Sec. 7. The money-material in its commodity uses. We are now prepared to take up the question: What determines the ratio at which money exchanges for other goods? And, as money comes to be the unit in which prices are generally expressed, the question becomes: What determines the general level of monetary prices? We have this problem in its simplest form in the case of a commodity-money such as gold. It may be looked upon merely as so much precious metal. The problem of its value as bullion is the same as that of the value of pig iron or of zinc, of meat or of potatoes. There is here no special monetary problem. The value of gold as bullion and its value as money are kept in equilibrium by choice and by substitution. The several uses of gold are constantly competing for it: its uses for rings, pens, ornaments, championship cups, photography, dentistry, delicate instruments, and as a circulating medium. If the metal becomes worth more in any one use, its amount is increased there and is correspondingly diminished in other uses.[3]

When coinage is free and gratuitous[4] the standard money is a commodity. Such coinage is essentially but the stamp and certificate that the coin contains a certain weight and fineness of metal. Where coinage is free and gratuitous each coin will be worth the same as the bullion that is in it so far as the citizens exercise their choice. They will not long keep uncoined metal in their possession when it is worth more in the form of money, nor will they long keep money from the melting-pot when it is worth more as bullion. Yet there may be a slight disparity between the bullion value and the monetary value before the metal is converted into coin or the coin melted down into metal.

This adjustment of the value of commodity-money to other things is made also on the side of supply, in the use of labor and material agents to produce the precious metals and to produce other things. Gold-mining, for example, is one among various industries to which men may apply their labor and their available material agents. Some mines are superior, others medium, others marginal which it barely pays to work. There is, therefore, a rise and fall of the margin of gold production with changes in prices and changes in the cost of production. Large new deposits of gold are discovered from time to time and new methods of extracting gold are invented. If, when it barely pays to work a mine, such changes occur, gold becomes worth less, and the poorer mines eventually must go out of use. As gold rises in value some abandoned mines again come into use. A similar variation may be noted in the utilization of marginal land, marginal factories, marginal forges, and marginal agents of every kind.[5]

Sec. 8. The general level of prices. We come now to a more peculiar aspect of the monetary value problem. In performing its function as general medium of trade, money determines the general level of monetary prices. We have the idea of a general level of prices whenever we contrast the price ratio of money to other commodities at one time with its ratio at another time. Now the monetary prices of the various commodities are constantly changing, and in somewhat different degrees, but on the average there may be a general trend upward or downward, and this is called a change in the general scale (or level) of prices, as contrasted with changes in the values of any two commodities in terms of each other. The general price level will be more fully discussed below (Chapter 6, section 3) in connection with the method of measuring by index numbers its changes. This brief explanation may, perhaps, be enough for our present purpose. Our question now is: What is the effect of changes in the quantity of money (considered apart from chance accompanying changes) upon the general level of prices?

Sec. 9. Effect of increasing gold production. Let us take a case where gold is in general use as money, and where for some time there has been no noticeable change in the amount of business, the methods of trade, and the general scale of prices. What would happen when new gold mines were found that were much easier to operate, and gold began to be produced at a much more rapid rate than formerly? The amount of gold as compared with other forms of wealth evidently would be increased. What if all the increase went into the industrial arts? The value of gold in its industrial uses would fall. Then a part of the increase must be diverted to monetary uses. When any man, by reason of the increasing gold supplies, gets a larger stock of money than he had before, the proportion formerly existing between his use for money and his monetary stock is altered. He has more money than meets his monetary demand at the existing prices. As he seeks to reduce his stock of money to due proportions by buying more goods, he thereby distributes a part of the excess of money to others. This bids up the prices of goods further until the total value of goods exchanged again bears the same ratio as before to the average monetary demand of each individual.

Take an extreme case: if twice as many dollars get into circulation in a community, either some few men may have far more dollars than before, while others have nearly the same number; or every man may have his due proportion of the new supplies, just twice as many as before in proportion to his income. The latter result, "other things being equal," is the logical one after equilibrium has been restored. If prices of goods remained the same as before, there would be twice as many pieces of money available to effect the same number of trades at the same prices. There is no reason why each person should tie up twice as large a proportion of his income in the form of money. If, however, there is a concerted movement to spend the surplus money, there results a general bidding down of the value of money, a general bidding up of the prices of goods. At what point will this movement stop? The rational conclusion must be that, other things being equal, the new equilibrium will be established when the ratio between the value of money and the price of the goods which each individual is purchasing becomes the same as before. The money being doubled, prices must be doubled, and likewise for any other change in quantity.

Sec. 10. The quantity theory of money. This explanation of the effect of changes in the quantity of money in a country upon prices (the general scale of prices) is known as the quantity theory of money. This theory has, for a century, been very generally accepted by competent students of the money problem. It may be summed up thus: other things being equal, the value of the monetary unit, expressed in terms of all other commodities, falls as the quantity of money increases, and vice versa. That is, prices rise and fall in direct proportion to changes in the total quantity. This is a simple explanation of a complex and difficult set of conditions. The phrase, "other things being equal," betokens the statement of a tendency where there are several factors. The quantity theory explains what happens when there is a change in one of the factors—the number of pieces of money. There are three large sets of facts to be brought into relationship with each other in the quantity theory: (1) the amount of business, or the number of trades effected; (2) the rapidity of circulation, depending on the methods by which business is done; (3) the amount of money available. According to the quantity theory we must expect that, when conditions (1) and (2) remain fixed, the value of money will vary inversely as its quantity. This quantity theory may be expressed in the formula P = MR/N when P is the symbol for price, or the general price level, N is (1) above, R is (2), and M is (3). P, therefore, changes directly with either M or R, or inversely with N.[6]

Sec. 11. Interpretation of the quantity theory. The quantity theory must be carefully interpreted to avoid various misunderstandings of it that have appeared again and again in economic discussion.

(1) It does not mean that the price level changes with the absolute quantity of money, independently of growth of population and of the corresponding growth in the volume of exchanges.

(2) It is not a mere per capita rule to be applied at a certain moment to different countries. For example, Mexico may have $9 per capita and the United States $35, while average prices may not differ in anything like that proportion. But in these two countries not only the amounts of exchanges per capita but the methods of exchange and the rapidity of the circulation of money differ greatly.[7]

(3) It cannot be applied as a per capita rule to the same country through a series of years, without taking account of the many changing factors. It is estimated that in 1800 the money stock was about $5 per capita in the United States, and in 1914 about $35[8], but average prices have not necessarily changed in the same ratio. In a period of years a country may change in a multitude of ways, in complexity of industry, modes of exchange, transportation, wealth, and income. These changes require, some larger, others smaller, per capita amounts of money to maintain the same level of prices. For example, the substitution of cash payments for book-credit in retail trade calls for a larger per capita stock of money; whereas an increased use of banks and checking accounts, by economizing the use of money, enables a smaller amount of money to maintain the same level.[9]

(4) Tho applied originally to standard money, the quantity theory applies to all other kinds of money circulating side by side and at a parity of value, so far as these fulfil the definition of money and are not merely supplementary aids of money. These substitutes for, or supplements to, money enable each dollar to do more work, to circulate more rapidly. If the standard money alone were doubled in quantity, while the various forms of fiduciary money (smaller coins, bank notes, government notes) remained unchanged, the quantity of money as a whole would not be doubled. Indeed, in such a case, the method of exchange would be greatly altered. According to the quantity theory, therefore, prices would not be expected to double.

Sec. 12. Practical application of the quantity theory. Despite the number of changing factors affecting the methods of exchange and the amount of business, the quantity theory is a rule unable at any moment. These various factors change slowly, and the quantity theory answers the question: What general change occurs in prices as a result of the increase or decrease of the money in a given community at a given moment? Like the law of gravitation and the law of projectiles, the theory must be interpreted with relation to actual conditions.

The quantity theory makes intelligible the great and rapid changes in prices which have followed sudden changes in the quantity of money. Inductive demonstration of broadly stated economic principles is usually difficult, but there have been many "monetary experiments" to teach their lessons. Many inflations and contractions of the circulating medium have occurred, now in a single country, again in the whole world; and the local or general results have helped to exemplify richly the working of the quantity principle. With the scanty yield of silver and gold mines during the Middle Ages, prices were low. After the discovery of America, especially in the sixteenth century, quantities of silver flowed into Europe. The great rise of prices that occurred was explained by the keenest thinkers of that day along the essential lines of the quantity theory, tho there were many monetary fallacies current at that time. The experience in England during the Napoleonic wars, when the money of England was inflated (by the forced issue of large amounts of bank notes) and prices rose above those of the Continent, led to the modern formulation of the theory by Ricardo and others about 1810. The discovery of gold in California and Australia in 1848-50 greatly increased the gold supply, and gold prices rose throughout the world. Between 1870 and 1890 the production of gold fell off while its use as money increased greatly, and prices fell. A great increase of gold production has occurred in the period since 1890. In part the rising prices since 1897 are explicable as the periodic upswing of confidence and credit, but in the main doubtless they are due to the stimulus of increasing gold supplies.[10] These are but a few of many instances in monetary history, which, taken together, make an argument of probability in favor of the quantity theory so strong as to constitute practically an inductive proof.

