Principles of Political Economy / Abridged with Critical, Bibliographical, and Explanatory Notes, and a Sketch of the History of Political Economy

by John Stuart Mill

§ 2. Credit a purchasing Power, similar to Money.

Money acts upon prices in no other way than by being tendered in exchange for commodities. The demand which influences the prices of commodities consists of the money offered for them. Money not in circulation has no effect on prices.

In the case, however, of payment by checks, the purchases are, at any rate, made, though not with the money in the buyer's possession, yet with money to which he has a right. But he may make purchases with money which he only expects to have, or even only pretends to expect. He may obtain goods in return for his acceptances payable at a future time, or on his note of hand, or on a simple book-credit—that is, on a mere promise to pay. All these purchases have exactly the same effect on price as if they were made with ready money. The amount of purchasing power which a person can exercise is composed of all the money in his possession or due to him, and of all his credit. For exercising the whole of this power he finds a sufficient motive only under peculiar circumstances, but he always possesses it; and the portion of it which he at any time does exercise is the measure of the effect which he produces on price.

Suppose that, in the expectation that some commodity will rise in price, he determines not only to invest in it all his ready money, but to take up on credit, from the producers or importers, as much of it as their opinion of his resources will enable him to obtain. Every one must see that by thus acting he produces a greater effect on price than if he limited his purchases to the money he has actually [pg 337] in hand. He creates a demand for the article to the full amount of his money and credit taken together, and raises the price proportionally to both. And this effect is produced, though none of the written instruments called substitutes for currency may be called into existence; though the transaction may give rise to no bill of exchange, nor to the issue of a single bank-note. The buyer, instead of taking a mere book-credit, might have given a bill for the amount, or might have paid for the goods with bank-notes borrowed for that purpose from a banker, thus making the purchase not on his own credit with the seller, but on the banker's credit with the seller, and his own with the banker. Had he done so, he would have produced as great an effect on price as by a simple purchase to the same amount on a book-credit, but no greater effect. The credit itself, not the form and mode in which it is given, is the operating cause.

§ 3. Great extensions and contractions of Credit. Phenomena of a commercial crisis analyzed.

The inclination of the mercantile public to increase their demand for commodities by making use of all or much of their credit as a purchasing power depends on their expectation of profit. When there is a general impression that the price of some commodity is likely to rise from an extra demand, a short crop, obstructions to importation, or any other cause, there is a disposition among dealers to increase their stocks in order to profit by the expected rise. This disposition tends in itself to produce the effect which it looks forward to—a rise of price; and, if the rise is considerable and progressive, other speculators are attracted, who, so long as the price has not begun to fall, are willing to believe that it will continue rising. These, by further purchases, produce a further advance, and thus a rise of price, for which there were originally some rational grounds, is often heightened by merely speculative purchases, until it greatly exceeds what the original grounds will justify. After a time this begins to be perceived, the price ceases to rise, and the holders, thinking it time to realize their gains, are anxious to sell. Then the price begins to decline, the holders rush into the market to avoid a still greater loss, and, [pg 338] few being willing to buy in a falling market, the price falls much more suddenly than it rose. Those who have bought at a higher price than reasonable calculation justified, and who have been overtaken by the revulsion before they had realized, are losers in proportion to the greatness of the fall and to the quantity of the commodity which they hold, or have bound themselves to pay for.

This is the ideal extreme case of what is called a commercial crisis. There is said to be a commercial crisis when a great number of merchants and traders at once either have, or apprehend that they shall have, a difficulty in meeting their engagements. The most usual cause of this general embarrassment is the recoil of prices after they have been raised by a spirit of speculation, intense in degree, and extending to many commodities. When, after such a rise, the reaction comes and prices begin to fall, though at first perhaps only through the desire of the holders to realize, speculative purchases cease; but, were this all, prices would only fall to the level from which they rose, or to that which is justified by the state of the consumption and of the supply. They fall, however, much lower; for as, when prices were rising, and everybody apparently making a fortune, it was easy to obtain almost any amount of credit, so now, when everybody seems to be losing, and many fail entirely, it is with difficulty that firms of known solidity can obtain even the credit to which they are accustomed, and which it is the greatest inconvenience to them to be without, because all dealers have engagements to fulfill, and, nobody feeling sure that the portion of his means which he has intrusted to others will be available in time, no one likes to part with ready money, or to postpone his claim to it. To these rational considerations there is superadded, in extreme cases, a panic as unreasoning as the previous over-confidence; money is borrowed for short periods at almost any rate of interest, and sales of goods for immediate payment are made at almost any sacrifice. Thus general prices, during a commercial revulsion, fall as much below the usual level as [pg 339] during the previous period of speculation they have risen above it; the fall, as well as the rise, originating not in anything affecting money, but in the state of credit.

Professor Jevons seriously advanced a theory that, inasmuch as the harvests of the world were the causes of good or bad trade, and that their deficiency would regularly be followed by commercial distress, then a periodic cause of bad harvests, if found, would explain the constant recurrence of commercial crises. This cause he claimed to have found in the sun-spots, which periodically deprive the crops of that source of growth which is usually furnished by the sun when no spots appear.[243] It has not received general acceptance.

In the United States financial disasters have occurred in 1814, 1819, 1825, 1837-1839, 1857, and 1873. Those of 1837 and 1873 seem to have been the most serious in their effects; but this field, so far as scientific study is concerned, has not been fully worked, and much remains to be learned about these crises in the United States. The crisis of 1873 was due to excessive railway-building. It was testified[244] concerning the New York banks in 1873 that “their capital needed for legitimate purposes was practically lent out on certain iron rails, railroad-ties, bridges, and rolling-stock, called railroads, many of them laid down in places where these materials were practically useless.”