Schumpeter on Money and the Financial Market

[From Joseph Schumpeter, Treatise on Money, chapter XII, “The Theory of the Money Process and of
the Functions of the Money Market.”¹]

Now we have again to work through the processes sketched in the simplest outline in Chapter V, this time in the forms of the money and credit spheres. All problems of a monetary-theoretical or monetary-policy nature, however difficult or interesting, are linked to changes in money and goods ﬂows. A stationary, hence constantly reproducing economic process exposed to no external disturbances is a very simple thing in terms of monetary theory, so that it would not be worth the eﬀort to get into all of its details. To the degree that we nonetheless need it as a basis for the presentation of some elementary principles, we will therefore restrict ourselves to the roughest outlines and a few points that at any rate deserve special mention.

[…]

The Money Process in the Stationary Economy

[293]2. Now let us ﬁrst take a stationary cycle, the periods of which are interleaved in such a manner that all households live on the product of the respective preceding period, all ﬁrms work on the product that will supply the following period, and we exclude all consumption and production goods that extend beyond the individual periods. In this case, transactions are limited to the sale of original productive services by ﬁrms and to purchases of consumer goods by households, and no occasion is given for the emergence of other consumption and production goods markets than these – in particular, for the emergence of real estate and securities markets. Inventories exist only in the sense that things involved in the process of manufacture, of being sold, and of being consumed, must be stored somewhere, but not as a result of processes contrary to expectations or the expectation of economic changes, and analogously for cash holdings or balances. The system of variables for such an economy would be constantly at its critical number, which is set equal to consumption expenditure.

In a pure account-settling system, at the end of each ﬁnancial year every household is charged an amount equal to ﬁfty-two times its weekly consumptive purchases, and is credited with an equal amount, ﬁfty-two times its weekly sales of performances, and vice versa for every ﬁrm. The social total amounts would be: debit = total credit = two times total income = two times consumption expenditure in the income period = critical number = ﬁfty-two times the total amount of balances. Cash requirements and actual cash holdings would be identical – disposition would be equal to one. We can distinguish corporate or business or ﬁnancial assets from household or consumer or income assets.⁴ Alternately, the one is zero while the other is equal to the amount of balances, while successively they equal each other. Taking our observations regarding the velocity of circulation (chapter X☩), the reader can easily deal with other cases of market order and payment technique, which are recommended as useful exercises. Regarding this, it is to be noted that the results only tell how those numbers would be if the market order and payment technique were otherwise, not as they would take shape if the market order and payment technique underwent change in the course of historical reality.

If this settlement is not conducted by a bank but by a banking system grouped around a central bank (clearinghouse), then the debits carried out at the central bank would dwindle to the amount of transactions between the banks, while the economic debit balance total would increase by that amount, [294]if the central bank has no other customers than banks and all interbank transactions lead to debits at the central bank. If the central bank has other customers too, as we generally assume, and if a portion of interbank transactions in the period eventually is deposited in oﬀsetting nostro and loro balances of the banks amongst themselves, then a statement about the formation of economic monetary expressions is generally the less possible as it depends on how many of the transactions of individual ﬁrms and individual households lead to transfers within their banks. The elimination of interbank transactions from the total number is therefore a dictate of money-theoretical clarity – which in most countries currently can be satisﬁed only with diﬃculty. The eﬀects that an association of banks has on the total number is thus also made clear.

If we set opposite this settling-up traﬃc a diﬀerent model, which works with the money method of physical handover, e.g., of fashioned metal pieces – with a speciﬁed scope for the barter economy sector and the opportunity for clearing – and we assume, for the sake of ease of comparison, the critical number to be the same as in the just-discussed model, we see that every week the – here entirely unproblematic – quantity of money ﬂows back and forth between consumer goods markets and means of production markets, so that each coin appears once in the income sphere and once in the capital sphere, hence the same money is alternately consumer and business money. The phenomena encountered only here in the actual sense, velocity, eﬃciency, frequency (V = 2E = 2F), by all means ﬁnd their analogue in pure settling-up traﬃc with the quotients, sales ÷ balances, or consumption goods sales/sales of means of production ÷ consumer balances/producer balances.

The Money Process in More Complex Situations

With a little practice in the handling of the presented theory, what has been said in previous chapters is entirely suﬃcient to treat the following cases, which arise ﬁrst from complications of our scheme, and then from those small diﬀerences the consequences of which can best be made clear when one hews to the principles of the scheme, even though they gain their full meaning in the money process in another context. The treatment will largely be left to the reader.

Intermediate Goods

A. Let us allow for ﬁrms that sell, not to households, but to other ﬁrms, such as ﬁrms that produce means of production. It would obviously be possible that these sales – on our Saturdays, or sometime between the end of the Monday [295]market of consumer goods and the beginning of the market of the original means of production on the following Saturday – proceed such that the consumer goods ﬁrms apply a portion of the balances or coinsto the purchase of intermediate goods that otherwise would remain idle that week. Their producers can, if their maximum production period is a week, spend this partial amount on original means of production on the same Saturday, so that households receive the same amount and on the following Monday spend the same amount buying consumer goods as in the earlier case. Frequency, income, total balances, consumption expenditure, the critical number, and price levels remain as they would have been had we allowed no other transactions than household-ﬁrm purchases and no other goods than consumer goods and original productive services. The only change is that the debit (= credit) total – total sales – is now increased by the amount of purchases of intermediate products, and the transactions of the capital sphere are therefore no longer equal to the transactions in the income sphere, even though “business money” and “consumer money” are still equal to each other, or to be precise, the existing balances or coins alternate between the two.⁵ The amount of capital itself as well, that is, the sum of the amount expended in the course of the production process, has increased by the number of purchases of intermediate goods.

A portion of actual economic processes in fact runs according to this scheme, but obviously only a portion. We account for another portion if we assume that the ﬁrms that produce intermediate goods make their payments, together with the consumer goods ﬁrms, just as before on Saturday, but only sell their intermediates to the latter on the following Monday, whereupon the consumer goods ﬁrms are not in the condition to apply the money that they take in on Monday to pay for the intermediate goods. Firms in the sphere of production, as we shall call the producers of the “produced means of production,” therefore must now keep their capital in readiness ahead of time, which under our conditions is possible only when consumer goods ﬁrms in turn ﬁnance the sales of intermediate goods from proceeds of the previous economic period, thus separate the corresponding portion of their capital from the proceeds of the previous Monday, hold onto it on Saturday and do not let it become income. By this means, the self-ﬁnancing of the stationary economic process is again realized, i.e., the principle of ﬁnancing from current revenues is implemented. Again, each piece of gold and, if we apply the image of “circulation” to deposits, each deposit unit stands over against both consumer goods and original means of production. But not all of these units do this with each revolution [296]of the wheel of the economy, as was the case before. Rather, an amount equal to the sum of purchases of produced means of production, even though made up of continuously diﬀerent individual coins, is withdrawn from the immediate back and forth between markets of consumer goods and original services, as in an oﬃce, for example, comprising ten functionaries, of which, on an alternating basis, one is always on an inspection trip and nine are always present. If a million coins are paid out as income on Saturday, and are spent on consumer goods on Monday, and half a million in produced means of production is purchased on Monday, then one and one-half million coins must circulate if the Monday transactions are simultaneously to be possible.

Compared with the previous case, then either total income, price level, etc. must be correspondingly lower given the same amount of money, or, if these are to maintain the same level, there must correspondingly be more money available. Frequency is correspondingly lower. The coins – that is, the portion of them that must run through the produced means of production, a pure “business sphere” – loses a step, as it were; suﬀers a phase delay. There is still no coin that is business money in the sense that it only circulates in the business sphere, but there is now business money in the sense that a “fund” exists that is not poured directly into income but rather stands alongside the fund earmarked for that. The equation between income, consumption expenditure, and the critical number now still exists. But the money supply and the deposit amount is now no longer equal to 1/52 of the annual sum of income, but is equal to 1/52 (1 + ½) of the same. The debit total exceeds twice the annual income by the annual amount of payments to producers of intermediate products, and by the same amount the transactions of the capital sphere exceed those of the income sphere. The generalization of these relationships is easy, as is the application to the case that the producers of intermediate goods in turn buy intermediate products, as do their producers in their turn, and so forth.

It should be quite clear that at least in the cases discussed so far, no ground exists as to why a special net income should attach to the production or possession of intermediate goods.

