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Henry H. Villard

I. I n t r o d u c t io n
In t h e social sciences our accumulated knowledge is so small and the
unexplored areas so vast that of necessity we measure progress by the
understanding we obtain of particular and pressing problems. Thus
Adam Smith did not write primarily as a scholar but rather as a social
surgeon to remove from the body politic the surviving malignant remnant
of Mercantilism, while the emphasis of Ricardo and Mill on diminishing
returns and the rent of land directly reflected their interest in the ulti­
mately successful campaign of the rising business classes to end the im­
pediment to further industrialization represented by the Com Laws.
In the same way recent monetary theory direcdy reflects the unprece­
dented depression which rocked the industrialized world during the nine­
teen-thirties; in the United States, perhaps worse hit than any other
country, the increase in productive capital, which had averaged 6 per
cent a year for the first three decades of the century, over the ’thirties as
a whole was negligible in amount. As a result the center of interest has
in general shifted from the factors determining the quantity of money
and its effect on the general level of prices to those determining the level
of output and employment. In addition, the purely monetary devices for
control, on which great store had been laid, were found to be broadly
ineffective, taken by themselves, in bringing about recovery from the
Great Depression. And finally, as a result of the way in which the war
was financed, it seems quite likely that it will prove impossible to use
such devices for the effective control of a future boom. The general
change in emphasis is well indicated by the altered character of univer­
sity courses: in 1930 an outstanding elementary text devoted 144 of its
1250 pages to Money and Banking and 16 to the Business Cycle; in 1947
a new elementary text devoted 205 of its 700 pages to National Income
and Employment and 55 to Money and the Interest Rate!
The implications of this decreased emphasis need to be made quite
clear. Basically it reflects a reduced interest in the factors influencing the
quantity of the available means of payment and an increased interest in



the factors influencing the level of spending* Apart from unguarded
statements monetary theorists have of course generally been aware that
money had not only to be created but also spent if it was to have any
effect on the economy. But up until relatively recently the economy ab­
horred any large amount of idle balances. Thus the emphasis of monetary
theorists was on changes in the quantity of money, accompanied by the
sometimes stated and sometimes implied assumption that balances, once
created, would not long stay idle. It is with monetary theory in this nar­
row sense that this paper will be mainly concerned.
This narrow construction of monetary theory perhaps requires defense.
There can be no question that the fields covered by monetary theory, the
theory of compensatory fiscal action, and business cycle theory are at least
closely related if not actually overlapping. Further, business cycle theory
to a major extent, and fiscal theory to a lesser extent, evolved out of mone­
tary theory; as a result courses and economists have often in recent years
been labeled “monetary” when in fact they were dealing with employ­
ment, output, and income. But a broad use of monetary theory would not
only make it a synonym for business cycle theory but also would make it
impossible to describe separately work dealing predominantly with the
factors influencing the quantity of money. In other words, it has seemed
desirable to separate monetary from fiscal and cyclical theory in such a
way as to minimize the overlapping between the fields. I sincerely hope
that those who have been accustomed to define monetary theory more
broadly will not take offense at the relatively limited meaning which is
used in what follows, and will remember that it is monetary theory in the
narrow sense which is described as having declined considerably in im­
portance in recent years. It should hardly be necessary to point out that
the depression greatly increased the importance of monetary, fiscal, and
cycle theory taken together.
This paper will start with a description of some of the recent changes
in environment, both to summarize the contribution of those who have
worked bn the statistical side of monetary problems and at the same time
to explain why the changes involved have been so largely responsible for
our decreased interest in the quantity equation in recent years. A second
section will be devoted to the concepts of monetary equilibrium which
were developed as alternatives to the quantity equation, while a third
will cover changes in the explanation of the determination of the rate of
interest. Two final sections will deal with the financing of the war and
the heritage that the war has left us.
Any summary of developments during such a dynamic period in mone­
tary thought cannot fail to be impressionistic. In a literal sense, therefore,



the summary will inevitably be wrong; but in a broader sense it is only
the surviving impact of thought which is important. The obscure and
forgotten passage or the uses to which discarded tools of analysis might
have been put are not what matter* however much they may delight the
historian and prove that there is nothing new under the sun. It is, then,
to the broad view that this essay will be devoted; he who seeks details
will have to look elsewhere.
I I . T h e C h a n g in g M o n e t a r y E n v ir o n m e n t a n d t h e D e c l i n e
o f t h e Q u a n t it y E q u a t io n

Few analytical devices in economics have been as useful over as long a
period as the quantity equation of exchange. By the start of the 1930’s
there was considerable agreement that the equation was perfecdy valid
when properly—
i.e., tautologically—
defined.1 As first propounded by Professor Fisher, T included "all things sold for money” during any period,
so that V became all uses of money to buy "things” and P a hybrid price
level applying to all sales of “things” for money. The implications of this
usage were not made clearer by a general tendency to refer to T in this
sense as “trade” and to P as the “general” price level. Even if there can
be no analytical objection to this formulation, when an attempt is made
to derive statistical values, especially from figures for bank debits, many
problems arise. Even today little is known regarding the extent to which
bank debits reflect “money to money” transactions, such as transfers of
funds from one account to another of the same economic unit; while the
inclusion of sales of not only current output but also such diverse things
as stocks and bonds, urban and agricultural land, and second-hand cars
and antique furniture— mention only a few examples—
makes it diffi­
cult either to calculate an appropriate price index for P or to. attach any
significance to the resulting level of T.
. Although somewhat less easy to understand and therefore less gener­
ally known, the “cash balance” version of the quantity equation (espe­
cially as it was used at Cambridge University) and other examples of die
income approach were more in line with recent developments.2 This does
not result from the cash balance equation itself—
most simply written as
M equals fe.PT where k equals i/V — the formulation is subject to the
same problems and criticisms as the Fisher equation if the various terms
use M to buy T, T specific items sold for M, and P prices of T when
sold for M, then the equation is valid because it is a truism. The charge that the equa­
tion was not valid arose because in some earlier presentations use had been made of such
approximations as existing price indexes, which rendered the equation formally incorrect.
*Por the derivations or these approaches, see A. W. Marszet, The Theory of Prices
CNew York, 1938), pp. 303-343 and 414-458.



are given the same meaning. But the emphasis was on k defined as the
relationship between people’s money balances and their incomes, so that
PT referred, not to the total value of monetary transactions, but to the
total value of transactions in current output— other words, the national
income. This relationship seems clearly more significant for business
cycle problems than Fishers V.8
It was a combination of this shift in theoretical interest from the "trans­
actions” to the more fruitful "income” version of the quantity equation
and the availability of national income estimates that made substantial
statistical progress possible during the 1930s, while the statistical work
itself stimulated further analysis of the variables involved. Thus relatively
full information regarding the behavior of the terms of the quantity
equation did not become available until the controversy over the "quan­
tity theory” as an explanation of prices had largely died down.4
Perhaps the best place to start a description of the statistical progress
which took place is with the clarification—
largely by Currie and Angell—
of the concept of "money,” which has come increasingly to mean cur­
rency outside the banking system (in the hands of the public) and
demand deposits (deposits subject to check), including all government
deposits but excluding all interbank deposits. Currie uses this meaning
exclusively, while Angell also computes values for "total” money (includ­
ing time and saving deposits) but lays greatest emphasis on money in the
first sense, which he calls "circulating” money. Although the term may
of course be applied to any of a number of concepts, it seems clear that
this definition is most useful when our interest centers upon the primary
function of money as a means of payment or upon the most "liquid” form
that assets can take. The emergence, moreover, of large holdings by indi­
viduals of U. S. Savings Bonds, which are payable in a specific number
of dollars on demand, has eliminated the claim of time and saving depos­
its to special consideration. This development, plus the general accept­
ance of the narrower meaning of money, has led to the development of a
new concept of "liquid assets” to include money, time and saving de­
posits, and U. S. Bonds, although there is of course no sharp line between
assets which are or are not "liquid” but rather an infinite series of gra­
9 This point is discussed further on pp. 323-324 below.
4The volumes which contributed most to our understanding of the statistical magni­
tudes involved were L. Currie, The Supply and Control of Money tn the United States
(Cambridge, Mass., 1934); J. W. Angell, The Behavior of Money (New York, 1936);
and idem, Investment and Business Cycles (New York, 1941)- Much interesting work
has also been done by the Board of Governors of the Federal Reserve System and the
Federal Deposit Insurance Corporation, particularly through the periodic surveys of de­
posit ownership which are published in the Federal Reserve Bulletin.
6 Estimates of the distribution among various holders of “liquid assets” in this sense
have been published periodically, in the Federal Reserve Bulletin since 1945.



Probably the most striking fact to emerge from recent statistical studies
is the constancy of income velocity before 1929 and the size of the appar­
ently permanent decline since that date. Between 1899 and 1929 income
velocity— national income divided by money as defined above—
from 2.72 to 3.35, a variation of less than 25 per cent; yet during the
same period income and money increased more than fivefold.®
In co m e V e l o c it y A f t e r
















i -93













* In billions. Through 1939 the estimates are from Angell,
loc. du Thereafter the total used is the sum of "Currency
outside banks,” "Demand deposits adjusted,” and “United
States Government deposits for the end of June as re­
ported in the Federal Reserve Bulletin,
t In billions. All estimates are the revised national income
series of the Department of Commerce.

After 1929 velocity declined rapidly to about 60 per cent of its predepression level; thereafter, except for the boom year of 1937, it did not
exceed 70 per cent of its previous level until the war. During the war
velocity first rose to 2.50 during the relatively tight credit conditions
which marked the start of large-scale war finance in 1942— level higher
than in any year since 1930—
and then declined to 1.50 as the money
supply expanded during the later years of the war.7 Figures for the period
since 1929 are given in the table above.
6J. W. Angell, Investment and Business Cycles, pp. 337-338.
7 During 1947 a decrease of 8 per cent in the supply of money (as a result of the
reduction in Government balances to very low levels) brought about a rapid rise in
velocity to a level dose to that of the ’thirties. It wiU be interesting to see how long
this increase continues.



