A Tract on Monetary Reform: Chapter V - Positive Suggestions for the Future Regulation of Money

A sound constructive scheme must provide—if it is to satisfy the arguments and the analysis of this book:

I. A method for regulating the supply of currency and credit with a view to maintaining, so far as possible, the stability of the internal price level; and

II. A method for regulating the supply of foreign exchange so as to avoid purely temporary fluctuations, caused by seasonal or other influences and not due to a lasting disturbance in the relation between the internal and the external price level.

I believe that in Great Britain the ideal system can be most nearly and most easily reached by an adaptation of the actual system which has grown up, half haphazard, since the war. After the general idea has been exhibited by an application in detail to the case of Great Britain, it will be sufficient to deal somewhat briefly with the modifications required in the case of other countries.

I. Great Britain.

The system actually in operation to-day is broadly as follows:

(1) The internal price level is mainly determined by the amount of credit created by the banks, chiefly the Big Five; though in a depression, when the public are increasing their real balances, a greater amount of credit has to be created to support a given price level (in accordance with the theory explained above in Chapter III., p. 84) than is required in a boom, when real balances are being diminished.

The amount of credit, so created, is in its turn roughly measured by the volume of the banks’ deposits—since variations in this total must correspond to variations in the total of their investments, bill-holdings, and advances. Now there is no necessary reason a priori why the proportion between the banks’ deposits and their “cash in hand and at the Bank of England” should not fluctuate within fairly wide limits in accordance with circumstances. But in practice the banks usually work by rule of thumb and do not depart widely from their preconceived “proportions.”51 In recent times their aggregate deposits have always been about nine times their “cash.” Since this is what is generally considered a “safe” proportion, it is bad for a bank’s reputation to fall below it, whilst on the other hand it is bad for its earning power to rise above it. Thus in one way or another the banks generally adjust their total creation of credit in one form or another (investments, bills, and advances) up to their capacity as measured by the above criterion; from which it follows that the volume of their “cash” in the shape of Bank and Currency Notes and Deposits at the Bank of England closely determines the volume of credit which they create.

51 The Joint Stock banks have published monthly returns since January 1921. Excluding the half-yearly statement when a little “window-dressing” is temporarily arranged, the extreme range of fluctuation has been between 11·0 per cent and 11·9 per cent in the proportion of “cash” to deposits, and between 41·1 per cent and 50·1 per cent in the proportion of advances to deposits. These figures cover two and a half years of widely varying conditions. The “proportions” of individual banks differ amongst themselves, and the above is an average result, the steadiness of which is strengthened by the fact that each big bank is pretty steadfast in its own policy.

In order to follow, therefore, the train of causation a stage further, we must consider what determines the volume of their “cash.” Its amount can only be altered in one or other of three ways: (a) by the public requiring more or fewer notes in circulation, (b) by the Treasury borrowing more or less from the Currency Note Reserve, and (c) by the Bank of England increasing or diminishing its assets.52

52 For the aggregate of its liabilities in the shape of deposits and of notes in circulation automatically depends on the volume of its assets.

To complete the argument, one further factor, not yet mentioned, must be introduced, namely (d) the proportion of the banks’ second-line reserve in the shape of their holdings of Treasury Bills, which can be regarded as cash at one remove. In determining what is a safe proportion of “cash,” they pay some regard to the amount of Treasury Bills which they hold, since by reducing this holding they can immediately increase their “cash” and compel the Treasury to borrow more either from the Currency Note Reserve or from the Bank of England. The ninefold proportion referred to above presumes a certain minimum holding of Treasury Bills, and might have to be modified if a sufficient volume of such Bills was not available. This factor (d) is, however, also important because the banks in their turn are open to pressure by the Treasury, whenever it draws to itself the resources of their depositors—whether by taxation or by offering them attractive longer-dated loans—and uses them to pay off, if not Ways and Means advances from the Bank of England (which reduces the banks’ first-line reserve of cash), then alternatively Treasury Bills held by the banks themselves (which reduces their second-line reserve of bills).

Items (a), (b), (c), and (d) together, therefore, more or less settle the matter. For the purpose of the present argument, however, we need not pay much separate attention to (a) and (b), since their effect is, for the most part, reflected over again in (c) and (d). (a) depends partly on the volume of trade but mainly on the price level itself; and in practice fluctuations in (a) do not directly affect the banks’ “cash,”—for if more notes are required under (a), more notes are issued, the Treasury borrowing a corresponding additional amount from the Currency Note Reserve, in which case the Treasury either repays the Bank of England, which diminishes the Bank’s assets and consequently the other banks’ “cash,” or withdraws an equivalent amount of Treasury Bills, which diminishes the other banks’ second-line reserve; i.e. a change in (a) operates on the banks’ resources through (c) and (d).53 Whilst as for (b), a change in the amount of what the Treasury borrows from the Currency Note Reserve is reflected by a corresponding change in the opposite sense in what it borrows in Ways and Means Advances or in Treasury Bills.