Eﬀect of Auxiliary Funds

B. Our models may seem cumbersome and unrealistic. At any rate, thinking through them promotes the understanding of the payment process and the essence and materialization of the national accounts [volkswirtschaftlichen Gesamtziﬀern], which is what matters. In particular, one realizes that this essence is not inﬂuenced by the disaggregation – nor, conversely, by the amalgam [297]ation – of the production process as such, but only by a payment-technical circumstance,⁶ which is usually – but not always – linked to such disaggregation or amalgamation. We characterize this circumstance as the insertion of new funds, or the withdrawal of existing funds, which must now (or must have been) supplied “in advance” with stocks. This immediately gives a useful generalization. Because obviously the same thing holds true for the emergence or disappearance of trading and agent ﬁrms and also for public treasuries. Even if a public treasury does nothing else than disburse the money it receives, such as for support payments, and if the supported households buy exactly the same goods and services as those households from which the sum has been withdrawn would have bought, the “loss of a step” may still occur, which is the only essential thing. At the same time we also see, in this case even more clearly that in the disaggregation of production, that this is not necessary, and that where it occurs, it may occur in very diﬀerent measure: obviously the treasury could also work in the way that it continuously makes expenditures as soon as revenues come in, and it is in no way unrealistic to assume that in many cases the market order allows enough space to, e.g., absorb the ﬂow of items. The case of the public purse further clariﬁes the important question of the eﬀect of tax rates on prices, frequency, and total number.

Durable Goods

C. Let us introduce goods into our scheme⁷ which serve either consumption or production for longer than a week. For this reason, these goods are not purchased by the individual household or the individual ﬁrm every Monday, although from the standpoint of their producer or seller, sales may still occur uniformly, i.e., in equal Monday quantities. As far as the individual households and ﬁrms are concerned, they must free up current amounts for these expenses that recur only over longer periods, so that cash items must be kept with them that are “staggered” from zero to the full amount of the outlay. Here we have a money pool from which as much continuously ﬂows in as emanates out, but which always coexists as a separate pool along with the rest of circulation needs, just like the model described in subsection B above. To the degree that it can occur that ﬁrms (e.g., because they originally arise at approximately the same time) or households (e.g., because they originally take possession of the relevant durable good at the same time) undertake the replacement en masse on the same Monday, so that everything is sold to these, nothing to others, it would alter our [298]image such that we picture the pond being periodically “drained” and thereafter “dammed up” for a longer period of time. Both cases are easily expressed algebraically, and both only concern a decreased frequencyof the relevant partial amounts and, because of this, a reduced average frequency. However, it is not always convenient to construct this average magnitude. Rather, it is often advisable to register the frequency diﬀerences as far as possible. This reveals to us what is wont to be called the opposition of “circulating” and “ﬁxed capital” or such like. If we imagine a continuous scale between, say, wages on the one hand, and especially durable things like buildings on the other, then we have everything we need to understand the essence and value of this distinction, its role in the monetary process, and the diﬃculties one confronts if one wishes to draw [the boundary] sharply and in the sense of a contrary or contradictory opposition.

Here as well, the equations apply: income per period = consumption expenditure over the same period = the critical number derived over the same period = monetary expression of the social product = production expenditure = half the debits = coins times (reduced) frequency = amount of consumer credit times frequency = amount of business credit times frequency. The goods transfers, which now take place from period to period, have their monetary counterpart in the cash holdings accumulated for replacement purchases. These goods transfers plus these stocks – which correspond to depreciation for accounting purposes – are thus in each case the (relative) “ﬁxed capital.”

External Disturbances

4.[sic] “External disturbances,” in particular the interventions of the political world in the economic organism, would exercise a much weaker and, above all, diﬀerent – and more easily describable – eﬀect if they impacted an actually stationary process that passively adapted to them according to the rules of statistical theory, and exhibited no impulse of its own. Then not only would the response of the ﬁnancial conduct of households and ﬁrms to such disturbance be easy to predict, but so also would the eﬀect of monetary and credit policy interventions as well, whether they be unintended side eﬀects of otherwise political actions, or whether they be undertaken with the intention of giving economic-policy shape to the money and credit side. Now, if one points out this assumption of many monetary-theoretical attainments and monetary-policy proposals of our day, everyone realizes that things are not actually like that. But unconsciously and implicitly, the assumption nevertheless always is made – a consequence of the fact that a satisfactory theory of the self-motion of the economy is lacking, a cause of the fact that the results of current monetary theory and its [299]application are so obviously inadequate. Hence it is that eﬀects are expected from the impulses which can be imparted to the economy by monetary- and credit-policy means, that experience belies, and hence it is that, with respect to the economic process, a freedom of movement is attributed to credit policy that turns it into virtually the sole determinant of the pace of economic life – a freedom of movement which it does not, in reality, have. In fact, the self-motion of the economy, which we delineate as “development,” is the dominant basic phenomenon that above all ﬁrst brings about the phenomena that we are accustomed to ﬁnd in our mental image of the capitalist economy, and turns the monetary process into what we observe in reality.

Only with the understanding of the money and credit side of this basic phenomenon does the understanding of the capitalist money process even begin – among other elements of the process, the understanding of the monetary eﬀects of growth and disturbances, monetary- and credit-policy interventions included, the results of which must appear to be completely random – “now this way, now that,” a conclusion that the practitioner draws with great promptness – when we try to analyze these eﬀects without relating them to the phases of the economic body’s own life. Therefore, we now wish to work out the monetary contours of these phases under the assumption that there is neither what we would call growth nor disturbance in the area under observation.

From chapter V on, which the reader should now consult, we have become acquainted with the essence of this basic phenomenon, which accounts for the self-motion of the economy. As we did there, we here wish ﬁrst, deviating from reality, to allow an economic body to grow from full static equilibrium, so that no elements of what is to be explained are included in the preconditions, which is another reason for the failures of important inherited theories. Furthermore, we also know that the phenomenon has an essentially wave-like character, and why it does, which fact is of particular importance to monetary theory and monetary policy. The phases of these waves are what we will refer to as economic phases. How many phases we distinguish is a matter of presentational convenience. Now we wish to deﬁne only two, which can be termed with the well-known words rise or prosperity, and fall (stagnation) or depression: we will often make use of the terms positive and negative phase. Finally, we know that there are always many such waves in progress at the same time – superimposing upon each other and interfering with each other. But for the sake of representational simplicity, we wish to express ourselves here generally as if there were only one wave, which comes down to speaking of a positive or negative phase, when the balance, so to speak, of all progressing waves is positive or negative. On the whole, the positive phases can be characterized by the implementation [300]of innovations, the negative by the adaptation to the situation created by innovations, especially the price and cost situation.

The Eﬀect of Development

We turn to the monetary-theoretical analysis of the positive phase. We represent the underlying process as the introduction of a better method of production – cheaper labor per unit of product – of an already available consumer good, which, however, requires intermediate goods – say machines – that do not yet exist. It is by no means a matter of indiﬀerence whether this is indeed so, or whether the innovation rather arises in the industry producing means of production, or whether it consists in the introduction of a new consumer good, etc. But our picture not only reﬂects a frequent process but also one that exhibits very many commonly occurring phenomena, from which transitions to other cases can easily be found. Entrepreneurs who go over to the production of consumer goods according to the new method might well obtain the required means of production through a low- or no-cost conversion of plant. Although this is not an insigniﬁcant case, we will assume, in order clearly to bring out the essence, that this is not the case, but rather that the entrepreneur does not “already have” any of the required means of production, and in general does not have other means, except possibly – but not necessarily – assets that can serve as collateral and facilitate borrowing.

Then the entrepreneurs who have not accumulated discretionary deposits – an aspect that actually is just as important, to be inserted in our picture later – obtain the amounts needed to purchase the means of production only by borrowing. Since there is no investment-seeking savings fund or such-like, they must obviously either induce people to give them cash which is used for the purposes of the stationary cycle and kept ready for it, or induce owners of means of production to lend them these means of production in kind or, for example, to provide work against a later promise of payment, or ﬁnally induce a bank to create new credit ad hoc for them to carry out their plans. The ﬁrst way is not excluded and plays a role that cannot be neglected in an economy already in full development. However, under our assumptions, i.e., especially if we begin from a strictly stationary circular ﬂow, such strict restrictions are set on this removal of coins or balances that we can disregard them for the time being. The second way is also undertaken in the real world. Many new hotels lend out their establishment, many shoe factories do so with their machinery, and it also happens that owners of, e.g., natural factors of production are won over by entrepreneurs for their plans, to provide the use of such factors or even to part with them in [301]return for the promise of later quid pro quo. But this mode – which with the production factor labor mostly is quite impossible – is set such narrow limits, particularly under our conditions, that we do better to turn to the third way, the way of the typical ﬁnancing of new things by the capitalist economy: ad hoc creation of purchasing power, and likewise restrict this to the creation of purchasing power by banks. We assume that banks add these credits to previously existing balances and do not, say, withdraw the corresponding amount or any part thereof from other customers. We also envision a multiplicity of competing banks grouped around a central bank, in accordance with the picture drafted in chapter VII.☩

