From Wicksell to Hayek
In Interest and Prices (1898), Knut Wicksell reformulated the quantity theory of money, introducing the market of credit and banking, in a desire to reconcile the former theory with cycle theory.
He stressed a new transmission mechanism. He criticised Ricardo for not taking the relationship between the interest rate and the price level into account. “In other words, the real cause of the rise in prices is to be looked for, not in the expansion of the note issue as such, but in the provision by the Bank of easier credit, which is itself the cause of the expansion” (Wicksell 1898 [1936]: 87).Wicksell introduced the role of the “bank discount rate”, that is, a credit rate charged by banks to their borrowers on the credit market. He also called this “credit rate” a “money rate”. This credit rate is compared with the “natural rate of interest”, defined as the equilibrium rate between supply and demand of real capital, which also corresponds to the rate at which there is an equilibrium between the supply and demand for commodities. In a world with bank credit, there could be a difference between the “natural” rate and the “bank credit rate”.
Wicksell assumed that the cycle was starting, because there was an increase in the natural rate. Entrepreneurs were to compare this rate of return on investment with the rate at which they borrow. If the discount rate is maintained at its previous level, this would alter the relationship between the supply and demand of commodities and would bring about a rise in all prices, until the rate of discount is realigned with the rate of return on investment. This occurs when the monetary system is a developed credit economy: in order to avoid liquidity difficulties, banks will increase their discount rate to reduce the demand for credit and the demand for cash. However, Wicksell (1898) introduced a system that he called the “organised credit economy”, in which payments are only made by transfers between current accounts at banks, and loans are also centralised at banks.
In this context, there is no longer any need for “cash”. It is an “imaginary system” that was not entirely completed in reality in this form. It is worth underlining that banks do not take liquidity risk. Wicksell indicated that in this system, the dates on which deposits are owed always correspond to the periods for which the loans have been granted, because every withdrawal of a deposit automatically entails the deposit of an equal sum elsewhere, or the repayment of a loan of an equivalent size. So the aggregate of banks taken as a whole can lend any desired amount of money at any desired rate of interest. Edgeworth (1888) had established a new theory of banking showing that it is possible to economise on the volume of bank reserves by centralising them. According to Wicksell, the monetary system is elastic and the discrepancy between the two rates can be maintained; banks can raise the general level of prices to any desired amount. The effects of a low rate are not only permanent but cumulative, and the general price level is unstable. It can be said that in this case, the level of prices is indeterminate and that this echoes the “real bills fallacy”. As a result, Wicksell was promoting a banking system policy that would bring the money rate into line with the natural rate.The problem of the “power of banks” was later emphasised by Dennis Robertson and Friedrich von Hayek. In Banking Policy and the Price Level (1926), Robertson highlighted the fact that banks can lend, through their credit, more than what is available from saving. Hayek, in Prices and Production (1931), criticised Wicksell. According to Hayek, a good starting point for the explanation of the cycle is the discrepancy between the two rates of interest noted by Wicksell, but this analysis has to be clearly separated from the quantity theory of money and the variations in the general level of prices to which Wicksell confines his theory, the latter being an erroneous conclusion. On the contrary, this discrepancy (by maintaining an excessively low money rate of interest), which is a characteristic of the existence of a bank credit system, is the cause of the modification in the structure of relative prices and the structure of production. As a result, Hayek stressed that cycles are related to banks, permitting the financing of faster economic development and investment than that made possible only by voluntary saving, thus imposing “forced saving” on economic agents. Hayek’s view was criticised by Piero Sraffa (1932), who argued that the “natural rate” is not independent of the money rate of interest and voluntary and forced savings cannot easily be discriminated. In disequilibrium there are as many natural or own rates of interest as there are commodities, and to ask banks to adjust the money rate to the natural rate makes no sense. Banks can influence income distribution by fixing the money rate.