MERCANTILISTS and CLASSICALS: Insights From Doctrinal History

Thomas M. Humphrey

Thomas M. Humphrey is a vice president and economist in the Research Department. He has 2 served as long-time editor of the Bank’s Economic Quarterly. The views expressed do not necessarily reflect those of the Federal Reserve System. 1 Introduction

Economists typically view their discipline as a The above sentiments express what every progressive science in which superior new ideas doctrinal historian knows, namely that much of relentlessly supplant inferior old ones in a Dar- what passes for novelty and originality in mon- winian struggle toward the truth. Thus it came etary theory and policy is really ancient teach- as something of a shock when Milton Friedman ing dressed up in modern guises.To be sure, the challenged this belief in the May 1975 issue of increasing application of mathematical modeling the American Economic Review. In response to has given these concepts greater rigor and pre- the question “What have we learned in the past cision. Likewise, better data and more powerful 25 years?”, Friedman argued that what mon- empirical techniques have improved our statis- etary economists have learned since 1950 are tical estimates of the relevant quantitative mag- hardly new ideas but rather a rediscovery of old nitudes. Still, the basic ideas themselves often ideas inherited from David Hume and his con- remain much the same.Thus instead of a steady temporaries more than 200 years ago. progression of new paradigms, one sees repeat- Three years later, the British economist ed cycles of existing ones whose periodic rise Ivor F. Pearce shocked his readers even more. and fall perpetually casts them in and out of He denied that the Keynesian Revolution had fashion. contributed a single new or useful idea to mon- By itself, this recycling of established ideas etary economics. Instead, he (1978, p. 93) insist- need be no cause for alarm.Theories may survive ed that “human history is guided not by new because experience indicates that they possess ideas, for there are none,” but rather by “some a high degree of validity and because no better ephemeral sub-group of...old ideas.” Such old theories have been found. The trouble is, how- ideas, “often believed to be new,” are “seized ever, that sound theories are not the only ones 3 upon as the...solution to whatever difficulties to survive. Unsound theories may coexist with immediate experience has made to seem the sound ones. important, and congealed into a crust of dogma Unfortunately, policymakers and the gener- by endless repetition and obeisance.” al public are in no position to realize as much. Preoccupied by the pressing problems of the day, they have neither the time, inclination, or training, nor indeed the duty to trace the histo- ry of the ideas they employ or endorse. They have no reason to be aware of earlier policy debates in which sound theories were distin- ...much of the history guished from fallacious ones. The result is twofold. Policymakers may subscribe to old of monetary theory theories under the mistaken impression that those theories are new.Worse, they may unwit- reduces to a struggle tingly deploy policies whose underlying theory has been challenged and found wanting in earli- er policy debates. between opposing Here is where the doctrinal historian can help. His comparative advantage lies in identify- mercantilist and ing the origin and tracing the evolution of rival monetary doctrines across a succession of writ- classical camps. ers, events, episodes, and policy controversies. Each such incident constitutes a test, or obser- Maynard Keynes’s mercantilism, the mercantilist vation, of the relative strengths and weaknesses doctrines of Keynes’s disciples yielded to Milton of the competing doctrines.While no single test Friedman’s classical monetarism, and so forth. can yield conclusive results, many such tests Even today, with central bankers in several may do so. Taken together, they reveal which nations expressing commitment to the classical doctrine has emerged from past experience as goal of price stability and monetarists advocat- the more robust analytically. By demonstrating ing systematic, zero-inflation rules for monetary as much, the historian specifies those ideas that policy, mercantilist undercurrents still run seem to offer the most effective basis for pub- strong. Supply-siders who argue that monetary lic policy. Of course, there is no assurance that policy must be accommodative to allow tax cuts the policymaker will heed the doctrinal histori- to work their magic echo mercantilist opinion. an and employ the best ideas. On the contrary, So too do those who contend that, with global he may reject them or temporarily accept and competition and rapid technological progress subsequently abandon them. Here again the his- holding inflation in check, monetary policy is torian has something to say. His study of the free to pursue nonprice objectives such as forces influencing the receptivity and imple- boosting growth and achieving full employment. mentation of ideas permits him to predict a Finally, observers who believe that monetary doctrine’s prospective success or failure. In this policy is powerless to stimulate the currently manner, the unique perspectives of doctrinal depressed Japanese economy harbor mercan- history may prove their worth. tilist fears of unspent hoards of idle cash. This article puts those perspectives to The following paragraphs attempt to spell work. It shows that from a broad standpoint, out the core propositions of the original mer- much of the history of monetary theory cantilist and classical views and to establish the reduces to a struggle between opposing mer- centrality of those propositions in the famous 4 cantilist and classical camps. Mercantilists, with Currency School-Banking School and Keynesian- their fears of hoarding and scarcity of money monetarist controversies – the two leading together with their prescription of cheap (low monetary policy debates of the nineteenth and interest rate) and plentiful cash as a stimulus to twentieth centuries.1 From this doctrinal histor- real activity, tend to gain the upper hand when ical exercise, three themes emerge. First, with unemployment is the dominant problem. Classi- some exceptions, classicals tend to be quantity cals, chanting their mantra that inflation is theorists; mercantilists, anti-quantity theorists. always and everywhere a monetary phenome- Second, classicals prefer rules; mercantilists, dis- non, tend to prevail when price stability is the cretion. Third, for all their cogency, classicals chief policy concern. may be doomed to face a perpetual mercantilist Currently, the classical view is in the dri- challenge. As long as some observers continue ver’s seat. By all rights it should remain there to believe, rightly or wrongly, that inflation and since it long ago exposed the mercantilist view deflation are nonmonetary, or real, phenomena as fundamentally flawed. It is by no means cer- and that unemployment is a monetary one tain, however, that the classical view’s reign is capable of correction by the central bank, the secure. For history reveals that, whenever one debate will be unending. view holds center stage, the other, fallacious or not, is waiting in the wings to take over when the time is ripe. In this manner,the mercantilism of John Law and Sir James Steuart gave way to the classicism of David Hume and David Ricardo, the Currency School’s classicism bowed to John 2 Mercantilist and Classical Monetary Doctrines

The roots of the debate trace back to the orig- from prices and real activity to money such that inal mercantilist writers of the preclassical era the money stock passively adapts to the needs 1550-1770. Those writers argued that a nation’s of trade, (6) overissue is impossible when the stock of precious metals constituted the source money stock is backed by the nominal value of of its plenty (wealth), power, prestige, and pros- real property, and (7) discretion outperforms perity. For countries possessing no gold mines, rules in the conduct of monetary policy. augmentation of those conditions required the accumulation of specie through foreign trade. John Law (1671-1729) Accordingly, mercantilists advocated protec- tionist policies in the form of export promotion The clearest and most emphatic statements of and import restriction schemes to obtain a per- the foregoing propositions came from John Law manent trade balance surplus matched by cor- and Sir James Steuart, two economists writing responding persistent inflows of specie from near the close of the mercantilist era.3 Of the abroad. two, Law’s name is synonymous with the money- This policy prescription was of course the stimulates-trade doctrine that forms the central mercantilists’ main claim to fame. But the hall- core and theme of his 1705 Money and Trade mark that secures them a permanent niche in Considered; with a Proposal for Supplying the the history of monetary doctrines was their Nation with Money. Writing against the backdrop contra- or anti-quantity theory of money. 2 They of a chronically depressed and underemployed used that theory to deny that money determines Scottish economy (his home country),he argued prices and to tout the employment benefits of that a shortage of metallic money was to blame, money-stock expansion fueled either by specie that a bank-issued paper currency must replace 5 inflows or by paper money creation should the deficient metallic one, and that the resulting those inflows languish. Consisting of at least expansion of the stock of paper notes would seven propositions, the mercantilists’ contra- permanently increase the level of output and quantity theory held that (1) money stimulates employment without increasing prices.4 His trade, (2) real cost-push forces determine the argument stemmed from his assumptions of price level and the inflation rate, (3) the interest (1) the availability of idle resources at unchanged rate is a purely monetary variable whose level, prices and (2) constant returns to scale in pro- high or low, is proof of the scarcity or abun- duction. Given these conditions, it followed that dance of money, (4) idle hoards absorb any cash the economy’s long-run aggregate supply curve not employed in driving trade, (5) causality runs was perfectly horizontal up to the point of full

Classicals sought to anchor money

with a fixed physical quantity

– mercantilists with the nominal

dollar value – of some real object.

