A Tract On Monetary Reform - Chapter 4

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Chapter III: THE THEORY OF MONEY AND OF THE FOREIGN EXCHANGES

The evil consequences of instability in the standard of value have now been sufficiently described. In this chapter we must lay the theoretical foundations for the practical suggestions of the concluding chapters. Most academic treatises on monetary theory have been based, until lately, on so firm a presumption of a gold standard régime that they need to be adapted to the existing régime of mutually inconvertible paper standards. Parts of this chapter raise, unavoidably, matters of much greater difficulty to the layman than the rest of the book. The reader whose interest in the theoretical foundations is secondary can pass on. I. _The Quantity Theory of Money_ This Theory is fundamental. Its correspondence with fact is not open to question. Nevertheless it is often misstated and misrepresented. Goschen’s saying of sixty years ago, that “there are many persons who cannot hear the relation of the level of prices to the volume of currency affirmed without a feeling akin to irritation,” still holds good. “The Quantity Theory is often defended and opposed as though it were a definite set of propositions that must be either true or false. But in fact the formulæ employed in the exposition of that theory are merely devices for enabling us to bring together in an orderly way the principal causes by which the value of money is determined” (Pigou). The Theory flows from the fact that money as such has no utility except what is derived from its exchange-value, that is to say from the utility of the things which it can buy. Valuable articles other than money have a utility in themselves. Provided that they are divisible and transferable, the total amount of this utility increases with their quantity;--it will not increase in full proportion to the quantity, but, up to the point of satiety, it does increase. If an article is used for money, such as gold, which has a utility in itself for other purposes, aside from its use as money, the strict statement of the theory, though fundamentally unchanged, is a little complicated. In present circumstances we can excuse ourselves this complication. A Currency Note has no utility in itself and is completely worthless except for the purchasing power which it has as money. Consequently what the public want is not so many ounces or so many square yards or even so many £ sterling of currency notes, but a quantity sufficient to cover a week’s wages, or to pay their bills, or to meet their probable outgoings on a journey or a day’s shopping. When people find themselves with more cash than they require for such purposes, they get rid of the surplus by buying goods or investments, or by leaving it for a bank to employ, or, possibly, by increasing their hoarded reserves. Thus the _number_ of notes which the public ordinarily have on hand is determined by the amount of _purchasing power_ which it suits them to hold or to carry about, and by nothing else. The amount of this purchasing power depends partly on their wealth, partly on their habits. The wealth of the public in the aggregate will only change gradually. Their habits in the use of money--whether their income is paid them weekly or monthly or quarterly, whether they pay cash at shops or run accounts, whether they deposit with banks, whether they cash small cheques at short intervals or larger cheques at longer intervals, whether they keep a reserve or hoard of money about the house--are more easily altered. But if their wealth and their habits in the above respects are unchanged, then the amount of purchasing power which they hold in the form of money is definitely fixed. We can measure this definite amount of purchasing power in terms of a unit made up of a collection of specified quantities of their standard articles of consumption or other objects of expenditure; for example, the kinds and quantities of articles which are combined for the purpose of a cost-of-living index number. Let us call such a unit a “consumption unit” and assume that the public require to hold an amount of money having a purchasing power over _k_ consumption units. Let there be _n_ currency notes or other forms of cash in circulation with the public, and let _p_ be the price of each consumption unit (_i.e._ _p_ is the index number of the cost of living), then it follows from the above that _n = pk_. This is the famous Quantity Theory of Money. So long as _k_ remains unchanged, _n_ and _p_ rise and fall together; that is to say, the greater or the fewer the number of currency notes, the higher or the lower is the price level in the same proportion. So far we have assumed that the whole of the public requirement for purchasing power is satisfied by cash, and on the other hand that this requirement is the only source of demand for cash; neglecting the fact that the public, including the business world, employ for the same purpose bank deposits and overdraft facilities, whilst the banks must for the same reason maintain a reserve of cash. The theory is easily extended, however, to cover this case. Let us assume that the public, including the business world, find it convenient to keep the equivalent of _k_ consumption units in cash and of a further _k´_ available at their banks against cheques, and that the banks keep in cash a proportion _r_ of their potential liabilities (_k´_) to the public. Our equation then becomes _n = p(k + rk´)_. So long as _k_, _k´_, and _r_ remain unchanged, we have the same result as before, namely, that _n_ and _p_ rise and fall together. The proportion between _k_ and _k´_ depends on the banking arrangements of the public; the absolute value of these on their habits generally; and the value of _r_ on the reserve practices of the banks. Thus, so long as these are unaltered, we still have a direct relation between the _quantity_ of cash (_n_) and the level of prices (_p_). My exposition follows the general lines of Prof. Pigou (_Quarterly Journal of Economics_, Nov. 1917) and of Dr. Marshall (_Money, Credit, and Commerce_, I. iv.), rather than the perhaps more familiar analysis of Prof. Irving Fisher. Instead of starting with the amount of cash held by the public, Prof. Fisher begins with the volume of business transacted by means of money and the frequency with which each unit of money changes hands. It comes to the same thing in the end and it is easy to pass from the above formula to Prof. Fisher’s; but the above method of approach seems less artificial than Prof. Fisher’s and nearer to the observed facts. We have seen that the amount of _k_ and _k´_ depends partly on the wealth of the community, partly on its habits. Its habits are fixed by its estimation of the extra convenience of having more cash in hand as compared with the advantages to be got from spending the cash or investing it. The point of equilibrium is reached where the estimated advantages of keeping more cash in hand compared with those of spending or investing it about balance. The matter cannot be summed up better than in the words of Dr. Marshall: “In every state of society there is some fraction of their income which people find it worth while to keep in the form of currency; it may be a fifth, or a tenth, or a twentieth. A large command of resources in the form of currency renders their business easy and smooth, and puts them at an advantage in bargaining; but on the other hand it locks up in a barren form resources that might yield an income of gratification if invested, say, in extra furniture; or a money income, if invested in extra machinery or cattle.” A man fixes the appropriate fraction “after balancing one against another the advantages of a further ready command, and the disadvantages of putting more of his resources into a form in which they yield him no direct income or other benefit.” “Let us suppose that the inhabitants of a country, taken one with another (and including therefore all varieties of character and of occupation), find it just worth their while to keep by them on the average ready purchasing power to the extent of a tenth part of their annual income, together with a fiftieth part of their property; then the aggregate value of the currency of the country will tend to be equal to the sum of these amounts.” _Money, Credit, and Commerce_, I. iv. 3. Dr. Marshall shows in a footnote as follows that the above is in fact a development of the traditional way of considering the matter: “Petty thought that the money ‘sufficient for’ the nation is ‘so much as will pay half a year’s rent for all the lands of England and a quarter’s rent of the Houseing, for a week’s expense of all the people, and about a quarter of the value of all the exported commodities.’ Locke estimated that ‘one-fiftieth of wages and one-fourth of the landowner’s income and one-twentieth part of the broker’s yearly returns in ready money will be enough to drive the trade of any country.’ Cantillon (A.D. 1755), after a long and subtle study, concludes that the value needed is a ninth of the total produce of the country; or, what he takes to be the same thing, a third of the rent of the land. Adam Smith has more of the scepticism of the modern age and says: ‘it is impossible to determine the proportion,’ though ‘it has been computed by different authors at a fifth, at a tenth, at a twentieth, and at a thirtieth part of the whole value of the annual produce.’” In modern conditions the normal proportion of the circulation to this national income seems to be somewhere between a tenth and a fifteenth. So far there should be no room for difference of opinion. The error often made by careless adherents of the Quantity Theory, which may partly explain why it is not universally accepted, is as follows. Every one admits that the habits of the public in the use of money and of banking facilities and the practices of the banks in respect of their reserves change from time to time as the result of obvious developments. These habits and practices are a reflection of changes in economic and social organisation. But the Theory has often been expounded on the further assumption that a _mere_ change in the quantity of the currency cannot affect _k_, _r_, and _k´_,--that is to say, in mathematical parlance, that _n_ is an _independent variable_ in relation to these quantities. It would follow from this that an arbitrary doubling of _n_, since this in itself is assumed not to affect _k_, _r_, and _k´_, must have the effect of raising _p_ to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form. Now “in the long run” this is probably true. If, after the American Civil War, the American dollar had been stabilised and defined by law at 10 per cent below its present value, it would be safe to assume that _n_ and _p_ would now be just 10 per cent greater than they actually are and that the present values of _k_, _r_, and _k´_ would be entirely unaffected. But this _long run_ is a misleading guide to current affairs. _In the long run_ we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. In actual experience, a change of n is liable to have a reaction both on _k_ and _k´_ and on _r_. It will be enough to give a few typical instances. Before the war (and indeed since) there was a considerable element of what was conventional and arbitrary in the reserve policy of the banks, but especially in the policy of the State Banks towards their gold reserves. These reserves were kept for show rather than for use, and their amount was not the result of close reasoning. There was a decided tendency on the part of these banks between 1900 and 1914 to bottle up gold when it flowed towards them and to part with it reluctantly when the tide was flowing the other way. Consequently, when gold became relatively abundant they tended to hoard what came their way and to raise the proportion of the reserves, with the result that the increased output of South African gold was absorbed with less effect on the price level than would have been the case if an increase of _n_ had been totally without reaction on the value of _r_. In agricultural countries where peasants readily hoard money, an inflation, especially in its early stages, does not raise prices proportionately, because when, as a result of a certain rise in the price of agricultural products, more money flows into the pockets of the peasants, it tends to stick there;--deeming themselves that much richer, the peasants increase the proportion of their receipts that they hoard. Thus in these and in other ways the terms of our equation tend in their movements to favour the stability of _p_, and there is a certain friction which prevents a moderate change in _n_ from exercising its full proportionate effect on _p_. On the other hand a large change in _n_, which rubs away the initial friction, and especially a change in _n_ due to causes which set up a general expectation of a further change in the same direction, may produce a _more_ than proportionate effect on _p_. After the general analysis of Chapter I. and the narratives of catastrophic inflations given in Chapter II., it is scarcely necessary to illustrate this further,--it is a matter more readily understood than it was ten years ago. A large change in _p_ greatly affects individual fortunes. Hence a change after it has occurred, or sooner in so far as it is anticipated, may greatly affect the monetary habits of the public in their attempt to protect themselves from a similar loss in future, or to make gains and avoid loss during the passage from the equilibrium corresponding to the old value of _n_ to the equilibrium corresponding to its new value. Thus after, during, and (so far as the change is anticipated) before a change in the value of _n_, there will be some reaction on the values of _k_, _k´_, and _r_, with the result that the change in the value of _p_, at least temporarily and perhaps permanently (since habits and practices, once changed, will not revert to exactly their old shape), will not be precisely in proportion to the change in _n_. The terms _inflation_ and _deflation_ are used by different writers in varying senses. It would be convenient to speak of an increase or decrease in _n_ as an inflation or deflation of _cash_; and of a decrease or increase in _r_ as an inflation or deflation of _credit_. The characteristic of the “credit-cycle” (as