Hawtrey’s Good and Bad Trade, Part VIII: Credit Money and Banking Systems

Having argued in chapters 5 through 9 that monetary disturbances could cause significant fluctuations in aggregate expenditure, income, output, and employment, and having argued in chapter 11 that shifts in demand would be unlikely to trigger significant aggregate fluctuations, Hawtrey was satisfied that he had established that monetary disturbances were the most likely cause of such fluctuations. Hawtrey therefore turns his attention in chapter 12 to a consideration of the law and economics of banking and of the two instruments (banknotes and checks) that banks are uniquely able to create. Continuing in this vein in chapter 13, Hawtrey surveys the range of national institutional arrangements then in existence under which banks were then operating.

Hawtrey observes that banks may cause monetary disturbances by providing either too much, or too little, money relative to the amount of money demanded by the public, thereby triggering a cumulative deviation from a point of stability. He then mentions another way in which banks may cause macroeconomic disturbances.

[B]ankers may be tempted to lend imprudently, and when their rashness finds them out, whether they pay the penalty in bankruptcy, or whether they manage to restore their business to a sound footing, in either case a quantity of credit money will have to be annihilated.

Hawtrey characterizes the essence of credit money as the commitment by a banker to pay money on demand “and that the right to obtain money on demand is given in such a form as to be a convenient substitute for cash to the possessor of the right.” For credit money supplied by a bank to be a convenient substitute for cash, the credit money of the bank must be usable and acceptable in payment. Credit money can be made usable and acceptable by way of two instruments: banknotes and checks. Most of chapter 12 is given over to a discussion of the similarities and differences between those two instruments.

A bank-note is a transferable document issued by the banker entitling the holder to obtain on demand a sum specified on its face. The problem of effecting payments is solved by the simple process of handing on the document itself.

Under the cheque system the banker places to his customer’s credit a certain sum, but gives him no transferable documentary evidence of the existence of this sum. But the customer can at any time direct the banker to pay any portion of the money to any third person. The direction is given in writing, and the handing over of the written document or cheque to this third person is, for practical purposes, the equivalent of a payment.

After noting a number of the obvious differences between checks and banknotes, Hawtrey lays down an important principle that in the nineteenth century was denied by the Currency School (who regarded banknotes as uniquely having the status of money and therefore sought quantitative limit on the creation of banknotes but not deposits), but upheld by the Banking School in the famous debates over the Bank Charter Act of 1844.

But for all these differences, there remains the fundamental identity of the right to draw any sum by cheque with the possession of banknotes representing in aggregate value the same sum. Either is simply the possession of so much credit money, and from the point of view of the banker makes the liability to pay that sum on demand. All that has been said in the preceding chapters on the subject of credit money applies impartially to both systems.

And yet in the next breath, Hawtrey seems to acknowledge that, in practice, the principle is not quite so clear cut.

But it does not follow that there are not important practical differences between the two kinds of credit money, even from the point of view from which we are now interested in the subject of banking. The most important of all arise from the fact that notes have a closer resemblance than cheques to cash. Indeed, there is really no hard-and-fast line between cash and notes at all – only a continuous gradation from bullion at one end, through legal tender full-valued coin, legal tender overvalued coin, legal tender inconvertible notes, legal tender convertible notes, finally to convertible notes that are not legal tender.

Ultimately, the points on which Hawtrey lays the most stress in distinguishing banknotes from cheques are that the incentive of a depositor a) to investigate the solvency of his bank is greater than the incentive of the acceptor of a banknote to investigate the solvency of the issuing bank, and b) the incentive of a depositor not to redeem his deposits if there is any question about his banker’s solvency is greater than the incentive of a noteholder not to redeem the banknote if such a question should arise concerning the issuer of a banknote in his possession. These two differential incentives make banknotes an inherently riskier instrument than a bank deposit.

The result is that while the demand of depositors are regulated by the real needs of business, the demands of note-holders are subject to capricious fluctuations which may arise at any time for a loss of confidence in the issuing banks.

Because of the perceived differential in risk associated with banknotes, the creation of banknotes has been subjected to more stringent regulation than the creation of deposits, regulations applying either to the permissible quantity of banknotes issued, or to the requirement that reserves be held against banknotes in the form of particular kinds of assets.

Hawtrey concludes chapter 12 with the following assessment of the role of confidence in a commercial crisis.

It is hardly too much to say that the normal working of the machinery of the money market cannot be understood until the relatively subordinate part played by the impairment of credit, that is to say, by the expectation that banks or other businesses will fail to meet the engagements, is fully realised. A contraction or depression of trade is ordinarily accompanied by a number of failures, especially if it be started by a commercial crisis. But even a crisis cannot be fully explained by a general loss of confidence. A crisis only differs in degree from an ordinary contraction of trade. The manufacture of credit money has so far outstripped the due proportion to the supply of cash that recovery is only possible by means of immediate and drastic steps. The loss of confidence may be very widespread, but it is still only a symptom and not a cause of the collapse.