[Footnote 1: The old-fashioned miser, however, withdraws his hoarded gold for the time from its usual monetary function as an indirect agent and treats it as a direct good yielding to him psychic income by its mere possession.]

[Footnote 2: See on kinds of income, Vol. I, p. 26 ff.]

[Footnote 3: See secs. 1 and 2 of this chapter; also Vol. 1, especially pp. 31-38 and 353-355.]

[Footnote 4: This means actually gratuitous, for any real difficulty in getting metal to or from the mint operates as a cost in the conversion of bullion into money, or vice versa; e.g., the gold may be in Australia and the mint in London.]

[Footnote 5: See Vol. I, pp. 138 ff. and 361 ff.

FIG. 1. GOLD PRODUCTION OF THE WORLD, 1493-1914.

The changes in gold production here shown have bearings not only upon problems of money, but in some respects upon nearly every modern economic problem. Compare in the present connection this figure with Figure 3, in Chapter 6, Section 4, showing changes in index numbers of prices.

]

[Footnote 6: This formula is presented by E.W. Kemmerer in "Money and Prices" (2d ed., 1909), p. 15 ff.]

[Footnote 7: See above, ch. 3, sec. 6, table.]

[Footnote 8:

PER CAPITA CIRCULATION OF MONEY (ESTIMATED) IN THE UNITED STATES IN VARIOUS YEARS.

1800......$4.99 1850......$12.02 1890......$22.82 1810...... 7.60 1860...... 13.85 1900...... 26.93 1820...... 6.96 1870...... 17.51 1910...... 34.33 1830...... 6.78 1880...... 19.41 1915...... 35.44 1840......10.91 ]

[Footnote 9: On the function of deposits, see below, ch. 7, sec. 11.]

[Footnote 10: Consult Figure 1 in ch. 4 and Figure 2 in ch. 6 for the graphic presentation of these and related facts.]



CHAPTER 5

FIDUCIARY MONEY, METAL AND PAPER

Sec. 1. Commodity and fiduciary defined. Sec. 2. Present monetary system of the United States. Sec. 3. Saturation point of fractional money. Sec. 4. Light-weight fractional coins. Sec. 5. Worn coins and Gresham's law. Sec. 6. A general seigniorage charge on standard money. Sec. 7. Coinage on governmental account. Sec. 8. The gold-exchange standard. Sec. 9. Nature of governmental paper money. Sec. 10. Irredeemable paper money. Sec. 11. Theories of political money.

Sec. 1. Commodity and fiduciary defined. The actual moneys in circulation in every modern country consist of a wide variety of pieces, differing in denomination, physical size, shape and materials, mode of issue, source or authority of issue, and legal character. Among these kinds, one is the standard and is a commodity-money.[1] In such cases the coinage is free and nearly gratuitous, and the value of the money is kept close to parity with its value as bullion by changing bullion into coin, or coin back into bullion, whenever there is an appreciable difference between the values in the two uses. This adjustment is brought about by the free action of the people. The government, having declared what is the standard money unit, and having provided a mint to make coins, leaves it to citizens, acting from the ordinary competitive motives, to decide when they will reduce or increase the number of coins in circulation.

The other kinds of money are not commodity-money and the materials of which they are made, whatever they be, are not worth as much in any other uses as they are in their present monetary form. Their value is always referred to, and adjusted to, that of the commodity-money, so long as any of it is in circulation. In contrast with commodity-money, these other kinds may be called fiduciary money. By fiduciary money we mean money that has not a commodity value equal to its money value, but which is generally accepted because each receiver has faith that others in turn will take it in the same way.[2]

Sec. 2. Present monetary system of the United States. Here is given a summary of the main features marking the present monetary system of the United States (in 1915).

Not all this variety is essential to an efficient monetary system and several of the kinds survive as the result of historical accidents (political and legislative). But all are now kept in accord with the value of the gold coin which, it will be observed, is the only kind the amount of which is not artificially limited. Silver dollars are no longer coined, subsidiary silver and minor coins are issued only in exchange for other money, as are gold and silver certificates in exchange for gold or for silver, which they merely represent while in circulation.

Sec. 3. Saturation point of fractional money. Fiduciary money is that on which regularly the issuer makes a seigniorage charge.[3] Let us consider now the effect of seigniorage on the value of money.

Fractional coins are those of smaller denominations than the standard unit of money, as shillings and pence in England, and half dollars, quarter dollars, dimes, nickels, and cents in America. Money to serve well a variety of uses must be of different denominations, and "small change" is necessary to make small purchases and for exact settlement in larger payments that are not multiples of the standard unit. The amount required (or most convenient to use) in each denomination of fractional coins is thus a more or less certain portion of each person's monetary demand, shaped by experience and fixed by habit. For example, within certain elastic limits of convenience quarters may be used for halves, and dimes for nickels (and vice versa); but each person has a point of preference. The total demand for each kind of change is the sum of the individual demands. This point where the amount of coins of any denomination (in relation to the whole monetary system) is most convenient may be called the saturation point of that kind of small change, up to which point the people prefer a share of their money in that form, and beyond which they will, if free to choose, exchange that kind for other denominations (smaller or larger). Each kind of money, as the cent, nickel, dime, has its own peculiar demand and its saturation point.

MONETARY SYSTEM OF THE UNITED STATES, 1915

Metals Weight, grains Fineness Ratio to gold 1. Gold coins 25.8 .90 100 2. Silver dollar 412.5 .90 15.988 to 1 3. Silver, subsidiary 385.8 .90 14.953 to 1 4. Nickel (5 cents) 77.0 .25 ........... 5. Copper (1 cent) 48.0 .95 ........... Metal Limit of issue Legal tender for Receivable for private debts public dues 1. Gold coins Unlimited. Unlimited. For all 2. Silver dollar Ceased in 1905 Unlimited. For all 3. Silver, Needs of the $10 $10 subsidiary people 4. Nickel (5 cts.) Do. 25 cts. 25 cts. 5. Copper (1 ct.) Do. 25 cts. 25 cts. Paper 6. Gold certificates Unlimited in ex- No For all change for gold 7. Silver In exchange for No For all certificates silver $ 8. US notes No new issues. Unlimited. Except customs 9. Treasury notes No new issues. Unlimited For all of 1890 10. National bank Capital of banks No Except customs notes. 11. Federal reserve Per cent. of At banks of For all notes. gold reserves reserve system Metal Exchangeable at Redeemable at In circulation treasury for treasury in Oct 1, 1915 1. Gold coins Gold certificates 616,000,000 U.S., Treas., or Fed, res. notes 2. Silver dollar Silver 65,000,000 certificates 3. Silver, Minor coins Lawful money[a] subsidiary in sums or mul- 162,000,000 tiples of $20 4. Nickel Do. > 62,000,000[d] 5. Copper Do. /

Paper 6. Gold certificates Subsidiary and Gold coin 1,172,000,000 minor coins [e] 7. Silver Silver and Silver dollars 482,000,000[f] certificates minor coins 8. US notes Subsidiary and Gold 337,000,000 minor coins 9. Treasury notes of Silver and Gold 2,200,000 1890 minor coins 10. National bank Subsidiary silver Lawful money[b] 761,000,000 notes and minor coins 11. Federal reserve Gold[c] Gold[c] 133,000,000 notes - Total[g]...........................................3,792,200,000

[Footnote a: "Lawful money" includes gold coin, silver dollars, U.S. notes, and Treasury notes.]

[Footnote b: Redeemable also in lawful money at bank of issue.]

[Footnote c: Redeemable also at Federal reserve banks in gold.]

[Footnote d: Not usually included in the estimates of total money in circulation.]

[Footnote e: Represented dollar for dollar by gold kept in the U.S. treasury.]

[Footnote f: Represented dollar for dollar by silver kept in the U.S. treasury.]

[Footnote g: Besides, there were about $312,000,000 in the U.S. Treasury not offset by outstanding paper. The total money stock (in circulation and in the Treasury, eliminating certificates representing gold and silver), was about $4,233,000,000, of which 70 per cent was metal (largely represented in circulation by paper certificates) and 30 per cent was paper. Of the 70 per cent 50 was gold, 18 was silver, and 2 was copper and nickel.]

Sec. 4. Light-weight fractional coins. The standard metal is usually too valuable to be suitable for coins of the smaller denominations. Therefore, when gold is the standard, copper, nickel, and silver remain in restricted use. But when coins of these metals are issued at weights corresponding with their bullion value, difficulties arise. Not only are they too heavy for convenience, but with every slight rise in their bullion value as compared with that of the standard metal, they become worth more as bullion than as coin and begin to disappear from circulation. This happened often throughout the Middle Ages and until the nineteenth century. The attempt was generally made to coin gold and silver at a ratio of weight corresponding exactly to their market values at a given moment and, every time the market conditions varied, the best full-weight coins of one of the two metals were taken out of circulation. [4]The country thus suffered for lack either of the larger gold coins or of fractional coins. At length, to remedy this difficulty, fractional silver coins, often called "token coins," were issued, in limited numbers, of less than full proportionate weight and bullion value.