the alternation of boom and depression is now described) consists in a tendency of _k_ and _k´_ to diminish during the boom and increase during the depression, irrespective of changes in _n_ and _r_, these movements representing respectively a diminution and an increase of “real” balances (_i.e._ balances, in hand or at the bank, measured in terms of purchasing power); so that we might call this phenomenon deflation and inflation of real balances. It will illustrate the “Quantity Theory” equation in general and the phenomena of deflation and inflation of real balances in particular, if we endeavour to fill in actual values for our symbolic quantities. The following example does not claim to be exact and its object is to illustrate the idea rather than to convey statistically precise facts. October 1920 was about the end of the recent boom, and October 1922 was near the bottom of the depression. At these two dates the figures of price level (taking October 1922 as 100), cash circulation (note circulation _plus_ private deposits at the Bank of England), and bank deposits in Great Britain were roughly as follows: It would take me too far from the immediate matter in hand to discuss why I take this definition of “cash” in the case of Great Britain. It is discussed further in Chapter V. below. Price Level. Cash Circulation. Bank Deposits. October 1920 150 £585,000,000 £2,000,000,000 October 1922 100 £504,000,000 £1,700,000,000 The value of _r_ was not very different at the two dates--say about 12 per cent. Consequently our equation for the two dates works out as follows: October 1920 _n_ = 585 _p_ = 1·5 _k_ = 230 _k´_ = 1333 October 1922 _n_ = 504 _p_ = 1 _k_ = 300 _k´_ = 1700 For 585 = 1·5(230 + 1333 × ·12), and 504 = 1(300 + 1700 × ·12). Thus during the depression _k_ rose from 230 to 300 and _k´_ from 1333 to 1700, which means that the cash holdings of the public at the former date were worth 23/30, and their bank balances 1333/1700, what they were worth at the latter date. It thus appears that the tendency of _k_ and _k´_ to increase had more to do, than the deflation of “cash” had, with the fall of prices between the two periods. If _k_ and _k´_ were to fall back to their 1920 values, prices would rise 30 per cent without any change whatever in the volume of cash or the reserve policy of the banks. Thus even in Great Britain the fluctuations of _k_ and _k´_ can have a decisive influence on the price level; whilst we have already seen (pp. 51, 52) how enormously they can change in the recent conditions of Russia and Central Europe. The moral of this discussion, to be carried forward in the reader’s mind until we reach Chapters IV. and V., is that the price level is not mysterious, but is governed by a few, definite, analysable influences. Two of these, _n_ and _r_, are under the direct control (or ought to be) of the central banking authorities. The third, namely _k_ and _k´_, is not directly controllable, and depends on the mood of the public and the business world. The business of stabilising the price level, not merely over long periods but so as also to avoid cyclical fluctuations, consists partly in exercising a stabilising influence over _k_ and _k´_, in so far as this fails or is impracticable, in deliberately varying _n_ and _r_ so as to _counterbalance_ the movement of _k_ and _k´_. The usual method of exercising a stabilising influence over _k_ and _k´_ especially over _k´_, is that of bank-rate. A tendency of _k´_ to increase may be somewhat counteracted by lowering the bank-rate, because easy lending diminishes the advantage of keeping a margin for contingencies in cash. Cheap money also operates to _counterbalance_ an increase of _k´_, because, by encouraging borrowing from the banks, it prevents _r_ from increasing or causes _r_ to diminish. But it is doubtful whether bank-rate by itself is always a powerful enough instrument, and, if we are to achieve stability, we must be prepared to vary _n_ and _r_ on occasion. Our analysis suggests that the first duty of the central banking and currency authorities is to make sure that they have _n_ and _r_ thoroughly under control. For example, so long as inflationary taxation is in question _n_ will be influenced by other than currency objects and cannot, therefore, be fully under control; moreover, at the other extreme, under a gold standard _n_ is not always under control, because it depends on the unregulated forces which determine the demand and supply of gold throughout the world. Again, without a central banking system _r_ will not be under proper control because it will be determined by the unco-ordinated decisions of numerous different banks. At the present time in Great Britain _r_ is very completely controlled, and _n_ also, so long as we refrain from inflationary finance on the one hand and from a return to an unregulated gold standard on the other. The second duty of the authorities is therefore worth discussing, namely, the _use_ of their control over _n_ and _r_ to counterbalance changes in _k_ and _k´_. Even if _k_ and _k´_ were entirely outside the influence of deliberate policy, which is not in fact the case, nevertheless _p_ could be kept reasonably steady by suitable modifications of the values of _n_ and _r_. In the case of the United States the same thing is more or less true, so long as the Federal Reserve Board is prepared to incur the expense of bottling up redundant gold. Old-fashioned advocates of sound money have laid too much emphasis on the need of keeping _n_ and _r_ steady, and have argued as if this policy by itself would produce the right results. So far from this being so, steadiness of _n_ and _r_, when _k_ and _k´_ are not steady, is bound to lead to unsteadiness of the price level. Cyclical fluctuations are characterised, not primarily by changes in _n_ or _r_, but by changes in _k_ and _k´_. It follows that they can only be cured if we are ready deliberately to increase and decrease _n_ and _r_, when symptoms of movement are showing in the values of _k_ and _k´_. I am being led, however, into a large subject beyond my immediate purpose, and am anticipating also the topic of Chapter V. These hints will serve, nevertheless, to indicate to the reader what a long way we may be led by an understanding of the implications of the simple Quantity equation with which we started. II. _The Theory of Purchasing Power Parity._ The Quantity Theory deals with the purchasing power or commodity-value of a given national currency. We come now to the _relative_ value of _two_ distinct national currencies,--that is to say, to the theory of the Foreign Exchanges. When the currencies of the world were nearly all on a gold basis, their relative value (_i.e._ the exchanges) depended on the actual amount of gold metal in a unit of each, with minor adjustments for the cost of transferring the metal from place to place. When this common measure has ceased to be effective and we have instead a number of independent systems of inconvertible paper, what basic fact determines the rates at which units of the different currencies exchange for one another? The explanation is to be found in the doctrine, as old in itself as Ricardo, with which Professor Cassel has lately familiarised the public under the name of “Purchasing Power Parity.” This term was first introduced into economic literature in an article contributed by Prof. Cassel to the _Economic Journal_, December 1918. For Prof. Cassel’s considered opinions on the whole question, see his _Money and Foreign Exchange after 1914_ (1922). The theory, as distinct from the name, is essentially Ricardo’s. This doctrine in its baldest form runs as follows: (1) The purchasing power of an inconvertible currency within its own country, _i.e._ the currency’s _internal_ purchasing power, depends on the currency policy of the Government and the currency habits of the people, in accordance with the Quantity Theory of Money just discussed. (2) The purchasing power of an inconvertible currency in a foreign country, _i.e._ the currency’s _external_ purchasing power, must be the rate of exchange between the home-currency and the foreign-currency, multiplied by the foreign-currency’s purchasing power in its own country. (3) In conditions of equilibrium the _internal_ and _external_ purchasing powers of a currency must be the _same_, allowance being made for transport charges and import and export taxes; for otherwise a movement of trade would occur in order to take advantage of the inequality. (4) It follows, therefore, from (1), (2), and (3) that the rate of exchange between the home-currency and the foreign-currency must tend in equilibrium to be the ratio between the purchasing powers of the home-currency at home and of the foreign-currency in the foreign country. This ratio between the respective home purchasing powers of the two currencies is designated their “purchasing power parity.” If, therefore, we find that the internal and external purchasing powers of the home-currency are widely different, and, which is the same thing, that the actual exchange rates differ widely from the purchasing power parities, then we are justified in inferring that equilibrium is not established, and that, as time goes on, forces will come into play to bring the actual exchange rates and the purchasing power parities nearer together. The actual exchanges are often more sensitive and more volatile than the purchasing power parities, being subject to speculation, to sudden movements of funds, to seasonal influences, and to _anticipations_ of impending changes in purchasing power parity (due to relative inflation or deflation); though also on other occasions they may lag behind. Nevertheless it is the purchasing power parity, according to this doctrine, which corresponds to the old gold par. This is the point about which the exchanges fluctuate, and at which they must ultimately come to rest; with one material difference, namely, that it is not itself a fixed point,--since, if internal prices move differently in the two countries under comparison, the purchasing power parity also moves, so that equilibrium may be restored, not only by a movement in the market rate of exchange, but also by a movement of the purchasing power parity itself. At first sight this theory appears to be one of great practical utility; and many persons have endeavoured to draw important practical conclusions about the future course of the exchanges from charts exhibiting the divergences between the market rate of exchange and the purchasing power parities,--undeterred by the perplexity whether an existing divergence from equilibrium will be remedied by a movement of the exchanges or of the purchasing power parity or of both. In practical applications of the doctrine there are, however, two further difficulties, which we have allowed so far to escape our attention,--both of them arising out of the words _allowance being made for transport charges and import and export taxes_. The first difficulty is how to make allowance for such charges and taxes. The second difficulty is how to treat purchasing power over goods and services which _do not enter into international trade at all_. The doctrine, in the form in which it is generally applied, endeavours to deal with the first difficulty by assuming that the percentage difference between internal and external purchasing power at some standard date, when approximate equilibrium may be presumed to have existed, generally the year 1913, may be taken as an approximately satisfactory correction for the same disturbing factors at the present time. For example, instead of calculating directly the cost of a standard set of goods at home and abroad respectively, the calculations are made that $2 are required to buy in the United States a standard set which $1 would have bought in 1913, and that £2·43 are required to buy in England what £1 would have bought in 1913. On this basis (the pre-war purchasing power parity being assumed to be in equilibrium with the pre-war exchange of $4·86 = £1) the present purchasing power parity between dollars and sterling is given by $4 = £1, since 4·86 × 2 ÷ 2·43 = 4. The obvious objection to this method of correction is that transport and tariff costs, especially if this term is taken to cover all export and import regulations, including prohibitions and official or semi-official combines for differentiating between export and home prices, are notoriously widely different in many cases from those which existed in 1913. We should not get the same result if we were to take some year other than 1913 as the basis of the calculation. The second difficulty--the treatment of purchasing power over articles which do not enter into international trade--is still more serious. For, if we restrict ourselves to articles entering into international trade and make exact allowance for transport and tariff costs, we should find that the theory is always in accordance with the facts, with perhaps a short time-lag, the purchasing power parity being never very far from the market rate of exchange. Indeed, it is the whole business of the international merchant to see that this is so; for whenever the rates are temporarily out of parity he is in a position to make a profit by moving goods. The prices of cotton in New York, Liverpool, Havre, Hamburg, Genoa, and Prague, expressed in dollars, sterling, francs, marks, lire, and krone respectively, are never for any length of time much divergent from one another on the basis of the exchange rates actually obtaining in the market, due allowance being made for tariffs and the cost of moving cotton from one centre to another; and the same is true of other articles of international trade, though with an increasing time-lag as we pass to articles which are not standardised or are not handled in organised markets. In fact, the theory, stated thus, is a truism, and as nearly as possible jejune. For this reason practical applications of the theory are not thus restricted. The standard set of commodities selected is not confined to goods which are exported from and imported into the countries under comparison, but is the same set, generally speaking, as is used for compiling index numbers of general purchasing power or of the working-class cost of living. Yet applied in this way--namely, in a comparison of movements of the _general_ index numbers of home prices in