CREDIT AND PRICES.*

By R. G. HAWTREY.

BANKERS create money. The medium of payment used in all the more important transactions is bank credit, that is to say, debts due from bankers. When a banker lends, two debts come into existence, a debt due from the borrower at some future date, and an immediate debt due to him from the banker. The latter can be assigned away by the borrower to meet his own liabilities. Whether the assignment is effected. by the drawing of a cheque or by the delivery of -a banknote is a matter of detail.

As. the creators of money, bankers assume a heavy responsibility towards the community. They cannot be left to create unlimited amounts of it at will. Under pre-War conditions the requisite restriction upon them was found in the gold standard. All debts were payable, if the creditor chose,in gold,and bankers had to be ready to pay their debts in gold whenever- required.

A golden age ! It is pardonable to think that a return to it would be itself the solution of all our monetary troubles.

It is axiomatic that, in some sense, the monetary unit ought to he stable in value in relation 'to commodities. It ought to represent, as nearly as may be, the same amount of wealth at the date when any pecuniary liability is diScharged as when it is incurred. . When the gold standard' was in general operation, it was recognized to be imperfect, in that the commodity value of gold, as measured by index numbers of prices, could be shown to vary perceptibly. From 1896 to 1918 the purchasing poWer of a pound "sterling fell by 28 per cent. This was plainly a hardship to all long-term • creditors, but not, 'in most people's opinion., so severe as to outweigh the advantages Of a simple and practical monetary system.

*It is desirable that I should make it' clear -that this article ;expresses my own personal views, and must not be connected in 4f.ny way with my official position at the Treasury.—R. G. H. ' If the injustice -as between debtors and creditors arising from the gradual influence of changes in the-annual supply upon the commodity value of gold were the only defect in the pre-War standard, few people would advocate any departure from it, But recent developments in economic opinion have revealed -some • more important aspects of the question. It has been shown that appar- ently moderate variations in the commodity value of the currency unit have far-reaching economic effects. More particularly a fall in the general_ level of prices has been shown to be intimately connected with those " epidemics" of unemployment which periodically harass the civilized world. That a credit contraction or curtailment of the supply of the means of payment depresses trade has long been well recognized in business circles.- But it is only recently that the full significance of the relation has beea worked -out.

Bank credit comes into existence in the course of the borrowing operations of traders. They do not borrow money to keep it idle, but pay it away, as quickly as they receive it, to those who are engaged in the productiori, transport and distribution of goods. To these latter the money is income, whether as profits, wages, interest or rent.- If-the borrowing. operations-are accelerated, that means that traders are buying more goods, and are paying away more money. The incomes of therecipients of this money are thereby increased, demand is stimulated, and the traders find that they sell more. If, on the-other hand, borrowing operations are retarded, the traders buy less goods, and pay away less money. Demand flags and the traders sell less.

But the very thing that makes traders desire to borrow more is an increase in business ; and, on the other hand, if they desire to diminish their borrowings, it is becaUse business falls off. In either case a vicious' circle is set Up. Because increased borrowing stimulates sales and raises prices, traders are tempted to borrow still more ; becanse decreased borrowing damps down sales and depresses prices, traders are still further deterred from borrowing. This short statement will perhaps be enough to show how sensitive business is bound to be to any change in credit conditions, though, needless to say, the subject is full of ramifications which space would not allow us to follow out.

Under pre-War conditions, quite apart from the long- period changes in the commodity value of gold, there occurred the well-known phenomena of the trade cycle, one of the most consistent of which was the alternation of a rise of prices during each period of active trade and a fall of prices during the ensuing period of depressed trade. A rise or fall of prices by one-fourth or one-fifth in the period of three to five years which would separate the maximum and the minimum was not unusual. An unemployment epidemic occurred with unfailing regu- larity in each period of falling prices. The gold standard by itself did not prevent variations of this extent in the general price leveL To show how they occurred and how they might be prevented, it is necessary to consider for a moment the mechanism of credit-control which has been evolved in this and other countries.

