Query: Whether a discovery of the richest gold mine that ever was, in the heart of the kingdom, would be a real advantage to us? The Querist.

The phenomena of commerce have their monetary aspects and the phenomena of finance have their commercial and economic reactions. The flow of goods from myriads of primary producers through various intermediate stages of mining or harvesting, collecting, transport, manufacture, wholesale and retail distribution, to myriads of ultimate consumers in a score of different countries is accompanied by a flow of 'money' in the opposite direction. The economy of this elaborate production-consumption complex is partly local, partly national, and partly cosmopolitan.

'The bank credit which originates in production is extinguished in consumption' says Mr Hawtrey. In the normal course of events the money which is brought into existence by borrowing from a bank in order to finance a manufacturing operation is paid away in various proportions to employees of the firm and to those who have sold materials to it. Part of it goes to meet standing charges, part of it goes in payment for public services, and part perhaps remains as profit to be distributed amongst shareholders or partners as dividends. It disappears and is spent in many directions, but the total is made up of the sum of the four elements, wages (including salaries), interest, rent, and profits.

Naturally the wage-earner and others who derive their income from a cotton factory do not spend all their money in buying the cotton goods which they have cooperated to produce. Yet if we suppose an isolated community whose whole economic activities are organised as part of a single business concern, all the incomes of its members would be spent in buying back as consumers the goods which as producers they had co-operated to make, and there would be no other market to which such a firm might look for the absorption of its products, except the market created by its own distribution of monetary payments.

In actual fact the purchasing power created to finance an operation of cotton production, and distributed to various wage receivers and others as income, is spent by them on a great variety of goods and services. Those who sell these goods and services buy other goods and services with the money the origin of which was the enterprise of the cotton manufacturer in borrowing from a bank, and they in turn buy other goods and services, and so on through many stages until in the end perhaps those in India who have sold tea, or in Brazil who have sold coffee, in exchange for some of this money, use the money to buy the cotton goods, for the production of which money was originally brought into existence as purchasing power.

The manufacturer of cotton casts his money upon the waters and it returns to him after many days, and many vicissitudes of ownership, from the ends of the earth to buy his cotton goods.

When this does happen, and unless it were the normal condition of affairs, modern business would be impossible. The cotton manufacturer is able to repay his loan to the bank, and the money which came into existence to facilitate an operation of production is extinguished when the operation has justified itself in consumption.

The smooth continuity of an electric current disguises the fact that its smoothness is due to infinitely rapid alternations of current travelling in opposite directions. Commerce too flows smoothly along in uniform volume when the alternating currents of goods and money are able to proceed on their way unimpeded. For purposes of illustration we have taken an isolated operation of cotton manufacture, and shown how the financing of its production brings money into existence as purchasing power, as a liability of the cotton manufacturer to a bank, which is ultimately extinguished when the cotton goods reach consumers.

When a boa constrictor eats a lamb its inside displays a bulge which gradually disappears as the process of digestion is completed. The financing of production, if production took place in isolated jerks, would produce a similar bulge in the volume of money which would gradually disappear as the goods were absorbed in consumption.

In actual fact, of course, the cotton manufacturer maintains, or tries to maintain, a continuous activity of production. Under normal circumstances money is constantly rolling in, in payment for past productive operations, and this is used to pay off old bank loans which are continuously being renewed to finance further productive activity. His indebtedness to the bank, and consequently his particular contribution to the total volume of money, may show a uniform, or only slightly varying volume, over a long period, but In a healthy state of commerce this uniform volume of indebtedness is not dead money, but the consequence of the continuous renewal of loans to replace loans which have been liquidated.

If, anywhere in the world economy, obstacles are placed to obstruct the free flow of goods from producer to consumer, the result will be to prejudice the volume and circulation of money as well as of goods. The volume of money is maintained when the business man sees a profitable outlet for his productive activity, and that cannot continue to exist unless there is the assurance that the goods will ultimately reach consumers.

If the cotton manufacturer finds that a market in India, or elsewhere, on which he formerly counted is cut off by the erection of a tariff wall or other impediment, and he cannot find a compensating outlet elsewhere, he will contract the scale of his operations. Old Bank loans will be paid off, as and when he gets paid for what he has already produced, but new loans will not be incurred in the same volume. His contribution to the total volume of purchasing power will thus be a diminishing one, and if a large part of the nation's commerce is affected. the total volume of purchasing power will lessen. He will probably dis-employ some or all of his workers, and use a smaller proportion of his productive capacity or none of it at all. The diminished consuming power of his dis-employed workers will impair the market for the products of other businesses, national and foreign, and thus a vicious circle of depression will be started which will tend to widen.

The monetary situation is not really any better if the cotton manufacturer is unable to wipe out his indebtedness to the Bank completely. It Is true that the complete liquidation of his indebtedness to the Bank would wipe out a part of the existing volume of money, but the continued existence of that part, through his inability to pay, represents a frozen asset to the Bank, affecting its willingness or ability to make new loans in other directions, and a milestone of debt to the cotton manufacturer which must impair his business efficacy.

