Hawtrey’s Good and Bad Trade, Part IV: The Inherent Instability of Credit

I don’t have a particularly good memory for specific facts or of books and articles that I have read, even ones that I really enjoyed or thought were very important. If I am lucky, I can remember on or two highlights or retain some general idea of what the book or article was about. So I often find myself surprised when reading something for the second time when I come across a passage that I had forgotten and experience the shock and awe of discovery while knowing, and perhaps even remembering, that I had read this all before once upon a time. That is just the experience I had when reading chapter 7 (“Origination of Monetary Disturbances in an Isolated Community”) of Good and Bad Trade. I think that I read Good and Bad Trade for the first time in the spring of 2009. On the whole, I would say that I was less impressed with it than I was with some other books of his that I had read (especially The Art of Central Banking and The Gold Standard in Theory and Practice), but reading chapter 7 a second time really enhanced my appreciation for how insightful Hawtrey was and how well he explained the underlying causes for what he called, in one of his great phrases “the inherent instability of credit.” He starts of chapter 7 with the following deceptively modest introductory paragraphs.

In the last two chapters we have postulated a perfectly arbitrary change in the quantity of legal tender currency in circulation. However closely the consequences traced from such an arbitrary change may correspond with the phenomena we have set out to explain, we have accomplished nothing till we have shown that causes which will lead to those consequences actually occur. . . .

At the present stage, however it is already possible to make a preliminary survey of the causes of fluctuations with the advantage of an artificial simplification of the problem. And at the outset it must be recognized that arbitrary changes in the quantity of legal tender currency in circulation cannot be of much practical importance. Such changes rarely occur. . . .

But what we are looking for is the origination of changes not necessarily in the quantity of legal tender currency but in the quantity of purchasing power, which is based on the quantity of credit money. . . . For example, if the banker suddenly came to the conclusion that the proportion of reserves to liabilities previously maintained was too low, and decided to increase, this would necessitate a reduction in deposits exactly similar to the reduction which in the last chapter we supposed them to make in consequence of a reduction in the actual stock of legal tender currency. Or there might casual variations in their reserves. These reserves simply consist of that portion of the existing supply of cash [i.e., currency] which happens for the moment not to be in the pockets, tills, cashboxes, etc., of the public. The amount of money which any individual carries about with him at any time is largely a matter of chance, and consequently there may very well be variations in the cash in circulation and therefore contrary variations in the reserves, which are really in the nature of casual variations . . . (pp. 73-74)

After explaining that the amount of cash (i.e., currency) held by the public tends to fluctuate cyclically because increasing employment and increasing wage payments involve an increasing demand for currency (most workers having been paid with currency not by check, and certainly not by electronic transfer, in the nineteenth and early twentieth centuries), so that banks would generally tend to experience declining reserves over the course of the business cycle, Hawtrey offered another reason why banks would be subject to cyclical disturbances affecting their reserve position.

[W]henever the prevailing rate of profit deviates from the rate of interest charged on loans the discrepancy between them at once tends to be enlarged. If trade is for the moment stable and the market rate of interest is equal to the profit rate, and if we suppose that by any cause the profit rate is slightly increased, there will be an increased demand for loans at the existing market rate. But this increased demand for loans leads to an increase in the aggregate amount of purchasing power, which in turn still further increases the profit rate. This process will continue with ever accelerated force until the bankers intervene to save their reserves by raising the rate of interest up to and above the now enhanced profit rate. A parallel phenomenon occurs when the profit rate, through some chance cause, drops below the market rate; the consequent curtailment of loans and so of purchasing power leads at once to a greater and growing fall in profits, until the bankers intervene by reducing the rate of interest. It appears, therefore, that the equilibrium which the bankers have to maintain in fixing the rate of interest is essentially “unstable,” in the sense that if the rate of interest deviates from its proper value by any amount, however small, the deviation will tend to grow greater and greater until steps are taken to correct it. This of itself shows that the money market must be subject to fluctuations. A flag in a steady breeze could theoretically remain in equilibrium if it were spread out perfectly flat in the exact direction of the breeze. But it can be shown mathematically that that position is “unstable,” that if the flag deviates from it to any extent, however small, it will tend to deviate further. Consequently the flag flaps. (pp. 76-77)

Hawtrey also mentions other economic forces tending to amplify fluctuations, forces implicated in the general phenomenon of credit.

