My own explanation of the causal sequence whereby expanding trade brings money into a country would be radically different from that given by Fisher in the first quotation. I should expect, first, that rising prices would encourage rising trade; I should then expect the rising volume of trade, with higher prices, to lead borrowers to need, and secure, larger loans from the banks, with, as loans and deposits rise in proportion to reserves, some slight increase in "money-rates," just enough to draw to the country the extra gold which bankers felt desirable to add to their reserves. I should expect the causal sequence to be the exact reverse of that which Fisher indicates. With falling prices, or waning volume of trade—which would usually come together,[320]—I should expect loans to be reduced, deposits to be reduced, money-rates to fall, and gold then to leave the country again. I should expect this sort of thing to happen normally, and not infrequently, and I should expect gold to come in and go out many times in the course of a business cycle. This would seem to be the sort of explanation which our modern theory of elastic bank-credit would give in connection with this problem. I shall not here go into details with the theory of elastic bank-credit. The theory has been too well established in the debates between the "Currency School" and the "Banking School"[321] in regard to bank-notes to need elaboration and defence here, and the essential identity of deposits and elastic bank-notes from this angle is one of the commonplaces of the literature of banking. What I am here concerned with is the highly significant fact that Fisher's "normal" theory finds no place for this highly important phenomenon. The quantity theory has no explanation of elasticity to give. On the basis of the quantity theory, and for all that the quantity theory can say, the Currency School was right! Fisher offers us, virtually, a "currency theory" of deposits. "Suppose, as has actually been the case in recent years, that the ratio of M´ to M increases in the United States. If the magnitudes in the equations of exchange in other countries with which the United States is connected by trade are constant, the ultimate effect on M is to make it less than what it would otherwise have been, by increasing the exports of gold from the United States or reducing the imports. In no other way can the price-level of the United States be prevented from rising above that of other nations in which we have assumed this level and the other magnitudes in the equation of exchange to be quiescent." (P. 162.) If "bank-notes" be substituted for "M´", in this quotation, we have here a perfect statement of the position of the "Currency School" in that great debate. Must this old issue be fought all over again? And yet, I defy any consistent quantity theorist to find any flaw in Fisher's argument on this point. There is no place for a theory of elastic bank-credit within the confines of the quantity theory. Fisher's recognition of this seems full and complete. He relegates all mention of elastic bank-credit to "transitions." The footnote quoted above, in which Laughlin's (somewhat extreme) doctrine based on the theory of elasticity is stated, denies categorically that there is any validity in it, except for transition periods. There is nowhere in the book any explanation of the theory of elasticity.[322] The references to it are few and grudging, and always in connection with the notion of transitions. The most important statement regarding elasticity (less than a page long) is on page 161, where again transitional influences are under discussion. What is a theory of money worth which can offer no explanation of so fundamental, important, and notorious a feature of modern money and banking?
There is a further, related, feature of banking for which the quantity theory can find no explanation. Among the items in a bank's balance sheet, the quantity theorist seizes upon reserves on the assets side, and deposits on the liability side, and builds his theory on the supposed close relation between them. We have seen that this close relation does not, in fact, exist. The range of variation is enormous.[323] But there is one close relation in the balance sheet of the bank concerning which the quantity theory is silent, and that is the relation between deposits and loans. For individual banks and for banks in the aggregate, for long run periods and for short run periods, for reasons that are clear and inevitable, these two magnitudes (or for banks of issue on the Continent of Europe, notes and loans), vary closely together. The relationship between them is the only relationship which does stand out as clearly beyond dispute, among all the items in the banking balance sheet. No assumptions of a "static state" are needed for its demonstration! The relation varies, of course. As banks increase or reduce their capital, as their reserve-percentages rise or fall, as they increase or decrease their holdings of bonds, we find reasons which alter the proportion between deposits and loans. But, despite this, the variation, as shown by figures for the United States, is slight. Assume, for example, a statement showing "loans and discounts" of $1,000,000, deposits, $1,000,000, cash reserve, $200,000. Reserves are then 20% of deposits, and loans are 100% of deposits. If reserves be increased by $100,000 and loans and discounts reduced, to compensate, by $100,000, we have a 50% variation in the ratio of reserves to deposits, with only a 10% variation in the ratio of loans and discounts to deposits. Since cash reserve is much the smaller item, almost always, the same absolute variation in it will affect it, in percentage, vastly more than it will affect loans and discounts. It is strange that a theory should seize on this highly variable ratio of reserves to deposits, and ignore the much more constant ratio[324] of loans and discounts to deposits.
