Letter to Friedrich Engels, February 3, 1851

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To Engels in Manchester

[London,] 3 February 1851

Dear Engels,

Is it on Mary [Burns: Irish working woman to be Engels' first wife] you're studying physiology, or elsewhere? If the first, I can understand that this n'est pas de l'hébreux [isn’t Hebrew] nor even Russian.

Up till now all that my new theory of rent has yielded is the commendable state of mind to which every worthy man necessarily aspires. However, I am at least satisfied that you should be satisfied with it. An inverse relationship of the fertility of the soil to human fertility must needs deeply affect a strong-loined paterfamilias like myself, the more so since mon mariage est plus productif que mon industries [my marriage is more productive than my industry].

I shall now submit to you just one illustration of the currency theory, my study of which might be described by Hegelians as a study of ‘otherness’, of the ‘alien’, in short of the ‘holy’.

The theory of Mr Loyd and tutti frutti [all sorts of others], from Ricardo onwards, consists in the following:

Let us assume that we have a purely metallic currency. If there were too much of it here, prices would rise and hence the export of commodities decrease. Their import from abroad into this country would increase. Thus imports would rise above exports. Hence an unfavourable balance of trade. An unfavourable rate of exchange. Hard cash would be exported, the currency would shrink, the prices of commodities would fall, imports decrease, exports increase, money flow back again; in short, the situation would attain its former equilibrium.

In the converse case likewise, mutatis mutandis.

The moral of this: since paper money must imitate the movement of metallic currency, and since artificial regulation must here take the place of what, in the other case, is natural law, the Bank of England must increase its paper issues if bullion flows in (e.g. by the purchase of government securities, exchequer bills, etc.) and reduce it by the reduction of discounts, or by the sale of government paper, if bullion decreases. However I contend that the Bank should take the opposite course and increase its discounts if bullion decreases and let them take their normal course if it increases. Upon pain of unnecessarily intensifying the impending commercial crisis. However, more of that une autre fois. [some other time]

What I wish to elucidate here goes to the basic principles of the matter. For my contention is that, even with a purely metallic currency, the quantity thereof, its expansion or contraction, has nothing to do with the outflow and inflow of precious metals, with the favourable or unfavourable balance of trade, with the favourable or unfavourable rate of exchange, except in the most extreme cases, which practically never occur but are theoretically determinable. The same contention is made by Tooke, but I have found no proof of it in his History of Prices for 1843-47.

As you can see, it’s an important matter. Firstly, the whole theory of circulation is denied in its very fundamentals. Secondly, it is shown that the progress of crises, even though the credit system be a condition of the same, is concerned with currency only in so far as crackbrained meddling by the authorities in its regulation may aggravate an existing crisis, as in 1847.

Note that in the following illustration it is assumed: The inflow of bullion goes hand in hand with flourishing trade, prices not yet high but rising, a surplus of capital, excess of exports over imports. The outflow of gold vice versa, mutatis mutandis. Now this is the assumption of those against whom the polemic is directed. They cannot gainsay it. In reality there may be 1,001 cases in which there is an outflow of gold, although the prices of other commodities in the country exporting it are far lower than in those to which the gold is being sent, e.g. as in England in 1809-11 and 1812, etc., etc. Yet the general assumption is, firstly, right in abstract, and, secondly, accepted by the currency chaps. Hence not to be debated here for the time being.

Let us assume, then, that a purely metallic currency is in circulation in England. But that does not presuppose that the credit system has ceased. Rather, the Bank of England would turn itself into both a deposit and lending bank. Save that its loans would consist simply in cash. If this assumption were to be rejected, what appears here as a deposits of the Bank of England would appear as hoards of private individuals and the loans of the Bank as loans of private individuals. Thus, in this context, the term Bank of England deposits is simply an abbreviation, to present the process, not in fragmented form, but concentrated in a focus.

Case I. Influx of bullion. Here the matter is very simple. A great deal of idle capital, hence increase in deposits. In order to make use of them the Bank would lower its rate of interest. Hence, expansion of business in the country. The circulation would only rise if business increased to the extent that additional currency was required to conduct it. Otherwise the surplus currency issued would flow back into the Bank as deposits, etc., as a result of maturing bills, etc. Thus currency does not act here as a cause. Its increase is ultimately the consequence of a greater amount of capital put to use, not vice versa. (Hence, in the case under discussion, the first consequence would be growth of deposits, i.e. of idle capital, not of circulation.)

