CREDIT POLICY AS A FACTOR IN
THE PRESENT WORLD DEPRESSION
AN ADDRESS BY GRAHAM F. TOWERS B.A., CHIEF
INSPECTOR, THE ROYAL BANK OF CANADA, MONTREAL.
26th February, 1931
PRESIDENT STAPELLS introduced the guest, who said
To a business world encouraged by post-war recovery, and by a number of years of relative prosperity, the extent of the present world-wide depression has been a decided shock. During the latter years of the prosperous period we were told frequently that a new era had dawned for business, and that the suffering and disorganization which arose from the trade cycles of the past need no longer be expected. Nevertheless, with such statements still fresh in our minds, we find ourselves in a depression of severity unequalled during the present generation. The best feature of it, in my opinion, is the fact that it is encouraging a closer examination of the reasons far its existence. In the opinion of many people the part played by currency and credit in business prosperity or business depression is of such extreme importance that it deserves to be given first consideration. Perhaps the best way to deal with this rather complicated subject is to lead off with a few simple statements which will, I hope, find ready acceptance on your part.
As business is conducted in terms of money it seems obvious to say that an increase in business requires an increase in money, if prices are to remain stable. During the history of the world money has consisted of various things, but for a long time gold has been preeminently the medium of exchange. Not so long ago gold coin was actually used, and if the gold standard countries of the world still used a currency which consisted entirely of gold I think we should have little difficulty in understanding that an increase in production and of trade must be accompanied by an increase in the supply of gold, unless prices are to be allowed to decline. Obviously business transactions can be conducted with a smaller supply of currency on a low price level than they can on a high price level. In the gold-using world which I have just pictured let us imagine that business ingenuity and hard work resulted in the production of an increased volume of goods. By an unlucky chance it is impossible to increase the supply of gold. The increased volume of goods comes on the market, but gold is then insufficient to provide an adequate medium of exchange. Trade is hampered, prices fall, and on the new and lower level there is then sufficient gold to conduct the world's business. If all currency consisted entirely of gold, or was backed 100 per cent by gold, no management of currency would be possible, and at a given level of production prices would depend on the chances of gold output. Fortunately the world has graduated from such a rigid system. Gold coin has almost altogether passed out of use as a medium for cash payments, or as a reserve for commercial banks. It is used as a reserve by central banks,, though not necessarily to the extent of 100 percent of the central bank's liability in the form of outstanding notes or reserve deposits of commercial banks. It should be noted here that in many countries the commercial banks are not in the habit of keeping any large amount of actual paper currency in their vaults. The greater part of their reserve consists of deposits with the central bank. These deposits constitute a call on the equivalent amount of currency; to all intents and purposes they are currency, and in future I intend to use the words "central bank currency" to embrace both the outstanding notes of the central bank and the reserve deposits which the commercial banks maintain with the central organization. The legal requirements of the central bank in most cases do not call for a gold reserve of more than forty per cent; thus for each million dollars of monetary gold there may be outstanding two and a half millions of central bank currency. By this system the world found a way of providing for the monetary requirements of an enlarged production, avoiding the imperative necessity of relying on the lucky chances of gold discovery, or, as an alternative, throttling business down to a price level which would probably have been a fraction of the existing figures. While I have taken forty per cent as the average of minimum legal requirements in connection with gold reserve, these reserves might under certain circumstances be as high as one hundred per cent. Within certain limits the percentage of reserve depends on the policy of those in authority. Thus man has replaced the mine as the determining factor in the quantity of currency in existence, and if the expansion and contraction of credit are important factors in the business cycle, the actions of those controlling central bank policy are of vital interest to the business world.
