[Bonus item] The means to reflation

Harrod, Letter to The Economist [1]




(1) I take it as a basic assumption that it is desirable to obtain an increased monetary demand for consumable goods unaccompanied by an increase in the supply of them or in the rost of producing them, as a necessary preliminary or concomitant to a much larger increase in the demand and supply of them.

(2) The orthodox manner of procuring such an unbalanced increase of demand, in a time of depression, is the encouragement of additions to the output of capital goods by low money rates, the incomes earned by those engaged on making these additions flowing in to swell consumers' demand. In a time of great over-capacity the demand for additional capital is so weak that low interest rates fail to bring about the result. Open-market operations by the central and other banks increase bank deposits in the country without increasing the flow of expend iture, the additional deposits being held by the public as investments in lieu of the securities bought up by the banks.

(3) As an alternative or additional method of increasing consumers' expenditure, Government works are advocated. This is without doubt sound. Let us, however, accept for the sake of argument the view of the sceptical, that the fields available for well-thought-out public works are too small to produce the expansion of buying power that is needed. There is much to be said for the view that these should, even when expansion is urgently required, be judged on their own merits. If public departments were forced to spend tens or hundreds of millions of pounds in the next twelve months, many follies might be perpetrated.

(4) A further suggestion for producing expansion is to allow a Budget deficit on current account. Foolish alarms could be quelled by a precise and definite explanation of the deliberate and controlled nature of the deficit. The deficit has this superiority over public works as a reflationary tap that it can be turned off more quickly when necessary. There is, however, one argument against such an expedient which does merit attention, namely, that it is unsound to burden the future with interest charges for loans to meet present current expenditure.

(5) Need and ought an expansionary or reflationary deficit to be financed by loan at all? If a loan can be avoided, there is no additional interest burden in future. Before the war inflation was generally held to be synonymous with the issue of non-interest-bearing paper. It was thought of as a method of finance alternative to either taxation or borrowing. The special methods of war finance led to the matter being regarded in a different way. But what has really created confusion of thought is the fact that people use banking accounts instead of currency notes as their normal "store of value."

(6) The principle should be established that Government capital undertakings ought to be financed by borrowing and reflationary deficits by the issue of non-interest-bearing paper. If this were accepted, the only solid argument against reflation by deficiency would be met, and the remaining problem would be a purely technical one.

(7) The technical difficulty is this. The reflationary paper, which might take the form of currency notes or of drafts on a Government account convertible into currency notes at will, would, under the present system, have the same effect on the joint-stock banks as Ways and Means advances by the Bank of England or an increase of Bank of England gold of an equivalent amount. It would increase their cash basis very considerably and might thus lead to untoward results. If the main principle were agreed to, the details of this difficulty could well be thrashed out by the authorities concerned. Let it suffice here to make a few suggestions.

(i) The effect of the reflationary paper on the position of the joint-stock banks could be offset to a moderate extent by open market sales by the Bank of England. Such sales, while not in the least degree offsetting the reflationary effects of the Government deficit, would leave the joint-stock banks in the same position as before. That position ought to be one in which their supply of cash is so great as to reduce money rates to the lowest practicable level.

(ii) If, however, the new Government paper exceeded in volume the amount of securities that it was convement for the Bank of England to sell, the cash holdings of the joint-stock banks would increase. In the absence of a sufficient rise in demand for trade accommodation, they could restore the ratio of cash to interest-bearing assets by increasing their investments. But this might lead to a top-heavy position. It might be better to get them to agree to increase their ratio of cash to deposits somewhat and make good the loss by cutting rates on deposits still further.

(iii) If a further cut in deposit rates were impracticable, the Government might agree to pay a rate of interest, not higher than the average rate paid by a bank on all its current and deposit accounts, in respect of the currency held by that bank in excess of its normal ratio. This would cost the Government little, but it would be a departure from the principle outlined.

These three suggestions are merely tentative. Some way out of the difficulty could easily be found, if the main idea were accepted.

(8) When the need for reflation was over, a proportion of the Sinking Fund could be allocated to wlthdrawing the non-interest-bearing paper.

(9) To understand this proposal aright, it is necessary to remember that it is desired to produce an unbalanced mcrease of consumers' expenditure. An easy-money policy tends in this direction, but needs supplementing. A further increase of deposits through open-market operations which does not stimulate capital output or consumers' expenditure has no reflationary value.

(10) The principle that, while Government expenditure on capital account should be met by borrowing, a reflationary deficiency on current account should be met by the issue of non-interest-bearing paper seems inexpugnable. Is there any flaw in the reasoning ?--I am, etc.,


Christ Church,


July 11, 1933.




1.. Published in The Economist, 22 July 1933, pp. 181-2.

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