Credit money is composed of the obligations of bankers, and if a banker cannot meet his obligations the credit money dependent upon him is wholly or partly destroyed. Again, against his obligations the banker holds equivalent assets, together with a margin. These assets are composed chiefly of two items, legal tender currency and loans to traders. The solvency of the banker will depend largely on the reality of these assets, and the value of the loans will depend in turn on the solvency of the borrowers. (p. 77)

Hawtrey describes one of the principal assets held by English commercial banks in his day, the mercantile bill, with which a dealer or wholesaler making an order from a manufacturer obligates himself to pay for the ordered merchandise upon delivery at some fixed time, say 120 days, after the order is placed. The IOU of the dealer, the bill, can be immediately presented by the manufacturer to his banker who will then advance the funds to the manufacturer with which to cover the costs of producing the order for the dealer. When the order is filled four months hence, the dealer will pay for the order and the manufacturer will then be able to discharge his obligation to his banker.

The whole value of the manufacturer’s efforts in producing the goods depends upon there being an effective demand for them when they are completed. It is only because the dealer anticipates that this effective demand for them will be forthcoming that he gives the manufacturer the order. The dealer, in fact, is taking the responsibility of saying how £10,000 worth of the productive capacity of the country shall be employed. The manufacturer, in accepting the order, and the banker in discounting the bill, are both endorsing the opinion of the dealer. The whole transaction is based ultimately on an expectation of a future demand, which must be more or less speculative. But the banker is doubly insured against the risk. Both the dealer and the manufacturer are men of substance. If the dealer cannot dispose of the goods for £10,000, he is prepared to bear the loss himself. He expects some of his ventures to fail, and others to bring him more than he counted on. Take the rough with the smooth he will probably make a profit. . . . And if the dealer becomes insolvent, there is still the manufacturer to save the banker from loss. . . . Where bills are not used a banker may lend on the sole credit of a dealer or manufacturer, relying on the value of the business to which he lends as the ultimate security for the loan.

Now if a contraction of credit money occurs, the consequent slackening of demand, and fall in the prices of commodities, will lead to a widespread disappointment of dealers’ expectations. At such a time the weakest dealers are likely to be impaired. An individual or company in starting a manufacturing business would usually add to the capital they can provide themselves, further sums borrowed in the form of debentures secured on the business and yielding a fixed rate of interest. . . . But when the general level of prices is falling, the value of the entire business will be falling also, while the debenture and other liabilities, being expressed in money, will remain unchanged. . . . [D]uring the period of falling prices, the expenses of production resist the downward tendency, and the profits are temporarily diminished and may be entirely obliterated or turned into an actual loss. A weak business cannot bear the strain, and being unable to pay its debenture interest and having no further assets on which to borrow, it will fail. If it is not reconstructed but ceases operations altogether, that will of course contribute to the general diminution of output. Its inability to meet its engagements will at the same time inflict loss on the banks. But at present we are considering credit, and credit depends on the expectation of future solvency. A business which is believed to be weak will have difficulty in borrowing, because bankers fear that it may fail. At a time of contracting trade the probability of any given business failing will be increased. At the same time the probability of any particular venture for which it may desire to borrow resulting in a loss instead of a profit will likewise be increased. Consequently at such a time credit will be impaired, but this will be the consequence, not the cause of the contracting trade. (pp. 79-80)

Finally, Hawtrey directs our attention to the credit of bankers.

We have already seen that the banker’s estimate of the proper proportion of his reserve to his liabilities is almost entirely empirical, and that an arbitrary change in the proportion which he thinks fit to maintain between them will carry with it an increase or decrease, as the case may be, in the available amount of purchasing power in the community. If a banker really underestimates the proper amount of reserve, and does not correct his estimate, he may find himself at a moment of strain with his reserve rapidly melting away and no prospect of the process coming to an end before the reserve is exhausted. His natural remedy is to borrow from other banks; but this he can only do if they believe his position to be sound. If they will not lend, he must try to curtail his loans. But if has been lending imprudently, he will find that on his refusing to renew loans the borrowers will in some cases become bankrupt and his money will be lost. It is just when a banker has been lending imprudently that his fellow-bankers will refuse to lend to him, and thus the same mistake cuts him off simultaneously from the two possible remedies. (pp. 81-82)

Interestingly, though he explains how it is possible that credit may become unstable, leading to cumulative fluctuations in economic activity, Hawtrey concludes this chapter by arguing that without changes in aggregate purchasing power (which, in Hawtrey’s terminology, means the total quantity of fiat and credit money). The problem with that formulation is that what Hawtrey has just shown is that the quantity of credit money fluctuates with the state of credit, so to say that economic activity will not fluctuate much if aggregate purchasing power is held stable is to beg the question. The quantity of credit money will not remain stable unless credit remains stable, and if credit is unstable, which is what Hawtrey has just shown, the quantity of credit money will not remain stable.

