expressed in plain terms, complete within its subject, and brought down and applied to the banking system and banking practice which prevail at present, and have proven themselves so well under the pressure of war that their permanence may be accepted. The substance of that chapter is here reproduced:

What determines the value of money? That is, the purchasing power of money as expressed by the money prices of other things. There is no such thing in fact as "the general purchasing power of money." Money lias, in reality, a large number of different values, expressed by the different quantities of different things that it will buy. If the price of wheat is one dollar per bushel, then one value—the wheat value--of money is a bushel per dollar. Similarly, the purchasing power of money in sirloin steak may be found in pounds per dollar. But how blend sirloin steaks, wheat and other things into one concept? The notion of the general value of money is simply a useful abstraction, based on a broad view of all its different specific values.

But when we fix our attention upon changes in the various purchasing powers of money, we are able to make a distinction between changes that are widespread and general and changes that affect only one or two commodities. For example, a new invention may decrease the price of a particular commodity without affecting the prices of other things except (if the demand for the commodity is elastic) by shifting demand from other things to the commodity in question -an effect which would usually be slight so far as the price of any one of these other things is concerned, for the demand would very likely be shifted from many different lines of consumption. Or if the demand for the commodity in question is relatively inelastic, a diminution in its price may increase the demand for other things. On the other hand, there are price fluctuations which are widespread and which show a general trend in one direction or the other, and these, with substantial accuracy, may be called changes in the value of money.

What are the underlying causes of these general changes in the values of money? The first impulse, perhaps, is to suggest that there is no new problem here, that the value of money is to be determined in the way that other values are determined, and to seek to frame an explanation in terms of marginal utility and the general laws of supply and demand. But the task is not so simple as that. The analysis of marginal utility, it is true, formed the basis of our explanation of the shifting of demand from one commodity to another, but it does not help us to explain the demand for money. Marginal utility depends upon the capacity of things to satisfy human wants, and money does not directly satisfy a single human want, except the abnormal wants of the miser. We want money only as we want the things that money will buy for us.

Supply and Demand.---In discussing the relations between the prices of things and their supply and demand, we arbitrarily limited our-selves to the consideration of one commodity at a time. That is, we assumed that the money price of the one commodity we were considering was alone variable, and that the prices of all other things remained, for the time being, constant. The consumer whom we pictured as willing to buy a certain amount of a commodity at a certain price or a larger amount at a lower price, was, by our premises, merely comparing variable dollars' worths of the commodity in question with fixed dollars' worths of other things. All the values of money, save one, were held constant, so that the imaginary consumer simply had to compare the utility of larger and smaller marginal dollars' worths of the one commodity with their cost measured in a dollar that represented perfectly definite amounts of all other things. But the problem of the value of money (understood as the problem of general changes in the different values of money) cannot be approached in that way; for the problem of the value of money is merely the-obverse of the problem of the money values of all other things. If we were studying the wheat value of money we could assume the sirloin steak value of money to be held constant. But our present problem is that of the wheat value of money and the sirloin steak value of money and all other values of money. We can't resort to the strategy of breaking the sticks in our bundle one by one.

The Quantity and Values of Money.-Using the word money in its broadest sense, including all "rights to receive money" that are used in making payments, it is clear that every sale of a commodity may be viewed as a purchase of money, and every purchase of a commodity as a sale of money. Going a step farther, and remembering that one wants money only because of the things money will buy, we may say that every sale of one commodity is a purchase of the power of acquiring other things. A seller cares nothing about the quantity of money—the number of dollars—he gets in exchange for his goods, except in so far as these dollars have certain relations with other things, including the things he buys as a consumer and the things he pays for under the head of "expense of production." Similarly, a buyer cares not how much money he parts with in exchange for a definite quantity of goods, except in so far as the money has alternative uses of greater or less importance. The quantity of money :the number of dollars in the aggregate supply of the instruments in which payments are made—has no significance apart from the values of the dollars.

These two things—quantity and value—are in the case of money bound together in a peculiar way. They are, in a very real sense, not only interdependent but interchangeable. A small amount of money of high purchasing power per unit will meet the needs of both buyer and seller just as well as a larger amount of money of lower purchasing power per unit.