two countries with movements in the rates of exchange between their currencies--the theory requires a further assumption for its validity, namely, that in the long run the home prices of the goods and services which do not enter into international trade, move in more or less the same proportions as those which do. “Our calculation of the purchasing power parity rests strictly on the proviso that the rise in prices in the countries concerned has affected all commodities in a like degree. If that proviso is not fulfilled, then the actual exchange rate may deviate from the calculated purchasing power parity.” Cassel, _Money and Foreign Exchange after 1914_, p. 154. So far from this being a truism, it is not literally or exactly true at all; and one can only say that it is more or less true according to circumstances. If capital and labour can freely move on a large scale between home and export industries without loss of relative efficiency, if there is no movement in the “equation of exchange” (see below) with the other country, and if the fluctuations in price are solely due to monetary influences and not to changes in other economic relationships between the two countries, then this further assumption may be approximately justified. But this is not always the case; and such a cataclysm as the war, with its various consequences to victor and vanquished, may set up a new equilibrium position. There may, for example, be a change more or less permanent, or at least as prolonged as the reparation payments, in the relative exchange values of Germany’s imports and exports respectively, or of those German products and services which can enter into international trade and those which cannot. Or, again, the strengthening of the financial position of the United States as against Europe, which has resulted from the war, may have shifted the old equilibrium in a direction favourable to the United States. In such cases it is not correct to assume that the coefficients of purchasing power parity, calculated, as they generally are calculated, by means of the relative variations of index numbers of general purchasing power from their pre-war levels, must ultimately approximate to the actual rates of exchange, or that internal and external purchasing power must ultimately bear to one another the same relation as in 1913. The Index Number calculated for the United States by the Federal Reserve Board illustrates how disturbing may be the influence of the change since 1913 in the relative prices of imported goods, exported goods, and commodities generally: Goods Goods All Imported. Exported. Commodities. 1913 100 100 100 July 1922 128 165 165 April 1923 156 186 169 July 1923 141 170 159 Thus the theory does not provide a simple or ready-made measure of the “true” value of the exchanges. When it is restricted to foreign-trade goods, it is little better than a truism. When it is not so restricted, the conception of purchasing power parity becomes much more interesting, but is no longer an accurate forecaster of the course of the foreign exchanges. If, therefore, we follow the ordinary practice of fixing purchasing power parity by comparisons of the _general_ purchasing power of a country’s currency at home and abroad, then we must not infer from this that the actual rate of exchange _ought_ to stand at the purchasing power parity, or that it is only a matter of time and adjustment before the two will return to equality. Purchasing power parity, thus defined, tells us an important fact about the relative changes in the purchasing power of money in (_e.g._) England and the United States or Germany between 1913 and, say, 1923, but it does not necessarily settle what the equilibrium exchange rate in 1923 between sterling and dollars or marks ought to be. Thus defined “purchasing power parity” deserves attention, even though it is not always an accurate forecaster of the foreign exchanges. The practical importance of our qualifications must not be exaggerated. If the fluctuations of purchasing power parity are markedly different from the fluctuations in the exchanges, this indicates an actual or impending change in the relative prices of the two classes of goods which respectively do and do not enter into international trade. Now there is certainly a tendency for movements in the prices of these two classes of goods to influence one another in the long run. The relative valuation placed on them is derived from deep economic and psychological causes which are not easily disturbed. If, therefore, the divergence from the pre-existing equilibrium is mainly due to monetary causes (as, for example, different degrees of inflation or deflation in the two countries), as it often is, then we may reasonably expect that purchasing power parity and exchange value will come together again before long. When this is the case, it is not possible to say in general whether exchange value will move towards purchasing power parity or the other way round. Sometimes, as recently in Europe, it is the exchanges which are the more sensitive to impending relative price-changes and move first; whilst in other cases the exchanges may not move until after the change in the relation between the internal and external price-levels is an accomplished fact. But the essence of the purchasing power parity theory, considered as an explanation of the exchanges, is to be found, I think, in its regarding internal purchasing power as being in the long run a more trustworthy indicator of a currency’s value than the market rates of exchange, because internal purchasing power quickly reflects the monetary policy of the country, which is the final determinant. If the market rates of exchange fall further than the country’s existing or impending currency policy justifies by its effect on the internal purchasing power of the country’s money, then sooner or later the exchange value is bound to recover. Thus, provided no persisting change is taking place in the basic economic relations between two countries, and provided the internal purchasing power of the currency has in each country settled down to equilibrium in relation to the currency policy of the authorities, then the rate of exchange between the currencies of the two countries must also settle down in the long run to correspond with their comparative internal purchasing powers. Subject to these assumptions comparative internal purchasing power does take the place of the old gold parity as furnishing the point about which the short-period movements of the exchanges fluctuate. If, on the other hand, these assumptions are not fulfilled and changes are taking place in the “equation of exchange,” as economists call it, between the services and products of one country and those of another, either on account of movements of capital, or reparation payments, or changes in the relative efficiency of labour, or changes in the urgency of the world’s demand for that country’s special products, or the like, then the equilibrium point between purchasing power parity and the rate of exchange may be modified permanently. This point may be made clearer by an example. Let us consider two countries, Westropa and the United States of the Hesperides, and let us assume for the sake of simplicity, and also because it may often correspond to the facts, that in both countries the price of exported goods moves in the same way as the price of other home-produced goods, but that the “equation of exchange” has moved in favour of the Hesperides so that a smaller number than before of units of Hesperidean products exchange for a given quantity of Westropean products. It follows from this that imported products in Westropa will rise in price more than commodities generally, whilst in the Hesperides they will rise less. Let us suppose that between 1913 and 1923 the Westropean index number of prices has risen from 100 to 155 and the Hesperidean index number from 100 to 160; that these index numbers are so constructed in each case that imported commodities constitute 20 per cent and home-produced commodities 80 per cent of the whole; and that the “equation of exchange” has moved 10 per cent in favour of the Hesperides, that is to say a given quantity of the goods exported by the Hesperides will buy 10 per cent more than before of the goods exported by Europe. The state of affairs is then as follows: _Westropa_: Price index of imported commodities (_x_) 167. „ home-produced „ (_y_) 152. „ all „ 155. _Hesperides_: „ imported „ (_x´_) 148. „ home-produced „ (_y´_) 163. „ all „ 160. Thus it appears that the purchasing power parity of the Westropean currency in 1923 compared with 1913 is (160/155 = )103; whereas the rate of exchange, compared with the 1913 parity, is (163/167 = 148/152 = )97. If the worsening of Westropa’s equation of exchange with the Hesperides is permanent, then its purchasing power parity (on the 1913 basis) will also remain permanently above the equilibrium value of the market rate of exchange. A tendency of these two measures of the value of a country’s currency to move differently is, therefore, a highly interesting symptom. If the market rate of exchange shows a continuing tendency to stand below the purchasing power parity, we have, failing any other explanation, some reason to suspect a worsening of the “equation of exchange” as compared with the base year. In the charts and tables below, the actual results are worked out of applying the theory to the exchange value of sterling, francs, and lire in terms of dollars since 1919. The figures show that, quantitatively speaking, the influences, which detract from the precision of the purchasing power parity theory, have been in these cases small, on the whole, as compared with those which function in accord with it. There seems to have been some disturbance in the “equations of exchange” since 1913,--which would probably show up more distinctly if it were not that the index numbers employed in the following enquiry are of the type which is largely built up from articles entering into international trade. Nevertheless general price changes, affecting all commodities more or less equally, due to currency inflation or deflation, have been so dominant in their influence that the theory has been actually applicable with remarkable accuracy. In the case, however, of such countries as Germany, where the shocks to equilibrium have been much more violent in many respects, the concordance between the purchasing power parity based on 1913 and the actual rate of exchange has suffered, whether temporarily or permanently, very great disturbance. The first of these charts, which deals with the value of sterling in terms of dollars, shows that whilst the purchasing power parity, calculated with 1913 as base, is often somewhat above the actual exchange, there is a persevering tendency for the two to come together. The two curves are within one point of each other in September-November 1919, March-April 1920, April 1921, September 1921, January-June 1922, and February-June 1923, which is certainly a remarkable illustration of the tendency to concordance between the purchasing power parity and the rate of exchange. On inductive grounds it would be tempting to conclude from this chart that the financial consequences of the war have depressed the equilibrium of the purchasing power parity of sterling as against the dollar from 1 to 2½ per cent since 1913, if it were not that this figure barely exceeds the margin of error resulting from the choice of one pair of index numbers rather than another from amongst those available. It will be interesting to see what effect is produced by the payment, just commenced, of the interest on the American debt. Nevertheless, if I had used the Board of Trade or the _Statist_ index number in place of the _Economist_ index number in the table below, the presumption of a slight worsening of the “equation of index” against Great Britain would be somewhat strengthened. This chart brings out clearly, as also do those for France and Italy, the susceptibility of the foreign exchange rates to seasonal influences, whereas the purchasing power parity is naturally less affected by them. In the case of France the curves are together at the end of 1919, diverge in 1920, come together again in the middle of 1921, and keep together until a divergence occurred again in the latter part of 1922. For Italy, rather unexpectedly perhaps, the relationship is extraordinarily steady, although here, as in the case of France and Great Britain, there are indications that the war may have resulted in a slight lowering of the equilibrium point, by (say) 10 per cent;--the parity, calculated with 1913 as the base year, has been almost invariably somewhat above the actual rate of exchange. The Italian curve illustrates in a remarkable way the manner in which the external and internal purchasing powers of the currency fall together, when the main influence at work is a progressive depreciation due to currency inflation. The use of any of the other Italian index numbers would have accentuated this indication. The table of American prices given on p. 94 above confirms the suggestion that the “equation of exchange” between the U.S. and the rest of the world as a whole has moved, say, 10 per cent in favour of the former. The broad effect of these curves and tables is to give substantial inductive support to the general theory outlined above, even under such abnormal conditions as have existed since the Armistice. During this period the movements of the relative price level in France and Italy due to monetary inflation have been so much larger than any shifting in the “equation of exchange” (a movement of more than 10 or 20 per cent in which would be startling) that their foreign exchanges have been much more influenced by their internal price policy in relation to the internal price policies of other countries than by any other factor; with the result that the Purchasing Power Parity Theory, even in its crude form, has worked passably well. GREAT BRITAIN AND THE UNITED STATES +--------------+------------------------+-------------+-----------+ | | Price Index Number. | | Actual | | Per cent of +------------+-----------+ Purchasing | Exchange | | 1913 Parity. | Great | United | Power | (Monthly | | |Britain |States | Parity. | Average). | +--------------+------------+-----------+-------------+-----------+ | 1919 