History of Economic Analysis part 73 pps

vests, favorable foreign exchange, removal of obstructions to foreign supplies and the emergence of new sources of raw materials, falling rates of freight and insurance, technological progress, increasing supply of capital, hence lower rates of interest—do not indeed reveal ideal analysis and there is much in them to find fault with from a theoretical standpoint. But at least they contain the most important factor—the tremendous increase in productive efficiency in consequence of the Industrial Revolution—and in addition most of the salient characteristics of that epoch, though Tooke failed at the analytic task of bringing them into their proper relations. In the second place, the variations in the purchasing power of money brought up the question of ‘justice’ as between creditors and debtors (or else, so far as the public debt was concerned, taxpayers). As always, ‘justice’ was what benefited the interest with which each writer sympathized. But more substantial arguments, sometimes crude, sometimes more refined, reinforced or even supplanted considerations of justice. ‘Squire’ Western made the point that there are situations in which, higher prices being the only alternative to widespread bankruptcy, a falling value of money might be deemed to be in the interest of creditors. Others emphasized that, on the whole, debtors represent the active elements in the economy so that a benefit to them in the end benefits everybody. Still others learned to qualify their dirges about the discouragement of industry through falling prices by stating ‘unless this fall is caused by a fall in costs’ 20 —though some were for price maintenance even in the face of falling costs. Like Hume (and Wicksell) most writers on currency preferred slowly rising to stable prices. Needless to say, the usual confusion between the prices a writer was interested in and the price level impaired arguments throughout; most writers, as we have seen above, were having a hard time in defining what they meant by ‘general prices.’ In the third place, definite ideas of monetary management were taking shape and some of them were more than mere repetitions of seventeenth-century argument. There was the idea of a stable price level; the idea of monetary stimulation of production (what we call pump priming); the idea of stabilizing interest rates; and the idea of stabilizing employment. Our few illustrative examples will be taken primarily from the economists of ‘scientific’ reputation. Thornton offered several suggestions for monetary management in times of crisis. Ricardo’s plan we have noticed already. Joseph Lowe’s tabular standard, 21 intended for voluntary use for the stabilization of long-run contracts, marks a distinct advance in monetary analysis. Inconvertible paper currency was sponsored by T.P.Thompson. 22 Poulett Scrope did not 20 Some writers, though not the better ones, mentioned fall in costs besides increase in supply. 21 The Present State of England (1822). In his Essay of 1807, Wheatley had already made a similar proposal. The idea itself, of course, goes back at least as far as Fleetwood. 22 He presented his ideas on monetary policy first in his Westminster Review article ‘On the Instrument of Exchange’ (1824; reprint 1830). They grew naturally out of a situation in which irredeemable paper had been actually circulating without blotting out sun and moon, whereas resumption proved a painful operation. Many people History of economic analysis 682 go so far as this but adhered to the metallic standard (gold or silver). 23 However, besides sponsoring and elaborating Lowe’s tabular-standard idea he tackled the whole complex of problems that arose from variations in the purchasing power of money, including their effects upon labor. He wrongly held that labor’s relative or absolute share in ‘gross produce’ must be reduced as the share of creditors (at fixed interest) increases, but he had the merit of emphasizing the influence of falling prices upon employment. This was also done by Bollmann. 24 The only other name I am going to mention, the name of the two heroes of the Birmingham Currency School, is Attwood. 25 The Birmingham Currency School is correctly described by the label it accepted itself: besides ‘Squire’ Western must have felt that it would be much better to carry the war system into peace practice, i.e. to retain it for good. Thomas Perronet Thompson, like Keynes in 1923—the basic recommendation of the Tract on Monetary Reform was precisely this, although Keynes retained a gold reserve—must therefore have voiced the feelings of many more people than were prepared to speak up. The ideas as well as the situations of 1824 and 1923 present in fact striking similarities, and both Thomas Perronet Thompson and Poulett Scrope, but most of all Thomas Attwood (see below) deserve to be known better than they are. So does Glocester Wilson, who, in his remarkable Defence of Abstract Currencies in Reply to the Bullion Report (1811), makes the statement that was often sneered at in the second half of the nineteenth century and yet contains a profound truth (which very naturally was commonplace among Austrian writers) that gold is no more essential to the guinea than is brass to the ruler that is made of it. 23 On Credit Currency…(1830) and Examination of the Bank Charter Question …(1833). The whole of the discussion now under survey, of course, bears in many points on questions of bank credit which we shall take up in the next section. In some points, the two discussions merge into one another and our attempt to separate them—which in any case has no other justification than expository convenience—breaks down occasionally. 