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§ 4.1 I have, thus far, considered loans, and the rate of interest, as a matter which concerns capital in general, in direct opposition to the popular notion, according to which it only concerns money. In loans, as in all other money transactions, I have regarded the money which passes, only as the medium, and commodities as the thing really transferred—the real subject of the transaction. And this is, in the main, correct: because the purpose for which, in the ordinary course of affairs, money is borrowed, is to acquire a purchasing power over commodities. In an industrious and commercial country, the ulterior intention commonly is, to employ the commodities as capital: but even in the case of loans for unproductive consumption, as those of spendthrifts, or of the Government, the amount borrowed is taken from a previous accumulation, which would otherwise have been lent to carry on productive industry; it is, therefore, so much subtracted from what may correctly be called the amount of loanable capital.

There is, however, a not unfrequent case, in which the purpose of the borrower is different from what I have here supposed. He may borrow money, neither to employ it as capital nor to spend it unproductively, but to pay a previous debt. In this case, what he wants is not purchasing power, but legal tender, or something which a creditor will accept as equivalent to it. His need is specifically for money, not for commodities or capital. It is the demand arising from this cause, which produces almost all the great and sudden variations of the rate of interest. Such a demand forms one of the earliest features of a commercial crisis. At such a period, many persons in business, who have contracted engagements, have been prevented by a change of circumstances from obtaining in time the means on which they calculated for fulfilling them. These means they must obtain at any sacrifice, or submit to bankruptcy; and what they must have is money. Other capital, however much of it they may possess, cannot answer the purpose unless money can first be obtained for it; while, on the contrary, without any increase of the capital of the country, a mere increase of circulating instruments of credit (be they of as little worth for any other purpose as the box of one pound notes discovered in the vaults of the Bank of England during the panic of 1825) will effectually serve their turn if only they are allowed to make use of it. An increased issue of notes, in the form of loans, is all that is required to satisfy the

1 [The first three paragraphs of this section were added in the 6th ed< (1865).]

demand, and put an end to the accompanying panic. But although, in this case, it is not capital, or purchasing power, that the borrower needs, but money as money, it is not only money that is transferred to him. The money carries its purchasing power with it wherever it goes; and money thrown into the loan market really does, through its purchasing power, turn over an increased portion of the capital of the country into the direction of loans. Though money alone was wanted, capital passes; and it may still be said with truth that it is by an addition to loanable capital that the rise of the rate of interest is met and corrected.

Independently of this, however, there is a real relation, which it is indispensable to recognise, between loans and money. Loanable capital is all of it in the form of money. Capital destined directly for production exists in many forms; but capital destined for lending exists normally in that form alone. Owing to this circumstance, we should naturally expect that among the causes which affect more or less the rate of interest, would be found not only causes which act through capital, but some causes which act, directly at least, only through money.

1 The rate of interest bears no necessary relation to the quantity or value of the money in circulation. The permanent amount of the circulating medium, whether great or small, affects only prices; not the rate of interest. A depreciation of the currency, when it has become an accomplished fact, affects the rate of interest in no manner whatever. It diminishes indeed the power of money to buy commodities, but not the power of money to buy money. If a hundred pounds will buy a perpetual annuity of four pounds a year, a depreciation which makes the hundred pounds worth only half as much as before, has precisely the same effect on the four pounds, and cannot therefore alter the relation between the two. The greater or smaller number of counters which must be used to express a given amount of real wealth, makes no difference in the position or interests of lenders or borrowers, and therefore makes no difference in the demand and supply of loans. There is the same amount of real capital lent and borrowed; and if the capital in the hands of lenders is represented by a greater number of pounds sterling, the same greater number of pounds sterling will, in consequence of the rise of prices, be now required for the purposes to which the borrowers intend to apply them.

1 [The text of this and the next seven paragraphs is an expansion in the 6th ed. (1865) of two paragraphs of the earlier editions.]

But though the greater or less quantity of money makes in itself no difference in the rate of interest, a change from a less quantity to a greater, or from a greater to a less, may and does make a difference in it.

Suppose money to be in process of depreciation by means of an inconvertible currency, issued by a government in payment of its expenses. This fact will in no way diminish the demand for real capital on loan; but it will diminish the real capital loanable, because, this existing only in the form of money, the increase of quantity depreciates it. Estimated in capital, the amount offered is less, while the amount required is the same as before. Estimated in currency, the amount offered is only the same as before, while the amount required, owing to the rise of prices, is greater. Either way, the rate of interest must rise. So that in this case increase of currency really affects the rate of interest, but in the contrary way to that which is generally supposed; by raising, not by lowering it.