Aug. | 242 | 216 | 89.3 | 87.6 | | Sept. | 245 | 210 | 85.7 | 85.8 | | Oct. | 252 | 211 | 83.7 | 85.9 | | Nov. | 259 | 217 | 83.8 | 84.3 | | Dec. | 273 | 223 | 81.7 | 78.4 | | 1920 Jan. | 289 | 233 | 81.0 | 75.6 | | Feb. | 303 | 232 | 76.6 | 69.5 | | March | 310 | 234 | 75.6 | 76.2 | | April | 306 | 245 | 80.1 | 80.6 | | May | 305 | 247 | 81.0 | 79.0 | | June | 291 | 243 | 83.5 | 81.1 | | July | 293 | 241 | 82.3 | 74.2 | | Sept. | 284 | 226 | 79.6 | 72.2 | | Oct. | 266 | 211 | 79.3 | 71.4 | | Nov. | 246 | 196 | 79.7 | 70.7 | | Dec. | 220 | 179 | 81.4 | 71.4 | | 1921 Jan. | 209 | 170 | 81.4 | 76.7 | | Feb. | 192 | 160 | 83.3 | 79.6 | | March | 189 | 155 | 82.0 | 80.3 | | April | 183 | 148 | 80.9 | 80.7 | | May | 182 | 145 | 79.7 | 81.5 | | June | 179 | 142 | 79.3 | 78.0 | | July | 178 | 141 | 79.2 | 74.8 | | Aug. | 179 | 142 | 79.3 | 75.1 | | Sept. | 183 | 141 | 77.0 | 76.5 | | Oct. | 170 | 142 | 83.5 | 79.5 | | Nov. | 166 | 141 | 84.9 | 81.5 | | Dec. | 162 | 140 | 86.4 | 85.3 | | 1922 Jan. | 159 | 138 | 86.8 | 86.8 | | Feb. | 158 | 141 | 89.1 | 89.6 | | March | 160 | 142 | 88.7 | 89.9 | | April | 159 | 143 | 89.9 | 90.7 | | May | 162 | 148 | 91.4 | 91.4 | | June | 163 | 150 | 92.0 | 91.5 | | July | 163 | 155 | 95.1 | 91.4 | | Aug. | 158 | 155 | 98.1 | 91.7 | | Sept. | 158 | 154 | 97.4 | 91.2 | | Nov. | 159 | 156 | 98.1 | 92.0 | | Dec. | 158 | 156 | 98.7 | 94.6 | | 1923 Jan. | 160 | 156 | 97.5 | 95.7 | | Feb. | 163 | 157 | 96.3 | 96.2 | | March | 163 | 159 | 97.5 | 96.5 | | April | 165 | 159 | 96.4 | 95.7 | | May | 164 | 156 | 95.1 | 95.0 | | June | 160 | 153 | 95.6 | 94.8 | +--------------+------------+-----------+-------------+-----------+ _Economist_ Index Number. U.S. Bureau of Labour Index Number, as revised. The U.S. Bureau of Labour Index Number divided by the _Economist_ Index Number. [Illustration: ENGLAND] FRANCE AND THE UNITED STATES +--------------+-------------+-----------+ | | Purchasing | | | Per cent of | Power | Actual | | 1913 Parity. | Parity. | Exchange. | +--------------+-------------+-----------+ | 1919 Aug. | 62 | 66 | | Sept. | 58 | 61 | | Oct. | 55 | 60 | | Nov. | 53 | 55 | | Dec. | 52 | 48 | | 1920 Jan. | 48 | 44 | | Feb. | 44 | 36 | | March | 42 | 37 | | April | 41 | 32 | | May | 45 | 35 | | June | 49 | 41 | | July | 48 | 42 | | Aug. | 46 | 37 | | Sept. | 43 | 35 | | Oct. | 42 | 34 | | Nov. | 43 | 31 | | Dec. | 41 | 30 | | 1921 Jan. | 42 | 33 | | Feb. | 42 | 37 | | March | 43 | 36 | | April | 43 | 37 | | May | 44 | 43 | | June | 44 | 42 | | July | 43 | 40 | | Aug. | 43 | 40 | | Sept. | 41 | 38 | | Oct. | 43 | 38 | | Nov. | 42 | 37 | | Dec. | 43 | 40 | | 1922 Jan. | 44 | 42 | | Feb. | 46 | 45 | | March | 46 | 47 | | April | 46 | 48 | | May | 44 | 47 | | June | 46 | 45 | | July | 48 | 43 | | Aug. | 47 | 41 | | Sept. | 46 | 40 | | Oct. | 46 | 38 | | Nov. | 44 | 35 | | Dec. | 43 | 37 | | 1923 Jan. | 40 | 34 | | Feb. | 37 | 32 | | March | 37 | 33 | | April | 38 | 35 | | May | 38 | 34 | | June | 37 | 33 | +--------------+-------------+-----------+ U.S. Bureau of Labour Index divided by French official wholesale Index. ITALY AND THE UNITED STATES +--------------+-------------+-----------+ | | Purchasing | | | Per cent of | Power | Actual | | 1913 Parity. | Parity. | Exchange. | +--------------+-------------+-----------+ | 1919 Aug. | 59 | 56 | | Sept. | 56 | 53 | | Oct. | 54 | 51 | | Nov. | 50 | 44 | | Dec. | 49 | 40 | | 1920 Jan. | 46 | 37 | | Feb. | 42 | 29 | | March. | 38 | 28 | | April | 36 | 23 | | May | 38 | 27 | | June | 40 | 31 | | July | 39 | 30 | | Aug. | 37 | 25 | | Sept. | 34 | 23 | | Oct. | 32 | 20 | | Nov. | 30 | 19 | | Dec. | 28 | 18 | | 1921 Jan. | 26 | 18 | | Feb. | 26 | 19 | | March | 26 | 20 | | April | 25 | 24 | | May | 27 | 27 | | June | 28 | 26 | | July | 27 | 24 | | Aug. | 26 | 22 | | Sept. | 24 | 22 | | Oct. | 24 | 20 | | Nov. | 24 | 21 | | Dec. | 23 | 23 | | 1922 Jan. | 24 | 23 | | Feb. | 25 | 25 | | March. | 27 | 26 | | April | 27 | 28 | | May | 28 | 27 | | June | 28 | 26 | | July | 28 | 24 | | Aug. | 27 | 23 | | Sept. | 26 | 22 | | Oct. | 26 | 22 | | Nov. | 26 | 23 | | Dec. | 27 | 26 | | 1923 Jan. | 27 | 26 | | Feb. | 27 | 25 | | March. | 27 | 25 | | April | 27 | 26 | | May | 27 | 25 | | June | 26 | 24 | +--------------+-------------+-----------+ U.S. Bureau of Labour Index Number divided by the “Bachi” Index Number. [Illustration: FRANCE] [Illustration: ITALY] III. _The Seasonal Fluctuation._ Thus the Theory of Purchasing Power Parity tells us that movements in the rate of exchange between the currencies of two countries tend, subject to adjustment in respect of movements in the “equation of exchange,” to correspond pretty closely to movements in the internal price levels of the two countries each expressed in their own currency. It follows that the rate of exchange can be improved in favour of one of the countries by a financial policy directed towards a lowering of its internal price level relatively to the internal price level of the other country. On the other hand a financial policy which has the effect of raising the internal price level must result, sooner or later, in depressing the rate of exchange. The conclusion is generally drawn, and quite correctly, that budgetary deficits covered by a progressive inflation of the currency render the stabilisation of a country’s exchanges impossible; and that the cessation of any increase in the volume of currency, due to this cause, is a necessary pre-requisite to a successful attempt at stabilising. The argument, however, is often carried further than this, and it is supposed that, if a country’s budget, currency, foreign trade, and its internal and external price levels are properly adjusted, then, automatically, its foreign exchange will be steady. So long, therefore, as the exchanges fluctuate--thus the argument runs--this in itself is a symptom that an attempt to stabilise would be premature. When, on the other hand, the basic conditions necessary for stabilisation are present, the exchange will steady itself. In short, any deliberate or artificial scheme of stabilisation is attacking the problem at the wrong end. It is the regulation of the currency, by means of sound budgetary and bank-rate policies, that needs attention. The proclamation of convertibility will be the last and crowning stage of the proceedings, and will amount to little more than the announcement of a _fait accompli_. Dr. R. Estcourt, criticising one of my articles in _The Annalist_ for June 12, 1922, writes: “The arrangement would not last for any appreciable period unless, as a preliminary, the Governments took the necessary steps to balance their budgets. If that were done, the so-called stabilisation speedily would become unnecessary; exchange would stabilise itself at pre-war rates.” This passage puts boldly an opinion which is widely held. There is a certain force in this mode of reasoning. But in one important respect it is fallacious. Even though foreign trade is properly adjusted, and the country’s claims and liabilities on foreign account are in equilibrium over the year as a whole, it does not follow that they are in equilibrium every day. Indeed, it is well known that countries which import large quantities of agricultural produce do not find it convenient, if they are to secure just the quality and the amount which they require, to buy at an equal rate throughout the year, but prefer to concentrate their purchases on the autumn period. Thus, quite consistently with equilibrium over the year as a whole, industrial countries tend to owe money to agricultural countries in the second half of the year, and to repay in the first half. The satisfaction of these seasonal requirements for credit with the least possible disturbance to trade was recognised before the war as an important function of international banking, and the seasonal transference of short-term credits from one centre to another was carried out for a moderate commission. Whilst the fact of seasonal pressure is well ascertained, the exact analysis of it is a little complicated. Food arrivals into Great Britain, for example, are nearly 10 per cent heavier in the third and fourth quarters of the year than in the first and second, and reach their maximum in the fourth quarter. (These and the following figures are based on averages for the pre-war period 1901–1913 worked out by the Cambridge and London Economic Service). Raw material imports are more than 20 per cent heavier in the fourth and first quarters than in the second and third, and reach their maximum in the three months November to January. Thus the fourth quarter of the year is the period at which there are heavy imports of both food and raw materials. Manufactured exports, on the other hand, are distributed through the year much more evenly, and are about normal during the last quarter. Allowing for the fact that imports are paid for, generally speaking, before they arrive, these dates correspond pretty closely with the date at which seasonal pressure is actually experienced by the dollar-sterling exchange. In France, since the war, imports in the last quarter of the year seem to have been quite 50 per cent heavier than, for example, in the first quarter. In Italy the third quarter seems to be the slackest, and the last quarter, again, a relatively heavy period. When we turn to the statistics for the United States we find the other side of the picture. August and September are the months of heavy wheat export; October to January those of heavy cotton export. The strength of the dollar exchanges in the early autumn is further increased by the financial pressure in the United States during the crop-moving period, which leads to a withdrawal of funds from foreign centres to New York. It was possible for this service to be rendered cheaply because, with the certainty provided by convertibility, the price paid for it did not need to include any appreciable provision against risk. A somewhat higher rate of discount in the temporarily debtor country, together with a small exchange profit provided by the slight shift of the exchanges within the gold points, was quite sufficient. But what is the position now? As always, the balance of payments must balance every day. As before, the balance of trade is spread unevenly through the year. Formerly the daily balance was adjusted by the movement of bankers’ funds, as described above. But now it is no longer a purely bankers’ business, suitably and sufficiently rewarded by an arbitrage profit. If a banker moves credits temporarily from one country to another, he cannot be certain at what rate of exchange he will be able to bring them back again later on. Even though he may have a strong opinion as to the probable course of exchange, his profit is no longer definitely calculable beforehand, as it used to be; he has learnt by experience that unforeseen movements of the exchange may involve him in heavy loss; and his prospective profit must be commensurate with the risk he runs. Even if he thinks that the risk is covered actuarially by the prospective profit, a banker cannot afford to run such risks on a large scale. In fact, the seasonal adjustment of credit requirements has ceased to be arbitrage banking business, and demands the services of speculative finance. Under present conditions, therefore, a large fluctuation of the exchange may be necessary before the daily account can be balanced, even though the annual account is level. Where in the old days a banker would have readily remitted millions to and from New York, hundreds of thousands are now as much as the biggest institutions will risk. The exchange must fall (or rise, as the case may be) until either the speculative financier feels sufficiently confident of a large profit to step in, or the merchant, appalled by the rate of exchange quoted to him for the transaction, decides to forgo the convenience of purchasing at that particular season of the year, and postpones a part of his purchases. The services of the professional exchange speculator, being discouraged by official and banking influences, are generally in short supply, so that a heavy price has to be paid for them, and trade is handicapped by a corresponding expense, in so far as it continues to purchase its materials at the most convenient season of the year. The extent to which the exchange fluctuations which have troubled trade during the past three years have been seasonal, and therefore due, not to a continuing or increasing disequilibrium, but merely to the absence of a fixed exchange, is not, I think, fully appreciated. During 1919 there was a heavy fall of the chief European exchanges due to the termination of the inter-Allied arrangements which had existed during the war. During 1922 there was a rise of the sterling exchange, which was independent of seasonal influences. During 1923 there has been a further non-seasonal collapse of the franc exchange due to certain persisting features of France’s internal finances and external policy. But the following table shows how largely _recurrent_ the fluctuations have been during the four years since the autumn of 1919:-- PERCENTAGE OF DOLLAR PARITY +------------+------------------+------------------+------------------+ |August-July.| Sterling. | Francs. | Lire. | | | Lowest. Highest. | Lowest. Highest. | Lowest. Highest. | +------------|------------------+------------------+------------------+ | 1919–1920 | 69 88 | 31 66 | 22 56 | | 1920–1921 | 69 82 | 30 45 | 18 29 | | 1921–1922 | 73 92 | 37 48 | 20 28 | | 1922–1923 | 90 97 | 29 41 | 20 27 | +------------+------------------+------------------+------------------+ On the experience of the past three years, francs and lire are at their best in April and May and at their worst between October and December. Sterling is not quite so punctual in its movements, the best point of the year falling somewhere between March and June and the worst between August and November. The comparative stability of the highest and lowest quotations respectively in each year, especially in the case of Italy, is very striking, and indicates that a policy of stabilisation at some mean figure might have been practicable; whilst, on the other hand, the wide divergences between the highest and lowest are a measure of the expense and interference that trade has suffered. These results correspond so closely to the facts of seasonal trade (see above, p. 108) that we may safely attribute m