24 Justus E.Bollmann, a physician who after some adventures in Europe settled in the United States, occupies a considerable position in the history of the theory of banking in America. The works that are relevant in the present connection are A Letter to Thomas Brand Esq.…on…a Resumption of Specie Payments (1819), and A Second Letter…on the Practicability of the New System of Bullion Payments (1819). As do his earlier works, Paragraphs on Banks (1810) and his Plan for an Improved System of the Money Concerns of the Union (1816), those Letters display a grasp of the problems involved that was far above average. 25 The brothers, Thomas and Mathias Attwood, were both bankers—Mathias also an extremely successful company promoter—and anything but cranks or visionaries. Mathias was simply a bimetallist who stated his case ably and soberly. But Thomas liked pamphleteering, agitation, mass meetings, and phraseological overstatement, and he had to pay the price: professionals did not take him quite seriously. They were wrong, however. A very considerable analytic performance might be distilled from his writings and evidences. See his Letter to Nicholas Vansittart, on the Creation of Money, and on its Action upon National Prosperity (1817); Observations on Currency, Population, and Pauperism (1818); A Letter to the Earl of Liverpool (1819); also his articles in the Globe, reprinted under the title The Scotch Banker in 1828. It is from these writings that any study of modern ideas on monetary management ought to start. Money, credit, and cycles 683 Anti-Gold Law League. As we might expect, many of its members were just inflationists. But Thomas Attwood was much more than that. If I have caught the meaning of his message, he was an anti-deflationist in the modern sense. He had an almost hysterical horror of what we call deflation and attributed to it every economic difficulty of his age. And in deflation itself he saw nothing but the vagaries of an essentially irrational system of money and credit. But whatever we may think of this diagnosis—many of us are bound to sympathize with it—it had the merit of serving as a magnifying glass that enabled him to see what the leading economists of the period refused to see, namely, that an ideally managed paper money could avoid some consequences of the gold automatism that are in fact functionless. So far as I know, he did not work out his principle fully and systematically. But, barring exaggerations, his advocacy of the principle itself is free from anything that deserves to be called freakish. His claim to being considered as a serious specialist on money is further strengthened by his recommendation to resume gold payments, if indeed they had to be resumed, at a reduced gold value of the pound—a remarkable anticipation of an idea of 1919. None of these ideas entered Mill’s authoritative text except as so many errors that need to be exposed. In his chapter ‘Of an Inconvertible Paper Currency’ (Principles, Book III, ch. 13), besides asserting that a power ‘to depreciate the currency without limit’ is an ‘intolerable evil,’ he encountered with a flat negative not only Attwood’s but also Hume’s and Thornton’s arguments about the possibility of monetary stimulation. From our standpoint, we have no right to object to Mill’s evident dislike of the idea. Nobody is in duty bound to approve of monetary management, and there were and are perfectly good reasons for distrusting the ability, independence, and what-not of the agencies that would have to undertake it. There are also reasons, good or bad, for wishing to put up with all the vagaries of automatic money rather than with the vagaries of politics. But we do have a right to object to Mill’s refusal to consider the theory of managed money and to face squarely the facts and problems that gave rise to the idea. By doing so, he impoverished monetary analysis and left it, in this respect, in a state that explains, though it does not justify, the impression so prevalent in our day that there is an immense scientific gulf between him and us. Nor is his chapter ‘Of a Double Standard’ (Book III, ch. 10) any more distinguished. What he had to say on bimetallism rests on the suspicion—in general well-founded, of course—that the sponsors of bimetallist schemes simply want to depress the purchasing power of money. Since he disapproved of this, he brushed the whole subject aside without entering seriously into the analytic problems involved, though a considerable literature on silver and on bimetallism developed during the period under survey—Henri Cernuschi’s Mécanique de l’échange appeared in 1865—and though it was clearly the duty of the writer of a treatise such as Mill’s to deal adequately with it irrespective of his sympathies. 