If the obstacle to the flow of goods is set up by the action of one's own country in restricting imports, the ultimate monetary effect is not essentially different. In the long run exporters of goods and services are paid in the currency of their own country by their fellows citizens who have imported goods and services from abroad.

If the volume of imports is artificially restricted, the ultimate source from which alone exporters can hope to be paid is to that extent diminished. The foreigner cannot continue to buy and consume our goods except to the extent to which we continue to buy and consume his. From the point of view of the internal economy, the export of goods and services is only an indirect way of producing for home consumption the goods and services we import from abroad. It is adopted by common consent when people are left to themselves, because it is cheaper and more advantageous to all concerned.

If the exporter of butter is thus regarded as indirectly the producer of potash and corrugated iron, it is clear that to put obstacles in the way of consuming foreign potash and corrugated iron at home is to put obstacles in the way of the profitable production of the butter for export.

When a foreign country puts a tax on Irish butter exported. the monetary effect at home here is immediate and obvious. The volume of purchasing power put into circulation in connection with the manufacture of butter must contract, correspondingly, as our butter market contracts. It is less obvious when we ourselves put a tariff on the import of something by which in fact our butter was formerly bought. The restricted sale of potash and corrugated iron by a neighbouring country will cause a reduction of the volume of purchasing power in that country, the effect of which will extend to us in common with all other countries having commercial relations with it.

Fiscal obstacles erected by our own and other countries are not the only obstacles which impede the flow of goods from producer to consumer. There are natural impediments of geography and distance which the ingenuity of modern transport has triumphantly surmounted. There is now an 'embarras de richesse' of modern transport methods.

Another important obstacle is represented by the numerous processes and stages, and the numerous changes of ownership through which a piece of material must pass before it emerges as a consumable good. Between the wool on the sheep's back and the coat on ours there stretches a long line of sheep farmers, wool merchants, cleaners, spinners, etc; in the long drawn out process of further manufacture and distribution a block may occur delaying or obstructing access to the ultimate consumer, and the monetary effect of such a block will be exactly the same as in the other cases.

What encourages the manufacturer to borrow and create purchasing power is the assurance that he will be able to sell his product to the person or firm who stands next to him one stage nearer the ultimate consumer. Normally there is a good deal of slack in these commercial relations. Intermediaries may increase or diminish their stocks within wide limits with immediate reactions on manufacturing activity.

But in the long run, the channels of distribution will become congested unless the rate at which they are cleared by consumption corresponds to the rate at which they are being filled by producers at the earlier stages. The most important single factor influencing the rate of consumption is retail trade price policy. The manufacturer has little or no influence over this policy. neither has the banking system; and if a situation exists in which retail price policy is restricting the rate of consumption, the producers at the earlier stages must diminish their productive activities, with consequent reactions on the volume of money and employment. In this way, as a result of purely commercial causes, the phenomena of a business depression can be produced without the operation of any monetary cause as a primary factor.

But monetary symptoms will appear as secondary phenomena, and in their turn will become causes aggravating the original disturbances, and tending to give a monetary appearance to what began as a commercial disorder.

(The effect of commercial obstructions on commercial credit is discussed more fully in the prologue and epilogue of "Why Ireland needs the Common Market". JJ 1968)

At first sight it may appear unwarranted to argue that commercial variations, resulting from tariffs or other causes, can give rise to business depressions and failing prices. In pre-World War experience, a policy of economic nationalism was traditionally associated with relatively high and rising prices. This view has been enshrined in the orthodox economic theory on which we were brought up. 'The purchasing power of gold is generally low n a country which levies many high Import duties', in other words prices are generally high. This statement of the case corresponded well enough with the facts of pre-1914 tariff experience.

The United States practised a policy of economic nationalism for a generation or more before the war, and the internal price level of that country was notoriously high. And yet, in our recent experience of economic nationalism made in scores of countries, we find a tendency to low and failing prices, not only in the few remaining gold-standard countries, but in the many which have frankly or covertly abandoned gold. There is here a situation which calls for a restatement of economic theory.

Without going into the question of how far the movements of gold in the pre-war world were 'automatic', there is no doubt that the universal disposition to regard gold as the financial basis of credit operated to some extent to neutralise the effect of a policy of economic nationalism in checking the international flow of goods.

If America restricted her imports by high tariffs, but sought to export the same volume of goods as before, other countries perforce sent her gold in payment for the balance, and this caused an expansion of credit and prices in America which caused foreign goods to come leaping in over the tariff wall, and brought about the consumption at home of some goods which otherwise would have been exported. In this way, by the effect of a gold influx in discouraging exports and encouraging imports of goods, a new equilibrium in the foreign trade of America would be established, in which exports once more paid for imports, and in certain events the surplus gold would even be drained back again.

