36. The belief that the gold standard maintained price stability may have contributed to the error, but that would not explain why the error persisted. I am inclined to the view that central banks, influenced at first by the real bills doctrine and later by habit, looked mainly at money market responses and ignored longer-term effects of their actions.
During the crises of 1857 and 1866, the bank relied entirely on bank rate until the government announced that it would indemnify the bank against issuance of currency in excess of its gold holdings. As table 2.1 shows, the rate was raised from 3 percent or 5.5 percent to 10 percent. During the Baring disturbance the maximum rate was 6 percent, and this rate remained in effect only four weeks. A considerable part of the difference in the discount policies of the two periods is explained by the alternative policies the bank developed. On receipt of the news that Baring would have to suspend payments, the bank increased its gold reserves by borrowing abroad, as it had done in 1839, and by purchasing gold. The governor of the bank then organized a syndicate of leading London banks to guarantee Baring’s liabilities. The disruption was short, and the sizable reduction in output that occurred several years later cannot be attributed to the Baring crisis.
Several important changes in the bank’s policies took place after the panic of 1847. In the panics of 1825 and 1847 the bank attempted to restrict the volume of loans. In 1857 and again in 1866 it made large loans at ever higher rates and made no attempt to restrict the volume. Within a few weeks of the start of the 1857 panic, the bank’s discounts doubled. The loss of gold was so great that it was forced to make use of the temporary power to issue notes without gold backing, that is, to temporarily suspend the provisions of the act of 1844. At the start of the 1866 panic in January, the bank had a larger reserve and did not have to suspend the act until March.
A second important change occurred between 1857 and 1866. The bank sold government securities during the crisis of 1857 in an attempt to reduce the growth of its portfolio. By 1866 the bank recognized the role of lender of last resort more clearly; it increased “private securities held” by a larger amount than in 1857 and made no attempt to sell government securities. Bagehot, a major critic of the bank’s directors, congratulated them for at last recognizing that the Banking Department was not an ordinary bank but the protector of the country’s reserve and the lender of last resort for the financial system.37
The series of panics from 1847 to 1866 also contributed a classic to the banking literature: Walter Bagehot’s book Lombard Street: A Description of the Money Market (1873). The book gives a clear description of the institutional arrangements of the time and proposes rules for the conduct of monetary policy. Bagehot did not criticize the bank for failing to respond to crises. Long before economists emphasized anticipations and policy credibility, Bagehot criticized the bank for failing to announce its policy in advance. A main point of the book is that directors of a central bank must publicly acknowledge their responsibility as lender of last resort and prepare for future crises under a commodity standard by holding a larger reserve than ordinary banks. Failure to do so creates and intensifies panics. In the course of the argument, Bagehot reveals a clear understanding of fractional reserve banking.
37. See Bagehot 1962, 80–81 and appendix D. Bagehot recognized that as lender of last resort, the bank should not sell at a time of panic. Exactly one hundred years later, the Federal Reserve at last recognized similar responsibilities. Faced with the prospect of failures by savings and loan associations, the System authorized the reserve banks to lend to the associations if required to prevent failures. The Federal Reserve came to recognize its role as lender of last resort to the entire financial system and thus to the economy. For the contrast with System thinking in 1929, see below, chapter 5.
Like Thornton, Bagehot distinguished between the appropriate response to an internal drain and an external drain. If an internal drain increased the demand for gold or Bank of England notes and there was no reason to be concerned about the exchange rate, the drain should be met by substantial loans from the bank. But if large amounts of gold went abroad, the crisis was external and should be met by raising the lending rate of the Bank of England. A rise in bank rate encouraged foreign lenders to buy bills in London and, by reducing internal demand and the price level in England, encouraged exports and reduced imports: “The rise in the rate of discount acts immediately on the trade of this country. Prices fall here; in consequence imports are diminished, exports are increased, and, therefore, there is more likelihood of a balance in bullion coming to this country after the rise in the rate than there was before” (Bagehot 1962, 23).38 Later the gold attracted by the higher rate reversed the decline in domestic demand and the price level.
Bagehot recognized that if the bank allowed an external drain to persist, it would face an internal drain as well. The domestic public, seeing the decline in the gold reserve, would exchange deposits and the note issues of country banks for gold and Bank of England notes. If the two drains occurred together, the Bank of England must discount willingly at a high rate.
Before we had much specific experience, it was not easy to prescribe for this compound disease; but now we know how to deal with it. We must look first to the foreign drain, and raise the rate of interest as high as may be necessary. Unless you can stop the foreign export, you cannot allay the domestic alarm. . . . And at the rate of interest so raised, the holders—one or more—of the final Bank reserve must lend freely. Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic, and enhances panic to madness. (Ibid., 27–28)39
38. Bagehot (1962, 22) referred to evidence of the effect of interest rates on short-term capital movements: “If the interest of money be raised, it is proved by experience that money does come to Lombard Street, and the theory shows that it ought to come . . . as soon as the rate of interest shows that it can be done profitably” (italics in the original). Bagehot did not offer comparable evidence of the effect of price changes on the balance of trade, although he discussed some related matters on 69–78 and suggested there that the effect on prices would be delayed.
