A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  2. A similar idea returned in the 1960s, when monetary policy was “assigned” to control the gold flow or balance of payments under fixed exchange rates.

  The wide gap between monetary theory and the practice of monetary policy, familiar to observers of the contemporary discussion of policy, had opened by the 1830s. The most able economists of the period participated in the discussion, and though they focused mainly on the longer-run consequences of policy actions and ignored short-term effects, they did not hesitate to recommend policy actions. Those bankers and economists whose writings show greatest interest in and knowledge of short-term operations and practices neglected, for the most part, the longer-run consequences of the policies and procedures they espoused. They tended to concentrate on the initial effects of policy actions and to ignore the longer-term consequences.3

  In the history of economic thought, the participants in these discussions are grouped into schools known as bullionists and antibullionists for the first quarter of the nineteenth century and into currency and banking schools for the second quarter and into the third. While the groupings may be useful for certain purposes, they suggest more direct confrontation of ideas than appears to have taken place or than could have taken place given that one side was concerned much more with ultimate effects, the other mainly with initial effects.4 Indeed, the “disputants” most often failed to agree on the subject under discussion or even to mention whether they were concerned with short- or long-run consequences. One main result is that the link between short- and long-run effects of policy remained unanalyzed (Viner 1965, 139–40).

  A second reason for the decline in the level of the discussion is related to the first. Throughout monetary history, the belief recurs that monetary policy has very limited effects on employment, expenditure, and output. Lacking an explicit theory of the transmission of policy changes, it was easy for the men who guided the Bank of England to mistake initial effects of a change in bank rate for the ultimate effect. Many of the writers in the so-called banking school, and many others in later generations, contributed to this belief by equating the effect of monetary policy with the change in the supply of “funds” in the money market. No reader of the discussions or interpretative accounts of nineteenth-century (or twentieth-century) monetary theory and policy can fail to be impressed by the frequency with which the idea reappears that any effect of monetary policy on the real economy is adventitious, the result of a particular and special conjuncture of forces that was either unlikely to be repeated or unlikely in the future to spread the effect far beyond the money market. Or if monetary actions had short-term consequences for the real economy, the effects were limited to specific sectors. Arguments about the “ineffectiveness” or noneffective-ness of monetary policy on the real economy became the official view of the working of policy.5

  3. Viner’s 1965 discussion of Ricardo’s analysis brings out this point and its importance for the policy discussion of the time.

  4. A central issue returns many times in monetary history: What is to be included as money? Bullionists and the currency school chose narrow definitions. The bullionists argued that the stock of gold (or silver) bullion determined the price level and the exchange rate. The currency school emphasized the note issue. They wanted a rule tying the note issue to the Bank of England’s gold reserve. See Schwartz 1987a.

  Ricardo’s dominant position and his failure to build on Thornton’s analysis of the ways in which the effects of monetary policy spread from the money market to economic activity, prices, and balance of payments meant that most of Thornton’s analysis was neglected. A century after Thornton’s promising start on a theory of money, his analysis leading to a statement of the principles by which monetary policy should be conducted to stabilize the economy had degenerated into the three main rules or principles for setting bank rate. These rules were accepted as basic at the start of the Federal Reserve System. First, there was the core principle of the gold standard: the central bank must raise or lower the discount rate as required to protect the gold stock and the exchange rate. Second, the central bank served as lender of last resort by offering to lend in a panic when markets did not function. Third, the central bank was to accommodate the needs of trade and agriculture by discounting only (or mainly) commercial paper, a principle known as the productive credit or real bills doctrine. This principle prevented purchases of government securities, mortgages, other long-term debt and the use of these instruments or equities as collateral for borrowing from the central bank.

  The details of doctrinal history are less important than their consequences for the theory and practice of central banking. A number of excellent summaries of the literature of the period are available: Bagehot 1962, Clapham 1945, Hawtrey 1962, Keynes 1930, Rist 1940, Sayers 1957, Schumpeter 1955, Thornton 1965, Viner 1965, and Wood 1939. Since many of the issues that arose, and their solutions, reflect the economic events of the period, the chapter begins with a description of the background events. The rest discusses three major contributions to monetary and central banking theory that were ignored, at great cost, during most of the twentieth century. First is Henry Thornton’s analysis of the control of money and credit under either a fluctuating or a fixed exchange rate. Second is Walter Bagehot’s discussion of the responsibility of the central bank as lender of last resort. Third is Irving Fisher’s distinction between real and nominal interest rates. Thornton’s work was not well known. Bagehot’s work was well known at central banks, and Fisher was active until the middle of the twentieth century. Yet none of the three had a major influence on the conduct of policy. If they had, monetary history would have been much different.

  5. Laidler (1992, 4) argues that Thornton was perhaps the only classical economist to recognize that monetary impulses contributed to a business cycle, not just a “credit” cycle. Several earlier writers discussed the transitional real effects of monetary changes on real output. Indeed, analyses of monetary effects are among the oldest propositions in economic theory. See Hegeland 1951.