What are the conditions under which a general change in the values of dollars is possible? Let us simplify the problem by assuming that the change is absolutely general and uniform; that if, for example, the price of a bushel of wheat is seventy-five cents and the price of a bushel of corn is fifty cents, an increase in the price of wheat to a dollar and a half is accompanied by an increase in the price of corn to a dollar, and by a similar doubling of the money prices of all other commodities and services. Things retain precisely the same exchange relations as before, except with reference to money. If prices have thus increased, all the values of money have diminished by one-half. As an intermediary, then, as a means of obtaining other things, money has only half its former potency.

Sellers are demanding and receiving twice as many dollars as before for given quantities of goods; buyers are offering and paying twice as many dollars as before per unit of goods pur-chased. Remembering now that we are using the word money in its broadest sense, including exchangeable credit instruments, it is evident that twice as much money as before passes from buyer to seller in exchange for every unit of everything else that passes from seller to buyer. But this means that one of two possible conditions must exist. Either (1) fewer exchanges are being made, or (2) exactly twice as much money as before is being exchanged for goods and services. So we reach the very important conclusion that there must be a definite relation between general changes in the values of money and changes in its quantity. We need not as yet concern ourselves with the question of which of these two related things is cause and which is effect. But that these two things are inseparably bound up, the one with the other, should now be clear.

If the number of units of goods and services of every sort annually exchanged for money remains constant, any increase or decrease in the amount of money used in making payments must be accompanied by an exactly proportionate general increase or decrease in prices. It is not necessary for the truth of this theorem that all prices should change in the same proportion.. The general change in prices may, for example, be upward, but some prices may rise by a smaller pro-portion or may even fall, provided these are off-set by sufficiently large increases in the prices of other things. An "exactly proportionate" general change in prices merely means such changes in specific prices as will make possible an underchanged volume of transactions with the increased or decreased number of dollars used in making payments. A general increase or decrease in price is of course identical with a general decrease or increase in the various specific values of money.

The Equation of Exchange.—Some aspects of the general relation between prices and the quantity of money can be conveniently represented by using algebraic symbols. Let M rep-resent the total amount of money in circulation, and let V represent its rate of turnover, or velocity of circulation, that is, the average number of times the various dollars in circulation are ex-changed for goods or services during the year.

Then MV will represent total money payments, measured in money units. Let T represent the total volume of trade, or, more accurately expressed, the total number of units of commodities and services exchanged for money during the year. Finally, let P represent the average price per unit paid for these commodities and services. The equation of exchange may now be stated in its simplest form :—MV =PT.

This equation, it is obvious, amounts to the statement that the quantity of money in circulation, multiplied by its average rate of turnover, is equal to the average price per unit paid for commodities and services, multiplied by the number of units sold. This, in turn, is equivalent to the yet simpler statement that the total amount of money paid for things during the year equals the sum of the prices of all the units purchased. Stated in this way, the equation of exchange is readily seen to be necessarily true.

Up to this point we have simplified our problem by counting as "money" everything, including credit instruments, expressed in terms of dollars and accepted in payment for other things. But there are some important problems connected with the relation of changes in the quantity of the generally accepted media of exchange (money in the "narrower sense") to changes in prices. So we shall now let M represent the quantity of the generally acceptable media of exchange, including metallic money, government paper money, and bank notes. The symbol M will be used to represent the quantity of the transferable "rights to demand money" that are used in making payments. These consist, almost entirely, of bank deposits subject to check. Then the equation of exchange becomes :—MV +M' V'= PT.

This is a statement in algebraic symbols of the fact that the amount of money in circulation, multiplied by its rate of turnover, together with the amount of bank deposits subject to check, multiplied by their average rate of turnover, must be equal to average unit prices, multiplied by the number of units of things exchanged for money or for deposit credit. This equation is identical with the other one, except that a distinction is now made between money and bank deposits. The principal advantage of the use of the equation of exchange, in fact, is that it enables us to discuss the relations between general changes in prices and changes in the amount of metallic and paper money, without becoming involved in difficulties of analysis and of exposition that would otherwise be very formidable. The problem becomes simply that of the relations between M and P in the equation of ex-change.