The banks undertake to turn credit into legal tender money, or legal tender money into credit at their customers' option. Instead of each bank maintaining a reserve sufficient to meet all contingencies, a single central bank makes itself responsible for holding a reserve of -money adequate for the needs of the country as a whole. Into it the other banks pay any surplus cash they may receive beyond what is required for their daily business ; from it they can draw out (or borrow if need be) enough to make good any deficiency of cash. -With a gold standard this cash (apart from subsidiary coin) must be gold or notes convertible into gold, and before the -War it was a primary duty of a-central-bank to maintain a gold reserve. The central bank was, us it were, a dealer in gold, under,- taking to buy or sell it in unlithited quantities at a fixed price. If the gold :reserve,- tire -central bank's stock in trade, was unduly increased or depleted, that meant that the price it was paying was too high or too lowi. But the price itself could not be altered. In order to correct the maladjustment, the central bank had ti) change, not the price of gold, but the value of the currency units in which the price was fixed, It had to induce iAp the one case a rise, and-in-the other a fall in the price level of commodities.

To reduce the price level, the central bank would have to deter the other banks from lending. It would charge more for its own loans.to_them,_and_would_sweep up cash from the market by 'selling securities. They in turn, looking at their own supplies of cash, would charge more td their own customers for discounts and advances. Borrowing would be checked, and a fall of prices would follow. Similarly, by lending cheap, and letting loose additional cash through the purchase of securities in the market, the central bank could stimulate borrowing and bring about a rise of prices. The whole system was directed_ to maintain the gold reserve at what was deemed to be a reasonable amount, but it worked entirely through adjustments in the commodity price level: The ultimate tendency was for the price level to gravitate towards the point at which the gold market was in equilibrium and gold reserves at their prescribed amounts. But instead of remaining fixed at that point the price level oscillated about it.

Though gold is a commodity, the demand for it for uses other than as money is very small in comparison with monetary movements. If, under pre-War condi- tions, credit was allowed to expand unduly in any country, and its monetary unit tended to fall in purchasing power relatively to those of other countries, the -result was that it had to sell gold to them. If credit contracted, and its monetary unit appreciated, it had to buy gold. To avoid any undesirable increase or decrease in its stock of gold, it had to keep the purchasing power of its monetary unit (and therefore reciprocally the prices of commodities) in equilibrium with those of foreign countries.

This equilibrium of international price levels was ensured, within narrow limits, by the gold standard, so long as it was effeetively. worked. But. international equilibrium was not inconsistent with fluctuations in the level of world *prices of commodities taken together. If prices tended to rise in all countries simultaneously, the only check upon the movement (apart from the negligible increase in the industrial demand for gold) was the absorption of gold (or of paper money convertible into gold) into active circulation. For reasons into which it is not necessary-to enter, this absorption lagged s. long way behind the expansion of credit to which it was attributable. Similarly when there was a general contraction of credit, and a fall of world prices, of com- modities, the return of money from circulation to the banks was glow.'' ' The consequence was that the central bank, so long as it was guided in its credit policy by the state of its gold - reserves, always tended to take action too late. In the interval between the beginning of d credit movement and the first appearance of any noticeable effect upon gold reserves, there was time for a very considerable price Movement. The inertia of an international credit system was Mich that the credit movement only-gathered Way _ gradually. Several years would . elapse between. the beginning of a credit expansion and the initiation of any decisive steps to counteract it. Thereafter several years of gradual contraction .(diversified perhaps with financial crises) might be necessary before sufficient gPld was wrung out of circulation to restore the gold reserves.

