Uneasy Money

In my previous installment in this series, I began discussing Hawtrey’s analysis of a banking system that creates credit money convertible into a pure fiat money. I noted what seem to me to be defects in Hawtrey’s analysis, mainly related to his incomplete recognition of all the incentives governing banks when deciding how much money to create by making loans. Nevertheless, it is worth following Hawtrey, even with the gap, as he works his way through his analysis .

But, before we try to follow Hawtrey, it will be helpful to think about where he is heading. In his analysis of a pure fiat money system, all — actually not quite all, but almost all — of the analytical work was done by considering how a difference between the amount of fiat money people want to hold and the greater or lesser amount that they actually do hold is resolved. If they hold less money than they want, total spending decreases as people try (unsuccessfully in the aggregate) to build up their cash balances, and if they hold more money than they want, spending increases as people try (unsuccessfully in the aggregate) to part with their excess cash hoaldings. Reaching a new equilibrium entails an adjustment of the ratio of total spending to the stock of fiat money that characterized the initial equilibrium. There may be an interest rate in such an economy, but a change in the interest rate plays no part in the adjustment process that restores equilibrium after a monetary shock (i.e., a change in the stock of fiat money). Hawtrey aims to compare (and contrast) this adjustment process with the adjustment process to a change in the quantity of fiat money when not all money is fiat money — when there is also credit money (created by banks and convertible into fiat money) circulating along with fiat money.

In analyzing a monetary disturbance to a credit-money system, Hawtrey takes as his starting point a banking system in equilibrium, with banks and individuals holding just the amount of currency, reserves and deposits that they want to hold. He then posits a reduction in the total stock of currency.

The first effect of the contraction of the currency is that the working balance of cash in the hands of individual members of the community will be diminished. The precise proportion in which this diminution is shared between bankers and other people does not matter, for those who have banking accounts will quickly draw out enough cash to restore their working balances. As soon as this process is completed we have two effects; first, that the greater part, indeed practically the whole, of the currency withdrawn comes out of the banks’ reserves, and secondly, that the total amount of purchasing power in the community (i.e., currency in circulation plus bank balances) is diminished by the amount of currency withdrawn. One consequence of the existence of a banking system is that a given diminution in the stock of currency produces at this stage much less than a proportional diminution in the total of purchasing power. (pp. 58-59)

Hawtrey goes on to explain this point with a numerical example. Suppose total purchasing power (i.e., the sum of currency plus deposits) were £1 billion of which £250 million were currency and £750 million deposits. If the stock of currency were reduced by 10%, the amount of currency would fall to £225 million, with total stock of purchasing power falling to £975 million. (Note by the way, that Hawtrey’s figure for total purchasing power, or the total stock of money, does not correspond to the usual definition of the money stock in which only currency held by the public, not by the banking system, are counted.) At any rate, the key point for Hawtrey is that under a fiat currency with a banking system, the percentage decrease (10%) in the stock of currency is not equal to the percentage decrease in the total stock of money (2.5%), so that a 10% reduction in the stock of currency, unlike the pure fiat currency case, would not force down the price level by 10% (at least, not without introducing other variables into the picture). Having replenished their holdings of currency by converting deposits into currency, the total cash holdings of the public are only slightly (2.5%) less than the amount they would like to hold, so that only a 2.5% reduction in total spending would seem to be necessary to restore the kind of monetary equilibrium on which Hawtrey was focused in discussing the pure fiat money case. A different sort of disequilibrium involving a different adjustment process had to be added to his analytical landscape.

The new disequilibrium introduced by Hawtrey was that between the amount of currency held by the banks as reserves against their liabilities (deposits) and the amount of currency that they are actually holding. Thus, even though banks met the demands of their depositors to replenish the fiat currency that, by assumption, had been taken from their existing cash balances, that response by the banks, while (largely) eliminating one disequilibrium, also created another one: the banks now find that their reserves, given the amount of liabilities (deposits) on their balance sheets, are less than they would like them to be. Hawtrey is thus positing the existence of a demand function by the banks to hold reserves, a function that depends on the amount of liabilities that they create. (Like most banking theorists, Hawtrey assumes that the functional relationship between bank deposits and banks’ desired reserves is proportional, but there are obviously economies of scale in holding reserves, so that the relationship between bank deposits and desired reserves is certainly less than proportional.) The means by which banks can replenish their reserves, according to Hawtrey, again following traditional banking theory, is to raise the interest rate that they charge borrowers. Here, again, Hawtrey was not quite on the mark, overlooking the possibility that banks could offer to pay interest (or to increase the rate that they were already paying on deposits) as a way of reducing the tendency of depositors to withdraw deposits in exchange for currency.