The mercantilist plan leaves

money anchorless. Essentially,

it anchors each dollar with another

dollar – no anchor at all. employment. It likewise followed that money- so vigorously by classical writers. induced increases in aggregate commodity As for the doctrine that low interest rates demand would, via rightward shifts along the spell monetary ease and high rates monetary supply curve, generate matching increases in tightness, Law accepted it without reservation. equilibrium real output without raising prices. Anticipating Keynes’s liquidity preference theo- Indeed, Law suggested that the price level might ry of interest, Law saw interest rates as the price even fall if scale economies in production ren- of money’s use, a price that varied inversely dered the aggregate supply curve negatively with the quantity available to use. Being purely sloped.5 In no case, however, would expansion monetary phenomena, low rates unambiguously of the stock of paper money raise prices. signified an abundance of money and high rates Having argued that causation runs from a scarcity of it. Law, an ardent advocate of low money to output, Law perceived that it could be rates, argued that they reduced the business- made to run in the opposite direction too.With man’s cost of capital and so spurred investment appropriate financial linkages put in place,output and real activity. For him, money exerted its could induce the very monetary means of its stimulus through indirect interest rate channels own expansion. Indeed, Law thought this out- as well as through direct expenditure ones. come was assured provided that banks issued money on productive loans secured by claims Sir James Steuart (1721-1780) to future product or its equivalent. Coaxed forth by real output in this fashion, the paper To Law’s doctrines, Steuart in his 1767 An money stock would grow in step with the real Enquiry into the Principles of Political Oeconomy demand for it such that its purchasing power added four more. First was his explicit rejection would be preserved unchanged. To ensure that of a monetary for a real cost-push theory of the nominal money stock automatically expand- inflation. Tracing a causal chain from the degree 6 ed equally with the real demand for it, he advo- of competition in labor markets to wage rates cated that paper notes be backed dollar-for- to unit labor cost to product prices, he con- dollar with the nominal value of land. Collater- cluded that cost and competition determine the alized by land, money would, he thought, enjoy prices of all goods and thus the price level as a stability of value. When economic development whole. Likewise, he held that the monopoly or cyclical recovery brought more land into cul- power of producers determines their profit tivation, the money stock, secured by the extra margins as embodied in the profit mark-up land, could expand to meet the growing needs component of individual and aggregate prices. In of trade at unchanged prices. Here was the pro- other words, he alleged that the same real totype of the real bills doctrine later attacked forces – market power and cost – that govern

170 0 1705 1709 1710 1712 Agricultural Revolution begins in Great Abraham In England, Thomas Britain. Farmworker productivity, scarcely Darby in- Newcomen invents a higher in 1700 than 20 centuries earlier, vents coke workable steam pump doubles in the next 100 years. smelting of for use in mines. Mercantilists iron ore. Classicals Mercantilist views are prevalent

John Law’s Money and Trade Considered “Domestic trade depends on the declares that money stimulates economic money. A greater quantity employs activity. more people than a lesser quantity. 150 Law introduces the prototype of the real A limited sum can only set a bills doctrine when advocating that number of people to work propor- paper notes be backed dollar-for-dollar with the nominal value of land. tion’d to it, and ’tis with little Law success laws are made for employ- U.K. PRICE LEVEL Unavailability of an inflation rate series for ing the poor or idle in countries 100 1700-1880 necessitated use of a price-level where money is scarce.” series instead (see left scale). After 1880, 90 an inflation rate series was used. John Law in Money and Source: Deane and Cole, British Economic Trade Considered Growth 1688-1959, Appendix. 80 relative prices account for absolute prices as recourse to paper substitutes and other expe- well. He advanced a relative price theory of the dients allows transactors to economize on coin absolute price level.6 whose velocity therefore rises.Via such devices, Steuart’s second contribution was his doc- velocity adjusts to ensure that the stock of coin trine of the hoards which he used to bolster his is just enough to purchase all the goods offered denial that money determines prices. He argued for sale at the predetermined level of prices. In that idle hoards of specie absorb excess cash this way, causation runs from prices to money from circulation just as they release into circu- and velocity. Here is the origin of the notion lation additional coin to correct a monetary that changes in the stock of circulating media shortage. Consequently, there can be no mon- (coin and its paper substitutes) merely validate etary excess or deficiency to spill over into the price changes that have already occurred and commodity market to affect prices. The hoard- do nothing to produce such changes. ing-dishoarding mechanism ensures as much.7 Finally, there was Steuart’s uncompromising For those occasional increases in the money stance on the perennial issue of rules versus dis- stock that do manage to elude the hoarding cretion in the conduct of policy. Like all mercan- mechanism and spill over into the commodity tilists, Steuart sided with discretion. Monetary market, he argued, like Law, that they produce rules, whether of fixed or feedback variety, met matching shifts in commodity demand along a with his skepticism as did all self-correcting horizontal supply schedule such that quantities adjustment mechanisms, natural or designed. To of output alter at unchanged prices. him, nothing but discretionary fine-tuning would Third was his reverse causation doctrine do.9 Such enlightened intervention was the hall- according to which causality runs from prices to mark of his omnipotent, ever-active, benevolent money and its circulation velocity rather than statesman whose job was to manipulate the vice-versa as in the quantity theory. Positing a volume of real activity in the national interest.10 two-step process, he said that cost and compe- Steuart’s statesman alone possessed the detailed 7 tition first determine prices. Then, with prices knowledge necessary to conduct what today is settled, the circulation velocity of coin adjusts known as a successful cheap-money,full-employ- to render the existing stock sufficient to accom- ment policy.The gap between actual and potential modate the prevailing level of real activity at the output,the monetary injection required to close given prices.8 If the money stock is excessive, the gap, and the interest rate necessary to draw wealth-holders remove the excess from circula- the required metal from idle hoards: all revealed tion, melt it down, and hold it in the form of themselves to the statesman’s astute and vigi- ornaments and bullion such that velocity falls. lant scrutiny. So too did the ever-changing cir- Conversely, if coin is deficient, the resulting cumstances to which he tailored his actions.

1717 1719 17 20 1730 South Sea Bubble

Law organizes his colo- Law flees France in nial trading enterprise, disgrace and spends the Mississippi Compa- his remaining days ny, and merges it two at the gambling tables years later with the of Venice. Banque Royale in France.

Law’s Mississippi Scheme South Sea Bubble, the sees excessive paper English equivalent of Law’s money expansion culminate speculation craze, bursts. in an inflationary boom and collapse in France. These propositions formed the core of mer- respect to the mercantilist prescription of pro- cantilist monetary theory which Law and tectionism as the path to opulence, both Smith Steuart deployed to analyze the underemployed and David Ricardo noted that wealth-enhancing, economies of their time. Of the two writers, efficient resource allocation requires not protec- only Law, the paper money mercantilist, was tionism but rather free trade in order to exploit able to translate his theory into action. His comparative advantages stemming from special- famous Mississippi scheme, which merged ization and division of labor.13 France’s national bank of issue with a trading and land development firm (the Mississippi Price-Specie-Flow and Company) while simultaneously promising to Quantity Theory Propositions reduce the French public debt, involved paper Other classicals joined the attack. David Hume money expansion on a mammoth scale.11 (1752) used his price-specie-flow mechanism to The resulting spectacular inflationary boom demonstrate the impossibility of the mercan- and collapse of Law’s system had three conse- tilist goal of a permanently favorable trade bal- quences.12 It revealed that the initial output ance and corresponding persistent specie stimulus of a monetary expansion eventually inflow. Hume (pp. 62-3) noted that the addi- vanishes leaving only inflation in its wake. It tional specie, by raising domestic prices relative served to discredit paper money and financial to foreign ones and so discouraging exports innovation schemes for many years to come. It, and spurring imports, would render the trade together with the similar debacle of the assignats, balance unfavorable and reverse the specie a nominally land-backed paper currency issued flow.14 The resulting drain of monetary metal by the French revolutionary government to would continue until domestic prices fell to the inflationary excess in the years 1794 to 1796, level consistent with trade balance equilibrium. provoked classicals to reject mercantilist trade Similarly, Hume (pp. 33, 37, 48) showed that the 8 and monetary theory root and branch. mercantilist fear of scarcity of money was unwarranted since any quantity of money, via a proportionate adjustment in the price level, Classical Counterpropositions could drive the trade of a nation. To prove as Denouncing the mercantilist identification of much, Hume (pp. 62-3) advanced a rigid version wealth with precious metals, Adam Smith of the quantity theory according to which an observed that national wealth consists not of exogenously given one-time reduction in the specie or bullion but rather of stocks of pro- stock of money has no lasting effect on real ductive resources – land, labor,and capital – and activity but leads ultimately to a proportionate the efficiency with which they are used. With change in the money price of goods.

