The Value of Money

by Benjamin M. Anderson

Now I wish to generalize this point. I shall show that the quantity theory conflicts with most of our doctrines of prices, as worked out in our systems of economics. I shall show that, in important cases, the quantity theory conflicts with the law of supply and demand, with the doctrine of cost of production, with the capitalization theory, and with the doctrine of imputation as worked out by the Austrians, whereby the prices of labor, land, and other agents of production rise or fall with the prices of the consumption goods which they produce. I shall show the conflict in important cases, and shall show also, in those cases, that it is not the quantity theory which can be sustained.

The general form of the conflict may be stated for all these theories. They are theories of the relations of particular prices, concerned with showing that individual prices are so related that they tend to vary together. A rise in one price, according to these theories, tends to bring about rises in others, and vice versa. The quantity theory, on the other hand, asserts a relation among individual prices such that a rise in one tends to bring about a fall in others—it requires a compensatory fall at one point, if there has been a rise somewhere else.

Let us take some cases. I shall take, first, the conflict between the quantity theory and the capitalization theory, as I can use the illustration just given in connection with it. I have, in a preceding chapter, given a statement of the capitalization theory. It is a theory concerned with the prices of long-time goods and income-bearers, as lands, houses, capital goods of various sorts that give forth their services through a series of years, stocks, bonds, etc. The prices of things of this sort, according to the capitalization[340] theory, depend on two factors: one, the money income expected from the income-bearer, the other, the prevailing rate of interest. This money income, except in the case of bonds, commonly depends on the prices of the products of the income-bearer, or (in the case of stocks) of the products of the concrete capital-goods to which the income-bearer gives title. If we may follow the Austrian division of goods into higher and lower "orders," or "ranks," we may say that the prices of the goods of higher ranks are the capitalizations of the prices of the goods of lower ranks specifically produced by them. Thus, concretely, if the price of wheat rises, we may expect the prices of land to rise, if the rate of interest remains the same. If the price of steel rises, we may expect the stocks of the U. S. Steel corporation to rise, also. If the prices of smokeless powder, and other war munitions soar, we may expect the prices of the stocks of the corporations involved to do precisely what they have done in the recent course of the stock market. All this, on the assumption that the rate of interest does not change, and that the risk factor remains constant. If these factors vary, the results will not present the mathematical exactitude that the formula calls for, but the general tendency will remain the same. On the other hand, if the incomes remain unchanged, but the rate of interest rises, then we may expect the capitalized prices to fall, and if the rate of interest falls, we may expect the capitalized prices to rise. From the standpoint of the present discussion, I suppose it might be fairest and best to state the capitalization theory on this point as Fisher himself states it. In his Elementary Principles of Economics (ed. 1912) after giving a table showing in figures the difference made in different capital prices by different rates of interest (p. 125) he states (126): "If the value of the benefits derivable from these various articles continues in each case uniform, but the rate of interest is suddenly cut down from 5% to 2½%, there will result a general increase in the capital values, but a very different increase for the different articles. The more enduring ones will be affected the most." And in his book, The Rate of Interest: "The orchard whose yield of apples should increase from $1,000 worth to $2,000 worth would itself correspondingly increase in value from, say, $20,000 to something like $40,000 and the ratio of the income to the capital value, would remain about as before, namely, 5%." (P. 15.) On the next page, he generalizes his notion: "One cannot escape this conclusion (as has sometimes been attempted) by supposing the increasing productivity to be universal. It has been asserted, in substance, that though an increase in the productivity of one orchard would not affect the total productivity of capital, and hence would not appreciably affect the rate of interest, yet, if the productivity of all the capital in the world could be doubled, the rate of interest would be doubled. It is true that doubling the productivity of the world's capital would not be entirely without effect upon the rate of interest; but this effect would not be in the simple direct ratio supposed. Indeed, an increase of the productivity of capital would probably result in a decrease, instead of an increase, of the rate of interest. To double the productivity of capital might more than double the value of the capital." (Rate of Interest, p. 16.)[341] Fisher reiterates this doctrine in his reply to Seager, in the American Economic Review, Sept. 1913, pp. 614-615.