Throughout his book, Bagehot (1962, 31–32, 79–82) made it clear that by “very large loans” he meant the absolute volume and not the volume of loans relative to the gold reserve.
Lombard Street is a clear and definite statement of some important principles of central banking. Consistent application of these principles would have avoided many of the worst consequences of monetary policy in the century that followed its publication. The book is a high point in the statement of the banking school view of the role of a central bank and its responsibilities.
The weakness of the book is the weakness of the bankers’ approach. Bagehot’s analysis of the relation between the operations on the money market and their consequences for the economy never reaches the level of Thornton’s. Throughout his book he shows an awareness of the feedback and response between monetary policy and the economy, but his astute observations never produce an incisive analysis of these effects to stand beside and supplement his analysis of the money market. Nowhere in the book does he attempt an analysis of the relation between discount rate and market rate that would be required to carry out his policy of increasing the gold reserve of the Bank of England. Nowhere does he mention that his policy of increasing the gold reserve at times requires deflation, although he was aware of this possibility. The appearance of the book before the start of a long period of deflation helps to explain this lack of attention, but examination of the many proposals to increase the bank’s reserve ratio, produced in response to his book, shows no recognition of the deflationary effect of the policies required to increase the bank’s gold reserve.
Bagehot’s book makes it clear that bankers and the banking school did not regard the international gold standard
as a completely self-regulating system, and the data in table 2.1 show that their actions were consistent with their views in this respect. The bank was expected to regulate the money market. Indeed, the views of the period erred far more on the side of minimizing or ignoring the consequences of variability for the economy than of overlooking the role of a central bank in keeping the exchange rate between the gold points.
39. Note that Bagehot assigns priority to maintaining the exchange rate. See also Thornton 1965, 93–99, for a similar argument and analysis of the crisis of 1793. Charles Rist (1940, 404–6) quotes several Frenchmen (Thiers, Burdeau, Vuitry) who recognized, in the middle of the nineteenth century, the role of a central bank as lender of last resort and holder of the reserve and also recognized some of the policies required to carry out these functions.
By automaticity of the gold standard, bankers most often meant that in the long run a central bank could not both keep the exchange rate fixed and prevent prices from rising or falling. Virtually every English nineteenth-century writer on banking understood that inflation or deflation must be accepted as the cost of keeping the market price of gold equal to the mint price. The statements of United States bankers and world central bankers during the 1960s on the importance of “discipline” and “confidence” could just as well have been made by English writers a century earlier.
The series of panics and disturbances after 1857 silenced any remaining adherents of the currency school view. Although the act of 1844 remained on the statute books, the Bank of England accepted de facto responsibility for controlling the reserves of the Banking Department and the broader responsibility for the functioning of the international monetary system. After 1870, world demand for gold rose as other countries joined England on the gold standard. The Bank of England accepted the resulting deflation as the price of maintaining convertibility, just as it accepted deflation after 1815 and 1919 as the price of restoring convertibility at the previous mint price.
The actions of the Bank of England after 1844 make it clear that the bank gradually accepted money market rates as the principal indicator of current monetary policy. Bank rate was set in relation to money market rates, and without any distinction between nominal and real rates. In both the inflation of the 1850s and 1860s and the deflation of the 1870s, 1880s, and early 1890s, the bank kept 2 percent as the minimum rate of discount. Neither the bank’s management nor the economists of the period recognized that under the gold standard, the bank’s refusal to lower the discount rate below 2 percent meant that the only equilibrium was at an anticipated rate of deflation equal to the actual rate. Alfred Marshall’s testimony before the Gold and Silver Commission of 1887–88 shows him to be struggling toward such an explanation without reaching it.40
One aspect of the act of 1844 that should not be overlooked is that the Bank of England was forced to respond to internal as well as external drains. The bank did not—and could not—ignore the series of bank failures and the internal drains as the Federal Reserve did in the 1930s. Any failure or hesitation to assist the banks by refusing to lend or restricting discounts increased the demand for loans, gold, and Bank of England notes. Wood (1939) summarizes the period up to 1858: “The principle was thoroughly engrained in the minds of the business community that good bills were convertible into Bank funds and, regardless of the state of the reserve, there were only two occasions (1825 and 1847) when the principle was called into question. On these occasions the Bank’s action was quickly reversed after an understanding with the Government.”