This plan, having been partially tried, was generally adopted by the United States in 1853 at a time when the silver dollar of 371.25 fine grains was legally rated at the same value as the gold dollars of 23.22 grains, and was freely coined. The fractional coins were made a little over 6 per cent lighter per dollar than the dollar coin; two half-dollars or four quarters or ten dimes contained 93.52 cents worth of silver. Since then silver bullion has become worth much less in terms of gold, and for years past the bullion value of the silver in a dollar of silver small change has been between 40 and 60 cents. Why then has the fractional coinage a monetary value equal to the standard money, dollar for dollar?

The answer is, because it is artificially limited in quantity, so that it does not pass the point of saturation in the field of its use. Its value rests on its monetary use; it is fiduciary money, not commodity money. It is limited simply by letting "the needs of the people" determine its amount. This is done by issuing it only in exchange for other money of the larger denominations, and by redeeming it in other money on demand. Fractional coins are issued on the request of banks in exchange for standard money. One needing "change" gets it at the bank; when the bank finds its supply falling short it gets more from the government mints. As business increased in 1898, the demand for nickels, dimes, and quarters became unprecedented, and the mints worked night and day to supply them. If these coins were made in great quantities and forced into circulation by the government through paying them out to creditors and officials, their quantity would become excessive and they would fall in value (be at a discount) compared with standard money. But as this is not done, and as, moreover, they are redeemed on demand at the treasury (and practically at every bank and post office) in other money, any slight tendency to depreciation in any locality is at once corrected. As it is, the government makes a seigniorage profit on the fiduciary coinage, as shown in the following table. [5] The fractional coinage is maintained at a parity with the standard money in accordance with the monopoly principle, expressed in the limitation of the amount.

Receipts:

Earnings (charges for refining, assaying, manufacture for other countries, etc.)......................... $392,000 Bullion recovered, by-products, old materials, etc... 143,000 Profits on seigniorage, subsidiary silver............ 3,013,000 Profits on seigniorage minor coinage and recoinage... 2,387,000 ————— Total receipts.......................................$5,935,000

Expenditures: All kinds............................................$1,138,000 ————— Net revenues from mint service.....................$4,797,000

Sec. 5. Worn coins and Gresham's law. Coins may be light-weight as the result of another cause—namely, the abrasion (wearing off) of the coins in circulation. Nearly always when this has occurred the worn coins have still been accepted as money,[6] and ordinarily without any depreciation. That is to say, they have a value as money greater than the value of the bullion that is in them. Everybody takes them without hesitation as readily as if they were full weight. If, however, at this point, new full-weight coins are put into circulation, these at once disappear while the old ones remain in circulation—a fact that has always been somewhat mystifying.

In explanation of the phenomenon was formulated "Gresham's law" of the circulation side by side of coins of different bullion value: bad money drives out good money. Sir Thomas Gresham (whose name has but recently been given to this so-called law), explained the principle to Queen Elizabeth when counseling her regarding the recoinage of the debased money of the realm as was done in 1560. He showed that when old, worn coins were in circulation and the mint began putting out full-weight coins, the old lighter ones remained as money, while the new ones, being heavier, were picked out by jewelers and by those needing to send money abroad.

Gresham's law has a paradoxical wording and is frequently misunderstood. "Bad" money means not counterfeit money, but merely money that has not as great a bullion value compared with its money value as some other kind of money then in circulation. But not every piece of such money will drive out every piece of good money. The law applies only under certain conditions, and within certain limitations. The "good" will be driven out only if the total amount of money in circulation is in excess of what would be needed if all were of full weight and of best quality. Paradoxically speaking, if there is not too much of the bad money, it is just as good as the good money. But even if good money is driven out, it may not leave the country. It may be hoarded, or be picked out by banks and savings-institutions to retain as their reserves, or be melted for use in the arts. Gresham's "law" becomes thus a practical precept. As applied to the plan of recoinage it is: Withdraw the worn coins as rapidly (in equal numbers) as you put new coins into circulation.

The continued circulation of "bad" money along side of "good" money (light-weight along side of full-weight coins), so long as the total number of coins is not in excess of the money demand for full-weight coins, is explained thus on just the same principle as is the circulation at parity of a light-weight fractional coinage, in the preceding section.

Sec. 6. A general seigniorage charge on standard money. The fiduciary coinage problem presents itself under a some-what different guise in case a seigniorage charge is made on all coinage, even of that metal used as the standard unit. In this case coinage is free but not gratuitous. In this case no bullion is brought to the mint unless the coined pieces the owners receive have a value equal to the bullion value plus the seigniorage charge. The power to impose a seigniorage charge is a monopoly power. Artificial limitation is present. Evidently, the number of coins that can be issued without depreciation is limited to that number which would circulate if they were made full weight without a seigniorage charge.[7] This number of pieces of full-weight metal is the saturation point of the money demand of the country. If more than that could in any way be put into circulation it would become worth less as money than as bullion, and would be melted or exported.

Assume that this full supply of money at a given moment is 100,000 pieces or dollars; then consider the effect of imposing a seigniorage charge of ten per cent on further coinage. The government alone having the right of coinage, the need of money would give the circulating medium a monopoly value. The value of the money would rise. When it had risen until the coin would buy any more than one-ninth more bullion than was in it, the citizens would begin to take metal to the mint. After the ten per cent charge was taken out they would receive a coin which, the containing one-tenth less bullion, would be worth very nearly the same as the metal taken to the mint. No considerable depreciation could take place unless the volume of business fell off so that less money was needed than before. In that case there would be no outlet for the excess of coins until they fell to their bullion value, i.e., till they lost the entire value of the seigniorage, the monopoly element in them. Melting or exporting them before that point was reached would cause to the owner the loss of whatever element of seigniorage value they contained. We thus have arrived at the general principle of seigniorage: when the number of coins issued is limited to the saturation point, a seigniorage charge does not reduce their money value; they are worth more as money than as bullion. And this holds good of a large seigniorage charge as well as of a small one, even up to the extreme limit of a charge of 100 per cent. In this last case the government would retain the whole of the bullion brought to it and would give in return a piece of money made of material (metal or paper) with a negligible value.

Sec. 7. Coinage on governmental account. The fiduciary coinage problem may be presented also when coinage is not free, and the times and amount of coinage are determined by law or by legally authorized officials. In this case the bullion must be obtained by purchase in the open market (and paid for by some form of legal money, or by bonds). Coinage is then said to be "on governmental account."

Now, assuming that the normal money-demand (the volume of business, or sum of exchanges) remains unchanged, let us consider what will result if the government begins to issue money in this way, when, as in the preceding case, 100,000 units of full-weight money are in circulation. This action might be taken most simply by recoining all the full-weight pieces that came into the treasury, making them contain 1/10 less precious metal, and paying out 1111 pieces for every 1000 received. Every time this was done there would be an excess of 111 pieces above the normal money-demand, and 111 full-weight pieces would be exported or melted (Gresham's law). The process (in strict theory) may be repeated 90 times, at which point 90,000 full-weight coins have been received, 100,000 light-weight coins have been issued to take their place and 10,000 full-weight coins have gone out of circulation. The total seigniorage charge would be 1-10 of 90,000, or 9000 units. No depreciation has taken place, and the pieces, by reason of their limitation, bear a money value in excess of the bullion that is in them.

Now the government, with the next 1000 pieces collected by taxation, could buy enough bullion (in the open market) to make another 1111. The excess of 111 pieces could not now be promptly removed by the melting down or exporting of 111 coins, for all those remaining in circulation have a bullion value 1/10 below their money value. As this process is repeated the excess must continue to grow from 100,000 to 111,111, and the value of the money piece in terms of bullion continue to fall from 10 to 9. At this point the 111,111 pieces would contain just the same amount of bullion and have just the same value as the 100,000 pieces did before. Thereafter no further profit would accrue to the government from issuing coins of that weight. To make a further profit it must again reduce the amount of pure metal in the coin.

This process was often repeated in the Middle Ages. A ruler, either by making a higher seigniorage charge or by coining on his own account, debased the quality or reduced the weight of the money of his realm. For a time the new coins, having the same monetary use, circulated at par with the old coins. The ruler, pleased with this almost magical power of getting a revenue with little trouble, continued to issue coins until suddenly the heavier coins began to be exported or melted, and the value of the other money fell, to the mystification alike of the prince and of his people. The reason is now perfectly plain: the number of coins was not kept within the proper limits and they went down to their bullion value. The only way a further profit could be made in this way was to debase the coin again. By successive steps the coinage came to consist almost entirely of cheaper alloy.