Hawtrey continues his discussion of banking and credit money in Chapter 13 with a survey of the existing monetary systems in 1913. He begins with the British monetary system, then proceeds to describe the French system, and then the Indian system (which became the prototype for the gold-exchange standard whereby a country could join the gold standard by maintaining a fixed exchange rate against another currency that was fully convertible into gold, e.g., sterling, without engaging in any gold transactions or holding any gold reserves). Hawtrey also gave summary descriptions of the Austria-Hungary and the German monetary systems, before concluding with a lengthier description of the peculiar US monetary system, the only major monetary system then operating without a central bank, as it existed in 1913 just before being drastically changed by the creation of the Federal Reserve System.

.Rather than summarize Hawtrey’s insightful descriptions of the extant monetary systems in 1913 on the eve of the destruction of the classical gold standard, I will close with comments on the following passage in which Hawtrey describes the what was viewed as the responsibility of the central bank at that time.

The responsibility for maintaining the solvency of the banking system as a whole rests almost entirely on the central bank, and the question arises, how is that bank to be guided in exercising that responsibility? How much gold ought to be kept in reserve and how great a change in the amount of the reserve should the central bank acquiesce in before taking steps to correct it?

This is the much discussed gold reserve question. The solution is, of course, a matter of practical experience, upon which it would be useless to dogmatise a priori. The gold reserve of any country is simply a working balance. Like all working balances, however low it falls, it fulfills its function provided it is never exhausted even at the moment of greatest strain. But the moment of greatest strain cannot necessarily be recognized when it comes. In practice, therefore, a standard, more or less arbitrary, is fixed for the gold reserve (e.g., a certain proportion of the liabilities of the central bank), and steps are taken to correct any material departure from the standard chosen. Under this system the standard reserve must be at least of such amount that if it begins to diminish it can stand whatever drain it may be subjected to in the interval before the remedial measures adopted by the central bank have become completely effective.

There are two related issues raised by this passage that are worthy of consideration. Hawtrey’s statement about what constitutes an adequate gold reserve is certainly reasonable; it is also seems cautious inasmuch as he seems to accept that a central bank must never allow its reserve to be exhausted. In other words, the bank must make sure that it in normal times it accumulates a reserve large enough to withstand any conceivable drain on its reserves and to take whatever steps are necessary to protect that reserve once it begins to experience a loss of reserves. That was certainly the dominant view at the time. But Hawtrey eventually came to recommend a different view, which he expressed on many occasions a decade later when he, unlike Keynes, supported the restoration of the international gold standard and supported the decision to restore the prewar dollar-sterling parity. Though supporting that decision, Hawtrey made clear that the decision to restore the gold standard and the prewar dollar-sterling parity should not be considered inviolable. Recognizing the deflationary risks associated with restoring the gold standard and the dollar-sterling parity, Hawtrey.elevated achieving a high level of employment over maintaining the gold standard as the primary duty of the Bank of England. If the two goals were in conflict, it was the gold standard, not high employment, that should yield. The clearest and most dramatic statement of this unorthodox position came in response to questioning by Chairman Hugh Macmillan when Hawtrey testified in 1930 before the Macmillan Committee, when Britain was caught in the downward spiral of the Great Depression. Macmillan asked Hawtrey if the precepts of central banking orthodoxy did not require the Bank of England to take whatever steps were necessary to protect its gold reserve.

MACMILLAN. Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY. I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken any action at that time so far as the question of loss of gold is concerned. . .

MACMILLAN. . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY. I do not know what orthodox Central Banking is.

MACMILLAN. . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY. . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Perhaps Hawtrey already understood the implications of his position in 1913, but a reader of his 1913 statement would not necessarily have grasped the point that he expressed so boldly in 1930.


7 Responses to “Hawtrey’s Good and Bad Trade, Part VIII: Credit Money and Banking Systems”

  1. 1 Mike Sproul October 30, 2013 at 3:21 pm

    “Indeed, there is really no hard-and-fast line between cash and notes at all – only a continuous gradation from bullion at one end, through legal tender full-valued coin, legal tender overvalued coin, legal tender inconvertible notes, legal tender convertible notes, finally to convertible notes that are not legal tender.”

    Here’s a hard-and-fast line: Bank notes and checking deposits, whether instantly convertible or not, are the liability of the issuing bank, while bullion and full-bodied coins are nobody’s liability. So new gold dug from the ground will cause inflation, while new bank notes or checking deposits, issued in exchange for an equal value of new bank assets, will not cause inflation.

