Uneasy Money

The first seven chapters of Hawtrey’s Good and Bad Trade present an admirably succinct exposition of the theory of a fiat monetary system with a banking system that issues a credit money convertible into the fiat money supplied by the government. Hawtrey also explains how cyclical fluctuations in output, employment and prices could arise in such a system, given that the interest rates set by banks in the course of their lending operations inevitably deviate, even if for no more than very short periods of time, from what he calls their natural levels. See the wonderful quotation (from pp. 76-77) in my previous post about the inherent instability of the equilibrium between the market rate set by banks and the natural rate.

In chapter 7, Hawtrey considers an international system of fiat currencies, each one issued by the government of a single country in which only that currency (or credit money convertible into that currency) is acceptable as payment. Hawtrey sets as his objective an explanation of the exchange rates between pairs of such currencies and the corresponding price levels in those countries. In summing up his discussion (pp. 90-93) of what determines the rate of exchange between any two currencies, Hawtrey makes the following observation

Practically, it may be said that the rate of exchange equates the general level of prices of commodities in one country with that in the other. This is of course only approximately true, since the rate of exchange is affected only by those commodities which are or might be transported between the two countries. If one of the two countries is at a disadvantage in the production of commodities which cannot be imported, or indeed in those which can only be imported at a specially heavy cost, the general level of prices, calculated fairly over all commodities, will be higher in that country than in the other. But, subject to this important qualification, the rate of exchange under stable conditions does represent that ratio between the units of currency which makes the price-levels and therefore the purchasing powers of the two units equal. (pp. 92-93)

That, of course, is a terse, but characteristically precise, statement of the purchasing power parity doctrine. What makes it interesting, and possibly noteworthy, is that Hawtrey made it 100 years ago, in 1913, which is five years before Hawtrey’s older contemporary, Gustav Cassel, who is usually credited with having originated the doctrine in 1918 in his paper “Abnormal Deviations in International Exchanges” Economic Journal 28:413-15. Here’s how Cassel put it:

According to the theory of international exchanges which I have tried to develop during the course of the war, the rate of exchange between two countries is primarily determined by the quotient between the internal purchasing power against goods of the money of each country. The general inflation which has taken place during the war has lowered this purchasing power in all countries, though in a very different degree, and the rates of exchanges should accordingly be expected to deviate from their old parity in proportion to the inflation in each country.

At every moment the real parity between two countries is represented by this quotient between the purchasing power of the money in the one country and the other. I propose to call this parity “the purchasing power parity.” As long as anything like free movement of merchandise and a somewhat comprehensive trade between two countries takes place, the actual rate of exchange cannot deviate very much from this purchasing power parity. (p. 413)

Hawtrey proceeds, in the rest of the chapter, to explain how international relationships would be affected by a contraction in the currency of one country. The immediate effects would be the same as those described in the case of a single closed economy. However, in an international system, the effects of a contraction in one country would create opportunities for international transactions, both real and financial, that would involve both countries in the adjustment to the initial monetary disturbance originating in one of them.

Hawtrey sums up the discussion about the adjustment to a contraction of the currency of one country as follows:

From the above description, which is necessarily rather complicated, it will be seen that the mutual influence of two areas with independent currency systems is on the whole not very great Indeed, the only important consequence to either of a contraction of currency in the other, is the tendency for the first to lend money to the second in order to get the benefit of the high rate of interest. This hastens the movement towards ultimate equilibrium in the area of stringency. At the same time it would raise the rate of interest slightly in the other country But as this rise in the rate of interest is due to an enhanced demand for loans, it will not have the effect of diminishing the total stock of bankers’ money. (p. 99)

He concludes the chapter with a refinement of the purchasing power parity doctrine.

It is important to notice that as soon as the assumption of stable conditions is abandoned the rate of exchange ceases to represent the ratio of the purchasing powers of the two units of currency which it relates. A difference between the rates of interest in the two countries concerned displaces the rate of exchange from its normal position of equality with this ratio, in the same direction as if the purchasing power of the currency with the higher rate of interest had been increased. Such a divergence between the rates of interest would only occur in case of some financial disturbance, and though such disturbances, great or small, are bound to be frequent, the ratio of purchasing powers may still be taken (subject to the qualification previously explained) to be the normal significance of the rate of exchange. (p. 101)