Readings in Money and Banking Part 21

It is in this principle, that there is a natural limit to the possible drain upon the exchange funds, that the security of the new system lies.... It is only the supply of local currency on the margin of possible export demands which needs to be safeguarded. The substratum, which can never leave the country unless under the influence of an almost inconceivable economic cataclysm, is a.n.a.logous in some respects to the "authorised" circulation of the Bank of England. It represents the irreducible minimum below which the local need for currency can never fall. If the supply on the margin of the international exchange movement is adequately guarded, then the whole system is secure. If it were conceivable that the demand for exchange would equal the whole amount of the local currency, or even the half of it, then it would be necessary to maintain exchange funds equal to the whole amount of token coins or the half of them in order to insure safety. But obviously this could never be the case.

This argument against the exchange standard is only a repet.i.tion of the dilemma sometimes presented by untrained minds in regard to bank-notes: what would happen if all the notes should be presented at one time for redemption? That question has been answered by banking experience; the question in regard to the gold exchange system has been and must be answered by experience in substantially the same manner. No country can be subjected to such stress as to consent to part with its entire monetary circulation, or even the half of it. On the contrary, every influence which tends to contract the circulation tends to create a condition which makes further contraction more difficult. Rates for the loan of money are affected, prices of imported goods are influenced, imports fall off and exports increase, and inevitably in the modern money market local equilibrium is restored, often with considerable strain, but none the less without pulling down the pillars of the financial temple.

The experience of last spring in India proves the adequacy of a reserve of 15 or 20 per cent. of the circulation to maintain the steady parity of a token coinage. There is apparently no evidence that serious distrust of the rupee arose, even when the Government was hesitating as to just what steps should be taken to meet the demand for exchange. Even if such distrust had arisen, however, it could have expressed itself through financial channels only by the demand for drafts on London.

These would not have been very valuable to the average local tradesman except as he was able to sell them back again to the banks for the very rupees which had aroused his distrust. In this respect the gold exchange standard may be said to put a brake upon the disposition to export currency from fear alone, when the exportation is not demanded by the balance of trade.

If any mistake was made in the management of the Indian currency, it was in the investment of too large a proportion of the gold standard reserve in securities. While investment in securities is naturally attractive because of the income earned, and while it is not subject to just criticism while kept within certain limits, the possession of actual gold to a considerable amount is highly desirable. It would not be necessary, perhaps, that such gold should be "earmarked." If the Indian Government had a large deposit account in such an inst.i.tution as the Union of London and Smith's Bank, or the London City and Midland, it would possess for the purposes of the Indian Government the character of gold. Drafts against such a deposit could be sold without the discount or delay which might be required in disposing of securities. It seems highly desirable, therefore, in spite of the prudence with which the recent pressure was met, that at least 30 or 40 per cent. of the gold standard reserve should in the future be kept either in "earmarked" gold or in the form of demand deposits.

In the case of the Philippine Islands the reserve is not "earmarked,"

but is at present entirely in the form of deposits with New York bankers. The problem in the Philippines is really child's play compared to that in British India. The entire circulation of the Philippine Islands is about 40,000,000 pesos (4,000,000), against which a large reserve has acc.u.mulated as the result of the recoinage at a reduced rate as well as by the profits on the original coinage. It is hardly conceivable that an emergency would arise which would impair this reserve; but if this should occur, the scratch of a pen in Was.h.i.+ngton would remedy the situation. This would be accomplished by depositing gold or its equivalent in the exchange fund in New York to the credit of the war and navy, and placing an equivalent amount of local currency at the command of the military forces in the Philippines. Such a deposit would operate to increase the resources at the command of military disbursing officers in the Islands without increasing the amount actually in circulation until the occasion arose to disburse it. The Panama currency has been steadily maintained at par by friendly interchanges of this sort, even with a very insignificant official exchange fund. No Governor of the Philippines, therefore, need have any fear of his ability to maintain the parity of the Philippine coinage.