Credit Creation the Driver of Development

This model, seemingly so unrealistic, actually embodies the fundamental mechanism of the capitalist process. For the moment we will continue to disregard everything secondary that attaches to it, in particular the fact that ﬁrms and households not only are the leading objects of the action of entrepreneurs and banks but also act in anticipation of that action by changing their ﬁnancial conduct, stockpiling, etc. Put this way, pared to its simplest form, and set in relation to our weekly scheme (with a ﬁnancial year), things look like this: entrepreneurs during the ﬁrst week of the year have the loan amounts booked to their accounts – we stipulate that the economic year shall begin with a Monday market, on which, as before, the equilibrium quantities of consumer goods are sold in entirety, and at the old prices. Through the grant of loans, the sum of balances increases during the course of this week by the amount of credit extended, and the critical number of the system increases correspondingly, but nothing else changes. In the market for productive services on the ﬁrst Saturday of the year, that portion of the new funds which the entrepreneur immediately spends on original productive services, especially labor services, now comes forward. The social production expenditure, still equal to the sum of income, increases by the amount of that portion of new balances, and the prices of services (the same amount as previously oﬀered) rise accordingly, including precisely the prices of the kinds of services demanded by the entrepreneurs that are naturally general for all ﬁrms, while the prices of the categories not demanded by the entrepreneurs rise according to existing “aﬃnities,” so that the prices of all services, while not rising equally, on balance rise by amounts corresponding to the increase in purchasing power. This increased total income on the second Monday buys the – not increased amount of – consumer goods, and so returns back [302]to the ﬁrms – but not to the ﬁrms of the entrepreneurs; rather to the “old” ﬁrms, that thereby book a cost surplus on this weekly production. Under our assumptions – which in this context as in others, have to be changed the closer we approach reality – this partial amount of the newly created balances “circulates” for the time being at the same frequency as the old balances.

There are therefore, since the ﬁrst period was omitted, ﬁfty-one occasions on which consumption goods can be purchased in the ﬁrst economic year. In addition, on the same Monday the entrepreneur purchases produced means of production. Insofar as only a part of the desired type of means is available, as is the case in the example that we treat, or insofar as they must ﬁrst be (in part) themselves produced, as is the case with, for example, new machines, we will assume that the complete amounts of the desired materials, and the completed machines, are ordered and paid for on this Monday. As one may easily convince himself, this does not restrict the generalizability of our results. This part of the new balances thereby only gains eﬀectuality vis-a-vis income on the second Saturday, and eﬀectuality on the consumer goods market only on the third Monday.

This is all we need in order to understand the disturbances that occur in the previously stationary circular ﬂow and the formation of total economic numbers. For, when we for example assume that the economic year under consideration is necessary and suﬃcient to establish the entrepreneurial ﬁrms and make them production-ready, so that their products begin to ﬂow on the ﬁrst Monday of the next economic year, and further that every week more loans are granted to them and credit is created in their favor in equal amounts, then these additional and successive “credit injections” into the economic body are not to be treated diﬀerently than the ﬁrst. It is only important to note that as long as these injections are carried out regularly, each subsequent one partially compensates for the eﬀects of the previous ones on the old ﬁrms.

While only this process is under way, i.e., before the new products reach the consumer market and the ﬂow of consumption goods broadens, not only does the social product not increase, but [the consumption goods market] narrows such that the social product decreases. This is simply the consequence of the withdrawal of means of production incurred by the old ﬁrms [by their being shifted to new ﬁrms]. In reality, we do not observe this, or we observe it only rarely, because we are usually dealing with reservoirs of unemployed workers, supplies, etc., that ﬁrms have available to them. However, our scheme also develops an extremely important characteristic for the understanding of reality.

The Money Process in Cyclical Downturn

[303]5. It would be to drag something accidental into our picture and distort its basic outline, should we in principle let this process be halted by the restriction that the banking constitution and currency legislation put on the increase of credit (deposit) volume. This may play a role often enough practically, even more often apparently, although a brake on this basis will not easily lead to a “crisis,” but, because it obviously takes place by a gradual tightening of credit conditions, will only lead to a progressive throttling of prosperity. Even so, in principle it is a matter of complete indiﬀerence whether the upswing in demand for credit really approaches the legal or bank-technical limit or not. And when attempts at explanation that rely on this aspect imply that without any such limit there would be no reason for such a boom not to prevail without interruption or end, then they fall into error. For we have already gotten to know that aspect inherent in the goods process that is independent of the monetary and credit system, whereby every boom comes to an end and compels a period of depression: the emergence of new products, their penetration into the previous circular ﬂow. Competition which, in both the consumer goods markets and the markets for means of production, new ﬁrms bring to old ones that, precisely through the emergence of the new, are rendered obsolete and undersold, is what that process of elimination and adjustment entails that is the essence of the period of depression – and the fundamental reason for the business losses that characterize it. We have now to introduce the money side of the matter into our model, and especially a very important aspect, which asserts itself in the depression and is peculiar to the money method.

To get an initial overview of the main contours of the money process in a depression, we wish to have the new products all appear at the same time beginning on the ﬁrst Monday of the second year, although it would of course be more faithful to reality to assume that the buildup by the new ﬁrms begins not just at one point in time, and indeed in the ﬁrst week of the ﬁrst year, but rather continues during the course of the year. Obviously the ﬂow of new goods begins only in a trickle but soon swings into line, so that the later stages of the boom are accompanied by a growing inﬂuence of the new products, which, until the culmination point, is overshadowed by the eﬀects of the buildup of production capacity and the credit creation to ﬁnance it. This process aﬀects the rate of change of boom symptoms, and bends, so to speak, the same graph downward, so that it continuously ﬂattens up to the culmination point.⁸ But if we [304]make the mentioned assumption, it does no damage materially while being useful presentationally; so also the further assumption, that all entrepreneurs have calculated correctly, and sales of new products run as expected.⁹

Under these assumptions it is especially clear that the purchasing power newly created in the ﬁrst year, the eﬀect of which on socioeconomic numbers [sozialen Ziﬀern] was in part due the fact that it emerged without expanding the ﬂow of consumer goods, whereby basically increasing money income purchased stable consumer goods quantities, now confronts increases in the ﬂow of goods that in turn do not face any expansion of the money ﬂow. If for example the new durable goods of the sphere of production are fully utilized in the second year, the Monday incomes of the new ﬁrms must be at least suﬃcient to cover not only the additional production costs of the second year, but also the original costs of the ﬁrst year. And if everything has gone as expected, entrepreneurial proﬁts and interest income must also pour in, in which case the deployment of the credit structure upon the production substructure, which resulted from the processes of the ﬁrst year, is now more than made up for.

But that’s not all. Recall our typical picture of the functioning of the credit mechanism in an area of study accustomed to the money method. We see that new ﬁrms not only bring new products on the market, but at the same time also take balances oﬀ the market, insofar as they repay loans from proceeds. We saw that this means the ipso facto extinction of balances. And that this happens quite automatically as a result of the crediting of the proceeds to their accounts. Let us imagine that those sums from Monday revenue that will be necessary on the following Saturday to buy original means of production, and on the following Monday to buy produced means of production, were initially reserved, whereby we can include in the latter amount the sum needed to cover the wear and tear on the equipment, which under our assumptions ought to be possible. Because if the plant produced in the ﬁrst year is completely utilized in the second, it must be rebuilt in the second or otherwise there could not be production in the third. And this must obviously be ﬁnanced through income, otherwise one would have a loss-making operation on his hands. In order to avoid unnecessary complications, we here merely add the assumption that rebuilding is actually paid for in regular weekly payments rather than the necessary sum being sporadically collected in order to be paid out all at once. The remainder, which under our assumptions is a positive magnitude and greater than the attributable [305]share of interest debt, is likewise reserved up to the amount thereof until Saturday, and paid out at the same time with the other income. The rate of proﬁt contained in Monday income reduces the debt.

In strict deposit logic, the settlement process of the negative phase runs like this: every Monday, the households (and those ﬁrms that purchase produced means of production) are charged an amount for goods purchased, which also includes the value of goods purchased from the new ﬁrms. This latter, partial amount reduces the balances of households (or ﬁrms), just like that part of the amount that is “remitted” to the old ﬁrm. And as was the old, so also the new ﬁrm will be credited accordingly. But while in the case of the old ﬁrm, this crediting leads to an expansion of balances corresponding to the diminished balances of its customers, thus leaving the social deposit sum unchanged, in the case of the new ﬁrm (possibly via a momentary increase of its balances) it leads to a debt reduction, hence to the extinction of balances and an equal reduction of the social deposit sum. The shrunken asset items are cancelled against a portion of the debt that sinks the “deposits” of the concerned banks. Of course, the entrepreneur must take up credit for the upcoming Saturday and, to the degree that he purchases produced means of production, for the upcoming Monday as well, so that the balances extinguished through receipts from consumer goods sales on the previous Monday are replaced again in part, but the further we come into the second year, the more this new deposit creation lags behind the antecedent deposit extinction, because income under our assumption – debt on January 1^st, plus current production outlays from January 1^st, plus interest on both – must be in excess of entrepreneurial proﬁt. Meanwhile, however, the outlays – and the corresponding new loans granted – continue for the preparation of production to be carried on in the third year, i.e., for the recovery of the outlay.