In addition to demonstrating the extent to which income velocity has
declined, recent studies have clarified the factors influencing the maxi­
mum level of income velocity.8 Of basic importance are the intervals
between successive payments during the circular flow of money from in­
come recipients to producers and back to income recipients, the degree of
overlapping of payment schedules (whether income received Friday is
used to pay bills Saturday or vice versa), and the degree of business inte­
gration; the amount of friction in the payment-transfer mechanism also
plays a role in the result. Because it is impossible to eliminate “financial”
transactions adequately, it is possible to determine only approximately
how many exchanges take place in the course of the circuit flow of an
average dollar from income recipient to producer and back again, but it
appears that, as we are presently organized, roughly ten dollars' worth of
'unfinished” output is exchanged for every dollar’s worth bought by in­
come recipients.0
The significance of these studies lies not so much in the actual numeri­
cal estimates made as in their conclusion that at least minimum balances
and maximum levels of income velocity are determined by relatively con­
stant factors unlikely to change rapidly except under the impact of run­
away inflations or drastic changes in payment practices or in the degree
of business integration. It is true that at present and probably in the future
actual balances will substantially exceed such minimum balances, which
reduces the practical importance of this information. But the understand­
ing of the monetary process that has been achieved is considerable, as can
be seen by comparison with formulations in which the level of actual bal­
ances is taken as being determined by the quantity of "ready purchasing
power” which people find it desirable “to keep by them.”.0 For such a
quantity would appear to be capable of rapid variation in any direction,
when in fact a reduction in balances below the minimum level is likely
to be difficult to achieve except under unusual circumstances.
Finally, these statistical studies have made clear that stock market
speculation can have a major effect on the level of exchange velocity
without reducing the amount of money available for purchasing current
output. Thus our broadest measure of exchange velocity indicates an in­
8Most of the credit again belongs to Professor Angell; see especially his article on
“The Components of Circular Velocity of Money," Quarterly Journal pf Economics,
February 1937, U , pp. 224-272.
9Idem, The Behavior of Money, p. 191* This includes “normal financial transactions
in which money is shifted between balances before being spent, but excludes transac­
tions connected with the stock market and the like. Additional discussion will be found
in H. H. Villard, Deficit Spending and the National Income (New York, 194O, p. 37,
note. •
“ See Alfred Marshall, Money, Credit and Commerce (London, 1923), p. 43 »•



crease of 85 per cent from 1922 to 1929 at a time when income velocity
was virtually constant. It was the distorting influence of changes of this
plus the difficulty of obtaining appropriate measures of the price
level involved—
which made the transactions version of the quantity equa­
tion so difficult to interpret.
To a major extent recent developments in monetary theory reflect the
implications of these findings—
especially the decline in income velocity.
For up to 1930 the relative constancy of the relationship between money
and income justified concentration on the factors determining the quan­
tity of money— monetary theory in the narrow sense which we employ.
When changes in the quantity of money could be expected to have a
broadly proportionate ultimate influence on incomes in either an upward
or downward direction—
despite year to year variations resulting from
minor changes in velocity— was natural to stress the importance of
monetary changes, which appeared to be both strategic and controllable.
Actually there probably still exists an upper limit to the expansion of the
national money income that is possible with a given quantity of money;
but, even if the limit is now somewhat lower than it was in the past, it
seems highly probable that ever since 1929 the quantity of money in ex­
istence could have supported a level of income substantially higher than
that which actually prevailed. Hence it is the factors determining the use
of a stock of money more than adequate to meet current or prospec­
tive requirements that have become of primary importance in recent
Furthermore, right up to the war, our production was less than that
permitted by our labor force and plant facilities. In other words, the
quantity of current output offered for sale, instead of increasing slowly
along a secular trend line, was subject to wide fluctuations from one
year to the next—
sometimes with little or no variation in prices. Hence
theoretical analysis has increasingly concentrated on setting forth both
the determinants of the flow of spending and the effect of the resulting
spending on output and employment, rather than the changes which the
quantity of money could be expected to have on the level of prices under
conditions in which it could be assumed that income velocity would be
relatively constant and output at about the highest level permitted by our
labor force and plant facilities.
It should be made quite clear that the quantity equations are no less
true for a period in which income velocity and output vary widely than
for a period in which they are relatively constant; they are merely less
useful. Although rarely if ever put forward in an unqualified form, the
essence of the ^quantity theory” was that a change in money could be



expected to have a proportionate effect on prices, which is only true when
there are no changes in either velocity or output. For the quantity equa­
tions to be most useful, the conditions underlying the quantity theory
must prevail. What is here suggested is that such conditions did in fact
generally prevail before 1929—
perhaps to a greater degree than was real­
ized at the time. But when income velocity started to vary widely after
1929, so that the quantity approach could only state that income would
be equal to the money supply multiplied by a variable of unknown mag­
nitude, other tools were developed to determine the level of incomes,
although the quantity equations of course remained not only formally
valid but useful for various purposes, especially elementary instruction.
In the same way, the fluctuations in output that have taken place in
recent years have made it far more difficult to determine the effect of
changes in spending on prices; but here, in contrast to the previous case,
relatively litde hjs been done in the way of developing alternative tools
of analysis.
Keynes* A Treatise on Money1 is especially interesting in this connec­
tion because it represents a transition from the monetary theory of the
quantity equations to the modern theory of income, output, and employ­
ment. In view of the emphasis on saving and investment contained in the
Treatise, it is easy to forget that its “Fundamental Equations” summa­
rized the factors determining the price levels of consumption goods and
output as a whole. Keynes started by distinguishing between the normal
income of entrepreneurs—
that “which, if they were open to make new
bargains with all the factors of production at the currently prevailing
rates of earnings, would leave them under no motive either to increase or
to decrease their scale of operations”12—
and their “windfall profits”—
difference between their actual receipts and their normal income* De­
fined in this fashion, windfall profits (positive or negative) become the
difference between the actual level of the national income and that level
which would be just sufficient to continue the current level of output at
the current level of factor costs—
which may appropriately be called the
‘ equilibrium” level.
The broader and more important of the two Fundamental Equations,
that determining the price level of output as a whole, was formulated by
Keynes in the following fashion:


I —S

n=o + ~o_

u London, 1930.
1 Ibid., Vol. 1, p. 125.


a su rvey


c o n te m p o r a r y e c o n o m ic s

where II was the price level of output as a whole, E normal income ex­
cluding windfall profits, O the volume of output, I the value of the cur­
rent production of investment goods, and S saving out of normal incomp.
Further, the Treatise makes clear that, under these definitions, windfall
profits are equal to I — S.13 Hence, as normal income plus windfall profits
equals actual income, this equation in fact tells us that actual income
divided by the volume of current output will give the price level of such
output; or alternatively that the actual price level will differ from the
“equilibrium” level by the excess of actual over “equilibrium” income
divided by current output
To state that the price level of current output is determined by the
actual expenditure on such output (i.e., the actual national income) di­
vided by the volume of such output clearly does not represent an improve­
ment of the quantity equations; hence the Treatise equations in reality
must (and will below) be judged in terms of their contribution to con­
cepts of monetary equilibrium. In other words, the analysis of the Trea­
tise, although cast in the form of quantity equations, in a broad way
marks the end of the equations as tools of new theoretical analysis in both
Great Britain and the United States. This of course does not mean that
the quantity equations were never heard of after 1930. Analytical and
statistical work like that already summarized was largely inspired by the
equations, while their place in elementary texts remained relatively se­
cure, because of the ease with which they imparted a preliminary un­
derstanding of monetary processes. But it seems fair to say that almost all.
new analytical work designed to explain the problems of the ’thirties rep­
resented a break from, rather than an evolution of, the quantity equation
approach, and made little use of quantity equation concepts.
To this generalization there is a notable and outstanding exception.
Professor Marget in his two-volume The Theory of Prices1 has sought
both to defend the equations against the aspersions cast on them by ad­
vocates of the newer approach (particularly Keynes) and also to renovate
the equations as tools of theoretical analysis, particularly the transactions
equation in the form originally propounded by Professor Fisher. There
can be no question of Marget’s contribution to the history of doctrine or
of the extent to which he has demonstrated the falsity of many Keynesian
generalizations, even when the generalizations remain suggestive.15 But
his contribution is considerably more than this; his painstaking discussion
18Ibid,, p. 138.
“ New York, 1938 and 1942.
Keynes suggestion that monetary and value theory have been inadequately inte­
grated, for example, for me remains suggestive even after Marget has demonstrated that
every economist since Aristotle applied the same methods of analysis to both fields.



of the equations themselves has added insight into problems that must be
faced in any careful formulation of the terms involved. To give but one
example, his analysis of possible discrepancies between “current output0
and “goods sold” is undoubtedly definitive.1
Margets plea for a return to the transactions type of equation, how­
ever, is less likely to be accepted. The fundamental issue is a perennial
one in economics: workability vs. completeness. It is Margets position
that any formulation that does not include all possible types of money
and all possible uses is less than complete* Hence he objects to income
velocity on the ground that it is a “hybrid” concept; for income velocity is
actually an average relationship between all balances and the national
income, most balances bising in fact hqld against the purchase of “un­
finished” output rather than against the purchase of the “finished” goods
and services whose value adds up to the national income. Any such aver­
age he rejects because it involves more than a simple relationship between
cash balances and the specific outlay against which they are held, which
is the only sort of relationship sufficiently definitive to be acceptable to
him. Thus he would meet the criticism that the transaction version of the
quantity equation has been relatively barren because it lumped various
things together, the economic significance of which was quite diverse, by
arguing for expansion of the formulation until each diverse item was
treated separately.
Whatever the ultimate appeal of such a program, it seems to me that,
in the present state of economics and probably also in the foreseeable
future, all workable relationships and analyses are bound to be both in­
complete and “hybrid” in the sense that they summarize complicated
variables. The important thing is that the relationship chosen should be
“strategic” and, if possible, relatively constant, in order to eliminate im­
mediate need for die more complete analysis which we are not yet in a
position to undertake. In fact, the very reason that the quantity equation
was originally so analytically useful and has continued as such an impor­
tant teaching aid is that it summarized all the manifold forces influencing
prices into exactly three variables.1 Hence Marget s plea is not so much
for what has been achieved by the transactions form of the quantity
equation as it has been used, but for what might be achieved in the future
if it were possible to break down the summary averages of the original
16 Op. dt., Vol. I, p. 538 ff.
17 While progress in understanding our complex economic environment will undoubt­
edly require increasingly complicated^analysis, most recent progress has taken the form of
developing more “strategic” groupings of a quite small number of variables. This is true
not only of the shift from the transactions to the income version of the quantity equation,
but also of the evolution of Keynes* ideas from the Treatise to the General Theory.



