A History of the Federal Reserve, Volume 1
Page 9
During the course of the century, the Bank of England (and others) learned to offset panics by serving as lender of last resort, to prevent large inflations or deflations by adopting the gold standard, and to manage short-term demands for credit by adjusting the discount rate to limit or increase the amount of discounts. Twentieth-century concerns about employment and economic growth were heard but had little effect.
Much of the academic writing failed the operational test that central bankers required. Definitions were not tight. There was little agreement and, with a few exceptions, no attention to the distinctions between temporary and persistent or transitional and permanent effects.
Ricardo, a leader of the bullionists, argued that the depreciation of the paper pound during the early years of the century could not be explained by the actual increase in paper money. The relevant change was the increase or decrease in paper money over the amount that would have circulated had there been convertibility. For this reason he tended to deny the validity of any simple comparisons between changes in paper money and changes in exchange rates. His argument, of course, allows for an effect of changes in the demand for money arising, as in Thornton, from changes in confidence and anticipated changes in the volume of transactions. Ricardo denied that these factors had operated between 1797 and 1810, however, and he offered no other explanation of changes in the demand for money. Further, like Thornton, Ricardo recognized that a change in the stock of money does not immediately affect prices and exchange rates, and he criticized his opponents for expecting immediate effects (Viner 1965, 135–42). Some of the other bullionists ignored these subtleties and wrote as if they too expected a very prompt and close adjustment between changes in money and changes in prices and exchange rates. A century later, rational expectationists also erred by understating the time required for the price level to respond to money.
By extension, the name bullionists is given to another group, those willing to extend the definition of money to include paper currency issued in fixed proportion to the stock of gold or specie. The Ricardians and their intellectual descendants in the currency school presented both views, and they inspired Sir Robert Peel, the author of the act of 1844. When writers in this tradition referred to deposits at the Bank of England or at other banks, they did not use the term money; they talked about means of payment, bills, credit, and sometimes the circulating media.
The group known as antibullionists generally denied that there could be an excess issue of paper money if banks restricted issues to the amount issued as part of the process of discounting commercial paper—at the time, bills of exchange. The core of their argument is that as long as the sources of the monetary base consist of gold and commercial paper, money cannot be overissued. The explanation they gave is that “no one would borrow at interest funds he did not need” (ibid., 148). If by chance a bank overexpanded notes or deposits, the excess issue would return to the bank either to reduce loans or, under convertibility, to acquire specie.43
The central argument of the antibullionists reappears periodically and had a powerful influence in the early days of the Federal Reserve System. The influence has become a less important cause of errors in policy, but it still survives in two distinct ways. One is the belief that some increases in “credit” are productive while others are “speculative,” a belief that in its milder form generates periodic concern about the “quality” of credit as an independent factor. The second is the notion that the monetary base is demand determined, an argument that has been used at times to absolve central banks of responsibility for their errors and even for their policies.
The antibullionists, and all later adherents of the real bills doctrine, failed to distinguish between propositions that superficially appear similar. The first is the proposition that in the long run there can be no inflation if the stock of money grows at the growth rate of real output. The second is that changes in output induce changes in the demand for bank credit and the stock of money but that if the credit is limited to the change in output, expenditures cannot increase more than output and therefore inflation cannot result.
43. After praising central bankers’ decisions for their “singular judgment and moderation,” Bagehot calls their responses to questions about why they acted as they did “almost classical by their nonsense.” Bagehot (1962, 86) quotes from testimony of the bank’s directors in 1810: “I cannot see how the amount of bank-notes issued can operate upon the price of bullion, or the state of the exchanges; and therefore I am individually of the opinion that the price of bullion, or the state of the exchanges, can never be a reason for lessening the amount of bank-notes to be issued. . . . Is the Governor of the Bank of the same opinion which has now been expressed by the Deputy-governor? Mr. Whitmore: I am so much of the same opinion, that I never think it necessary to advert to the price of gold, or the state of the exchanges, on the days on which we make our advances.”
Thornton was the first to distinguish these two arguments and to recognize that the fallacy in the second argument resulted from the failure to differentiate nominal quantities and rates of interest from real quantities and rates of interest. The error, said Thornton, was the error of John Law, who “considered security as everything and quantity as nothing.”44 Under an inconvertible paper currency, real bills provide no effective limitation of the currency and no defense against depreciation of the exchange rate. With a convertible currency the situation is no better, because the bank could not maintain convertibility if it allowed the base to be determined by the demands of the merchants. Thornton’s argument against the usury laws, discussed above, is a trenchant criticism of the real bills doctrine for the failure to distinguish between nominal and real rates. The antibullionists never replied to this argument.