  The main issues in dispute during the period are familiar to contemporary economists. Can the monetary system be controlled? If so, which variables should be controlled, and how should this be done? What are the consequences of alternative systems of control? Did the central bank have an opportunity to exercise discretion, or is the real stock of money constant, so that central bank policy ultimately determined only the division of the real stock of money between gold (foreign exchange) or specie and paper? Should the central bank protect its own reserve, or is its main responsibility to protect the financial system in time of crisis? How could either or both of these ends be achieved? The answers to these and other questions given by central bankers and economists reveal the way the theory of central banking developed in the nineteenth century and the state of the art in the early twentieth century when the Federal Reserve was founded.

  BACKGROUND EVENTS AND ARRANGEMENTS

  During most of the eighteenth century the main policy actions involved the choice of standards, the establishment of de facto or de jure rules, and the provision of currency. By the end of the century England was on a de facto bimetallic standard at a ratio that undervalued silver, so full-weight silver coins did not circulate, and the currency consisted of gold, underweight silver coins of small denomination, and note issues of the Bank of England and other banks.6 Bills of exchange had come into use, and in some areas endorsed bills served as a medium of exchange. Usury laws restricted interest rates, including the rate on advances from the Bank of England (bank rate), to a 5 percent maximum. Bank rate for inland bills was put at 5 percent in 1746. The rate on foreign bills rose from 4 to 5 percent in 1773 and did not change again until 1822.

  6. The Bank of England received its charter in 1694 to assist in the financing of war with France. See Dowd 1991 for a brief history of the bank and Clapham 1944 for a detailed history.

  In 1697 the Bank of England was granted a charter to operate as a joint stock bank, but until 1826 oth
er banks could not have more than six partners. The restriction of joint stock banking meant that partners were required to pledge their personal fortunes in periods of crisis. Consequently there were numerous small individually owned banks and very few branch banks.7

  The main business of a banker consisted in issuing notes and discounting bills of exchange.8 Since a large number of country banks accepted bills and issued banknotes, and since many of the bills were drawn by small local merchants in payment for merchandise, it became common for country bankers to develop correspondent relationships with London bankers to provide information and clearing arrangements. This tendency strengthened because the supply of bills of exchange did not grow at a uniform rate throughout the country. London became the financial center through which deficit areas were able to sell bills to surplus areas. Country bankers held deposits with their London correspondents and purchased or sold bills. The continued increase in the number of country banks during the early nineteenth century made it increasingly difficult for London bankers to clear the bill market by operations between correspondents. A new institution, the bill broker, arose in London to perform part of the market clearing function.

  The growing importance of the bill broker resulted also from the arrangements prevailing at the time. First, the usury laws prevented the London banks from changing rates to attract a larger volume of Bank of England notes and gold from country banks and to reduce the supply of bills. Second, the Bank of England adopted rules designed to reduce the demand for discounts from country bankers. To be eligible for discount at the Bank of England, bills had to be endorsed by two London names, one of which was the merchant or manufacturer accepting the bill. Many of the bills originating in the country did not meet this requirement.

  As the system functioned at the start of the 1790s, the country banks maintained deposits and bought or sold bills from correspondent bankers in London. Bill brokers operated in the market in much the same way that a federal funds broker operates in the present New York money market. When the quantity of money demanded in London (bills supplied to London) exceeded the quantity of money supplied, bill brokers searched for buyers in the sections known to have surplus reserves. Just as the present-day federal funds market redistributes reserves from surplus to deficit banks, the bill brokers and correspondent banking system of the time drew bills and money to and through the London money market. The Bank of England participated in the market process as a banker. In addition, the bank absorbed gold and its own note issues as the market required and, without formally committing itself to do so, functioned as lender of last resort by advancing to banks on eligible paper.9

  7. There are a number of estimates for the earlier years. After 1808, country banks required a license to issue notes, so the number of licensees gives a more accurate estimate. The number rose from approximately 700 in 1809 to a peak of 940 in 1814. Thereafter the number of country banks declined, at first because of losses from deflation and after 1826 because of the growth of joint stock and branch banking. By 1842 the number had fallen to 429. See Wood 1939, 14.

  8. Bank of England notes did not become legal tender until 1833. London banks stopped issuing notes in 1793.

  The system had an obvious flaw. With the rate of discount set at the maximum permitted under the usury law of 1714, the bank could not keep the market price of gold equal to the mint price of gold, maintain convertibility, and discount all of the eligible paper offered in periods of expansion. The reason is that the bank had only one means, and that a very ineffective means, of limiting or reducing the rate of monetary expansion: using qualitative controls or eligibility requirements to reduce the amount of discounts. After 1793 the government chose to finance the budget deficit incurred to wage the Napoleonic Wars by borrowing from the bank, so the bank’s notes and deposits increased. The monetary expansion and deficit spending generated an increase in private expenditure. Under the prevailing payments system, this meant an increase in the number of bills of exchange drawn, including bills eligible for discount at the bank.