If M and M' increase in equal proportion, while V, V' and T remain fixed, P must also increase proportionally. That is, all other things being equal, an increase in the amount of money in circulation and in bank deposits must be accompanied by a proportionate increase in prices. To what extent, in fact, are these "other things" likely to remain equal?

In the first place, a sudden increase in the amount of money in circulation is very sure to increase T, the total volume of trade, by leading to increased purchases. But in the long run the increase or decrease of the total volume of trade must depend upon the natural resources of the country, the productive energies of the people, and the degree to which division of labor has been achieved. It can have no permanent dependence upon the amount of money in circulation.

In the second place, a sudden increase in the supply of money is likely to bring about a temporary decrease in V, its velocity of circulation, because a larger amount of money may, for the time being, be kept idle. But with a given volume of transactions at given prices, V must in the long run depend very largely upon the habits of the people with respect to the amount of "pocket money" usually kept on hand. Changes in habits of this kind are slow, and may safely be neglected in studying the movement of prices through even a considerable number of years.

In the third place, when we come to consider the effect of an increase in M upon the magnitude of M', the amount of bank deposits subject to check, we find that these two things are necessarily connected. For an increase in M, the amount of money in circulation, is very sure to be accompanied by an increase in bank reserves. Additions to the country's stock of money will distribute themselves, ultimately, between bank reserves and hand-to-hand circulation, and the proportions of the country's monetary stock al-lotted to these two uses usually fluctuate only between more or less definite, even if gradually changing, limits. But an increase in bank re-serves normally brings with it an increase on M', the amount of bank deposits subject to check. Even in the absence of minimum reserve laws, the ratio of aggregate bank reserves to aggregate bank deposits is found, for the time being, to fluctuate around an approximately constant proportion. An increase in M, therefore is very sure to result in an increase in M'.

It follows, then, that despite a certain amount of variability in the other factors in the equation of exchange, an increase in M, carrying with it a roughly proportionate increase in M', must normally have as its most important concomitant a simliar general increase in prices. This, it will be noted, is in harmony with the conclusion we had already reached without the aid of the equation of exchange. But that conclusion was stated in terms of the "amount of money (and credit instruments) exchanged for goods and services," the volume of trade being constant. We now see that a similar conclusion holds true when stated in terms of the quantity of money in circulation, the only qualifying factors being probable changes of greater or less importance in (1) the rate of turnover of money, (2) the ratio of the amount of money in bank reserves to the total amount of money in circulation, (3) the ratio of bank reserves to bank deposits and (4) the rate of turnover of bank deposits. Allowing for the influence of these qualifying factors, an increase or decrease in the quantity of money, the volume of trade being constant, must be accompanied by a proportion-ate general increase or decrease in prices. This principle, known as "the quantity theory of prices," has long been one of the most important theorems of economics.

General changes in prices must, of course, accompany changes in any of the factors in the equations of exchange unless these happen to counteract one another. If the volume of trade increases more rapidly than the supply of money, and other things remain equal, prices must de-crease. This is the apparent explanation of the general fall in prices between 1873 and 1897. The growing use of checks in making payments is substantially like an increase in the supply of money. It increases the ratio of money in bank reserves to money in hand-to-hand circulation, and thereby increases the ratio of M' to M. Unless offset by changes in other factors, this must be accompanied by rising prices. An improvement in the organization of the banking system, making possible a smaller normal ratio of aggregate bank reserves to aggregate bank deposits, must also tend to increase prices. Along with a phenomenal increase in the quantity of money in the past twenty years there has been in fact a large increase in both the ratio of de-posits to money and the rate of turnover to deposits.

The quantity theory of prices, even when stated in the form of the equation of exchange, tells us nothing about the process of general price changes; nothing, that is, about the mechanism by which a change in the quantity of money operates to bring about general changes in prices. No one has ever given a complete description or analysis of this process, and doubt-less no one description would fit all instances of general price change brought about by changes in the quantity of money. But some aspects of the matter are tolerably clear.