But, for the sake of clarity we can imagine something that usually happens, at least in part: that entrepreneurial proﬁts are applied to the reduction of the borrowing requirement to replace equipment, or more vividly: to cover the debits run up for this. Conceivably it would be so large that the new equipment would emerge in the third year debt-free and with a suﬃcient balance for current production expenses (working capital), in which case the newly created credit would be completely extinguished, the social deposit sum would be reduced to the level it had before the onset of this wave of development, and that while the social product has increased. If proﬁt is even greater, the remaining balances are reduced by this additional amount, but the social sum is not touched. Even when things do not turn out quite so pleasingly for the entrepreneur, the newly created credit, always assuming that things develop according to expectation, eventually is extinguished even if only after a longer period of [306]time, and a condition would be reached in which the ﬁrm ﬁnances its activities from current income.

The Money Process in Crisis Situations

If we recall the conceptual tools that our basic construction presents to us, it is not diﬃcult to formulate the social meaning of this method of implementation and adaptation of the new into the pre-existing economic body. Money and credit do not play a merely subservient role therein, in the sense that they register only what would happen independently of them, although neither are they a ﬁrst cause [primum movens] that would produce a wavemotion – an alternation of positive and negative phases of the economic process, that without them would not exist. We are now in a position to recognize, precisely because of this fact, the truth and the falsehood in the so-called monetary crisis theories, which are not easily distinguishable. The account-settling systemachieves something that in the economic system of private property could not otherwise be accomplished with the same eﬀectiveness, and which becomes the vehicle of phenomena that are anchored in the money method and the credit system. It is the lever that lifts the existing means of production in capitalist society out of their previous courses and makes them subserve new uses. For this reason – through an ability, on the face of it not contained in the term “account-settling system,” temporarily to commandeer transactions in existing goods – it really is the midwife of the new, but not more than that. It does not create the new, nor does it initiate it. It does for the capitalist economic process what would be done by the arrangement of the central oﬃce in the socialist process, in which certain means of production are made available for a new production direction or method. Such allocation of means of production would obviously only be incidental in the process of socialist economic change, not the essence or the “alpha and omega” of it. And nothing other than such commandeering of the means of production and their assignment to entrepreneurs (= to new purposes) is what, in the core of its essence, capitalist credit achieves. We can get an even clearer picture when we contemplate entrepreneurs and banks.

The allocation of the means of production is done by the allocation (credit) of ad hoc newly created purchasing power that appears in addition to existing balances. This purchasing power comes ﬁrst on the market of means of production, then on the market of consumer goods, etc., always by turns brought to bear on income and revenue formation, on an equal footing with the previously existing purchasing power. But in contrast to the previously existing purchasing power, newly created purchasing power, in its ﬁrst appearance, is [307]nor derived from antecedent production revenues. To resort to a metaphor that we have already used but which is here helpful, we can express this with the phrase that newly created (credit) purchasing power in the hands of the one who ﬁrst receives it, thus in our case the entrepreneur, but other (credit) purchasing power just as well, is a claim for goods, a ticket of access to the ﬂow of (production) goods, but is not, like this latter, a certiﬁcate of accomplished production.

Deposit creation in the positive phases and autodeﬂation in the negative phases do not aﬀect reality as simply as in our model. Nevertheless, it is obvious that a major characteristic of historical reality at this point becomes visible from our theoretical height, because factually the price level increases in times of prosperity and decreases in times of depression – not entirely without exception, nor entirely promptly, yet still with such regularity that superﬁcial analysis not only sees therein the essential feature of economic waves, but even their cause. Let us now picture a historical sequence that for over a suﬃciently long time, say over a century, is subject to no external disturbance, neither monetary nor political nor social, in particular nothing in terms of economic policy (tariﬀ legislation, change of bank organization, etc.), and let us have a number of successive development-waves arise and subside during this period. Then we would conclude that the price level conducts its phased upward and downward movements about a declining axis: If in each positive phase the price level increases, and in each subsequent negative phase it decreases more than it had just risen, then obviously all the normal or equilibrium points lying between every two waves, given the same critical number and consumer spending, will show declining price levels. This important result, which we may call the law of the falling price level, is also conﬁrmed by the history of the last hundred and ﬁfty years. During this time, the price levels of all countries that can be called “capitalist” and have halfway decent price statistics have fallen steadily whenever left to themselves, i.e., in particular when increases in gold production, protectionism, capital inﬂows, etc. have not interrupted the process, and have done so in spite of the likewise continuous expansion of bank-mediated elements in the account-settling system, which naturally counteracts the fall in the price level. The objective eﬀect or “social meaning” of the matter is easy to interpret: we are dealing with a method of channeling the fruits of economic development to households that do not directly, like the entrepreneur, make development proﬁts, precisely thereby absorbing the growing surplus product.

Saving and Interest in the Money Process

[308]7. To complete the argument of this section, it still remains to us to list some of the important phenomena that the described process, even in its simplest form, of necessity had to yield, and without which they would not exist or would function in a diﬀerent manner than they do.

The Origin of Interest

A. The emerging entrepreneurial proﬁt, and the circumstance that, in order to gain it, one especially needs coins or credit for the purchase of means of production, creates a premium for instantly available, “present” purchasing power units over future ones. In the stationary production process, present and future deposit units stand at par: during the course of a ﬁnancially balanced production process, there is no reason to set the units currently passing through cash holdings in relation to those that, at the corresponding point in time in the next phase, will ﬂow in equal numbers through cash holdings ; there is even less reason to value them as greater or lesser. For in equilibrium each production outlay reproduces itself.¹⁰ But if, as in the case now under consideration, the production process on the one hand promises a surplus, but on the other hand cannot be ﬁnanced out of current income – which is not yet to hand – so that the sum needed for production outlays must be procured [beschaﬀt] by special act (in the hitherto considered model, likewise created [geschaﬀen] by special act), the procurement of which is the necessary precondition for everything else and eventually also for obtaining the surplus – the entrepreneurial proﬁt – then the item set up in the expense calculations of the entrepreneur stands for, besides that item of proceeds that will refund it, precisely a “share” [Kopfanteil] of the entrepreneur’s proﬁt, which viewed from this angle is dependent upon the “principal” to be borrowed. In this sense, the equation holds for the entrepreneur: principal now to be borrowed K = sum of future revenue S, S > K [i.e., S must at least equal K plus a “share”].

[309]B. If under pressure from the demand for capital by the entrepreneur, a premium on current deposit units has arisen, then this phenomenon, if indeed it is suﬃciently marked and lasts long enough, will spread back over the entire economic body and be a part of all transactions that make up the economic process. It, then, penetrates actually into all calculations and into all economic actions of all ﬁrms and households so thoroughly that not only they, but even the scientiﬁc observer, apparently no longer can imagine the economic process without interest. In particular, the interest rate now becomes a general cost element, not only in those cases, which we will get to know, in which others than new ﬁrms are forced to pay interest, but also, and quite apart from any actual interest payment, because now everyone takes into consideration that if he lends his cash on hand to an entrepreneur instead of applying it to its intended purpose, he can capture a surplus, interest. The intended use is therefore henceforth charged with a cost element in the sense of “opportunity cost,” and so the interest rate becomes a factor of production costing and ﬁnancial conduct for all people.

Saving as Response to Interest

C. In these connections, the following two facts here interest us:

1) We have seen that even in our case we could allow saving in our stationarily reproducing economic process, although it nevertheless is recommended to refrain from this aspect because it ﬁts better into a model based on an aspiration of people to change their economic situation, and because saving could play only a modest role in a fundamentally stationary economy. In all cases, however, saving becomes a diﬀerent and much more signiﬁcant phenomenon, both qualitatively and quantitatively, in a world inundated by waves of development. Above all, with the possibility of deriving interest income from investment in the production process, a new motive of saving emerges that must act on the magnitude of the portion of income that is saved – if we assume saving also in the stationary economic process – and which must create the phenomenon, if it did not otherwise exist. But for all that, the eﬀect of the process in the sequence of the development waves must likewise be novel.

Saving is provision for capital expenditure. With ﬁrms, real investment can be made directly, while with households, investment initially only means transfer of balances to ﬁrms that then make the real investment – whether it be that the households directly leave their balances to ﬁrms (which we will disregard), or whether they buy securities (part of which …¹¹), or whether, ﬁnally, [310]savings deposits represent deﬁnitive investment for them. But making funds available already has an eﬀect – because the bank can pass them on or create more as a result.

