Readings in Money and Banking Part 14

1. What is the amount of money rendered unnecessary by the use of credit paper?

2. What is the influence of the vast volume of credit transactions on the value of money or the level of prices?[41]

3. Why is it that our per capita circulation is so large and where is the money in active circulation?...

1. We will take these questions up in order.... No one can say ... with definiteness what is the amount of money released if 75 or 80 per cent.

of our business transactions are settled by means of credit paper. This is a matter in which the long experience of practical bankers is the only safe guide, because the amount in question is changing from day to day as the conditions change. No simple rule about it can be laid down....

One point needs to be carefully borne in mind. However great the volume of credit exchanges, however extensive the use of credit may become in a community, they can never fully displace sales for direct money payment.

The extensive use of credit is not of itself a sign that a community is well off. Credit is used in poor as well as in rich communities. Its extensive use in a poor and undeveloped country is likely to indicate a lack of capital rather than an abundance of wealth. Every community tends to use the cheapest medium of exchange accessible to it. If its capital is of very high value for producing goods for direct consumption, a community will be averse to investing much of it in a medium of exchange.

This is the reason why undeveloped countries, as our own was a century ago, try to effect their exchanges by means of credit paper to a larger extent than wealthier communities. Under such conditions paper money is commonly thought to be the cheapest medium of exchange. If, now, part of the money exchanges are replaced with credit exchanges, the amount of money released, or the amount without which the community could now get on, would be the whole amount formerly used in money payments ... minus the reserve necessary to do this credit business. The important point, however, is that less money is necessary. How much less we can not be sure. We can get some light on the subject, however, by noting the volume of business done by credit paper and the balances which from time to time are carried as a basis of settlement.

It is important to note also that an increase in the volume of credit transactions does not necessarily mean that we must get a proportionate increase in our reserve of money. Every refinement of the credit mechanism makes it possible to do a larger volume of business on the same reserve....

The volume of business that can be done by credit paper depends on several circ.u.mstances. Obviously, in the first place, it depends upon the banking facilities of the country. If the banks are widely distributed, if they are willing to deal in transactions small enough to be within the reach of large numbers of people, many more transactions will be settled through them than would otherwise be the case. This fact undoubtedly explains in large measure the development of what may be called the "banking habit" among the people of the United States.

Undoubtedly our people pay by check much more commonly and much more largely than people of any other country. We settle smaller transactions by check; our banks are willing to carry smaller accounts. Indeed, the rapid industrial development of our country is probably due in no small degree to our system of independent banks and the facility with which we have permitted banks to be established. The small independent bank in the country community has felt that its interests and success were bound up with the interests and success of the community, and, therefore, has undoubtedly been willing to do more for the general interests than a branch of a large bank in some remote commercial center would have felt like doing, even if it had been justified in doing so. The small capital with which we have permitted banks to be established also has undoubtedly been a contributing factor to our rapid economic development, as well as to the promotion of the banking habit among our people.

In the next place, the density of population is, of course, an important factor for the growth of credit exchanges. A larger volume of business is settled by bank paper in a commercial center than in an agricultural community, even though the proportion of total business thus settled may not be larger. However, it is necessary that there should be a certain number of people within reach of a common center in order to have a bank established there. Of course the smaller the bank the fewer the people thus required. Thus again our inclination in the past to favor the establishment of the small independent banks has facilitated the spread of banking and promoted the volume of business settled in the country districts by credit payment and stimulated the banking habit among our people.

Finally, the general education and intelligence of the ma.s.s of the people is an important factor. Men do not use banks unless they have confidence in them, and they have come to be regarded as a settled part of the ordinary commercial mechanism of the community. Our people are people of a wide general education and high order of intelligence. They understand the place and work of the bank in a community much better than the same number of people, for example, in a European country. This fact is strikingly brought out by a study of the proportion of retail business settled by means of checks, in what are called the "foreign"

districts of our large cities, on the one hand, and in an agricultural community on the other. The European immigrant is not a man who has had banking connections in his home country, and he does not use them here, even though the facilities are more numerous.

Such evidence as there is seems to indicate that payment by check has shown an increase during the past few years:

(a) In the first place, the returns of our reports show a larger percentage in retail trade....

(b) The prosperity of the farmers in the Central West has enabled many to have bank accounts who fifteen years ago could not carry balances.

The writer's information from central Illinois is strongly in this direction.

(c) The third evidence is found in the growth of the number of small banks, especially in the country districts....

(d) The appearance of a considerable proportion of checks in the deposits of mutual savings banks is also, to some degree, significant....