26 The little that can be said in this book about 26 For a time. Ricardo had advocated silver as a standard metal. History of economic analysis 684 those problems will be deferred to Part IV (ch. 8). Gold production moved on a low level until the 1840’s. When Russian and then Australian and Californian gold came in to change the situation, facts and effects were zestfully debated throughout the 1850’s and 1860’s. There could be no reasonable doubt that the new gold was exerting some influence upon prices but there was all the more doubt whether this influence, counteracted as it was by the flow of gold to India, China, and other countries and by the concomitant increase in the output of goods, was strong enough to raise English prices by any appreciable amount. 27 This implied investigation of the modus operandi of the new gold upon monetary systems, credit, interest, output, and so on all over the world. Nobody doubted that first effects were upon interest; that the easy reserve situation prevented what might have been a financial crisis in 1853; but that high profits and speculation, engendered by the monetary stimulation of the economic process, would lead to stringencies and accentuate cyclical ups and downs. 28 With due respect to many a sensible piece of analysis that a more complete report would have to mention, I cannot but conclude that the gains for economic analysis were slender and that the economists of that time missed an opportunity to build the lessons of those experiences into their general theory of money. This shows also in the way in which the plethora of gold affected opinion on bimetallism. On the whole, people enjoyed the prosperity that the gold discoveries seemed to have brought: Providence was, for the time being, popular with the stock exchange. Dissent was not lacking, however, and some of the dissenters began to think of the adoption of a silver standard as a remedy for the gold inflation, that is, for reasons exactly opposite to those that had recommended the silver standard to some writers around 1820 29 and were again to recommend it from the 1870’s on. In addition, however, history was putting economists under obligation by performing an interesting experiment in bimetallism under their very eyes. France had then a de facto bimetallist system at the rate of 1:15½. As gold fell it began to flow into French circulation and reserves and to drive out the silver. This was the famous parachute effect, as Chevalier called it, that is to say, the effect of bimetallism to absorb 27 On samples from this literature and on the level of this discussion, see Sayers (op. cit. 1935, secs. II and V). M.Chevalier’s On the Probable Fall in the Value of Gold (1857; English trans. by Richard Cobden, with a preface, 1859) should be particularly noticed, as should Cairnes’s contribution, three articles, ‘Essays on the Gold Question’ (1859–60), republ. in Essays in Political Economy…(1873). The discussion gave, of course, a powerful impulse to the development of price- index numbers. It produced Jevons’ A Serious Fall in the Value of Gold…(1863) and the Depreciation of Gold (1869), both reprinted in Investigations in Currency and Finance (ed. by Professor Foxwell, 1884). 28 Mill’s views on the modus operandi of the new gold are concisely formulated in a letter of his to Cairnes (see the Mill-Cairnes correspondence publ. by G.O’Brien, Economica, November 1943, p. 279). 29 On the most important English sponsor of the silver standard, James Maclaren, see Sayers, op. cit., 1933, passim. Money, credit, and cycles 685 the depreciating and to set free the appreciating monetary metal and so to stabilize the value of the monetary unit, at least so long as the latter was not entirely displaced. It does not reflect much credit upon economists that this effect had not occurred to them before. 30 But it reflects still less credit on them that they did not understand it fully when they had it before their eyes. The first economist to work out the complete theory of the bimetallist standard at a fixed ratio was Walras. 4. THE THEORY OF CREDIT Even today, textbooks on Money, Currency, and Banking are more likely than not to begin with an analysis of a state of things in which legal-tender ‘money’ is the only means of paying and lending. The huge system of credits and debits, of claims and debts, by which capitalist society carries on its daily business of production and consumption is then built up step by step by introducing claims to money or credit instruments that act as substitutes for legal tender and are allowed indeed to affect its functioning in many ways but not to oust it from its fundamental role in the theoretical picture of the financial structure. Even when there is very little left of this fundamental role in practice, everything that happens in the sphere of currency, credit, and banking is construed from it, just as the case of money itself is construed from barter. Historically, this method of building up the analysis of money, currency, and banking