53 If the additional issue of notes is covered by transferring gold from the Bank of England, this is merely an alternative way of diminishing the Bank of England’s assets.

Thus we can concentrate our attention on (c) and (d) as the main determining factors of the price level.

Now (c), namely the assets of the Bank of England, consist (so far as their variable part is concerned) of

(i.)Ways and Means advances to the Treasury.(ii.)Gilt-edged and other investments.(iii.)Advances to its customers and bills of exchange.(iv.)Gold.

An increase in any of these items tends, therefore, to increase the other banks’ “cash,” thereby to stimulate the creation of credit, and hence to raise the price level; and contrariwise.

And (d), namely the banks’ holdings of Treasury Bills, depend on the excess of the expenditure of the Treasury over and above what it secures (i.) from the public by taxation and loans, (ii.) from the Bank of England in Ways and Means advances, and (iii.) by borrowing from the Currency Note Reserve.

It follows that the capacity of the Joint Stock banks to create credit is mainly governed by the policies and actions of the Bank of England and of the Treasury. When these are settled, (a), (b), (c), and (d) are settled.

How far can these two authorities control their own actions and how far must they remain passive agents? In my opinion the control, if they choose to exercise it, is mainly in their own hands. As regards the Treasury, the extent to which they draw money from the public to discharge floating debt clearly depends on the rate of interest and the type of loan which they are prepared to offer. A point might be reached when they could not fund further on any reasonable terms; but within fairly wide limits the policy of the Treasury can be whatever the Chancellor of the Exchequer and the House of Commons may decide. The Bank of England also is, within sufficiently wide limits, mistress of the situation if she acts in conjunction with the Treasury. She can increase or decrease at will her investments and her gold by buying or selling the one or the other. In the case of advances and of bills, whilst their volume is not so immediately or directly controllable, here also adequate control can be obtained by varying the price charged, that is to say the bank rate.54

54 It is often assumed that the bank rate is the sole governing factor. But the bank rate can only operate by its reaction on (c), namely, the Bank of England’s assets. Formerly it acted pretty directly on two of the components of (c), namely, (c) (iii.) advances to customers and bills of exchange and (c) (iv.) gold. Now it acts only on one of them, namely, (c) (iii.). But changes in (c) (i.) the Bank’s advances to the Treasury and (c) (ii.) the Bank’s investments can often be nearly as potent in their effect on the creation of credit. Thus a low bank rate can be largely neutralised by a simultaneous reduction of (c) (i.) or (c) (ii.) and a high bank rate by an increase of these. Indeed the Bank of England can probably bring the money-market to heel more decisively by buying or selling securities than in any other way; and the utility of bank rate, operated by itself and without assistance from deliberate variations in the volume of (c) (ii.), is lessened by the various limitations which exist in practice to its freedom of movement, and to the limits within which it can move, upwards and downwards.

Therefore it is broadly true to say that the level of prices, and hence the level of the exchanges, depends in the last resort on the policy of the Bank of England and of the Treasury in respect of the above particulars;—though the other banks, if they strongly opposed the official policy, could thwart, or at least delay it to a certain extent—provided they were prepared to depart from their usual proportions.

(2) Cash, in the form of Bank or Currency Notes, is supplied ad libitum, i.e. in such quantities as are called for by the amount of credit created and the internal price level established under (1). That is to say, in practice;—in theory, a limit to the issue of Currency Notes has been laid down, namely the maximum fiduciary issue actually attained in the preceding calendar year. Since this theoretical maximum was prescribed, it has never yet been actually operative; and, as the rule springs from a doctrine now out of date and out of accordance with most responsible opinion, it is probable that, if it were becoming operative, it would be relaxed. This is a matter where the recommendations of the Cunliffe Committee call for urgent change, unless we desire deliberately to pursue still further a process of Deflation. A point must come when, a year of brisk trade and employment following one of depression, there will be an increased demand for currency, which must be met unless the revival is to be deliberately damped down.

Thus the tendency of to-day—rightly I think—is to watch and to control the creation of credit and to let the creation of currency follow suit, rather than, as formerly, to watch and to control the creation of currency and to let the creation of credit follow suit.

