A Tract on Monetary Reform

by John Maynard Keynes

[54] It is often assumed that the bank rate is the sole governing factor. But the bank rate can only operate by its reaction on (c), namely, the Bank of England’s assets. Formerly it acted pretty directly on two of the components of (c), namely, (c) (iii.) advances to customers and bills of exchange and (c) (iv.) gold. Now it acts only on one of them, namely, (c) (iii.). But changes in (c) (i.) the Bank’s advances to the Treasury and (c) (ii.) the Bank’s investments can often be nearly as potent in their effect on the creation of credit. Thus a low bank rate can be largely neutralised by a simultaneous reduction of (c) (i.) or (c) (ii.) and a high bank rate by an increase of these. Indeed the Bank of England can probably bring the money-market to heel more decisively by buying or selling securities than in any other way; and the utility of bank rate, operated by itself and without assistance from deliberate variations in the volume of (c) (ii.), is lessened by the various limitations which exist in practice to its freedom of movement, and to the limits within which it can move, upwards and downwards.

Therefore it is broadly true to say that the level of prices, and hence the level of the exchanges, depends in the last resort on the policy of the Bank of England and of the Treasury in respect of the above particulars;—though the other banks, if they strongly opposed the official policy, could thwart, or at least delay it to a certain extent—provided they were prepared to depart from their usual proportions.

(2) Cash, in the form of Bank or Currency Notes, is supplied ad libitum, i.e. in such quantities as are called for by the amount of credit created and the internal price level established under (1). That is to say, in practice;—in theory, a limit to the issue of Currency Notes has been laid down, namely the maximum fiduciary issue actually attained in the preceding calendar year. Since this theoretical maximum was prescribed, it has never yet been actually operative; and, as the rule springs from a doctrine now out of date and out of accordance with most responsible opinion, it is probable that, if it were becoming operative, it would be relaxed. This is a matter where the recommendations of the Cunliffe Committee call for urgent change, unless we desire deliberately to pursue still further a process of Deflation. A point must come when, a year of brisk trade and employment following one of depression, there will be an increased demand for currency, which must be met unless the revival is to be deliberately damped down.

Thus the tendency of to-day—rightly I think—is to watch and to control the creation of credit and to let the creation of currency follow suit, rather than, as formerly, to watch and to control the creation of currency and to let the creation of credit follow suit.

(3) The Bank of England’s gold is immobilised. It neither buys nor sells. The gold plays no part in our system. Occasionally, however, the Bank may ship a consignment to the United States, to help the Treasury in meeting its dollar liabilities. The South African and other gold which finds its way here comes purely as a commodity to a convenient entrepôt centre, and is mostly re-exported.

(4) The foreign exchanges are unregulated and left to look after themselves. From day to day they fluctuate in accordance with the seasons and other irregular influences. Over longer periods they depend, as we have seen, on the relative price levels established here and abroad by the respective credit policies adopted here and abroad. But whilst this is, for the most part, the actual state of affairs, it is not, as yet, the avowed or consistent policy of the responsible authorities. Fixity of the dollar exchange at the pre-war parity remains their aspiration; and it still may happen that the bank rate is raised for the purpose of influencing the exchange at a time when considerations of internal price level and credit policy point the other way.

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This, in brief—I apologise to the reader if I have compressed the argument unduly—is the present state of affairs, one essentially different from our pre-war system. It will be observed that in practice we have already gone a long way towards the ideal of directing bank rate and credit policy by reference to the internal price level and other symptoms of under- or over-expansion of internal credit, rather than by reference to the pre-war criteria of the amount of cash in circulation (or of gold reserves in the banks) or the level of the dollar exchange.

I. Accordingly my first requirement in a good constructive scheme can be supplied merely by a development of our existing arrangements on more deliberate and self-conscious lines. Hitherto the Treasury and the Bank of England have looked forward to the stability of the dollar exchange (preferably at the pre-war parity) as their objective. It is not clear whether they intend to stick to this irrespective of fluctuations in the value of the dollar (or of gold); whether, that is to say, they would sacrifice the stability of sterling prices to the stability of the dollar exchange in the event of the two proving to be incompatible. At any rate, my scheme would require that they should adopt the stability of sterling prices as their primary objective—though this would not prevent their aiming at exchange stability also as a secondary objective by co-operating with the Federal Reserve Board in a common policy. So long as the Federal Reserve Board was successful in keeping dollar prices steady the objective of keeping sterling prices steady would be identical with the objective of keeping the dollar sterling exchange steady. My recommendation does not involve more than a determination that, in the event of the Federal Reserve Board failing to keep dollar prices steady, sterling prices should not, if it could be helped, plunge with them merely for the sake of maintaining a fixed parity of exchange.

If the Bank of England, the Treasury, and the Big Five were to adopt this policy, to what criteria should they look respectively in regulating bank-rate, Government borrowing, and trade-advances? The first question is whether the criterion should be a precise, arithmetical formula or whether it should be sought in a general judgement of the situation based on all the available data. The pioneer of price-stability as against exchange-stability, Professor Irving Fisher, advocated the former in the shape of his “compensated dollar,” which was to be automatically adjusted by reference to an index number of prices without any play of judgement or discretion. He may have been influenced, however, by the advantage of propounding a method which could be grafted as easily as possible on to the pre-war system of gold-reserves and gold-ratios. In any case, I doubt the wisdom and the practicability of a system so cut and dried. If we wait until a price movement is actually afoot before applying remedial measures, we may be too late. “It is not the past rise in prices but the future rise that has to be counteracted.”[55] It is characteristic of the impetuosity of the credit cycle that price movements tend to be cumulative, each movement promoting, up to a certain point, a further movement in the same direction. Professor Fisher’s method may be adapted to deal with long-period trends in the value of gold but not with the, often more injurious, short-period oscillations of the credit cycle. Nevertheless, whilst it would not be advisable to postpone action until it was called for by an actual movement of prices, it would promote confidence and furnish an objective standard of value, if, an official index number having been compiled of such a character as to register the price of a standard composite commodity, the authorities were to adopt this composite commodity as their standard of value in the sense that they would employ all their resources to prevent a movement of its price by more than a certain percentage in either direction away from the normal, just as before the war they employed all their resources to prevent a movement in the price of gold by more than a certain percentage. The precise composition of the standard composite commodity could be modified from time to time in accordance with changes in the relative economic importance of its various components.