Now my concern here is not with the points at issue as between Fisher and Seager: the "impatience" vs. the "productivity" theories of interest. For the present, I shall accept Fisher's doctrine on that point as true.[342] I am here interested in Fisher's doctrine that a doubling of the general productivity of capital would double, or more than double, the prices of capital instruments, including land. How is such a general rise in prices possible, if the quantity theory be true? Is not this a rise in general prices from causes outside the equation of exchange? That Fisher means the money-prices of capital goods when he speaks of capital-values is perfectly clear. In the second quotation, he speaks of "capital-value of $40,000", and in general, his definition of value runs in terms of price (e. g., Purchasing Power of Money, pp. 3-4, and Elementary Principles, p. 17). Fisher has no absolute value concept in his system. We have in the passages cited two doctrines, both of which contradict the quantity theory: (1) that a reduction in the rate of interest will raise capital-prices (which are the largest factor by far in the price-level), and (2) that an increase in the product of capital goods means, not only more money paid for the products, but also more money paid for the production-goods. Incidentally, the general imputation theory would call for more money paid to laborers as well. How can all this be, on the quantity theory? And what can the poor equation of exchange do in such a case, if money does not increase, if bank-credit is limited by money, if velocities of circulation are fixed by individual habits and convenience, if trade increases as a consequence of the increased number of goods produced, and if prices rise? It will not help much to assume that the productivity of gold mines is doubled also. The quantity of money does not depend very much on the annual production of gold. Besides, money need not, from the standpoint of the quantity theory, be made of gold. It might be irredeemable Greenbacks, fixed in quantity by law, or even dodo-bones! Would not the capitalization theory apply in the Greenback Period? I shall not try to solve the riddle. I am not responsible for it!

The conflict between the capitalization theory and the quantity theory may be more simply stated. Assume that the prices of consumers' goods and services rise, quantity of money and volume of exchanges remaining unchanged. On the quantity theory, other prices, the prices of producers' goods and services, lands, and securities, would have to come down enough to compensate, in order that the price-level might remain unchanged. For the capitalization theory, however, the prices of lands, securities, and long time capital goods in general would have to rise, since the incomes on which they are based have risen. Wages of labor engaged in making consumers' goods would also have to rise, on the general imputation theory.

The quantity theory conflicts with the capitalization theory. The quantity theory as presented by Fisher conflicts with the capitalization theory as presented by Fisher. Which theory is true? Would prices rise thus, or would they be held down in some way by the limitations on the quantity of money? I hold that I have already proved, in the reasoning given in connection with my hypothetical island, and in the case of the South with its cotton, that the capitalization theory tendency would prevail. The prices of products rise, and then the prices of the labor, land, and other capital goods which have produced them, rise, the rise in the prices of the capital goods behaving in accordance with the laws of the capitalization theory, and all of the rises after the initial rise in products being in accordance with the imputation theory of the Austrians.

This conflict suggests an interesting point. Various elements in our economic theory, added from time to time by different writers, have necessarily come from different philosophical and sociological view-points, and have behind them different philosophical, psychological, and sociological assumptions. The quantity theory, developing, as shown in the chapter on "Supply and Demand and the Value of Money," largely in isolation from the general body of economic theory, has a background of psychological and sociological assumptions quite different from that of many other doctrines. In the chapter on "Dodo-Bones," I stated these assumptions. The quantity theory rests in a psychology of blind habit. It assumes a rigidity in the social system such that it might be likened to a machine, with a hopper into which money is poured, which grinds out prices at the other end. I set this in contrast with the psychological assumptions underlying the commodity theory of money. That theory rests on the "banker's psychology." It assumes a highly reflective and calculating attitude on the part of economic men, with the disposition to look behind appearances for the security, to test things out, to get to bedrock in business affairs. Now the capitalization theory likewise assumes this banker's psychology. In its refinements, as represented by the mathematical formulæ in the appendices of Fisher's Rate of Interest, it assumes a degree of precision in business calculation which few experts in bond departments apply, and which the highly fluid and alert dealers in Wall Street certainly have not time for, even if they had that degree of mathematical knowledge! In practice, it need not be said, particularly in the case of the prices of lands, the capitalization theory finds its predictions very imperfectly realized! But the two theories, resting in such divergent psychological assumptions, may be expected, a priori, to conflict. That they do conflict is not remarkable.