Parts of this chapter raise, unavoidably, matters of much greater difficulty to the layman than the rest of the book. The reader whose interest in the theoretical foundations is secondary can pass on.

I. _The Quantity Theory of Money_

This Theory is fundamental. Its correspondence with fact is not open to question. Nevertheless it is often misstated and misrepresented. Goschen’s saying of sixty years ago, that “there are many persons who cannot hear the relation of the level of prices to the volume of currency affirmed without a feeling akin to irritation,” still holds good.

“The Quantity Theory is often defended and opposed as though it were a definite set of propositions that must be either true or false. But in fact the formulæ employed in the exposition of that theory are merely devices for enabling us to bring together in an orderly way the principal causes by which the value of money is determined” (Pigou).

The Theory flows from the fact that money as such has no utility except what is derived from its exchange-value, that is to say from the utility of the things which it can buy. Valuable articles other than money have a utility in themselves. Provided that they are divisible and transferable, the total amount of this utility increases with their quantity;--it will not increase in full proportion to the quantity, but, up to the point of satiety, it does increase.

If an article is used for money, such as gold, which has a utility in itself for other purposes, aside from its use as money, the strict statement of the theory, though fundamentally unchanged, is a little complicated. In present circumstances we can excuse ourselves this complication. A Currency Note has no utility in itself and is completely worthless except for the purchasing power which it has as money.

Consequently what the public want is not so many ounces or so many square yards or even so many £ sterling of currency notes, but a quantity sufficient to cover a week’s wages, or to pay their bills, or to meet their probable outgoings on a journey or a day’s shopping. When people find themselves with more cash than they require for such purposes, they get rid of the surplus by buying goods or investments, or by leaving it for a bank to employ, or, possibly, by increasing their hoarded reserves. Thus the _number_ of notes which the public ordinarily have on hand is determined by the amount of _purchasing power_ which it suits them to hold or to carry about, and by nothing else. The amount of this purchasing power depends partly on their wealth, partly on their habits. The wealth of the public in the aggregate will only change gradually. Their habits in the use of money--whether their income is paid them weekly or monthly or quarterly, whether they pay cash at shops or run accounts, whether they deposit with banks, whether they cash small cheques at short intervals or larger cheques at longer intervals, whether they keep a reserve or hoard of money about the house--are more easily altered. But if their wealth and their habits in the above respects are unchanged, then the amount of purchasing power which they hold in the form of money is definitely fixed. We can measure this definite amount of purchasing power in terms of a unit made up of a collection of specified quantities of their standard articles of consumption or other objects of expenditure; for example, the kinds and quantities of articles which are combined for the purpose of a cost-of-living index number. Let us call such a unit a “consumption unit” and assume that the public require to hold an amount of money having a purchasing power over _k_ consumption units. Let there be _n_ currency notes or other forms of cash in circulation with the public, and let _p_ be the price of each consumption unit (_i.e._ _p_ is the index number of the cost of living), then it follows from the above that _n = pk_. This is the famous Quantity Theory of Money. So long as _k_ remains unchanged, _n_ and _p_ rise and fall together; that is to say, the greater or the fewer the number of currency notes, the higher or the lower is the price level in the same proportion.

So far we have assumed that the whole of the public requirement for purchasing power is satisfied by cash, and on the other hand that this requirement is the only source of demand for cash; neglecting the fact that the public, including the business world, employ for the same purpose bank deposits and overdraft facilities, whilst the banks must for the same reason maintain a reserve of cash. The theory is easily extended, however, to cover this case. Let us assume that the public, including the business world, find it convenient to keep the equivalent of _k_ consumption units in cash and of a further _k´_ available at their banks against cheques, and that the banks keep in cash a proportion _r_ of their potential liabilities (_k´_) to the public. Our equation then becomes

_n = p(k + rk´)_.

So long as _k_, _k´_, and _r_ remain unchanged, we have the same result as before, namely, that _n_ and _p_ rise and fall together. The proportion between _k_ and _k´_ depends on the banking arrangements of the public; the absolute value of these on their habits generally; and the value of _r_ on the reserve practices of the banks. Thus, so long as these are unaltered, we still have a direct relation between the _quantity_ of cash (_n_) and the level of prices (_p_).

My exposition follows the general lines of Prof. Pigou (_Quarterly Journal of Economics_, Nov. 1917) and of Dr. Marshall (_Money, Credit, and Commerce_, I. iv.), rather than the perhaps more familiar analysis of Prof. Irving Fisher. Instead of starting with the amount of cash held by the public, Prof. Fisher begins with the volume of business transacted by means of money and the frequency with which each unit of money changes hands. It comes to the same thing in the end and it is easy to pass from the above formula to Prof. Fisher’s; but the above method of approach seems less artificial than Prof. Fisher’s and nearer to the observed facts.

We have seen that the amount of _k_ and _k´_ depends partly on the wealth of the community, partly on its habits. Its habits are fixed by its estimation of the extra convenience of having more cash in hand as compared with the advantages to be got from spending the cash or investing it. The point of equilibrium is reached where the estimated advantages of keeping more cash in hand compared with those of spending or investing it about balance. The matter cannot be summed up better than in the words of Dr. Marshall:

“In every state of society there is some fraction of their income which people find it worth while to keep in the form of currency; it may be a fifth, or a tenth, or a twentieth. A large command of resources in the form of currency renders their business easy and smooth, and puts them at an advantage in bargaining; but on the other hand it locks up in a barren form resources that might yield an income of gratification if invested, say, in extra furniture; or a money income, if invested in extra machinery or cattle.” A man fixes the appropriate fraction “after balancing one against another the advantages of a further ready command, and the disadvantages of putting more of his resources into a form in which they yield him no direct income or other benefit.” “Let us suppose that the inhabitants of a country, taken one with another (and including therefore all varieties of character and of occupation), find it just worth their while to keep by them on the average ready purchasing power to the extent of a tenth part of their annual income, together with a fiftieth part of their property; then the aggregate value of the currency of the country will tend to be equal to the sum of these amounts.”

_Money, Credit, and Commerce_, I. iv. 3. Dr. Marshall shows in a footnote as follows that the above is in fact a development of the traditional way of considering the matter: “Petty thought that the money ‘sufficient for’ the nation is ‘so much as will pay half a year’s rent for all the lands of England and a quarter’s rent of the Houseing, for a week’s expense of all the people, and about a quarter of the value of all the exported commodities.’ Locke estimated that ‘one-fiftieth of wages and one-fourth of the landowner’s income and one-twentieth part of the broker’s yearly returns in ready money will be enough to drive the trade of any country.’ Cantillon (A.D. 1755), after a long and subtle study, concludes that the value needed is a ninth of the total produce of the country; or, what he takes to be the same thing, a third of the rent of the land. Adam Smith has more of the scepticism of the modern age and says: ‘it is impossible to determine the proportion,’ though ‘it has been computed by different authors at a fifth, at a tenth, at a twentieth, and at a thirtieth part of the whole value of the annual produce.’” In modern conditions the normal proportion of the circulation to this national income seems to be somewhere between a tenth and a fifteenth.

So far there should be no room for difference of opinion. The error often made by careless adherents of the Quantity Theory, which may partly explain why it is not universally accepted, is as follows.

Every one admits that the habits of the public in the use of money and of banking facilities and the practices of the banks in respect of their reserves change from time to time as the result of obvious developments. These habits and practices are a reflection of changes in economic and social organisation. But the Theory has often been expounded on the further assumption that a _mere_ change in the quantity of the currency cannot affect _k_, _r_, and _k´_,--that is to say, in mathematical parlance, that _n_ is an _independent variable_ in relation to these quantities. It would follow from this that an arbitrary doubling of _n_, since this in itself is assumed not to affect _k_, _r_, and _k´_, must have the effect of raising _p_ to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form.

Now “in the long run” this is probably true. If, after the American Civil War, the American dollar had been stabilised and defined by law at 10 per cent below its present value, it would be safe to assume that _n_ and _p_ would now be just 10 per cent greater than they actually are and that the present values of _k_, _r_, and _k´_ would be entirely unaffected. But this _long run_ is a misleading guide to current affairs. _In the long run_ we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

In actual experience, a change of n is liable to have a reaction both on _k_ and _k´_ and on _r_. It will be enough to give a few typical instances. Before the war (and indeed since) there was a considerable element of what was conventional and arbitrary in the reserve policy of the banks, but especially in the policy of the State Banks towards their gold reserves. These reserves were kept for show rather than for use, and their amount was not the result of close reasoning. There was a decided tendency on the part of these banks between 1900 and 1914 to bottle up gold when it flowed towards them and to part with it reluctantly when the tide was flowing the other way. Consequently, when gold became relatively abundant they tended to hoard what came their way and to raise the proportion of the reserves, with the result that the increased output of South African gold was absorbed with less effect on the price level than would have been the case if an increase of _n_ had been totally without reaction on the value of _r_.

In agricultural countries where peasants readily hoard money, an inflation, especially in its early stages, does not raise prices proportionately, because when, as a result of a certain rise in the price of agricultural products, more money flows into the pockets of the peasants, it tends to stick there;--deeming themselves that much richer, the peasants increase the proportion of their receipts that they hoard.

Thus in these and in other ways the terms of our equation tend in their movements to favour the stability of _p_, and there is a certain friction which prevents a moderate change in _n_ from exercising its full proportionate effect on _p_.

On the other hand a large change in _n_, which rubs away the initial friction, and especially a change in _n_ due to causes which set up a general expectation of a further change in the same direction, may produce a _more_ than proportionate effect on _p_. After the general analysis of Chapter I. and the narratives of catastrophic inflations given in Chapter II., it is scarcely necessary to illustrate this further,--it is a matter more readily understood than it was ten years ago. A large change in _p_ greatly affects individual fortunes. Hence a change after it has occurred, or sooner in so far as it is anticipated, may greatly affect the monetary habits of the public in their attempt to protect themselves from a similar loss in future, or to make gains and avoid loss during the passage from the equilibrium corresponding to the old value of _n_ to the equilibrium corresponding to its new value. Thus after, during, and (so far as the change is anticipated) before a change in the value of _n_, there will be some reaction on the values of _k_, _k´_, and _r_, with the result that the change in the value of _p_, at least temporarily and perhaps permanently (since habits and practices, once changed, will not revert to exactly their old shape), will not be precisely in proportion to the change in _n_.

The terms _inflation_ and _deflation_ are used by different writers in varying senses. It would be convenient to speak of an increase or decrease in _n_ as an inflation or deflation of _cash_; and of a decrease or increase in _r_ as an inflation or deflation of _credit_. The characteristic of the “credit-cycle” (as the alternation of boom and depression is now described) consists in a tendency of _k_ and _k´_ to diminish during the boom and increase during the depression, irrespective of changes in _n_ and _r_, these movements representing respectively a diminution and an increase of “real” balances (_i.e._ balances, in hand or at the bank, measured in terms of purchasing power); so that we might call this phenomenon deflation and inflation of real balances.

It will illustrate the “Quantity Theory” equation in general and the phenomena of deflation and inflation of real balances in particular, if we endeavour to fill in actual values for our symbolic quantities. The following example does not claim to be exact and its object is to illustrate the idea rather than to convey statistically precise facts. October 1920 was about the end of the recent boom, and October 1922 was near the bottom of the depression. At these two dates the figures of price level (taking October 1922 as 100), cash circulation (note circulation _plus_ private deposits at the Bank of England), and bank deposits in Great Britain were roughly as follows:

It would take me too far from the immediate matter in hand to discuss why I take this definition of “cash” in the case of Great Britain. It is discussed further in Chapter V. below.