1730 1733 174 0 John Kay invents the flying shuttle, a device for throwing a weaving shuttle faster than could be done manually. It, together with other inventions including the spinning jenny and the power loom, lead to the mechanization of industry and the development of textile mills in England.

Mercantilist views are prevalent

Richard Cantillon writes Essai sur la Nature du Commerce en Général (published in 1755) partly 150 as a critique of Law’s system.

Hume

100

90

U.K. PRICE LEVEL U.K. 80 Distinction between are temporarily sticky, or inflexible, in response Absolute and Relative Prices to money stock changes. Such stickiness Hume Hume’s classical followers immediately seized attributed to the imperfect information price- upon his quantity theory and deployed it against setters possess on money-stock changes and the mercantilists. David Ricardo applied it to their resulting failure to perceive and act upon refute cost-push theories of the price level.15 the changes. Distribution effects constituted for Accusing cost-pushers of confounding relative him another source of temporary nonneutrali- prices (market exchange ratios) with the ab- ty, or transitory influence on real activity, inas- solute,nominal,or general level of prices,Ricardo much as new money is initially concentrated in flatly denied that a rise in costs – wage costs in few hands and only gradually becomes dispersed particular – could raise general prices without throughout the economy.17 an accompanying expansion of the money stock. With prices sticky and money’s circulation True, he did acknowledge that a wage hike velocity given, it follows that changes in the might raise the prices of labor-intensive goods money stock are absorbed by output which and so require consumers to spend more on accordingly deviates temporarily from its natu- those goods. But he also insisted that without ral equilibrium level. Prices only begin to adjust accommodating increases in the money stock when price-setters discover that their invento- to foster spending, consumers would have less ries of goods and labor are abnormally high or to spend on capital-intensive goods whose prices low. Eventually, monetary and price-perception would therefore fall. The upshot was clear. Any errors are corrected as are initial distribution wage-induced rise in some relative prices would effects. At that point, the price level fully adjusts be offset by compensating falls in others leaving to the new money stock and output returns to the general average of all prices unchanged. its natural equilibrium level. Here is the source of the classical doctrine of the short-run non- Short-Run Nonneutrality and neutrality and long-run neutrality of money.18 9 Long-Run Neutrality Propositions Classicals reserved their severest criticism for Classical Case For Rules John Law’s money-stimulates-trade doctrine. Four remaining mercantilist arguments clam- Hume insisted that the doctrine holds in the ored for demolition. Classicals were glad to short run but not the long.16 At first, money- oblige. First was the mercantilist claim that dis- stock changes indeed affect output and employ- cretion was superior to rules. Classicals coun- ment. Eventually, however, the output stimulus tered with the opposite claim that rules vanishes and only higher prices remain. Law’s replaced destabilizing activist intervention with doctrine holds in the short run because prices smoothly operating, or stabilizing, automatic

1750 1760

Seven Years War (1756-1763) Industrial Revolution in Great Britain (1750-1850)

Swedish Bullionist Controversy (1755-1765)* “Money, however plentiful, has David Hume, in his essays no other effect, if fixed, than to “Of Money,” “Of Interest,” *After Sweden switched from a metallic to an inconvertible and “Of the Balance of Trade,” paper currency in 1745, the resulting price inflation and raise the price of labour...and... advances the classical ideas exchange rate depreciation provoked a policy debate commodities.... In the progress of the price-specie-flow mech- over the cause of these phenomena. Mercantilists traced toward these changes, the augmen- anism, the quantity theory, the cause to external real shocks to the balance of pay- and the long-run neutrality ments and prescribed export promotion and import restric- tation may have some influence, and short-run nonneutrality tion schemes as remedies. Others, notably P. N. Christiernin, by exciting industry; but after the of money. found the cause in the Riksbank’s overissue of notes. He prices are settled, suitably to the urged halting the excess issue but refrained from prescrib- ing a roll-back of prices to their pre-inflation level fearing new abundance of gold and silver, such deflation would bring an intolerable transitory loss it has no manner of influence.” of output and employment.

David Hume in “Of Interest” adjustment mechanisms. Unlike Steuart, classi- creates, in the form of factor payments, incomes cals held a low opinion of the knowledge, capa- sufficient to buy the goods off the market. And bilities, and motivation of the policy authorities. those incomes indeed will be spent. The insatia- In particular, classicals, especially Ricardo, John bility of wants together with the unlikelihood Wheatley,and other Bullionist critics of the Bank that rational people would hoard their savings of England,feared that central bankers operating indefinitely in the form of sterile money ensures under the kind of floating exchange rate, incon- as much. vertible paper regime prevailing in England dur- Far from going unspent, saving automatically ing the Napoleonic Wars, would, if left to their translates itself into investment. People deposit own discretion, pursue inflationary policies. their savings with banks to earn interest. Those Since classicals regarded stability of the value intermediaries,upon lending the saving to capital- of money as the overriding policy objective, ist entrepreneurs to finance investment projects, they advocated rules obligating policymakers to guarantee that it enters the spending stream just achieve that goal. One such rule was the gold as surely as if it were consumption spending.The standard.By requiring the maintenance of a fixed upshot is that full-capacity supply creates its own currency price of gold, this rule, provided that demand such that mercantilist fears of general the gold price of goods also remained fairly gluts and permanent stagnation are unfounded. steady, was tantamount to stabilizing the money Say’s Law of Markets identifies the natural level price of goods. And with the price level stable, of real activity with full employment.19 money could function reliably as a unit of account and medium of exchange. In so doing, it could Real Interest Rate make its maximum contribution to the efficient As for the mercantilist argument that the inter- operation of the real economy and cease to be est rate is purely a monetary phenomenon, a source of financial crises and panics. Hume, Ricardo, and Henry Thornton all repudi- 10 ated it.20 They contended (1) that the natural Say’s Law of Markets equilibrium rate of interest is a real magnitude Next in line for rejection was the mercantilist determined by productivity and thrift, and claim that deficient aggregate demand con- (2) that money, being neither of those variables, demns cash-poor economies to perpetual cannot affect the natural rate whose level is unemployment. Not so, wrote the classicist therefore resistant to monetary control. True, Jean Baptiste Say in his 1803 Traité d’économie they conceded that a one-time monetary injec- politique. The value of goods produced equals tion could temporarily depress the loan rate of the cost of the inputs absorbed in their fabrica- interest below its equilibrium level. But they tion. It follows that the very act of production stressed the transience of this effect. They

1760 1769 17 70 James Watt’s steam engine adds a con- denser to Newcomen’s atmospheric engine, boosting its efficiency by a factor of four. Seven Years War (1756-1763) Industrial Revolution in Great Britain (1750-1850)

Mercantilist views are prevalent Swedish Bullionist Controversy (1755-1765) “It is the business of a statesman... to...guard against...stagnation.... Sir James Steuart’s An Enquiry into He must facilitate circulation 150 the Principles of Political Oeconomy by drawing into the hands of the enunciates four main doctrines of mercantilism: real forces determine public...coin...locked up [in idle the price level, hoarding prevents hoards]; and he must supply the money from affecting prices, the Steuart actual deficiency of the metals, by monetary circulation determines the level of real activity, and discretion [issuing] paper credit.” 100 outperforms rules in the conduct Sir James Steuart in An Enquiry 90 of monetary policy. into the Principles of Political Oeconomy, Vol. II