(3) The Bank of England’s gold is immobilised. It neither buys nor sells. The gold plays no part in our system. Occasionally, however, the Bank may ship a consignment to the United States, to help the Treasury in meeting its dollar liabilities. The South African and other gold which finds its way here comes purely as a commodity to a convenient entrepôt centre, and is mostly re-exported.

(4) The foreign exchanges are unregulated and left to look after themselves. From day to day they fluctuate in accordance with the seasons and other irregular influences. Over longer periods they depend, as we have seen, on the relative price levels established here and abroad by the respective credit policies adopted here and abroad. But whilst this is, for the most part, the actual state of affairs, it is not, as yet, the avowed or consistent policy of the responsible authorities. Fixity of the dollar exchange at the pre-war parity remains their aspiration; and it still may happen that the bank rate is raised for the purpose of influencing the exchange at a time when considerations of internal price level and credit policy point the other way.

* * * * *

This, in brief—I apologise to the reader if I have compressed the argument unduly—is the present state of affairs, one essentially different from our pre-war system. It will be observed that in practice we have already gone a long way towards the ideal of directing bank rate and credit policy by reference to the internal price level and other symptoms of under- or over-expansion of internal credit, rather than by reference to the pre-war criteria of the amount of cash in circulation (or of gold reserves in the banks) or the level of the dollar exchange.

I. Accordingly my first requirement in a good constructive scheme can be supplied merely by a development of our existing arrangements on more deliberate and self-conscious lines. Hitherto the Treasury and the Bank of England have looked forward to the stability of the dollar exchange (preferably at the pre-war parity) as their objective. It is not clear whether they intend to stick to this irrespective of fluctuations in the value of the dollar (or of gold); whether, that is to say, they would sacrifice the stability of sterling prices to the stability of the dollar exchange in the event of the two proving to be incompatible. At any rate, my scheme would require that they should adopt the stability of sterling prices as their primary objective—though this would not prevent their aiming at exchange stability also as a secondary objective by co-operating with the Federal Reserve Board in a common policy. So long as the Federal Reserve Board was successful in keeping dollar prices steady the objective of keeping sterling prices steady would be identical with the objective of keeping the dollar sterling exchange steady. My recommendation does not involve more than a determination that, in the event of the Federal Reserve Board failing to keep dollar prices steady, sterling prices should not, if it could be helped, plunge with them merely for the sake of maintaining a fixed parity of exchange.

If the Bank of England, the Treasury, and the Big Five were to adopt this policy, to what criteria should they look respectively in regulating bank-rate, Government borrowing, and trade-advances? The first question is whether the criterion should be a precise, arithmetical formula or whether it should be sought in a general judgement of the situation based on all the available data. The pioneer of price-stability as against exchange-stability, Professor Irving Fisher, advocated the former in the shape of his “compensated dollar,” which was to be automatically adjusted by reference to an index number of prices without any play of judgement or discretion. He may have been influenced, however, by the advantage of propounding a method which could be grafted as easily as possible on to the pre-war system of gold-reserves and gold-ratios. In any case, I doubt the wisdom and the practicability of a system so cut and dried. If we wait until a price movement is actually afoot before applying remedial measures, we may be too late. “It is not the past rise in prices but the future rise that has to be counteracted.”55 It is characteristic of the impetuosity of the credit cycle that price movements tend to be cumulative, each movement promoting, up to a certain point, a further movement in the same direction. Professor Fisher’s method may be adapted to deal with long-period trends in the value of gold but not with the, often more injurious, short-period oscillations of the credit cycle. Nevertheless, whilst it would not be advisable to postpone action until it was called for by an actual movement of prices, it would promote confidence and furnish an objective standard of value, if, an official index number having been compiled of such a character as to register the price of a standard composite commodity, the authorities were to adopt this composite commodity as their standard of value in the sense that they would employ all their resources to prevent a movement of its price by more than a certain percentage in either direction away from the normal, just as before the war they employed all their resources to prevent a movement in the price of gold by more than a certain percentage. The precise composition of the standard composite commodity could be modified from time to time in accordance with changes in the relative economic importance of its various components.

55 Hawtrey, Monetary Reconstruction, p. 105.

As regards the criteria, other than the actual trend of prices, which should determine the action of the controlling authority, it is beyond the scope of this volume to deal adequately with the diagnosis and analysis of the credit cycle. The more deeply that our researches penetrate into this subject, the more accurately shall we understand the right time and method for controlling credit-expansion by bank-rate or otherwise. But in the meantime we have a considerable and growing body of general experience upon which those in authority can base their judgements. Actual price-movements must of course provide the most important datum; but the state of employment, the volume of production, the effective demand for credit as felt by the banks, the rate of interest on investments of various types, the volume of new issues, the flow of cash into circulation, the statistics of foreign trade and the level of the exchanges must all be taken into account. The main point is that the objective of the authorities, pursued with such means as are at their command, should be the stability of prices.