On the other hand, the increase of that part of the population which consists of the wage-earning cla.s.s, by whom the use of checks is small, is undoubtedly greater than that of our other cla.s.ses of population.

However, the wealthy cla.s.ses, though fewer in number, have more to spend and their use of checks raises the proportion of credit paper in payments.

We can not expect any social movement to continue steadily in one direction for an indefinite time. Such evidence as inquiries of this character furnish seems to show that there is a certain ebb and flow in the proportion of checks used in business payments. With a given amount of money a certain proportion of it can be used for bank reserves on which to build credit transactions. For a time the volume of business will increase more rapidly than the money supplies, so that the proportion of credit business to the whole will increase, the improvement of the credit machinery in the meantime facilitating the movement. But the perfection of the facilities for utilizing to the utmost a given reserve, or a slowly increasing one, will come to a stop after a time, and it will be necessary to increase the money supply for any further expansion of credit. In the language of business, another unit of capital must be added to plant. The unit added to the social capital devoted to exchange--that is, the additional amount of money--will be larger than is necessary for most profitable immediate use, consequently the proportion of money exchanges will for a time show an increase. We may conclude, therefore, that the volume of business done on credit gradually increases as the population and total amount of business are enlarged, but at a decreasing rate and with occasional or periodic r.e.t.a.r.dations.

2. _Relation of credit exchanges to the volume of money and prices._--It is pertinent to inquire, now, what effect, if any, this great settlement of indebtedness by means of credit paper has upon the value of money.

Evidently, it can influence this value, or the general price level, only as it changes the amount of demand for money. We have seen reason, now, to think that 80 per cent. of our business transactions are settled by means of credit paper. Credit paper cancellation enables a larger amount of business to be done with the same amount of money and has an effect in determining the value of money by increasing the demand for reserves....

... The use of credit paper in effecting credit exchanges makes possible a far larger volume of business than could otherwise be done, and that this increased volume of business must in some way influence prices seem[s] undeniable....

... We are told by many that there is a vast amount of credit transactions embodied in banking and clearing-house statistics which may be termed "fict.i.tious." That is to say, they are not a part of the necessary work of exchange in a community. For example, the cotton and wheat crops are sold several times over on the exchanges of the country, but not all these purchases and sales are a necessary part of the process of getting the cotton from the planter to the manufacturer.

These sales, we are told, are purely speculative and born out of the credit organization, which, it is urged, merely makes the transactions possible.... However,... these exchanges actually exist. All the purchases involved const.i.tute a part of the demand for means of settlement. Therefore they are to be regarded as a proper part of the exchange business of the country, and in some degree they must influence the need for money....

... The demand for money to effect exchanges includes, first, demand for money for direct exchanges; second, demand for reserves for credit exchanges. Some goods exchange by direct barter and still more probably by indirect barter. If these last exchanges just cancelled one another, the credit paper that grows out of them would also cancel, and no balances would remain to be settled with money. Usually, however, they do not cancel, and the balance must be settled with cash; hence a reserve is necessary.... This demand for reserve is certainly one of the influences that go to determine the value of money. In short, the demand for money includes a demand for direct payment and a demand for reserve....

3. _Our monetary circulation._--Our per capita circulation, as estimated by the Comptroller of the Currency, has increased from $21.10 in 1906 to $34.72 in 1908.[42] This is larger than the per capita circulation of other great industrial and commercial countries with the exception of France. Why is it necessary and where is it? It is necessary, perhaps, for the following reasons:

(a) A larger amount of money is needed in this country because, in the first place, our prices range higher. If the prices of articles commonly consumed range 20 per cent. higher than they do abroad, the people who buy them and pay for them with money need a larger amount to make their purchases. The same cause makes a larger reserve necessary to exchange a given volume of goods by credit. The demand for money, therefore, both for reserve and direct money transactions, is greater on account of the higher scale of prices.

(b) The same kind of reasoning applies to our wage scale. Whether the wage scale be the cause of the higher cost of living or the higher cost of living be the cause of the higher wage scale, more money will be needed in proportion to the trade. If wages are paid with checks, more money will be needed by the amount that the reserve must be increased to furnish a basis for the checks.

(c) Our country is more spa.r.s.ely settled than England, France, or Germany. In spite of the large increase in the banking facilities of the country, it still remains true that very many places are remote from banks, so that business, so far as it is not barter, will probably be carried on with money. It is necessary, therefore, to have a larger amount of money than if population were denser....

(d) It may be that our spirit of individualism plays some part. So large a proportion of our wage-earning population have come from conditions where they had opportunity to handle very little money, that they like to carry money on their persons. It makes them feel, as one man said to the writer, "more independent." To quote the same informant, they would "rather pay higher prices and have more money to pay with."