This was the credit cycle, which is one with the *trade cycle. TO prevent epidemics of unemployment, what is required is to smooth out the credit cycle. This is within the power of the central banks, in whose hands the regulation Of credit rests. They must not be content to rely on the state of their gold reserves for guidance, but must watch the price level itself, and aim directly at, keeping it, ay. nearly as may be, constant. If we get back to an international gold standard, with a world price level dependent on credit conditions in all gold- using countries, this can only be - accomplished by - co- ordinated action on the part of the central banks of the different countries. It is fear that this--co-ordinated action cannot be secureddis much as any other reason, that has led,Mr.- Keynes, in his-brilliant and much -discuised " Tract on Monetary Reform," 'to advOcate the abandon- mtnt of the gold standard in favour of a stabilized paper standard. One great step forward-,-- however, was taken by the Genoa Conference, which not only recorded resolu- tions in favour of international action, but showed how gold reserves could be'so managed is-to -secure Otabilizta- tion of the value of gold... And since_ then the Federal Reserve Banks of the United States have been following a_policy of :credit stabilization with a gold standard; and have obtained a very remarkable degree of succesi. This _promises well for future- international co-operation: The policy of stabilization of prices has met with * good deal of criticism. Some critics contend that it Is not practicable. Prices, it is said,- are determined l* economic conditions, and any attempt to influence them is bound to break down. But prices express a -relation between commodities on the one hand and money ' the other, and in this relation an essential factor is the supply of money. The supply of money, taken in tl e "wide sense of media of payment, is dependent upon the action of the banks. - That the banks can influence prices is really as much assumed in the pre-War credit system based on gold reserves. as in the stabilizatiOn policy. This is made abundantly clear in the excellent exposition of the pre-War system contained in the famous Interim Report of the Cunliffe Committee (see particu- larly paragraphs 5-6 and 18-21).

' Undeniably there are serious practical difficulties in the use of a price index as a guide to credit policy. It will record variations due to changes in the demand or supply of individual commodities which.do not proceed from monetary causes, and these variations will not invariably average out. A 'slavish conformity to au index number will not always be right, though it would nearly alivays- give better results than Conformity to the gold reserve test.. But the central' bank ought to ''supplei ment the evidence of the index number with all the know; ledge it can gain .of the state of trade—the activity of output and sales, the state of employment, the expecta- tions of business -men. On such matters the authorities Of a central bank are alWays in- a -position to be well- informed and to exercise a reasonedjudginent _ -But, it may be asked, if the price index itself cannot be relied on, what is left as the- meaning of the stabiliza- tion policy ? Perhaps in the long run the best test of - stability of money is to be found in wages. The labour . market is more nearly a unit thin the markets for different . kinds of commodities. Wages may, no doubt,: be rising in one industry and ,at the same timer falling in another, but the labour market is not exposed to disturbing factors such as natural abundance or scarcity, or changes in productive processes, to anything like the same extent as the - commodity markets.

If the price of human effort can be stabilized, money itself may be- regarded as stabilized ; there will- be little room for variation in the prices of commodities except such as can be traced- to non-monetary causes. Unfortunately the labour market is less- sensitive than • the commodity markets and . less easily-subjected to a statistical _test. *Stability of wages can only remain in the background, to.be appealed to as a corrective upon the commodity price index, when the guidance given by that index is doubtful.

On the other hand the conditions out-of which changes in wages grow are easily recognizable. They are the well-known phases of the trade cycle. The stabiliiation of wages and the stabilization of employment are a . single problem. The object of the central bank should be so' to regulate credit as to avoid giving traders an' inducement either to accelerate Or to retard their pur- chases of commodities. Whenever such an inducement in either direction begins to • take effect, a vicious circle " of expansion or contraction is set up ; of that the central bank ought .quiekly- to be aware, even when the effect is still- confined 'to an ' acceleration or retardation, of Sales and is not yet visible in prices. By prompt action the tendency can be stopped. Thus-and -thus only can production be steadied and unemployment in its epidemic form be prevented. - - „ StabiliiatiOnThif these lines iS.:iiot7-a' Complete solution of the problem of credit - control: -. An, international' gold standard implies, stable foreign exchanges, and this would at times involve compromising- with the internal stability of prices. But most of the difficulties that have been and are still experienced are themselves due to quite unnecessary and preventable departures from stability. Given a predominant approximation to stability, the requisite modifications would be small in extent and easily produced.