Prices and Production, Lecture I: Part II

            In the first lecture of Prices and Production, Hayek goes on to describing a short history of monetary theory hitherto (bear in mind that the lectures the book was written from were given in 1931). He divided the history into four parts: 1. the history of theories on what would result from inflation, 2. of theories that analyze how the quantity of money influences the interest-rate, and 3. the doctrine of forced savings, and 4. the interweaving of the previous three into a single doctrine mostly through the influence of Knut Wicksell.

I. Theories of Inflation

            Though John Locke, and Germiniano Montanari had clearly stated the quantity theory of money, it was out of the inadequacies of these theories that Richard Cantillon first successfully deduced the economic results of inflation in his Essai Sur la Nature du Commerce en Général. About Locke’s theory, Cantillon wrote:

“He realized well that the abundance of money makes everything dear but he did not analyse how that takes place. The great difficulty in this analysis consists in discovering by what path and in what proportion the increase of money raises the price of things.”

Though Locke had described what will occur as a result of inflation, Cantillon was not satisfied by that, and in a chapter that W.S Jevons later called: “one of the most marvelous things in the book”, he attempts to analyze how inflation would work. Starting from the assumption that new gold, or silver mines were discovered, he goes on to describe how the income of all the individuals connected with production are influences first, and then how their expenditures ripple through the economy. Eventually, he concludes that only those whose incomes rise early once the quantity of money is increased are benefited by inflation, and that those whose incomes rise later are harmed.

            In his Political Discourses, David Hume gives a shorter, and also more renowned exposition of the same ideas that Cantillon did. Though, at the time Hume wrote this, manuscripts of the Essai were only in private circulation, it is hard to believe that Hume was never introduced to Cantillon’s since there is such a resemblance between the two. Unlike Cantillon, though, he elucidates clearly that he believed: “it is only in this interval or immediate situation, between the acquisition of money and the rise of prices, that the increasing quantity of gold and silver is favorable to industry.” The Classical economists did not see any necessity, or even possibility, for improving Hume’s analysis until the later gold rushes in California (1848-1855) and Australia (1851-around1872). It was then J. E. Cairnes’ Essay on the Australian Gold Discoveries that refined the earlier theories of Cantillon, and Hume into its most advanced form before modern explanations based of subjective theories of value.

            Though it was inevitable that eventually the effects of inflation would be traced back towards the actions of individuals, it took a generation until there were serious attempts to explain this process via marginal utility. Eventually, it was in this form that the problem was tackled by Mises. However, though these theories succeeded in explaining the influence of an increase in the quantity of money upon the economy, they failed in assisting economists in making any general statements about the effects that any alteration in the money supply brings. To Hayek, everything depends on where the new money is injected into circulation, and the vice versa- where it is withdrawn from circulation; a factor that the Classical economists had not integrated into their theories.

II. Theories on the Influence of the Quantity of Money on the Interest Rate

            The existence of some relation between the quantity of money and the rate of interest was recognized early on, with the earliest musing being in the writings of Locke and Dutot. The first to clearly describe a theory of this was Henry Thornton in his An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, which was published in 1802 during the beginning of the discussion of Bank Restriction. In the Paper Credit of Great Britain, which ends up becoming a technical treatise on money and monetary policy, Thornton defends the Bank of England against claims that its excessive issuing of paper money during England’s involvement in the French Revolutionary War as well as the Napoleonic Wars was responsible for the general raising of prices during this time period[1]. Especially of interest was Thornton’s refutation that there existed a natural tendency for the circulation of the Bank of England within limits that would prevent a dangerous depreciations; instead, he asserted that the circulation might increase beyond all limits if the interest rate is held low enough by the Bank.

These opinions were reiterated by Thornton in the first of his two speeches on the Bullion Report, and during this he stated that the interest rate was “a very great and turning point.” In this speech, after restating his theory in the Paper Credit of Great Britain, he supplements his analysis with a new theory on the relations between price and interest, which ought not to be confused with his other theory. Thornton’s theory provided a theory of the influence of an expected rise of prices on the money rate of interest, which was rediscovered by Alfred Marshall and Irving Fisher. This theory though did not concern Hayek enough to have more than a brief statement about it.

Thornton’s theory was generally accepted amongst the bullionists; however, once that school of thought was under attack by the banking school, it had been forgotten even though it would have been a sufficient repudiation of the latter. However, the theory was accepted by Ricardo in his 1809 pamphlet, and it was also given a more catchy tone by referring the interest rate falling bellow its “natural” level. Ricardo also repeated his endorsement of Thornton’s theory in his Principles of Political Economy and Taxation, published in 1817, that should have ensured the theory would have become generally known. It was also appeared in the 1810 Bullion Report that suggested Great Britain return to a gold standard with convertible note issues, and a control over the quantity of paper money in circulation[2].

Another interesting theory, that of “pressure and anti-pressure of capital upon currency”, was created by Thomas Joplin, the creator of the currency doctrine. However, this doctrine was interwoven with so many fallacies that later generation did not comprehend the contributions of Joplin. The principle that Joplin discovered was that for “every great fluctuation in prices that has occurred since the first establishment of our banking system” there has been a supply of capital that exceeded the demand. When the supply exceeds demand, the result is a compression of the country’s circulation, and when the demand exceeds the supply, it has the effect of expanding the circulation. He proceeds to provide an analysis of how the interest rate’s function serves to equalize the demand for, and the supply of capital, and how that rate affects productive enterprise. Also, Joplin goes on to advocate a metallic currency since a banker would always now the state of the market with one in that he would not be able to lend money until it has been saved, and placed into his ownership.