is readily understandable: from the fourteenth and fifteenth centuries on (and even in the Graeco-Roman world) the gold or silver or copper coin was the familiar thing. The credit structure—which moreover was incessantly developing—was the thing to be explored and to be analyzed. The legal constructions, too—remember that most economists who were not businessmen were jurists—were geared to a sharp distinction between money as the only genuine and ultimate means of payment and the credit instrument that embodied a claim to money. But logically, it is by no means clear that the most useful method is to start from the coin—even if, making a concession to realism, we add inconvertible government paper—in order to proceed to the credit transactions of reality. It may be more useful to start from these in the first place, to look upon capitalist finance as a clearing system that cancels claims and debts and carries forward the differences—so that ‘money’ payments come in only as a special case without any particularly fundamental importance. In other words: practically and analytically, a credit theory of money is possibly preferable to a monetary theory of credit. 1 The situation of this period’s theory of credit and banking may now be 30 Ricardo, e.g., did notice this mechanism (Principles, ch. 27) by which the standard would be sometimes gold and sometimes silver. But he saw nothing in it but ‘an inconvenience which it was highly desirable should be remedied.’ 1 I hope that this sentence is self-explanatory. It will, however, be illustrated in the money chapter (8) of Part IV by a discussion of one of the consequences of economists’ failure to go through with the idea adumbrated above. History of economic analysis 686 characterized like this. The English leaders from Thornton to Mill did explore the credit structure, and in doing so made discoveries that constitute their chief contributions to monetary analysis but could not be adequately stated in terms of the monetary theory of credit. But they failed to go through with the theoretical implications of these discoveries, that is, to build up a systematic credit theory of money, 2 and on principle clung to the monetary theory of credit. So they produced in the end something that was neither the one nor the other. An eminent critic of our day who is a strong adherent of the monetary theory of credit, Professor Rist, was therefore, formally, within his rights when he accused some of the authors of that period of having ‘confused’ money and credit. Their waverings in the use of terms certainly suggest this. 3 Keeping this in mind, we shall in this section discuss cursorily (a) the most interesting of the period’s conquests in the theory of credit, and then (b) a few more points about banking and central banking that are most conveniently presented with reference to the quarrels between the ‘currency’ and ‘banking’ schools over the principles embodied or supposed to be embodied in Peel’s Act of 1844—though those quarrels, unlike the ones over war inflation and resumption, produced more heat than light. 4 (a) Credit, 5 Prices, Interest, and Forced Savings. As soon as we realize that there is no essential difference between those forms of ‘paper credit’ that are 2 We might see the outlines of such a theory in the works of Macleod. But they remained so completely outside of the pale of recognized economics that we transfer them and their author to Part IV. Compare also Wicksell’s dictum, mentioned above. 3 Yet, as we know, facts and ideas that were familiar to the projectors of the seventeenth century and, in a purified form, to the scientific economists of the first half of the eighteenth, such as Boisguillebert, Cantillon, and Verri, might have set the writers of 1800–1850 on the track of what I believe to be a more adequate analysis. But these Facts and ideas were practically forgotten by 1800—or a shudder at John Law’s practices was all that was left of them—and they had to be rediscovered by men who worked in the strait-jacket of the monetary theory of credit. 4 The reader is again referred to the works of Viner, Marget, and Rist. And also to V.F.Wagner, Geschichte der Kredittheorien (1937); Harry E.Miller, Banking Theories in the United States before 1860 (1927; a book the reader will find particularly useful since it is impossible in this sketch to do justice to the important American literature on banking); and L.W.Mints, A History of Banking Theory (1945), a work that reports on over 600 items but, as a consequence of its wholesale and uncritical condemnation of the commercial-bill theory of banking, pours away the baby with the bath water. 5 Writers had difficulty in defining ‘credit.’ Accordingly, the term was very loosely used all along. Thornton defined it as ‘confidence,’ which is an obvious logical misfit. We come nearer to what these writers wanted to express and what that difficulty was when we learn that Mill (Book III, ch. 12, 1) averred that it was Credit which acts on prices and not ‘banknotes, bills, and cheques.’ He meant that an individual’s power to purchase, which is the objective element behind demand in terms of numéraire, is not fully represented by the amount of the credit instruments that are actually used in ‘payment’ or even, so we should add, by the deposits, overdrafts, etc. against which checks are drawn, but by the total amount that an individual could command if he Money, credit, and cycles 687 used for paying and lending, 6 and that demand, supported by ‘credit,’ acts upon prices in essentially the same manner as does demand supported by legal tender, we are on the way toward a serviceable theory of the credit structure and, in particular, toward the discovery of the relations between prices and interest. Before turning to the period’s theory of these relations we must, however, consider the obstacles that prevented many authors from accepting the two propositions just alluded to. We have already seen that the monetary theory of credit in itself constitutes such an obstacle because, developing the theory of the network of credit ‘payments’ from the case of payment in specie, it assigns to legal- tender money a logically privileged position. But we still have to consider some practical reasons that seem to militate against an analysis that puts, say, ‘money’ and ‘deposits’ on essentially the same footing. In the first place, the law treats different types of means of payment differently. In the case of legal-tender money, it insists on acceptance; in the case of an accepted and endorsed bill of exchange, it does not. For the legal mind, the two are anything but ‘essentially the same thing,’ since the credit instrument is on the face of it a claim to money. In the second place, and in connection with this, ‘money’ and ‘paper credit,’ and again the various forms of ‘paper credit,’ are not in practice equally well qualified for every purpose. They are not perfect substitutes for one another: legal-tender money is a universal means of payment; bank notes and deposits are less widely acceptable; the accepted and endorsed bill of exchange can circulate only in a relatively small circle of business concerns. And only legal-tender money is recognized, in most historical cases, as the ultimate reserve money of the banking system. These differences are of course quite important, and nobody would think of trying to explain the way in which a given monetary system functions without taking account of them. And this is why Thornton’s perception of the fact that the different means of payments may, on a certain level of abstraction, be treated as essentially alike was a major analytic performance, for the mere practitioner will in general be impressed by the technical differences rather than by the fundamental sameness. 7 But precisely for the same reason, it is quite understandable that, though Thornton’s view eventually prevailed with J.S.Mill, the opposite view found sponsors all along. And this was one of the reasons, though not the only one, why some writers wanted to, i.e. the amount that is actually at his disposal in some measurable form plus something that might be called potential credit, which defies measurement, yet is a factor in any given situation. And we may assume, I think, that it is this total that people meant when they used the term Credit. 6 For jurists, I repeat that the word ‘paying’ is not used in the legal sense, and is meant to comprise, besides what constitutes legally definitive payment (solutio), also much of what legally is a mere substitute for definitive payment (datio in solutionem). 7 We might, therefore, speak of a genuine discovery of Thornton’s, were it not for the fact that it had been made long before. See, e.g., the Discourse of 1697, attributed to Pollexfen, mentioned above, Part II, chs. 3 and 7. History of economic analysis 688 stoutly denied that ‘credit’ acts upon prices. 8 Now we turn to the subject of Prices and Interest or, as we may also call it, of the Real and the Money Rate of Interest. Within the scholastic system, interest being simply the price for the use of money, the phrase Real and Money Rate of Interest is a label on an empty box—there was no problem of any direct relation of this kind, any more than there is in the Keynesian system. 9 But when, under A.Smith’s influence, Barbon’s analysis began to prevail, according to which interest was that part of business gains that accrued to the purveyor of physical capital, the question was bound to arise how this interest was related to the interest in the market of money loans, which after all is a distinct phenomenon. A.Smith answered 10 in effect that the loan rate of the money market was simply the shadow of the ‘rate of profit’ on real capital—the latter being ‘lent in the form of money’ as the later slogan has it—and that quantity of money, however defined, had nothing at all to do with it. I cannot emphasize sufficiently that this remained the dominant opinion throughout the nineteenth century, at any rate until Wicksell; that it was, as will be presently explained, also Ricardo’s; and that even Thornton’s contributions to the problem of the relation between ‘money,’ prices, and the ‘real’ rate of interest (important though they were), which point to a different conclusion, were largely forgotten. Thornton related the volume and the velocity of money and other circulating media to interest in the four following ways. (1) He was the first to point out that a high rate of discount will attract gold from abroad. (2) He also pointed out the relevance of the prevailing money rate of interest for the public’s willingness to hold cash. 11 (3) Further, he pointed out the effect upon the loan rate of expectations about the future course of prices. 