The operative point in the sphere of the problem of saving is that saving ensues in the process of waves of development and helps satisfy its credit needs. The paradox of the theory of the saving process, the unsatisfactory description of the eﬀects of saving and investing, the diﬃculties, so to speak, of theoretically accommodating savings, all stem from the fact that one wishes to observe it in a state of equilibrium or in a uniform economy, i.e., an economy that above all progresses along constant cost curves. Since in that case it can only be a question of the expansion of production beyond equilibrium points, the problem emerges as to how that is possible without loss; and almost automatically, saving slides into the position of troublemaker. It is essential to recognize this problem as a pseudo-problem and classify saving within the overall process in which it is actually taking place.

2) We have also seen that, in the money process of the stationarily reproducing economy, the amount of cash holdings depends but little on the will of households and ﬁrms, and crucially on the market order and payment technique, which decide where and how long coins and balances must remain in cash holdings: the holdings are where they are, not because economic considerations of ﬁrms and households form this amount of holdings, but because the “existing” sums must be somewhere, and must be sluiced by the objective order of the payment system precisely to where we actually encounter them every day. For individuals, they are the single nearly intractable variable, independent of individual free choice. The situation in reality is otherwise: the cash on hand that every ﬁrm and every household has, does not simply turn up there, but is that which it wishes to have, according to situation, prospects, and intentions. The cash balance is tractable and determined by economic considerations in quite the same way as goods stocks, and is quite as “rationally” acquired and changed, and therefore is a variable in completely the same sense.

One source of this fact, whereby cash on hand is turned, if we can so express it, from a passive into an active element of the money process, originates in credit creation. We have already seen another when introducing the concept of disposition, which receives its full meaning, as we will see in greater detail shortly, in a business world evolving through the ﬂuctuations of positive and negative phases. We here come up against a third source of this “active” role of cash, namely the interest rate. If one can receive a premium with a price character for the temporary transfer of a balance, one not only will oﬀer deposits that one does not need, or the purpose of which one gives up for the sake of interest, [311]but also those that one does need and still desires to direct to a purpose, if this “need” and the requirement of this provision lie in the future – though it be perhaps in the near future, perhaps even the very next day. Note that whoever so acts, has not saved, but rather invests; so that such temporary investment is a phenomenon in itself, that must be distinguished from investment in the sense outlined earlier, because it has a diﬀerent eﬀect on the monetary process. We speak of it, in directly understandable conciseness, as “diversion.” Next we note that the possibility of temporarily disposing of cash on hand in a useful manner yet gains practical importance if it is customary at any time temporarily to acquire others’ cash holdings at interest. Therefore one is not strictly bound to a time limit given by the purpose for which the deposit is held. One might even adopt the policy of lending income to the extent that it is not encumbered by simultaneous maturities, and borrowing for all ongoing expenditure to the extent that it is not covered by simultaneously received income. In that case it comes down merely to comparing rates of interest receivable and payable, and comparing the costs of these borrowing and lending operations.

Obviously what we have here is “purchasing power creation.” We see that the process is not identical to the lending that entails renunciation of expenditure and hence does not increase the sum of goods transactions. Nor is there an increase in frequency; the market order and payment technique remain what they were. Also disposition, people’s spending decisions, has not changed. Rather, something happens that works just as if more coins were made available. This increase in purchasing power would not be visible statistically in a monetary system that only knows of the circulation of coins, which explains in part why so many practitioners deny the phenomenon of purchasing power creation. If that happened without the intervention of banks – and to the degree that it does so actually happen – it would be a case of “purchasing power through commerce,” a method by which the economy partially could free itself from the bridle of money. However, we wish to disregard this, and assume, following the way things usually happen, that all the diversion takes place through banks.

Forms of Saving

We wish to distinguish between three forms of saving. First, major corporations can lend cash on the money market that they do not currently need. After that, households and ﬁrms can invest such funds short-term – either in short-term assets, or by putting short-term funds into long-term investments that nevertheless can be cashed in at any time. We will get into these two modes later. Finally, they can just leave their currently surplus funds with the bank. By [312]virtue of this practice, the banking system realizes the tendency toward temporary use of cash on hand or, what is the same, toward limiting cash holdings to the immediately required minimum, in almost perfect manner.

Insofar as the banks pay interest on checking balances to their customers and these customers are satisﬁed with this interest, the tendency of balances toward a minimum is overridden. The deposit amounts not currently required by customers are not put to use elsewhere, but the fact that they are not otherwise turned to account amounts to nothing more than the eﬀect that the banks, which because of this need less cash and, where the reserve position stands at their discretion, fewer reserves, correspondingly can extend more credit. For the rest, this simply explains the practice (and the possibility) of interest payments on checking balances. We also become acquainted with a new motive that moves customers to give bank-mediated shape to their cash management. Finally, the tension of the bank status at certain periods, during which those deposit amounts are used by customers, becomes understandable. But that’s it.

When customers turn their momentarily surplus deposit balances into time deposits, this makes possible a credit that arises in the place of the cancelled checking balance. At this stage, the former is thereby “compensated.” And if the customer then in turn wishes to have the time deposit revert back to the original checking balance, the new borrower in our case pays back and by this act extinguishes the corresponding deposit amount, so that again there is compensation. Therefore the deposit amount, apart from momentary ﬂuctuations between the points in time of credits and debits, has not changed, any more than it would have if the holder of the original deposit amount had immediately lent out that amount.

The Short-Term Character of Capitalist Finance

We can now better understand a major characteristic of the ﬁnancial management of the capitalist economy, which is just as important as it is strange, and very much has to do with both the eﬀectiveness and the sensitivity to disturbance of the capitalist machine. We observe, namely, that a very large part of the capitalist process is ﬁnanced, as it were, overnight, which ﬁnancing solves its monetary and credit problems only for the moment, and that even the most enduring and most regular things ﬁnancially are taken care of day to day, short-term for long-term. This fact will present itself more clearly to our minds (and by the way, this aspect of things was touched on during our overview of the credit technique), if we consider the fact that, even viewed superﬁcially, lasting and long-term ﬁnancing, such as a bond issue, in turn rests on a short-term [313]basis. There are of course many reasons for this, especially because momentarily changing situations and momentary external disturbance, and the expectations people harbor with respect to both these circumstances and their eﬀects, compel provisional measures and interim solutions. But the fundamental cause of this situation lies in the just depicted aspect, that every household, every ﬁrm, every bank tries “otherwise to turn to account” momentarily excess cash holdings and ultimately become borrowers for their own needs.

This puts business credit and its role ﬁrst in the proper light. Under the assumptions of the current thought process, “circulating” capital naturally must be put at the disposal of the new ﬁrm by the ﬁnancing bank, in just the same way as must the layout for production equipment and its accoutrements, ﬁxed capital – and this circulating capital must be “newly created,” as far as the just-introduced aspect of saving¹² does not render that creation unnecessary. The old ﬁrm, i.e., the ﬁrm associated with the stationary circular ﬂow, in principle requires none because it supports its production expenditure from income. Otherwise, only as much lending of this nature would be outstanding in the area under study as would be granted freshly to new ﬁrms for the ﬁrst time or in the further course of things, until these liability items are paid oﬀ and the new ﬁrm – having become an “old” one – can cover current production expenditure from income. But in reality this is not only not the case, but almost the reverse of things. By virtue of the urge to temporary investment, the old ﬁrms expose their balances, so that they routinely become borrowers. And the new never penetrate to the point that they are funded by income. Rather, all ﬁrms now develop demand for business loans and for obvious reasons precisely this business tends to become the typical – “regular” – banking activity, whereby the bank in each case, for just as obvious reasons, prefers the loan application of the proven and settled ﬁrm to the loan application of the new ﬁrm.

To understand the nature and the role of working capital, it is nevertheless very important to understand that this appearance of reality does not represent the fundamental character of the matter but conceals it, in fact inverts it. Because, in [an economy undergoing development, business expenditure is ﬁnanced through credit, this¹³] generates ﬂuctuations that link to seasonal processes in the economic body but stem from the development wave, and gain their practical importance from the economic phase with which they coincide. In times in which payments pile up, for example each “last day of” and even on [314]the “payment date” of a week, we ﬁnd tension in bank status. On dates or date sequences in which large payments of a certain kind are ﬁrst prepared and then have to be completed, the same holds true. Hence, especially where income tax is to be paid at one time, the income tax deadline is noticeable in banking statistics. Thus also the movement of crops, particularly in countries with heavy capitalization. Thus generally the campaigns of industries that do not produce or sell evenly over the year. Thus also the travel time and the business of annual festivals, particularly Christmas shopping. Conversely, after these dates a relaxation occurs: bank loans sink, their cash and reserve holdings increase, and these times are particularly favorable to monetary policy interventions because the credit organism is then relatively insensitive and can be shaped, in particular curbed, without major disruption of economic activities. If, for example, the central bank wishes to put on the brakes, then at that moment, for example immediately after the settlement of Christmas shopping, it needs, through central bank investments, to absorb the excess reserves of member banks that otherwise would make them more inclined to easier lending; and the undesired credit expansion is relatively painlessly rendered impossible, while the same experiment undertaken before the holiday season could trigger a collapse.