U.K. PRICE LEVEL U.K. 80 pointed out that the monetary injection puts that any random shock which raises land’s price upward pressure on prices. And since with high- would, by raising land’s value, increase money’s er prices more loans are needed to finance a backing and so justify an expansion of its supply. given real quantity of investment projects, it fol- The consequent expansion would further bid lows that loan demands increase.The rise in loan up land’s price thereby justifying still further demands reverses the initial fall in the loan rate increases in the money stock which would raise and restores it to its natural level thereby frus- prices again and so on ad infinitum. In short, trating attempts to keep it low. Supplementing backing money with the nominal value of land – the price-induced rise in loan demand is a fall in or, for that matter, with commercial paper rep- loan supply.For as prices rise,people need more resenting the nominal value of goods in the cash to mediate hand-to-hand transactions. The process of production and distribution – would resulting conversion of notes and deposits into destabilize prices rather than stabilize them. coin precipitates a cash drain from banks that Price stability required another principle of diminishes bank reserves. To protect their monetary limitation. reserves from depletion, banks raise their loan Thornton’s refutation of the nominal backing rates. Or what is the same thing, they contract idea completed the list of the original classical their loan supply.The contraction of loan supply rebuttals of mercantilist monetary doctrine. combines with the rise in loan demand to Having contested this doctrine once, however, restore the interest rate to its natural equilibri- classicals and their descendants were called um level determined by productivity and thrift. upon to counter it repeatedly throughout the nineteenth and twentieth centuries. Mercan- Criticism of Backing Theories of Money tilist views, despite their devastating initial Last but not least was Law’s idea of a land- rejection, reemerged to form the Banking collateralized paper money stock.Henry Thorn- School position in the famous Currency School- ton was merciless in his criticism. He excoriated Banking School controversy that took place in 11 the plan on the grounds that it would fail to England in the mid-1800s. Most of the usual limit the money supply and in so failing would suspects – cost-push, hoarding, reverse causali- render the price level indeterminate.21 The plan’s ty, discretion, nominal backing – appeared in the flaw, wrote Thornton, is that it ties money to Banking School’s roundup. In opposing them, the nominal or dollar value, rather than to the classicals, in their Currency School guise, found fixed physical acreage, of land. By anchoring occasion to deploy the same quantity theoretic, each dollar to another dollar,it sets up a dynam- price-specie-flow concepts they had earlier ically unstable price-money-price feedback loop deployed against Law and Steuart. rendering prices indeterminate. The result is

1776 1780 1788 1790 Henry Court invents the puddling process leading to Signing of the Declaration of Independence larger-scale iron furnaces and a 30-fold expansion in the output of iron between 1760 and 1899. American Revolution (1775-1783) French Revolution (1789-1799)

Classical views are prevalent Assignat Experiment in France (1789-1795)* Adam Smith publishes “Some of the best English writers...set out with observing, Wealth of Nations, refuting that the wealth of a country consists, not in its gold and *Instituted by the French revolutionary mercantilist protectionist government, the assignat experiment doctrines with classical free silver only, but in its lands, houses, and consumable goods..., reprises Law’s land-backed paper money trade principles. He also however, the lands, houses, and consumable goods...slip out scheme. The resulting inflation provokes refutes the mercantilist claim of their memory, and...their argument frequently supposes a classical, or anti-mercantilist, backlash that money (gold) constitutes in monetary thought. national wealth. that all wealth consists in gold and silver.” Smith Adam Smith in Wealth of Nations

“Without once mentioning it [Sir James Steuart’s book], I flatter myself that every false principle in it will meet with a clear and distinct confutation in mine.”

Smith in a letter to William Pulteney (1772) 3 Currency School-Banking School Debate (1830-1850)

Ending a 24-year experiment with inconvertible mum required reserve ratio and willing to sac- paper, Britain had restored the gold convert- rifice safety for profit, could and did continue to ibility of her currency in 1821. The ensuing issue notes even as gold was flowing out, delay- Currency-Banking debate focused on whether ing contraction until the last possible moment, the note component of such a convertible, gold- and then contracting with a violence that sent standard currency required regulation to pre- shock waves throughout the economy. vent overissue.22 The Currency School’s classical predecessors, notably David Ricardo, Henry Currency School’s Monetary Rule Thornton, and others, had assumed that a con- vertible currency needed no such protection. If What was needed, the Currency School the currency were convertible, they reasoned, thought, was a rule removing the note issue any excess note issue which raised British prices from the discretion of bankers and placing it relative to foreign prices would be converted under strict regulation. To be effective, this rule into gold to make cheaper purchases abroad.23 should require the banking system to contract The resulting loss of specie reserves would its note issue one-for-one with losses of gold immediately force banks to contract their note reserves so as to put a gradual and early stop to issue thus quickly arresting the drain and specie drains. Such a rule would embody the restoring the money stock and prices to their Currency School’s principle of metallic fluctuation pre-existing equilibrium level. Given smooth according to which a mixed currency of paper and rapid adjustment (monetary self-correc- and coin should be made to behave exactly as if tion), convertibility alone was its own safeguard. it were wholly metallic, automatically expanding 12 A series of monetary crises in the 1820s and and contracting to match inflows and outflows 1830s, however, convinced the Currency School of gold.24 that adjustment was far from smooth and that Departure from this rule, the Currency convertibility per se was by no means a guaran- School argued, would permit persistent overis- teed safeguard to overissue.It was an inadequate sue of paper. Such overissue, by forcing a pro- safeguard because it allowed banks, commercial tracted efflux of specie through the balance of and central, too much discretion in the manage- payments, would in turn endanger the gold ment of their note issue. Banks, facing no mini- reserve, threaten gold convertibility, compel the need for sharp contraction, and thereby precip-

1790 1792 1793 1800 1802 1803 Opening of the New Eli Whitney invents Louisiana York Stock Exchange the cotton gin. Purchase French Revolution (1789-1799) Industrial Revolution in Great Britain (1750-1850)

Classical views are prevalent Assignat Experiment in France (1789-1795) Bullionist-Antibullionist Debate (1797-1821)*

*After England suspends gold payments and goes on an inconvertible paper standard Henry Thornton in in 1797, the resulting inflation provokes perhaps the most famous monetary his Paper Credit of 150 controversy of all time. Led by David Ricardo, the bullionists blame the Bank of Great Britain refutes England for creating inflation through excessive issues of paper notes. Antibullionists Law’s idea of back- attribute the price rises to such real shocks as domestic crop failures, overseas ing money with the military expenditures, and the wartime disruption of foreign trade. They stress nominal value of cost-push influences exerting upward pressure on the individual prices of specific land saying it would commodities and posit the real bills doctrine to argue that money, advanced on render the price loan to finance sound business projects, cannot affect prices. level indeterminate. 100 Thornton 90 Jean Baptiste Say enunciates his Law of Markets (1803).

U.K. PRICE LEVEL U.K. 80 itate financial panics. Such panics would be note issue, reductions that restore general exacerbated if internal gold drains coincided prices to their target equilibrium level. Here with external ones as domestic money holders, too was the classical preference for rules – in alarmed by the possibility of immanent suspen- this case a 100 percent gold reserve require- sion of cash payments, sought to convert paper ment rule – rather than discretion in the con- currency into gold. No such consequences duct of banking policy. would ensue, the School felt, if the currency conformed to the metallic principle. Forced to Banking School behave like gold (regarded by the School as the stablest of monetary standards), the currency The rival Banking School flatly rejected the would be spared those sharp procyclical fluctu- Currency School’s prescription of mandatory ations in quantity that amplified disturbances 100 percent gold cover for notes. Indeed, the arising from real shocks. Banking School denied the need for statutory The Currency School scored a triumph note control of any kind. Instead, the School when its monetary rule was enacted into law. argued that a convertible note issue was auto- The Bank Charter Act of 1844 embodied its matically regulated by the needs of trade and prescription that, except for a small fixed required no further limitation. This conclusion amount of notes issued against government stemmed directly from the real bills doctrine and securities, bank notes were to be backed by an the law of reflux which together posited guaran- identical value of gold. In modern terminology, teed safeguards to overissue obviating the need the Act established a marginal gold reserve for monetary control. requirement of 100 percent behind note issues. The School’s real bills doctrine stated that With notes rigidly tied to gold in this fashion, the money stock could never be inflationary or their volume would start to shrink as soon as deflationary if issued by way of collateralized specie drains signaled the earliest appearance of loans advanced to finance transactions in the 13 overissue. Monetary overexpansion would be nominal volume of real goods and services. corrected automatically, swiftly, and gently Similarly, the law of reflux asserted that overis- before it could do much damage. Here was a sue was impossible because any excess notes practical policy application of Hume’s quantity would be returned instantaneously to the banks theoretic, specie flow doctrines. Here was the for conversion into coin or for repayment of notion of a channel of influence running from loans. Both doctrines embodied the notions of note overissue to rising prices to trade deficits a passive, demand-determined money supply to gold drains to corrective reductions in the and of reverse causality running from prices and

1810 1812 1817 1820 War of 1812 Britain invades U.S. Napoleonic Wars (1800 -1815)