The reverse will happen as the effect of calling in, or diminishing in quantity, a depreciated currency. The money in the hands of lenders, in common with all other money, will be enhanced in value, that is, there will be a greater amount of real capital seeking borrowers; while the real capital wanted by borrowers will be only the same as before, and the money amount less: the rate of interest, therefore, will tend to fall.

We thus see that depreciation, merely as such, while in process of taking place, tends to raise the rate of interest: and the expectation of further depreciation adds to this effect; because lenders who expect that their interest will be paid, and the principal perhaps redeemed, in a less valuable currency than they lent, of course require a rate of interest sufficient to cover this contingent loss.

But this effect is more than counteracted by a contrary one, when the additional money is thrown into circulation not by purchases but by loans. In England, and in most other commercial countries, the paper currency in common use, being a currency provided by bankers, is all issued in the way of loans, except the part employed in the purchase of gold and silver. The same operation, therefore, which adds to the currency also adds to the loans: the whole increase of currency in the first instance swells the loan market. Considered as an addition to loans it tends to lower interest, more than in its character of depreciation it tends to raise it; for the former effect depends on the ratio which the new money bears to the money lent, while the latter depends on its ratio to all the money in circulation. An increase, therefore, of currency issued by banks, tends, while the process continues, to bring down or to keep down the rate of interest. A similar effect is produced by the increase of money arising from the gold discoveries; almost the whole of which, as already noticed, is, when brought to Europe, added to the deposits in banks, and consequently to the amount of loans; and when drawn out and invested in securities, liberates an equivalent amount of other loanable capital. The newly-arrived gold can only get itself invested, in any given state of business, by lowering the rate of interest; and as long as the influx continues, it cannot fail to keep interest lower than, all other circumstances being supposed the same, would otherwise have been the case.

As the introduction of additional gold and silver, which goes into the loan market, tends to keep down the rate of interest, so any considerable abstraction of them from the country invariably raises it; even when occurring in the course of trade, as in paying for the extra importations caused by a bad harvest, or for the high-priced cotton which, under the influence of the American civil war, was imported from so many parts of the world. The money required for these payments is taken in the first instance from the deposits in the hands of bankers, and to that extent starves the fund that supplies the loan market.

The rate of interest, then, depends essentially and permanently on the comparative amount of real capital offered and demanded in the way of loan; but is subject to temporary disturbances of various sorts from increase and diminution of the circulating medium; which derangements are somewhat intricate, and sometimes in direct opposition to first appearances. All these distinctions are veiled over and confounded, by the unfortunate misapplication of language which designates the rate of interest by a phrase (" the value of money ") which properly expresses the purchasing power of the circulating medium. The public, even mercantile, habitually fancies that ease in the money market, that is, facility of borrowing at low interest, is proportional to the quantity of money in circulation. Not only, therefore, are bank notes supposed to produce effects as currency, which they only produce as loans, but attention is habitually diverted from effects similar in kind and much greater in degree, when produced by an action on loans which does not happen to be accompanied by any action on the currency.

For example, in considering the effect produced by the proceedings of banks in encouraging the excesses of speculation, an immense effect is usually attributed to their issues of notes, but until of late hardly any attention was paid to the management of their deposits; though nothing is more certain than that their imprudent extensions of credit take place more frequently by means of their deposits than of their issues. "There is no doubt," says Mr. Tooke,* "that banks, whether private or joint stock, may, if imprudently conducted, minister to an undue extension of credit for the purpose of speculations, whether in commodities, or in over-trading in exports or imports, or in building or mining operations, and that they have so ministered not unfrequently, and in some cases to an extent ruinous to themselves, and without ultimate benefit to the parties to whose views their resources were made subservient." But, "supposing all the deposits received by a banker to be in coin, is he not, just as much as the issuing banker, exposed to the importunity of customers, whom it may be impolitic to refuse, for loans or discounts, or to be tempted by a high interest? and may he not be induced to encroach so much upon his deposits as to leave him, under not improbable circumstances, unable to meet the demands of his depositors? In what respect, indeed, would the case of a banker in a perfectly metallic circulation differ from that of a London banker at the present day? He is not a creator of money, he cannot avail himself of his privilege as an issuer in aid of his other business, and yet there have been lamentable instances of London bankers issuing money in excess."

In the discussions, too, which have been for so many years carried on respecting the operations of the Bank of England, and the effects produced by those operations on the state of credit, though for nearly half a century there never has been a commercial crisis which the Bank has not been strenuously accused either of producing or of aggravating, it has been almost universally assumed that the influence of its acts was felt only through the amount of its notes in circulation, and that if it could be prevented from exercising any discretion as to that one feature in its position, it would no longer have any power liable to abuse. This at least is an error which, after the experience of the year 1847, we may hope has been committed for the last time. During that year the hands of the bank were absolutely tied, in its character of a bank of issue; but through its

* Inquiry into the Currency Principle* oh, xiv,

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