equation into all the components necessary to deal with all separable
price levels. One can, I believe, with all sincerity wish such an under­
taking well and at the same time doubt both its probable achievements
and the impact that it is likely to have on monetary theory in the imme­
diate future.
The importance of not only monetary theory but also monetary policy
declined in the latter half of the 1930 s< For once a “reflation” such as
was achieved by 1935 has been brought about, further increases in the
money supply by Central Bank action alone are likely to lead to broadly
compensating decreases in income velocity— least over the range of in­
creases which are possible without arousing insuperable political opposi­
tion; hence at such times monetary control devices are not likely to be of
much aid in combating a depression. From the point of view of control,
therefore, their main use would have been to prevent a boom from getting
out of hand after the existing supply of excess or idle balances had been
exhausted. Our failure to recover fully before the outbreak of the war
meant that they did not have a chance to undertake this modest role, and
now even this role is likely to have been reduced, if not largely elimi­
nated, as a result of the repercussions which the use of such controls
would entail on the debt structure which we have inherited from the
war. As a result we face an urgent need at the present time to develop
alternative methods of control; this problem will be more fully considered
when our postwar heritage is discussed below.
I I I . M o n e t a r y E q u i li b r i u m , P e r io d A n a l y s i s , a n d t h e

General Theory

As the extent to which the banking system could vary the money
supply became clear, efforts had been made on the Continent, and espe­
cially in the Swedish literature, to formulate what would have occurred
“naturally” or “normally” in the absence of monetary “disturbances.”
Keynes* Treatise was primarily responsible for drawing attention, in
Great Britain and the United States, to the resulting concept of an “equi­
librium” in which money would be “neutral” in its effects oh the econ­
omy. Changes in money were thought of as being brought about by the
rate of interest, which was either so low as to cause banks to create addi­
tional funds to be added to those in existence or so high as to induce
people to pay off bank loans and in this way reduce the money supplyWicksells pioneer formulation ran in terms of discrepancies between the
“market” or actual rate of interest and the “natural” rate, which he de­
fined as that rate which would keep prices constant, as he was working at



a time when the major emphasis was on price stability.18 This meant that
an increase in the money supply equal to the increase not only in popu­
lation but also in productivity would be "natural” under the definition
used* On the other hand, Hayek, following the Austrian tradition of
studying the effects of the imposition of money on a completely "non­
monetary” economy, defined the "natural” rate as that which would keep
the effective quantity of money (money times velocity) constant, so that
it would be "natural” for the price level of output to fall during periods
of technological progress or when the supply of the productive factors
was increasing. In other words, Hayeks definition meant that when there
was no divergence between the two rates of interest, the level of the na­
tional money income would be constant. Finally, Keynes in the Treatise,
as we have seen, defined "normal” income as that which provided just
enough entrepreneurial income to maintain the present level of employ­
ment and output at present factor prices.
The fundamental common problem faced by all these analyses was to
define "equilibrium”; in the main it was the difficulty of giving meaning
to this concept that caused the whole approach to be abandoned. This is
, true even when the emotional connotations of "natural,” "normal,” or
"neutral” are discarded and the problem is stated in terms of "equilib­
rium” without normative significance; and it also applies whether the
mechanism of change is stated in terms of discrepancies between saving
and investment or "market” and "natural” rates of interest.
For example, as the role of payment practices and the degree of busi­
ness integration in determining income velocity became clearer, even a
theoretical definition of a "natural” rate which would eliminate "mone­
tary” disturbances when there were changes in these factors became in­
creasingly difficult.19 For the distinction between "real” and "monetary”
factors is a tenuous one at best. It was often argued that a release of
money as a result of the reduction in money payments that follows from
increased business integration should be offset if money was to remain
“neutral”; but would not integration reduce exchange value even in a
barter economy and therefore constitute a "real” rather than a "mone­
tary” factor? Or should the release of money resulting from integration
be offset only to the extent that it exceeded the decrease of exchange
value that would have taken place in a barter regime?
It was the Treatise more than any other volume that brought the prob­
lem of equilibrium to a head and represented a crossroads in the develop38Constant prices in this formulation also made saving equal to investment. For a sum­
mary of some of the other meanings given the “natural” rate by Wicksell, see A. W.
Marget, op. cit., Vol. I, pp. 201-204.
MCf. G. Haberler, Prosperity and Depression, 3rd ed. (Geneva, 1941), pp. 61-62.



ment of monetary theory.2 For the fundamental distinction that Keynes
made in the Treatise between "normal” income and "profits” premised
the existence of a lag in the adjustment of factor contracts, entrepreneur­
ial commitments, or both: if entrepreneurs revised their commitments or
labor reopened its contracts just as soon as there was a change in income,
then there could be no difference between "normal” income and "profits.”
In the Treatise Keynes showed little interest in this problem, except to
argue that a sufficient lag did exist to make his distinction between actual
and "normal” income worth while, As a result the Treatise was criticized
both because of the ambiguity of its discussion of the lag involved and for
the extent to which the time period in question could be expected to
vary over the course of the business cycle. Against these criticisms there
were two possible lines of defense: either the various factors influencing
the revision of contracts could be examined, and explicit assumptions
could be made regarding the time period in question; or a "timeless”
analysis could be developed and the problem avoided in this fashion. In
the first of these directions lies modem period analysis, with its explicit
assumptions regarding lags and leads, the fixity of contracts, and similar
factors; in the other, the instantaneous analysis of Keynes* General
Theory of Employment, Interest and Money.2
It is too early to attempt any definitive appraisal of the relative fruit­
fulness of the two approaches, but it seems fair to say that round one has
gone to the instantaneous approach. I should make clear that in judging
"fruitfulness” I am laying major weight on the impact on public policy
that has been or seems likely to be achieved before the economic system
under study changes so drastically as to move the whole matter into the
field of the economic historian. For however much the careful step-bystep procedure of period analysis commends itself as the only way to
attain complete knowledge of the operation of our economic system, to
date most examples can best be described as methodological explorations
rather than positive contributions,22 The difficulties to be faced are for­
midable. Least important, perhaps, is the criticism leveled against the
Treatise to the effect that entrepreneurs are always out of adjustment'
2 Chronologically Hayek follows ,the Treatise, hut his methodological approach really
belongs with the analyses of the preceding period.
21 London, 1936.
~ The best example of D. H. Robertson’s work is his article in the Economic Journal
(September 1933, XLIII) and the best summary of the Stockholm School is that of Bertil
Ohlin, also in the Economic Journal (March and June 1937, XLVII). A possible except
tion to the generalization in the text and the outstanding example of sustained work
along period analysis lines is J. R. Hicks* Value and Capital (Oxford, 1939), although;
as the title suggested, the author is not mainly concerned with problems in the field of
monetary andbusiness cycle theory.



during a period of expansion or contraction.23 Once the emphasis shifts
away from equilibrium” to period analysis, it becomes clear that lack of
adjustment is to be expected. For it is the purpose of such analysis to
show why the economy is out of balance, what is done about it, and what
the consequences are.
Far more important is the fact that no satisfactory bridge has been built
between a mechanical analysis in which income received in one period is
disposed in the next and an expectational analysis in which emphasis is
placed on the extent to which the expectations held at the start of the
period are in fact realized during the period. The mechanical approach
puts major emphasis on such things as the flow1 of funds through the
economic system from producer to income recipient and back again and
the expansion or contraction of output through successive intervals of
time. It has the advantage of showing how various changes take place
within the institutional framework of the particular economy; but, be­
cause it does not deal with expectations, it gives little light on many of
the factors responsible for the changes involved. The expectational ap­
proach, on the other hand, just because it does not demonstrate in stepby-step fashion the way in which funds move through an economy or
output changes, often finds itself dealing with expectations which are
inevitably doomed to disappointment from the start, as they involve a
change of output or a movement of funds faster than the institutional
arrangements of the system permit.2 As with Professor Marget, who in
fact advocates a form of period analysis, one can wish period analysis
every success and yet remain skeptical as to whether it will prove fruitful
within the immediate future even for problems which the Keynesian ap­
proach has been least successful in handling.25
In contrast to the complexities of period analysis, the approach of the
General Theory attempts to explain changes in the level of economic
activity by means of a handful of variables: the quantity of money and
liquidity preference determine the rate of interest; the rate of interest and
23R. F. Harrod, The Trade Cycle (Oxford, 1936), p. 66.
2 Hicks’ analysis (oj?. cif.) again comes closest to meeting this problem, but the
degree of simplification involved seems to me larger than can ultimately be accepted for
monetary and business cycle theory. For income recipients at least, Robertson’s analysis
falls mainly in the first class, while most of the Swedish work falls in the second, al­
though the line between the two approaches is not always sharp.
8 Haberler in the course of an extended discussion of period analysis (op. ciu, pp. 1775
195) suggests that the mechanical and expectational approaches are likely to come to­
gether because the concept of expectations regarding uses of future income raises so many
difficulties that the time period at issue may be shortened until the expectations are
related to income actually realized in some past period— other words, to Robertson's
“disposable” income. If this in fact is to be the bridge between the two approaches, then
the doubts expressed regarding fruitfulness seem confirmed, because so short a period
would eliminate much or the content of the expectational approach..



the marginal efficiency of capital determine the level of investment; and
the level of investment and the marginal 'propensity to consume deter­
mine income, output, and employment. In his enthusiasm for explaining
“dynamic” changes in the simplest possible terms Keynes is sometimes
reminiscent of the quantity theorist in believing that his analysis explains
rather more than it actually does. In the marginal propensity to consume
and the multiplier, for example, Keynes wanted and thought he had a
largely constant factor which would permit us to say that “when there is
an increment of aggregate investment, income will increase by an amount
which is [the multiplier] times the increment of investment”2 —
6 just as a
quantity theorist would say that, when there is an increase in money,
income will increase by an amount which is income velocity times the
increase in money.
If it were true that the propensity to consume were relatively constant,
Keynes would of course be correct in taking investment as the major
variable, just as the quantity theorist took money when changes in in­
come velocity were small. In the General Theory considerable space was
devoted to arguing that the propensity reflected a stable psychological
law which applied over wide ranges of income and broad periods of
time.27 But the stability of the propensity has been widely questioned in
theoretical discussion.28 Moreover, the statistical attempts to verify the
stability of the consumption function have run into serious difficulties;
the main source of error in the predictions of postwar income and em­
ployment made toward the end of the war was apparently the result of
inadequate estimates of the possible level of consumption, which in turn
appear to have been caused by overestimates of the stability of the con­
sumption function.29
4 General Theory, p. 115. My italics. The multiplier is equal to one divided by one
minus the propensity to consume.
2 The notation of Keynes reflects his belief in the constancy of the “marginal” pro­
pensity to consume by making it equal to what I would think should be described as the
“average” propensity to consume. Thus he writes A Yw = k A Iw where 1 — j£ = 3 y^*
( General Theory, p. 115 ); but this can only be true if

• Hence if ^ yw rep-

resents the average propensity to consume for the change in income AYWKeynes is in
fact assuming that the 4marginal” and “average” propensity are the same— alterna­
tively that the “marginal” propensity is constant-over the range of income AYW
8 B. Ohlin, “Some Notes on the Stockholm Theory of Savings and Investment,”
Economic Journal, June 1937* XLVII, pp. 221— D. Robertson, “A Survey of Modem
Monetary Controversy,” The Manchester School, 1938, pp. 133—
153; and G. Haberler,
PP* 222-232, are among the critics of the alleged stability. For further references,
see below, p. 329, note 30.
8 See W. Woytinsky, “What Was Wrong in Forecasts of Postwar Depression/*
Journal of Political Economy, April 2947, LV, pp. 142-151, and references there cited.