Price Level. Cash Circulation. Bank Deposits. October 1920 150 £585,000,000 £2,000,000,000 October 1922 100 £504,000,000 £1,700,000,000

The value of _r_ was not very different at the two dates--say about 12 per cent. Consequently our equation for the two dates works out as follows:

October 1920 _n_ = 585 _p_ = 1·5 _k_ = 230 _k´_ = 1333 October 1922 _n_ = 504 _p_ = 1 _k_ = 300 _k´_ = 1700

For 585 = 1·5(230 + 1333 × ·12), and 504 = 1(300 + 1700 × ·12).

Thus during the depression _k_ rose from 230 to 300 and _k´_ from 1333 to 1700, which means that the cash holdings of the public at the former date were worth 23/30, and their bank balances 1333/1700, what they were worth at the latter date. It thus appears that the tendency of _k_ and _k´_ to increase had more to do, than the deflation of “cash” had, with the fall of prices between the two periods. If _k_ and _k´_ were to fall back to their 1920 values, prices would rise 30 per cent without any change whatever in the volume of cash or the reserve policy of the banks. Thus even in Great Britain the fluctuations of _k_ and _k´_ can have a decisive influence on the price level; whilst we have already seen (pp. 51, 52) how enormously they can change in the recent conditions of Russia and Central Europe.

The moral of this discussion, to be carried forward in the reader’s mind until we reach Chapters IV. and V., is that the price level is not mysterious, but is governed by a few, definite, analysable influences. Two of these, _n_ and _r_, are under the direct control (or ought to be) of the central banking authorities. The third, namely _k_ and _k´_, is not directly controllable, and depends on the mood of the public and the business world. The business of stabilising the price level, not merely over long periods but so as also to avoid cyclical fluctuations, consists partly in exercising a stabilising influence over _k_ and _k´_, in so far as this fails or is impracticable, in deliberately varying _n_ and _r_ so as to _counterbalance_ the movement of _k_ and _k´_.

The usual method of exercising a stabilising influence over _k_ and _k´_ especially over _k´_, is that of bank-rate. A tendency of _k´_ to increase may be somewhat counteracted by lowering the bank-rate, because easy lending diminishes the advantage of keeping a margin for contingencies in cash. Cheap money also operates to _counterbalance_ an increase of _k´_, because, by encouraging borrowing from the banks, it prevents _r_ from increasing or causes _r_ to diminish. But it is doubtful whether bank-rate by itself is always a powerful enough instrument, and, if we are to achieve stability, we must be prepared to vary _n_ and _r_ on occasion.

Our analysis suggests that the first duty of the central banking and currency authorities is to make sure that they have _n_ and _r_ thoroughly under control. For example, so long as inflationary taxation is in question _n_ will be influenced by other than currency objects and cannot, therefore, be fully under control; moreover, at the other extreme, under a gold standard _n_ is not always under control, because it depends on the unregulated forces which determine the demand and supply of gold throughout the world. Again, without a central banking system _r_ will not be under proper control because it will be determined by the unco-ordinated decisions of numerous different banks.

At the present time in Great Britain _r_ is very completely controlled, and _n_ also, so long as we refrain from inflationary finance on the one hand and from a return to an unregulated gold standard on the other. The second duty of the authorities is therefore worth discussing, namely, the _use_ of their control over _n_ and _r_ to counterbalance changes in _k_ and _k´_. Even if _k_ and _k´_ were entirely outside the influence of deliberate policy, which is not in fact the case, nevertheless _p_ could be kept reasonably steady by suitable modifications of the values of _n_ and _r_.

In the case of the United States the same thing is more or less true, so long as the Federal Reserve Board is prepared to incur the expense of bottling up redundant gold.

Old-fashioned advocates of sound money have laid too much emphasis on the need of keeping _n_ and _r_ steady, and have argued as if this policy by itself would produce the right results. So far from this being so, steadiness of _n_ and _r_, when _k_ and _k´_ are not steady, is bound to lead to unsteadiness of the price level. Cyclical fluctuations are characterised, not primarily by changes in _n_ or _r_, but by changes in _k_ and _k´_. It follows that they can only be cured if we are ready deliberately to increase and decrease _n_ and _r_, when symptoms of movement are showing in the values of _k_ and _k´_. I am being led, however, into a large subject beyond my immediate purpose, and am anticipating also the topic of Chapter V. These hints will serve, nevertheless, to indicate to the reader what a long way we may be led by an understanding of the implications of the simple Quantity equation with which we started.

II. _The Theory of Purchasing Power Parity._

The Quantity Theory deals with the purchasing power or commodity-value of a given national currency. We come now to the _relative_ value of _two_ distinct national currencies,--that is to say, to the theory of the Foreign Exchanges.

When the currencies of the world were nearly all on a gold basis, their relative value (_i.e._ the exchanges) depended on the actual amount of gold metal in a unit of each, with minor adjustments for the cost of transferring the metal from place to place.

When this common measure has ceased to be effective and we have instead a number of independent systems of inconvertible paper, what basic fact determines the rates at which units of the different currencies exchange for one another?

The explanation is to be found in the doctrine, as old in itself as Ricardo, with which Professor Cassel has lately familiarised the public under the name of “Purchasing Power Parity.”

This term was first introduced into economic literature in an article contributed by Prof. Cassel to the _Economic Journal_, December 1918. For Prof. Cassel’s considered opinions on the whole question, see his _Money and Foreign Exchange after 1914_ (1922). The theory, as distinct from the name, is essentially Ricardo’s.

This doctrine in its baldest form runs as follows: (1) The purchasing power of an inconvertible currency within its own country, _i.e._ the currency’s _internal_ purchasing power, depends on the currency policy of the Government and the currency habits of the people, in accordance with the Quantity Theory of Money just discussed. (2) The purchasing power of an inconvertible currency in a foreign country, _i.e._ the currency’s _external_ purchasing power, must be the rate of exchange between the home-currency and the foreign-currency, multiplied by the foreign-currency’s purchasing power in its own country. (3) In conditions of equilibrium the _internal_ and _external_ purchasing powers of a currency must be the _same_, allowance being made for transport charges and import and export taxes; for otherwise a movement of trade would occur in order to take advantage of the inequality. (4) It follows, therefore, from (1), (2), and (3) that the rate of exchange between the home-currency and the foreign-currency must tend in equilibrium to be the ratio between the purchasing powers of the home-currency at home and of the foreign-currency in the foreign country. This ratio between the respective home purchasing powers of the two currencies is designated their “purchasing power parity.”

If, therefore, we find that the internal and external purchasing powers of the home-currency are widely different, and, which is the same thing, that the actual exchange rates differ widely from the purchasing power parities, then we are justified in inferring that equilibrium is not established, and that, as time goes on, forces will come into play to bring the actual exchange rates and the purchasing power parities nearer together. The actual exchanges are often more sensitive and more volatile than the purchasing power parities, being subject to speculation, to sudden movements of funds, to seasonal influences, and to _anticipations_ of impending changes in purchasing power parity (due to relative inflation or deflation); though also on other occasions they may lag behind. Nevertheless it is the purchasing power parity, according to this doctrine, which corresponds to the old gold par. This is the point about which the exchanges fluctuate, and at which they must ultimately come to rest; with one material difference, namely, that it is not itself a fixed point,--since, if internal prices move differently in the two countries under comparison, the purchasing power parity also moves, so that equilibrium may be restored, not only by a movement in the market rate of exchange, but also by a movement of the purchasing power parity itself.

At first sight this theory appears to be one of great practical utility; and many persons have endeavoured to draw important practical conclusions about the future course of the exchanges from charts exhibiting the divergences between the market rate of exchange and the purchasing power parities,--undeterred by the perplexity whether an existing divergence from equilibrium will be remedied by a movement of the exchanges or of the purchasing power parity or of both.

In practical applications of the doctrine there are, however, two further difficulties, which we have allowed so far to escape our attention,--both of them arising out of the words _allowance being made for transport charges and import and export taxes_. The first difficulty is how to make allowance for such charges and taxes. The second difficulty is how to treat purchasing power over goods and services which _do not enter into international trade at all_.

The doctrine, in the form in which it is generally applied, endeavours to deal with the first difficulty by assuming that the percentage difference between internal and external purchasing power at some standard date, when approximate equilibrium may be presumed to have existed, generally the year 1913, may be taken as an approximately satisfactory correction for the same disturbing factors at the present time. For example, instead of calculating directly the cost of a standard set of goods at home and abroad respectively, the calculations are made that $2 are required to buy in the United States a standard set which $1 would have bought in 1913, and that £2·43 are required to buy in England what £1 would have bought in 1913. On this basis (the pre-war purchasing power parity being assumed to be in equilibrium with the pre-war exchange of $4·86 = £1) the present purchasing power parity between dollars and sterling is given by $4 = £1, since 4·86 × 2 ÷ 2·43 = 4.

The obvious objection to this method of correction is that transport and tariff costs, especially if this term is taken to cover all export and import regulations, including prohibitions and official or semi-official combines for differentiating between export and home prices, are notoriously widely different in many cases from those which existed in 1913. We should not get the same result if we were to take some year other than 1913 as the basis of the calculation.

The second difficulty--the treatment of purchasing power over articles which do not enter into international trade--is still more serious. For, if we restrict ourselves to articles entering into international trade and make exact allowance for transport and tariff costs, we should find that the theory is always in accordance with the facts, with perhaps a short time-lag, the purchasing power parity being never very far from the market rate of exchange. Indeed, it is the whole business of the international merchant to see that this is so; for whenever the rates are temporarily out of parity he is in a position to make a profit by moving goods. The prices of cotton in New York, Liverpool, Havre, Hamburg, Genoa, and Prague, expressed in dollars, sterling, francs, marks, lire, and krone respectively, are never for any length of time much divergent from one another on the basis of the exchange rates actually obtaining in the market, due allowance being made for tariffs and the cost of moving cotton from one centre to another; and the same is true of other articles of international trade, though with an increasing time-lag as we pass to articles which are not standardised or are not handled in organised markets. In fact, the theory, stated thus, is a truism, and as nearly as possible jejune.

For this reason practical applications of the theory are not thus restricted. The standard set of commodities selected is not confined to goods which are exported from and imported into the countries under comparison, but is the same set, generally speaking, as is used for compiling index numbers of general purchasing power or of the working-class cost of living. Yet applied in this way--namely, in a comparison of movements of the _general_ index numbers of home prices in two countries with movements in the rates of exchange between their currencies--the theory requires a further assumption for its validity, namely, that in the long run the home prices of the goods and services which do not enter into international trade, move in more or less the same proportions as those which do.

“Our calculation of the purchasing power parity rests strictly on the proviso that the rise in prices in the countries concerned has affected all commodities in a like degree. If that proviso is not fulfilled, then the actual exchange rate may deviate from the calculated purchasing power parity.” Cassel, _Money and Foreign Exchange after 1914_, p. 154.

So far from this being a truism, it is not literally or exactly true at all; and one can only say that it is more or less true according to circumstances. If capital and labour can freely move on a large scale between home and export industries without loss of relative efficiency, if there is no movement in the “equation of exchange” (see below) with the other country, and if the fluctuations in price are solely due to monetary influences and not to changes in other economic relationships between the two countries, then this further assumption may be approximately justified. But this is not always the case; and such a cataclysm as the war, with its various consequences to victor and vanquished, may set up a new equilibrium position. There may, for example, be a change more or less permanent, or at least as prolonged as the reparation payments, in the relative exchange values of Germany’s imports and exports respectively, or of those German products and services which can enter into international trade and those which cannot. Or, again, the strengthening of the financial position of the United States as against Europe, which has resulted from the war, may have shifted the old equilibrium in a direction favourable to the United States. In such cases it is not correct to assume that the coefficients of purchasing power parity, calculated, as they generally are calculated, by means of the relative variations of index numbers of general purchasing power from their pre-war levels, must ultimately approximate to the actual rates of exchange, or that internal and external purchasing power must ultimately bear to one another the same relation as in 1913.

