The Influence of the
Rate of Interest on Prices
Knut Wicksell
[Reprinted from Economic Journal, XVII,
1907, pp. 213-220.
Read before the Economic Section of the British Association, 1906]
The thesis which I humbly submit to criticism is this. If, other
things remaining the same, the leading banks of the world were to
lower their rate of interest, say 1 per cent below its ordinary
level, and keep it so for some years, then the prices of all
commodities would rise and rise and rise without any limit whatever;
on the contrary, if the leading banks were to raise their rate of
interest, say 1 per cent above its normal level, and keep it so for
some years, then all prices would fall and fall and fall without any
limit except Zero.
Now this proposition cannot be proved directly by experience,
because the fact required in its hypothesis never happens.
The supposition was that the banks were to lower or raise their
interest, other things remaining the same, but that, of course, the
banks never do; why, indeed, should they? Other things remaining the
same, the bank-rate is sure to remain the same too, or if, by any
chance, e.g., by mistake, it were altered, it would very soon come
round to its proper level. My thesis is, therefore, only an abstract
statement, and somebody, perhaps, will ask: what is the use of it
then? But I venture to assert that it may be of very great use all
the same. Everybody knows the statement of Newton that, if the
attraction of the sun were suddenly to cease, then the planets would
leave their orbits in the tangential direction; this, too, of
course, is only an abstract proposition, because the solar
attraction never ceases, but it is most useful nevertheless; indeed,
it is the very corner-stone of celestial mechanics; and in the same
way I believe that the thesis here propounded, if proved to be true,
will turn out to be the corner-stone of the mechanics of prices, or
rather one of its corner-stones, the influence of the supply of
precious. metals and of the demand for commodities from the
gold-producing countries being the other.
Before going further, however, we must answer one more question.
Our supposition might be not only unreal as to facts, but even
logically impossible; and then, of course, its use would be nil.
According to the general opinion among economists the interest on
money is regulated in the long run by the profit on capital, which
in its turn is determined by the productivity and relative abundance
of real capital, or, in the terms of modern political economy, by
its marginal productivity. This remaining the same, as, indeed, by
our supposition it is meant to do, would it be at all possible for
the banks to keep the rate of interest either higher or lower than
its normal level, prescribed by the simultaneous state of the
average profit on capital?
This question deserves very careful consideration, and, in fact,
its proper analysis will take us a long way towards solving the
whole problem.
Interest on money and profit on capital are not the same thing,
nor are they immediately connected with each other; if they were,
they could not differ at all, or could only differ a certain amount
at every time. There is no doubt some connecting link between them,
but the proper nature and extent of this connection is not so very
easy to define.
If we look only at credit transactions between individuals,
without any interference of banks, the connection between interest
and profit indeed seems obvious. If by investing your capital in
some industrial enterprise you can get, after due allowance for
risk, a profit of say, 10 per cent, then, of course, you will not
lend it at a much cheaper rate; and if the borrower has no recourse
but to individuals in the same situation as you, he will not be able
to get the money much cheaper than that.
But it is a very different thing with the modern forms of credit,
which almost always imply the mediation of some bank or professional
money-lender. The banks in their lending business are not only not
limited by their own capital; they are not, at least not
immediately, limited by any capital whatever; by concentrating in
their hands almost all payments, they themselves create the money
required, or, what is the same thing, they accelerate ad libitum the
rapidity of the circulation of money. The sum borrowed today in
order to buy commodities is placed by the seller of the goods on his
account at the same bank or some other bank, and can be lent the
very next day to some other person with the same effect. As the
German author, Emil Struck, justly says in his well-known sketch of
the English money market: in our days demand and supply of money
have become about the same thing, the demand to a large extent
creating its own supply.
In a pure system of credit, where all payments were made by
transference in the bank-books, the banks would be able to grant at
any moment any amount of loans at any, however diminutive, rate of
interest.
But then, what becomes of the connecting link between interest
and profit? In my opinion there is no such link, except precisely
the effect on prices, which would be caused by their difference.
When interest is low in proportion to the existing rate of
profit, and if, as I take it, the prices thereby rise, then, of
course, trade will require more sovereigns and bank-notes, and
therefore the sums lent will not all come back to the bank, but part
of them will remain in the boxes and purses of the public; in
consequence, the bank reserves will melt away while the amount of
their liabilities very likely has increased, which will force them
to raise their rate of interest.
The reverse of all this, of course, will take place when the rate
of interest has accidentally become too high in proportion to the
average profit on capital. So far, you will easily remark, my
proposition is quite in accordance with well-known facts of the
money market. If it be not true, if, on the contrary, as Thomas
Tooke asserted, and even Ricardo in his earlier writings seems to
have believed, a low rate of interest, by cheapening, as they put
it, one of the elements of production, would lower prices, and a
high rate of interest raise them -- a most specious argument,
resting, however, on the unwarrantable assumption that the
remuneration of the other factors of production could, under such
circumstances, remain the same -- then the policy of banks must be
the very reverse of what it really is; they would lower their rates
when prices were getting high and reserves becoming low, they would
raise them in the opposite case.
