The 1911, 1912, and 1913 Economic Journal Articles on Banking, Interest, and Speculation

Following his completion of Part II of the Economics Tripos, Lavington published three articles in the Economic Journal in 1911, 1912, and 1913. These laid part of the theoretical foundations for his 1921 study on the English capital market and developed from his grasp of English and German monetary literature which had been part of the reading for his economic studies. They may also have reflected his preliminary banking experience with the Capital and Counties Bank. These articles in turn dealt with ‘The Social Importance of Banking’ (Lavington 1911), ‘Uncertainty and Its Relation to the Rate of Interest’ (Lavington 1912), and ‘The Social Interest in Speculation on the Stock Exchange’ (Lavington 1913). The 1912 paper earned him a considerable reputation as a new monetary economist, and was quite influential. His 1912 and 1913 articles were cited by Frank Knight (1921: 199, fn. 1) as two of the half dozen contributions to the economic literature on uncertainty which by then had appeared in Great Britain and the USA.

Lavington’s 1911 article (only eight pages) assessed the social importance of the banking system through its facilitation of capital movements, its provision of currency, and the other objectives which greatly contributed to the community’s social well-being. It explains how banks as part of the system of financial intermediation carried out these functions under the then still existing gold standard. Banks have the power to create money through their ability to offer current (chequing) accounts whose use by bank customers influences the size of the money supply (ibid.: 54-55). The 1911 article also discussed whether banks were operating under free competition or whether they exerted some monopoly power given their abovenormal profitability (ibid.: 55-56). Lavington dismissed the view that banking profits constituted ‘a social evil’—after all, they were distributed to a substantial number of shareholders in the form of dividends. Moreover, with bank boards fully elected by shareholders, the self-interest of a competitive banking system closely resembled the public interest (ibid.: 57). Lavington (ibid.) claimed that free competition was preserved in modern banking, despite the growth in size of trading banks and the establishment of branch banking. Growth in size also entailed some economic and social advantages. Some of these arose as the benefits of economies of scale; scale enhanced the security that banks could offer to deposit holders, while size would not diminish the local knowledge of bank managers. More generally, developments in modern banking gave money supply greater elasticity to meet changes in demand from business and the public over the course of the business cycle. Such flexibility could also yield harmful consequences through changes in the price level. A brief discussion of the operation of the money multiplier of the gold reserve in the creation of new bank deposits indicated this (ibid.: 58-59). Bank rate variations were useful for controlling such changes in the quantity of money, while combined action by the banking system on discount rates regulated currency supply effectively (ibid.: 59-60). Lavington (ibid.: 60) concluded with the statement that the self-interest of competing banks enhanced the material welfare of society which recent (but unmentioned) changes to the banking system had also encouraged.

Lavington (1912) addressed the problem of uncertainty in relation to the rate of interest and, more generally, issues of financial intermediation. Lavington (ibid.: 398) started this investigation by stressing that the future can only be imperfectly foreseen and that ‘the cost of imperfect foresight is a continuous maladjustment of resources’. Imperfect knowledge about the future also lowered productivity and enhanced the social costs of production, while its consequences raised the level of risk in rational business decision making, hence raising the necessary ‘compensating probability of exceptional gain’ (ibid.). A diagram of the ‘curve of prospective returns’ illustrated how any demand for resources under conditions of uncertainty required an additional return. Alternatively, Lavington (ibid.: 399) argued that ‘[uncertainty is a disutility for which a payment must be made in addition to the net rate of interest’. Following J.B. Clark, Lavington (ibid.: 400) described uncertainty as a form of ignorance in business decision making, as a consequence of financial insecurity, since investment which locked in resources thereby increasing their immobility, greatly added to uncertainty. However, uncertainty could be lowered for a firm by the cost of creating a financial reserve for it (ibid.: 401). More generally, uncertainty could be reduced through insurance and through issuing low-risk securities (such as government bills), an organizational characteristic (ibid.: 403-405). Lavington’s conclusions expressed overall results on uncertainty and the rate of interest. Costs of insecurity are maximized for capital invested ‘in an irredeemable security with a narrow mar?ket’ (ibid.: 406) which thereby needed a higher return. Moreover, similar bank securities attracted similar rates of return, while imperfections in financial markets could be eliminated by superior organization. In short, the presence of appropriate financial institutions lowered uncertainty, and enabled increased closer investment of capital which raised productivity and national income levels (ibid.: 406, 407, 409).

Lavington (1913) discussed the social value of speculation within a setting of the need to develop specialized financial institutions to take advantage of the efficiency gains from this increased division of labour. Appropriate speculative machinery, he argued, was an essential feature of the circulation of goods in an organized market. This also applied to capital market transactions bringing saving and investment decisions into balance despite the different motivations of savers and investors. Saving provided uncommitted productive resources by the act of foregoing their present enjoyment, while investment was command over capital resources and their employment enabled by the act of saving. Marshall’s Principles of Economics had firmly established these simple propositions of saving—investment analysis. In modern economies, the process of placing saved resources in the hands of productive investors is the task of the capital market, comprising the banking system, the stock exchange, and trade credit. Lavington (ibid.: 36-37) described the securities created in their transactions as an efficient manner of risk-spreading, a role in which speculation on security prices played an active part. Referring to his 1912 paper on uncertainty and rates of return, and the need for financial intermediation in this, the stock exchange could be taken to make the securities it traded more marketable, thereby lowering their insecurity. Speculator activity tended to equalize the rates of return on what could be called ‘equivalent investments’, thereby enhancing the degree of competiveness in financial markets, always a good outcome (ibid.: 45-49). Lavington concluded that competitive financial markets enabled prices to move closer to investment values, lowering cost of production by the more productive use of resources whose supply price was lowered by this type of financial intermediation. Speculation, in short, was useful for raising human welfare, a proposition previously made by Marshall.

Lavington (1911, 1912, 1913) gave his preliminary position on the nature, the advantages, and the modus operandi of the financial system as it existed in the decade before the start of the First World War. Banking here played a crucial role as the major creator and effective regulator of currency supply, best carried out by large, competitive banks earning profits. Lowering uncertainty was also assisted by a good financial system, by enabling firms to create the necessary financial reserves as a safeguard for preserving their security. The 1913 article reviewed the positive role of speculation in stimulating the saving-investment mechanism, thereby raising productivity through increased capital intensity in production and lowering production costs. Lavington’s (1921) study of the capital market in England revisited this territory and explained it in considerably more detail.