Certainly much of the appeal of the Keynesian approach lay in the
stability of the multiplier which Keynes premised. For the idea that, once
investment was given, saving, income, and employment would all fall
into line through the operation of a (more or less) uniquely determined
multiplier gave a certain grandeur to the analysis, which made it appear
capable of explaining a wide variety of situations and therefore quite
"dynamic” in character. When it is realized that the marginal multiplier
(for small changes in investment), the average multiplier (for appreci­
able changes), and the total multiplier (for investment as a whole) may
have substantially different values, the analysis comes to be seen as con­
siderably more limited and pedestrian in its scope and therefore more
"static” in character. But the set of relationships which Keynes set forth—
even if some of the components are less constant than he cared to admit
will certainly have a continuing impact on economic thinking because
the variables he related to one another are of fundamental importance to
any understanding of the problems with which he was concerned.
Any more complete attempt to appraise the full impact of the Keynes­
ian approach, even if' it were as yet possible to do so, would take us
beyond the confines of this paper. But it is perhaps worth while to con­
clude by pointing out that all that has been said regarding the alternative
approaches can be rephrased in terms of the saving-investment contro-:
.versy. For it was the failure to keep factor contracts and entrepreneurial
commitments up to date which was responsible for the difference in the
Treatise between actual and "normal” income and therefore between
saving and investment. Saving was confined to the income involved in
the contracts and commitments made at the start of the "period,” while
investment was related to the income actually realized at the end of the
"period,” which could, of course, be more or less than that involved at
the start. As a result a major factor determining the size of the discrep­
ancy between saving and investment was the speed with which contracts
and commitments were revised— slower the revision the larger the dis­
crepancy. Had the "period analysis” character of the difference between
saving and investment in the Treatise been more fully recognized, it is
possible that the advent of the General Theory would not have been
marked by the extended and largely fruitless controversy as to whether
saving and investment are equal or unequal.8
What the General Theory did in effect was to stress that during any
period saving was equal to spending on investment. (This follows be­
cause saving was defined as income less consumption, and income is
8 Sixteen of the major articles on this subject are cited in H. H. Villard, of. cit., p. 28,



equal to spending on total output and consumption to spending on con­
sumption; hence by subtraction saving is equal to spending on invest­
ment.) The main reason that this caused so much difficulty was that
most economists have instinctively thought as consumers, who received
income in the present period and then elected whether or not to spend it
in a future period.31 Hence most economists have typically—
and fre­
quently unconsciously—
meant by saving the difference between the in­
come of the present period and the consumption of a future period—
difference which might either be held idle or invested in the future
period. In contrast, Keynes emphasized relationships within a single
period, stressing that the income of any given period would not have
been received unless an identical amount of spending on consumption
and investment had taken place.8 What caused so much misunder­
standing and difficulty was the mental adjustment involved in not pur­
suing the usual more or less instinctive time sequence but instead identi­
fying saving with the simultaneous spending on investment which gave
rise to the income of the present period, rather than with the spending
which might or might not take place in a future period.
What Keynes succeeded in doing was to make clear that discrepancies
between saving and investment, at least in the ex post meanings given
the terms before the General Theory, depended on implicit or explicit
period analysis. For when saving was thought of as income which was
“hoarded” rather than spent on consumption, what must have been
referred to was income of a period different from that in which the
“hoarding” was thought of as taking place; for if the money involved
has been “hoarded” in the sense of not being spent on output in the
present period, then it would not have been part of present income.33
That it was desirable to make clear the “period analysis” character of all
ex post differences between saving and investment is obvious. Yet in
appraising the over-all effect of the way in which this matter was pre­
81 The definition given by Keynes added to the confusion. Fot he defined saving as
“the excess of income over consumption” (General Theory, p. 62). While actually the
“cxcess” in any period— the economy as a whole but not necessarily for every indi­
vidual within the economy— always identical with spending on investment during the
period, the casual reader is likely to think of it as a sum which could be “hoarded.”
38This does not deny that what happened in one period may influence what happens
in a subsequent period, nor does it imply that the amount spent during a given period
must “come out of” the income of that period, as this depends on the length of the
period. If the period is so short that there is no time for any money to be spent more
than once, then all the spending of the period will “come out of” previously unused
cash balances and total income will be less than cash balances; if, however, tne period
is long enough, money may be spent often enough for total income to be a multiple of
average cash balances.
8 This is, of course, true only for the economy as a whole, as the “hoarding” of one
individual may be oflFset by the “dishoarding” of another.



sented in the General Theory, I think it fair to say that it greatly impeded
progress in economic thinking—
and this despite the fact that the General
Theory as a whole certainly made the greatest contribution to our ulti­
mate understanding of economic fluctuations of any volume published
in the decade of the ’thirties. For it was a paradox of Keynes’ greatness
that he treated what was a minor clarification of concept as a great new
discovery, thereby completely confounding his less nimble-witted col­
though it is only fair to admit that Keynes’ disciples were fre­
quently plus royalistes que le roi. The resulting years of controversy were
only ended by the war; their effect was not only to divert much effort
of economists into “translating” Keynes into more conventional terms
but also to present to the layman the spectacle of a science deeply divided.
It is perhaps the ultimate irony of his career that Keynes, with his intense
interest in practical programs to reduce business fluctuations, should have
contributed so much to the failure of American economists as a group
either to develop an agreed program for mitigating the business cycle or
to carry any appreciable weight in public decisions on matters of economic
IV. L i q u i d i t y P r e f e r e n c e a n d I n t e r e s t
During recent years Keynes’ General Theory represents the outstand­
ing development in interest theory, so that it is appropriate to start with
a consideration of that volume. It is the contention of the General Theory
that the rate of interest is entirely determined by two factors: the supply
of money and liquidity preference; in other words, liquidity preference
is a function which relates the money supply to the rate of interest.
Keynes argues that people have three reasons for desiring “liquidity” :
the transactions-motive, the precautionary-motive, and the speculativemotive. The first of these is the familiar concept of balances needed to
bridge the gap, for both business and income-recipients, between receipts
and expenditures connected with current output;34 the second is to
provide for contingencies requiring sudden expenditure and for unfore­
seen opportunities of advantageous purchases” and is thought of as vary­
ing with the level of income;35 and the third is to secure profit from
■8 To the more usual formulation Keynes added the need for funds ^due to the time4
lag between the inception and the execution of the entrepreneurs decisions, which he
called the demand for “finance.” See “Mr. Keynes and Finance: Comment, Economic
Journal, June 1938, XLVIII, p. 319. The fundamental structure of the Keynesian analy­
sis is unaffected by this addition, which is simply another factor adding to the demand
for transaction (and probably also precautionary) balances.
3 General Theory, p. 196. The distinction between precautionary and speculative
balances has always seemed to me finely drawn.



knowing better than the market what the future will bring forth”—
other words, from the expectation that money will decline in value less
than other assets.8 In short, as Keynes uses them, transaction and pre­
cautionary balances are “active” balances held in connection with the
production of current income and speculative balances are “idle” bal­
ances held on capital account. Note that it is all these balances which
are related to the interest rate by liquidity preference; hence “liquidity
preference,” as Keynes uses the term, covers considerably more than
a speculative desire to hold assets in liquid form because it is thought
that illiquid assets are likely to depreciate in value.8
As with so much of Keynes’ work, an appreciable part of the novelty
of his treatment of interest arises from either terminological innovations
or unusual assumptions. Take, for example, the fact that in Keynes*
formulation changes in the desire to save appear not to have any effect
on the interest rate. Keynes tells us that economists have generally
assumed “that, ceteris paribus, a decrease in spending will tend to
lower the rate of interest and an increase in investment to raise it. But
if what these two quantities determine is, not the rate of interest, but the
aggregate volume of employment, then our outlook on the mechanism
of the economic system will be profoundly changed. A decreased readi­
ness to spend will be looked on in a quite different light if, instead of
being regarded as a factor which will, ceteris paribus, increase investment,
it is seen as a factor which will, ceteris paribus, diminish employment.”38
To what extent is this a real and not merely an apparent contrast with
the usual formulation, in which changes in the “readiness to spend”—
or in saving in a non-Keynesian sense—
are thought of as having an
important influence on the rate of interest?
Actually Keynes’ startling conclusion that “a decreased readiness to
spend” will diminish employment rather than increase investment follows
directly from the fact that he includes liquidity preference within the
ceteris paribus assumption; in other words, he assumes that liquidity
preference is unaltered despite a “decreased readiness to spend.” But
this is another way of saying that the individual wishes to hold idle the
money he was previously ready to spend; for if the quantity of money
and liquidity preference (and therefore the rate of interest) are un­
changed, then a decrease in spending can only mean that the funds
involved have been shifted from transaction and precautionary balances
8 Ibid., p. 170.
9 Haberler suggests that the relationship between speculative balances and the rate
of interest be called “liquidity preference proper” to distinguish it from the relationship
between all balances and the rate of interest \jov» cit., p. 210).
8 General Theory, p. 185.