The special insight brought by Hawtrey to this analysis is that a particular group of entrepreneurs (traders and merchants), whose largest expense is the interest paid on advances from banks to finance their holdings of inventories, are highly sensitive to variations in the bank lending rate, and adjust the size of their inventories accordingly. And since it is the manufacturers to whom traders and merchants are placing orders, the output of factories is necessarily sensitive to the size of the inventories that merchants and traders are trying to hold. Thus, if banks, desiring to replenish their depleted reserves held against deposits, raise interest rates on loans, it will immediately reduce the size of inventories that merchants and traders want to hold, causing them to diminish their orders to manufacturers. But as manufacturers reduce output in response to diminished orders from merchants, the incomes of employees and others providing services and materials to the manufacturers will also fall, so that traders and merchants will find that they are accumulating inventories because their sales to dealers and retailers are slackening, offsetting the effect of their diminished orders to manufacturers, and, in turn, causing merchants and traders to reduce further their orders from manufacturers.

As this process works itself out, prices and output will tend to fall (at least relative to trend), so that traders and merchants will gradually succeed in reducing their indebtedness to the banks, implying that the total deposits created by the banking system will decrease. As their deposit liabilities decline, the amount of reserves that the banks would like to hold declines as well, so that gradually this adjustment process will restore an equilibrium between the total quantity of reserves demanded by the banking system and the total quantity of reserves that is made available to the banks (i.e., the total quantity of currency minus the amount of currency that the public chooses to hold as cash). However, the story does not end with the restoration of equilibrium for the banking system. Despite equilibrium in the banking system, total spending, output, and employment will have fallen from their original equilibrium levels. Full equilibrium will not be restored until prices and wages fall enough to make total spending consistent with a stock of currency 10% less than it was in the original equilibrium. Thus, in the end, it turns out that a 10% reduction in the quantity of currency in a monetary system with both fiat money and credit money will cause a 10% reduction in the price level when a new equilibrium is reached. However, the adjustment process by which a new equilibrium is reached, involving changes not only in absolute prices and wages, but in interest rates, is more complicated than the adjustment process in a pure fiat money system.

Hawtrey summed up his analysis in terms of three interest rates. First, the natural rate “which represented the actual labour-saving value of capital at the level of capitalisation reached by industry. This ratio of labour saved per annum to labour expended on first cost is a physical property of the capital actually in use, and under perfectly stable monetary conditions is equal to the market rate of interest.” Second the market rate which “diverges from the natural rate according to the tendency of prices. When prices are rising them market rate is higher, and when falling lower, than the natural rate, and this divergence is due to the fat that the actual profits of business show under those conditions corresponding movements.” Third, there is the profit rate, “which represents the true profits of business prevailing for the time being,” and does not necessarily coincide with the market rate.

The market rate is in fact the bankers’ rate, and is greater or less than the profit rate, according as the bankers wish to discourage or encourage borrowing. . . .

Consequently, for the banker’s purposes, a “high” rate of interest is one which is above the profit rate, and it is only when the rate of interest is equal to the profit rate that there is no tendency towards either an increase or decrease in temporary borrowing. In any of the three cases the rate of interest may be either above or below the natural rate. If the natural rate is 4% and the profit rate in consequence is only 2%, a market rate of 3% is “high,” and will result in a curtailment of borrowing. If prices are rising and the profit rate is 6%, a market rate of 5% is “low,” and will be compatible with an increased borrowing.

In the case we are now considering we assumed the disturbance to be a departure from perfectly stable conditions, in which the market rate of interest would be identical with the “natural” rate. On the contraction of the currency occurring the bankers raised the market rate above the natural rate. But at the same time the fall of prices began, and there must consequently be a fall of the profit rate below the natural rate. As we now see, the market rate may actually fall below the natural rate, and so long as it remains above the profit rate it will still be a “high” rate of interest.

When the restoration of the bank reserves is completed the market rate will drop down to equality with the profit rate, and they will remain equal to one another and below the natural rate until the fall of prices has gone far enough to re-establish equilibrium. (pp. 66-67)

Although it seems to me that Hawtrey, in focusing exclusively on the short-term lending rate of banks to explain the adjustment of the banking system to a disturbance, missed an important aspect of the overall picture (i.e., the deposit rate), Hawtrey did explain the efficacy of a traditional tool of monetary policy, the short-term lending rate of the banking system (the idea of a central bank having not yet been introduced at this stage of Hawtrey’s exposition). And he did so while avoiding the logical gap in the standard version of the natural-rate-market-rate theory as developed by both Thornton and Wicksell (see section 3 of my paper on Ricardo and Thornton here) explaining why changes in the bank rate could affect aggregate demand without assuming, as do conventional descriptions of the adjustment process, that the system was adjusting to an excess demand for or an excess supply of bank deposits.