Birmingham School (1817-1821)** “Mr. Law considered security as every David Ricardo’s The High Price thing, and quantity as nothing. He of Bullion blames inflation on **Led by Thomas Attwood, the Birmingham the Bank of England. School opposes restoration of gold convert- forgot that there might be no bounds ibility of the British pound at the pre-war to the demand for paper; that the Thornton (1802) and Ricardo Ricardo writes Princi- parity. They fear the resulting deflation will increasing quantity would contribute (1817) write that the equilibrium ples of Political Economy cause unemployment. They advocate continu- interest rate, being determined by and Taxation. He denies ation of the wartime regime of floating- to the rise of [the price of] commodi- productivity and thrift, is resistant that a rise in wage exchange-rate inconvertible paper currency ties; and [that] the rise...require, and to monetary control. Classicals rates could raise prices that brings high and rising prices. In short, seem to justify, a still further increase.” reject Law’s money-stimulates- without an accompany- the inflationist, full-employment-at-any-cost trade doctrine saying that the ing expansion of the writers of the Birmingham School oppose Henry Thornton in a speech neutrality-of-money proposition money stock. a return to the gold standard. on the Bullion Report (May 11, 1811) renders it invalid in the long run. Ricardo economic activity to money rather than vice tion, (3) that changes in the stock of money are versa as in the Currency School’s view.25 offset by compensating changes in the stock of According to the reverse causality hypothesis, money substitutes leaving the total circulation changes in the level of prices and production unchanged, and (4) that discretion is superior to induce corresponding shifts in the demand for rules in the conduct of monetary policy. bank loans which banks accommodate via vari- The Banking School put these propositions ations in their note issue. In this way, prices help to work in its critique of the classical monetary determine the note component of the money doctrines of the Currency School. Those doc- stock, the expansion of which is the result, not trines, of course, contended that note overissue the cause, of price inflation. As for the price is the root cause of domestic inflation and level itself, the Banking School attributed its specie drains. In opposing them, the Banking determination to factor incomes or costs School argued as follows: Overissue is impossi- (wages, interest, rents, etc.), thus positing a cost- ble since the stock of notes is determined by push theory of price movements. The impor- the needs of trade and cannot exceed demand. tance of cost-push theorizing to the Banking Therefore, no excess supply of money exists to School cannot be overestimated. It even led spill over into the goods market to bid up prices. Thomas Tooke, the School’s leader, to argue In any case, causality runs from prices to money that high-interest-rate tight-money policies rather than vice versa. Finally,specie drains stem were inflationary since they raised the interest from real rather than monetary shocks to the component of business costs.26 balance of payments and are totally independ- ent of domestic price-level movements. Mercantilist Ideas These arguments severed all but one of the The concepts of cost inflation, reverse causality, links in the Currency School’s monetary trans- and passive money are the hallmarks of an mission mechanism running from money to 14 extreme anti-quantity theory of money to prices to the trade balance, thence to specie which the Banking School adhered. Additional flows and their impact on the monetary base, mercantilist hallmarks included the School’s and finally back again to the money stock. The propositions (1) that international gold move- final link was broken when the Banking School ments are absorbed by idle hoards of excess asserted that gold flows come from idle hoards specie reserves without affecting the volume of – buffer stocks of excess specie reserves – and money in active circulation, (2) that gold drains not from the volume of money in circulation. stem from real shocks to the balance of pay- Falling solely on the hoards, gold drains would ments rather than from domestic price infla- find their monetary effects neutralized (steril-

1820 1829 1830 U.K. overtakes the G. Stephenson’s Stephenson’s engines pull Netherlands in man- steam locomotive, the first fully scheduled trains. hour productivity. Rocket, wins contest. Railroad age begins.

Industrial Revolution in Great Britain (1750-1850)

Classical views are prevalent

“Restore the depreciated “Mr. Attwood opines, that the multiplication of the circulat-

state of the currency and ing medium, and the consequent diminution of its value... Thomas Tooke, leader of the Banking you restore the reward of give employment to labour...to an indefinite extent.... School and author of the six-volume 150 industry,...confidence,... Mr. Attwood’s error is that of supposing that a depreciation History of Prices (1837-1857), stress- es the real bills doctrine, the notion production,...consumption, of the currency really increases the demand for all articles, of reverse causality, and the cost- [and] everything that and consequently their production, because, under some push theory of price movements. constitutes the commercial circumstances, it may create a false opinion of an increase Lord Overstone (Samuel Jones Loyd), leader of the Currency School, uses prosperity of the nation.” of demand; which false opinion leads, as the reality would the quantity theory to argue that 100 Mill do, to an increase of production, followed, however, by a mandatory 100 percent gold cover Thomas Attwood in 90 fatal revulsion as soon as the delusion ceases.” for bank notes is needed to prevent The Remedy: or, Thoughts overissue. on the Present Distresses John Stuart Mill in “The Currency Juggle”

U.K. PRICE LEVEL U.K. 80 Classicals see the economy

as inherently self-regulating.

Mercantilists see it as requiring

government intervention

and discretionary fine-tuning.

ized) by the implied fall in excess reserves. To lation via control of the gold and bank note ensure that these hoards would always be suffi- component alone since limitation of that com- cient to accommodate gold drains, the Banking ponent would simply induce the public to School recommended that the Bank of England resort to money substitutes (deposits and bills hold larger metallic reserves. of exchange) instead. In other words, the circu- With regard to the Currency School’s pre- lation is like a balloon; when squeezed at one 15 scription that discretionary policy be replaced end, it expands at the other. More generally, the by a fixed rule, the Banking School rejected it Banking School questioned the efficacy of base on the grounds that rigid rules would prevent control in a financial system that could generate the banking system from responding to the an endless supply of money substitutes. needs of trade and would hamper the central The Currency School, however, rejected this bank’s power to deal with financial crises. criticism on the grounds that the volume of Finally, the Banking School asserted the deposits and bills was rigidly constrained by the impossibility of controlling the monetary circu- volume of gold and notes and therefore could

1840 1844 1846 1848 1850 Potato crop failure in Gold is discovered Ireland spurs waves of in California. emigration to America.

Currency School-Banking School Debate (1830-1850)

“The prices of commodities do not The 1844 Bank Charter Act embodies the Currency depend on the...amount of the whole School prescription that, except for a small fixed fiduciary issue, bank notes must be backed pound- of the circulating medium: but... for-pound by gold, thus establishing a marginal on the contrary, the amount of the gold reserve requirement of 100 percent. circulating medium is the conse- Tooke’s An Inquiry into the Currency Principle quence of prices.” uses cost-push theorizing to claim that interest rate hikes and reductions, by raising and low- Thomas Tooke in An Inquiry ering business costs, cause corresponding rises Tooke into the Currency Principle and falls in the price level. be controlled through the latter alone. In short, power in the hands of the central bank. These the total circulation was like an inverted pyra- shortcomings in no way invalidated the School’s mid resting on a gold and bank note base, with monetary theory of inflation which was superi- variations in the base inducing equiproportion- or to any explanations its critics had to offer. al variations in the superstructure of money As for the Banking School, it rightly stressed substitutes. In counting deposits as part of the the importance of checking deposits in the pay- superstructure, the Currency School excluded ments mechanism. But it was wrong in insisting them from its concept of money. It did so on that the real bills doctrine,which tied note issues the grounds that deposits, unlike notes and to loans made for productive purposes, would coin, were not generally acceptable in final pay- prevent inflationary money growth. Like Henry ments during financial crises. Thornton, the Currency School triumphantly exposed this flaw by pointing out that rising Evaluation prices would generate a growing demand for – In retrospect, the Currency School erred in fail- and nominal collateral backing of – loans to ing to define deposits as money to be regulated finance the same level of real transactions.These like notes. This failure enabled the Bank of Eng- collateralized loan demands, when accommo- land to exercise discretionary control over a dated in the form of deposit and note creation, large and growing part of the circulating medi- would enlarge the money stock. In this way um, contrary to the School’s intentions. The inflation would justify the monetary expansion School also erred in failing to recognize the necessary to sustain it and the real bills criterion need for a lender of last resort to avert liquidi- would fail to limit the quantity of money in exis- ty panics and domestic cash drains. By the end tence. Also, by 1900 Knut Wicksell and Irving of the nineteenth century it was widely recog- Fisher had rigorously demonstrated the same nized that the surest way to arrest an internal point made by Thornton in 1802, namely that an 16 drain was through a policy of liberal lending. insatiable demand for loans and a corresponding Such drains were caused by panic-induced inexhaustible supply of eligible bills results when demands for high-powered money (gold coin the loan rate of interest is below the expected and Bank of England notes) and could be termi- rate of profit on capital. In such cases, the real nated by the Bank’s announced readiness to bills criterion provides no bar to overissue. satiate those demands. The Currency School nevertheless remained opposed to such a policy, fearing it would place too much discretionary

1850 1855 1856 1859 1860 1862 First iron Cunard Henry Bessemer Darwin writes U.S. issues its first steamer crosses revolutionizes the On the Origin legal-tender fiat cur- the Atlantic in nine steel industry of the Species. rency, the greenbacks. and a half days. with his new con- verter process. U.S. Civil War (1861-1865)

Classical views are prevalent

William Stanley Jevons, in his A Serious Fall in the Value of Gold Ascertained and its Social Effects Set Forth, calculates the 150 geometric mean of the prices of 39 major and 79 minor commodities to establish that the general price level had risen and the value of gold had fallen in the order of 9 to 15 percent since 1845-1850. Written Jevons 15 years after the California and Australian gold discoveries, Jevons’s pathbreaking 100 work on index number construction and application lends strong statistical support 90 to the quantity theory approach to price- level determination.