Take an artificially simple case. Imagine an isolated community with no foreign trade and with no banks. Suppose that a group of men find a long-forgotten hoard of gold, large even as compared with the existing stock of gold in circulation. Without increasing their own activities as producers, the finders are now able to purchase larger quantities of goods. These additional purchases, it is important to note, are the direct result of the increase in the supply of money, and could not have been made without it. The merchants into whose hands the money comes in turn expend it to replenish their stocks and for other purposes. And so the money passes from hand to hand, increasing the number of exchanges—the volume of trade—just about proportionately to the increase in money.

But this increase in the volume of trade cannot be the end of the process. More goods than before are passing into the possession of their ultimate consumers. The country's stock of ex-changeable goods is being depleted more rapidly than it can be replenished out of the country's normal agricultural and industrial output. In short, the purchasing power of the community, at the old level of prices, is now more than sufficient to buy the current output. Under the pressure of competing purchasers, desiring to exchange money for goods, prices will rise. And if the industrial output cannot be permanently increased the rise in prices will be proportionate to the increase in the money supply, so that finally the larger supply of money will have brought with it no permanent increase in the number of exchanges.

The conditions under which general price changes resulting from an increase in the quantity of money occur in actual life, are much more complex; and yet there is no reason to suppose that in its fundamentals the process is essentially unlike that which we have just outlined. There is, however, the difference that additions to the supply of money usually find their way at first into bank reserves, where their immediate effect is to lower the discount rate. This leads to increased bank lending and to large bank de-posits, and the immediate purchasing power of the community, in the form of its power to draw bank checks, is correspondingly increased. Increased purchases will be made, and so far as the immediate effect upon prices is concerned, it is immaterial that a large part of the increase may be in purchases of labor, raw materials, and supplies; i. e., in expenditures for "productive" rather than for "final" consumption. Prices must rise, and this will draw a larger amount of money into hand-to-hand circulation. With higher prices people will find it convenient to keep somewhat larger amounts of money on hand as "pocket money." Finally, unless new disturbing factors appear, equilibrium will be reached between the amount of money in bank reserves and the amount of money in hand-to-hand circulation. It seems probable, then, that the sequence of processes by which an increase in the supply of money actually brings about a general increase in prices may often be (1) larger bank reserves, (2) lower discount rates (3) larger bank deposits, (4) more purchases, (5) higher prices, (6) more money drawn into hand-to-hand circulation. Prices get their initial upward impetus from. the larger bank reserves, but the in-crease in the amount of money in hand-to-hand circulation helps to support and maintain the higher price-level.

Thus far we have neglected to take account of the very important facts : (1) that gold has other than monetary uses; (2) that the production of gold will itself depend in part upon its purchasing powers; and (3) that international gold shipments are also partly dependent upon the relative purchasing power of money in one country and another.

From the estimates of the Director of the Mint it appears that in recent years from one-fourth to one-third of the world's annual production of gold finds its way into industrial uses. The United States mints and assay offices refine nearly all the crude gold bullion produced in or brought to this country, and allow the depositor to take the proceeds in money or in bars of gold for industrial use as he prefers. But even with-out this convenient arrangement there would be a constant balancing or comparison of the relative advantages of the industrial and monetary uses of gold. The number of dollars which can be got by selling gold for money and by actually converting gold into money, must, of course, always be approximately equal.

There are, however, two things quite distinct from the direct process of selling gold bullion for money which help to fix the ratios of ex-change between gold and other things. Consumers, on the one hand, are constantly weighing the relative profit of producing things made from gold and things made from other materials. It is clear that gold will be distributed between its industrial and monetary uses in such a way as to equalize the exchange ratios of gold and other things for the two uses. If, for example, an in-crease in the stock of money (whether gold or not) results in increased prices; i. e., in decreased purchasing values of gold, a relatively larger amount of the gold annually brought to the mints will tend to flow into industrial uses, and thus to limit the increase in the amount of money and the consequent rise in prices.