Sec. 8. The gold-exchange standard. In a number of silver-using countries and colonial dependencies near the end of the nineteenth century, the fluctuations of the value of silver in terms of gold was a constant source of difficulty in the payment of foreign obligations to gold standard countries. Yet there were strong reasons in the habits of the people and in the industrial conditions of the country to forbid the adoption of gold and the disuse of silver as the actual money in circulation. The method adopted, that of the gold-exchange standard, involved these features.

(1) Closing the mints of the country to the free coinage of silver, as was done most notably in India in 1893 and in Mexico in 1904.

(2) Adoption of a fixed ratio of exchange between the silver coins in circulation and some gold coin which is made the standard of value in all transactions (as the dollar or the pound sterling), the money in circulation thus being all or nearly all of a fiduciary nature.

(3) Regulation and limitation of the amount of money in circulation so that a fixed parity between it and gold may be maintained (a) by the limited issue of coins only on governmental account, (b) by the sale, at a fixed rate, of foreign exchange bills payable abroad in the standard unit, the money paid for the bills being withheld from circulation in a special reserve, (c) by the purchase of foreign bills of exchange at a fixed rate, thus paying out and putting again into circulation some of the fiduciary money in the special reserve.

These monetary changes furnish numerous illustrations and demonstrations of the quantity theory of money as applied to the entire circulating medium of a country.[8]

Sec.9. Nature of governmental paper money. The problem of seigniorage presents itself in its most extreme form when money is made of paper. Paper money is issued either by a government or by a bank. We will consider governmental notes here, reserving until Chapter 7 the case of bank notes.

The issue of paper money in some cases grew out of the practice of debasing metal. However this may have been, governmental paper money may be looked upon as money for which a seigniorage of one hundred per cent is charged. The gain of seigniorage from paper money is greater and is just as easily secured as that from coinage of metals. Governmental paper money is called "political money," in contrast with commodity money. However, all coins that contain an element of seigniorage, or monopoly value, are to that degree "political money." The typical paper money is irredeemable; that is, it cannot be turned into bullion money on demand. It is simply put into circulation, usually with the "legal-tender" quality. Money has the legal-tender quality (as the term is used in the United States) when, according to law, it must be accepted by citizens as a legal discharge for debts due them, unless otherwise provided in the contract. The prime purpose of making money legal tender is to reduce the danger of dispute as to payments; but another purpose often has been to force people to use a depreciated money whether they would or not. The purpose of the issue of political money is usually to gain the profit of seigniorage for the public treasury, and often it has been the desperate expedient of nearly bankrupt governments. Governmental paper money differs from bank notes in that its value does not necessarily depend on the promise of redemption by the issuer. It differs from promissory notes and bonds in that its value is not based on the interest it yields, but mainly on its monetary uses. The issue of paper money may save the government the payment of interest on an equal amount of bonds. The promise to receive paper in payment for taxes or for public lands may help to maintain its value by reducing its quantity, but nothing short of its prompt redemption in standard coins makes it truly redeemable.

Sec. 10. Irredeemable paper money. The most notable examples of paper money in the eighteenth century were the American colonial currencies, the continental notes, and the French assignats. In all the American colonies before the Revolution, notes or bills of credit were issued which were in most cases legal tender. Parliament forbade the issues, but to no effect. Without exception they were issued in large amounts and without exception they depreciated. The continental notes were issued by the Continental Congress in the first year of the war (1775), and for the next five years. The object at first was to anticipate taxes, and it was expected that the states would redeem and destroy the notes, but this was not done. The notes passed at par for a time, but depreciated rapidly as their number increased. It has been estimated that the country had less than $10,000,000 of coin before the war, and when, in 1780, over $200,000,000 of notes were in circulation they were completely discredited: hence the phrase "not worth a continental." Specie then quickly came back into use. A few years later the leaders of the French Revolution, failing to learn the lesson of the American experience, issued, on the security of land, notes called assignats in such enormous quantities that they became worth no more than the paper on which they were printed. The paper money issued under the English bank restriction act of 1797-1820 is especially notable because it gave rise to the controversy which did much to develop the modern theory of the subject. Parliament forbade the Bank of England to redeem its notes in coin because the government wished to borrow the coin the bank held. The result was the issue of a large amount of bank money not subject to the ordinary rule of redemption on demand. It was virtually governmental paper money. The notes depreciated and drove gold out of circulation, and it was not until 1821 that specie payments were definitely resumed.

The United States, under the Constitution, did not try legal-tender paper money till 1862 when paper notes (called greenbacks, because of the color of ink with which the reverse side was printed) were first issued, later increased to a total of about $450,000,000. Other interest-bearing notes were issued with the legal-tender quality and circulated as money to some extent. Greenbacks depreciated in terms of gold, and gold rose in price in terms of greenbacks until, in June, 1864, it sold at 280 a hundred. Fourteen years elapsed after the war before these notes rose to par, in terms of gold (in December, 1878), and they became legally redeemable in gold January 1, 1879. This was called "the resumption of specie payments."

Almost every nation has at some time issued political money. During the Franco-Prussian War in 1870, France, through the medium of its great state bank, made forced issues of notes of a political nature, which only slightly depreciated. Many countries—Russia, Austria, Portugal, Italy, and most of the South and Central American republics—have had or still have depreciated paper currencies.

At once, at the outbreak of the great war in 1914, the governments of the warring nations began to exercise a strict control over the issue of paper money, sought to gather into the public treasury all the specie, and to give paper (either governmental notes or bank notes) practically a forced circulation, making it almost the sole circulating medium. The values of the paper moneys have fallen in all the countries, especially in Germany and Russia. In such cases the money partakes somewhat of the characters both of bank notes and of political money. Resorted to in desperate extremities, political money has usually proved to be a costly experiment. A result usually unintended is the derangement of business and of the existing distribution of incomes. The rapid and unpredictable changes in prices gives opportunity for speculative profits, but injure legitimate business. This incidental effect on debts and industry offers the main motive to some citizens for advocating the issue of paper money. It is peculiarly liable to be the subject of political intrigue and of popular misunderstanding. It is this danger, more than anything else, which makes political money in general a poor kind of money.

Sec. 11. Theories of political money. There are two extreme views regarding the nature of paper money, and a third which endeavors to find the truth between these two. First is that of the cost-of-production theorists, who declare that government is powerless to influence value, or to impart value to paper by law. They deny that there is any other basis for the value of money than the cost of the material that is in it. Money made of paper, on a printing press, has a cost almost negligibly small, and, therefore, they say it can have no value. The facts that it does circulate and that it is treated as if it had value are explained by the cost-of-production theorists as follows: while the paper note is a mere promise to pay, with no value in itself, it is accepted because of the hope of its redemption, just as any private note. Depreciation, according to this view, is due to loss of confidence; the rise toward par measures the hope of repayment.

Taking a very different view, the extreme fiat-theorists assert that the government has unlimited power to maintain the value of paper money by conferring upon it the legal-tender quality. The meaning of fiat is "let there be," and the fiat-money advocates believe that the government has but to say, "Let there be money," to impart value to a piece of paper. The typical fiat-money advocates in the United States were the "Greenbackers," who wished to retain the greenbacks issued in the Civil War and to increase the amount greatly. They saw in paper money an unlimited source of income to the government. They proposed the payment of the national debt, the support of the government without taxes, and the loan of money without interest to citizens. All might live in luxury if the extreme fiat-money theorists could realize their dreams. The depreciation that has taken place in nearly every case where government notes have been issued, the fiat-theorists declare to be due to a mild enforcement of the law of legal tender. To them the fact that paper money may circulate for a time at par appears a reason why it always should. They do not recognize that there is a saturation point in the use of money, and that its use is still further limited by the fear of larger issues.

The almost universally accepted opinion among economists rejects both of these views, tho recognizing in each a certain limited aspect of the truth. The cost-of-production view quite overlooks the features in which paper money differs from ordinary credit paper. The value of one's promises to pay depends on his reputation and his resources; the resources constitute the basis of value. Bonds have value because they yield interest and are payable at a definite time in standard money. But paper money, lacking this basis for its value, has another basis in its money use, in its power to buy goods.

The theory of paper money here outlined makes the value of paper money a special case of monopoly value. As the power of any private monopoly over price is relative, not absolute, so is that of the government over the value of political money. The money use is the source of value of the paper notes. It is this which gives the economic condition for value in paper money and strictly limits the power of the government—a fact overlooked by the fiat-theorists. Business conditions remaining unchanged, the limit of possible issue without depreciation is the number of units in circulation before the paper money was issued, the saturation point of full-weight and full-value coins. Whenever governments have failed to stop at that point, paper money has depreciated. But under wise and honest control and regulation political paper money might serve the monetary function very effectively.

[Footnote 1: The problem of a legally authorized double standard, bimetallism, is treated in the next chapter. An irredeemable paper money may be, for a time, the standard money.]