m o n e ta r y t h e o r y


to speculative balances.8 Under these circumstances investment need
not increase and employment as a result will fall. But there is no reason
why liquidity preference must remain unchanged, and when it is re­
moved from ceteris paribus, quite different results from those which
Keynes indicates are possible. For the money freed by the “decreased
readiness to spend” may well decrease the individuals liquidity prefer­
ence, which in turn can be expected to reduce the rate of interest and
increase investment, exactly as in the more conventional formulations.4
Had Keynes said that when an individual saves in order to "hoard,” the
social effects are quite different than when an individual saves in order
to invest, his meaning would have been clearer but his statement less
Of course, the concept of “hoarding” is not a part of the Keynesian
system. This is understandable because the instantaneous approach of
the General Theory avoids so far as possible specific reference to time
periods, while “hoarding” in its usual meaning must have a time dimen­
sion. For “hoarding” which is timeless becomes identical with holding
money; accordingly, as all money must be held by someone at all times
if it is to be counted as money, it becomes correct to say that all money
is “hoarded” and that changes in “hoarding” from one period to the
next are the same thing as changes in the quantity of money. From this
it follows that “it is impossible for the actual amount of hoarding to
change as a result of decisions on the part of the public, so long as we
mean by 'hoarding' the actual holding of cash. For the amount of hoard­
ing must be equal to the quantity of money • . . ; and the quantity of
money is not determined by the public.”4 Here again is a startling
result based on an unusual meaning for a common term; but in this case
the usage on which the result depended was reasonably clear.
What have these changes and innovations contributed to interest
theory? The pervading emphasis which Keynes has laid on the depend­
ence of saving and interest on the level of income has been of great im­
portance. The “classical” theory of saving and interest had been most
concerned with long-run problems in which it seemed appropriate to take
the level of income as more or less fixed and to investigate the forces
determining the amount of such income which would be saved and
8 Following Haberler’s suggestion, the situation is one in which “liquidity preference
proper” has increased sufficiently to absorb the money freed by the decreased readiness
to spend.”
4 Again following Haberler, if there is no change in the individual’s “liquidity prefer­
ence proper,” the money freed by the “decreased desire to spend” can be expected to act
on the rate of interest and the level of investment in the same way as any decrease m
over-all liquidity preference.
4 General Theory, p. 174.




invested. Keynes was by no means the first person to indicate that saving
and interest were influenced by the level of income and much of his
criticism of “classical” theory, if it was meant to apply to all the work of
all his predecessors and not to those “real capital” theorists who were
primarily concerned with long-run equilibrium, can only be characterized
as overly exuberant. In fact, Keynes himself came to agree that he was
“shying at a composite Aunt Sally of uncertain age.”43 But exuberance
aside, Keynes clearly deserves credit for emphasizing the extent to
which an increase in investment, working through an increase in income,
could be expected to provide an offsetting quantity of saving. In part
this emphasis was the result of the definitional identity between saving
and investment; but back of this lay the real fact that large changes in
saving and investment were possible with litde change in the level of
interest if accompanied by large changes in income. In fact it is quite
possible that the start of an upturn will bring such a release of specu­
lative (idle) balances that at least the early periods of recovery may be
accompanied by a lower rate of interest than that which had previously
In addition to his emphasis on changes in income, Keynes' most im­
portant contribution has been the insight which he has given us on the
behavior of speculative balances, both in general and especially as a
result of changing anticipations regarding the rate of interest. Applied to
perpetual bonds, which present the simplest as well as the most extreme
case, Keynes points out that it is impossible for the rate anticipated a
year hence to exceed the current rate by more than the square of the
current rate.4 For otherwise it would be more profitable to hold money
than bonds, as the reduction in the capital value of such securities during
the year as a result of the rise in the interest rate would be greater than
the sum received as interest. Of course most bonds are not perpetual,
so that rate increases in excess of the square of the current rate can be
anticipated without causing a complete shift into idle balances. But
clearly whenever appreciable rate increases are anticipated the effective­
ness of monetary policy is gready reduced, and recovery is likely to be
slow even if vigorous action is taken by the monetary authorities. For
when the recession phase has come to an end and prices of securities are
high and yields low as a result of a reflationary “cheap money” policy, a
time may come when any further expansion of the money supply will
flow overwhelmingly into idle (speculative) balances because investors
° “The ‘Ex-Ante’ Theory of the Rate of Interest,” Economic Journal, December

xLvn, P. 663.


I9 3 7 j

0 General Theory, p. 202. If the current rate is 3 per cent, the anticipated rate cannot
be more than 3.09 per cent.



generally believe that the present low level of the interest rate will not
be maintained.4
In appraising the probable importance in actual practice of such a
situation, Keynes himself has repudiated the extreme possibility that
all additional funds will flow into idle balances, stating that while this
"might become practically important in future, I know of no example
of it hitherto. Indeed, owing to the unwillingness of most monetary
authorities to deal boldly in debts of long term, there has not been
much opportunity for a test.”4 Yet it is by assuming implicitly or ex­
plicitly what is in effect an “absolute liquidity preference” under which
the demand for idle (speculative) balances is insatiable, that Keynes
achieves his most striking differences from other theorists. In appraising
his contribution one has again to weigh the real insight that he has given
us against the confusion that has resulted from his perennial inclination
to treat an unusual, and therefore startling, situation as if it applied
generally— short, to make a "general theory” of a special case.
Much of the credit for clarifying the issues raised by liquidity prefer­
ence belongs to J. R. Hicks, whose Value and Capital, appearing just
before the war turned economists' minds to other things, marked the
end in Great Britain of the controversies raised by the General Theory.
Hicks agrees with Keynes and most other modem interest theorists that
the determination of the rate of interest is not adequately explained by
"real capital” theories relating to "real” economies. But, while stressing
in the Walrasian tradition that the interest rate can only be determined
in relation to other prices, he finds it a matter of convenience whether
the rate is treated as "determined” by the demand and supply of loan
funds or of money.4 The first treatment he suggests is most useful when
attention is to be focused on the difficulties which result from the fact
that "the” rate of interest is in fact a complex of rates, while the second
serves to stress the closeness of the connection between the demand for
money and interest rates— matter stressed not only by Keynes but also
by Hicks himself.4
Hicks' contribution, of course, is far broader than a clarification of
4 Of course, if the expectation of rising rates is not realized, it will in time give wav;
hence Keynes* analysis applies fundamentally to cyclical problems. It also implies sizable
rationality on the part of those holding balances, which is hardly completely correct.
Thus during the war period individual holdings of currency increased faster than their
holdings of deposits and much faster than the money holdings of business as a whole.
Those holding actual cash-for the quite complicated reasons that they do hold cash-are
obviously acting from different motives than those which Keynes has indicated.
4 General Theory, p. 207.
4 Op. cit., Ch. XII, especially pp. 160-162.
4 Ibid., pp. 237-239.



controversy, representing an outstanding reformulation of theory. In
the case of interest, he suggests that the fundamental explanation grows
out of the fact that money has “general acceptability” while other
securities (in the broadest possible sense) do not; in other words, money
is the most perfect type of security and interest a measure of the imperfect
“moneyness” of other securities. “The nature of money and the nature
of interest are therefore very nearly the same problem. When we have
decided what it is which makes people give more for those securities
which are reckoned as money than for those securities which are not,
we shall have discovered also why interest is paid*”4 In the General
Theory, besides the obvious risk of default, we have seen that Keynes
placed great stress on the risk of future changes in interest rates. Hicks
believes that this is an incomplete formulation and that interest cannot
be explained by risk-premiums alone. For even if there is no risk of
default or of changes in interest rates, there would remain: ( 0 the cost
of converting money into securities (i.e., investment costs); and (2) the
cost of “rediscounting” the security if money comes to be desired before
the security matures (i.e., possible disinvestment costs). Hence the
interest rate in equilibrium must be high enough to cover these costs
for the marginal lender, as well as risks of rate changes and default.4
As to relative interest rates, Hicks feels that no serious problems
arise; for the actual span of rates from long to short can either be ex­
plained “in terms of expectations about the future course of the short rate”
or alternatively “in terms of expectations about the future course of the
long rate.”50 While this may be adequate for the relatively rational in­
habitants of the simplified models with which Hicks is dealing, it is not
of much aid in explaining the complexities of the actual behavior of the
numerous interest rates found in the real world. By far the greatest amount
of factual information on actual rate behavior over a long period of time
is contained in Frederick R. Macaulays study for the National Bureau.51
Series starting before the Civil War are presented for call money and com­
mercial paper rates, for railroad bond yields, and for railroad stock
prices, as well as much information on such related financial series as
bank clearings and commodity prices. Despite the wealth of material
presented, however, the study, as its title indicates, is fundamentally
concerned with the problems which arise when an attempt is made to
4 Ibid., p. 163.

“ Ibid., Ch. XIII.
“ Ibid., p. 152.
a Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond
Yields and Stock Prices in the United States Since 1856 CNew York, 1938D* See also
David Durand, Basic Yields of Corporate Bonds, 1900-1942 (New York, 1942).



find some order in the array of rates. Macaulay concludes that “statistical
examination reveals that the relations (between long- and short-term
rates) as they actually occur show a definite tendency to run counter
to these theoretical rationalistic expectations” based on “complete knowl­
edge of the pertinent facts and logical use of such knowledge.”5 In
what is perhaps his most interesting contribution, he explains this result
by the extent of irrationality in the real world, the chief cause of which
is the inability of human beings to foresee the future, let alone adjust
the present to it.”5 Certainly the facts that are presented and the diffi­
culties in interpreting them that Macaulay poses make it clear that the
behavior of relative interest rates is still to be fully explained.
V. W a r F in a n c e
By far the most difficult period in which to appraise fairly the role of
monetary economics is during the war. First of all, many economists
were in the government service, where their contributions were buried
in unpublished memoranda; hence it should be remembered that the
somewhat critical remarks which follow are made on the basis of the
work of those who remained able to publish. Secondly, my basis of
judgment is not confined to monetary matters narrowly conceived, but
I know of no way of appraising policy in regard to the numerous mone­
tary problems raised by a modem war except in terms of the contribution
that is made to winning the war^In short, I propose to appraise, with
the qualifications indicated and the benefits of hindsight, the contri­
butions of monetary economics to the war mobilization. My conclusion
is that the record is not one of which economists can be proud. The re­
mainder of this section sets forth the reasons for this judgment
Total war requires the largest possible expansion of the labor force
(including those in the armed services), the greatest possible increase
in hours worked, and the quickest possible transfer of labor from peace­
time to wartime production. In the United States, from early in 1940 to
the wartime peak, hours worked in all manufacturing industry increased
20 per cent, the total labor force increased 25 per cent (of which per­
haps a quarter was the result of the normal growth of the population),
and employment (excluding relief but including the armed forces)
increased 45 per cent. Hence, if the hours worked elsewhere rose as
much as in the manufacturing industry, at the peak we expanded our em­
ployed labor resources (including the armed forces) by almost 75 per
“ Op. ciuf p. 3; italics in original; parenthesis supplied.