Whether the exchange standard would stand the strain of a great war is yet to be subjected to practical test.[84] It may be said, however, that its capacity to meet such a test would run upon all fours with the capacity of any monetary system which does not consist exclusively of gold coin. The experience of France in the war with Prussia seemed to justify the suspension of specie payments for the purpose of husbanding the national stock of gold. The history of the Spanish exchange, where the coins have followed the value of the bank-notes instead of that of silver bullion, is another case in point. Both Russia and j.a.pan, however, in the war of 1904-5, succeeded in maintaining complete convertibility of their bank-notes. There is no reason why the gold exchange standard should not be successfully maintained so long as the country where it was established retained its national independence and pursued a sound financial policy. The issue of large amounts of debt would not in itself impair the stability of the standard, unless the Government, in order to obtain gold, ravished the exchange funds in financial centres. The questions involved would be substantially the same as those involved in maintaining the parity of bank-notes or paper money: first, the disposition of the Government to maintain its credit; secondly, the resources which the Government was able to command.

Without either good intentions or monetary resources, the monetary system, along with the fiscal system, would break down. It is not apparent, however, that a country operating upon the gold exchange system would find any greater difficulty in maintaining the system than the Bank of j.a.pan had in maintaining the convertibility of its notes during the war with Russia.

If there were a disposition in time of war to transfer capital abroad by excessive demands upon the exchange funds, it could be counteracted in three ways. One would be the automatic influence of the deficiency of currency which would arise at home. Another would be the issue of loans abroad, from which exchange demands could be met. A third would be the deliberate elevation by a small percentage of the charge for exchange.

This would amount to a slight depreciation in the currency, but if kept within prudent bounds, it would probably permit the maintenance of an adequate circulation without disturbance to local prices and without even a theoretical depression below the 2 or 2-1/2 per cent. which affected the notes of the Bank of France in the war of 1870.

The gold exchange system may indeed be said to be an extension of the bank-note system to token coins. The token coin is, in effect, a metallic bank-note, whose maintenance at gold par is subject to the rules of sound banking. Its advantages over the bank-note in undeveloped countries are that it conforms to a strong prejudice in favour of "hard money," not subject to the vicissitudes of tropical climes, and that the output can be more safely regulated, where new coins are issued only for gold, than where a bank may increase its note issues to take over a.s.sets of speculative or doubtful character. In the advanced countries, with a highly organised credit system, gold, and gold alone, is the proper form of full legal-tender coin; but in the less advanced countries of the Orient silver token coins have the advantage that they conform in size and denominations to the small scale of local transactions, that they are not so rapidly absorbed by h.o.a.rding, and that their very non-exportability enables the Government to keep in circulation a quant.i.ty of currency which might under a different system be drained away to richer countries, and leave the community denuded of an adequate medium for carrying on exchanges.

OBJECTIONS TO THE GOLD-EXCHANGE STANDARD FOR THE STRAITS SETTLEMENTS ANSWERED

[85]... the establishment of the gold standard in the Straits Settlements ... in the spring of 1903 ... provided for the recoinage of the British and Mexican dollars then circulating in the Malay Peninsula into new Straits Settlements dollars ... of the same weight and fineness as the British dollar, and for the subsequent raising of the value of these new dollars to an unannounced gold par by means of limiting the supply, in accordance with the principle by which India raised the gold value of the rupee....

The objections urged to the adoption of the gold-exchange standard are [were]: (1) That it would unduly interfere with the [foreign exchange]

business of the banks. (2) That it would encourage banks to work on dangerously low cash balances, knowing as they would that they could obtain dollars of the Government on a moment's notice by the purchase of cable transfers on Singapore from the crown agents for the colonies in London. (3) That there would be danger of the Government's notes [a part of the circulating medium] depreciating unless they were redeemable in gold in the country itself. (4) That the monetary circulation of the Straits Settlements was too small to make the plan feasible there. (5) That the plan would require a larger reserve fund than would otherwise be necessary, because the Government would be compelled to keep a reserve both in London and Singapore; and that in each place the reserve would have to be large, because drafts on the fund through the sale of telegraphic transfers would not give the Government any such warning in advance of the demands liable to be made as would enable it to replenish the reserve.