Expenses of Gold Production.-There is an-other way in which society makes direct comparisons between the value of gold and the value of other things. Mining, like agriculture, is subject to the law of increasing expenses, and the tendencies of prices to equal the maximum ex-penses of production per unit holds true for both industries. Not only are there marginal mines, mines which it just pays to operate, but in the most productive mines there are margins—certain depths, for example, beyond which the expense of mining more than eats up the value of the product. Through the operators of mines, society is continually comparing the cost in labor and capital of the production of gold with the cost, similarly measured, of the things that can be bought with the gold produced. If the gold produced at the margin will purchase things which consumers deem of less importance than other things which might have been produced with the use of no more capital and labor, capital and labor will gradually be shifted from their marginal use in gold mining to the production of other things which might have been produced balancing between the monetary and industrial uses of gold, we have a direct value-comparison of gold and other things.

The Bureau of the Mint some years ago under-took an investigation into the relation of the expense of gold mining to the amount of gold produced. The conclusion reached is worth quoting in this connection:

In every mining district there are mines producing at good profits, mines producing at small profits, mines barely paying expenses, and mines operated at a loss, but with the hope they will do better. Every increase in costs would submerge the latter more deeply, add to the list of the unprofitable, and probably close some of them. A higher scale of working costs will bring losing experiments to an earlier conclusion, reduce profits, and make mining ventures generally less attractive, and thus diminish the output.

To summarize:—Marginal utilities and subjective values are found in the industrial uses of gold. The particular form of the law of normal price that is operative in agriculture also holds true in gold mining (although it has to be stated in a somewhat different way). An increase in the supply of gold diminishes its marginal utility in industrial uses. This is bound to decrease the values of gold as money, on account of the ease with which the supply of gold can be shifted to one use or the other. Such a rise of prices, how-ever, cannot continue indefinitely. The increase of prices and wages brings increasing expenses in gold mining, and unless new gold mines are found or cheaper ways of getting gold from old mines are invented, the output of gold will have to decrease.

These things have a steadying influence upon prices. Tendencies toward extreme fluctuations in prices are held in check by the resulting changes in the expense of mining gold and by the automatic changes in the proportions of the annual gold product that flow into monetary circulation and into industrial uses. It is in these ways that the significance of the fact that the monetary standard is itself a commodity appears.

Although probably more gold was produced between 1850 and 1875 than from 1492 to 1850, yet the annual production of gold since 1896 has been from two to three times as large as it was between 1850 and 1875.

Most of this great output of gold comes from relatively few countries. At present the British empire supplies over one half and the United States (including Alaska) nearly one fourth of the total product. The causes of this enormous increase were, in part, the opening of new gold fields in South Africa, Canada, Alaska, and the mountain states, and in part the improvements in methods of extracting gold from low grade and refractory ores, in which connection the development of the "cyanide process" has been of special importance. Dredging for gold in the beds of rivers which drain gold-yielding lands is a very recent development of considerable importance. Notwithstanding the decrease in the value of gold, the bulk of the gold produced in California today is from ore bodies that twenty-five or thirty years ago were generaIIy considered worthless.

The effects of this enormous output have been felt in both Europe and America in a general increase of both prices and wages. There are some who expect that the values of gold will continue to depreciate for a long time in the future.

Account must be taken, however, of the automatic check which the increase in wages and prices is bound to put on the production of gold by increasing mining expenses. On the other hand, still further economies in productive methods are possible.

Increase in the amount of money available for bank reserves leads to the expansion of credit, stimulates business, and increases prices. The same results are achieved, although not in the same way, by a sudden debasement of the stand-and of value, or by the introduction of irredeemable paper money as the medium of exchange. Prices are gradually increased under such conditions, there being an unmistakable tendency to adjust them to the change in the dollar or other unit of the medium of exchange. The rising prices stimulate business by increasing profits. Profits are increased because most of the ex-penses of production are incurred before the goods are sold, so that the rise in prices increases the margin between prices and the expenses of production; and because, moreover, some of the expenses of production do not usually rise as rapidly as do prices. An expansion of business activity of the kind already described is apt to be the result, and this is not generally soon re-strained by insufficient bank reserves, for depre ciated money is usually, though not always, money that is coined or issued in large quanti-ties.