a s u r v e y o f c o n t e m p o r a r y e co n o m ic s

cent of the prewar level. Even the labor force increase appears to have
surpassed that of Germany and equaled that of Great Britain, as the
percentage of our population in the labor force by the end of the war
was comparable to the similar British figure throughout the year, and
actually exceeded it during our seasonal peaks of employment.54 But
both Germany and Britain relied heaivily upon labor compulsion in
comparison with our overwhelming use of monetary incentives; yet the
use of monetary incentives did not cost us excessively in comparison with
Britain, as the British cost of living between 1939 and 1945 rose almost
exactly the same amount as ours.
This mobilization of our resources was accomplished by arrangements
which J. K. Galbraith has called the “disequilibrium system.” 55 In essence
this system brings about a divergence between income and “spending”
in the sense of expenditure on consumption, which is another way of
saying that it brings about a large volume of saving. The purpose of this
saving is to supplement— an amount highly important at the margin—
the monetary incentives which would be provided by income alone if
income were restricted to permissible expenditure on consumption plus
voluntary saving. The system must of course be operated in such a way
as to preserve the public s faith in the future value of money, in order
to make sure that the large volume of saving continues to have an in­
centive value. As long as it is operated in this way, it seems clear that
it will provide considerably more monetary incentives than either an
“equilibrium” system or an uncontrolled inflation.56 The only alternative
would seem to be greater reliance on non-monetary incentives, which
must in the main involve compulsion.
In the United States the divergence between income and spending
was, to a major extent, the result of adequately effective price control;
There are of course other possibilities; either some variant of the Kalecki
plan, involving control over *total spending, or some type of forced
saving could have been used. But I suspect that the incentive to earn
additional income was greater under price control than under either
alternative. For the Kalecki plan would have placed a legal limitation
MBoth the growth in the American population and the sharp seasonal fluctuations in
the labor force make comparisons difficult; the estimates presented in the text make no
allowance for seasonal changes and should therefore not be compared directly with those
for other countries.
8 “The Disequilibrium System/* American Economic Review, June 1947, XXXVII,
pp. 287-302.
“ Galbraith suggested (ibid,, p. 293, note) that the system he described might be
called a “forced equilibrium*’ but prefers “disequilibrium** as shorter and more suggestive.
I think 'controlled disequilibrium” is more descriptive, in order to give us a phrase—
controlled disequilibrium**— characterize an unrestrained inflation.



on the dollars that could be spent and a forced saving plan would have
compelled workers to take part of their earnings in bonds redeemable
only after the war. Under price control, on the other hand, the failure
to spend was entirely voluntary— result of the goods people wanted
not being available. Hence I believe that workers would in all probability
work harder under price control, if only because they knew that they
could, if they wanted to, “blow” their earnings at once on something.
Moreover, as some price control and rationing of especially scarce goods
was inevitable, the greater administrative ease with which price control
could be extended until it became widespread was a point in its favor
compared with control of spending or forced saving, which must be on
a broad basis from the start.
In the United States the operation of the economy in such a way as to
preserve the public’s faith in the future value of money (and therefore
of savings fixed in terms of money) appears to me to have involved only
a postwar problem. For the large increase in money during the war did
not in fact undermine people’s confidence in their savings during the
war i t s e l f Just what weight should be given to the postwar effects of
different methods of war finance in a total war is not easy to determine.
Obviously most people would prefer victory with a postwar financial
problem to defeat; but it is equally obvious that the large holdings of
liquid assets which accumulate under a “disequilibrium system” make it
undesirable to scrap controls and raise wages substantially immediately
after the end of the war. That this need not be done is amply demon­
strated by Great Britain, whose cost of living was in 1947 at about
the same level as at the end of the war. Moreover, it should be re­
membered that a smaller increase of money during the war would have
had little effect in holding down postwar spending unless stabilization
of the wartime pattern of interest rates on government bonds was aban­
doned after the war.®8 But the reader should be warned that economists
who discount the extent to which maximum incentives were needed
during the war, who feel that practical politics will bring about a quick
abandonment of wartime controls after the war, and above all who bewPut more technically, this amounts to saying that the wartime “margin of tolerance’*
was not exceeded. Maximization of the effectiveness of a ‘‘disequilibrium system would
involve, among other things, a comparison of the incentive to further expansion of the
labor force provided by higher unspent incomes with the resulting pressure on current
and postwar prices. The fact that the labor force was expanding (allowing for seasonal
factors) right up to V-E Day without undue pressure on current prices seems to me
to indicate that whether the system was carried too far depends on the effects on postwar
prices that can be attributed to it. Whether it was not carried far enough need not be
8 This point is elaborated in the final section on our postwar heritage.



lieve in the importance of rehabilitating monetary controls, will be
critical of the “disequilibrium system” because of the postwar problems
created by the large holdings of liquid assets to which such a system gives
If this analysis of the system which permitted our effective war mobi­
lization has been broadly correct, it seems to me appropriate to judge the
publications of economists during the period in which the system was
being constructed by their contribution to its erection.5 Broadly, I think
it is fair to say that much of the advice given hindered completion of
the system and therefore our mobilization for war. Economic literature
at the start was overwhelmingly concerned with the prevention of
inflation, so that it was not until relatively late in the war that the diffi­
culties and limitations of an all-out anti-inflationary program began to
be'considered. In the main this concentration on inflation apparently
resulted partly from an unawareness of the magnitude of the potential
expansion of our labor resources or of the required shifts within the labor
force and pardy from general doubt regarding the efficacy of price con­
trols, especially in the absence of widespread rationing.
The general literature is largely devoid of attempts to determine the
probable expansion of the labor force and employment during the war—
to say nothing of output, which presented a much more difficult problem
because of its changing composition.6 It is true, of course, that estimates
of future income underlay all estimates of the “inflationary gap”; but those
using the “gap” immediately focused on the effect of spending the esti­
mated income on the diminishing supply of consumption goods, rather
than on the real factors involved. Thus we find that J. P. Wemette, writ­
ing in September 1941 “as though the country were actually engaged in a
serious war,” urged that, if perfection was impossible, the “government
should lean toward over use of non-expansionist financial methods,” as
“everyone agrees that taxes should be heavy enough to avoid inflation.”6
Again William Fellner, writing in early 1942, believed that a tax program
to bridge the gap would mean an effective rate of 30 per cent on the in­
come of those with incomes of $3,000, 40 per cent of $4,000 incomes, 50
per cent of $5,000 incomes, and 90 per cent of $20,000 incomes, which
could be expected to eliminate individual savings; yet there is no discus891 am acutely aware of the problem of criticism based on hindsight; but if the pre­
scriptions of economists were wrong even for reasons which seemed excellent at the time,
we must face the fact that the economic advice given was undesirable.
6 What one would have liked would have been something, however crude, comparable
to E. E. Hagen and N. B. Kirkpatrick’s “The National Output at Full Employment in
I 95° < -American Economic Review, September 1944, XXXIv, pp. 472-500.
a "Financing the Defense Program,* American Economic Review, December 194
XXXI, pp. 755, 761, 763.



sion of the effects on production of this level of taxation.0 When one adds
the work of the Iowa State group led by A. G. Hart,8 the estimates of
Shoup, Friedman, and Mack,8 and the general interest in the “inflation­
ary gap,” as well as the discussion of the spending tax— cite but a few
outstanding examples— seems clear that the emphasis was heavily on
Certainly the "inflationary gap” was the most important analytical tool
developed during the period, if judged only by the number of alternative
meanings that were spawned. Perhaps its most generally accepted mean­
ing was what has been called the “consumer expenditure gap”—
difference between what consumers would like to spend on consumption
and the value, at a specified price level, of the goods and services esti­
mated to be available. But the "total expenditure gap,” the “disposable
consumer income gap,” and the “tax gap” were also distinguished, as
well as whether the “gap” was “total” or “primary.”8 In general, interest
in the gap diminished before any general agreement on definitions was
reached; certainly there was little statistical contribution in the pub­
lished literature, as events moved too rapidly.8 Looking back on the
history of the concept, I venture to predict that far more work in clarify­
ing the meaning of the “gap”—
especially in relating the required taxes
Cor deficits) to the desired effect on the national income—
will have to
be done before the high hopes of future usefulness held at the time will
be justified.
The failure to relate monetary policy to the possible expansion of the
labor force was matched by a lack of interest in the required shifts
within the labor force; yet these shifts raised serious implications for
any stabilization program. For the use of monetary incentives necessarily
6 “War Finance and Inflation,” American Economic Review, June I942>XXXII, pp.
246, 248, 251.
6 Paying for Defense (Philadelphia, 1941).
6 Taxing to Prevent' Inflation: Techniques for Estimating Revenue Requirements
(New York, 1943).
6 See W. A. Salant, “The Inflationary Gap,” and M. Friedman, "Discussion of the
Inflationary Gap,” American Economic Review, June 1942, XXXII, pp. 308-320.
0 The important volume of Shoup, Friedman, and Mack did not appear until the sum­
mer of 1943, though its estimates were for the amount of taxes needed in Jura 1942.
This book is probably the most important to emerge from the discussion of the gap,
though its concepts are somewhat different from the more widely used estimates of the
Office of Price Administration. Clark Warburton’s “Monetary Expansion and the Infla­
tionary Gap,” American Economic Review, June 1944, XXXIV, pp. 303-327, appeared
even later and involved a new meaning of the “gap” which made it equal to the change
in money holdings of individuals and business enterprises. Most saps are ex ante in
character, as ex vost we identify what consumers wanted to spend during any period
with actual value of goods and services purchased during the period; but Warburton s
“gap” of course ha* both an ex ante and an ex post aspect, and may be negative as well
as positive.



involves an increase in average incomes, unless one is prepared to set
up differentials in favor of war industries by cutting wages in existing
which seems sufficiently detrimental to morale to be unac­
ceptable during a major war even assuming it to be administratively fea­
sible. To take an arbitrary example, if a third of the working force were
to be shifted and it was felt that a 50 per cent average differential (in­
cluding overtime and the like) was necessary, an average increase in
labor incomes of 17 per cent would result. Yet one of the earliest pleas
for stabilization of prices states that ‘ monetary stabilization must be
supplemented by a labor policy which assures that particular wages
will not rise while there exists an 'excess supply’ of that grade of labor,
and that wages*will rise when a ‘shortage’ of that grade of labor exists.”6
There was apparently no recognition that this sort of wage policy, if the
shifts involved were of any size, would be inconsistent with the pro­
gram of price stabilization that was advocated.
It was not until early in 1943 that a careful analysis was presented
by Friedman of the continuing importance of the role of income in
organizing resources during wartime and of the desirability, in contrast
to peacetime, of divorcing spending on consumption from the receipt of
income.6 Such a divorce could be achieved by taxation of incomes, forced
savings, or a tax on spending— last being the alternative chosen by
Friedman. At the same time Shoup discussed at length the effect of
various types of taxation (particularly the income tax) on the supply of
effort and therefore the volume of output.6 The net effect of these
contributions was to favor the use of the spendings tax as part of the
fiscal program, as a result of explicit recognition of the limitations of
income taxation because of its effect on incentives.
The spendings tax was an American version of the Kalecki plan.7
Kalecki had proposed that everyone be issued a quantity of coupons for
purchases in retail stores, but in this form the plan involved both ad­
ministrative difficulties and problems of equity. The spendings tax
represented an alternative method of controlling total spending and in
this way preserving the flexibility of the price system.7 Whatever its
W L. Bach, “Rearmament, Recovery, and Monetary Policy,” American Economic
Review, March 1941, XXXI, p. 32, My italics.
6 “The Spendings Tax as a Wartime Fiscal Measure,” American Economic Review,
March 1943, XXXIII, pp. 50-62.
0 “Problems in War Finance,” American Economic Review, March 1943, XXXIII,
pp. 74-97.
10 General Rationing, Bull., Institute of Statistics (Oxford, England), January it ,
1941, Vol. 3, No. 1.
71 The standard arguments for the superior economy of a price system were usually
offered; but such arguments really apply to long-run adjustments and wartime problems
are short-run in character. As economic theory tells us .litde about the process of adjust-