The above arguments, all of which were urged upon the writer either by officials or business men in the Straits Settlements, do not appear to be conclusive for the following reasons, which may conveniently be stated in the same order as the objections.[86] (1) If the rates for the sale of government drafts were fixed at the "gold points," as they presumably would be under the gold-exchange standard, and if only drafts of large amounts were to be sold by the Government, redemption by the sale of drafts would not interfere appreciably more with the business of the banks than would redemption in coin. Under these circ.u.mstances the banks themselves would be the princ.i.p.al purchasers of government drafts, and such drafts would be purchased and forwarded merely in lieu of the s.h.i.+pment of sovereigns. (2) The sale of telegraphic transfers, while desirable in the interest of currency elasticity, is by no means a necessary feature of the gold-exchange standard. If the Government were opposed to making a minimum legal reserve requirement of banks, it could limit its sales of drafts to demand drafts or even, if need be, to short-time drafts. (3) If government notes were redeemable in silver dollars on demand, and if the silver dollars were redeemable in gold exchange on demand, depreciation would be impossible in a country where the people have the confidence in the Government which they have in the Straits Settlements. (4) The system of the gold-exchange standard is better suited to a country with a small circulation than to one with a large circulation. It is evidently easier to maintain a small reserve abroad than a large one and the operations with a small reserve are less disturbing to the money market of the financial center in which the reserve is located. (5) It is not probable that the Straits Settlements would require so large a reserve under the gold-exchange standard as it will under the system to be adopted. Under either system it would need a sovereign reserve and a dollar reserve. Under the system to be adopted both reserves will be located in Singapore; under the gold-exchange standard the dollar reserve would be located in Singapore and the sovereign reserve in London. The sale of cable transfers is not a necessary part of the system, as above pointed out; and, even if it were, the movement of market rates of exchange would ordinarily give ample warning of a demand for dollar drafts or sovereign drafts.

Emergency cases, if such should arise, could be met through the temporary transfer of funds to the gold reserve from the security portion of the note guarantee fund, or through the transfer of dollars to the credit of the home government in Singapore in exchange for an equivalent amount of sovereigns placed to the credit of the Straits government in London.... A prolonged and severe drain upon the reserve fund, which in a country like the Straits Settlements would be an extremely improbable contingency if the Government withdrew from circulation dollars presented in the purchase of government drafts, could of course always be met by the forward sale on the London silver market of the redundant dollars piling up in the Government's dollar reserve in Singapore. The gold-exchange standard would probably enable the country to get along with a smaller gold reserve than will the system to be adopted, inasmuch as it would keep gold coins out of circulation and the demands upon it would be limited to the requirements of meeting foreign trade balances--the only monetary use to which the dollars could not be applied. The Straits Settlements, inasmuch as it is a country for whose trade requirements silver coins are better adapted than gold, and a country which is anxious to maintain its reserve at as small an expense as possible, would in fact seem to be a place peculiarly adapted to the gold-exchange standard. The premiums which the Government would realize on its sale of exchange, together with the interest it would obtain on that part of its reserve deposited abroad, would doubtless yield sufficient profit, as in the Philippines, to pay the expenses of administering the currency system and to provide in addition a substantial annual increment to the gold reserve.

FOOTNOTES:

[80] Charles A. Conant, _The Gold Exchange Standard in the Light of Experience, The Economic Journal_, Vol. 19, June, 1909, pp. 190-200.

[81] _Le Marche Financier en 1907-8_, p. 711.

[82] These figures are from the annual budget statements of the Minister of Finance.

[83] For some of these doubts see _London Bankers' Magazine_, October, 1908, Lx.x.xVI, p. 435.