U.K. PRICE LEVEL U.K. 80 4 The Keynesian Revolution and Monetarist Counter-Revolution (1936-1985)

Classicals won the Currency-Banking dispute. reductions to absorb the impact of monetary Their victory lasted until ex-classical John May- expansion. Absent such phenomena, however, nard Keynes, having defected to the opposite Keynes’s model implied that monetary stimuli side, routed them in 1936.27 But they regained affect real activity rather than prices. Like Law, their crown when monetarists (with help from he stressed that the stimulus works through an the new classical school) dislodged Keynesian interest rate channel. More money means lower macroeconomics in the 1970s and 1980s. interest rates, a cheapened cost of capital, and Keynes launched his attack in the midst of thus a rise in investment spending.The increased the Great Depression when the stark conditions investment induces additional rounds of con- of stagnation, poverty, and mass unemployment sumption spending causing aggregate demand mocked the classical notion of a self-equilibrat- to rise by a multiple of the new investment ing, fully employed economy. Clearly the time spending. With idle resources available to draw was ripe for a mercantilist revival. That revival upon,production expands to meet the increased took the form of the Keynesian Revolution with aggregate demand. In expounding his interest the leader’s General Theory as its bible. In that rate transmission mechanism, Keynes praised book, Keynes replaced the full capacity, quantity his mercantilist forebears for anticipating it. theoretic doctrines of the classicals with at Indeed, the “Notes on Mercantilism” section of least four propositions inherited from Law and his General Theory argues that the notion of a Steuart. linkage running from money to interest rates to investment to output constituted the rationale 17 for the mercantilists’ advocacy of export sur- Keynes’s Mercantilist Propositions pluses financed by specie inflows. First, like Law, he argued that in times of mass Second, like Steuart, Keynes held that prod- unemployment the primary stimulative effects uct prices are determined by unit labor cost of expansionary monetary policy fall on real plus a markup to cover profits and nonlabor output and employment rather than on prices. costs. Here is the mercantilist notion of the That is, they do so unless negated by liquidity price level as a nonmonetary phenomenon.28 traps and interest-insensitive investment de- True, Keynes admitted that monetary expansion mand schedules, both of which cause velocity through its stimulus to employment might,

1870 1871 1873 1876 1880 Alexander Graham Bell invents the telephone.

Called by pro-silver forces the “Crime of 1873,” the Coinage Act of that year omits the silver dollar from the list of coins to be minted, thus ending the legal status of bimetallism in the U.S.

Walter Bagehot’s Lombard Street spells out the classic lender-of-last-resort pre- 20 scription for quelling liquidity panics and averting bank runs. The central bank must announce its readiness to 15 satiate all panic-induced demands for cash – to “lend freely at a high rate.”

U.K. UNEMPLOYMENT (%) Marshall Alfred Marshall in an unpub- Bagehot 10 Series begins at 1851. Reliable estimates lished manuscript originates the for earlier periods unavailable. Cambridge cash balance ap- 5 Sources: (1851-1855) Mitchell, Abstracts proach to the value of money. of British Historical Statistics, p. 64. (1856-1879) Layard, Nickell, and Jackman, Unemployment: Macroeconomic Performance 0 and the Labour Market, p. 3. because of diminishing returns to labor, raise interest rates. Keynes called this pathological unit labor costs and so prices. But he tended to condition absolute liquidity preference. minimize or disregard money’s price-raising When this condition rules, no increase in the effects. Instead, he treated the price level as an money stock, no matter how large, can reduce institutional datum governed by nominal wage the interest rate. Suppose the central bank rates which autonomous forces – union wage- expands the money stock by purchasing bonds setting policy, worker money illusion, and the on the open market. Such bidding puts incipient like – render downwardly inflexible at low levels upward pressure on bond prices. But the slight- of employment. By expressing prices in terms of est rise of the latter induces bondholders to sell exogenously given factor costs, he pointed the to the central bank and then to hoard the cash way to a cost-push theory of the price level. His proceeds. Since at the floor rate of interest the immediate followers, Joan Robinson, Nicholas demand for money is insatiable and the willing- Kaldor, and Richard Kahn, certainly interpreted ness to sell bonds absolute, no amount of open him this way and accordingly denied money a market operations can overcome absolute liq- role in price determination.29 uidity preference and reduce interest rates. Third, Keynes restated Steuart’s doctrine of And with rates at their irreducible minimum, hoarding in the form of his concept of the liq- they cannot fall to stimulate real activity. Here is uidity trap. The trap, he wrote, might come into Keynes’s expression of the mercantilist fear that operation in deep depressions when the inter- monetary expansion cannot be counted upon est rate falls to a level so low that everybody to stimulate spending because the new money unanimously believes it cannot stay there but may disappear into idle hoards. must return to its conventional normal height. Fourth, Keynes found still another obstruc- At the floor rate, all are indifferent between tion to block the interest rate channel. Even if holding cash or earning assets whose prices, monetary injections were successful in lowering 18 which vary inversely with the interest rate, are interest rates, those injections still might fail to expected to fall. Indeed, asset prices are expect- stimulate real activity if investment spending ed to fall by an amount such that the resulting were unresponsive to the lower rates. If so, then anticipated capital loss just equals the interest two obstacles – an interest-insensitive invest- return on the assets. As there is no advantage ment schedule as well as a liquidity trap – could to holding such assets instead of zero-yield render monetary policy ineffective in a depres- cash, the latter becomes a perfect substitute for sion. In both cases, a rise in the money stock the former in individuals’ portfolios. At this would be offset by a fall in velocity leaving total point,the demand for money becomes insatiable spending unchanged. With variable velocity and infinitely sensitive to the slightest change in absorbing the impact of money stock changes,

1880 1883 1890 1893 Thomas Alva Edison invents U.S. overtakes U.K. Bank panic the electric light bulb. in man-hour productivity. and gold runs sap U.S. gold reserve.

Classical views are prevalent Bimetallism Debate (1880-1896)*

20 *This controversy concerning the cause of the post-1879 secular price defla- tion pits gold standard advocates against proponents of a bimetallic currency. The former group attributes price deflation to real cost-reducing forces such as rapid technological progress, improvements in transportation and 10 communication, and increased competition. By contrast, bimetallists attrib- ute deflation to the failure of the gold-backed money supply to grow as fast as real output and the demand for real cash balances. Monometallists 0 thus stress the mercantilist, or cost-push, view of price-level determination while bimetallists stress the classical, or quantity theory, view.