  From 1790 to 1795 the bank saw total securities (private and public) rise from approximately £8 million to £16 million and bullion reserves decline from £8 million to £4 million. The price index (base 100 in 1821–25) started to rise in 1793. Between 1792 and 1795, prices increased by 30 percent, a 9.9 percent compound annual rate of increase (Gayer, Rostow, and Schwartz 1978). To stem the gold outflow, the bank attempted to reduce the size, or perhaps the portfolio’s growth rate, by restricting the banks’ right to discount. Any step of this kind, however, raised fears that the resources of the financial system would prove inadequate to redeem outstanding bills at the fixed rate of interest. The policy of controlling the quantity of discounts by rationing, exhortation, and eligibility requirements failed on this occasion, as on many subsequent occasions. With the gold reserve reduced to less than £1.5 million, the bank asked the government to order an end to convertibility. From 1797 to 1821, the pound was an inconvertible currency.

  9. After the crisis of 1825, there were two changes in the arrangements just described. The responsibilities of the Bank of England were more widely recognized, although not acknowledged officially, and bill brokers performed many of the market functions previously performed by London banks, especially the function of absorbing and holding or supplying bills as the market demanded. In recognition of the changed roles of brokers and banks, by 1830 the Bank of England accepted deposits and made advances to the largest brokers. As the system evolved, the London banks no longer borrowed from the Bank of England; instead, the bill brokers borrowed, often for months. See Scammell 1968, 134–42.

  LESSONS FROM RESTRICTION AND RESUMPTION

  The events of the next twenty-five years and the analysis they engendered make the period known as Restriction and Resumption a remarkable epoch in the histories of money, monetary theory, and of particular interest here, the theory and practice of central banking. A key figure in the early discussion is Henry Thornton, whose contributions to monetary and banking theory reveal an understanding of monetary process and policy that is far better than can be found in much of the professional writing a century or more after his death.

  Thornton’s contributions fall into five main areas. First, he provided a thorough discussion of the way the monetary arrangements of his day worked in practice and discussed some of the main implications of alternative arrangements and alternative monetary standards, including an in-convertible paper currency. He recognized that money produced by the banking system, paper credit, was part of the (circulating medium) means of payment. The effect of bank deposits on prices was the same as an increase in currency or gold. Second, he analyzed the monetary aspects of international exchange. David Hume had developed the basic flow analysis of monetary changes acting on home prices relative to foreign prices, thus on gold flows. Thornton for the first time used this analysis to explain the effects of actual price changes on international currency movements and the domestic economy. His discussion of currency movements is superior to the work on the same subject for the next century. Third, he saw clearly the difference between nominal and real interest rates, distinguished expected from actual rates, and offered an explanation of the rise in interest rates during an unanticipated inflation that is superior to the discussion in many later textbooks.10 In his testimony of 1797 and in his book, he attacked both the usury law and a fixed rate of discount on the grounds that by fixing the rate the bank relinquished control of money (the circulation). He argued that the discount rate had to be changed to raise or lower the cost of borrowing when the (anticipated) rate of return to real assets changed (Thornton 1965, 253–54). Thornton saw that the absolute level of the rate was not a proper criterion. The nominal rate had to be judged relative to the nominal rate of profit or, in modern usage, the return to capital. Fourth, his contributions do not appear as vague suggestions or dimly perceived truths occurring in the midst of an otherwise flawed argument. They are part of a carefully articulated e
xplanation of the relation of money, prices, output, interest rates, credit, and balance of payments.

  10. Hawtrey (1962, 16) argues that Thornton failed to recognize the time dimension in real rates of return (or mercantile profit). This conclusion is based on an incomplete examination. In a speech on the Bullion Report, Thornton (1965, 336 and elsewhere) computes a net rate of return with dimension dollars per dollar per year in the course of his explanation of why an unanticipated inflation increases the realized profits of the borrower. Speaking of the merchants during an inflation, he wrote (336): “There was an apparent profit over and above the natural and ordinary profit on mercantile transactions. This apparent profit was nominal, as to persons who traded on their own capital, but not nominal as to those who traded with borrowed money, the borrower, therefore, derived every year from his trade, not only the common mercantile profit . . . but likewise the extra profit which he [Thornton] had spoken of. This extra profit was exactly so much additional advantage, derived from being a trader on borrowed capital and was so much additional temptation to borrow. Accordingly, in countries in which currency was in a rapid course of depreciation, supposing that there were no usury laws, the current rate of interest was often, . . . proportionably augmented. Thus, for example, at Petersburgh, at this time, the current interest was 20 or 25 percent, which he [Thornton] conceived to be partly compensation for an expected increase of depreciation of the currency” (italics added). Thornton then gave examples of the working of this principle from the experiences of Russia, Sweden, France, and America. In his book, (1965, 254) Thornton wrote: “The temptation to borrow, in time of war, too largely at the bank [of England] arises, as has been observed, from the high rate of mercantile profit. . . . [C]apital, by which the term bona fide property was intended, cannot be suddenly and materially increased by any emission of paper. That the rate of mercantile profit depends on the quantity of this bona fide capital and not on the amount of the nominal value . . . [is] easy to point out.”