The previous section concluded by noting that "substitution over time will be strongly stabilizing" for the dynamic system being analyzed. The author therefore begins this section by asking "whether the system will still be stable if the opportunity for substitution over time is withdrawn." He explains that such a condition would mean that "elasticities of expectations become all equal to 1." (In other words, changes in current prices will cause changes in expected prices in exactly the same proportion.)
The author notes that this assumption would seem to be extremely plausible and for that reason has been "taken for granted by the majority of economists." But as he also notes,
Just for this reason, it has caused an immense amount of trouble. The most natural assumption which one can make for dealing with dynamic problems is one of the most dangerous assumptions, for it involves treading on the very borderland between stability and instability.
He blames the reliance on this assumption for "much of the bewilderment of 'monetary theory'" in the first half of the twentieth century (recall that the first edition of Value and Capital was published in 1939).
The author credits Knut Wicksell, with giving "the first indication that something was wrong" in his book Interest and Prices, published in 1898.
Roughly, what his central argument amounts to is this. In equilibrium, there corresponds to a particular rate of interest a particular relation between current prices in general and expected prices in general. If the rate of interest is lowered, current prices will rise; if expected prices had remained unchanged, this process would restore equilibrium with current prices bearing a higher ratio to expected prices. But if expected prices rise pari passu ["in even step"], the equilibrium tendency is defeated; current prices can never catch up. The system is involved in the famous 'cumulative process'.
On a closer look, however, the author points out that Wicksell's system involves a pure credit economy, with all transactions involving payment in interest-bearing bills. Thus "there is no place in his system for a money that does not bear interest; it is neither demanded nor supplied." So the mathematical conditions for temporary equilibrium involve one fewer equation than those in Hicks's system. If each system had n ‒ 1 real commodities, then because Hicks's system additionally includes both money and interest-bearing securities, his equilibrium conditions involve n + 1 equations and n + 1 unknowns (although as we have seen, one of them is redundant, so they reduce to n equations and n unknowns).
In Wicksell's system, however, there is no supply or demand for money, so one equation is dropped from his equilibrium conditions (as compared with Hicks's system). Another equation is dropped as before, because accounts must balance, so there remain n ‒ 1 equations, which are insufficient to determine n unknowns.
The author (Hicks) goes on to explain that Wicksell's conditions do determine the relative prices of the various commodities, along with the rate of interest, but "The general level of money prices (the value of money) is left indeterminate." He illustrates this with an example in which there is an increase of 5% in all prices (emphasis on all). This change "will leave every one's position unchanged, so long as the rate of interest does not vary." Prices are up, but incomes are up by the same amount. Demands and supplies thus remain the same. Since the 5% increase is an arbitrary choice, the conclusion is that the system could be in equilibrium "at any level of money prices."
As Hicks puts it, "Wicksell's price-system consists of a perfectly determinate core‒—the relative prices of commodities and the rate of interest‒—floating in a perfectly indeterminate aether of money values." The implication of the "utterly arbitrary" nature of the money-price level is that "any slight and temporary disturbance of data may shift it about to a large extent." Even "slight divergencies" between the rate of interest as determined by 'real' causes and the "momentary money rate ... are sufficient to set up large changes in the price-level."
Hicks concludes that the belief, among Wicksell and his immediate followers, in a possible discrepancy between the money rate of interest and the natural rate is a rather unfortunate "delusion."
If the theory is interpreted strictly, the possible discrepancy is only a virtual discrepancy; as soon as the discrepancy becomes actual, the theory breaks down. For this reason the theory is of very little use as a guide to banking policy, the field in which it was thought to have direct applicability.
He concludes the section by previewing another way to look at "the whole matter ... which incidentally enables us to dispense with Wicksell's assumption of a Pure Credit Economy."
