1 The Effect of the Increasing Gold Production on Bonds and Preferred Stocks Having a Fixed Rate of Income
In this division of the question the crux of the whole matter is interest on money. The question might, in fact, be stated thus: “What is the effect of increasing gold supply on money interest rates?” and having solved that problem, the original inquiry is answered.
To reach a reasonable solution we must first examine the effect of an unduly increasing supply of gold on commodity prices. Over-production in any quarter inevitably leads to lower prices. Gold being a fixed standard cannot decline in figures, but it does so in fact. That is to say, the flexible prices of things which gold will buy rise to fill the gap. Thus, since 1896, prices of commodities have risen 50%. The man who loaned money ten years ago finds its purchasing power impaired 33⅓%, when it is returned to him today, for the reason that commodity prices having advanced 50% in the interim, his dollar will now buy only 66⅔% of what it would buy in 1897. This impairment of principal will be covered, in part at least, by interest rates. This effect, if not recognized and arbitrary would adjust itself automatically, regardless of whether or not investors recognize the influence of changing values of gold, for money, finding higher returns in other quarters, would speedily desert the long-term, fixed-interest investment field, and prices of such securities would decline through lack of demand.
On the subject of interest rates Mr. Holt says:
“But there is another reason why interest rates should be high when prices are rising. When money is shrinking in value interest rates should be high to make up, or partly make up, the losses on the principals of loans. To illustrate: Suppose that prices are rising 10% a year. This means that the purchasing power of money is declining about 10% a year. Suppose, then, that $100 were loaned for one year at 5%. At the end of the year the lender would have $105; but with this $105 he could buy only about as much as he could have bought with $95, at the beginning of the year. In reality, he has received no interest at all but has, instead, paid $5 to the man for holding his $100. The man with money to loan cannot afford to do business in this way. He is usually as wise as are his neighbors, and fully as able to protect his own interests and to get all his money is worth, either by buying real property, investing in bonds and stock or by loaning on notes or on call.”
In submitting the above contentions it must be fairly stated that there is some diversity of opinion as to the effects of gold on interest rates. A few writers demur to the theory; others hold that the effect is nil, and one or two openly adopt the negative side of the discussion, and state that more money means lower rates of interest. The majority of recent investigators, however, appear to be accepting the theory as given herein, and it may be added that prices of the class of securities considered have borne out the hypothesis faithfully, and that the minority have failed to offer convincing explanations of this readjustment. It will not do to point to the fact that money has been fully employed in constructive rather than investment fields of late; for while this is true enough, it does not explain why gilt-edged bonds such as British Consols have declined in value, while stocks and shares which did not bear the onus of circumscribed returns have advanced. There are, of course, contributory causes: the Labor-Socialistic Government in England no doubt affects the prices of consols, but this influence is specific, and loses most of its force when we consider that not only these particular securities, but practically all others of their class the world over have suffered a radical decline. In other words, interest rates have grown comprehensively higher. The theory appears sound, is borne out by events, and mere denial does not weaken it. It may well be accepted until its opponents succeed in giving us something more convincing in its place.
In support of the theory, Mr. Holt reproduces the following table of British bonds from Moody’s Magazine for October, 1906.
PRICES OF BRITISH INVESTMENT BONDS.
| % | 1906 | 1905 | 1904 | 1896 | ||
|---|---|---|---|---|---|---|
| British Consols | 2½ | 86½ | 89⅛ | 88½ | 113⅞ | 1 |
| Met. Consols | 3½ | 102 | 104 | 104½ | 128¾ | |
| London County | 3 | 88½ | 94½ | 93 | 128¾ | |
| Leeds | 4 | 108 | 109 | 111½ | 130½ | |
| Liverpool | 3½ | 107 | 109 | 109 | 144¼ | |
| Manchester | 4 | 123 | 128¾ | 124¾ | 159 | |
| New South Wales | 3½ | 100½ | 100 | 96 | 112¼ | |
| Queensland | 3½ | 99½ | 99 | 96 | 111½ | |
| Canada | 3 | 98½ | 100½ | 97 | 107¼ | |
| Cape | 3½ | 97 | 98 | 95 | 120 | |
| Lon. & N. Western | 3 | 93 | 96 | 95 | 124¾ | |
| Midland | 2½ | 76 | 79 | 78 | 124¾ | 2 |
| Great Western | 4 | 123 | 127 | 123½ | 164 | |
| Average | 3.3 | 100.2 | 101.8 | 100.9 | 128.4 |
“Thus,” comments the writer, “these 13 British bonds, supposedly the safest and least speculative of all securities, have declined an average of over 28 points in ten years. Considering incomes and present prices, the unfortunate investors in these bonds have not only received less than 1% on their investments, during the last ten years, but, should they sell their bonds, they would find that the proceeds have lost 30% of the purchasing power of a similar amount ten years ago. Altogether, they have suffered a net loss, over incomes, of more than 20%, or over 2% a year.”
There are other economic influences affecting interest rates through gold supply, but the one given appears to the writer the most direct and forcible when applied to readjustment of prices to income.
In weighing the influence of increasing gold production and its effect upon interest rates through the advancing prices of commodities, the student is liable to fall into one grave error. He may perhaps jump to the conclusion that gradually advancing prices of commodities mean gradually advancing rates of interest. This is not at all the case. A sustained ratio of advance means sustained high rates of interest—nothing more. In order to make this clear let us go back to the original principle.
Increasing prices for commodities mean an impairment of the purchasing power of money. If the purchasing power of money is impaired 2% per annum through increasing prices of commodities, and the normal rate of interest is 4%, we can cover the deficiency by making the interest rate 6% and leaving it there as long as this ratio of impairment is maintained. In other words the man who loans $1,000 at 6% loses $20.00 per annum in the impairment of capital and receives normal interest of $40.00 per annum and $20 extra to cover his loss in capital. Strictly speaking the extra 2% is not interest at all, but an amortization payment. It matters not how high prices ultimately go, he receives each year a bonus sufficient to cover his loss in capital, and the interest rate remains 6%.
Therefore, if prices of commodities advanced for ten years and then ceased to advance, but were maintained at the highest figures reached, interest rates would fall because there would be no further impairment of capital, and what was formerly amortization, would become usury. On the other hand, if a new ratio of increase should occur in commodity prices and they should advance 4% per annum, interest rates would, if fully adjusted, reach 8%-4% for normal interest, and 4% for impairment of capital.