[84] Throughout August, 1914, while sterling rates in other countries rose to unprecedented heights, India succeeded in maintaining rates on London in the neighborhood of the gold export point--a striking testimony to the soundness of the Indian arrangements.--EDITOR.

[85] E. W. Kemmerer, _A Gold Standard for the Straits Settlements II., Political Science Quarterly_, Vol. XXI, No. 4, p. 663, 678-680.

[86] The answers given to the objections just stated have been confirmed and strengthened by the actual operation of the gold-exchange standard as later adopted by the Straits Settlements.--EDITOR.

CHAPTER XIII

A PLAN FOR A COMPENSATED DOLLAR

[87]In the _Purchasing Power of Money_ (1911) I sketched a plan for controlling the price level, _i. e._, standardizing the purchasing power of monetary units. This plan was presented more briefly, but in more popular language, before the International Congress of Chambers of Commerce, at Boston, September, 1912. The details were most fully elaborated in the _Quarterly Journal of Economics_, February, 1913.

Following these and various other presentations of the subject, especially the discussion at the meeting of the American Economic a.s.sociation in December, 1912, the plan was widely criticized by economists, both favorably and unfavorably, as well as by the general public.

On the whole the plan has been received with far more favor than I had dared to hope and even the adverse criticism has usually been tempered by a certain degree of approval.

The object of the present paper is briefly to state the plan and to answer the more important and technical objections which have been raised. Answers to the more popular objections, omitted from this article through lack of s.p.a.ce, will appear in a book, _Standardising the Dollar_, which I hope to publish in 1915.

I shall begin with a skeleton statement of the plan; s.p.a.ce is lacking for more. In brief, the plan is _virtually_ to vary each month the weight of the gold dollar, or other unit, and to vary it in such a way as to enable it always to have substantially the same general purchasing power. The word "virtually" is emphasized, lest, as has frequently happened, any one should imagine that the actual gold coins were to be recoined at a new weight each month. The simplest disposition of existing gold coins would be to call them in and issue paper certificates therefor. The virtual gold dollar would then be that varying quantum of gold _bullion_ in which each dollar of these certificates could be redeemed. The situation would be only slightly different from that at present, since very little actual gold now circulates; instead, the public uses gold certificates, obtained on the deposit of gold bullion at the Treasury, and redeemable in gold bullion at the Treasury at the rate of 25.8 grains, nine-tenths fine, per dollar. The only important change which would be introduced by the plan is in the redemption bullion; we would subst.i.tute for 25.8 a new figure each month. The gold miner, or other owners of bullion, would, just as now, deposit gold at the United States Mint or Treasury and receive paper representatives, while the jeweler, exporter, and other holders of these certificates would, just as now, present them to the Treasury when gold bullion was desired.

There would also be a small fee or "bra.s.sage," of, say, 1 per cent. for "coinage," _i. e._, for depositing the bullion and obtaining its paper circulating representative. In other words, the Government would buy gold bullion at 1 per cent less than it sold it. This pair of prices, for buying and selling, would be s.h.i.+fted in unison, both up or both down, from month to month, it being provided, however, that no single s.h.i.+ft should exceed 1 per cent., a figure equal to the amount by which the two differ. The object of this proviso is to prevent speculation in gold.

To determine each month what the pair of prices should be, or, what is practically the same thing, to determine what amount of gold bullion should be received and paid out in exchange for paper, recourse would be had to an official index number of prices. If, in any month, the index number is found to deviate from the initial par, the weight of bullion in which it shall be redeemable the next month is to be corrected in proportion to this deviation. Thus, the depreciation of gold would lead to a heavier virtual dollar; and an appreciation, to a lighter virtual dollar.