(e) Doubtless there is a good deal of h.o.a.rding by people who distrust banks or are not near enough to use them. It might be urged that no larger proportion of people here h.o.a.rd than is the case in Europe.

Without disputing this, it is true, however, that if only the same proportion h.o.a.rd and in the same relative amounts as is done by corresponding cla.s.ses of the population, the absolute amount thus withdrawn would be larger because of our higher scale of wages and prices....

FOOTNOTES:

[39] David Kinley, _The Use of Credit Instruments in Payments in the United States_, pp. 1, 2; 199-216. Senate Doc.u.ment No. 399. 61st Congress, _2d Session_.

[40] In this discussion the phrase "credit doc.u.ments" or "credit instruments" does not include bank notes.

[41] [The effect of credit exchanges on the value of money, treated at length in the next chapter, is only briefly discussed in the extracts here reproduced.]

[42] [Approximately $40 in 1916.]

CHAPTER XI

A SYMPOSIUM ON THE RELATION BETWEEN MONEY AND GENERAL PRICES

The form of this chapter was suggested by the proceedings of a session of the 1910 Meeting of the American Economic a.s.sociation, devoted to a consideration of the causes of the rise in prices between 1896 and 1909. Selections from papers there presented, and from the relative discussion, make up a considerable part of the chapter, and it is suggested that all of the selections, except the last, may well be considered for purposes of study as having come from the papers and discussion of the session referred to, although numerous additions and subst.i.tutions have been made in order to render the treatment one of principles involved in the determination of general prices without special reference to any particular period of years.

IRVING FISHER[43]: Overlooking the influence of deposit currency, or checks, the price level may be said to depend on only three sets of causes: (1) the quant.i.ty of money in circulation; (2) its "efficiency"

or velocity of circulation (or the average number of times a year money is exchanged for goods); and (3) the volume of trade (or amount of goods bought by money). The so-called "quant.i.ty theory,"[44] _i.e._, that prices vary proportionately to money, has often been incorrectly formulated, but (overlooking checks) the theory is correct in the sense that the level of prices varies directly with the quant.i.ty of money in circulation, provided the velocity of circulation of that money and the volume of trade which it is obliged to perform are not changed.

The quant.i.ty theory has been one of the most bitterly contested theories in economics, largely because the recognition of its truth or falsity affected powerful interests in commerce and politics. It has been maintained--and the a.s.sertion is scarcely an exaggeration--that the theorems of Euclid would be bitterly controverted if financial or political interests were involved.

The quant.i.ty theory has, unfortunately, been made the basis of arguments for unsound currency schemes. It has been invoked in behalf of irredeemable paper money and of national free coinage of silver at the ratio of 16 to 1. As a consequence, not a few "sound money men,"

believing that a theory used to support such vagaries must be wrong, and fearing the political effects of its propagation, have drifted into the position of opposing, not only the unsound propaganda, but also the sound principles by which its advocates sought to bolster it up.[45]

These attacks upon the quant.i.ty theory have been rendered easy by the imperfect comprehension of it on the part of those who have thus invoked it in a bad cause.

Personally, I believe that few mental att.i.tudes are more pernicious, and in the end more disastrous, than those which would uphold sound practice by denying sound principles because some thinkers make unsound application of those principles. At any rate, in scientific study there is no choice but to find and state the unvarnished truth.

The quant.i.ty theory will be made more clear by the equation of exchange, which is now to be explained.

The equation of exchange is a statement, in mathematical form, of the total transactions effected in a certain period in a given community. It is obtained simply by adding together the equations of exchange for all individual transactions. Suppose, for instance, that a person buys 10 pounds of sugar at 7 cents per pound. This is an exchange transaction, in which 10 pounds of sugar have been regarded as equal to 70 cents, and this fact may be expressed thus: 70 cents = 10 pounds of sugar multiplied by 7 cents a pound. Every other sale and purchase may be expressed similarly, and by adding them all together we get the equation of exchange _for a certain period in a given community_. During this same period, however, the same money may serve, and usually does serve, for several transactions. For that reason the money side of the equation is of course greater than the total amount of money in circulation.

The equation of exchange relates to all the purchases made by money in a certain community during a certain time. We shall continue to ignore checks or any circulating medium not money. We shall also ignore foreign trade and thus restrict ourselves to trade within a hypothetical community. Later we shall reinclude these factors, proceeding by a series of approximations through successive hypothetical conditions to the actual conditions which prevail to-day. We must, of course, not forget that the conclusions expressed in each successive approximation are true solely on the particular hypothesis a.s.sumed.