U.S. INFLATION RATE (%) -10 Inflation rate measured as the annual Fisher rate of change of the GDP deflator. Source: Barro, Macroeconomics, 5th ed., p. 8. -20 none would be transmitted to nominal income. so resistant to it, would produce intolerably The rigid links connecting money to nominal large and protracted reductions in output and income and prices as postulated by the classics employment. John Law of course held similar would be severed or severely weakened. presuppositions, as did other mercantilists.30 Steuart had said exactly the same thing in 1767. There remained the mercantilist ideas of reverse causation, passive money, and futility of base control of money and of inflation. Nicholas Post-Keynesian Extensions Kaldor supplied these ideas in his 1982 The To Keynes’s own mercantilist doctrines, Scourge of Monetarism. Representing the peak of Keynes’s followers writing in the inflationary post-Keynesian skepticism of the relevance of post-World War II period added others. Some the quantity theory, Kaldor’s Scourge denied the interpreted inflation as a cost-push phenome- possibility of base control given the central non emanating from union bargaining strength, bank’s duty to guarantee bank liquidity and the business monopoly power, oligopoly adminis- financial sector’s ability to engineer changes in tered prices, commodity shortages, supply the turnover velocity of money via the manufac- shocks, and other real and institutional forces ture of money substitutes. Kaldor’s transmission putting upward pressure on factor costs and mechanism runs from trade unions to wages to profit mark-ups.Then too, “cheap money” advo- prices to money and thence to bank reserves. cates held that expansionary monetary policy Unions determine wages, wages determine could be used to peg interest rates at low lev- prices, prices influence loan demands, and loan els so as to minimize the interest burden of the demands, via their accommodation in the form public debt while simultaneously stimulating of bank-created checking deposits, determine real activity. An alternative version of the same the money stock, with central banks permis- argument, associated with the Phillips curve sively supplying the necessary reserves.Far from trade-off approach to policy questions, held that exerting an activating influence, money appears 19 monetary policy could peg the unemployment at the end of the causal chain. rate at permanently low levels at the cost of a stable (nonaccelerating) rate of inflation. Monetarists’ Response to Underlying all these arguments were the Keynes and the Keynesians: presuppositions (1) that full employment is the the Classical Comeback dominant policy concern, (2) that the employ- ment benefits of monetary stimuli exceed their Even as Keynesianism was riding high, critics inflationary costs, and (3) that disinflationary were sniping at it from the sidelines. Eventually monetary policy,because entrenched inflation is these criticisms would culminate in a monetarist

1896 1898 1900 1903 1908 1910 Blaming the gold standard for deflation and Wright Brothers Henry Ford introduces its evils, W.J. Bryan delivers his Cross-of-Gold take first flight. his Model T. speech as new gold fields and the invention of the cyanide process are producing inflation- ary floods of monetary gold.

Knut Wicksell, in his Interest and “There is a certain level of the...rate of interest... Prices, explains how spreads between such that the general level of prices has no tendency 20 natural (equilibrium) and market loan rates of interest produce cumulative to move either upwards or downwards. This we changes in the general price level. call...the natural capital rate.... If...the...[loan] rate 15 of interest is set and maintained below this normal Wicksell level...prices will rise and will go on rising.... If...the rate...is maintained...above...the natural 10 Irving Fisher in his Appreciation and Interest rate, prices will fall continuously and without limit.” distinguishes between nominal and real interest U.S. UNEMPLOYMENT (%) 5 rates, with the expected rate of price change Knut Wicksell in Interest and Prices Sources: (1880-1889) Combines estimated decade constituting the difference between the two. average rate and estimated peak year rate (1885). Lebergott, Manpower in Economic Growth, pp. 179-180, 189. 0 (1890-present) Barro, Macroeconomics, 5th ed., p. 6. 20

U.S. INFLATION RATE (%) -20 -10 20 10 0 Classical views are prevalent spending. Contrary toKeynes’s Contrary claimthatidle spending. andAnna confirmingmoney’sSchwartz power toaffect MiltonFriedman, Warburton, consump- tion function. his into balances real incorporated he Keynes mighthave realized asmuch had tions. demand even underextreme Keynesian condi- money ishardly powerless toaffect aggregate Say’s Law holdsand then, Inprinciple, supply. same result directly by increasing themoney Thecentralbankcanachieve the balance effect. towaitfor fallingpricestoactivatetherealsary it isunneces- Indeed, employment isreached. stimulates consumptionspendinguntil full Theriseinreal cashbalances wealth portfolios. ofcashbalancesinconsumers’ chasing power, orpur- Lower pricesinturnraisethereal value, goods exerting downward pressure onprices. pressed economy impliesanexcess supply of condition shouldholdinaslumpsincede- Thelatter possess somedownward flexibility. and(2)prices consumers’ spendingdecisions, in theform ofreal money balancesinfluences denied they coulddosoprovidedit (1)wealth schedules couldbarfullemployment. investment interest-insensitive and traps liquidity Keynesian that denied Patinkin,it Don Pigou,and C. A. Enunciated by GottfriedHaberler, effect. sical comeback. least eightmilepostsmarktheroute oftheclas- At cantilist doctrinesandrestore classicalones. counterrevolution thatwould dethrone mer- 1910 Second cametheempiricalwork ofClark First came the theory ofthereal balance First camethetheory 921913 1912 in the entire economic literature. in theentire money of theory thequantity of andbest most complete exposition The Purchasing Power Money of Fisher publishesIrving hisclassic System. Federalthe Reserve U.S. creates Congress World War I 31 That is, , the (1914-1918) ul bobtemnysokchange. stock money the absorb fully to priceseventually adjusted and (3)withalag, (2)money’s initialimpactwasonoutput, U.S.reces- sions, most causing factor chief the been had money stockthrough itsimpactonspending Warburton establishedthat(1)anerratic negate money’s impactonnominalexpenditure, hoards andoffsettingvelocity movements might Neglect of this important considerationcould Neglect ofthisimportant because loandemandwasweak orstrong. because money waseasyortightbutrather Theratemightbelow orhighnot ones. business loandemands–aswell asmonetary determinants–notably impact ofnonmonetary Itisunreliable becauseitregisters the ness. an is easeortight- unreliable indicatorofmonetary they said, Therate, Meltzer disagreed. Brunnerand ease ortightness. monetary accurately measured thedegree of variable, tary apurely mone- claimed thattheinterest rate, Thattheory interest ratesasapolicyguide. zer’s 1967 critiqueoftheLaw-Keynes of theory for theGreat Depression. showed thatclassicaldoctrinecouldaccount They also ty andlong-runneutralityofmoney. nonneutrali- classical doctrineoftheshort-run effectively reestablished the growth, monetary tion islargely orsolely theresult ofexcessive er withFriedman’s findingsthatpersistentinfla- togeth- Thesestudies, Depression ofthe1930s. of themoney stockwasthecauseofGreat by showingburton thataone-third contraction (1963)and Schwartz thencorroborated War- Third came KarlBrunner’s andAllanMelt- 1920 *Reichsbank deploy officials mer- phenomenon. etary, anonmonetary, than rather wasamon- The hyperinflation were right. Reichsbank. The critics onthe blame squarely to putthe arguments expectations rational with supplemented reasoning theory classicaluse quantity Critics hyperinflation. the caused ofoverissue deutsche marks argumentstodenycantilist that 32 Friedman German hyperinflation (1922-1923) * matic stabilizerworking torestore aggregate Sucharulewould operateasanauto- output. growth rateequaltothetrend growth rateof recommend arigidrulefixingthemoney stock’s Friedman’s solution wasto mired inaslump. actions may hittheeconomy whenitisalready anti-inflation booming justascontractionary precisely thewrong timewhentheeconomy is aimed atfightingrecessions may take effect at actions Theresult isthatexpansionary moves. bank cannotpredictimpactofits theshort-run thecentral make forecast errors inevitable, Becausesuchlags policydestabilizing. monetary time lagsrender countercyclical discretionary Friedman (1960) arguedthatlongandvariable monetaristmilestone. constituted thefourth est rate. to discredit theLaw-Keynes oftheinter- theory Thiscritiquedidmuch policy. cyclical monetary pro- central bankwould engineeraperverse, the easeortightness, with thoseofmonetary By confounding theeffects ofloandemands the money supply andsoescalatetheinflation. mightexpand high rateassignalingtightmoney, misinterpreting the theauthorities, rate high, booming credit demandsrendered theinterest stock andthereby intensifythedepression. mightcontractthemoney nifying easymoney, misinterpreting thelow rateassig- authorities, the loan demandsrendered theratelow, whenslackbusiness intimesof depression, ple, For exam- destabilizingpolicy. lead toperverse, 1927 atlantic flight. trans- makes first LindberghCharles Milton Friedman’s rules casefor monetary intimesofinflationwhen Contrariwise, 1929 crashes. market U.S. stock The Great Depression Depression The Great Keynes 1930 “I want to do justice to schools to of“I want thought do justice to to R.F. to 27,(August Harrod 1935) letter Johna Maynardin Keynes age-long of common tradition sense.” andpredecessors am an returning to important show that I...have and...to theimbecile lasthundred for years as havetreated which the classicals (1929-1933) ae notePilp uv,nopermanent intothePhillipscurve, rated expectationsare incorpo- when inflationary They showed that augmented Phillipscurve. this conclusionwiththeaidofanexpectations- (1968) andEdmund Phelps(1967) established MiltonFriedman regardless oftheinflationrate. level equilibrium natural, its to returns ployment ral ratehypothesis according towhichunem- The sixthmilestonewasthemonetarists’natu- Natural RateHypothesis price level isindependentofthemoney supply. beliefs thatmoney stimulates tradeandthatthe school.This Keynesian experience didmuch todiscredit mercantilist the and Law John of tions predic- the to according combination impossible andacceleratinginflation–an unemployment, rising growth, appearance ofrapid monetary Thatepisodesaw thesimultaneous 1970s. wasthestagflationexperienceof classicals, than any otherturnedthetideinfavor ofthe prices remain stable. the sametrend rateasreal outputsuchthat and thatlong-runaggregate demand grows at would ensure thatmoney actscountercyclically suchrule-inducedcorrections In thisway, stimulus. en undertheimpactofmonetary would eventually quick- asinrecessions, growth, ofmoney stock spendingthatfallsshort versely, Con- could notbesustainedandmust slacken. outruns therule-determinedmoney stock spendingthat Inflationary employment path. full- spending toitslong-runnon-inflationary, h fhmlsoe andtheonethatmore The fifthmilestone, Mercantilist views are prevalent 1936 mercantilist revival. and ushers ina Keynesian Revolution the economics starts His assault onclassical Interest, and Money. Employment, of Theory publishes John Maynard Keynes The General 1940 0 5 10 15 20

