P8. Banking Policy and Stable Prices (1) 
[Letter to The Economist, Monthly Banking Supplement, 6 October 1934, p. 8]
6 October 1934
Sir,--I have noticed that recently your paper has sometimes seemed inclined to lend its support to a view, which I regard as unsound. It concerns the theory of money; I would not venture to write to you on a theoretical subject were it not one, views on which are liable, if they become prevalent, to seep through and influence public policy in important respects. I quote an example from your last Book Supplement (page 1):
- The main argument is this: The natural state of affairs in a `progressive' economy, where money is `neutral,' would be a price level falling in proportion to the increase in general productivity. Suppose, however, that the banking system, in the attempt to stabilise prices, issues a volume of loans greater than the volume of savings available, the market rate of interest will fall below the equilibrium rate, and `over-investment' ... will take place. This may go on while the general price level is stable. ... This argument would probably not be denied to-day by any but a few economists. 
If there are but few, I am one of those few. But I hope and believe that the majority would deny it. You correctly observe that this argument results from some very interesting speculations of Professor Hayek's.  But in this particular matter the argument, I venture to affirm, goes astray.
According to this reasoning, it is important that the total of funds coming into the loan market should not exceed the volume of current savings; but if, to keep prices up, banks have to make additional loans, total loans will exceed current savings, the rate of interest will be unduly depressed, investment unduly stimulated and an aftermath of trouble ensue.  The reasoning is ingenious and plausible, but, unfortunately, it leaves out of account one important factor in the situation. In the normal course of progress the community will require from time to time to add to the value of its holding of cash (bank deposits and currency). Now, this means that a certain part of its savings (income not spent on consumption) does not come forward into the loan market, but is used to supplement the value of its holding of money. While, on the one hand, the total flow of loans is supplemented by additional bank loans, it is depleted by part of the community's savings being held off the loan market in order to supplement the value of its holding of money. 
Total loans will be equal to savings, not if the banks make no loans at all, but if the value of the loans they make is equal to the value of savings which people hold off the loan market in order to supplement the value of their monetary holding. The other view that any bank loans will serve to make total loans exceed savings is so unsymmetrical that its advocates might well have been led to suspect that some cross-entry in their national book-keeping had been omitted.  And so, in fact, it had.
Now, it might be objected that if the community learns to turn its money over more effectively, it will not need to supplement the value of its money holding when its real income increases. That is perfectly true. But if that happens, it follows that the policy of stable prices will not require the banks to make additional loans. The entry, as well as the cross-entry, will be zero, and prices will be effectively kept stable.
But in the (probably) more normal case when the community does require to add to the value of its monetary holding, some savings are side-tracked to this purpose, and unless the banks make some additional loans, total loanable funds will be less than the savings of the community, and the market rate of interest will be unduly elevated. (N.B.--The community in this case gets the extra value in the form of money, which it requires, through the enhancement of the value of its existing stock, due to the fall of prices. This process, though in a sense illicit, none the less absorbs savings.)
I am not prepared to argue that the equating of loanable funds to savings is the sole, sufficient, or even necessarily the proper objective of banking policy. What I do contend is that if this be taken as an objective, the view that the banks should make no additional loans is untenable. This brings me to my final point. If it is required to equate loanable funds to savings, this entails that additional bank loans should be equal to the value of savings side-tracked into the holding of additional value in the form of money. This equality can only be secured on one condition, and that is that the banks make sufficient additional loans to keep prices stable!
The last proposition is susceptible of rigorous proof, but one which demands, I fear, a close effort of attention. It is required that the value of additional bank loans should be equal to the value of the increment in the value of the community's holding of money. (I suppose for this argument a non-gold money.) If prices are stable, the value of additional bank loans is equal to the value of the increment in the value of the community's monetary holding. If prices are rising, the former value is greater than the latter, and if prices are falling, the former value is less. E.g. if the banks make additional loans worth £100, when prices are rising, the increase in the value of the community's holding of money must be something less than £100. For since it only has £100 of new money, and since each unit of money is worth less, the addition to the value of its total stock of money must be less than £100. By similar reasoning, if prices are falling, the addition to the value of its total stock of money must be more than £100, for it has 100 new pounds, and the value of every pound it already had is also enhanced.
It follows that sufficient additional bank loans to keep prices stable will alone serve to achieve the desired equation of loanable funds to savings.--I am, Sir, etc.,
R. F. Harrod
Christ Church, Oxford. September 23, 1934.
Harrod had sent offprints of his Economica article to ÆHaberler (see letter 366 ), ÆRobertson (see letter 370 ) and ÆKahn (letter 375 ). Robertson immediately wrote a "brief assault" ("Mr. Harrod and the Expansion of Credit", 1934) in the "hope of drawing [...] a riposte" from Harrod (letter 370 , [jump to page] ; see also letters 372 and 373 ). Harrod's "Rejoinder to Mr. Robertson" was included in the same issue of Economica ( 1934:11 ). Meanwhile Harrod wrote this letter to The Economist. After further discussion on the Economica article (letter 367 ), Haberler wrote a reply to Harrod's letter to The Economist ("Banking Policy and Stable Prices", 1934; see also letter 384 ); Harrod's rejoinder ("Banking Policy and Stable Prices (2)", 1934:10 , here as press item 9 ) was included in the same issue (other contributions to the debate, all published in the same issue, came from ÆNicholas Kaldor, Harold Barger, Hubert Blake, Jack Stafford; some of their comments are cited in notes to press item 9 ). Later, besides continuing the discussion in private correspondence (letters 378 , 388 ), Haberler and ÆBode criticized Harrod's views in an article on "Monetary Equilibrium and the Price Level in a Progressive Economy: A Comment" (Economica, n.s. vol. 2, February 1935, pp. 75-81; see also letters 394 , 395 , 396 , 401 , 414 , 415 , 427 , 429 , 435 , 436 ), to which Harrod replied in the same issue ("Rejoinder to Drs. Haberler and Bode", 1935:1 ).
The correspondence with Kahn was also interlaced with the correspondence with Robertson and Haberler, and Kahn regularly commented on the other exchanges (letters 375 , 376 , 382 , 383 , 387 , 389 , 392 , 400 , 402 , 405 , 410 , 416 ). Further comments came from ÆDurbin (letter 404 ), while ÆRobbins wrote for the editorial board of Economica (letter 417 R). Other people were indirectly involved in the debate, as Haberler sent copies of Harrod's letters to, and discussed them with, Robertson, Kaldor and ÆLindahl, and sent Harrod some of the replies or reported the outcome of the discussions (letters 384 , in particular note 11 , 393 , 421 and 422 ).
2. The Economist, "Stable Prices or Neutral Money?", Monthly Book Supplement, 21 July 1934, p. 1. The passage (except of course the last sentence) summarizes M. A. Abram's Money and a Changing Civilisation (London: John Lane, 1934).
3. Reference is to F. A. Hayek, Prices and Production (1931).
4. See in particular Hayek, Prices and Production (1931), lecture II § 6 (pp. 75-81).
5. See Harrod, "The Expansion of Credit in an Advancing Community" ( 1934:8 ), pp. 297-98.
6. See Harrod, "The Expansion of Credit in an Advancing Community" ( 1934:8 ), p. 298.
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