In post-1918 times the cult of stability of internal prices, and the technique of sterilising gold, have reached such a pitch that this automatic machinery no longer works. Countries can continue to receive gold without experiencing a rise in their internal price levels. In effect gold is no longer regarded as the basis of credit, but the central banks of creditor countries, instead of giving monetary form to a well-conceived economic basis of credit, have contributed to the destruction of credit itself, and of the money which is its offspring.

The consequence of all this is that there is now (1937) no automatic monetary mechanism which will restore the circulation of goods, restricted by policies of economic nationalism. One incidental result has some scientific interest for the development of monetary theory. It is now clearly seen that economic nationalism can be essentially deflationist in effect. It lowers the general level of prices in the world as a whole, if the policy is simultaneously practised by many important nations.

Another incidental result is that it becomes clear in the economic sense that credit is not based on gold at all and never was. It is based on the business man's assurance that what he proposed to produce will eventually be consumed.

Once that assurance is destroyed, from whatever cause, credit will collapse, even if the vaults of central banks are full of gold, nd money is being thrown at unwilling borrowers at less than 1%. This assurance might be called the commercial basis of credit. The commercial basis of credit can co-exist with the financial basis, as hitherto understood, and both can combine to produce an inflation of prices even when the economic basis of credit is non-existent.

In recent years n France and America the financial and economic basis of credit was adequate, but money refused to come into existence and circulate as purchasing power because the commercial basis of credit was lacking. The first step in the revival of trade must always be the stimulation of consumer demand. Private enterprise cannot and will not exert itself to produce unsaleable goods, and add to its own financial responsibilities in the process. But the financial and the economic basis of credit are matters of objective fact. The commercial basis depends on business men's appreciation of these facts, and is therefore essentially psychological.

Granting that consumer demand must first be stimulated if business is to revive, the question how best that is to be achieved is entirely one of economic politics. There is no special merit or demerit in public works policies or cheap money policies if considered in the abstract. The whole problem is to get the production and consumption economies back into balance and adjustment, and the best policy is that which, in any given set of concrete circumstances, will achieve that result on a basis of maximised economic production.

The real economic basis of credit is the existence of a surplus of labour and materials capable of being used to produce something for which there is or will be an economic demand. When the international flow of goods and gold are alike free, a country which continues to receive gold from abroad is in fact producing a surplus of goods and exporting that surplus to other countries. The fact of the influx of gold Is in such circumstances prima facie evidence that the economic basis of credit exists in the country concerned.

Such a country is in fact making a present of its current surplus of goods to the rest of the world, and regard for ts own economic interests would suggest that it ought to expand its production of capital goods, improve its economic equipment, and thus lay the foundations of an enlarged output of consumers goods to be enjoyed eventually by its own people. This automatically happens when gold is treated as the basis of credit, so that an influx of gold leads to an expansion of credit, with the inevitable accompaniment of increased activity in the capital market, and increased production of capital goods.

When the international flow of goods is subject to artificial obstructions this happy coincidence between the metallic basis of credit and the economic basis is disrupted. If a country follows a policy of economic nationalism the influx of gold that balances surplus exports does not prove the existence of an economic basis for the expansion of credit. The surplus in such a case is not evidence of a capacity to expand beyond a given standard of consumption, but evidence of a compulsory reduction of a given standard of living, on account of the inability of people to buy the same volume of imported goods as formerly. It is a form of 'induced abstention' resulting from commercial policy, and is parallel to the 'induced saving' which a policy of inflationary finance and rising prices imposes on consumers.

Artificial restrictions on the flow of goods intensify the movements of gold and impair the accuracy of a gold influx as an indicator of the existence of the economic basis of credit in the country concerned. Yet so long as gold is treated as the basis of credit, it sets in motion monetary forces which neutralise the worst consequences of economic nationalism.

Success in sterilising gold as the basis of credit -- a post-1918 achievement -- enables policies of economic nationalism to achieve their logical results in the destruction of international trade.

Thus after a somewhat devious argument we come back to an international monetary standard and freedom of commerce within and between nations as necessary elements in a sound credit situation. The argument has not been altogether a waste of time, if it has served to bring out the essential commercial and economic elements in the basis of credit, of which gold can never be more than a convenient but occasionally misleading index.

This essay was written in 1937 when one was mainly preoccupied with the effect of economic nationalism on international trade. Now in 1968 there are two important regions becoming Free Trade areas but not in relation to the outside world. Economic Regionalism could become merely economic nationalism writ large; and therefore the points made in this thirty year old essay are relevant to the present and prospective world situation. It was only necessary to alter or add a word or two to the original draft. JJ 1968)

One final query: if consumer demand is not the most essential element in the basis of credit why do advertisers spend millions of pounds annually in commending their products to consumers?

Some navigational notes:

Copyright Dr Roy Johnston 1999