12 (4) 8 Tooke must be classed with them, even after he had recognized the fundamental sameness of notes and deposits, if we take some of his utterances literally. But the denial in turn admits of different interpretations. We shall return to the argument below. 9 Of course, if we dig more deeply, the problem does reappear in both systems. 10 The key performance was D.Hume’s essay ‘Of Interest’ (Political Discourses, 1752). A.Smith quoted approvingly its argument against the view of Locke, Law, and Montesquieu that the American gold and silver had been the cause of the fall of the rate of interest that occurred in Europe (Wealth, p. 337), but neglected to make full use of the rest of Hume’s theory that, anticipating much later work, went some way toward giving the monetary factor its due. Thornton improved upon Hume’s position, but neither he nor J.S.Mill was quite fair in their criticism of him. Hume, as we know, was anticipated, in several essential points, by Cantillon. 11 While it should be admitted that the loss involved in holding idle cash varies with the rate of interest and that this fact does make some difference, the empirical correlation between large cash holdings and low rates of interest must not be considered as causally explained by this fact: large cash items and low rates are primarily consequences of decisions to restrict operations in depressive situations, and there would be correlation between them even if there were no functional relation at all. 12 This piece of analysis, succinctly presented in the first of the two ‘Speeches’ Money, credit, and cycles 689 Finally, soaring high above the commonplace controversy on the question whether or not banks have the power ‘to inflate the currency,’ he presented (all the essentials of) a complete analysis of the market for loanable funds that pivots on the fundamental equilibrium theorem, that the loan rate (money interest) tends to equal expected marginal profits of investment (marginal efficiency of capital). 13 This requires some elaboration. First, Thornton’s theorem occurs in the course of an argument to the effect that there does not exist, within the logic of the credit mechanism itself and apart from convertibility, any restriction that will prevent bank credit from exceeding the limit beyond which it will cause an inflationary increase in prices; 14 and that, in particular, ‘sound banking practice,’ that is, the practice of lending on good security only or even discounting bona fide commer- appended to the Library of Economics reprint of Paper Credit, pp. 335–6, is nothing short of admirable. It is easy to see that in a period of falling (rising) prices the creditor gets more (less), in terms of goods, than he bargained for. It is less easy, but still easy, to realize that this fact, if foreseen, will influence the terms of the loan contract, a lower (higher) rate in terms of money being stipulated for than would be the case otherwise. But Thornton saw that this is inconclusive, at least if expected price changes are moderate, unless the mechanism be uncovered by which that result is brought about even in the absence of what we may call conscious expectations. So he pointed out that if prices rise (fall), the debtor will make gains beyond (below) expectations, that this will induce him to borrow more (less)—so long as this lasts, the case merges into (4)—and that this will tend to adjust the rate of interest to rising (falling) price levels. It should be observed that, as a short-run qualification, this fits perfectly into what has been called in the text the ‘recognized opinion’ about the relation between the rate of profit on real capital and the money loan rate. Thornton’s idea was taken up again, independently, by Irving Fisher in 1896 (see below, Part IV, ch. 5, sec. 7b) and before that by Marshall. 13 It is for the reader to decide whether or not this formulation, clad in modern terminology, renders Thornton’s meaning faithfully: while it rests on many other passages, it is meant to convey particularly the paragraph on pp. 253–4 of Paper Credit. No essential discrepancy, considering the banking practice of the time, is involved in Thornton’s speaking of the rate of the Bank of England. Nor should qualms be caused by Thornton’s speaking simply of ‘the current rate of mercantile profit.’ Apart from the fact that my rendering of this phrase might be considered fair, even if there were nothing further to support it, the element of expectation enters into many other arguments of Thornton’s (see p. 158) and was perfectly familiar in the literature of the period (J.S.Mill used it in Principles, Book III, ch. 12, 3). But the addition of the adjective ‘marginal’ to ‘profits,’ at least in the form of the profits of the least favored firm, is an improvement that was added by Ricardo. If my reading be unobjectionable, it must also be unobjectionable to say that Thornton propounded a theorem that is fundamental to the Marshall-Wicksell-Hawtrey analysis. This is also Professor von Hayek’s opinion. 