SOME ASPECTS OF RECENT PRICE FLUCTUATIONS

BY HARVEY W. PECK

The quantity theory of money, in its baldest formulation, is that prices are determined by the relation between the quantity of money, its rate of circulation, and the volume of trade, or, technically, MV=T. Professor Fisher, in recognizing that most modern transactions are effected through banking operations that obviate the direct use of money, restates the formula, adding deposits and their velocity to the left side of the equation. The new equation, then, reads: MV+M'V'T, or the total currency or purchasing power multiplied by its velocity or rate of turnover equals the total amount of goods sold, multiplied by the price of each article. Money and goods, then, represent definite quantities. As the volume of trade has increased more rapidly than the world's supply of gold, bank deposits, a cheaper and more convenient medium of exchange, have been invented to aid the operation of money in effecting exchanges. Yet bank deposits are based on money; both loans and deposits are a function of cash, and maintain normally a fixed relation to the basic monetary metal.

Deposits are a function of money. They add to the exchange power of money by increasing its velocity or rate of turnover. Professor Fisher has discussed the causes that affect the velocities of the circulation of money and deposits

(1) the habits of the individual; (2) the system of payments in the community and (3) the general causes. Extravagance, increasing density of population, and improvement in the means of transportation mean a more rapid turnover of money. The use of book credit, the habit of paying checks rather than money, and the regularity and frequency of receipts and disbursements, all increase the efficiency, the rate of turnover of money. If checks come back to the bank, and do not dally, like notes, in the pockets of the people, the same amount of gold in the vaults of the

bank will evidently subserve so many more transactions. These habits of the people and these improvements in the banking system, however, do not liberate deposits from gold. The relation is still fixed, but the ratio of deposits to money rises, say to 10-1, or 20-1. Money operating through the bank reserve regulates the rate of circulation; hence, the quantity of currency; hence, the general price level.

Money has a tendency to do this, but the tendency is subject to certain qualifications. First, as to transitional periods. "Normally" money flows into bank reserves so as to allow an expansion of currency, M+M'; just enough to keep pace with the growth of population and the demand for goods, and thus maintains stable prices. But actually this does not often happen, as the fortunes of mining are partly accidental. Yet if money does not increase fast enough, the banking system can be improved, and the ratio of M to M' increased, so that total currency will still balance the volume of trade. Yet this does not happen uniformly, but proceeds by jumps, as in the invention of the Clearing House and the Federal Reserve System. "Normality," therefore, becomes the exception rather than the rule.

One phase of "abnormality," due to an increased supply of gold, Professor Fisher explains somewhat as follows: An increased quantity of gold coming in the form of gold certificates into the vaults of banks allows a proportional expansion of deposit credits. So the rate of interest is lowered as an inducement to the business man to enlarge his operations so that business may grow up to the currency. This expansion of currency causes prices to rise; and since business men operate for a time on fixed costs, they rapidly expand their businesses to reap the extra profits due to the rise in prices. Their demand reacts upon the rate of interest, which now rises, but not at first as fast as prices. M' (deposits) may expand beyond its normal ratio to M (money.) With the rise of interest, some firms, being unable to renew their loans at the former rate, and having overexpanded their operations, fail, and destroy confidence in the

whole business situation. Then loans and deposits contract, prices fall, velocity of money and deposits decrease, profits decline, and M' contracts to less than the normal ratio to M. The fault here, according to Fisher, is that bankers have not kept more stable the rate of interest, changing it more gradually under the pressure of monetary forces.

According to Professor Fisher, then, the equation of exchange normally works automatically. Increased power of investment, hence, economic growth and development, is largely dependent upon an increase in the world's supply of gold or an improvement in the banking system that makes possible a more effective use of gold. The causative line of growth is gold (and banking) to business to economic betterment. Our welfare is ultimately grounded on gold.