Periods of prosperity induced in this way are inevitably short-lived and usually end in severe crises, but this does not make them any the less real. Nor should the fact that such artificial conditions of business are apt to be accompanied by excessive speculation and other unhealthy features, blind us to the fact that they accomplish some good. The encouragement given to venturesome undertakings lead to the trial of new methods of production, to the development of new natural resources, to undertakings of vast proportions, to a general freeing of industrial organization and methods from the restraints of habit and tradition. The foundations of modern large-scale industry in the United States were laid in the period between the civil war and the panic of 1873. The period of state bank note inflation preceding the panic of 1837 was a period in which the industrial map of the United States was almost wholly changed—and in the long run for the better.

A rapid increase in the supply of standard money may have a similar effect. A tremendous expansion of international trade followed the gold discoveries in California and Australia. In the sixteenth century, increases in the supply of the money metals, historians are agreed, hastened the fall of the medieval economic system. The almost unparalleled development of industry and industrial organization in the United States since 1897 must, with its good features as well as its bad, be attributed in part to the increased supply of gold.

Business prosperity, however, does not always coincide with the real economic welfare of the masses of the people. If prices are rising faster than money wages, real wages are obviously declining. A period of falling prices is very apt to be a period of increasing well-being for those whose incomes are wages or salaries, although here we have to remember that even if daily pr weekly wages do not fall so rapidly, as prices, an increase of unemployment may affect total yearly incomes adversely.

Crises are frequently recurring phenomena of current economic life. They are of all degrees of severity, but are generally characterized by a scarcity of bank credit, a sudden drop in prices, a subsequent period of industrial depression, lack of employment for wage earners, and kindred symptoms.

Crises are frequently attributed to "overproduction," or when that expression is criticized (because human wants are never fully satisfied) to "under consumption." The two expressions are different ways of describing the same thing, and both are misleading because they put the emphasis in the wrong place.

Production and consumption have to do with quantities of things and their fitness to satisfy human want. Crises spring from mishaps in the price process; they relate to what might be called the dollars and cents aspect of economic life. It is difficult, even impossible, for observers to analyze all the factors entering into a particular crisis, and it is even more difficult to formulate a theory of crises that will be of general applicability. There are some important things about crises, however, that are relatively well known.

It is a significant fact that crises generally occur only as sharp interruptions of periods of business prosperity, when credit is abundant, prices relatively high, and employment plentiful. Whatever may be the cause of a period of exceptional business prosperity it is apt to contain within itself the seeds of its own destruction. The point will appear clearly if we put together two conclusions : first, that the supply of loanable funds in the form of bank credit is a function of two variables-the supply of personal credit, and the supply of money available for bank reserves; second, that personal credit is based on the probable amount of future money incomes and probable future prices of property.

Suppose, for example, that business conditions are prosperous, and promise to continue so, and that there is a plentiful supply of money in the bank reserves. Expected prices and expected profits are large, expected interest payments seem certain. The power to get this future in-come depends, however, upon the possession of land, capital goods, franchise and other privileges, the established business relations that give rise to "good will values," or upon the possession of income-yielding securities such as mortgages, bonds, and stocks. Under such conditions, these things command good prices in the market and may easily be hypothecated, either formally or implicitly, in order to secure purchasing power —bank credit. The bank credit thus created is put into further investments of capital and into the creation of further business opportunities. These things serve in turn, so long as their income-yielding power seems certain, as the basis of further extensions of bank credit; and thus the process of business expansion continues in a cumulative fashion.

