CHAPTER XIV

THE VOLUME OF TRADE AND THE VOLUME OF MONEY AND CREDIT

In the argument so far I have said nothing of the reverse relationship, the dependence of the volume of money and the volume of credit on trade. The two are indeed _inter_dependent. Interdependence suggests circular theory, and is often a phrase to cover circular reasoning.[313] In the case of the relation under discussion, however, I have, I trust, already abundantly protected myself against the charge of circular reasoning by _denying_ that either volume of money and credit on the one hand, or volume of trade on the other hand, is a true cause at all. Both are mere abstract names, designating highly heterogeneous individual occurrences, which, _individually_ are cause or effect. In general, both volume of money and credit, on the one hand, and volume of trade on the other hand, are results of common causes, which are the _verae causae_ of economic phenomena--values, psychological phenomena. The whole thing is to be explained immediately and primarily in terms of social relationships and mental processes,--in terms of social values.

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

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

I have so far said nothing of the case where there are stocks of the money metal to be got from outside markets. But if a country is expanding its trade, does not money come in? The quantity theorists would, indeed, admit this, in general, though their reason is a bad one, namely: that expanding trade lowers prices, and lower prices make the market attractive to foreign buyers, who then send in money for the goods. I shall later discuss this aspect of the theory.[314] For the present, I merely interject the question as to the probability of an expansion of trade when prices are falling. Increasing _stocks_ of particular goods may well mean lower prices for these goods and if they be articles of export the lower prices may well increase the export trade, and bring money in. But this increase in _stocks_ of articles of _export_ is very different from total _trade_ within the country; and lower prices in articles of export are very different from a generally lower price-level.[315]

Will expanding trade in a country increase credit? I come here to one of the striking features of Fisher's doctrine--a feature in which I think he is fundamentally true to the quantity theory. He finds no way in which expanding trade can directly increase credit. Expanding trade can increase credit, (a) only by changing the habits of the people, so as to alter the ratio, M to M', or (b) by reducing the price-level, and so bringing in money from abroad, whence, as M is now increased, M' rises proportionately. "An increase in the volume of trade in any one country, say the United States, ultimately increases the money in circulation (M). In no other way could there be avoided a depression in the price-level in the United States as compared with foreign countries. [He should say, from the standpoint of his theory, that increasing trade will cause a fall in the price-level, and so bring in more money.] _The increase in M brings about a proportionate increase in M'._[316] Besides this effect, the increase in trade undoubtedly has some effect in modifying the habits of the community with regard to the _proportion_ of check and cash transactions, and so tends somewhat to increase M' relatively to M; as a country grows more commercial the need for the use of checks is more strikingly felt."[317] In a footnote to this paragraph, he defines the issue still more sharply. "This is very far from asserting as Laughlin does that 'The limit to the increase in legitimate credit operations is always expansible with the increase in the actual movement of goods'; see _Principles of Money_,[318] New York (Scribner), 1903, p. 82. We have seen, in Chapter IV, that deposit currency is proportional to the amount of money; a change in trade may indirectly, _i. e._, by changing the _habits_ of the community, influence the proportion, but, except for transition periods, it cannot influence it directly."[319]