40. Rist (1940, 291–97) and Hawtrey (1962, 227–31) discuss Marshall’s testimony but fail to see clearly the distinction he tries to draw between nominal and real rates. In the Treatise, Keynes also admits to finding Marshall’s statement to the commission unclear (Keynes 1930, 1:191–92). Fisher (1930b, 1:43 n. 7) recognizes Marshall’s proposition as a weak association between inflation and nominal interest rates.
The bank’s understanding of its responsibilities during crises improved so much after 1858 that it organized the banking community and participated in the guarantee of Baring’s assets in 1890 in full knowledge that these were illiquid. “Good bills” were, of course, preferred, but the bank showed by this action that convertibility could be maintained and the crisis ended if it acted promptly and did not refuse to lend.
FISHER ON REAL AND NOMINAL RATES
At the end of the nineteenth century, Irving Fisher (1896) analyzed the relations between real and nominal interest rates using a number of examples to illustrate his argument. He repeated and extended the argument in subsequent work. His economic writings and policy campaign for a stable standard of value recognized that stable purchasing power of money would remove most of the problem.
Fisher’s discussion (1930b) is much clearer than Thornton’s.41 He distinguishes between perfect and imperfect foresight. Under perfect foresight, expected appreciation or depreciation of purchasing power is fully reflected in the market rates (39, 41–42). People do not anticipate correctly: “When the cost of living is not stable, the rate of interest takes the appreciation and depreciation into account to some extent, but only slightly and, in general, indirectly.” Fisher does not fully explain why the public always underestimates the rate of price change.42
Fisher’s explanation of the relation (1930b, 439) is similar to Thornton’s: “Rising prices increase profits both actual and prospective, and so the profit taker expands his business. His expanding or rising income stream requires financing and increases the demand for loans.”
41. I use his last complete statement (Fisher 1930b), but the argument is not very different from his 1896 tract or his 1907 book. The same argument is made in Fisher 1920, 56–58.
42. The conclusion rests partly on correlation between interest rates and price changes reported later in his book (Fisher 1930b, 410–11) and partly on his finding that nominal rates are less variable than calculated real rates (413–15). His empirical work does not take account of the constraint on sustained inflation imposed by the gold standard.
Fisher was not an obscure author of unread economic tracts. He was the leading American academic economist and an active participant in policy discussions. He worked hard to get his ideas about money and monetary standards adopted. In the 1920s a citizens’ league promoted his ideas. Congress considered legislation to mandate his monetary standard. Yet I have found no mention of the distinction between real and nominal interest rates in Federal Reserve minutes during the deflation from 1929 to 1933 or until late in the inflation of the 1960s and 1970s. In both periods, and in many others, the Federal Reserve (and other central banks) used an absolute standard to judge whether interest rates were high or low and associated high and low market rates with tight and easy money.
Why was the distinction between nominal and real interest rates lost? Central bankers seem generally to have regarded Fisher as a bright but annoying crank. The Federal Reserve Board was dominated throughout the 1920s and early 1930s by advocates of the real bills doctrines who, like their predecessors, denied any relation between their actions and inflation or output. They ignored Fisher’s emphasis on the role of money, much as the banking school dismissed the arguments of the currency school without meeting them.
Further, Fisher often minimized the empirical relevance of the distinction between real and nominal rates. He viewed foresight as typically poor, so that interest rates did not reflect anticipations very accurately, if at all. But lack of foresight does not eliminate the importance of the effect of inflation on interest rates. The more myopic the public is, the larger are the losses and gains, and the effects on realized returns, when inflation or deflation occurs.
Fisher’s writings are also exemplary for the clear distinction he makes between permanent effects and temporary, transitional changes. Chapter 4 of his Purchasing Power of Money (1920) is concerned entirely with transitional effects. The same is true of his paper later in that decade relating inflation to unemployment. This insightful work h
ad no influence on or meaning for adherents of the real bills doctrine, so it had no influence on policy decisions in the first twenty-five or thirty years of the Federal Reserve’s history. Later much of the staff and many of the policymakers adopted a type of Keynesian analysis that emphasized short-term or transitional effects and ignored long-term, permanent effects.
MONEY, CREDIT, VELOCITY, AND INTEREST RATES
Perhaps the most disconcerting aspect of the nineteenth-century discussion is that as central bankers improved their understanding of the effects of their actions, the techniques of central banking, and the responsibilities of the central bank during crises, their understanding of how their actions affected economic activity declined. The distinction between nominal and real magnitudes is more carefully observed at the beginning of the century than at the end. There is a clearer analysis at the start than at the end of the effect of substituting one means of payment for another. The distinction between money and credit blurred during the century, and most of the now familiar arguments about the “ineffectiveness of monetary policy” appeared. Although these issues returned to the academic literature at the end of the century, there is no evidence that academic writing had much influence on central banking. The gold standard and the real bills doctrine dominated policy action.
A History of the Federal Reserve, Volume 1 Page 8