The account-settling system of a stationarily reproducing economic process would not yield such ﬂuctuations. Also, all large payments or payment accumulations, be they ever so discontinuous, would continuously be taken care of by households and ﬁrms, and the collected balance totals would just disappear from their accounts on the due dates to appear in the accounts of the receivers, so that the position of the banking organization as a whole on these dates would be diﬀerent than usual only insofar as its cash holdings would be temporarily reduced, but only for sums that at other times would be stored unused in its basements.

An income tax deadline, for example, can have the eﬀect that it actually has, therefore, only because the taxpayer either takes up credit ad hoc for the fulﬁllment of the payment, or temporary liquidates his investments. And this fact makes sense and becomes understandable only through the credit requirement of new combinations and the premium of the unit of account premised thereon. This also takes care of the fact that an approaching due date of this type tightens things up not only for the banks but also for business, which have removed from them precisely the temporarily available means earmarked for the purpose of tax payments. Also the necessary funds for the “movement of the harvest” would already have been made available to the participants in a stationary economic process from the proceeds of the previous harvest. When that is not the case, and a new ﬁnancing problem arises every time (even if the [315]harvest is just as great as the previous one, and prices and costs have not changed), which must be solved by creating additional balances and withdrawing balances from other courses, this has only to do with [… ¹⁴].

The tension of the bank status is eliminated and relaxation is precipitated by the fact that the recipients are credited with their income and do not use it immediately and completely, or, when the income extinguishes debits, do not borrow immediately and to the same extent. The tightening of money transactions that generally arises in those cases in which ﬁrms are not the recipients of the deadline payments (such as income tax) and in those cases in which sectors of commerce that are not involved in these cash receipts (such as with the movement of crops) receive those deadline payments, is eliminated by the recipient spending or beginning to borrow again. Both tension and relaxation are mitigated thereby.

The Money Market

E. Hereby (A-D) emerges a new market that we shall call the money market, which is of central importance to the remainder of our discussion. Of course, we could include this type of market in the image of the stationary circular ﬂowof the economy, but nothing particularly interesting would happen there and no one would recognize it as the anchorage or epitome of unique phenomena in such an economy or, from the mere recording of events in the pan-economic accounts that would take place there, even connect it to the concept of a market at all. In this sense it owes not only its practical and theoretical importance, but also its existence, to development, although once present it also incorporates the monetary operations of the circular ﬂow. It was development that ﬁrst made immediately disposable sums of money into a “commodity” with a “price.” We are so used to this amazing fact that we must immediately add that both expressions do not yet cease to be metaphorical and never should be used in entirely the same sense that they have in the world of goods. This already results from the relation to the payment system characteristic of this market, thus to that single activity of all other markets, which make its functions in the economic body understandable and which make it into the central organ thereof. This relationship between payment or settlement and credit is embodied in the banking organism and is equally fundamental to both the domestic money market of an area and the international market. The division of labor that creates special types such as bill brokers in many cases overshadows it, and [316]superﬁcial or erroneous interpretations easily attach themselves to such – seemingly eminently “real” – component parts of the great machine.

Exchange of Present for Future Balances

1) Nevertheless, it is here – in contrast to the problem area of the value of money – that the scheme of supply and demand applies, as the reader has already seen in section A above. Here it is appropriate and faithful to reality¹⁵ to characterize disposable balances as the commodity itself and not, as the language of practice partly does, the securitization given for it,¹⁶ although for other purposes, particularly for the description of the various specialty markets (the bill market, etc.) another form of expression may recommend itself. We can, adopting a felicitous formula of Böhm-Bawerk‘s, deﬁne what happens on the money market as an exchange of present against future balances. Only this deﬁnition must be extended in two directions: ﬁrst, the word “present,” when we include inter-regional and international processes, can be understood not only in time but also in location, so that balances available elsewhere can then be set alongside future balances. Second, present balances can be exchanged against future balances in two basic forms, which one ought to distinguish: the “money lender” may in future receive back the principal plus a premium (interest), or he can, instead of the sum of these two items, receive a basically¹⁷ permanent return.

This simpliﬁes the picture in terms of a single viewpoint and eliminates apparent problems. But it distances us from customary terminology.

The Primacy of Created Deposits

2) Viewed from the standpoint of our model of economic development, the basic operation of the money market consists in the ﬁnancing of new combinations of existing means of production by ad hoc newly created deposits. The strangeness that still adheres to this view disappears when we formulate it a little more cumbrously: the basic operation of the money market consists in the ﬁnancing of production, trade, and speculation, the transactions of which ultimately require a special ﬁnancing operation, since new combinations are being established with the help of “means,” of which newly created ad hoc means have the logical priority.

[317]The Character of Demand

Demand on the money market thus is built upon the following components: demand from entrepreneurs in our sense; demand from ﬁrms that as a result of real income boosted by development, likewise in our sense, now can expand their production over that amount that corresponded to the previous equilibrium;¹⁸ demand from ﬁrms that have occasion for production expansion due to population growth, progress in saving or changes in taste; demand from ﬁrms that temporarily wish to deal with stagnating sales, declining prices, or rising costs by taking on credit; demand from ﬁrms and households desirous of taking speculative advantage of opportunities or speculatively fending oﬀ threats; and ﬁnally, in the limiting case of fully developed credit traﬃc, demand from all ﬁrms in the full amount of their circular ﬂow-oriented production costs, including interest payable and taxes, if we imagine that each item of income ﬁnds its way to the money market and each expenditure is taken out of the money market – that in this way each ﬁrm’s cash holding is woven into the nexus of the money market. To this bulk are added demand for consumer credit, that we can divide conveniently into consumptive public credit in all its forms, from the bank-mediated current account credit line to “interest in perpetuity” (“rente perpetuelle”), to household consumer credit, the main form of which, installment credit (“installment selling”),¹⁹ admittedly usually is subsumed in the credit demand of concerned ﬁrms, and for the quasi-consumptive credit of that business community that, like a large part of agriculture, is not in a situation to use the credit it takes up to generate a surplus return to cover interest and repayment rates.

The Character of Supply

The “supply” of the credit market must be spoken of with even greater caution than demand. For here we have even less than with the latter to do with the supply of a phenomenon analogous to a commodity, especially even less with analogous objective determinants of supplied “quantities.” As we know, this supply is composed of the deposit supply of banks, i.e., the deposit supply that the banks control, plus the deposit supply subject to the dispositions of others, such as for example when someone buys a share or acts directly on the “open market” at the expense of his bank account. Even the non-banking lenders – insurance companies, state funds, large corporations, households – make use of the mediation of banks (except when they lend coins or paper money, which [318]we wish to disregard here) at least to carry out their operations and usually also for further aid. But their supply is not subject to the dispositions of the banks and sometimes thwarts them.

Regarding the character of the supplied deposits, the sum that the banks are able and willing to create afresh is to be diﬀerentiated from incrementing amounts of savings and reserves, furthermore also diﬀerentiated from the sums that are released by transacted deals, and ﬁnally from the amount of deposits that, although earmarked for other purposes, are made available for temporary investment. As we also already know, these sums are not independent of each other. They inﬂuence each other and sometimes relieve each other. And for the individual bank and the banking system, the savings and reserve totals of customers, the freed and temporarily available balances, are among the factors that determine how much in new balances the bank or the system can create.

In the supply provided by banks, the diﬀerence between customer credit and interbank credit is especially to be noted. Balances that lenders mutually make available to each other of course are merely determinants of the sums corresponding to industrial, commercial, and consumptive demand, and must be separated out when this is the case. In particular, central bank credit granted to or allowable to member banks, and the credit such banks grant to other banks, making central banking functions accessible to them (see above, pp. 165 f.), is an aﬀair in itself. But it cannot be stressed enough that this class of transactions cannot be separated from the economically relevant transactions with business clientele. Suppose, e.g., that a central bank, that also serves industrial clientele, in accordance with our basic scheme, discounts a bill from one such customer. This customer now has a deposit balance at the central bank. If it disposes of that balance in favor of a ﬁrm that has a diﬀerent bank, the latter now acquires this deposit, which increases its reserve, just as if it had directly taken up central bank credit. And so there is one whole set of transactions that at the same time has both customer- and interbank-credit signiﬁcance, and is attributable to both categories.

A similar phenomenon is based on the aspect of temporary investment. If a concern issues a bond, it signiﬁes demand for one type of credit. But it also signiﬁes supply of another type. Because the payments that it receives, or even a deposit that it receives with respect to expected payments, and which it does not need immediately, it can oﬀer short-term, so that balances make their appearance that simultaneously or nearly simultaneously are both demanding and supplying, which then on the market leads to well-known, and at ﬁrst sight astonishing movements, whereby the market “tightens” in one direction while it “loosens” in another.