A more direct proof of my thesis is required, however, and might
be given in some such way as this. If as a merchant I have sold my
goods to the amount of ú100 against a bill or promissory note
of three months, and I get it discounted at once by a bank or a bill
broker, the rate of discount being 4 per cent per annum, then in
fact I have received a cash price for my goods amounting to ú99.
If, however, the hill is taken by the bank at 3 per cent, then the
cash price of my goods has ipso facto risen, if only a quartet of 1
per cent; very likely not even that, because competition probably
will force me to cede part of my extra profit to the buyer of the
goods. In other cases, however, when long-term credit comes into
play, the immediate rise of prices might be very much greater than
that. If the rate of discount remains low, the interest on long
loans is sure to go down too; building companies and railway
companies will he able to raise money, say at 4 per cent instead of
5 per cent, and therefore, other things being the same, they can
offer, and by competition will be more or less compelled to offer
for wages and materials, anything up to 25 per cent more than
before, 4 per cent on ú125 being the same as 5 per cent on ú100.
But, further -- and this is the essential point to which I would
call your special attention -- the upward movement of prices,
whether great or small in the first instance, can never cease so
long as the rate of interest is kept lower than its normal rate,
i.e., the rate consistent with the then existing marginal
productivity of real capital. When all commodities have risen in
price, a new level of prices has formed itself which in its turn
will serve as basis for all calculations for the future, and all
contracts. Therefore, if the bank-rate now goes up to its normal
height, the level of prices will not go down; it will simply remain
where it is, there being no forces in action which could press it
down; and consequently if the bank-rate remains lower than its
normal height, a new impetus towards forcing up the prices will
follow, and so on. The opposite of all this will take place when the
rate of interest has become too high in proportion to average
profit, and so in both cases a difference between the two rates
remaining, the movement of prices can never cease, just as the
electric current never ceases as long as the difference of tension
between the poles remains.
The proposition that a low rate of interest will raise prices, a
high rate of interest lower prices, is in some respects anything but
new; it has been stated more than once, but a formidable objection
was always triumphantly brought against it in the shape of
statistical facts; indeed, if you consider the figures given, e.g.,
by Sauerbeck in his well-known tables in the Journal of the
Statistical Society, you will generally find that high prices do not
correspond with a low rate of interest, and 9ice 9ersa; it rather
comes the opposite way, interest and prices very often rising and
falling together. But this objection quite loses its importance;
nay, more, it turns into a positive support of our theory, as soon
as we fix our eyes on the relativity of the conception of interest
on money, its necessary connection with profit on capital. The rate
of interest is never high or low in itself, but only in relation to
the profit which people can make with the money in their hands, and
this, of course, varies. In good times, when trade is brisk, the
rate of profit is high, and, what is of great consequence, is
generally expected to remain high; in periods of depression it is
low, and expected to remain low. The rate of interest on money
follows, no doubt, the same course, but not at once, not of itself;
it is, as it were, dragged after the rate of profit by the movement
of prices and the consequent changes in the state of bank reserve,
caused by the difference between the two rates. In the meantime this
difference acts on prices in just the same way as would be the case
if, according to our original supposition, profit on capital were to
remain constant, and interest on money were to rise or fall
spontaneously. In one word, the interest on money is, in reality,
very often low when it seems to be high, and high when it seems to
be low. This I believe to be the proper answer to the objection
stated above, as far as the influence of credit on prices is
regarded; occasionally, of course, as in times of wild speculation
or panics, the problem is complicated very much by the action of
other factors, which need not here be taken into consideration.
Granted, then, our theory to be true in the main or in the
abstract, what will be its practical consequences? to what extent
would the leading money institutions be able to regulate prices?
A single bank, of course, has no such power whatever; indeed, it
cannot put its rates, whether much higher or much lower than
prescribed by the state of the market; if it did, it would in the
former case lose all profitable business; in the latter case its
speedy insolvency would be the inevitable consequence.
Not even all the banks of a single country united could do it in
the long run; a too high or too low rate would influence its balance
of trade, and thereby cause an influx or reflux of gold in the
well-known way, so as to force the banks to apply their rates to the
state of the universal money market.
But supposing, as, indeed, we have done, that all the leading
banks of the commercial world were to follow the same course, then
gold could have no reason to go to one place more than to another,
and so the action exercised on prices would have its sway without
any hindrance from the international movement of money. Still, even
then it would, under the present circumstances, have its obvious
limits. As I remarked at the outset, the influence of credit or the
rate of interest is only one of the factors acting on prices; the
other is the volume of metallic money itself, especially, in our
times, the supply of gold, and so long as the gold itself remains
the standard of value, this factor evidently will take the lead in
the long run. Were the production of gold materially to diminish
while the demand for money be unaltered, the banks no doubt, by
lowering their rate of interest, might for a while profitably react
against the otherwise inevitable pressure on prices, but only for a
while, because, even if the rather unnecessary stiffness of present
hank legislations could be slackened, the evergrowing demand for
gold for industrial purposes would gradually reduce the bank stores,
and could only be checked by raising the price of gold -- that is,
by lowering the average money prices.