The Index Number calculated for the United States by the Federal Reserve Board illustrates how disturbing may be the influence of the change since 1913 in the relative prices of imported goods, exported goods, and commodities generally:

Goods Goods All Imported. Exported. Commodities. 1913 100 100 100 July 1922 128 165 165 April 1923 156 186 169 July 1923 141 170 159

Thus the theory does not provide a simple or ready-made measure of the “true” value of the exchanges. When it is restricted to foreign-trade goods, it is little better than a truism. When it is not so restricted, the conception of purchasing power parity becomes much more interesting, but is no longer an accurate forecaster of the course of the foreign exchanges. If, therefore, we follow the ordinary practice of fixing purchasing power parity by comparisons of the _general_ purchasing power of a country’s currency at home and abroad, then we must not infer from this that the actual rate of exchange _ought_ to stand at the purchasing power parity, or that it is only a matter of time and adjustment before the two will return to equality. Purchasing power parity, thus defined, tells us an important fact about the relative changes in the purchasing power of money in (_e.g._) England and the United States or Germany between 1913 and, say, 1923, but it does not necessarily settle what the equilibrium exchange rate in 1923 between sterling and dollars or marks ought to be.

Thus defined “purchasing power parity” deserves attention, even though it is not always an accurate forecaster of the foreign exchanges. The practical importance of our qualifications must not be exaggerated. If the fluctuations of purchasing power parity are markedly different from the fluctuations in the exchanges, this indicates an actual or impending change in the relative prices of the two classes of goods which respectively do and do not enter into international trade. Now there is certainly a tendency for movements in the prices of these two classes of goods to influence one another in the long run. The relative valuation placed on them is derived from deep economic and psychological causes which are not easily disturbed. If, therefore, the divergence from the pre-existing equilibrium is mainly due to monetary causes (as, for example, different degrees of inflation or deflation in the two countries), as it often is, then we may reasonably expect that purchasing power parity and exchange value will come together again before long.

When this is the case, it is not possible to say in general whether exchange value will move towards purchasing power parity or the other way round. Sometimes, as recently in Europe, it is the exchanges which are the more sensitive to impending relative price-changes and move first; whilst in other cases the exchanges may not move until after the change in the relation between the internal and external price-levels is an accomplished fact. But the essence of the purchasing power parity theory, considered as an explanation of the exchanges, is to be found, I think, in its regarding internal purchasing power as being in the long run a more trustworthy indicator of a currency’s value than the market rates of exchange, because internal purchasing power quickly reflects the monetary policy of the country, which is the final determinant. If the market rates of exchange fall further than the country’s existing or impending currency policy justifies by its effect on the internal purchasing power of the country’s money, then sooner or later the exchange value is bound to recover. Thus, provided no persisting change is taking place in the basic economic relations between two countries, and provided the internal purchasing power of the currency has in each country settled down to equilibrium in relation to the currency policy of the authorities, then the rate of exchange between the currencies of the two countries must also settle down in the long run to correspond with their comparative internal purchasing powers. Subject to these assumptions comparative internal purchasing power does take the place of the old gold parity as furnishing the point about which the short-period movements of the exchanges fluctuate.

If, on the other hand, these assumptions are not fulfilled and changes are taking place in the “equation of exchange,” as economists call it, between the services and products of one country and those of another, either on account of movements of capital, or reparation payments, or changes in the relative efficiency of labour, or changes in the urgency of the world’s demand for that country’s special products, or the like, then the equilibrium point between purchasing power parity and the rate of exchange may be modified permanently.

This point may be made clearer by an example. Let us consider two countries, Westropa and the United States of the Hesperides, and let us assume for the sake of simplicity, and also because it may often correspond to the facts, that in both countries the price of exported goods moves in the same way as the price of other home-produced goods, but that the “equation of exchange” has moved in favour of the Hesperides so that a smaller number than before of units of Hesperidean products exchange for a given quantity of Westropean products. It follows from this that imported products in Westropa will rise in price more than commodities generally, whilst in the Hesperides they will rise less. Let us suppose that between 1913 and 1923 the Westropean index number of prices has risen from 100 to 155 and the Hesperidean index number from 100 to 160; that these index numbers are so constructed in each case that imported commodities constitute 20 per cent and home-produced commodities 80 per cent of the whole; and that the “equation of exchange” has moved 10 per cent in favour of the Hesperides, that is to say a given quantity of the goods exported by the Hesperides will buy 10 per cent more than before of the goods exported by Europe. The state of affairs is then as follows:

_Westropa_: Price index of imported commodities (_x_) 167. „ home-produced „ (_y_) 152. „ all „ 155. _Hesperides_: „ imported „ (_x´_) 148. „ home-produced „ (_y´_) 163. „ all „ 160.

Thus it appears that the purchasing power parity of the Westropean currency in 1923 compared with 1913 is (160/155 = )103; whereas the rate of exchange, compared with the 1913 parity, is (163/167 = 148/152 = )97. If the worsening of Westropa’s equation of exchange with the Hesperides is permanent, then its purchasing power parity (on the 1913 basis) will also remain permanently above the equilibrium value of the market rate of exchange.

A tendency of these two measures of the value of a country’s currency to move differently is, therefore, a highly interesting symptom. If the market rate of exchange shows a continuing tendency to stand below the purchasing power parity, we have, failing any other explanation, some reason to suspect a worsening of the “equation of exchange” as compared with the base year.

In the charts and tables below, the actual results are worked out of applying the theory to the exchange value of sterling, francs, and lire in terms of dollars since 1919. The figures show that, quantitatively speaking, the influences, which detract from the precision of the purchasing power parity theory, have been in these cases small, on the whole, as compared with those which function in accord with it. There seems to have been some disturbance in the “equations of exchange” since 1913,--which would probably show up more distinctly if it were not that the index numbers employed in the following enquiry are of the type which is largely built up from articles entering into international trade. Nevertheless general price changes, affecting all commodities more or less equally, due to currency inflation or deflation, have been so dominant in their influence that the theory has been actually applicable with remarkable accuracy. In the case, however, of such countries as Germany, where the shocks to equilibrium have been much more violent in many respects, the concordance between the purchasing power parity based on 1913 and the actual rate of exchange has suffered, whether temporarily or permanently, very great disturbance.

The first of these charts, which deals with the value of sterling in terms of dollars, shows that whilst the purchasing power parity, calculated with 1913 as base, is often somewhat above the actual exchange, there is a persevering tendency for the two to come together. The two curves are within one point of each other in September-November 1919, March-April 1920, April 1921, September 1921, January-June 1922, and February-June 1923, which is certainly a remarkable illustration of the tendency to concordance between the purchasing power parity and the rate of exchange. On inductive grounds it would be tempting to conclude from this chart that the financial consequences of the war have depressed the equilibrium of the purchasing power parity of sterling as against the dollar from 1 to 2½ per cent since 1913, if it were not that this figure barely exceeds the margin of error resulting from the choice of one pair of index numbers rather than another from amongst those available. It will be interesting to see what effect is produced by the payment, just commenced, of the interest on the American debt.

Nevertheless, if I had used the Board of Trade or the _Statist_ index number in place of the _Economist_ index number in the table below, the presumption of a slight worsening of the “equation of index” against Great Britain would be somewhat strengthened.

This chart brings out clearly, as also do those for France and Italy, the susceptibility of the foreign exchange rates to seasonal influences, whereas the purchasing power parity is naturally less affected by them.

In the case of France the curves are together at the end of 1919, diverge in 1920, come together again in the middle of 1921, and keep together until a divergence occurred again in the latter part of 1922.

For Italy, rather unexpectedly perhaps, the relationship is extraordinarily steady, although here, as in the case of France and Great Britain, there are indications that the war may have resulted in a slight lowering of the equilibrium point, by (say) 10 per cent;--the parity, calculated with 1913 as the base year, has been almost invariably somewhat above the actual rate of exchange. The Italian curve illustrates in a remarkable way the manner in which the external and internal purchasing powers of the currency fall together, when the main influence at work is a progressive depreciation due to currency inflation.

The use of any of the other Italian index numbers would have accentuated this indication. The table of American prices given on p. 94 above confirms the suggestion that the “equation of exchange” between the U.S. and the rest of the world as a whole has moved, say, 10 per cent in favour of the former.

The broad effect of these curves and tables is to give substantial inductive support to the general theory outlined above, even under such abnormal conditions as have existed since the Armistice. During this period the movements of the relative price level in France and Italy due to monetary inflation have been so much larger than any shifting in the “equation of exchange” (a movement of more than 10 or 20 per cent in which would be startling) that their foreign exchanges have been much more influenced by their internal price policy in relation to the internal price policies of other countries than by any other factor; with the result that the Purchasing Power Parity Theory, even in its crude form, has worked passably well.

GREAT BRITAIN AND THE UNITED STATES

+--------------+------------------------+-------------+-----------+ | | Price Index Number. | | Actual | | Per cent of +------------+-----------+ Purchasing | Exchange | | 1913 Parity. | Great | United | Power | (Monthly | | |Britain |States | Parity. | Average). | +--------------+------------+-----------+-------------+-----------+ | 1919 Aug. | 242 | 216 | 89.3 | 87.6 | | Sept. | 245 | 210 | 85.7 | 85.8 | | Oct. | 252 | 211 | 83.7 | 85.9 | | Nov. | 259 | 217 | 83.8 | 84.3 | | Dec. | 273 | 223 | 81.7 | 78.4 | | 1920 Jan. | 289 | 233 | 81.0 | 75.6 | | Feb. | 303 | 232 | 76.6 | 69.5 | | March | 310 | 234 | 75.6 | 76.2 | | April | 306 | 245 | 80.1 | 80.6 | | May | 305 | 247 | 81.0 | 79.0 | | June | 291 | 243 | 83.5 | 81.1 | | July | 293 | 241 | 82.3 | 74.2 | | Sept. | 284 | 226 | 79.6 | 72.2 | | Oct. | 266 | 211 | 79.3 | 71.4 | | Nov. | 246 | 196 | 79.7 | 70.7 | | Dec. | 220 | 179 | 81.4 | 71.4 | | 1921 Jan. | 209 | 170 | 81.4 | 76.7 | | Feb. | 192 | 160 | 83.3 | 79.6 | | March | 189 | 155 | 82.0 | 80.3 | | April | 183 | 148 | 80.9 | 80.7 | | May | 182 | 145 | 79.7 | 81.5 | | June | 179 | 142 | 79.3 | 78.0 | | July | 178 | 141 | 79.2 | 74.8 | | Aug. | 179 | 142 | 79.3 | 75.1 | | Sept. | 183 | 141 | 77.0 | 76.5 | | Oct. | 170 | 142 | 83.5 | 79.5 | | Nov. | 166 | 141 | 84.9 | 81.5 | | Dec. | 162 | 140 | 86.4 | 85.3 | | 1922 Jan. | 159 | 138 | 86.8 | 86.8 | | Feb. | 158 | 141 | 89.1 | 89.6 | | March | 160 | 142 | 88.7 | 89.9 | | April | 159 | 143 | 89.9 | 90.7 | | May | 162 | 148 | 91.4 | 91.4 | | June | 163 | 150 | 92.0 | 91.5 | | July | 163 | 155 | 95.1 | 91.4 | | Aug. | 158 | 155 | 98.1 | 91.7 | | Sept. | 158 | 154 | 97.4 | 91.2 | | Nov. | 159 | 156 | 98.1 | 92.0 | | Dec. | 158 | 156 | 98.7 | 94.6 | | 1923 Jan. | 160 | 156 | 97.5 | 95.7 | | Feb. | 163 | 157 | 96.3 | 96.2 | | March | 163 | 159 | 97.5 | 96.5 | | April | 165 | 159 | 96.4 | 95.7 | | May | 164 | 156 | 95.1 | 95.0 | | June | 160 | 153 | 95.6 | 94.8 | +--------------+------------+-----------+-------------+-----------+

_Economist_ Index Number.