Overproduction, it is true, is present, but it is the overproduction of the means of production and of acquisition—of railways, factories, and ,business schemes—and it is accompanied by the overappraisal, the overcapitalization, of these things. An extensive period of increasing prosperity of this kind is, however, scarcely possible unless the supply of money is increasing; for bank reserves as well as the amount of expected personal incomes condition the supply of purchasing power. Very often, in fact, it may be a sudden increase in the supply of money avail-able for bank reserves that gives the initial impetus to the rapid expansion of business. Larger reserves, lower discount rates, larger investments, an increased volume of trade, is the normal sequence in such cases. Periods of rising prices are periods of rising profits; for fixed charges, the rate of interest (even on new borrowings), and wages, do not usually rise as rap-idly as prices. These rising profits are, of course, the direct cause of the overinvestment in production goods and the overcapitalization of business opportunities.

Any one of a number of things may be sufficient to precipitate a panic under such conditions. The whole business structure may fall to pieces through sheer topheaviness. That is, so much production today is indirect, so large a share of productive effort is devoted to forwarding in indirect ways the production of goods that will be ripe for human use only in the comparatively distant future, that the mere operations of sup-ply and demand among business men themselves may maintain prosperous business conditions for some time. But in the long run the maintenance of the values of the producer's goods and privileges depends on the demand, and hence on the income, of ultimate consumers. Wages do not usually rise as rapidly as prices in periods of business expansion. This simple fact may in itself keep the average purchasing power of consumers from expanding rapidly enough to furnish a solid support for the growing structure of capital values.

Crop failures may precipitate a panic by diminishing the purchasing power of those engaged in agriculture, and possibly, by reducing exports, and thus necessitating the taking of gold from the bank reserves to ship to Europe in payment for our imports. When the credit situation is at all strained, the failure of one important bank may be enough to precipitate a panic. The bank's creditors are prevented from meeting their own obligations ; the solvency of others is in turn de-pendent upon them, and thus losses in expected and often already hypothecated income are transmitted from firm to firm and from industry to industry in a constantly widening circle. The reduction of bank reserves by reason of the flow of money into hand-to-hand circulation in order to effect exchanges at the higher level of prices, may itself be a contributing cause of, a panic.

Whatever may be the immediate cause of a panic, it is bound to grow, in a condition of inflated capital values, with tremendous rapidity. The collapse of credit leads to forced sales of property in order that credit obligations may be met. These reduce prices, lessen the security on which credit is founded, and render banks less able and less willing to make loans. Moreover, the hoarding of money, which is apt to be a feature of a panic, has a destructive effect on bank reserves. In a serious panic the liquidation of obligations has to work itself out. Then the industrial process starts afresh, with lowered values imputed to capital goods and to business opportunities, and with property rights shifted, in some measure, to creditors.

Crises seem to be unpreventable so long as competition and the credit system dominate in industry. Yet there are some recent developments that may make them less frequent, and possibly less serious.

The "integration of industry," whereby a whole series of productive processes, from the production of the raw material to the sale of the finished product, are brought together under one management, decreases the number and complexity of credit relations between producers, and tends to prevent the undue expansion of those parts of the productive process that are farthest removed from the consumer. The strong position of the steel industry in the United States is a case in point.

The improvements in the bargaining power of wage earners resulting from their organization have enabled them partly to prevent the widening of the gap between wages and prices in prosperous times, as recent American statistics show. On the other hand, crop failures are and always will be a factor of uncertainty. The best way of softening the rigors of a panic and of restoring normal conditions promptly is through a wise use of the lending power inherent in a system of really elastic bank reserves, just as the best way of preventing panics is through a firm control of discount rates when all other conditions are ripe for a period of business inflation. It is in these ways, perhaps, that the new federal reserve system can best serve the country.

The relation of changes in the purchasing power of money to long-time debts and credits has some very important aspects. If prices increase, the principal of a loan represents less purchasing power at the time of repayment than at the time the loan was made. If prices decrease, the reverse is, of course, true. In periods of cheap-money agitations the additional burdens imposed upon debtors in a period of decreasing prices are emphasized. An important function of money, then, is found in its use as a standard of deferred payments.