14 Thornton was primarily concerned with the lending of the Bank of England and with its note issue. He was, however, fully aware of the complications that arise from the influence of this issue upon the country-bank issue and upon the behavior of London bankers and ‘other discountants.’ This seems to justify the generalizing statement of our text. History of economic analysis 690 cial bills only, does not constitute such a restriction. The reasons for this are, of course, that an expansion of loans, unless accompanied by a compensating reduction of expenditure by people other than the borrowers, will increase money incomes, hence raise demand schedules for goods and services (not necessarily their prices), so that every wave of additional borrowing tends to justify itself ex post; and that such an expansion of loans can—at least in favorable situations—be induced by the offer to lend at a rate that is below expected marginal profits. In other words, the equilibrium of Thornton’s theorem is unstable: an increase in loans beyond the equilibrium amount will eventually (though not necessarily at first) result in an increase in prices and, if the rate of interest continues to be kept at its old level (the level that induced the first expansion), further borrowing will continue to be profitable at the new level of prices; further expansion of credit will follow, and so on, without any assignable limit, and we shall have the Wicksellian Cumulative Process (for restatement and criticism, see below, Part IV, ch. 8, sec. 2). To enforce stability, other conditions, such as convertibility—direct or indirect— of notes and deposits in gold, are therefore necessary. This practical conclusion, if not the whole of Thornton’s analysis, was widely accepted, among others by King, Ricardo, Joplin, and Senior. J.S.Mill also accepted it though, presumably under the influence of Tooke, he toned it down. Lord King was, so far as I know, the first to follow Thornton in his Thoughts on the Effects of the Bank Restriction (1803). Ricardo accepted the doctrine resolutely, at least in the faulty form that, if banks ‘charge less than the market rate of interest, there is no amount of money which they might not lend’ (Principles, ch. 27, but see High Price of Bullion, 1810). Senior expressed himself similarly (see Industrial Efficiency and Social Economy, S.L.Levy ed., 1928, vol. II; the essay is a review of Lord King’s pamphlet), using the term ‘usual’ rate. Since the market or usual rate itself may be below that equilibrium level which would prevent credit inflation, Ricardo and Senior must be interpreted to have meant something akin to Wicksell’s ‘real rate.’ Ricardo seems to indicate this by another faulty phrase that occurs in the paragraph from which I have quoted and lets interest be ‘regulated’ by ‘the rate of profits which can be made by the employment of capital and is totally independent of the quantity or of the value of money.’ Clearly two different sets of considerations fight each other in this paragraph. On the one hand, Ricardo meant to uphold what has been described above as the Smithian view of the relation between the ‘real’ and the money rate of interest. On the other hand, no practical financier could deny that any increase of the circulating medium, no matter whether of gold or notes or anything else, will tend to depress the rate of interest at least temporarily. So he reconciled Thornton’s theory, which does not fit at all well into his quantity theory, first, by underlining the ‘temporarily’ and, second, by emphasizing, to the exclusion of everything else, the inflationary effect of such an increase, as we shall presently see. Tooke might have pointed out, and to some extent did point out, that there are many qualifications to the proposition that low interest raises prices. As it was, probably carried away by his controversial ardors, he in the end denied the existence of any such nexus as unreasonably as he denied the existence of any nexus between quantity of money and prices. J.S.Mill, on this point as elsewhere, ‘rationalized’ Tooke. This he did by the formula that the lending by banks qua lending does act on the interest late and not on prices; but that, since the ‘currency in common use, being a Money, credit, and cycles 691 . the money chapter (8) of Part IV by a discussion of one of the consequences of economists’ failure to go through with the idea adumbrated above. History of economic analysis 686 characterized. ‘regulated’ by ‘the rate of profits which can be made by the employment of capital and is totally independent of the quantity or of the value of money.’ Clearly two different sets of considerations. those forms of ‘paper credit’ that are 2 We might see the outlines of such a theory in the works of Macleod. But they remained so completely outside of the pale of recognized economics that