Neither the antibullionists nor other proponents of the real bills doctrine recognized that it is the total quantity of notes, not their backing, that affects the price level. Commodities are sold and resold; each sale gives rise to a real bill. In the limit, there may be one increase in output backing many real bills.
As long as the payments system remained relatively simple, there was very little discussion of the definitions of money and the monetary base. Disputes about the definition start after the development of a market for bills of exchange and their use as a medium of exchange, the growth of deposit banking, and the increased use of banknotes in place of specie. Many of these disputes came to the fore during the Restriction period. Under convertibility, the requirement to pay gold on demand limited the quantity of money. The use of inconvertible paper raised questions about the effect of paper money on prices and exchange rates. In fact several different, but related, questions arose. One was whether the deposits at the Bank of England were money, and if they were money why they differed, if at all, from deposits at any other bank. To some writers if seemed obvious that because one liability is a substitute for another, there is no reason to draw fine distinctions between types of liabilities. A related issue is the possibility of controlling the stock. Those who emphasized substitutability generally concluded that efforts to control the stock of money, however defined, were a waste of time. Others focused on the gold stock and currency, items they believed to be money. Other items they regarded as part of the “circulating medium.” Related to these issues were disputes about the appropriate indicator of Bank of England policy—exchange rates, gold stock, gold flows, interest rates, or balance of payments—and about the variables that determined prices and exchange rates.
44. See Viner 1965, 150–51, for the quotation in the text, the comparison of Thornton and Ricardo on this point, and the views of the directors of the Bank of England.
One long-lasting source of confusion in the monetary literature can be traced to the absence of accepted definitions. Since money originally meant gold or bullion, an increase in paper money was described as an increase in velocity. The reasoning was that the gold was held as a reserve by the issuer of notes, who thereby increased the “circulation”
of the reserves he held (see Schumpeter 1955, 319). The source of this confusion lies in the origins of the banking system, particularly the “goldsmith” principle, under which goldsmiths could hold gold but could not increase its “circulation” by issuing claims in excess of the amount held. When the definition of money broadened to include notes as well as specie, the definition of monetary velocity changed also. Velocity included the “turnover” of notes, including the notes that might have been issued had bankers not elected to hold deposits at the Bank of England. The spread of deposit banking was often described, therefore, as an increase in monetary velocity.
Adding to the confusion was the practice of referring to an increase in deposits as an increase in credit, or sometimes as an increase in bank credit, and the related practice of referring to the stock of deposits as a stock of credit. For example, when Hawtrey discusses currency and credit, he means what is now called currency and deposits. Many of the writers who wrote that velocity declined secularly meant the same thing that others meant when they wrote that in the long run the ratio of currency to deposits declined with habits of payment.
A difficulty with any attempt to interpret parts of the discussion is that writers who denied that some asset or group of assets should be labeled money often did not make it clear whether they meant there was no point to defining the assets that serve as medium of exchange or that prices and the exchange rate did not depend on the quantity of money, however defined. Thomas Tooke, an early and prolific writer of the banking school, appears to have believed that the bank could affect the price level and exchange rate by changing market interest rates. But he also believed there was no need for interference by the Bank of England if bankers discounted real bills and notes and deposits remained convertible. For him the world price level was determined by the world’s gold stock, but he offered no explanation of English prices and denied that money, credit, or base money bore any consistent relation to prices. Most Federal Reserve officials remained in this tradition in the 1920s. They denied that their actions affected prices. A modern version of Tooke’s argument is found in Sayers 1957, 5, which argues that “to label something as ‘money’ . . . is to build on shifting sand.”45
Later writers in the banking school tradition (Bagehot, for example) believed that the exchange rate and gold flows could and should be regulated by the bank. Bagehot emphasized that the bank had to regulate reserves, but a main reason for his emphasis is that the point was often denied. Under the act of 1844, currency issues were tied closely to gold movements, and it seems likely that if the currency issues were not regulated, Bagehot would have argued for control of both uses of the base—reserves and currency. Viner (1965, 243–44) points out that many in the banking school thought of banknotes and bank deposits as money, meaning mediums of exchange, even if they were vague about the effect of money on prices.46
All of this was a far cry from Thornton, who recognized that the “possession of a right to draw [deposit] obtained in the one case, is exactly equivalent to the possession of the note [banknote] obtained in the other” (1965, 134). But few later writers saw that both reserves and currency affected market rates, money, and prices; most did not or, if they did, were inclined to emphasize one type of money rather than another.