theoretical merits—
and I believe that the importance and extent of
economic flexibility can easily be overstated in wartime7 —
2 there can be
no doubt that the spendings tax would itself have raised serious problems
of equity and administration. Perhaps the most serious of the former
would have been the treatment of housing expenditure— home owner
vs. the rich renter whose contractual rent is in excess of his entire per­
missible spending. Even K. E. Poole, though he concludes that the plan
is administratively workable, admits that “the administration of the
spendings tax would apparently have to be substantially better than that
of an income-capital gains tax of approximately equal efficiency.”7 Hence
it is understandable that Congress did not show much enthusiasm for
the proposal.
Advocates of the spending tax did not feel that any extended evaluation
of price control and rationing as an alternative method of limiting spend­
ing was necessary. Wallis stated simply that "specific controls, such as
price ceilings and rationing . . . cannot control inflation,”7 and Fellner
argued that "price control and rationing are inadequate substitutes for
anti-inflationary fiscal policies. Direct controls can be expected to fore­
stall inflation only if the pressure against which they have to operate
is held within rather narrow limits.”7 This is not surprising, as those
in charge of price control themselves had grave doubts as to the potency
of the weapon they were using; the Statement of Considerations accom­
panying the General Maximum Price Regulation, according to Gal­
braith, "carried a heart-felt warning that it would not work unless strong
steps were taken to restore and maintain equilibrium at the then ruling
ment, it also has little to say regarding the short-run wastes involved in reaching adjustment. Hence the applicability of the usual arguments to wartime problems is not cle&r.
A similar point in criticism of the Kalecki plan was made by R. E. Holben, "General
Expenditure Rationing with Particular Reference to the Kalecki Plan,” American Eco­
nomic Review, September 1942, XXXII, pp. 5I3~523> who also opposed closing the gap
"during the present transition stage” (p. 522) of the war economy.
73Thus W. A. Wallis, an early advocate of the spendings tax, argued that the “possi­
bilities of substitution quickly convert what would otherwise be an acute specific shortage
into a mild general shortage in M
How to Ration Consumers* Goods and Control Their
Prices,” American Economic Review, September 1942, XXXII, p. 511. It seems to me
that “quickly” refers to periods longer than the war itself!
73“Problems of Administration and Equity under a Spending Tax/ American Eco­
nomic Review, March 1943, XXXIII, pp. 63-73. As proposed, it would have been neces­
sary for those with capital to show that all assets sola were balanced by assets purchased.
It seems to me that the possibilities for evasion on the part of those possessing capital, and
especially those engaged in small businesses, would be sufficient to make the tax politi­
cally unacceptable, especially when it was known that it would almost certainly be in
effect for too short a time for efficient administration to develop and when Poole admits
that hoarded cash and anticipatory buying would inevitably make the tax inequitable for
“the first year or two” (p. 67).
ciu, p. 502.
O f. ciu, p. 235.



prices.”7 Yet, despite the widespread doubts of economists and most of
the standard texts, price control, even without extensive formal rationing,
proved unexpectedly effective as a device for limiting spending. But as
price control alone takes a relatively small administrative staff, the pro­
gram was less wasteful of manpower than had been feared. Further,
for a short period and with a large second-hand market, the inequity of
“bare-shelf rationing” (resulting from goods not being available) also
turned out to be bearable.7 Hence the method of limiting spending so
as to control inflation which economists, by and large, would have been
the last to recommend was not only the one used, but was used with
outstanding success.
Compared with previous wars, perhaps the most remarkable thing
about the recent war was the lack of interest in, or discussion of, methods
of raising the money to meet war expenses. This is because the technical
problem of ensuring that the government had the dollars it needed when
it needed them presented no difficulty. We understood how to provide
smoothly, through an expansion of bank deposits (and therefore cur­
rency), the sums which were not raised by taxation or voluntary saving
and we did not delude ourselves into believing that individual borrow­
ing secured by government bonds was less inflationary than an equivalent
credit extension by outright purchase.
There are, of course, many who feel that the banks should not have
been allowed to absorb as much of the increase in the debt as they actu­
ally did, or that the “pattern of rates” on government securities should
not have been stabilized at the levels actually selected. But it is not clear
that a change in the amount taken by the banks or the pattern of rates
used would have had any appreciable effect on our ability to wage
war. Hence these matters raise in the main the important question of
the controls to be used in the postwar period, which will be discussed
in the following section. The only probable objection to this general­
ization is likely to be that a higher rate of interest during the war might
have decreased spending and increased voluntary saving.7 But the
Savings Bond program generally and the Savings Bonds themselves
*6Op. ciu, p. '290, note.
17 As impersonal (highly competitive) markets are the exception rather than the rule,
business usually distributed short supplies of goods reasonably equitably to maintain dis­
tributive channels and trade relations. In fact, it is likely that many of the advantages
of a spendings tax would be lost because business would not have allocated goods where
demand was greatest (even at the expense of maximum wartime profits) for fear of the
treatment of its distributors that would be involved!
7 Whether people could have been induced to hold more government bonds and less
bank deposits is again a postwar problem; for during the war the holders of the balances
were induced over all to keep them idle, and an idle balance has no more effect than
an equal amount of government bonds.



represented relatively generous treatment for most saving likely to have
resulted from a voluntary reduction in spending. Until we know more
about the effect of interest on savings, I doubt whether there is much
more that can be said in appraisal of the program actually pursued.7

VI. T h e P o s t w a r H e r i t a g e
By the end of the 1930s it had become quite clear that monetary
policy (in the sense here used) could not by itself promote recovery.
But I think it would have been fairly generally agreed that there re­
mained for monetary policy an important role in setting the scene for
recovery and in ensuring that the subsequent prosperity did not become
inflationary. The government debt which we inherited from the war,
however, has drastically restricted the ability of the Federal Reserve
System to move against inflation.8 Of the present gross federal debt
totaling $260 billion roughly $100 billion, or 40 per cent, is held by
commercial banks and the Federal Reserve System. The normal state­
ment of the problem facing the Federal Reserve System is that, so long
as the banks continue to hold such a large amount of securities, they will
be able to obtain whatever reserves they wish by selling securities to the
Reserve banks, thus causing a multiple expansion of the money supply.
I think this statement obscures the fundamental issue. Even if the
banking system held no federal bonds whatsoever so that all openmarket purchases or sales were from the general public, attempts to con­
trol the general credit situation, either by open-market operations or
changes in reserve ratios, would inevitably lead to unacceptable reper­
cussions on the government bond market; in other words, the problem
would be the same as it now is. Hence the essence of the situation is that
control has been taken from the Reserve System, not by the bond hold­
ings of the banks, but by the decision to stabilize the price of government
bonds and therefore the general structure of interest rates.
Before discussing the desirability of this decision it is worth making
clear that the banking system could be shielded relatively easily, from the
effects of changes in the rate of interest— if one prefers it the other
way round, the Reserve System could be shielded from the effects of bank
holdings of government bonds. A rash of proposals has been put forward
T Cf. Seymour E. Harris, “A One Per Cent War?” American Economic Review, Sep­
tember 1945, XXXV, pp. 667-671.
8 The debt inherited from the war has also restricted to a lesser extent the ability of
the System to bring about easier credit conditions, because of the resulting capital gams
on government bonds.



to achieve this end;81 but the simplest to understand, as well as in all
probability the most effective, would involve giving the Reserve System
the power: ( i ) to raise member bank reserve requirements to any level;
(2 ) to pay interest on member bank reserve balances; and (3 ) to lower
as much as is necessary its own Gold Certificate reserve requirements
against Federal Reserve notes and deposits.8® With these powers the
Reserve System would be able to acquire most bonds now held by the
banks by extensive open-market operations offset by increased reserve
requirements to levels between 60 and 75 per cent; the loss of earnings
on government bonds could be offset, to whatever extent desirable, by
the interest paid on the reserve balances which the banks would have ac­
quired. In this way the banking system would be rendered almost com­
pletely impervious to changes in the price of government securities, and
the ratio of capital to assets other than reserve balances raised to a higher
level than it has been in decades.8
While these changes could be made relatively easily,8 they are almost
“ Originally proposed by L. H. Seltzer to deal with the prewar problem of excess
reserves, the idea has recently been advocated not only by Seltzer, “A Uniform Treasury
Certificate as Bank Reserve, Commercial and Financial Chronicle, February 28, 1946*
pp. 1087, 1116-1117, but also by the Committee for Economic Development, Jobs and
Markets (New York, 1946); S. E. Leland, “The Government, the Banks and the
National Debt/' Commercial and Financial Chronicle, January 17, 1946, pp. 242,
281-284; and R. L Robinson, “Monetary Aspects of Public Debt Policy,” Postwar Eco­
nomic Studies, No. 3, Board of Governors or the Federal Reserve System (Washington,
1946). As originally proposed, the banks would have been required to hold some sort
of special government security; but the possible variations are almost endless. All security
reserve proposals involve serious administrative complexities because two types of reserves
would have to be adjusted every time deposits shifted between banks*.After considerable
study I am convinced that the proposal summarized in the text is simpler to understand,
as well as more effective, than any alternative* For this reason I have concentrated on it
rather than undertake an extended discussion of a somewhat specialized subject..
8 If it was proposed to save the Treasury money—
i.e., pay less interest on reserve
balances than was received on government securities pu rchased—arrangements would
have to be made, to the extent that the matter is not already coverea in the recent
Reserve-Treasury agreement regarding excess earnings, for the Reserve System to return
whatever difference there was to the Treasury.
88Two problems would remain: the plan could not be applied as outlined above to
non-member banks and transitional arrangements would have to be made for the few
surviving banks—
largely concentrated in the Dallas District of the Reserve System—
which still have the major portion, of their assets in forms other than government securi­
8 Judging from the economic, not the political point of view. The fact that this variant
would give the Reserve System the power to determine the interest to be paid on reserve
and therefore the general level of bank earnings—
-insures widespread bank
opposition; it might be necessaiy to guarantee a fixed return on reserve balances by giving
banks a “certificate of deposit’ bearing a rate of interest fixed contractually for a term
of years. Doubt regarding the chances of political action has also been expressed in strong
terms by Allan Sproul, President of the New York Reserve Bank, “Monetary Manage­
ment and Credit Control,” American Economic Review, June 1947, XXXVII, p. 34^It is also worth noting that freeing of interest rates would require a modification of
various government loan and loan-insurance plans, such as those applying to residential



