Money and credit

Ever since he had begun to work on monetary issues, Wicksell, like Ricardo before him, was searching for an invariable standard for the valuation of goods and capital. The common standard of value is money, but its own exchange value in terms of goods, measured by changes in the general price level or by the rate of inflation, is rather vola­tile.

Wicksell (1898 [1936]: ch. 5) argued that the venerable quantity theory of money is the only framework capable of explaining the changes in the value of money consistently. Yet he criticized the traditional approach for being far from reality, as it proceeded from exogenous variations in the volume of money and assumed the velocity of its circulation to be invariable in the short run. Writing in the late nineteenth century, Wicksell pointed out, with some foresight, that modern economies are characterized by financial systems in which money proper (in terms of cash) is almost completely substituted by bank deposits. These are endogenously created in the process of bank lending, and payments are effectuated simply by transfers of bank deposits. Wicksell’s special trick of adapt­ing the quantity theory to such modernities was to define both the long-term evolution of money and banking and the short-run variations in the volume of “deposit money” as “changes in the virtual velocity” of the circulation of cash, the monetary base (1898 [1936]: ch. 6) The latter is but a liquidity reserve for the banking system as a whole and circulates only in cases of “external drains”.

Wicksell accordingly developed his modernized quantity theory under the assumption of a “pure credit economy”. In its extreme form, the banks face no reserve constraints at all, as they operate in a worldwide system where no drains can happen. In such a system, the banks make profits on the spreads between the deposit and the loan rates of interest. They can increase the volume of “deposit money” or “credit money” at any rate, as long as they expand their business in step, netting out their claims on each other in the clear­ing process. Wicksell understood as early as 1898 that global financial markets have a tendency to increase both the credit and the money supply.