I shall show a similar conflict between the quantity theory and the law of costs. In general, the quantity theorist thinks that he has reconciled his theory with cost theory by pointing out that reduced costs manifest themselves in increasing production, which means increasing trade, which should, on the quantity theory, mean lower prices.[343] I need not, for my purposes, analyze this doctrine in detail, though I am disposed to consider it an accident that the two theories converge at this point. For the present, I shall analyze a case where reducing costs actually come as a consequence of the reduction in the volume of trade, and inquire whether such a case will lead, as the cost theory would assert, to lowered general prices, or, as the quantity theory would assert, to higher general prices. The case is that where by improved methods of handling goods, it is possible to dispense with middlemen. Concretely, assume that retailers of milk get in direct touch with dairymen, so that middlemen are eliminated, and that as a consequence the price of milk is reduced two cents a quart. What of the general price-level? T (trade) is reduced. There are less exchanges. Volume of trade does not mean volume of goods produced, but volume of exchanges. With a reduced trade, the quantity theory must assert that prices of commodities other than milk must, on the average, rise, not merely enough to compensate for the fall in milk, but more than that, enough to compensate for the reduced trade as well. But how can the other prices rise? Well, a point comes up obviously: the buyers of milk save two cents a quart. They can spend it for something else. This will raise the prices of other things. But, on the other hand, the middlemen now have less to spend. They have exactly as much less as the others have more, the extra money that milk buyers have being, in fact, the money that the middlemen would otherwise have had. The one offsets the other. There is, then, no reason for the average of other prices to rise. Suppose we carry the process one step further. After a while, the middleman will find other work to do. Then they will have incomes again to spend. But in going to work again, they will be engaged in production, and so will, in general, be increasing the volume of trade. The quantity theorist could not expect a rise in prices from this!

And here we are given a clue to a fundamental confusion in the quantity theory, a confusion which, accepted by the reader, gives the quantity theory much of its plausibility. I refer to the confusion between volume of money, and volume of money-income.[344] The two need not be the same. The two generally are not the same. In the case I have described, the one has changed without a change in the other. Now if one wishes to view the process of price-causation from the standpoint of money offered for goods,—an essentially superficial,[345] but frequently useful, view-point—it is clearly money-income, rather than mere quantity of money in the country that is important. Into the determination of volume of money-income, however, come factors of a high degree of complexity, among them, prices for which there is no possible place within the confines of so simple and mechanical a doctrine as the quantity theory.

In passing, I notice a point to which I called attention in discussing Fisher's factors in the equation of exchange. I refer to his definition of velocity of circulation as the average of "person-turnovers" of money.[346] In the illustration given, there is no reason to suppose that this average is changed. The middlemen simply drop out of the average. They have no money to turn over! But velocity of circulation, defined as "coin-transfer," (cf. supra, p. 204) has clearly changed. The course of money has been short-circuited. It goes through fewer hands in the course of a given period. This last concept of velocity of circulation is clearly the one that must be used, if the equation of exchange is to be kept straight. But this fact should make it clear that velocity of circulation, instead of being the inflexible thing that Fisher has described, resting in individual habits and practices, a true causal factor in the price making process, is really a highly flexible thing, in large degree a passive function of trade and prices.