The Theory of Money and Credit - Ludwig von Mises [171]
We have already had an opportunity of finding out where the error in this argument lies. The quantity of fiduciary media flowing from the banks into circulation is admittedly limited by the number and extent of the requests for discounting that the banks receive. But the number and extent of these requests are not independent of the credit policy of the banks; by reducing the rate of interest charged on loans, it is possible for the banks indefinitely to increase the public demand for credit. And since the banks—as even the most orthodox disciples of Tooke and Fullarton cannot deny—can meet all these demands for credit, they can extend their issue of fiduciary media arbitrarily. For obvious reasons an individual bank is not in a position to do this so long as its competitors act otherwise; but there seems to be no reason why all the credit-issuing banks in an isolated community, or in the whole world, taken together could not do this by uniform procedure. If we imagine an isolated community in which there is only a single credit-issuing bank in business, and if we further assume (what indeed is obvious) that the fiduciary media issued by it enjoy general confidence and are freely employed in business as money substitutes, then the weakness of the assertions of the orthodox theory of banking is most clear In such a situation there are no other limits to the bank's issue of fiduciary media than those which it sets itself.
But even the Currency School has not treated the problem in a satisfactory manner It would appear—exhaustive historical investigation might perhaps lead to another conclusion—that the Currency School was merely concerned to examine the consequences of an inflation of fiduciary media in the case of the coexistence of several independent groups of banks in the world, starting from the assumption that these groups of banks did not all follow a uniform and parallel credit policy. The case of a general increase of fiduciary media, which for the first half of the nineteenth century had scarcely any immediate practical importance, was not included within the scope of its investigations. Thus it did not even have occasion to consider the most important aspect of the problem. What is necessary for clearing up this important problem still remains to be done; for even Wicksell's most noteworthy attempt cannot be said to have achieved its object. But at least it has the merit of having stated the problem clearly.
Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about.[15] Up to this point Wicksell commands assent; but his further argument provokes contradiction.
According to Wicksell, at every time and under all possible economic conditions there is a level of the average money rate of interest at which the general level of commodity prices no longer has any tendency to move either upward or downward. He calls it the normal rate of interest; its level is determined by the prevailing natural rate of interest, although, for certain reasons