The other extreme, which at present seems much more likely to
occur: a plethora of gold supply, and the rise of prices thereby
caused, could not be effectually met in any way, so long as free
coinage of gold exists.(1*)
On the other hand, if this most essential step on the way to a
rational monetary system should be taken, if the free coining of
gold, like that of silver, should cease, and eventually the banknote
itself, or rather the unit in which the accounts of banks are kept,
should become the standard of value, then, and not till then, the
problem of keeping the value of money steady, the average level of
money prices at a constant height, which evidently is to be regarded
as the fundamental problem of monetary science, would be solvable
theoretically and practically to any extent. And the means of
solving it need not be sought in some more or less fantastic scheme
like that of a central issuing bank for all the world, as it is
sometimes proposed, but simply in a proper manipulation of general
bank-rates, lowering them when prices are getting low, and raising
them when prices are getting high.
Nor would this system be at all artificial, because the point
about which the rate of interest would then oscillate, and to which
it would constantly gravitate, would be precisely what I have called
above its normal level, that one prescribed by the simultaneous
state of the marginal prOductivity of real capital, the alterations
of which we, of course, cannot control, but only have to comply
with.
P.S. -- When this paper was read at the British Association
meeting it was objected by Mr. Palgrave that the banks could not
possibly be charged with the regulation of prices, their liberty of
action -- if I understood him right -- being, in his view,
restricted by the necessity of protecting their own reserves as well
from getting too low in consequence of an unfavorable balance of
trade, as from running to an unprofitable height by an influx of
gold. This, no doubt, is true, but it must not be forgotten that the
international rate policy of banks has, as it were, two degrees of
freedom, in so far as the international movement of gold can be
checked or modified, not only by raising the rate of discount in the
country from which the metal flows, but also by lowering it in the
country, or countries, to which gold is flowing. In other words, the
action of the banks against each other, which has for its object the
proper distribution of money, or the levelling of the niveau of
prices between different countries, might logically be concomitant
with a common action for the purpose of keeping the universal value
of money and level of prices at a constant height, which, however,
under present circumstances only can be done within the limits
prescribed by the general supply of gold.
On the other hand, it was remarked by Professor Edgeworth that if
the free coinage of gold be suppressed, the Governments themselves
have in their hand the regulating of general prices. This, too, is
true, at any rate so long as the present large production of gold
persists; and even if it should cease, and gold become scarce, the
Governments, no doubt, might supplant the lack in currency by a
judicious emission of paper-money. But a single Government has in
this respect only the choice between two alternatives; it may try to
keep the value of its money steady towards the commodities, but then
it necessarily sacrifices the parity of its exchanges; or else it
may manage to keep its exchanges strictly at par, but then it has of
itself no power over the level of prices. Some international
agreement, either regarding the amount of gold to he coined by each
country or else involving a common rate-policy of the banks as
described above, must needs come into play, shall both those
purposes -- the steadiness of the average value of money and the
parity of exchanges -- be fulfilled together; and it seems to me,
although I may he mistaken, that for several reasons such agreements
could he far more easily and effectually made by the banks, with the
support, that is, of the Governments, than by the Governments
themselves exclusive of the banks.
For a more detailed analysis of the practical side of the
question and of the whole argument, I must refer to my book,
Geldzins und Guterpreise (Jena: Gustav Fischer, 1898; being the
further development of an article in Conrad's Jahrbucher, Bd. 13,
1897), as well as to my printed University Lectures (Bd. I: 2, 1906,
in Swedish).
NOTES:
- It is not easy to describe or
imagine the exact manner in which an excess or deficiency in the
ordinary gold supply affects prices, although its ultimate effect
on them cannot well be doubted. As in our days the new gold
generally finds its way as soon as possible to the banks, the
common impression seems to be that it by so much increases the
loanable funds of the banks, and therefore in the first instance
causes the rate of interest to go down. This, no doubt, would be
true if the new gold in its totality were deposited by its owners
as capital for lending purposes, and in so far as this may be the
case it indeed affords an illustration, and the only practical
one, of the lowering of bank rates effecting a rise of prices. But
mostly, I suppose, the gold comes to us not as lending capital,
but as payment for the imports of the gold-producing countries,
and if so its acting on the prices will be much more immediate and
its effect on the rate of interest very slight. It is even
possible that the rise of prices, caused by the increased demand
for commodities from the gold countries, will forerun the arriving
of the gold, the necessary medium of exchange being in the
meantime supplied by an extension of the credit, so that the rate
of interest perhaps will rise from the beginning. In any case the
ultimate effect an increased gold supply will be a rise, not a
fall, in the rate of interest (and of vice versa with a lacking
supply of gold), because the large mining enterprises and the
buying up of gold by the non-producing counties have actually
destroyed large amounts of real capital and thereby given the rate
of profit a tendency to rise. This all may be the explanation of
some rather perplexing features in economic history, a rise of
prices even when apparently caused by a surplus of gold supply
very seldom being accompanied by a low rate of interest, but
generally by a high one.