There are, of course, other details and possible variants of the plan, some of which will be referred to later when necessary. The objections to the plan are cla.s.sified under the following heads:

1. "_The plan a.s.sumes the truth of the quant.i.ty theory of money._" There is nothing whatever in the plan itself which could not be accepted by those who reject the quant.i.ty theory altogether. On the contrary, the plan will seem simpler, I think, to those who believe a direct relations.h.i.+p exists between the purchasing power of the dollar and the bullion from which it is made--without any intermediation of the quant.i.ty of money--than it will seem to quant.i.ty theorists.

2. "_It contradicts the quant.i.ty theory._" This objection, the opposite of that above, is raised by some, who, like Professor Boissevain, believe in the quant.i.ty theory, but imagine that the operation of the plan could not affect the quant.i.ty of money at all (or would not affect it to the degree needed). But evidently an increase in the weight of the virtual dollar, _i. e._, a reduction in the price of gold bullion, would tend to contract the currency, by diverting gold from the mint into the arts; because its reduced price would cause an increased demand and consumption. A decrease, of course, would have the opposite effect.

3. "_It might aggravate the evils it seeks to remedy._" This objection, raised by Professor Taussig and a few others, is based on the preceding.

It is claimed that an increase in coined money may take place for years "without visible effect on prices; then comes a flare-up, so to speak."

I doubt if Professor Taussig meant the first half of this statement to be quite so strong. The evidence only justifies the statement that the rise is slow at first and rapid later while similarly the effect of a scarcity of money is slow at first and rapid later. Professor Taussig then proceeds to apply the same idea to my plan:

The c.u.mulative consequence would be like the c.u.mulative consequence of a long continued decline in gold production.

After a season or two of declining bank reserves, tight money, and so on, a sudden collapse might be occasioned, and apparently caused, by the announcement of some particular seigniorage adjustment. Then there might be a decline in prices much greater than in proportion to the bullion change.

But the working of the compensated dollar would not be in the least a.n.a.logous to the operation of gold inflation or contraction, even as Professor Taussig supposes it. The plan always works c.u.mulatively _toward_ par, never c.u.mulatively _away from_ par. One often sees a wagon with its wheels on a street-railway track having some difficulty getting off; the front wheels have to be turned at a large angle before they are forced out of their grooves; then of a sudden they jump away. This is a.n.a.logous to the delayed "flare-up" of prices which Professor Taussig supposes under the influence of a long continued decline or increase in the gold supply. But if the driver instead of trying to turn out is trying to keep the wagon on the track he will pull the horse back at every tendency to turn to the right or left. The more the horse turns to the right the harder will the driver endeavor to turn him to the left.

Clearly the effect of the driver's efforts will be to avert or delay, not to aggravate or hasten, any jumping out of the grooves which other causes may tend to produce.

In other words, if it takes as much time as Professor Taussig fears for a pressure on prices to move them, then so much the more certain is it that, under the plan, deviations from par, though they may be persistent, cannot be either rapid or wide. A long continued small deviation gives plenty of time for the counter pressure exerted by the compensating device to acc.u.mulate and head off any wide deviation.

Suppose that, following Professor Taussig's ideas, some cause such as an increase of gold production would, in the absence of the compensated dollar plan, gradually lift the price level as follows: during the first year, not at all; during the second year, 1 per cent.; during the third year, 2 per cent.; after which would come a "flare-up" of 10 per cent.

We may suppose then that, if the plan were in operation during the first year, there being no deviation visible, there would be no change in the weight of the dollar. After the first month of the second year when prices were 1 per cent. above par, the weight of the dollar would according to the plan be raised 1 per cent. If this were unavailing, so that in the second month the deviation were still 1 per cent., the weight of the dollar would be again increased 1 per cent. Every month, as long as the deviation of 1 per cent. lasts, the weight of the dollar would receive an _additional_ 1 per cent. Unless some effect were produced on the supposed original schedule of deviations, the weight of the dollar of the second year would be increased 12 per cent., and by the end of the third year by 24 per cent. more, or 36 per cent. in all.