[Footnote 2: The faith (fides) is not always that the issuer of the money (whether it be a bank or the government) will redeem the money on demand at any future time; for fiduciary money may circulate while irredeemable, that is, either carrying no promise of redemption in the standard money or in fact not being redeemed. Yet undoubtedly actual redemption on demand or a good prospect of future redemption is one of the circumstances stimulating the faith and the readiness of each person in turn to receive fiduciary money.]

[Footnote 3: In the broad sense as above defined, ch. 3, sec. 10.]

[Footnote 4: See next section on worn coins.]

[Footnote 5: Receipts and Expenditures of Mint Service in 1914:]

[Footnote 6: It makes no difference what may be deemed the cause of their acceptance; whether it be habit, public opinion in business circles, or the act of law making them a legal tender; the essential thing is that they continue to be accepted as money.]

[Footnote 7: In this and following numerical examples no account is taken of the possibility that the standard metal may depreciate in the world market in terms of all other goods as a result of its diminished use as money in one or more countries. This properly belongs in a complete theoretical treatment of the subject.]

[Footnote 8: See "Modern Currency Reforms" (1916), by E.W. Kemmerer, professor of Economics and Finance in Princeton University, for a detailed treatment of this remarkable series of monetary changes, probably unequaled in instructiveness to the student of monetary theory.]



CHAPTER 6

THE STANDARD OF DEFERRED PAYMENTS

Sec. 1. Relative positions of gold and silver; historical. Sec. 2. Gold production, first half of nineteenth century. Sec. 3. Concept of the general price level. Sec. 4. Index numbers. Sec. 5. Gold production and monetary legislation, 1850 to 1879. Sec. 6. Definition of the standard of deferred payments. Sec. 7. Increasing importance of the standard. Sec. 8. Fluctuating standard and the interest-rate. Sec. 9. Notable changes in prices. Sec. 10. Nature and object of bimetallism. Sec. 11. The movement for national bimetallism in America. Sec. 12. Rising prices after 1896. Sec. 13. Defectiveness of the gold standard. Sec. 14. Various ideal standards suggested. Sec. 15. The tabular standard.

Sec. 1. Relative positions of gold and silver: historical. It is not possible within the limits of our space to enter here into the details of the world's monetary history. It must suffice for our purpose to sketch briefly the period preceding the nineteenth century. Both gold and silver were used as moneys in Europe in the Middle Ages, tho silver was much the more common. The two metals continued to be used side by side in Europe and in the new settlements in America, silver for the smaller and gold for many of the larger transactions. Both were made legalized forms of money (and standards of deferred payments) in units of specified weights and fineness, the weights bearing a certain ratio to each other. Thus it was possible for a debtor to discharge his obligations with that one of the two metals that at the moment was the cheaper at the legal ratio. Fluctuations in the prices of gold in terms of silver were at times such as to cause a large part of the full-weight coins of one or the other metal to leave circulation (in accordance with Gresham's law). So from time to time the ratio was slightly changed by law in the various countries to permit the circulation or to bring back the kind of money that had been undervalued in terms of the other. But it is a very remarkable fact that from the time of Xenophon until the discovery of America (a period of nearly 2000 years), the market ratio of silver to gold bullion in Europe remained pretty close to 10 to 1, being only temporarily altered by sudden and unusual occurrences. From 1492 to 1660 the ratio changed to 15 to 1, where it remained with remarkable stability until about the year 1800. At the establishment of the mint of the United States in 1792 that ratio was found to exist. Men had come to look upon the ratio of 15 to 1 as the natural order, determined (it was sometimes said) providentially by the deposit of the two metals in due proportion in the earth's surface. But as we now see it, this in part was mere chance and in part was due to the equalizing effect of the wide use of both metals so that the one could be easily substituted for the other in case of a divergence of the market ratio from the legal ratio as money. From the year 1500 until 1800 the Western hemisphere was the main source of the precious metals, the alluvial deposits were widely scattered, were gradually discovered, were usually found in small quantities, and were extracted in primitive ways. The existing stock of precious metals, gold and silver, more than other products of mine and field, is at any time the accumulation of many years' production, and is changed very little, proportionally, by a large change of output in any year or short period. It changes in volume as does a glacier fed by the snows of many years, not as does a river, filled by a single rainfall. For a short time after the discovery of America (from 1493 to about 1544) the average coining value[1] of the world's production of gold, nearly all found in America, was about 1-1/2 times as great as that of silver; but thereafter for three centuries from about 1545, the annual value of silver produced was between 1-1/2 to 4 times as great as that of gold, averaging about twice as great. Silver was the money chiefly in use in the ordinary transactions in all of the principal countries of the world.

Sec. 2. Gold production, first half of nineteenth century. We have now to note some great changes in the production of gold in the nineteenth century, changes both absolute and relative to that of silver. The market ratio of the two metals had been gradually changing before 1792 and continued to change. Gold was slowly becoming more valuable in terms of silver and the legal ratio of 15 to 1 in the United States (at which both metals were admitted free to the mint) proved to have undervalued gold. Gold largely left circulation and silver and bank notes formed the greater part of our circulating medium. Then, in 1834, soon after the production of gold had begun to increase somewhat more rapidly than that of silver, the legal ratio of the United States was changed to 16 to 1. This brought a good deal of gold back into circulation and gradually drove out most of the silver (the heavier coins disappearing first).

In the decade 1841-50 the average annual value of the gold production had, for the first time since the early sixteenth century, exceeded that of silver. Then, from 1848 to 1850, came the great gold discoveries in California and in Australia. In 1851 the value of gold produced was one and one-half times that of silver; in 1852 was three times, and in 1853 four times as great; and then slowly declined, but continued every year as late as 1870 to be over twice as great. This caused the displacement of silver by gold and drove out a large proportion of the silver coins of smaller denominations. This led to the law of 1853, authorizing subsidiary coinage (on government account only) of lighter weight.[2] Let us observe the effect on prices that was brought about by the discoveries of 1848-49, and, first, we must consider briefly the method of measuring and expressing general changes in prices.

Sec. 3. Concept of the general price level. The price of any good is some other good or group of goods given for it in trade.[3] The standard unit of money coming to be the most convenient expression for price (whether or not money be actually passed from hand to hand in that particular trade), prices usually are monetary prices, and more specifically are prices in gold, or in silver, or in whatever constitutes the standard money unit. But the price of each good is a definite, separate fact, which expresses the ratio at which that commodity is sold. The price of any particular kind of goods may fluctuate in either direction as compared with the prices of other goods at the same time. For example, iron and many other goods may rise while wheat and many other goods fall in price. There is, therefore, no such thing as an actual general change in the prices of goods in terms of money, but it may be seen that the prices of large classes of goods, often of nearly all goods, change upward or downward at the same time and in the same general direction. We thus have need to distinguish between changes in the valuations of particular kinds of goods in terms of each other and general changes in the valuation of a number of different goods in terms of the monetary unit.

To get some idea of whether such a general trend occurs, the algebraic sum of all the changes in the particular prices of a selected group of goods may be taken, and for convenience this may be reduced to an average price (by dividing the sum by the number of articles). Such an average is called a general price and, when comparing it with the general price of another time, we speak of changes up or down in general prices, or in the general scale of prices, or in the price level.

When gold is the standard unit, its value is the converse of general prices; as prices go up the value of gold goes down, and gold is said to depreciate. As prices go down, the value of gold goes up and gold is said to appreciate. Rising prices mean falling value of gold (and at the same time falling purchasing power), and vice versa.

[Illustration: FIG. 2. INDEX NUMBERS OF PRICES. The four series of prices here shown begin at different periods; the American in 1840 (Aldrich report 1840-1889 and Bureau of Labor from 1890 on); the English in 1846; the German in 1851; the French in 1857. We have adjusted each of these series to a base of the average prices for 1890-1899, in accord with the basic period used by the American Bureau of Labor.

The reader must be on his guard against misunderstanding the diagram. It does not represent the heights of the prices of the different countries compared with each other either at any one date or for the entire period. For example, the heights of the lines at the year 1860, do not indicate that American prices were lowest and French the highest at that date, or, indeed, tell anything whatever directly on that point. The various series of prices are compared within themselves, every year with the average of the prices for 1890-1899 in each country, respectively. The only comparison allowable, therefore, between the several lines, is that between the fluctuations, both as to their times and as to their directions, both as to the larger tidal movements and as to the lesser wave-like movements within the business cycles. The Figure does indicate that both American and German prices have risen somewhat as compared with the English and French prices, since the period before 1860.

This figure should be studied in connection with Figure 1, in ch. 4, sec. 9, on gold production. The Figures indicate that the rapidly growing monetary use of gold offset a large part of the effects of increasing gold production between 1840-1860 and 1884-1914. Between 1884 and 1896 prices actually continued to fall after gold production had begun to climb. Likewise the growing monetary use of gold accentuated strongly the effects, between 1873 and 1883 of a comparatively small decrease in gold production.]