U.S. Bureau of Labour Index Number, as revised.

The U.S. Bureau of Labour Index Number divided by the _Economist_ Index Number.

[Illustration: ENGLAND]

FRANCE AND THE UNITED STATES

+--------------+-------------+-----------+ | | Purchasing | | | Per cent of | Power | Actual | | 1913 Parity. | Parity. | Exchange. | +--------------+-------------+-----------+ | 1919 Aug. | 62 | 66 | | Sept. | 58 | 61 | | Oct. | 55 | 60 | | Nov. | 53 | 55 | | Dec. | 52 | 48 | | 1920 Jan. | 48 | 44 | | Feb. | 44 | 36 | | March | 42 | 37 | | April | 41 | 32 | | May | 45 | 35 | | June | 49 | 41 | | July | 48 | 42 | | Aug. | 46 | 37 | | Sept. | 43 | 35 | | Oct. | 42 | 34 | | Nov. | 43 | 31 | | Dec. | 41 | 30 | | 1921 Jan. | 42 | 33 | | Feb. | 42 | 37 | | March | 43 | 36 | | April | 43 | 37 | | May | 44 | 43 | | June | 44 | 42 | | July | 43 | 40 | | Aug. | 43 | 40 | | Sept. | 41 | 38 | | Oct. | 43 | 38 | | Nov. | 42 | 37 | | Dec. | 43 | 40 | | 1922 Jan. | 44 | 42 | | Feb. | 46 | 45 | | March | 46 | 47 | | April | 46 | 48 | | May | 44 | 47 | | June | 46 | 45 | | July | 48 | 43 | | Aug. | 47 | 41 | | Sept. | 46 | 40 | | Oct. | 46 | 38 | | Nov. | 44 | 35 | | Dec. | 43 | 37 | | 1923 Jan. | 40 | 34 | | Feb. | 37 | 32 | | March | 37 | 33 | | April | 38 | 35 | | May | 38 | 34 | | June | 37 | 33 | +--------------+-------------+-----------+

U.S. Bureau of Labour Index divided by French official wholesale Index.

ITALY AND THE UNITED STATES

+--------------+-------------+-----------+ | | Purchasing | | | Per cent of | Power | Actual | | 1913 Parity. | Parity. | Exchange. | +--------------+-------------+-----------+ | 1919 Aug. | 59 | 56 | | Sept. | 56 | 53 | | Oct. | 54 | 51 | | Nov. | 50 | 44 | | Dec. | 49 | 40 | | 1920 Jan. | 46 | 37 | | Feb. | 42 | 29 | | March. | 38 | 28 | | April | 36 | 23 | | May | 38 | 27 | | June | 40 | 31 | | July | 39 | 30 | | Aug. | 37 | 25 | | Sept. | 34 | 23 | | Oct. | 32 | 20 | | Nov. | 30 | 19 | | Dec. | 28 | 18 | | 1921 Jan. | 26 | 18 | | Feb. | 26 | 19 | | March | 26 | 20 | | April | 25 | 24 | | May | 27 | 27 | | June | 28 | 26 | | July | 27 | 24 | | Aug. | 26 | 22 | | Sept. | 24 | 22 | | Oct. | 24 | 20 | | Nov. | 24 | 21 | | Dec. | 23 | 23 | | 1922 Jan. | 24 | 23 | | Feb. | 25 | 25 | | March. | 27 | 26 | | April | 27 | 28 | | May | 28 | 27 | | June | 28 | 26 | | July | 28 | 24 | | Aug. | 27 | 23 | | Sept. | 26 | 22 | | Oct. | 26 | 22 | | Nov. | 26 | 23 | | Dec. | 27 | 26 | | 1923 Jan. | 27 | 26 | | Feb. | 27 | 25 | | March. | 27 | 25 | | April | 27 | 26 | | May | 27 | 25 | | June | 26 | 24 | +--------------+-------------+-----------+

U.S. Bureau of Labour Index Number divided by the “Bachi” Index Number.

[Illustration: FRANCE]

[Illustration: ITALY]

III. _The Seasonal Fluctuation._

Thus the Theory of Purchasing Power Parity tells us that movements in the rate of exchange between the currencies of two countries tend, subject to adjustment in respect of movements in the “equation of exchange,” to correspond pretty closely to movements in the internal price levels of the two countries each expressed in their own currency. It follows that the rate of exchange can be improved in favour of one of the countries by a financial policy directed towards a lowering of its internal price level relatively to the internal price level of the other country. On the other hand a financial policy which has the effect of raising the internal price level must result, sooner or later, in depressing the rate of exchange.

The conclusion is generally drawn, and quite correctly, that budgetary deficits covered by a progressive inflation of the currency render the stabilisation of a country’s exchanges impossible; and that the cessation of any increase in the volume of currency, due to this cause, is a necessary pre-requisite to a successful attempt at stabilising.

The argument, however, is often carried further than this, and it is supposed that, if a country’s budget, currency, foreign trade, and its internal and external price levels are properly adjusted, then, automatically, its foreign exchange will be steady. So long, therefore, as the exchanges fluctuate--thus the argument runs--this in itself is a symptom that an attempt to stabilise would be premature. When, on the other hand, the basic conditions necessary for stabilisation are present, the exchange will steady itself. In short, any deliberate or artificial scheme of stabilisation is attacking the problem at the wrong end. It is the regulation of the currency, by means of sound budgetary and bank-rate policies, that needs attention. The proclamation of convertibility will be the last and crowning stage of the proceedings, and will amount to little more than the announcement of a _fait accompli_.

Dr. R. Estcourt, criticising one of my articles in _The Annalist_ for June 12, 1922, writes: “The arrangement would not last for any appreciable period unless, as a preliminary, the Governments took the necessary steps to balance their budgets. If that were done, the so-called stabilisation speedily would become unnecessary; exchange would stabilise itself at pre-war rates.” This passage puts boldly an opinion which is widely held.

There is a certain force in this mode of reasoning. But in one important respect it is fallacious.

Even though foreign trade is properly adjusted, and the country’s claims and liabilities on foreign account are in equilibrium over the year as a whole, it does not follow that they are in equilibrium every day. Indeed, it is well known that countries which import large quantities of agricultural produce do not find it convenient, if they are to secure just the quality and the amount which they require, to buy at an equal rate throughout the year, but prefer to concentrate their purchases on the autumn period. Thus, quite consistently with equilibrium over the year as a whole, industrial countries tend to owe money to agricultural countries in the second half of the year, and to repay in the first half. The satisfaction of these seasonal requirements for credit with the least possible disturbance to trade was recognised before the war as an important function of international banking, and the seasonal transference of short-term credits from one centre to another was carried out for a moderate commission.

Whilst the fact of seasonal pressure is well ascertained, the exact analysis of it is a little complicated. Food arrivals into Great Britain, for example, are nearly 10 per cent heavier in the third and fourth quarters of the year than in the first and second, and reach their maximum in the fourth quarter. (These and the following figures are based on averages for the pre-war period 1901–1913 worked out by the Cambridge and London Economic Service). Raw material imports are more than 20 per cent heavier in the fourth and first quarters than in the second and third, and reach their maximum in the three months November to January. Thus the fourth quarter of the year is the period at which there are heavy imports of both food and raw materials. Manufactured exports, on the other hand, are distributed through the year much more evenly, and are about normal during the last quarter. Allowing for the fact that imports are paid for, generally speaking, before they arrive, these dates correspond pretty closely with the date at which seasonal pressure is actually experienced by the dollar-sterling exchange. In France, since the war, imports in the last quarter of the year seem to have been quite 50 per cent heavier than, for example, in the first quarter. In Italy the third quarter seems to be the slackest, and the last quarter, again, a relatively heavy period. When we turn to the statistics for the United States we find the other side of the picture. August and September are the months of heavy wheat export; October to January those of heavy cotton export. The strength of the dollar exchanges in the early autumn is further increased by the financial pressure in the United States during the crop-moving period, which leads to a withdrawal of funds from foreign centres to New York.

It was possible for this service to be rendered cheaply because, with the certainty provided by convertibility, the price paid for it did not need to include any appreciable provision against risk. A somewhat higher rate of discount in the temporarily debtor country, together with a small exchange profit provided by the slight shift of the exchanges within the gold points, was quite sufficient.

But what is the position now? As always, the balance of payments must balance every day. As before, the balance of trade is spread unevenly through the year. Formerly the daily balance was adjusted by the movement of bankers’ funds, as described above. But now it is no longer a purely bankers’ business, suitably and sufficiently rewarded by an arbitrage profit. If a banker moves credits temporarily from one country to another, he cannot be certain at what rate of exchange he will be able to bring them back again later on. Even though he may have a strong opinion as to the probable course of exchange, his profit is no longer definitely calculable beforehand, as it used to be; he has learnt by experience that unforeseen movements of the exchange may involve him in heavy loss; and his prospective profit must be commensurate with the risk he runs. Even if he thinks that the risk is covered actuarially by the prospective profit, a banker cannot afford to run such risks on a large scale. In fact, the seasonal adjustment of credit requirements has ceased to be arbitrage banking business, and demands the services of speculative finance.

Under present conditions, therefore, a large fluctuation of the exchange may be necessary before the daily account can be balanced, even though the annual account is level. Where in the old days a banker would have readily remitted millions to and from New York, hundreds of thousands are now as much as the biggest institutions will risk. The exchange must fall (or rise, as the case may be) until either the speculative financier feels sufficiently confident of a large profit to step in, or the merchant, appalled by the rate of exchange quoted to him for the transaction, decides to forgo the convenience of purchasing at that particular season of the year, and postpones a part of his purchases.

The services of the professional exchange speculator, being discouraged by official and banking influences, are generally in short supply, so that a heavy price has to be paid for them, and trade is handicapped by a corresponding expense, in so far as it continues to purchase its materials at the most convenient season of the year.

The extent to which the exchange fluctuations which have troubled trade during the past three years have been seasonal, and therefore due, not to a continuing or increasing disequilibrium, but merely to the absence of a fixed exchange, is not, I think, fully appreciated.

During 1919 there was a heavy fall of the chief European exchanges due to the termination of the inter-Allied arrangements which had existed during the war. During 1922 there was a rise of the sterling exchange, which was independent of seasonal influences. During 1923 there has been a further non-seasonal collapse of the franc exchange due to certain persisting features of France’s internal finances and external policy. But the following table shows how largely _recurrent_ the fluctuations have been during the four years since the autumn of 1919:--

PERCENTAGE OF DOLLAR PARITY

+------------+------------------+------------------+------------------+ |August-July.| Sterling. | Francs. | Lire. | | | Lowest. Highest. | Lowest. Highest. | Lowest. Highest. | +------------|------------------+------------------+------------------+ | 1919–1920 | 69 88 | 31 66 | 22 56 | | 1920–1921 | 69 82 | 30 45 | 18 29 | | 1921–1922 | 73 92 | 37 48 | 20 28 | | 1922–1923 | 90 97 | 29 41 | 20 27 | +------------+------------------+------------------+------------------+

On the experience of the past three years, francs and lire are at their best in April and May and at their worst between October and December. Sterling is not quite so punctual in its movements, the best point of the year falling somewhere between March and June and the worst between August and November.

The comparative stability of the highest and lowest quotations respectively in each year, especially in the case of Italy, is very striking, and indicates that a policy of stabilisation at some mean figure might have been practicable; whilst, on the other hand, the wide divergences between the highest and lowest are a measure of the expense and interference that trade has suffered.

These results correspond so closely to the facts of seasonal trade (see above, p. 108) that we may safely attribute m