But it is clear that by this time, with so swollen a dollar, the "flare-up" scheduled for the fourth year could not occur, but that a counter movement would set in--in fact, would have set in long before the dollar became so heavily counterpoised. Nor could the result of the counterpoise, even if so heavy, be to swing suddenly prices far below par. Prices would, by hypothesis, yield slowly and again give time for taking the counterpoise off. If the price level sank, say to 1 per cent.

below par for six months, then to 2 per cent. for another six months and to 3 per cent. in the next six months, evidently the entire 36 per cent.

would be taken off in eighteen months (since 1 6 + 2 6 + 3 6 = 36). The compensating device is thus similar to the governor on a steam engine. It is the balance wheel that is largest and hardest to move which is the most easily controlled by the governor. So if the "flare-up" theory is true, the system will work more perfectly than if it were not true.

4. "_It would not work unless every single mint in the world employed it._" This is an error. Although it could be easily shown to be politically inadvisable for one nation alone to operate the plan, this would not be economically impossible. Those who hold the contrary are deceived by the term "mint price." They reason that our mint price ($18.60 an ounce of gold, 9/10 fine) and England's mint price (3 17_s._ 10-1/2_d._ for gold 11/12 fine) are now "the same," and that, consequently, if our price were lowered 1 per cent., _i. e._, to $18.41, while the English price remained unchanged, _all_ our gold would be taken to England to take advantage of the "higher" price there. But these comparisons between English and American prices are based on the present "par of exchange" ($4.866 of American money for the English sovereign): which par of exchange is in turn based on the relative weights of the dollar and the sovereign. As soon as our dollar were made 1 per cent. heavier, not only would the new American mint price go down 1 per cent., but the par of exchange would also go down 1 per cent., to $4.82. Consequently, the new mint price of $18.41, although in figures it is lower than the old, yet, being in heavier dollars, would still be "the same" as the English mint price of 3 17_s._ 10-1/2_d._ This sameness of mint price as between the two countries means at bottom merely that an ounce of gold in America is equivalent to an ounce of gold in England.

It is true that each increase in the weight of the virtual dollar in America--in other words, each fall in the official American price of gold--would at first discourage the minting of gold in America. The miner would _at first_ send his gold to London, where the mint price was the same as formerly, and realize by selling exchange on the London credit thus obtained. But the rate of exchange would soon be affected through these very operations, by which he attempted to profit, and his profit would soon be reduced to zero; the export of gold to England would increase the supply of bills of exchange in America drawn on London and lower the rate of exchange until there would be no longer any profit in sending gold from the United States to England and selling exchange against it. When this happened it would be as profitable to sell gold to American mints at $18.41 per ounce as to s.h.i.+p it abroad; and $18.41 in America would be the exact equivalent at the new par of exchange ($4.82) of the English mint price of 3 17_s._ 10-1/2_d._

5. "_The system would be destroyed by war._" Professor Taussig fears that if money were stabilized, the system would itself be upset by war.

"Any war would put an end to it." To this I would reply: first, that if war did put an end to it the system would do good so long as it lasted and its discontinuance would do no more harm than the existence of our present unscientific system is doing at all times; secondly I do not see any reason for thinking that war would put an end to it.

Possibly Professor Taussig has in mind the first form in which I explained the plan, _viz._, in my book, _The Purchasing Power of Money_.

In that form one country was to serve as a centre and all other countries were to have the gold exchange standard in terms of gold reserves in the central country, just as now the Philippines have a gold exchange standard with reference to the United States and India with reference to England. Professor Taussig's objection would undoubtedly apply, to some extent, in cases where the plan was carried out through the gold exchange mechanism. But where the system was independently established in each country simply parallel to the systems in other countries, there would be no more need for its abandonment in case of war than for the abandonment now by Germany of the gold standard because England, its enemy, has the gold standard also. We know, of course, that in time of war, the gold standard is often temporarily abandoned in favor of a paper standard; and the new proposal would not escape such a difficulty. This, however, would not be due to the international character of the plan, but to the exigencies of war.