Three years after Joplin, in 1826, Thomas Tooke accepted Thornton’s doctrine and developed upon it come minor points in Considerations on the State of the Currency. In 1832, J. Horlsey Palmer restated the theory before the parliamentary committee on the Renewal of the Bank Charter. As late as 1840, the theory that “demand for loans and discounts at a rate below the usual rate is insatiable” was treated as a matter of factor by Nassau William Senior, and it was incorporated into John Stuart Mill’s Principles of Political Economy, though in a somewhat emasculated form.

III. The Doctrine of Forced Savings

            Another important pre-modern development was the theory that an increase in the quantity results in an increase of capital, which has come under the popular name of “forced saving.” This doctrine analyzes the influence that an increase in the quantity of money has upon the production of capital, whether directly or indirectly through the interest rate.

            Jeremy Bentham was the first to state this theory, and he did so with lucidity that was unmatched until Hayek’s own time. He did so in his Manual of Political Economy that he wrote in 1804; however, it was not published until 1843, leading to its diminished value for the evolution of this doctrine. He referred to this economic phenomenon as “forced frugality,” and he utilized it to describe the manner by which a government can increase the “addition to the mass of future wealth” through applying funds raised by taxation, or through printing paper money to the production of capital. Though Bentham’s ideas were most likely known in private circles, the fact that they were not published until forty years after being written drastically lessens their influence upon the science of economics.

            The first author to have spoken about forced savings in print is Theodore Robert Malthus in an 1811 unsigned response to Ricardo’s first pamphlet. During his response, Malthus complained that his contemporaries never seemed aware of the effects that the circulation of money had upon the “accumulations which are destined to facilitate future production” – i.e capital. He goes on to demonstrate that a change in the proportion between capital and revenue to the advantage of capital would direct the produce of the country into the hands of the productive classes – those who sell as well as buy goods. Nevertheless, even though he recognized that an increase in the issuing of notes had an effect of augmenting the national capital did not blind Malthus to the inherent injustice of this process. Rather than advocating this as a government agenda, Malthus merely presents this as a rational explanation for why a rise in prices is generally found in sync with national prosperity.

            The fact that Ricardo responded to Malthus’ forced savings doctrine at length should have defiantly familiarized the economics academia to Malthus’ thesis, even though it was not appreciated at that time. An exception to this attitude was a series of memoranda to the Bullion Report that Dugald Stewart prepared for Lord Lauderdale in 1811 that were subsequently reprinted as an appendix to his lectures on Political Economy. In them, Stewart objected to the oversimplified version of the quantity theory that the Bullion Report utilized in favor of a more “indirect connection between the high prices and an increased circulating medium.” In fact, he comes very close to the argument previously made by Malthus, eventually even referring to the original article that he had published.

There were later references to forced savings most notably by Thomas Joplin, R. Torrens, and John Stuart Mill, in the fourth of his Essays on Some Unsettled Questions of Political Economy. In fact, J.S. Mill’s essay “On profits and Interest,” which was written either in 1829 or 1830, goes as far as to declare that, due to the activity of bankers, “revenue” may be “converted into capital; and thus, strange as it may appear, the depreciation of the currency, when effected in this way, operates to a certain extend as a forced accumulation.”[3] He goes on as to admit that he believed that the reason for this was thanks to “further anomalies of the rate of interest which have not, so far as we are aware, been hitherto brought within the pale of exact science.” However, the first edition of his Principles, though he did add a footnote onto the chapter: “Credit as a Substitute for Money” of the sixth edition in 1865 a footnote that closely resembled Malthus’ thesis enough that is likely Mill had read his works on the matter.

V. Knut Wicksell’s Contributions

            After the publication of J.S. Mill’s Principles there was an interest only in the first two of the developments discussed below until the further development, or perhaps even independent re-discovery, of the forced saving doctrine by Léon Walras, in 1879. This is of interest only because it is through Walras that the idea was passed over to Knut Wicksell, who succeeded in welding all the separate doctrines into a single one.

            The reasons why Wicksell was able to achieve the success that he did is because his attempt was supported by Böhm-Bawerk’s modern theory of interest. However, Wicksell did not become famous for the improvements he added upon the previous theories, but his fallacious attempt to establish a connection between the interest rate, and the alterations in the general price level. Shortly put, Wicksell’s theory is, in Hayek’s words: “if it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings” (Hayek, pg. 23); the equilibrium rate of interest was the natural interest rate. However, in a money economy, the actual, or money interest rate – “geldzins”- can differ from the equilibrium one because capital’s demand and supply are not communicated per their natural forms, but through money, whose quantity for the purposes for capital can be arbitrarily altered by banks.

            So long as the money rate of interest is the same as the equilibrium rate, the interest rate has a neutral effect on the prices of goods; but, this changes once the two are no longer equal. When banks lower the money interest rate, something they can do by lending more than what has been entrusted upon them (i.e. by adding to the circulation), it has the result of raising prices; if they raise the money interest rate, it has the opposite effect of lowering prices. Wicksell, though, then jumped to the conclusion that if the two rates agree, then the price level must remain stable, even though all one is able to state on this matter is that if the money in interest rate coincides with the equilibrium one, there is no monetary influence on the price level. The rise of the price level is a result of entrepreneurs spending on production the increased quantity of money created by the banks that resulted, as displayed by Malthus, in the process of what Wicksell now coined as enforced, or compulsory saving.

            It is only necessary now to point out that it was the Wicksellian theory that Mises improved by an inquiry of the different influences that a money rate of interest that differs from the equilibrium one affects the prices of conumers’ goods, and producers’ goods. By doing this, Mises modified the Wicksellian theory into a satisfactory explanation of the credit cycle that can support the analysis of Prices and Production.