The Value of Money

by Benjamin M. Anderson

Fisher's argument to show the passiveness of prices takes the form of a reductio ad absurdum. "To show the untenability of such an idea let us grant for the sake of argument that—in some other way than as effect of changes in M, M´, V, V´, and the Q's—the prices in (say) the United States are changed to (say) double the original level, and let us see what effect this will produce on the other magnitudes in the equation."[333] Then, if the equation of exchange is to be maintained, either M or M´ or their velocities must be increased, or trade must be reduced. But he holds that none of these is possible. (1) Money will be reduced. High prices drive money away to other countries. Nor can gold come in via the mints. "No one will take bullion to the mints when he thereby loses half its value."[334] On the contrary, men will melt down coin. Nor will high prices stimulate mining. Rather, by raising the expenses of mining, they will discourage mining. (2) Bank-deposits cannot increase. Bank-deposits depend on the amount of money, and as that is reduced, they must be reduced, to keep their normal ratio to the volume of money. (3) The appeal to velocities is no more satisfactory. These have been already adjusted to individual convenience.[335] (4) Nor can trade be decreased. Since the average person will not only pay, but also receive, high prices, there is no reason why he should reduce his purchases. "The price-level is normally the one absolutely passive element in the equation of exchange."[336]

"But though it is a fallacy to think that the price-level in one community can, in the long run, affect the money in that community, it is true that the price-level in one community may affect the money in another community. This proposition has been repeatedly made use of in our discussion, and should be clearly distinguished from the fallacy above mentioned. The price-level in an outside community is an influence outside the equation of exchange of that community, and operates by affecting its money in circulation and not by directly affecting its price-level. The price-level outside New York City, for instance, affects the price-level in New York City only via changes in the money in New York City."[337]...

"Were it not for the fanatical refusal of some economists to admit that the price-level is in ultimate analysis effect and not cause, we should not be at so great pains to prove it beyond cavil." To explain this "fanatical refusal," Fisher alludes to the "fallacious idea" that the equation of exchange cannot determine the price-level, because the price-level has already been determined by other causes, usually alluded to as "supply and demand." He urges, however, that supply and demand, cost of production, etc., relate, not to the price-level, but only to particular prices: that the price-level is a factor prior to, and independent of, the particular prices, and is presupposed by theories like supply and demand, cost of production, etc.[338]

The reductio ad absurdum, at first blush, looks impressive. One obvious criticism suggests itself, however, and it will be found to give a clue to a much more fundamental criticism: is it reasonable to assume a doubling of all prices? Above all, must the assumption involve the doubling of the price of gold bullion? Part of the argument to show that gold bullion would not be minted rests on that assumption. But, more fundamental, for such an all round doubling of prices, no cause could be assigned. Of course the hypothesis of an increase in prices without any cause is absurd, and Fisher easily disposes of it. But suppose we assign some concrete causes, outside the equation of exchange, which might affect prices, and see how the thing works then!