[319]

The Interest Rate as Barometer?

3) The structure of the supply of and demand for deposits explains a curious contradiction in the factual picture of this market. The distribution and redistribution of the money of account of the economy-wide settlement process takes place on it in a manner geared to strengthening the false basic assumption that here something is being disposed of that has an independent separate existence. Because here, directly or indirectly, every economic act seeks possibilities of implementation and every actual or potential [vorhandene oder schaﬀbare] unit seeks to be turned to account: all processes of the region under investigation indeed ﬂow together in this market. However incomparable they may be with each other, here they are all commensurable and communicating. The abstract balances of all households and ﬁrms are squared here, they all form a cumulative situation. Here present and future values, present and future possibilities ﬁnd their common denominator. Although there is no tendency to form a single “rate” of proﬁts in our sense and, e.g., a weighted average of business proﬁts over a period of time only makes statistical sense, not theoretical sense, theoretically at any one time there should be a single interest rate as the price element of a homogeneous commodity²⁰ in a single market. This interest rate would give the most meaningful of all our time series and the best index for the pulse of the economy. It would indeed earn the name of a “gauge of the economy,” which is so often attributed to it.

Note that the rate of interest naturally expresses the current overall situation of the funds market [Guthabenmarkt], which in turn is the immediate resultant of all current economic conditions and processes, whether temporary or permanent. It is the nature of the funds market, because all the diﬀerent purposes of the economic world are to be capable of being compared, to make them comparable from the standpoint of the current point in time, temporally as well as materially, as would happen in an economic central oﬃce. If we bring this into connection with the knowledge previously gained to the eﬀect that temporary provision is made for balances requiring ﬁnancing, then the totality of the momentarily available “means” confronts the totality of currently existing demand variables, taking both as homogeneous masses. Of course there are funds, long-term assets and purposes, that seek satisfaction in a legally long-term form, such as bonds. But the mechanism of the market entails ﬁrst, that they be made serviceable to short-term purposes, and second that, because of their fundamentally given marketability, they can be satisﬁed only with funds available short-[320]term. It follows that there are no economic – as opposed to legal – long-term assets in fully developed capitalism at all,²¹ and furthermore that the rate of interest by its very nature is always short-term. The long-term interest commitment, which a bond bears, is only of technical importance; the real interest comes to expression in the yield, that changes from day to day in the ﬂow of ﬁnancing-requirement balances and which conforms to the essentially short-term situation. When we speak of the long-term interest rate – the so-called “customary” [landesübliche] rate is a special form of it – we do not mean a particular phenomenon, but simply the average magnitude observed over a longer period of time, which may ﬂuctuate around the actual interest rate, just as the long-term wheat price is not understood to be a particular kind of price that exists next to other wheat prices, but only a variable adjusted for seasonal or even cyclical and random ﬂuctuations, which has the nature of a statistical norm.

But if we approach the material of interest rates observable in reality with this expectation, a disappointment awaits us. We ﬁnd many interest rates and, worse yet, not one of them provides us with what we need; not one can be addressed as “the” theoretical interest rate. And even if we could catch sight of one of them in that above-mentioned gauge, then we would be dealing with an instrument that served a child as a toy before it came into our hands. Only²² with this restriction can we oﬀer the partial consolation that changes in the various interest rates provide more insight than their absolute values.

The metaphor of the toy is not in the ﬁrst place here directed at the interest rate being subject to conscious inﬂuence of monetary policy considerations. Because after all, this could lie within the logic of the mechanism. Even an active discount policy, which does not simply express the market situation, can just correct aberrations and wish to ensure the systematic functioning of the machine, and in a deeper sense be merely “declaratory.” When under a gold drain the central bank increases its bank rate and makes this increase eﬀective by investments, this need not signify anything except that an existing imbalance should be corrected. We already know enough about the nature of the credit organism to understand that without such aids it can function systematically [321]only under particularly favorable circumstances. Or, if the public is to be led back to normal cash management, and inﬂation is to be inhibited by “artiﬁcial” rate increases, the process by which this occurs does not ipso facto drop from the range of aspects of which the monetary life process is composed. But the rate of interest is also shaped from other points of view. Above all, there is always a politically very powerful desire for “cheap money” or – economically not much less senseless – as constant a rate of interest, or at least as constant a central-bank rate, as possible. The banking world and its central organ, which is especially exposed to political pressure, accedes to this wish, so that even the discount rate and current account rates of member banks are less ﬂexible than accords with their organic role. This is the case to an even greater degree with regard to the central bank rate. Recently the idea that these kinds of adjustments are a cure for depression has led to manipulations of rates and in particular the money supply that rob interest rates of their meaning and, to the degree that they have an eﬀect, are the fountainhead of bad investments.

But in reality, money interest is not just a spoiled gauge; it does not function satisfactorily even judged on its own terms. It is known to lag behind other symptoms in the change of phases. The reason is that there is unemployment of credit [Guthaben] as well as unemployment of workers. The statistical recognition of this phenomenon is complicated by the fact that while the unemployed worker is still present and can be counted, the unemployment of credit is expressed only in part in the inertia of the “existing,” [bestehenden] and in part by the fact that credit that no one wants cannot “arise” [entstehen] at all. If during previous periods a particular enterprise regularly conducted bill issues, bill discountings, and deposit creations, but in the current period has ceased to do so, and therefore presents no bill at the relevant bank, then the credit does not materialize and the potential presence of balances could at most be tapped from unused elements of the reserves of that bank. Every situation and every transaction of this market must be viewed in the light of these two types of [variations]. We will return to this point below.

More importantly, thirdly, we are not dealing with a perfect market of free competition. Such is known to exist if, ﬁrst, none of the demanders or suppliers is strong enough to inﬂuence prices by its individual behavior, and second, every demander and every supplier is willing and able to transact indiscriminately with any supplier or demander. The ﬁrst condition is not always met, the second never, which is why this market is divided into submarkets, where diﬀerent prices and opposite price trends can prevail.

[322]A large part of the non-bank supply of credit, particularly the actual savings supply, is supplied by “facilities” [Anlagen] determined by the public authorities. In Germany, for example, the rules on trustee security status [Mündelsicherheit], the area of operation of savings banks, insurance companies, social security agencies, and so on, work in this direction, which put these means almost entirely at the service of the borrowing requirement of the empire, the territorial states, the municipalities, agriculture, and the residential home. This removes these sums completely from direct consideration of other borrowers or of loans in other forms, and an interest rate diﬀerential arises that is not, or not fully, explanatory by risk diﬀerentials. Tax incentives and the like work in the same direction. Furthermore, many providers do not have access, or direct access, to many parts of the funds market. For example, private savers cannot just discount bills. Finally, the majority of remaining non-bank supply has its own habits or preferences that determine the path taken. Savers’ hidebound and very pronounced inclinations (which by the way diﬀer greatly in diﬀerent countries – for example, their preference in some countries to invest in government bonds), belong to this category,²³ along with savers’ habitual overvaluation of shares, sometimes also the overvaluation of “cheap,” i.e., the most dubious, debt securities. That such external interventions, arational aspects, risk diﬀerentials, special advantages and disadvantages of eligible business representations and instruments embodying them (bills of exchange, bonds, stocks, and so on), or their characteristic sureties (guarantees, inventories, stock market securities, real estate, and so on), lead to various – stipulated as well as actually attained – returns, from which the element of pure interest that they may contain can hardly ever be satisfactorily separated out, is not further surprising.

Moreover, the fundamental marketability of each title in reality only imperfectly replaces the right to recover the amount surrendered, above all the right to recover it at short notice or at once. This aspect is particularly important for the part of the money supply that is seeking temporary investment while it is waiting to be used for other intended purposes in the future, and thus it is especially important for the part of the bank-mediated supply’s “secondary reserve” and for the parts of the supply held by non-bank ﬁrms that wish to exploit their “cash in hand” temporarily. This aspect is particularly important for the part of supply that is seeking temporary investment while intended for other purposes, thus especially for part of bank-mediated supply’s “secondary reserve” and for the supply of non-bank ﬁrms that wish to exploit their “cash in hand” [323]temporarily. These sums are needed by the suppliers themselves. They are supplied because they are not immediately²⁴ needed. This means now not only that only particular, and not just any, demanders, intended purposes, and types of instruments come into consideration, but also that this part of the supply is inelastic, that is, interest-rate insensitive – it takes what it can get, regardless²⁵ of whether that is a lot or a little, and it is available independently of the interest rate oﬀered.

