A Tract on Monetary Reform

by John Maynard Keynes

Like other forms of taxation, these exactions, if overdone and out of proportion to the wealth of the community, must diminish its prosperity and lower its standards, so that at the lower standard of life the aggregate value of the currency may fall and still be enough to go round. But this effect cannot interfere very much with the efficacy of taxing by inflation. Even if the aggregate real value of the currency falls for these reasons to a half or two-thirds of what it was before, which represents a tremendous lowering of the standards of life, this only means that the quantity of notes which the Government must issue in order to obtain a given result must be raised proportionately. It remains true that by this means the Government can still secure for itself a large share of the available surplus of the community.

Has the public in the last resort no remedy, no means of protecting itself against these ingenious depredations? It has only one remedy,—to change its habits in the use of money. The initial assumption on which our argument rested was that the community did not change its habits in the use of money.

Experience shows that the public generally is very slow to grasp the situation and embrace the remedy. Indeed, at first there may be a change of habit in the wrong direction, which actually facilitates the Government’s operations. The public is so much accustomed to thinking of money as the ultimate standard, that, when prices begin to rise, believing that the rise must be temporary, they tend to hoard their money and to postpone purchases, with the result that they hold in monetary form a larger aggregate of real value than before. And, similarly, when the fall in the real value of the money is reflected in the exchanges, foreigners, thinking that the fall is abnormal and temporary, purchase the money for the purpose of hoarding it.

But sooner or later the second phase sets in. The public discover that it is the holders of notes who suffer taxation and defray the expenses of government, and they begin to change their habits and to economise in their holding of notes. They can do this in various ways:—(1) instead of keeping some part of their ultimate reserves in money they can spend this money on durable objects, jewellery or household goods, and keep their reserves in this form instead; (2) they can reduce the amount of till-money and pocket-money that they keep and the average length of time for which they keep it,[11] even at the cost of great personal inconvenience; and (3) they can employ foreign money in many transactions where it would have been more natural and convenient to use their own.

[11] In Moscow the unwillingness to hold money except for the shortest possible time reached at one period a fantastic intensity. If a grocer sold a pound of cheese, he ran off with the roubles as fast as his legs could carry him to the Central Market to replenish his stocks by changing them into cheese again, lest they lost their value before he got there; thus justifying the prevision of economists in naming the phenomenon “velocity of circulation”! In Vienna, during the period of collapse, mushroom exchange banks sprang up at every street corner, where you could change your krone into Zurich francs within a few minutes of receiving them, and so avoid the risk of loss during the time it would take you to reach your usual bank. It became a seasonable witticism to allege that a prudent man at a café ordering a bock of beer should order a second bock at the same time, even at the expense of drinking it tepid, lest the price should rise meanwhile.

By these means they can get along and do their business with an amount of notes having an aggregate real value substantially less than before. For example, the notes in circulation become worth altogether $20,000,000 instead of $36,000,000, with the result that the next inflationary levy by the Government, falling on a smaller amount, must be at a greater rate in order to yield a given sum.

When the public take alarm faster than they can change their habits, and, in their efforts to avoid loss, run down the amount of real resources, which they hold in the form of money, below the working minimum, seeking to supply their daily needs for cash by borrowing, they get penalised, as in Germany in 1923, by prodigious rates of money-interest. The rates rise, as we have seen in the previous chapter, until the rate of interest on money equals or exceeds the anticipated rate of the depreciation of money. Indeed it is always likely, when money is rapidly depreciating, that there will be recurrent periods of scarcity of currency, because the public, in their anxiety not to hold too much money, will fail to provide themselves even with the minimum which they will require in practice.

Whilst economists have sometimes described these phenomena in terms of an increase in the velocity of circulation due to loss of confidence in the currency; nevertheless there are not, I think, many passages in economic literature where the matter is clearly analysed. Professor Cannan’s article on “The Application of the Apparatus of Supply and Demand to Units of Currency” (Economic Journal, December 1921) is one of the most noteworthy. He points out that the common assumption that “the elasticity of demand for money is unity” is equivalent to the assertion that a mere variation in the quantity of money does not affect the willingness and habits of the public as holders of purchasing power in that form. But in extreme cases this assumption does not hold; for if it did, there would be no limit to the sums which the Government could extract from the public by means of inflation. It is, therefore, unsafe to assume that the elasticity of demand is necessarily unity. Professor Lehfeldt followed this up in a subsequent issue of the Economic Journal (December 1922) by a calculation of the actual elasticity of demand for money in some recent instances. He found that between July 1920 and April 1922, the elasticity of demand for money fell to an average of about ·73 in Austria, ·67 in Poland, and ·5 in Germany. Thus in the last stages of inflation the prodigious increase in the velocity of circulation may have as much, or more, effect in raising prices and depreciating the exchanges than the increase in the volume of notes. The note-issuing authorities often cry out against what they regard as the unfair and anomalous fact of the notes falling in value more than in proportion to their increased volume. Yet it is nothing of the kind; it is merely the result of the one method to evade a crushing burden left open to the public, who discover for themselves, sooner than the financiers, that the law of unit elasticity in their demand for money can be escaped.

Nevertheless, it is evident that so long as the public use money at all, the Government can continue to raise resources by inflation. Moreover, the conveniences of using money in daily life are so great that the public are prepared, rather than forego them, to pay the inflationary tax, provided it is not raised to a prohibitive level. Like other conveniences of life the use of money is taxable, and, although for various reasons this particular form of taxation is highly inexpedient, a Government can get resources by a continuous practice of inflation, even when this is foreseen by the public generally, unless the sums they seek to raise in this way are very grossly excessive. Just as a toll can be levied on the use of roads or a turnover tax on business transactions, so also on the use of money. The higher the toll and the tax, the less traffic on the roads, and the less business transacted, so also the less money carried. But some traffic is so indispensable, some business so profitable, some money-payments so convenient, that only a very high levy will stop completely all traffic, all business, all payments. A Government has to remember, however, that even if a tax is not prohibitive it may be unprofitable, and that a medium, rather than an extreme, imposition will yield the greatest gain.

Suppose that the rate of inflation is such that the value of the money falls by half every year, and suppose that the cash used by the public for retail purchases in shops is turned over 100 times a year (i.e. stays in one pocket for half a week on the average); then this is only equivalent to a turnover tax of ½ per cent on each transaction. The public will gladly pay such a tax rather than suffer the trouble and inconvenience of barter with trams and tradesmen. Even if the value of the money falls by half every month, the public, by keeping their pocket-money so low that they turn it over once a day on the average instead of only twice a week, can still keep the tax down to the equivalent of less than 2 per cent on each transaction, or more precisely 4d. in the £. Even such a terrific rate of depreciation as this is not sufficient, therefore, to counterbalance the advantages of using money rather than barter in the trifling business of daily life. This is the explanation why, even in Germany and in Russia, the Government’s notes remained current for many retail transactions.