It would at least be possible to avoid, for example, such action as has been taken lately (in Great Britain) whereby the supply of “cash” has been deflated at a time when real balances were becoming inflated,—action which has materially aggravated the severity of the late depression. We might be able to moderate very greatly the amplitude of the fluctuations if it was understood that the time to deflate the supply of cash is when real balances are falling, i.e. when prices are rising out of proportion to the increase, if any, in the volume of cash, and that the time to inflate the supply of cash is when real balances are rising, and not, as seems to be our present practice, the other way round.

II. How can we best combine this primary object with a maximum stability of the exchanges? Can we get the best of both worlds—stability of prices over long periods and stability of exchanges over short periods? It is the great advantage of the gold standard that it overcomes the excessive sensitiveness of the exchanges to temporary influences, which we analysed in Chapter III. Our object must be to secure this advantage, if we can, without committing ourselves to follow big movements in the value of gold itself.

I believe that we can go a long way in this direction if the Bank of England will take over the duty of regulating the price of gold, just as it already regulates the rate of discount. “Regulate,” but not “peg.” The Bank of England should have a buying and a selling price for gold, just as it did before the war, and this price might remain unchanged for considerable periods, just as bank-rate does. But it would not be fixed or “pegged” once and for all, any more than bank-rate is fixed. The Bank’s rate for gold would be announced every Thursday morning at the same time as its rate for discounting bills, with a difference between its buying and selling rates corresponding to the pre-war margin between £3 : 17 : 10½ per oz. and £3 : 17 : 9 per oz.; except that, in order to obviate too frequent changes in the rate, the difference might be wider than 1½d. per oz.—say, ½ to 1 per cent. A willingness on the part of the Bank both to buy and to sell gold at rates fixed for the time being would keep the dollar-sterling exchange steady within corresponding limits, so that the exchange rate would not move with every breath of wind but only when the Bank had come to a considered judgement that a change was required for the sake of the stability of sterling prices.

If the bank rate and the gold rate in conjunction were leading to an excessive influx or an excessive efflux of gold, the Bank of England would have to decide whether the flow was due to an internal or to an external movement away from stability. To fix our ideas, let us suppose that gold is flowing outwards. If this seemed to be due to a tendency of sterling to depreciate in terms of commodities, the correct remedy would be to raise the bank rate. If, on the other hand, it was due to a tendency of gold to appreciate in terms of commodities, the correct remedy would be to raise the gold rate (i.e. the buying price for gold). If, however, the flow could be explained by seasonal, or other passing influences, then it should be allowed to continue (assuming, of course, that the Bank’s gold reserves were equal to any probable calls on them) unchecked, to be redressed later on by the corresponding reaction.

Two subsidiary suggestions may be made for strengthening the Bank’s control:

(1) The service of the American debt will make it necessary for the British Treasury to buy nearly $500,000 every working day. It is clear that the particular method adopted for purchasing these huge sums will greatly affect the short-period fluctuations of the exchange. I suggest that this duty should be entrusted to the Bank of England to be carried out by them with the express object of minimising those fluctuations in the exchange which are due to the daily and seasonal ebb and flow of the ordinary trade demand. In particular the proper distribution of these purchases through the year might be so arranged as greatly to mitigate the normal seasonal fluctuation discussed in Chapter III. If the trade demand is concentrated in one half of the year the Treasury demand should be concentrated in the other half.

(2) It would effect an improvement in the technique of the system here proposed, without altering its fundamental characteristics, if the Bank of England were to quote a daily price, not only for the purchase and sale of gold for immediate delivery, but also for delivery three months forward. The difference, if any, between the cash and forward quotations might represent either a discount or a premium of the latter on the former, according as the bank desired money rates in London to stand below or above those in New York. The existence of the forward quotation of the Bank of England would afford a firm foundation for a free market in forward exchange, and would facilitate the movement of funds between London and New York for short periods, in much the same way as before the war, whilst at the same time keeping down to a minimum the actual movement of gold bullion backwards and forwards. I need not develop this point further, because it is only an application of the argument of Section III. of Chapter III. which will be most readily intelligible to the reader, if he will refer back to the previous argument.