That this close relation between deposits and loans should obtain follows naturally from the theory of elastic bank-credit. The two are built up together. When there are expanding business and rising prices, men borrow more from the banks; as they borrow, they receive deposit credits; the individual who receives the deposit credit may check against it, but it is redeposited by another man, and so, while the deposits of one bank need not grow out of its loans, still, for banks in general, deposits are large because loans are large. For a given bank, the relation holds closely, because the bank lends, in general, to active business men, who will have income as well as outgo, and whose income will, on the average, at least balance their outgo. Thus, through loans, deposits are linked with volume of trade and prices. Trade and deposits wax and wane together.[325] On the other hand, in the absence of rising prices and increasing trade, reserves may increase greatly without forcing an increase in deposits. Loans cannot increase without an increase in deposits. The linkage between deposits and trade is definite, causal, positive, statistically demonstrable. The linkage between reserves and deposits is, at most, negative—if reserves get too low, deposits and loans may be checked in their expansion. But this—to the extent that it is true, which we leave, for detailed analysis, for Part III—gives a very much looser relation indeed than the direct relation between loans and deposits.
The quantity theory has offered no explanation of this relation between loans and deposits. What explanation could a theory offer, which rests in the notion that volume of trade on the one hand, and volume of money and bank-credit on the other hand, are independent magnitudes?[326] I do not mean that quantity theorists are silent regarding the relation of loans and deposits. I mean that they do not attempt, in any discussion I have found, to apply the quantity theory to the explanation of that relation. What shall we say of a theory which, ignoring these easily proved, easily explained, and vital facts regarding bank-credit, offers as its sole explanation of volume of bank-credit a theory so untenable as that of a fixed ratio between volume of bank-credit and volume of money in circulation, with causation running from money to deposits?
Professor Fisher says little about bills of exchange. Here, surely, we have a credit instrument which grows directly out of trade, in general, and whose volume expands and contracts with trade. When banks discount bills of exchange, and issue notes, or grant deposit credits, against such discounted bills, the connection of bank-credit and volume of trade is obvious. The same thing holds largely, however, when promissory notes are discounted. Such notes are usually given by those who plan to use the credits granted in commercial or speculative transactions. The bill of exchange differs from the promissory note in practice, however, in that it itself is often a medium of exchange, without going into the bank's portfolio. "The bill of exchange, therefore, before it gets to the bank usually[327] performs a series of monetary transfers, for the small dealer naturally prefers to pass on the bill, if possible, in making a payment, instead of handing it over to his bank, which would either deduct a certain percentage in the way of discount, or else accept the bill at its face value, crediting the customer with the amount on the date of maturity, while business men (other than bankers) are in the habit of taking bills of exchange as they would cash."[328] This quotation describes conditions in Germany. The same authorities (p. 176) give figures showing a rapid development in the volume of bills of exchange, rising from about 13 billions of marks in 1872 to about 31 billions in 1907. These figures show that bills of exchange are a big factor in German business life,—a conclusion that is strengthened when they are compared with the figures for giro-transfers on pp. 188-189 of the same article, or with the figures for note issue on p. 209.[329] In the United States, of course, the use of bills of exchange has become comparatively unimportant in domestic commerce,[330] though there is a movement to revive them, since the new Federal Reserve system has come in. Their chief importance is in connection with foreign trade. Is it possible that Professor Fisher's reason for wishing to minimize foreign trade[331] is the unconscious desire to get rid of the annoying bills of exchange, which so obviously tend to make bank-credit and volume of trade interdependent, and which further spoil the quantity theory by serving as a flexible substitute for both money and deposits?
I regret the necessity for this elementary exposition of familiar things. But Fisher's theory has no place for these familiar things—and Fisher has merely made very explicit the logic of the quantity theory!
As applied to modern conditions, the quantity theory is obliged to assert—and Fisher does assert:
(a) that there is a causal dependence of bank-credit on money, and "normally" a fixed ratio between them;
(b) that velocity of circulation of money and credit instruments are independent of quantity of money and credit instruments;
(c) that, in general, money and volume of credit (taken together), velocities, and trade, are independent magnitudes, each governed by separate laws, though Fisher concedes some reaction of trade on velocities;