My own explanation of the causal sequence whereby expanding trade brings money into a country would be radically different from that given by Fisher in the first quotation. I should expect, first, that rising _prices_ would encourage rising trade; I should then expect the rising volume of trade, with higher prices, to lead borrowers to need, and secure, larger loans from the banks, with, as loans and deposits rise in proportion to reserves, some slight increase in "money-rates," just enough to draw to the country the extra gold which bankers felt desirable to add to their reserves. I should expect the causal sequence to be the exact reverse of that which Fisher indicates. With falling prices, or waning volume of trade--which would usually come together,[320]--I should expect loans to be reduced, deposits to be reduced, money-rates to fall, and gold then to leave the country again. I should expect this sort of thing to happen normally, and not infrequently, and I should expect gold to come in and go out many times in the course of a business cycle. This would seem to be the sort of explanation which our modern theory of _elastic_ bank-credit would give in connection with this problem. I shall not here go into details with the theory of elastic bank-credit. The theory has been too well established in the debates between the "Currency School" and the "Banking School"[321] in regard to bank-notes to need elaboration and defence here, and the essential identity of deposits and elastic bank-notes from this angle is one of the commonplaces of the literature of banking. What I am here concerned with is the highly significant fact that Fisher's "normal" theory finds no place for this highly important phenomenon. The quantity theory has no explanation of elasticity to give. On the basis of the quantity theory, and for all that the quantity theory can say, the Currency School was right! Fisher offers us, virtually, a "currency theory" of deposits. "Suppose, as has actually been the case in recent years, that the ratio of M' to M increases in the United States. If the magnitudes in the equations of exchange in other countries with which the United States is connected by trade are constant, the ultimate effect on M is to make it less than what it would otherwise have been, by increasing the exports of gold from the United States or reducing the imports. In no other way can the price-level of the United States be prevented from rising above that of other nations in which we have assumed this level and the other magnitudes in the equation of exchange to be quiescent." (P. 162.) If "bank-notes" be substituted for "M'", in this quotation, we have here a perfect statement of the position of the "Currency School" in that great debate. Must this old issue be fought all over again? And yet, I defy any consistent quantity theorist to find any flaw in Fisher's argument on this point. There is no place for a theory of elastic bank-credit within the confines of the quantity theory. Fisher's recognition of this seems full and complete. He relegates all mention of elastic bank-credit to "transitions." The footnote quoted above, in which Laughlin's (somewhat extreme) doctrine based on the theory of elasticity is stated, denies categorically that there is any validity in it, except for transition periods. There is nowhere in the book any explanation of the theory of elasticity.[322] The references to it are few and grudging, and _always_ in connection with the notion of transitions. The most important statement regarding elasticity (less than a page long) is on page 161, where again transitional influences are under discussion. What is a theory of money worth which can offer no explanation of so fundamental, important, and notorious a feature of modern money and banking?

There is a further, related, feature of banking for which the quantity theory can find no explanation. Among the items in a bank's balance sheet, the quantity theorist seizes upon reserves on the assets side, and deposits on the liability side, and builds his theory on the supposed close relation between them. We have seen that this close relation does not, in fact, exist. The range of variation is enormous.[323] But there is one close relation in the balance sheet of the bank concerning which the quantity theory is silent, and that is the relation between deposits and _loans_. For individual banks and for banks in the aggregate, for long run periods and for short run periods, for reasons that are clear and inevitable, these two magnitudes (or for banks of issue on the Continent of Europe, _notes_ and loans), vary closely together. The relationship between them is the only relationship which does stand out as clearly beyond dispute, among all the items in the banking balance sheet. No assumptions of a "static state" are needed for its demonstration! The relation varies, of course. As banks increase or reduce their capital, as their reserve-percentages rise or fall, as they increase or decrease their holdings of bonds, we find reasons which alter the proportion between deposits and loans. But, despite this, the variation, as shown by figures for the United States, is slight. Assume, for example, a statement showing "loans and discounts" of $1,000,000, deposits, $1,000,000, cash reserve, $200,000. Reserves are then 20% of deposits, and loans are 100% of deposits. If reserves be increased by $100,000 and loans and discounts reduced, to compensate, by $100,000, we have a 50% variation in the ratio of reserves to deposits, with only a 10% variation in the ratio of loans and discounts to deposits. Since cash reserve is much the smaller item, almost always, the same absolute variation in it will affect it, in percentage, vastly more than it will affect loans and discounts. It is strange that a theory should seize on this highly variable ratio of reserves to deposits, and ignore the much more constant ratio[324] of loans and discounts to deposits.

That this close relation between deposits and loans should obtain follows naturally from the theory of elastic bank-credit. The two are built up together. When there are expanding business and rising prices, men borrow more from the banks; as they borrow, they receive deposit credits; the individual who receives the deposit credit may check against it, but it is redeposited by another man, and so, while the deposits of one bank need not grow out of its loans, still, for banks in general, deposits are large because loans are large. For a given bank, the relation holds closely, because the bank lends, in general, to active business men, who will have income as well as outgo, and whose income will, on the average, at least balance their outgo. Thus, _through loans_, deposits are linked with volume of trade and prices. Trade and deposits wax and wane together.[325] On the other hand, in the absence of rising prices and increasing trade, reserves may increase greatly without forcing an increase in deposits. Loans cannot increase without an increase in deposits. The linkage between deposits and trade is definite, causal, positive, statistically demonstrable. The linkage between reserves and deposits is, at most, negative--if reserves get too low, deposits and loans may be checked in their expansion. But this--to the extent that it is true, which we leave, for detailed analysis, for