Sec. 4. Index numbers. The process of calculating general prices and changes in them has in it, inevitably, something of arbitrariness and incompleteness. For not all prices can be included, but only those of articles of somewhat standardized grades and those that are pretty regularly sold in markets where prices are publicly quoted. Any list of articles that can be selected is of unequal importance to different persons and classes of persons, at different places, at different times, and for different purposes. And yet the study of general prices as shown by any broadly selected list reveals changes which in some measure affect the interests of every member of the community.

General prices are conveniently compared from one time to another through the use of index numbers. An index number of any article is the per cent which its price at any certain date is of its price at another date (or of the average for a series of prices) taken as a base or standard. Thus if the average price of cotton in the base year were 10 cents (taken as 100) and the price rose to 12 cents, the index number would be 120. A tabular index number is the per cent which the price of a selected group of articles at any certain date is of the price of the same group of articles at a date which has been taken as the base.[4]

The principal index numbers of the leading countries are here shown. The fact that from 1862 to 1879 inclusive prices in the United States were expressed in an irredeemable paper standard makes comparisons for that period misleading. A better idea is obtained by using as the base for each of the several series, the average of prices in each country for the years 1890 to 1899.

Sec. 5. Gold production and monetary legislation, 1850 to 1879. The unprecedented increase in gold production between 1849 and 1853, and the continuance of production in volume about four-fold as great as that of the decade 1840-49 was reflected at once in a rise of prices. This was a period of prosperity in business culminating in the crisis of 1857 (felt more or less in all the leading countries). This prosperity accelerated the effect of increasing quantities of the standard money. Credit was stimulated and the rate of circulation and the efficiency of money were increased. Prices rose to a temporary maximum in 1857 and then fell as a great international financial crisis occurred. The great new supplies of gold had been readily taken ("absorbed") into the monetary circulation of the world, to meet the needs of rapidly growing commerce and industry. In the European countries,[5] prices in terms of gold, tho fluctuating somewhat, kept at about the same level from 1860 to 1870. The years 1871 and 1872 were very prosperous and showed rapidly rising prices which reached a maximum in 1873, when a financial panic occurred.

In that very year, just as the gold production for the first time since 1851 had fallen below $100,000,000, several notable changes in monetary legislation were made which made gold more important in the circulation of a number of countries.

In 1873 Germany made gold the standard throughout the new German Empire (having prepared the way by legislation in 1871 which made gold a legal tender alongside of silver), and provided that silver was thenceforth to be used only in the subsidiary coinage. The same year Belgium, and the next year the other countries of the Latin Union (France, Switzerland, and Italy) took steps which resulted in demonetizing silver; that is, in limiting its coinage to governmental account, and in making gold their one standard money.

The United States at that time had neither gold nor silver regularly in circulation (except in California), and there was a long-continued discussion of "a return to specie payments," which meant the return to a metallic standard, and the redemption of greenbacks on demand. Meantime in 1873 a law was passed making the gold dollar "the unit of value," and dropping out the standard silver dollar from the list of coins authorized to be issued at the mint.[6] From 1873 until 1879, prices (in greenbacks) were falling in this country very rapidly because the country with the increase in population, wealth, and business, was "growing up to" its unchanging currency supply. For a like reason at the same time gold prices throughout the world were falling. While this country was lowering its level of prices from an inflated paper money to a gold commodity basis, the gold basis itself was sinking to a lower level. The very demand of our treasury and banks for gold caused the retention of our own gold product (which between 1864 and 1876 had been nearly all exported) and required an enormous net importation of gold between 1878 and 1888. This reduced suddenly by one-half the amount available each year from our production for the rest of the world.

Sec. 6. Definition of the standard of deferred payments. These various changes in the purchasing power of the standard money had great effects upon industrial conditions. Particularly had they shifted the positions and claims of debtors and creditors, because of the enormous importance of money as "the standard of deferred payments," Let us now get a more definite understanding of that term.

As a medium of exchange, money comes to be the unit in which most prices are expressed and compared; in other words, it becomes the common denominator of prices.[7] This makes it also the most convenient unit in which to express the amount of credit transactions and of existing debts.[8] A credit transaction is a trade lengthened in time; one party fulfils his part of the contract, the other party promises to give an equivalent at a later date. The equivalent may be in any kind of goods; for example, in barter one may part with a horse on the promise of a cow to be received later; or a small horse on the promise of a large one; or a flock of sheep on the promise of its return at the end of the year with a part of the increase of the flock. A simple standard in which to express the debt is the thing borrowed, as horse, sheep, wheat, house. Again, the thing to which the value of debts is referred may be a thing quite different from the goods borrowed and, with the growth of the monetary economy and the use of the interest contract, money comes more and more to be used as the standard. At length the law declares that, in the absence of any other agreement, the amount of a debt is to be payable in terms of the unit of standard money, which thus is made legal tender as well as the customary standard of deferred payments. A standard of deferred payments is the thing of value in which, by law or by contract, the amount of a debt is expressed and payable.

Sec. 7. # Increasing importance of the standard.# Until the use of money develops, the use of credit is difficult and limited; it becomes easy when the value of all things is expressed in terms of a common circulating medium. It therefore generally is true that the importance of money as the standard of deferred payments increases with the use of money as a medium of trade. The volume of outstanding debts expressed in terms of money now very greatly exceeds the total value of the circulating medium. Changes in the general level of prices have, therefore, great effects upon all existing debts. The value of all debts changes in the same proportion as does that of the standard unit of money; when this rises or falls in value, it means increase or reduction, in the same ratio, of the purchasing power of every creditor. It is as if he had in his possession metal dollars equal in amount to the face of the debt, and they had changed by so much in purchasing power. The debtor's interests in such changes are, of course, just the reverse of the creditor's interests.

Outstanding contract debts may be roughly divided into two classes: short-time loans, running less than a year; and long-time loans, running for a year or more.[9] Fluctuations are rarely rapid and great enough to affect appreciably the debtors and creditors in the case of short-time loans. The results are appreciable in the case of loans running from one to five years, and may be very great in the case of loans made for still longer periods, such as the bonded indebtedness of nations, states, municipalities, and business corporations, and as mortgages given by farmers on their land or by owners of city real estate. A multitude of interests are thus affected by a change in the value of money. When money rises in purchasing power, receivers of fixed incomes are gainers. When it falls in purchasing power, they lose. Receivers of fixed incomes from loans include not merely private investors, but also many educational and charitable institutions which dispense their incomes for public purposes. Wages and salaries of many kinds go up and down less rapidly than do other prices, and thus to some extent wage-earners are in the position of passive capitalists[10] as regards changes in the monetary standard. In a capitalistic age, therefore, almost every individual is affected in some way by a change in the value of money.

Sec. 8. Fluctuating standard and the interest-rate. In connection with the standard of deferred payments there is presented a problem of the effect that fluctuations of the standard may have upon the interest-rate.[11] As the general price-level falls or rises, the monetary standard conversely appreciates or depreciates.[12] If these changes are slight in amount and imperceptible in their direction they may not affect considerably the motives of borrowers and lenders. Therefore, the rate of interest this year in long-time loans would be just that resulting in the expectation, on all hands, of a stationary level of general prices. Suppose that rate to be 5 per cent on the standard investment (such as real-estate loans and good bonds). Then the lender of $1000 will receive each year a $50 income and at the end of the investment period $1000 principal, each dollar of which will purchase the same composite quantum of goods that a dollar would have purchased at the time the loan was made. Likewise, the borrower would pay interest and principal in a standard that reflected an unchanging general level of prices. But, now, if the general level of prices unexpectedly falls 1 per cent within the year, the creditor of a loan maturing at the end of the year would receive (principal and interest) $1050 which will purchase 1 per cent more goods per dollar than the sum he loaned, or (approximately) $1060 worth of goods. Hence, he has received, in quantum of goods, a yield of 6 per cent on his investment. If this change continues for five years, the lender of a five-year loan would receive each year $50 having a purchasing power successively 1, 2, 3, 4, and 5 per cent greater than the same sum had at the making of the loan; and at the end of the five years would collect the principal, having a purchasing power 5 per cent greater. The lender, on his part, would have to pay interest and repay the principal in a money that is to be obtained only in exchange for a larger sum of goods than that which could be bought with each dollar that he borrowed. This means that, with individual exceptions, creditors generally gain and debtors lose by falling prices.