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6 Responses to “Hawtrey’s Good and Bad Trade, Part IV: The Inherent Instability of Credit”


  1. 1 Blue Aurora October 5, 2013 at 1:12 am

    Even though you might not have the best recollection of details learned from books, David Glasner, do you recall when you first learned of Ralph Hawtrey and when you read his work in economics for the first time? (If you mentioned that before on this blog, I unfortunately must’ve overlooked those posts.)

    That stated, do you have any major criticisms of Ralph Hawtrey’s theoretical edifice, and if yes, could you please elaborate on that?

  2. 2 JW Mason October 5, 2013 at 7:39 am

    Fascinating, thanks for posting this. A lot to chew on.

    One interesting thing is the assumption that prices of final goods vary more, or sooner, than the prices of inputs or factors. Hume made the same argument for the short-term expansionary effects of inflation: “It is easy to trace the money in its progress through the whole commonwealth; where we shall find, that it must first quicken the diligence of every individual, before it encrease the price of labour,” etc.

    But this is the opposite of how we typically think of inflation today. Now we think of it starting on the input side and only then working its way to final goods. Seems like an important shift.

  3. 3 David Glasner October 5, 2013 at 6:40 pm

    Blue Aurora, Hawtrey is a name that I recall from my days as an undergraduate. I probably ran across his name in some of the Austrian writings that I was reading in those days. Certainly, I would have come across it in Leijonhufvud’s book on Keynes published in 1968 when I was still an undergrad at UCLA. But I have no specific recollection of being partcularly interested in him. But somehow or other I knew that he was still alive and even writing about economics, so that also might have piqued my interest in him. I can’t remember exactly when I became really interested in his work, but I am guessing that it was after I left UCLA, and was teaching at Marquette University in Milwaukee. I was then writing my paper “A Reinterpretation of Classical Monetary Theory,” and became interested in the monetary approach to the balance of payments which Harry Johnson and his students were writing many important papers about in the middle and late 1970s. In his paper on the historical origins of the monetary approach Johnson mentioned Hawtrey several times, and I think that is when I first actually picked up something that he wrote. It was probably either his book on the gold standard or The Art of Central Banking. That is when I found his monetary explanation of the Great Depression. I was amazed, because I had already heard almost exactly the same explanation from Earl Thompson, who had independently come up with the same explanation as Thompson. Some time afterwards, and I can no longer really remember how long, and I was talking casually with Ron Batchelder, also a student of Earl Thompson, and mentioned to him that I had found that Thompson’s theory had been anticipated by Hawtrey, he responded that he had found the theory in Cassel. That’s how we came to write our paper on Hawtrey and Cassel.

    JW Thanks for your comment. I am glad that you are finding these posts useful. I agree that there are different ways to think about the sequence of price changes in inflation. It wasn’t only Hume who thought that prices would change more quickly than wages. The same idea is in Thornton, and I believe it was always a widely, though not universally, accepted stylized fact. The neoclassical synthesis seemed to regard it as the key insight of Keynesian economics, though that is probably not quite what they meant. Of course there was also the idea that labor costs or monopolistic unions driving up wages that were the source of inflation, which was certainly a popular theory of inflation after World War II, but I am not sure if that is what you are referring to.

  4. 4 Blue Aurora October 5, 2013 at 8:06 pm

    I see, David Glasner. However, do you have any major criticisms of Ralph Hawtrey, or no?

  5. 5 David Glasner October 5, 2013 at 8:17 pm

    Blue Aurora, I guess it depends on what you mean by a major criticism. In my recent posts, I have mentioned a few points about which I have some disagreement with or criticism of Hawtrey, but I wouldn’t say that they are major. I am not sure that I would accept his theory of the value of fiat money, but I am not really satisfied with anyone’s theory of the value of fiat money. So I am afraid that I don’t have a really good answer for you.


  1. 1 Hawtrey’s Good and Bad Trade, Part V: Did Hawtrey Discover PPP? | Uneasy Money Trackback on October 8, 2013 at 7:31 pm

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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