    And this is indefensible:

    “the incentive of a depositor not to redeem his deposits if there is any question about his banker’s solvency is greater than the incentive of a noteholder not to redeem the banknote”

    Nobody cares whether they lose a dollar because of accepting a bad note or a bad check.

    “the standard reserve must be at least of such amount that if it begins to diminish it can stand whatever drain it may be subjected to”

    An insolvent bank will fail in a run no matter how high a fraction of its assets are held as cash. A solvent bank, on the other hand, is immune to a run. All the bank has to do it put a 60-day suspension clause on its notes or checking deposits. Once convertibility is suspended the run stops, and the bank has 60 days to either use its assets to buy back its own notes or deposits, or else to sell its assets for cash, with which to pay off its notes and deposits after 60 days.


  2. 2 David Glasner October 30, 2013 at 7:56 pm

    Mike, You are certainly right that Hawtrey was overlooking the distinction between inside and outside money, but if you go and read the entire passage, I think that you will see that he had a better grasp (which is not to say a complete grasp) of the distinction than is evident from the passage I quoted. I didn’t want to go into too much detail, but perhaps there wasn’t enough.

    About redemption of banknotes versus deposits, I again did not quote enough of Hawtrey. His argument was that a depositor, having a relationship with his banker, may be reluctant to jeopardize that relationship by demanding cash from his banker. The possessor of a banknote will have no relationship with the bank that issued it, and therefore will have less reluctance to demand redemption than would a depositor. That argument may have been valid 100 years ago, maybe even 50 years ago, but I agree that it is almost certainly not valid today.

    Outside of Scotland, could a bank suspend the convertibility of its liabilities without becoming legally insolvent?


  3. 3 Mike Sproul October 30, 2013 at 8:18 pm


    In the panic of 1837, nearly all the banks in the US suspended convertibility, even though it was illegal. (If enough people do it, it’s as good as legal.) Economists (including Hawtrey) don’t seem to appreciate the benefits of being able to suspend. If a run starts against a solvent bank, then a 60-day suspension gives the bank time to unwind its balance sheet without its customers suffering any losses, and meanwhile the bank’s notes will trade very close to par, since people know they will get full value in just 60 days.

    If the bank is insolvent, and has maybe 20% less assets than needed to redeem the money it has issued, then suspension at least stops the bank run. Then the bank’s notes will trade for 80% of par while the bank uses its 60 days to liquidate in an orderly fashion, instead of facing the chaos of a bank run.

    Big difference between 1837 and the 1930’s. Suspension was also illegal in the 1930’s, but improved communication and technology allowed the suspension to be legally enforced, so rather than all US banks suspending, 3000+ banks faced runs and collapsed.

    The line between inside/outside money is fuzzy. The line between gold and bank notes is clear.


  4. 4 David Glasner October 30, 2013 at 8:50 pm

    Mike, I agree that suspension of convertibility may be appropriate under some circumstances, and the 1837 episode is certainly important. But as you point out, under modern conditions, there would have to be a legal mechanism for suspension to be workable. I think 1837 may have been the worst depression of the 19th century, so we wouldn’t want to follow that precedent too closely in any event.

    Yes the line between gold and banknotes is clear, except that banknotes under many monetary systems — and even when issued by private institutions — have been so heavily regulated that they were actually more similar to gold certificates or too fiat money than to the liabilities of private banking institutions. I think that’s what Hawtrey was getting at in the quote that you found objectionable.


  5. 5 Blue Aurora November 3, 2013 at 6:37 pm

    Out of curiosity David Glasner, were you able to find any reference to the Real Bills Doctrine (AKA the “Commercial Loan Theory of Banking” and the “Needs of Trade Doctrine”) in the works of Ralph Hawtrey that you have read?

    I asked you this question some time ago, and I don’t believe I got an answer to that.


  6. 6 David Glasner November 5, 2013 at 1:56 pm

    Blue Aurora, I recall doing a bit of searching for the real bills doctrine in the books by Hawtrey in my possession. I am sorry to say that I now don’t have a clear recollection of what I found or didn’t find, but that suggests to me that I didn’t find much. However, i did find a review by Hawtrey of Lloyd Mints’s book A History of Banking Theory, which is a kind of extended diatribe about the real bills doctrine. I believe the review appeared in the mid-1930s in the Journal of the Royal Statistical Society for which Hawtrey wrote many reviews of books on economics (under the initials R. G. H.). You could search for it on Jstor. I can’t remember exactly what Hawtrey wrote but it was mildly favorable with some critical remarks.


  7. 7 Blue Aurora November 9, 2013 at 11:58 pm

    Thanks, David Glasner.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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