US debates regarding quantity theory and the elasticity of the banking system

Although in the United States of America, monetary and banking thought referred to Ricardo, Tooke and John Stuart Mill, it freed itself from British debates. The context and the problems to be solved were distinct.

The explanation of the great deflation brought quantity theorists - namely, the very influential Francis Amasa Walker (1840-1897) - into conflict with the Credit School led by James Laurence Laughlin (1850-1897). According to Walker, the de facto demon­etisation of silver - known as the crime of 1873 - had reduced the quantity of money. Quoting Stuart Mill, Walker defined the demand for money as “the amount of money­work to be done” (1888: 129), meaning the volume of goods to be exchanged against money, and argued that “the value of money, like the value of anything else, is purely a question of demand and supply” (ibid.: 128). As the supply of money - “the money­force available to do the money-work required to be done” (ibid.: 131) - was reduced, the demand for money increased and the value of money therefore increased, that is, the price level decreased. Since the deflation of prices increases the real value of debts, it impoverishes debtors, including farmers, and brings about a contraction of economic activity, in other words, a depression. The restoration of bimetallism would remove all of these disasters.

Opposing the inductive method to Walker’s deductive methods, the Credit School showed that there was statistically absolutely no correlation between the general level of prices and the quantity of money for the period 1860-91, and then asserted that the quantity theory is refuted by facts, explaining that the banking system provides the means of circulation necessary for trade and concluding that deflation is not caused by a lack of money, but by technical innovations that bring about a decrease in the produc­tion and transport costs of goods.

After 1896, a new generation of quantity theorists opted for the gold standard and tried to validate the old theory statistically. In his PhD thesis, “Money and credit instruments in their relation to general prices” (1903), published in 1907, Edwin Walter Kemmerer statistically tested an equation - already present in one of Irving Fisher’s arti­cles published in 1897 - that Kemmerer understood as the equilibrium condition between monetary demand and the monetary supply, including credit: PQ = MV + M'V'. Eight years later, in his Purchasing Power of Money (1911), Fisher called this the “equation of exchanges” and improved its statistical verification. Furthermore, he provided an analysis of the real effects of the inherent, unpredictable and unavoidable changes in the value of money under the existing system of the gold standard. A falling value of money owing to the discovery of a new gold mine would lower the costs of borrowing, induce the development of bank credit financed by the issue of demand deposits, thus bringing about a rise in prices, but not in wages, that is, a cumulative process leading to the impoverishment of the workers and provoking bank illiquidity and then ending in a financial crisis. The symmetrical set of effects of the rising value of money due to a crisis, or associated with a trend in economic and trade growth, had already been described by the bimetallists. Fisher thought that changing the legal price of the ounce of gold every month - the “compensated dollar” plan - would correct the destabilising characteristics of the gold standard. But he did not convince his contemporaries.

There was more consensus among theorists in the analysis of the recurrent crises of the national banking system and the recurrent increases in the interest rate on the money market during periods of harvest. Quantity and anti-quantity theorists agreed that these situations were due to a periodical lack of elasticity in the issuing of banknotes. Both schools of thought believed that the supply of gold by the Treasury (deposits in banks) is insufficient to do away with liquidity banking crises and both argued for the creation of a central bank that could issue banknotes by discounting commercial credit. Concerning banking theory, it is worth noting that the distinction between insolvency and illiquid­ity had been well understood since the 1873 Coe Report, which was written to establish the rules for the issuing of clearing house loan certificates. Concerning monetary policy, at first, the Credit School’s real bills view dominated. The establishment of the Federal Reserve in 1913 and the discovery of the open market tool in the 1920s shed new light on everything.