The two points that the banking school emphasized most were the determination of interest rates in the money market and the determination of the exchange rate by the demand for and supply of pounds. If they saw beyond these points to the effect of changes in the base on money and of money on prices, market interest rates, and exchange rates, they did not stress the latter relations, and some denied them vigorously. As early as the 1830s John Horsley Palmer, a governor of the bank, had testified that the bank affected market rates by changing the “circulation” and suggested that during periods of crisis, market indicators are useful indicators of the state of the money market (Wood 1939, 45–47). With the passage of time and a series of crises and disturbances, this view gained adherents. The avoidance of panics seemed a more attainable goal if bank failures and internal drains could be avoided. Panics appeared to be money market responses, so avoiding panics required stability of the money market. Moreover, with the increased size and growing emphasis on short-term capital movements under the gold standard, market interest rates and other money market variables gained acceptance as indicators of near-term gold flows. As maintenance of the exchange rate and the bank’s reserve became the principal goal of bank policy, stability of the money market became its primary concern, the best means of ensuring exchange rate stability and avoiding domestic crises.
45. My interpretation of Tooke is based on the discussion in Wood 1939, 56–58. A succinct statement of Sayers’s views is in Sayers 1957. This point and the notion that the relation between components of “liquidity” is ever changing catch essential points of Sayers’s argument on this issue. Most of these issues returned in the early years of the Federal Reserve.
46. Viner notes (1965, 246) that Mill included potential borrowing power as a part of credit.
Some of the writers in the banking school deserve praise, however, for recognizing that the private sector is able to produce a variety of substitute means of payment. They described the development of branch banking, the pooling and centralization of bank reserves, and the use of deposits and bills of exchange as innovations that increased credit by finding more efficient uses of a given monetary base. They failed to see that the introduction and use of deposits and other substitutes for base money are limited by the return from producing substitutes. Nor did they see the related point that more efficient use of a given stock of base money does not imply loss of control of the stock of means of payment by the central bank.47
The failures of the banking school included a failure to analyze the monetary system as part of the economy and often to define terms. Its adherents made no attempt to distinguish substitution in demand from substitution in supply, the use of substitutes from the production of substitutes. As late as 1867 Thomas Hankey, a director of the Bank of England, denied that either the bank or the banking system could create or destroy means of payment (Viner 1965, 255 n. 3). His argument repeats the central notion on which the act of 1844 rested and shows that Hankey was unable to distinguish partial substitutes from perfect substitutes. Bagehot’s criticism of Hankey and those who shared his view stresses the difference between bank reserves and bank deposits but not the difference between partial and perfect substitutes or between substitutes in demand and substitutes in supply.
The fundamental relation governing substitution on the demand side is that for each type of “money” the sum of the marginal product per dollar (or other unit) and the anticipated rate of deflation must equal the return per dollar (unit) in services and income. If two means of payment are relatively poor substitutes in supply, equilibrium is reestablished mainly by relative price changes, with little change in relative supplies. At the opposite pole, if the two are relatively close substitutes in supply, equilibrium is reestablished by changes in the respective outputs, with little change in relative returns to the two assets.
47. The substance of banking school views on these matters (and on many others) is not strikingly different from the discussion of banking and financial innovation by many contemporary bankers and financial writers. Each major innovation in financial markets brings forth comments designed to establish that the central bank has lost (or will lose) control, so that monetary policy is “impossible” or ineffective. Recall the discussion of Eurodollars in the 1960s.
In the British monetary system, in our own, and in most others, currency and checking deposits are close substitutes in supply at a fixed supply price. Anyone who wishes to exchange one means of payment for the other does so at a fixed exchange rate. Technological change or other change in the relative cost or relative return from using one means of payment rather than the other affects relative demands. The return received by holders and users of these assets and the (real) demand for t
he sum changes. However, under a fractional reserve banking system, changes in relative demand for currency and deposits mainly change the combined nominal stock of the two and the price level at which the combined stocks are held.
The writers of the banking school, and many of those who repeated their arguments, observed the use of substitute means of payment and concluded, incorrectly, that the use of substitutes meant that each substitute means of payment had the same effect on the price level or the exchange rate as any other. Or if they were more sophisticated, they regarded changes in “credit” as changes in the “velocity” of the existing means of payment. They argued that the changes in velocity permanently changed the price level, the exchange rate, or the gold stock. For them money was a weighted average with the weights equal to the respective, but ever changing, velocities. Hence, they concluded, there was no point to defining money and no prospect of controlling money. These notions survive in discussions of “unstable velocity,” the impossibility of defining money, or the importance of controlling total “liquid assets,” credit, or the total liabilities of all financial institutions.