Case II. This is where the matter really begins. Export of bullion is assumed. Beginning of a period of pressure. Unfavourable rate of exchange. At the same time a poor harvest, etc. (or else dearer raw materials for industry) necessitate ever larger imports of commodities. Suppose that the accounts of the Bank of England at the beginning of such a period appear as follows:

a)	Capital	£14,500,000	Government Securities	£10,000,000
	Rest	£ 3,500,000	Bills of Exchange	£12,000,000
	Deposits	£12,000,000	Bullion or Coin	£ 8,000,000
		£30,000,000		£30,000,000

The Bank is in debt, since it has been assumed that no notes exist, only the 12 millions of Deposits. According to its principle (in common with the deposit and circulation banks, only a third of its liabilities have to be in cash), its 8 millions of bullion is too large by half. To make more profit it lowers the interest rate and raises its discounts, e.g. by 4 millions, which are exported for corn, etc. The Bank’s accounts then appear as follows:

b)	Capital	£14,500,000	Government Securities	£10,000,000
	Rest	£ 3,500,000	Bills of Exchange	£16,000,000
	Deposits	£12,000,000	Bullion or Coin	£ 4,000,000
		£30,000,000		£30,000,000

From these figures it follows that:

Merchants, as soon as they have to export gold, act first upon the Bank’s bullion reserve. The gold thus exported diminishes its (the Bank’s) reserve without having the slightest effect on the currency. Whether the 4 millions are in its cellars or aboard a ship bound for Hamburg is all the same so far as the currency is concerned. It finally becomes evident that a significant drain of bullion, in this case £4 millions sterling, can take place without in any way affecting either the currency or the business of the country in general. Throughout the whole period, that is, during which the bullion reserve, which was too large in relation to liabilities, is being reduced to no more than its due proportion to the same.

c) But let us suppose that the circumstances which necessitated the drain of 4 millions continue, shortage of corn, rise in the price of raw cotton, etc. The Bank grows concerned about its security. It raises the interest rate and limits its discounts. Hence, pressure in the world of commerce. What effect does this pressure have? Withdrawals are made from the Bank’s deposits, its bullion falls proportionately. Should the deposits fall to 9 millions, i.e. be reduced by 3 millions, those 3 millions must come from the Bank’s bullion reserve. This would therefore fall (4 millions — 3 millions) to 1 million against deposits of 9 millions, a proportion which would be dangerous to the Bank.. If, then, the Bank wishes to maintain its bullion reserve at one third of the deposits, it will diminish its discounts by 2 millions.

The accounts would then appear as follows:

	Capital	£14,500,000	Government Securities	£10,000,000
	Rest	£ 3,500,000	Bills of Exchange	£14,000,000
	Deposits	£ 9,000,000	Bullion or Coin	£ 3,000,000
		£27,000,000		£27,000,000

It follows that, as soon as the drain becomes so great that the bullion reserve reaches its due proportion in relation to deposits, the Bank will raise the interest rate and reduce the discounts. But then the deposits begin to be affected and, as a result of their decrease, the bullion reserve decreases but so, to an even greater extent, does the discount of bills. The currency is not in the least affected. A portion of the bullion and deposits withdrawn fills the vacuum which the contraction of the Bank’s accommodation creates in the circulation at home, while another portion finds its way abroad.

d) Supposing that imports of corn, etc., continue and the deposits sink to 4,500,000, the Bank, in order to maintain the necessary reserve against its liabilities, would reduce its discounts by a further 3 millions, and the accounts would appear as follows:

	Capital	£14,500,000	Government Securities	£10,000,000
	Rest	£ 3,500,000	Bills under discount	£11,000,000
	Deposits	£ 4,500,000	Bullion or Coin	£ 1,500,000
		£22,500,000		£22,500,000

On this assumption the Bank would have reduced its discounts from 16 to 11 millions, that is, by 5 millions. The necessary requirements of the circulation replaced by the deposits withdrawn. But simultaneously shortage of capital, rise in the price of raw materials, decrease of demand, hence of business activity, hence ultimately of the circulation, of the necessary currency. The surplus portion of the same would be sent abroad in the form of bullion to pay for imports. The currency is the last to be affected, and it would only be reduced to less than the necessary quantity should the bullion reserve fall below the minimal proportion to deposits.

With regard to the above, it should also be noted that:

1. Instead of reducing its discounts, the Bank could dispose of its public securities, which, on this assumption, would be unprofitable. However same result. Instead of reducing its own reserve and discounts, it would reduce those of private persons who put their money in public securities.

2. I have assumed here a drain of 6,500,000 on the Bank. In 1839 there was one of 9-10 millions.

3. The process assumed in the case of a purely metallic currency can lead, as with paper, to a closure of the till, as happened twice in Hamburg in the eighteenth century.

Write soon.

Your
K. M.