I think if the events of any business cycle were recalled we should all agree that expansion or contraction of credit did play an important part in the ups and downs of those cycles. The story has unrolled itself before our eyes, and those of previous generations, time and again during the last hundred years, but as soon as one depression is over its lesson is forgotten almost immediately. Here is the sequence; low rates in the long-term money market of the principal financial countries induce borrowing for new projects undertaken by governments and companies. While these new developments are under construction they put no goods on the market for sale. On the contrary, their purchases of material and their employment of workers lead to an increased demand for goods from existing sources of supply. Domestic and international trade is given an immediate stimulus. The business of the world is encouraged" and becomes more optimistic, resulting in fresh projects being undertaken. If this development proceeds too rapidly, credit supplies commence to show the strain, and eventually the cost of borrowing discourages new enterprises and leaves old ones unfinished. Employment drops, purchasing power is curtailed, manufacturers reduce their purchases of raw materials, supplies of unpurchased goods mount, and the cry of over-production is heard in the land. What is the characteristic sign of over-production?-the answer immediately is, a fall in price; but when we say price we mean exchange value. We mean that a larger quantity of the over-produced commodity has to be offered for commodities which are not suffering from over-production. If all commodities experienced a price decline of equal percentage, a bushel of wheat or five pounds of cotton will command five pounds of copper at the new level just as they did at the old. In such a case it is only the value of money that has changed. In the early stages of a change in money values we never find that all commodities decline on an equal basis. First amongst the sufferers are the raw products. Before these products reach the consumer they have a substantial percentage added to their cost in the form of transportation, manufacture and distribution, and in all these activities the wage cost is an important, often a preponderant factor. In our modern civilization wage rates change slowly" and so we always find, during a period of depression, that the price of manufactured goods is quite out of line with the changed price of raw materials. The farmer who one year paid one hundred bushels of wheat for a certain manufactured article, must next year pay two hundred bushels of wheat for the same article. His purchases are necessarily halved, and while the rates of wages which factory workers receive may remain the same, the amount of wages they receive is reduced by unemployment; their purchasing power is limited, and world trade receives a further blow. Disorganization ensues, and we have the amazing spectacle of an apparent over-production of all the principal commodities of the world at a time when millions of unemployed are only too anxious to find some means of obtaining those over-produced commodities.
We all realize this has been happening during the last year and a half, and it is plain that if raw material prices are to remain as they are, finished goods cannot be sold at previous prices to raw material producers; therefore the value of finished goods must be reduced proportionately. Certain costs of production, such as interest on funded debt, are fixed for a period of years; others, such as rent and taxes, are slow to change; price reductions are made in the first instance at the expense of profit, and in the latter by cutting wages. The world then starts off on a new price level which, in the present instance, might be twenty per cent below the old one. Even if these statements are obvious, I think it worth while to make them because it is desirable that we should have their meaning fixed clearly in our mind. They mean that the world of business would, in such circumstances, reestablish itself on an even keel after a drastic change in the value of money. They mean that after great loss and suffering on the part of millions, no one will be a whit better off except a small minority of the creditor class and the few people who gambled on the short side at the right time. Simple as this is, far too many people are unable to recognize that it is a change in the value of money which is largely responsible for the present state of depression. They refuse to realize that if money remains at this changed value innumerable and painful adjustments have to be made. Thus we still have with us, though in diminished number, those cheerful prophets who characterized last year as merely one of psychological depression" or those who, ascribing the trouble to over-production, must logically advocate curtailment on a world-wide scale of all the apparently over-produced commodities. It is forgotten that the total purchasing power of the world is governed by the total volume of production valued at current prices, and that purchasing power can be increased only by increased production.
Let me retrace my steps and review briefly the conclusions that I have suggested. First, other things being equal, an increase in the volume of business requires an increase in the supply of money if prices are to be maintained. If all money consisted entirely of gold an increase in the volume of business necessitates an increase in the supply of monetary gold. But gold is now used only as a reserve by central banks. Within certain limits the central bank currency can be expanded or contracted, irrespective of any change in the supply of gold. Central bank currency is the foundation for general bank credit. Lastly, easy money conditions always accompany an expansion period of the business cycle, and scarcity of credit is in evidence at the commencement of any depression of importance.