Fisher states on p. 95 that "other elements in the equation of exchange than money and commodities[339] cannot be transported from one place to another." And in the passage quoted above he maintains that price-levels in one country can influence price-levels in another country, or even price-levels in one city can influence price-levels in another city, only via changes in money, in the second country or city. But other elements in the equation are directly transferable, in fact. Deposits, e. g., in London, to the credit of New York bankers, may be transferred to Paris, directly, by cable or by letter, and prices are constantly being directly passed from one country or market to another by the same media. Let us suppose a strong case, to put our principle in relief. Assume an island, which produces a staple widely used, whose chief centre of production is outside the island. Assume that this staple, an agricultural product, rises greatly in price, owing to a blight, which promises to be permanent, in the main producing region. The blight does not affect the island, however. Let this product be the main product of our island, which we shall assume to be small. Let the island have communication with the outside world by boat only once in three months. Let it be, however, in constant communication by cable. Word comes by cable of the rise in the price in the staple. The staple at once rises in the island. No new money has come in to cause it. Will this be a rise in the price-level? Will there be compensating reductions in the prices of other things to leave the price-level unchanged? What prices can fall? Not the prices of goods that have been imported to the island, surely. They will rather tend to rise, because everybody on the island will feel richer than before, and will be disposed to buy more freely. Meanwhile, merchants and bankers on the island will be more ready to extend credit than before, so that they will be able to buy more freely. What else can fall? Not the prices of the land! Rather, the land will rise in price greatly, because the increased price of the staple, expected to be permanent, will promise bigger rents, and the price of the land, being a capitalization of the annual rental, will rise very much more than anything else—it will rise to the extent of the capitalized price of the increase in the rents. Wages, likewise, will rise, since the price of the product of labor has risen. And the capital instruments in use in producing the staple will also rise, though not so much as land and wages, inasmuch as they can be brought in from outside at the end of three months. What is there that can fall—except, perhaps, such goods as are exclusively designed for the construction of poorhouses! A significant particular price rises—that is the first step; then, from causes familiar to all students of economics, other related prices rise; there is a general sympathetic rise in prices, the price-level has risen independently, from causes outside the equation of exchange. But now, can this rise sustain itself? Well, what can bring it down? When the ship comes, at the end of three months, it will bring in additional supplies of the articles of import, and they will go down to their old level. Will they go any lower than the old level? What is there to cause them to do so? The outside price-level should be higher now, rather than lower, since the stock of the staple in question is reduced, and nothing else increased to compensate. Nor can any reason be assigned why other prices on the island: the staple in question, lands, wages, etc., should fall at all from the level they reached when the news first came.

Incidentally, our ship may also bring in more gold. The bankers, finding their deposits expanding, may feel it well to cable orders for more gold to increase their reserves, especially as they have been subject to somewhat unusual calls for cash for hand to hand circulation—though this last need they might well have been meeting by expanding their note issue.

Is there anything else to be said? Is not the new equilibrium stable? And is not the causal sequence precisely the reverse of that assigned by the quantity theory? First. a rise in prices; second, an expansion of credit, book-credit, notes and deposits; third, money comes in. If anyone is particularly anxious about the equation of exchange in this process, he may add to my expansion of credit an increase in velocities to keep it straight!

I may add that I see nothing in the "transition" I have described to cause trade to be reduced. Rather, I should expect the rising prices to make trade more active—or better, I should expect the rising values of goods, etc., of which rising prices are the symptom, to make trade more active, particularly as there would be an increase in speculation to bring about readjustments, and to "discount" the prosperity. Nor can I find any reason why trade should be reduced below the old level in the new normal equilibrium. It would make no difference, however, if trade were reduced either transitionally or normally, since the point at issue is the possibility of a rise in prices originating from causes outside the equation of exchange, and compelling a readjustment of a permanent character in the other factors of the equation. The quantity theorist is at liberty to make this readjustment in any way he pleases. My point is made if he has to make the readjustment, and if the price-level stays up!

I have put my illustration in an extreme form to throw the whole thing in relief, and to make the demonstration free from a host of complexities. But is not the causal process essentially the same if we substitute, say, the Southern States for our island, and cotton for our staple? So long as the telegraph bringing news of the ruin of cotton production in India and Egypt, with the higher price of cotton, can come in ahead of the money that the quantity theorist might imagine rushing in a race with it on the train to be offered for the cotton, my point is made. In point of fact, there would be a general rise in prices and wages in the South, which, leading to an expansion of credit, would only gradually and in no definite ratio lead to an increase in money drawn from outside. Buyers outside would pay, not with money, but with checks drawn on New York, and Southern bankers would use their discretion as to how much actual cash they would bring in. With the elastic note issue of our Federal Reserve system, I see no reason to anticipate that money would be drawn to the South in an amount proportionate to the increase in prices. Even if it were, the causation would not run from money to prices, and that is the point at issue. If rising prices can cause increasing money, the whole quantity theory is upset, whatever the proportions involved.

It will be noted that my illustration might be put partly in the form of the supply and demand argument. Increasing demand for cotton in the South leads to higher price of cotton; higher price of cotton makes cotton-growers richer, and enables them to increase their demand for imported goods, for land, and for labor. Supply and demand comes into conflict with the quantity theory, and does not suffer in the conflict! Supply and demand determine particular prices, and particular prices determine the price-level!