certainly not worth making unless it is planned to use changes in interest
rates as a control device.8 Apart from variations in interest rates it is true
that the reserve proposal outlined would aid in checking the multiple
expansion of deposits which results when banks “play the pattern of
rates” by selling short-term securities to the Reserve System in order
to buy long-term issues from the market During the war we under­
took to stabilize a “pattern of rates” which was based on and adjusted to
the prewar degree of rate instability; hence this pattern can continue
without support only so long as banks think it will not continue. If they
become increasingly convinced of its permanence, the low end of the pat­
tern will increasingly require support at a time when securities at the
high end may be above par. In other words, when a particular pattern
is chosen, support (and therefore expansion) is called for whenever any
■portion of the pattern starts to fall below par, not the pattern as a whole.
If most short-term securities were transferred from the banks to the
Reserve System in line with the reserve balance proposal oudined above,
in effect the System could adjust its holdings in such a way as to con­
form with the pattern that it was committed to maintain, so that inter­
vention would only be necessary when the pattern as a whole required
support But the importance of such a change would depend upon the
extent of the divergence between the market pattern and the pattern
chosen for stabilization, as weakness at the low end would have to be
balanced by strength at the high end if the pattern as a whole was not to
require support. At present, however, the high end is exhibiting so little
strength that almost nothing would be achieved from not being obliged
to support the low end if it were necessary to support the pattern as a
whole. Hence the interest-bearing reserve plan, or any other variant of
the security reserve proposals, does not seem worth the candle unless in­
terest rate changes are to be resurrected as a control device.
Should this be done? Despite the great theoretical interest in the rate
of interest up to the war there has been increasing doubt as to whether
the practical importance of interest changes was commensurate with its
place in theory. Just before the war a group of Oxford economists inter­
viewed business men regarding the effect of the interest rate on their busi­
ness decisions and concluded: “The majority deny that their activities
have been, or are likely to be, directly affected in any way by changes in
interest rates. Of those who take the view that they might sometimes be
affected, few suggest that the influence is an important one.”8 The same
* Use of interest rates as a control device of course involves not only changes in rediscount rates but also open market operations and the like, which change rates by changing
the availability of credit.
8 H. D. Henderson, “The Significance of the Rate of Interest, Oxford Economic
Papers, No. i, October 1938, p. 9.



problem has been examined by Professor F, A. Lutz; he concludes that
changes “will not affect” decisions regarding inventories, are “not likely
to influence investment decisions in manufacturing industry,” under cer­
tain circumstances “may affect investment decisions in the area of public
utilities (including railroads) and residential construction,” and under
certain circumstances would also affect “the readiness of financial insti­
tutions to grant credit or to float bonds and stocks, so that the interest
rate may influence the volume of investment even without changing the
profit calculations of entrepreneurs.”8 While the last two categories are
of major importance in capital formation, the limited circumstances in
which they are influenced by interest rate changes make it clear that the
weapon is a less powerful one than we had thought in the past. But
should we nonetheless seek to use it, even if we know that it is likely
to turn out to be a weak reed?
From the factual point of view we are really asking whether the tail
should be allowed to wag the dog. For total private debt is only perhaps
one-third of all debt. This means that any permanent rise in the rate
of interest will ultimately increase the cost of perhaps 80 per cent of all
with ihe resulting adverse effects on income distribution— order
to affect decisions involving 20 per cent. It is true that during certain
phases of the business cycle the percentage of the annual changes in the
debt (and therefore of the current offsets to saving) influenced by changes
in the rate of interest may be considerably greater than 20 per cent; the
extent to which this is likely to be the case will of course depend on the
future fiscal policy of the Federal Government. But the ultimate cost in
adverse effects on income distribution is obviously far greater than when
the Federal Government was a minor debtor, adjusting itself to policy
determined with other considerations in mind. Further, there is also an
increasing belief that the amount saved out of current income (in
Keynesian terminology, the marginal propensity to consume) is quite
insensitive to changes in the rate of interest, so that consumer spending
can far better be influenced by direct control over instalment credit and
the like rather than through general changes in the level of interest rates.
Even the extent to which people utilize their existing liquid asset hold­
ings is not likely to be much influenced by interest rate changes.
Nor are the secondary effects of interest rate changes likely to be
large.8 The actual pattern of bond holdings casts doubt on whether small
9 “The Interest Rate and Investment in a Dynamic Economy/* American Economic
Review, December 1945, XXXV, p. 830.
8 By far the most comprehensive discussion of this problem is that of L. H. Seltzer,
“Is a Rise in Interest Rates Desirable or Inevitable?** American Economic Review,
December 1945, XXXV, pp. 831-850, who suggested most of the points made in the text



increases would prevent holders from selling their securities to the banks
(and thus hold down bank expansion); and there is not much more
reason to believe that such increases would *mop up” idle balances, or
that such balances would remain “mopped up” even if a temporary shift
was brought about. On the other hand, large increases in the rate of in­
terest might well be dangerous. Not only would there be the possibility
that the decline in the price of government securities would be inter­
preted as a breakdown in government credit, but in the short run bank
capital would be endangered and in the long run bank earnings would
be unacceptably large—
unless in both cases some variant of the interestbearing reserve balances plan had previously been put into effect.
Perhaps the best argument for reinstating monetary controls is that we
have so few others. Seltzer, after rejecting interest rate changes, could
only name budgetary policy, Savings Bond campaigns, and control over
margin and consumer credit, concluding that the problem of control over
inflation was still unsolved.8 Since then control over consumer credit
has been dropped; only “jawbone control” by the Council of Economic
Advisers has been added. Of course this situation holds no terror for the
confirmed believer in secular stagnation. As monetary controls since the
middle of the 1930*5 have, in any event, been merely potentially impor­
tant in checking a boom, their loss will not disturb anyone convinced that
booms have disappeared.
Nor does this terrify the advocate of “functional finance,” who is quite
willing to rely almost exclusively on budgetary policy.0 After the level
of government expenditure had been decided by balancing the social
utility of additional government expenditure against additional private
expenditure at roughly the full employment level of income, the extent
of taxation would be entirely determined by the need to contract or
expand the national income so as to keep it at the level required for full
employment— the debt fall where it may. Theoretically there is much
to be said for this approach; certainly it has helped to clarify our under­
standing of the underlying issues. But its terminology is well calculated
to scare the daylights out of Congressmen, who must be prevailed upon
to put it into effect!
Even conservative use of budget policy, unadorned by the trapping of
“functional finance,” has made little progress. There is no inclination to
delegate even limited control over taxation to the executive; yet without
some such delegation—
unless similar p9wer be given to a Congressional
rapid action cannot be expected. On the expenditure side—
8 Ibid., pp. 846-847.
0 A. P. Lemer, Economics of Control (New York, 1944



assuming that increased expenditure would be part of conservative budget
policy—there is also little that has been done in the way of advanced
planning. Perhaps most fundamental of all, there is meager general
understanding of the probability of a major business cycle or of the mag­
nitudes that would be involved with our present level of national income.
True, the inauguration of the Council of Economic Advisers may in time
help notably. But it seems fair to say that the present period is woefully
lacking in devices for control of the level of economic activity. It is on
the ground that any weapon is better than none when the arsenal is
almost empty that the advocate of the re-establishment of the use of
monetary controls can base his case at the present time.
The weakness of the case for a reinstatement of monetary controls in­
volves a further decline in die importance of monetary theory in general
and interest rates as a control device in particular. This in turn has stimu­
lated work on other aspects of the interest rate as well as different types
of controls.8 One aspect much in need of further investigation is what
does determine where investment is undertaken, and therefore the way
in which capital is allocated. The extent of the tendency of business men
to confine new investment to lines similar to those in which they are
already engaged particularly needs investigation. Another important prob­
lem is the role played by the risk element. The difficulties that small busi­
ness experiences in obtaining long-term capital may result from a reluc­
tance on the part of the lender to appear to “gouge” the borrower by
charging a rate sufficient to cover the actual risks involved, while the bor­
rower may be unwilling to pay, not because the rate would be burden­
some, but because it would reflect on his credit standing! It has long been
pointed out that part of the control over credit exercised by commercial
banks was through changes in the freedom with which funds were made
available at constant rates of interest. A similar situation probably prevails
among other lenders as well. It is probable that much future research
will deal with the organization and functioning of particular credit
markets, and especially with the non-price elements involved. Already
such markets as those for consumer credit, residential mortgages, and
stock market funds have been singled out for special stimulation or con­
trol, and the trend is likely to continue.
Another area where further research is needed is in regard to the
management of the present volume of government debt. While much has
appeared regarding the debt, it has usually been from the point of view
“ See H. C. Wallich, “The Changing Significance of the Interest Rate,” American
Economic Review, December 1946, XXXVI, pp. 761-787; and idem, “Debt Manage­
ment as an Instrument of Economic Policy,” ibid., June 1946, XXXVI, pp. 292-310.



of the restraints exercised by the debt on monetary or fiscal policy. What
we need to know is how to manage the structure and composition of the
debt in such a way as to reinforce monetary and fiscal policy; particularly
what we do not want is to have debt management determined predomi­
nantly by technical considerations— be “for the sake of the debt.” Al­
though developed to combat inflation during the war, the Savings Bond
program probably represents the most outstanding innovation in our debt
structure. With close to one-fifth of the total federal debt in this form,
an important stabilizing influence on economic activity is likely to emerge
if, as seems likely, people expand their holdings during periods of pros­
perity and redeem their securities to maintain their consumption during
periods of depression. The general precedent set in connection with Sav­
ings Bonds—
and also in the opposite direction in regard to eligibility for
bank purchase—
might be extended to other separable groups. The argu­
ment that present levels of interest unduly burden institutions such as
savings banks, insurance companies, and corporations not operating for
profit has recently been met by the issuance of special securities limited
to such investors. When knowledge has been accumulated about the
effects of these and similar changes, it should be possible to design a
policy of debt management which would give maximum aid to both
economic stabilization and the achievement of other objectives of eco­
nomic policy.