It is time now to pass from the general to the particular and see how the theory fits in with the events of the last ten years. The United States emerged from the war as the dominant factor in the world's financial affairs. Her banking position in 1921 was over-expanded, but coincident with the reversal in business, gold started to flow to the United States in enormous quantities. Between the years 1921 and 1925 the net import of gold into the United States was in excess of $1,500,000"000. The commercial bank indebtedness to the federal reserve system was soon paid off, and the country found itself left with enormous financial resources available for investment; the easy money conditions leading to an expansion were clearly in evidence. Low rates and lack of a pressing demand for capital from the domestic market caused them to turn their eyes towards foreign possibilities, and as so often happens in that country, they moved swiftly and enthusiastically. The year 1924 was the first in which foreign financing took place on a large scale, but during the five years ending in 1928 the United States loaned over $6,000,000,000 of new money to other countries-which means that during those five years the United States created sufficient credit to put $6,000,000,,000 of purchasing power into the hands of other nations. Such an efflux of credit in a five year period is unique in the world's history, and the effect on world trade was amazing. Naturally the lender of those dollars shared liberally in the resulting prosperity, and prices of common stocks of United States corporations rose rapidly. Thus was created an additional demand for credit to finance the rising stock market. I might interject a word of explanation here by saying that additional credit is required to finance a rising stock market only to the extent that existing stock owners withdraw their profits. Such withdrawals took place on a large scale in the United States, and were used to a certain extent to purchase articles for consumption, and to a larger extent to purchase newly created issues of securities. Thus the market whose rise had been due to prosperity, intensified the prosperity by the very circumstances of its rise. It seemed as if the millennium had been reached, until finally the intensified demand for credit raised rates all over the world to commercially impossible levels. In many cases it was impossible to borrow money, no matter what rate was offered. The door was shut in the face of foreign countries, and foreign government bonds are in many cases still selling in New York at something amounting to panic levels. The inevitable curtailment in world business, and the subsequent decline in international trade" can be measured only in terms of many billions of dollars. There is really no question that, during the latter years of the period I have described, the United States took the world on a credit spree, and put a strain on the credit resources of the world which would shortly have become unbearable. Strenuous action on the part of the central bank finally resulted in the bubble being pricked, but opinion is now becoming quite definite that our present position would be immeasurably better if the United States had taken proper measures early in 1928. Such, at any rate, is the substance of much of the testimony being received by the committee of the United States Senate which is presently engaged in the examination of banking matters. But if early action on the part of the central banks is highly desirable at a time when over-expansion of credit is leading the world into trouble, strenuous measures to ease credit are essential as soon as the tide turns. Otherwise, a chain of circumstances is set up which leads to excesses in the deflationary movement even more disastrous than those which are to be seen during inflationary periods. It is from such excessive deflation that the world is suffering at the present time.
It should be noted that the proper criterion of easy money conditions is not to be found in the call loan rates or the rates on short term bills. New, developments and the satisfactory functioning of international finance depend on conditions in the long-term money market, and the forcing of funds in this direction is one of the principal functions which a central bank can perform in endeavoring to stem the tide of depression. Contrary to the general impression, the long-term money market of the United States has never been in a really easy position since the depression began, and in my opinion is not in a really easy position today. Thus the world's principal long-term money market is still closed for repairs, while France" whose resources qualify her for a leading position in this respect, is only now taking the first step towards assuming her share of responsibility for world financing. Great Britain, on the other hand, has done everything possible to continue foreign financing to the greatest extent that her resources will permit, and in the course of keeping rates as low as possible in London she has parted freely with her gold. It must be recognized that not all central banks have the power to exert major influence in these matters. The power of an individual central bank to act is limited by the extent of its gold resources.
Now the Central bank organizations of France and the United States control something over sixty per cent of the world's supply of monetary gold, and the balance of the world's gold is distributed in such a way that no other country is in a position to take independent action to ease world credit conditions without risking the loss of its gold supply. Thus the unbalanced situation in respect to the location and control of the world's gold supply places the main responsibility for any action on France or the United States. In the latter country, the bond market is not in; a satisfactory position, and if domestic issues are to be hampered and international financing practically eliminated by this situation it will be difficult in the near future to find a satisfactory basis for the re-establishment of world trade and the recovery of commodity prices. Short term funds have accumulated, but an easy money policy on the part of the central bank is desirable to stimulate the movement of money towards the bond market. France, too, should accelerate her action in these matters, so that more of her gold may be available as a basis for the credit requirements of the world. The total supply of gold in the world is ample for the support of present price levels, and for the financing of normal expansion in business., provided that too much of it is not allowed to remain idle in the hands of the wealthy countries through accumulation of excessively high reserve percentages. 'Thinking along these lines" then, the problem is not gold shortage. The problems of the moment are two in number-understanding and cooperation-and of these, I think understanding is the more important. It is inconceivable to me that the world should continue much longer to tolerate these drastic changes in the value of the medium of exchange, the last one of which, as we are seeing, has disorganized the world's commerce to a marked extent. Acute necessity in the past has usually produced the needed invention, and we must hope and believe that it will not fail to do so in the present circumstances. I thank you very much. (Loud and continued applause).
Mr. H. D. Burns, Assistant General Manager of the Bank of Nova Scotia, expressed the thanks of the Club for the thoughtful address.