But this is fully true only in respect to loans already made. For just to the extent that such a movement of prices comes to be more or less regularly in the same direction, both borrowers and lenders are able to take it into account, and as experience shows, do take it into account.[13] When prices fall men become more eager to sell wealth, to lend the proceeds, and more reluctant to borrow for investment at the prevailing rate of interest and at the prevailing prices. There is an incentive to divest one's self of ownership (e.g., by selling stocks) and to become a lender (e.g., by buying bonds). This whole situation is reversed in a period of rising prices. The result is that the rate of interest in any long continued period of falling prices (such as from 1873 to 1896) has a trend downward and in a period of rising prices (such as from 1897 to 1915) has a trend upward. This movement of readjustment would not go on indefinitely, even if the same trend of prices continued; for in the strict theory of the case the adjustment would be complete when the interest rate had changed by just the amount of the annual change in the level of prices. For example, if 5 per cent is the static normal rate of interest, then when prices are falling 1 per cent each year, the adjusted rate of interest would be 4 per cent; and when prices were rising 1 per cent each year, the adjusted rate of interest would be 6 per cent. Such adjustments serve to some extent to neutralize the effects of changes in the standard of deferred payments so far as concerns new loans made in view of just such a change and in expectation of its continuance. But no one can foresee exactly, and most persons take little account of, such a change until it has continued for several years in the same direction. The adjustment is therefore never very prompt or very exact. In some years the general level of prices has risen more than 5 per cent, or more than enough to offset the entire interest received by most lenders. A man with dollars to invest would have been as well off if he had kept them buried during that period.[14]

Sec. 9. Notable changes in prices. In most cases the true effects of monetary changes escape recognition. In a few cases, however, the change has been so great as to cause an economic revolution. Such was the change in prices following the discovery of America, which occurred soon after the old feudal dues had come to be generally expressed in terms of money instead of labor services. In modern times, since the mass of debts has become greater than ever before, such changes bring even graver economic consequence. The increase in the output of gold in 1849-57,[15] caused what was the most rapid, if not the greatest money inflation that had occurred since the sixteenth century. The substitution of gold for silver by some countries at that time, by making a great additional market for gold, helped to check the fall in its value. Indeed, a considerable decline in the output of gold after 1870 combined with its widening use to cause in 1873 the beginning of a great fall of gold prices. The resulting increase in the burden of outstanding debts was felt by all debtors, but particularly by great numbers of the agricultural classes both in Europe and in America. Their tribulations were aggravated by the fact that at that time (especially from about 1873 to 1896) the prices of their products were falling much more rapidly than were general prices, as a result of the very rapid extension of the agricultural land supply.[16] There was complaint, agitation, and demand for relief on the part of many interests in France, Germany, England, and the United States. As a result, the money question became in this country a leading political issue and continued to be such between 1873 and 1900.

Sec. 10. Nature and object of bimetallism. First came "the greenback movement," which, lasted until after 1880.[17] This then gave way to an agitation for bimetallism. Bimetallism is the plan of using two metals as standard moneys. Bimetallism is legally authorized when both metals are admitted to the mints for free coinage at an established ratio of weight. Bimetallism may be legally authorized, but not actually working, for, if the market-value long continues to vary appreciably from the legal ratio, only one of the metals may in fact be left in circulation. This situation is called limping bimetallism (or the halting double standard), tho this is a contradiction of terms. National bimetallism is confined to a single country, as was the case in the United States before the Civil War, or in France before 1867. International bimetallism is that resulting from an agreement among several nations to use two metals on the same terms.

The theory of bimetallism is that the government can act on the value of the two metals through the principle of substitution. The metal tending to become dearer will not be coined, the other will be coined in greater quantities. The degree of influence that can thus be exerted on the value of the two metals depends on the size of the reservoir of the metal that is rising in value. When it all leaves circulation, the law on the statute book permitting it to be coined becomes a mere phrase. In such a case there is bimetallism de jure, but monometallism de facto. The greater the league of states the greater is the likelihood that the plan will continue to work. The only notable historical instance of international bimetallism is that of the Latin Union, which united France, Belgium, Italy, and Switzerland in an agreement remaining actually in force from 1866 to 1874. A strong movement developed between 1878 and 1892 in favor of forming a great international bimetallic union of states.

One object of the movement was to put an end to the great fluctuations in the rates of exchange of money between the silver-using and gold-using countries, fluctuations which occasioned much uncertainty and loss to individuals engaged in foreign trade. The rise in the price of gold-exchange in the silver-using countries (notably India) meant also an increase in their burden of taxation. These countries collected their revenues in silver, but they had to pay their debts, principal and interest, in gold. Another object of this movement was to prevent the burden of individual debts from increasing by reason of the rise in the value of the single standard, gold. It was, indeed, hoped that by bringing silver much more into use, the value of gold would be reduced, thus bringing relief to the debtor classes. Still another object of the bimetallic movement was to aid the silver miners and silver-producing districts by creating a larger market for silver.

Several international conferences were held which were taken part in by some of the leading financiers of the world representing their respective governments. The United States was foremost in advocating the policy, France at first favored it, as did in large measure the British Indian administration, tho England was in the main opposed. The movement came to nothing.

Sec. 11. The movement for national bimetallism in America. When all hope of international bimetallism failed, the efforts of many of its advocates were turned to the plan of legalizing national bimetallism in the United States at a ratio of 16 to 1. This was very different from the market ratio. Gold had become before 1860, in fact, the standard of our money system, and after 1873 it was the only metal admitted to free coinage. Silver, little by little, had been losing purchasing power in terms of gold, until from being worth, in 1873, one-sixteenth as much, ounce for ounce, it became, in 1896, worth but one-thirtieth as much as gold. The power of silver to purchase general commodities fell much less than the change in its ratio to gold would indicate, gold having risen in terms of most other goods as well as of silver. Nevertheless, the proposal to open the mints to the free coinage of silver at the ratio of 16 to 1 in the year 1896 threatened a sudden and marked cheapening of money.[18] Probably gold would have been entirely driven out as money and silver would have taken its place as the standard. In any event "free silver" would have accomplished the purpose of making the standard of deferred payments cheaper. It was at first a debtors' movement, but to succeed it had to enlist the support of other large classes of voters. And thus it developed into the more sweeping theory that wages, welfare, and prosperity were favored by a larger supply of money quite apart from the effect it would have upon debts.

In its extreme form the free-silver plan was a fiat scheme, for some of its supporters believed that by the mere passage of the law the two metals could be made to bear to each other any ratio desired. But its most intelligent advocates recognized that the force of the law was limited by economic conditions. The victory of the gold standard in the campaign of 1896 was, it would seem, due more to the well-founded fear that a sudden change of the money standard would cause a panic than to a popular understanding of the question.

The free-silver advocates got what they desired, a reversal of the movement of general prices, through an occurrence for which no political party could claim the credit. In 1883 the gold production of the world was less than $100,000,000. From that date, with the opening of newer gold-yielding territory in South Africa and in the Klondike, the annual output of gold had been increasing rapidly and almost steadily. The methods of extracting gold theretofore had still been in large part of a primitive sort. But intricate machinery was taking the place of crude tools, chemical processes had been introduced (notably, the cyanide process), and the principal product began to come from the regular and certain working of deep mines rather than from chance surface discoveries. In many parts of the world were enormous deposits of low-grade ores, before useless, that could be worked economically by the new methods.

The general price level fluctuated, but on the whole tended downward between 1884 and 1893 (the year of panic), and reached a minimum in the year 1895 in Germany, 1896 in England, and 1897 in America. It is noteworthy that the very year 1896, which marked the height of the political agitation to abandon the gold standard for silver, saw the gold production for the first time in all history surpass the two hundred million dollar mark. The gold output had caught up with, and began to surpass, the normal monetary demands of the world, meaning by that phrase, the amount of gold needed to maintain a stationary level of prices.

Sec. 12. Rising prices after 1896. The whole character of the monetary problem then changed. A period of rising prices set in, which has continued to the present time. By 1913 prices had risen just about 50 per cent above the low level of 1896. The rise has been, and still is, at the average rate of nearly 3 per cent each year. This caused a reversal of the former positions of advantage and disadvantage on the part of debtor and creditor respectively. The purchasing power of a 3 per cent annual interest on notes and bonds has been offset by the decrease in the purchasing power of the principal of the debt. The burden of the average debt began relatively to decrease. A wide field for enterpriser's profits was opened up by the rapid displacement of prevailing prices in all quarters of the industrial world. The price of manufacturer's products rose in advance of the rise of costs of many raw materials and especially of the labor costs of manufacture. The average enterpriser's gain was the average wage-worker's loss. Wages (and salaries), as nearly always in the case of a change of price levels, moved more slowly than did the prices of most of the commodities which are bought with wages, thus causing great hardship to large classes living on comparatively slowly moving incomes.[19] Extremes meet, and these classes include both those living on passive investments, and those dependent on their daily labor for a livelihood.

Thus we escape the evils of a rising standard of deferred payments, only to meet those of a falling standard. And as long as we have so fluctuating a standard these difficulties must arise again and again, continually repeated, causing unmerited gains and losses to individuals. Let us conclude with a brief consideration of the fundamental principles involved in this problem.