It is much the same with demand. This also contains inelastic (although highly variable) elements, especially the credit demand from ﬁrms that, locked into running contracts, must continue to run even at a temporary loss, and credit demand for certain transactions, e.g., those of such a speculative nature as not to be calculated precisely to a few percent, or for situations in which one absolutely must have a certain amount to stave oﬀ bankruptcy or extreme developments. In itself, this would not matter – every demand has inelastic elements, for example, demand on the part of relatively wealthy segments for bread is inelastic. But while this demand for bread otherwise ﬂows together indiscriminately with other, more elastic elements, the inelastic part of demand in the credit market – in turn in part – is thrown on to very speciﬁc sources of supply, and in particular certain categories of bank means, while other sources of supply are not accessible or are diﬃcult to access, so that a semi-independent special market is created. And otherwise, for the most disparate reasons demand has a preference for many types of instruments or sources of supply, which are only in keeping with some and not all suppliers. In addition to the interest rate, the nature and timing of recovery claims always comes into consideration for demand, which often make the cheapest money unacceptable. But the latter is not thereby dispensed with. We again emphasize that, in order to understand the situation, it is essential to see that in this case the cheapest money helps to ﬁnance the actually selected contract ﬁgure. When an industrial company receives a “long-term” bond, other people, the signatories, as a rule take up “short-term” loans to make the payment. But here the basic principle of the instantaneous ﬁnancing possibilities of the single market comes indirectly into its own, for which reason we assumed it. But it entails that a spread arises between the interest of such bonds and the interest of the credit drawn by the signatories, or that, as we might also put it, the interest burden borne by the bond debtor is split, or can be split, into various returns of diverse balances standing behind one another. The signatory, who himself takes on “credit” to make the pay-in, [324]fulﬁlls the function of freeing the bond debtor from concern for ongoing funding, and for this receives, as it were, a kind of commission.

The motives that demand may have to prefer certain sources of supply are legion. Depending on the condition of the market, bank lending recommends itself sometimes more, sometimes less than bond issues, and these in turn more or less than share issues. Business policy may make “dependency” upon a bank desirable (because the “dependency” of a ﬁrm on a bank often in practice means that the bank is dependent on the debtor, and must keep re-borrowing to preserve what has already been lent) or policy may make desirable precisely independence from banks. It may be desirable to face a large number of small bondholders or shareholders, or else certain types of shareholders (as it is easier to live with some than with others), or to exclude speculation or, on the contrary, precisely to put it in the service of credit provision. All of which reinforces the tendency to the formation of special markets and diﬀerentiates the interest rate, especially in the form of price diﬀerences of instruments (shares and bonds), despite the same return and quality.

The Money Market as Heart of the Capitalist Economy

Therefore, our originally derived conception of a homogeneous credit market, that brings all demand for and supply of all credit to a common denominator and settles all balances at every moment for the moment, is valid only at a higher level of abstraction.²⁶ It should be seen in the light of the facts outlined above, and must be modiﬁed as soon as we turn to the reality of the presented material. But by no means does it lose its cognitive value with respect to this. Rather, this homogeneous market remains the basis for understanding the interactions of all of the submarkets that arise in practice, and from practice it can be divided into a variety of ﬁne subdivisions and according to various aspects, in particular the types of instruments and business forms, as for example the private discount market, the overnight and time money markets [Taggelds und des ﬁxen Geldes], the foreign exchange market, the bill market, the bond market (from now on, by the word “bonds” we mean all corporate bonds in the broadest sense), the market for government bonds (we mean “consols”), the stock market,²⁷ the market in mine share certiﬁcates [Kuxenmarkt], the mortgage market, and so on – all of which are nothing else than merely commercially and bank-technically hived-oﬀ parts of a whole that can be fully grasped only as [325]such. The contradiction between the uniform rate of interest postulated in theory, which [is] the expression of the instantaneous position of the entirety of economic life and which would in principle be applied to all economic activities envisaged at that moment, and the multiplicity of interest rates often manifesting opposing tendencies, is therefore only apparent and disappears when one penetrates through the surface of appearances.

This is also the reason why all previously proposed classiﬁcations of the funds market in wholes to which are attributed theoretical meaning, and which are more than the just mentioned submarkets of practice, have proven to be unsatisfactory. Practice itself distinguishes between the money and capital markets, and in general by the former – the language varies in diﬀerent countries – comprehends that which the money market articles of the daily newspapers report on, the traﬃc in stock exchange money [Börsengeld], and thus also overnight, term [Ultimo], time money [Fixgeld], in private discounts, in foreign currency, mostly also in commercial bills, as well as central bank operations and the ongoing public ﬁnancial requirement; by the latter, on the other hand, is understood the conditions and processes of the stock and bond markets. But this means nothing more than the stressing of those elements in the funds market that eminently characterize the current situation. Never can this money market report be kept free of elements that are anchored in the capital market in this sense.²⁸ From which one sees that it is only a short, and thereby incomplete, report on the “money and capital market” touching only on the most important factors.²⁹

Science was and often still is inhibited in the task of unbiased recognition of the contours of reality in this area, and in the provision of clear terms, by the eﬀort to put the phenomena of the monetary sphere into the straitjacket of a conception of “capital” that disregards money and its self-movements. On the money market or capital market, it is deﬁnitely real goods, machinery, or raw materials that are disposed of, or at least it is the “power of disposition” over such “in money form,” which has led to quite unrealistic constructions of contexts and equally unrealistic ideas about what is to be viewed as normal, what abnormal, what is essential and what is nonessential. When ﬁnally [a] thorough analysis indeed has shown the existence of a multiplicity of sub-markets but also the inconsistency of drawing a fundamental distinction between money and capital markets, only the separation according to “maturity” is left, a consequence [326]drawn by Spiethoﬀ in his prominent treatise.³⁰ It could here essentially be adopted if on the one hand it did not incline to overshadow the nature of interlacement of these two markets and evoke the idea that they are two diﬀerent things, while on the other hand it does not do justice to the multiplicity of operations. This, then, is the value of our consistent view, that it brings to mind the coordination of all of the many sub-markets into which the funds market is divided, so that the analysis remains an analysis of the “capital and money market.” Henceforth, we adopt the name “money market” for it.

It is always money, available or creatable funds, and not just goods, not goods “in the form of money” or “in the form of money-capital,” which is transferred on the “money” or “capital” or “money and capital markets.” There is no point in disﬁguring this completely straightforward factual situation with ambiguous words or hasty attempts at interpretation. The making of quite misleading links between money and goods operations and the blurring of essential processes have been the result. In particular, the triad made up of saving – capital in money form – capital goods (by which is meant primarily industrial plants, buildings, and machinery), which was popular with the older theory, led to the erroneous conviction that capital in the capital market was withdrawn from the circulation of the income sphere, that purchasing power creation could not increase it, and that there is a necessary or even a clear relationship between those three things. Therefore a necessary correlation between savings and durable goods devoted to the generation of future production was constructed, between “money capital” and “real capital,” which correlation was continuously fashioned on a special capital market; but this is an image of a case that, while certainly intellectually possible, is very unique and becomes false when made into the theoretical base case.

But at bottom the older theory viewed the task that arises more correctly than does much recent research. Just because the money market directly has to do only with money of account, and with “capital formation” only in the sense of providing credit, with “use of capital” only in the sense of allocating these assets to whatsoever demand, it can never be understood by itself, with e.g. the help of a mechanism of bank reserves, interest rates, and the like. This attempt leads to an overestimation of the causal role of monetary operations and thus become a source of errors regarding crisis management and so on.³¹ [327]Rather, there is now only a particular problem, how the money market and goods markets working together produce those cash and goods ﬂows that make up the economic process. Before we enter this set of problems again, we still need to add some other elements to our outline of principles of explanation. It should only be noted ….³

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¹⁰It is recommended that the reader concede the theory that the interest rate, as a necessary element of capitalist production, is a consequence of its development and would be absent in a stationarily reproducing economic process – consumption interest, and production interest as a result of consumption interest, could nevertheless exist, if not to the extent that it actually exists – at least as a representational hypothesis of the presented analysis. Should he however not be able to free himself from the prejudice of the omnipresence of interest, let him, as was already suggested in chapter 5, in the above representation replace the equilibrium rate of interest of zero by a positive magnitude (not necessarily a constant) and then allow what is said to apply to those ﬂuctuations that indisputably are entailed by entrepreneurial demand.

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²¹In particular it is not the case that long-term investment necessarily requires long-term funding. The individual borrower may be satisﬁed for the long term and protected against premature reclamation through the appropriate choice of legal form. But, economically speaking, things do not end with the pay-in of the loan amount – instead, the bond remains an element of the short-term market condition, as long as it lives: it is shuﬄed back and forth, its price is adjusted daily – it is, so to speak, reﬁnanced every day.

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³⁰Arthur Spiethoﬀ, “Der Begriﬀ des Kapital- und Geldmarktes” [The Concept of the Capital and Money Market], in Schmollers Jahrbuch [Schmoller’s Yearbook], 44, 1920, pp. 981-1000.

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