There remains the question of the regulation of the Note Issue. My proposal here may appear shocking until the reader realises that, apart from its disregarding the conventions, it does not differ in substance from the existing state of affairs. The object of fixing the amount of gold to be held against a note issue is to set up a danger signal which cannot be easily disregarded, when a curtailment of credit and purchasing power is urgently required to maintain the legal tender money at its lawful parity. But this system, whilst far better than no system at all, is primitive in its ideas and is, in fact, a survival of an earlier evolutionary stage in the development of credit and currency. For it has two great disadvantages. In so far as we fix a minimum gold reserve against the note issue, the effect is to immobilise this quantity of gold and thus to reduce the amount actually available for use as a store of value to meet temporary or sudden deficits in the country’s international balance of payments. And in so far as we regard an approach towards the prescribed minimum or a departure upwards from it as a barometer warning us to curtail credit or encouraging us to expand it, we are using a criterion which most people would now agree in considering second-rate for the purpose, because it cannot give the necessary warning soon enough. If gold movements are actually taking place, this means that the disequilibrium has proceeded a very long way; and whilst this criterion may pull us up in time to preserve convertibility on the one hand or to prevent an excessive flood of gold on the other, it will not do so in time to avoid an injurious oscillation of prices. This method belongs indeed to a period when the preservation of convertibility was all that any one thought about (all indeed that there was to think about so long as we were confined to an unregulated gold standard), and before the idea of utilising bank-rate as a means of keeping prices and employment steady had become practical politics.

We have scarcely realised how far our thoughts have travelled during the past five years. But to re-read the famous Cunliffe Report on Currency and Foreign Exchange after the War, published in 1918, brings vividly before one’s mind what a great distance we have covered since then. This document was published three months before the Armistice. It was compiled long before the unpegging of sterling and the great break in the European exchanges in 1919, before the tremendous boom and crash of 1920–21, before the vast piling up of the world’s gold in America, and without experience of the Federal Reserve policy in 1922–23 of burying this gold at Washington, withdrawing it from the exercise of its full effect on prices, and thereby, in effect, demonetising the metal. The Cunliffe Report is an unadulterated pre-war prescription—inevitably so considering that it was written after four years’ interregnum of war, before Peace was in sight, and without knowledge of the revolutionary and unforeseeable experiences of the past five years.

Of all the omissions from the Cunliffe Report the most noteworthy is the complete absence of any mention of the problem of the stability of the price-level; and it cheerfully explains how the pre-war system, which it aims at restoring, operated to bring back equilibrium by deliberately causing a “consequent slackening of employment.” The Cunliffe Report belongs to an extinct and an almost forgotten order of ideas. Few think on these lines now; yet the Report remains the authorised declaration of our policy, and the Bank of England and the Treasury are said still to regard it as their marching orders.

Let us return to the regulation of note issue. If we agree that gold is not to be employed in the circulation, and that it is better to employ some other criterion than the ratio of gold reserves to note issue in deciding to raise or to lower the bank rate, it follows that the only employment for gold (nevertheless important) is as a store of value to be held as a war-chest against emergencies and as a means of rapidly correcting the influence of a temporarily adverse balance of international payments and thus maintaining a day-to-day stability of the sterling-dollar exchange. It is desirable, therefore, that the whole of the reserves should be under the control of the authority responsible for this, which, under the above proposals, is the Bank of England. The volume of the paper money, on the other hand, would be consequential, as it is at present, on the state of trade and employment, bank-rate policy and Treasury Bill policy. The governors of the system would be bank-rate and Treasury Bill policy, the objects of government would be stability of trade, prices, and employment, and the volume of paper money would be a consequence of the first (just—I repeat—as it is at present) and an instrument of the second, the precise arithmetical level of which could not and need not be predicted. Nor would the amount of gold, which it would be prudent to hold as a reserve against international emergencies and temporary indebtedness, bear any logical or calculable relation to the volume of paper money;—for the two have no close or necessary connection with one another. Therefore I make the proposal—which may seem, but should not be, shocking—of separating entirely the gold reserve from the note issue. Once this principle is adopted, the regulations are matters of detail. The gold reserves of the country should be concentrated in the hands of the Bank of England, to be used for the purpose of avoiding short-period fluctuations in the exchange. The Currency Notes may, just as well as not—since the Treasury is to draw the profit from them—be issued by the Treasury, without the latter being subjected to any formal regulations (which are likely to be either inoperative or injurious) as to their197 volume. Except in form, this régime would not differ materially from the existing state of affairs.

The reader will observe that I retain for gold an important rôle in our system. As an ultimate safeguard and as a reserve for sudden requirements, no superior medium is yet available. But I urge that it is possible to get the benefit of the advantages of gold, without irrevocably binding our legal-tender money to follow blindly all the vagaries of gold and future unforeseeable fluctuations in its real purchasing power.