There is a partial, but only partial, compensation for the injustice to debtors and creditors resulting from general changes in prices to the fact that the interest rate usually increases when prices increase and decreases when prices de-crease. This is largely because rising prices increase profits, thus inducing business men to pay higher interest rates in order to secure larger supplies of funds for investment; while falling prices decrease profits and lessen the demand for loanable funds. The result of this is that the changing purchasing power of the principal of a loan is to some extent offset or discounted by changes in the rate of interest. The decline in interest rates as prices fall makes it possible for debtors to pay off their old obligations with funds borrowed at a lower rate of interest. Creditors cannot so easily take advantage of the fact that interest rates are increasing when the purchasing power of the principal of their outstanding loans is decreasing. Nevertheless, more emphasis has been given to the question of the standard of deferred payments in periods of declining prices, when debtors are injuriously affected, than in periods of rising prices when creditors are the losers.

The United States is rapidly ceasing to be a "debtor nation," and the farmers in particular are becoming less distinctively a debtor class. We may expect, therefore, that in a future period of declining prices we shall hear less about the injustice of our variable standard of deferred payments.

Index Numbers.—General changes in prices are indicated statistically by the use of index numbers. An index number, in the most general sense, is some magnitude which varies with some other magnitude or complex of magnitudes, and whose variations can therefore be taken as representing or indicating the other variations. In studying the variation of the price of some specific thing we need no index number; but when we have to deal with the variations of many different prices we find the use of index numbers necessary.

The simplest way to form an index number of general changes in prices is first to select a list of things whose prices are to be taken into ac-count, next to ascertain the average price per unit paid for each of these things in each successive month or year of the period being studied, and finally to take the sum of these unit prices in each of a number of successive months or years as the index numbers. Such index numbers show the variations in the total expense of a purchase consisting of one unit each of the commodities included in the list.

Thus, if bananas of a certain grade sell at a certain time for 15 cents a dozen, oranges at 40 cents and peaches at 25 cents; and if a month later the prices are 20 cents for bananas, 50 cents for oranges, and 20 cents for peaches, the summed prices used as index numbers are 80 cents and 90 cents respectively. This means merely that the total money cost of a dozen each of these fruits has increased by 12% per cent.

For some purposes we get more significant results by weighting the specific prices in accordance with the relative importance of the different commodities. If, for example, we think that twice as many bananas as peaches were ordinarily used, and three times as many oranges as peaches, we may take as our weighted sum at the earlier date: 25 plus (2x.15) plus (3x.40), or $1.75. For the later date the weighted sum is $2.10, indicating a general rise of 20 per cent in the retail prices of this small group of commodities. Accurate weighting is thus of great importance in forming index numbers from a small list of price quotations. If a very large list of prices is used, weighting becomes of less importance, for there is no necessary connection between the importance of a commodity and the degree to which it has risen or fallen in price. Errors due to the lack of weighting or to imperfect weighting thus tend to offset each other. But even with a large and thoroughly representative list of prices, the highest degree of accuracy in index numbers cannot be reached without careful weighting.

Index numbers of prices and wages are available for the United States for the period since 1860, and some figures have been compiled for earlier years. For the period 1860-1880, Mitchell's are the best; the period from 1890 to the present is covered by the United States Bureau of Labor Statistics, and for the gap from 1880 to 1890 Falkner's are available. Several financial journals also publish tables of price changes.

Some writers have suggested the possibility of a tabular monetary standard, to be maintained by frequently changing the money unit in accordance with the showings of an officially kept system of index numbers. To do this by periodically altering the amount of bullion in standard coin would be impracticable, while to abandon the use of a standard commodity and to at-tempt to regulate prices by issuing flat money and controlling the amount in circulation would be, as we have seen, chimerical. A tabular standard of deferred payments might be put in operation by laws providing for the increase or diminution of the principal of debts according to changes in prices. It is probable, however, that this would be satisfactory to neither debtors nor creditors. Moreover, should the tabular standard of deferred payments be adjusted according to changes in wages and other incomes, or ac-cording to general changes in the prices of commodities and services? The really essential thing is to have a commodity standard of value that shall be as stable as possible, and to maintain the convertibility of all other forms of money with it.

With gold as the standard of value, and with all other forms of money redeemable in gold, changes in prices are not apt to be rapid enough to work much injustice to either debtor or creditor.

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