Sec. 13. Defectiveness of the gold standard. Money is, in general, for both borrowers and lenders the most convenient standard of deferred payments. But from the usage of speaking of all things in terms of gold, arises the popular notion that the value of gold is always the same, while the value of other things changes. In truth, a fixed objective standard of value is not possible of attainment. Altho the value of gold is stable as compared with most things, it rests on the estimates made by men and is constantly changing with conditions. The current new supplies of gold are comparatively regular. For centuries at a time there was little change in the methods of mining gold and there were no radical changes in its output. The nature of the use of gold, likewise, is such as to made changes in the amount of it needed, under ordinary conditions, more stable than is that of most other goods. Moreover, the stock of gold in monetary uses is but slowly worn out; it is, therefore, a large reservoir into which flows a comparatively small stream of annual production; the existing stock is twenty or thirty times the annual output. Yet the value of gold expressed in other things is never quite stable, and sometimes several influences combine to affect it greatly and suddenly. Recent inventions, chemical and mechanical, moreover, have considerably altered the conditions of production. While, therefore, it is the best standard yet devised and put into actual practice, it is very imperfect. A standard better than a single metal, more stable than a single commodity, is desirable if it can be found.

Sec. 14. Various ideal standards suggested. It may, perhaps, be agreed that the ideal standard of deferred payments is one that would insure justice between borrower and lender. Yet different views may be and have been taken as to what constitutes justice in this matter. The suggestion is attractive that repayment should involve the return of enjoyment equal to that which could be purchased with the sum at the time of the loan. Such a standard is impossible of perfect realization in any general way, for men's circumstances are constantly changing. To insure even to the average man the same amount of enjoyment is only roughly possible. The same goods do not afford the same enjoyment when conditions, either subjective or objective, have changed. Another suggestion is that the goods returned should represent the same sacrifice as those loaned. Here again the difficulty is in the lack of a standard applicable to all men. Whose sacrifice? That of the lender, who may be rich, or that of the borrower, who may be poor? Some have supposed that the condition of equal sacrifices was met by the labor standard, according to which the sum returned should purchase the same number of days of labor as when borrowed. But what kind of labor is to be taken, that of the lender or that of the borrower or that of some one else? Labor is of many different qualities, which can be exactly compared only through their objective value in terms of some one good.[20]

It must be recognized that any possible concrete standard of deferred payments will sometimes work hardship in individual cases. The best average results for justice and social welfare will be secured by measuring debts in some standard that will change least often, and least rapidly, in relation to the great majority of people of all classes in the community.

Sec. 15. The tabular standard. Apart from the difficulties of its practical operation, a standard better than a single metal and more stable than a single commodity would be a tabular standard, consisting of a number of leading commodities in fixed proportions, such as is used in calculating index numbers expressing the general scale of prices. Such a standard averages the fluctuations of particular goods and would give a fair approximation in practice to the ideals of equal sacrifice and equal enjoyment (on the average tho not in individual cases). While some natural materials are growing more scarce and call for more sacrifice, other products are by industrial progress becoming more plentiful. This kind of standard has been viewed with favor by many monetary authorities, and despite the administrative difficulties ways may yet be found for putting it into practice.

After determining the tabular standard, the actual regulation of the quantity of money to make prices conform to the standard might be accomplished in one of several ways. It might be done by letting the value of the gold dollar fluctuate as it does now, while requiring a greater or less number of dollars to be given in fulfilment of all outstanding contracts. For example, if prices by the tabular standard fell from 100 to 95 in the time between the origin of a debt of $100 and its payment, the debt would be discharged by paying $95; if prices rose to $110, the debt would be discharged only by the payment of $110.

By the plan of a "compensated gold dollar" the legal weight of the gold coins would be increased or decreased from time to time to conform with the tabular standard. Still a third method would be to regulate the issue of standard paper money, contracting and expanding its amount by issue and redemption, by deposit in and withdrawal from depository banks, at regular intervals to bring prices into conformity with the tabular standard. These are as yet but distant possibilities, and for some time to come gold will continue to serve as the standard money in the same manner as in the past.

[Footnote 1: The amount of silver is here expressed at its coining value; this is not the commercial value, but rather the number of silver dollars 371.25 fine grains weight that could be made out of the silver produced. Silver and gold of equal coining value are, therefore, as to weight always in the ratio of 16 to 1.]

[Footnote 2: See above, ch. 5, sec. 4.]

[Footnote 3: See Vol. I, p. 45 ff. See also above, ch. 4, sec. 8.]

[Footnote 4: Numerous tabular index numbers have been worked out for different countries and periods. The main results of the more recent ones have been brought together with critical comments, by Professor Wesley C. Mitchell, in Bulletin 173 of the U.S. Bureau of Labor Statistics, July, 1915, from which the figures here used are quoted.]

[Footnote 5: The price movements in the United States between 1860 and 1879 must be left out of consideration here, for the excessive issues of greenbacks drove gold out of circulation and made greenbacks the standard money, except in California and elsewhere on the Pacific Coast where, by public opinion, gold was retained as the circulating medium.]

[Footnote 6: This change was what later was referred to in political discussions as "the crime of '73." The dollar referred to was the standard silver dollar; at the same time the coinage of a trade dollar was authorized (intended to be used only in foreign trade), which, after 1876, was not legal tender in the United States.]

[Footnote 7: See Vol. I, p. 262.]

[Footnote 8: See Vol. I, p. 263, on credit transactions, and p. 302, on the interest contract.]

[Footnote 9: See Vol. I, p. 304.]

[Footnote 10: See Vol. I, p. 319.]

[Footnote 11: This could not be treated in connection with the interest-rate in Vol. I, Part IV, for the reason that even its elementary treatment must presuppose the fuller study of the nature of money and the study of changes in the level of prices, that has just been given in this and the three preceding chapters. The theory of interest in Vol. I, therefore, is a static theory in respect to the standard of deferred payments, and requires adjustment to apply to a condition of a changing price-level.]

[Footnote 12: See above, sec. 3.]

[Footnote 13: Mention was made in Vol. I of the prospect of profit as affecting the motives of commercial borrowers; e.g., pp. 298, 335, 348, 495.]

[Footnote 14: The modern explanation of this phenomenon was worked out in the period of falling prices before 1896 and hence was referred to as the theory of "appreciation and interest" (meaning the relation of the appreciating dollar to a falling rate of interest). More generally the theory is that of the relation of a changing standard of deferred payments and the rate of interest.]

[Footnote 15: See ch. 4, sec. 12, and above secs. 1, 2, 4, 5.]

[Footnote 16: See Vol. I, on agricultural leases, p. 159, wheat prices, p. 436, and changes in the land supply, p. 442.]

[Footnote 17: See ch. 5, sec. 11.]

[Footnote 18: The advocacy of this proposal was called "the free-silver movement" because it involved resuming the free coinage of silver at the legal ratio of 16 to 1.]

[Footnote 19: This happened to coincide with a relative increase of the price of food-products and of other necessities of daily life at a greater rate than general prices. This aspect of the much discussed rising cost of living must be carefully distinguished from that of the change of the general price level, and also from that of the relatively slower change of wages. See Vol. I, pp. 437, 445-446 on population and food supply.]

[Footnote 20: See on the labor theory of value, Vol. I, pp. 210, 228-229, 502.]



PART III

BANKING AND INSURANCE



CHAPTER 7

THE FUNCTIONS OF BANKS

Sec. 1. Nature and classes of banks. Sec. 2. Functions of banks. Sec. 3. The essential banking function. Sec. 4. Time deposits. Sec. 5. Demand deposits. Sec. 6. Discount and deposit. Sec. 7. Nature of banking reserves. Sec. 8. Bills of exchange, domestic. Sec. 9. Issue of notes. Sec. 10. Divergent views of typical bank notes. Sec. 11. Banking credit as a medium of trade. Sec. 12. Productive services of banks. Sec. 13. Income of banks.

Sec. 1. Nature and classes of banks. Banks perform a variety of useful functions in every modern community. All these functions touch in some way upon the use of money, and banking problems always are related to money problems. It is our purpose now to understand the general nature and work of banks in relation to the general business activity of the community. A bank, as one first comes to know it, is a building (or a room in some building) in which there is a fire- and burglar-proof safe. In this room are men receiving and paying out money and acting as bookkeepers. Gradually one comes to understand that the bank is perhaps not the building but the business organization that is there performing these transactions.

In the United States there were in 1913 about 26,000 banks reported.[1] These may be classified first according to the source from which they derive their charters or authority to do a banking business as: national, state, and private. The last are unchartered and act under the general state laws governing private contracts; in general they are unsupervised.[2] Banks may be classified also according to the two main types of business they perform, as banks for savings and commercial banks. Most banks do mainly a general commercial business; some are distinctly banks for savings; but in truth this dividing line can be less and less sharply drawn between banks as wholes; rather the distinction must be made between the savings function and the commercial discount function, which are more and more being performed by one and the same bank. The trust company usually well exemplifies this union of functions. This will best be explained in connection with the subject to which we now turn, the analysis of the functions which banks perform.