The obstacle to orderly economic development is the period of "abnormality," the change in the relative ratio of gold and goods that causes the price level to fluctuate, business unsettle, deferred payment contracts turn into speculation, and creditors and debtors alternately suffer hardships. The automatic working of the equation of exchange has until now made these disturbances inevitable, as they were due to variations in the world's supply of gold. For this serious situation Professor Fisher proposes a simple remedy: use only representative paper money, and vary the gold back of the dollar according to the variations in the index number of general prices.

By way of criticism I would say that if currency were gold, or maintained a fixed relation to gold, and if the velocity of circulation remained constant, this would seem a practicable device; but these conditions do not fit the facts of our financial situation. Total bank deposits M'V' maintain a highly fluctuating ratio to the quantity of money in circulation and the amount of bank reserves. And the present financial system is getting farther and farther away from the idea of a supply of gold as a necessary bank reserve. The actual dollar of exchange not many months ago was about 95 cents credit and five cents gold. A slight alteration

in the quantity of gold behind the five cents, as per Fisher's scheme to control prices, would seem to have a negligible effect. Thus, if the price index should rise 1% in a month, the effect would be for the value of the actual dollar of exchange to increase 1% of 5% or one-twentieth of 1% as soon as the new mint price of gold could alter the value of all the gold in existence that was offered for goods. Unless the quantity theory worked with a snap, the general price level would be scarcely altered. Ultimately, by acting as a brake on the expansion of deposits, it might tend to check the rise of prices; but a crisis might intervene before its influence got under way, so that it might actually reinforce a tendency for prices to fall below the average level.

The present financial situation is, indeed, a glowing criticism of the quantity theory. We have much more gold, notes, and deposits than before the war, yet the price level is rapidly falling. The quantity theory can be saved only by pointing out that the velocity of circulation of deposits has greatly decreased. The theory, then, loses its utility, for what we want to know is why velocity has decreased. The money is here, but the ratio of currency to money suddenly changes. The useful theory will explain why the rate of circulation of deposits falls, why individuals cease purchasing. This theory can be formulated only by a study of the conditions under which holders of credit will use it, under which banks will extend purchasing power. The analysis of money. then, may be superseded by an analysis of the supply and demand of goods.

If we go back to the definition of credit as the exchange of goods against goods, we may escape from the difficulty. Before formulating the constructive part of the paper, I will rapidly survey, on the basis of my reading, four historical periods of price changes in order to secure data for generalization. These periods are as follows: (1) 1873-1896; (2) 1896-1914; (3) 1914-1920; (4) 1920, April-present.

The first period was one of falling prices. Professor Fisher explains this by saying that the demand for gold,

consisting of growing trade and the monetary demands of countries that had just adopted the gold standard, outstripped the supply, so that prices declined. McLeod explains this decline as due to inventions, cheaper transportation, overproduction, and collapse of speculation after 1873. Hobson holds that prices fell because the demand for credit exceeded the supply. The demand for credit increased because the area of profitable investment in western United States and Canada, Argentina, South Africa, and Australia had greatly expanded.

From 1896 to 1914 prices rose steadily. This Professor Fisher explains by the increase in the world's production of gold. Hobson has other reasons: the retardation of the supply of goods owing to increased expenditure on articles produced under the law of diminishing return, increased consumption of luxuries, wars, wasteful competition, high tariffs, and restraint of output by monopolistic combinations of capital and labor. Besides, there was an overbalance of producer's goods over consumer's goods.

So far the champions of both the Quantity School and the Credit School seem to offer cogent evidence. Probably the explanation of the Quantity men is at least part of the truth; as the inelasticity of the National Banking System is notorious. But whether prices were determined predominantly by gold or by credit that was erected putatively on the basis of gold to reap the gains of investments, one is still to ascertain.

From 1914 to 1920 prices rose rapidly. Professor Fisher would doubtless say that owing to our immense sale of material to Europe, gold flowed into the vaults of American banks and there was made the basis of a corresponding expansion of loans and deposits. At the same time the Federal Reserve System with its greater centrality and mobility of reserves greatly increased the quantity and efficiency of reserves, and so correspondingly increased the deposits that could be made in member banks. This increase in gold and greater proportional increase in credit would be sufficient