U.S. UNEMPLOYMENT (%) World War II (1939-1945) 21 22

U.S. INFLATION RATE (%) -20 -10 20 10 0 Mercantilist views are prevalent cate inflationary expectations–anabsolute cate inflationary iftheauthoritiessoughttoeradi- Accordingly, inflation turnsouttobelower thanexpected. reported learning fashiononly whenactual, error- oradaptive, downward inmechanical, agents revise anticipations theirinflationary Those versions embodiedtheassumptionthat of theexpectations-augmentedPhillipscurve. Theirfear stemmedfrom early versions pursue. contended thatdisinflationwastoocostly to they still Even so, the naturalratehypothesis. accelerating inflation. only atthecostofever-they are available atall, ifindeed Suchgainscanbehad, rate ofinflation. nent employment gainstobehadatany steady arbitrarily low levels sincethere are noperma- of inflationtopegtheunemployment rateat Onecannotuseahigherstablerate permanent. never stimuli are temporary, Inflationary right. Theclassicalswere rate ofunemployment. intoavertical lineatthenatural Phillips curves al inflationtransforms downward-sloping theadjustmentof expectedtoactu- In thisway, unemployment toitsnaturalequilibriumlevel. resulting riseinreal wageswould restore the incorporated intonominalwagerates, andtherefore anticipated, was fully perceived, Butoncetheincreased inflation temporarily. couldstimulate employment andoutput wages, by lowering real Unanticipated risesininflation, trade-offsmightstillexist. edged thatshort-run they acknowl- like David Hume, True, exploited. inflation-unemployment trade-offsremain tobe 1940 prime minister of Britain. minister Great prime Sir WinstonChurchill becomes Many Keynesians eventually cametoaccept World War II (1939-1945) 941945 1944 Fund and World Bank. Monetary International establishment the of order forthe calls for post-warmonetary WoodsBretton plan D-Day first atomicfirst bomb ofInvention the 33 moyte nterpiefrcss Provided embody themintheirpriceforecasts. policyactionsand future disinflationary dictable, andtherefore pre- account allsystematic, they would take into anticipations rationally, For ifpeopleformed their Keynesians feared. ment costofdisinflationmightbefarlessthan theunemploy- Onthecontrary, out process. then disinflationneednotbeapainfuldrawn- are formed rationally ratherthanmechanically Neil Wallace (1975) showed thatifexpectations Lucas(1972)Robert and Thomas Sargentand tations withFriedman’s naturalratehypothesis, Muth’s (1961) seminalwork onrationalexpec- PairingJohn disposed ofthisKeynesian concern. The seventh monetarist/new classicalmilestone the CostofDisinflation Rational ExpectationsLower output andemployment. albeitatthecostofmuch lost the economy, inflation eventually would besqueezedoutof bothactualandanticipated adjustment process, Through thislongandpainfulerror-learning the expectedratewould adjustwithalag. pressure ontheactualrateofinflationtowhich excess unemployment would putdownward Theresulting ployment above itsnaturallevel. policytoraiseunem- monetary contractionary sequence required thecentralbanktoemploy This verged onthedesired targetrate. the lattertoadjusttoward theformer asitcon- tion below expectedinflationthereby inducing policy –they would have toforce actualinfla- requirement ofany successfuldisinflationary ing adepression. full employment follow- spending and restore to consumption stimulate worksto balance effect cashexplain how areal and DonPatinkin (1948) A.C. Pigou (1943, 1947), HaberlerGottfried (1941), revolution. counter- monetarist thestage set forthe to ian emerges model theKeynes- of Criticism 1950 spending. money’sof influence power to investment models, schedule trap and interest-unresponsive Keynes’s to contrary liquidity work provides evidence, Clark Warburton’s empirical 1953 for DNA. helical structure adoublepropose and Francis Crick James Watson Phillips et oee,lcsceiiiy Privateagents lackscredibility. however, ment, Theannounce- inflation predictions accordingly. will believe theannouncementandrevise their Itassumespeople sue apolicyofpricestability. pur- to intention its announces bank exploit.The inflation-unemployment trade-offto temporary expectationssoitcanhavetionary afavorable tuning centralbankwantstoeradicateinfla- fine- Supposeadiscretionary, simplicity itself. theargumentis and David Gordon (1983a,b), Edward Prescott (1977) Barro andby Robert Enunciated by FinnKydland and credibility. for rulesby showing how they reinforce policy argument whichstrengthened theclassicalcase timeinconsistency The lastmilestonewasthe Time InconsistencyCaseFor Rules lower thanKeynesians feared. analysis showed thatthesecostscouldbemuch the Nevertheless, some unemployment cost. rationally expecteddisinflationwould incur even that markets failtoclearinstantaneously, are tosomedegree stickyorinflexiblesuch Inaworld inwhichwagesandprices sanguine. this conclusionproved tobeabittoofacileand ofcourse, Inactuality, excess unemployment. zero targetlevel withnocostintermsof would bebrought toits actual andexpected, inflation, Consequently, ployment togenerateit. there would benoneedfor excessunem- gap, Withno no gap would develop between them. tion anddisinflationwould coincidesuchthat actualandexpectedratesofinfla- ible fashion, cred- policymakers behaved inanon-haphazard, cost of highercost of stable inflation. rates of nently lower unemployment ratesatthe thepolicymakers achieveting to perma- permit- as relationship astable trade-off Keynesians interpret thePhillipscurve 1958 lyetrate. ployment unem- the to tion infla- price and wage of rate the relating curve Phillips empirical his presents Phillips A.W. 1960 rate rule. money growth his famous k-percent Friedman enunciates Milton discretion, over forrules case Simons’sHenry 1936 of In thetradition 1961 Cuban Missile Crisis WallBerlin iserected. 1962 fied the Great Depression. theGreat fied orintensi- caused contraction monetary States: 1870-1960United monumental rate Warburton byshowing, intheir corrobo- Friedman and Anna Schwartz 1963 is assassinated. JohnF.President Kennedy Friedman A Monetary History of the of History A Monetary classical casefor rules. time inconsistencyargumentreinforced the the classicalview wasatthewheelonceagain. four orfive decadesofmercantilist dominance, After a new consensusdefinitely hademerged. But ed aneclecticamalgamofcompetingviews. mainstream opinionassimilat- On thecontrary, embraced. ones monetarist all were course.Nor of all Keynesian doctrineswere abandoned, Not mercantilism toward classicalmonetarism. opinion away from theextremes ofKeynesian opments wastoshiftmainstream monetary price stability. with aprecommitment bindingitirrevocably to rule replacing thebank’s power discretionary Thatsomethingisamonetary tation toinflate. that public the centralbankwillnotsuccumbtotemp- the convince to something is Needed ise credibly nottocreate surpriseinflation. ployment isthecentralbank’s inabilitytoprom- dropping tozero atthenaturalrateofunem- Whatprevents inflationfrom immediately high. andyet equilibriuminflationistoo would be, unemployment isnolower thanitotherwise Theresult isthatequilibrium tion tocheat. els highenoughtoremove thebank’s tempta- expectationsatlev- and tomaintaininflationary rational publictodiscounttheannouncement Such knowledge inducesthe employment. surprise inflationinorder toboostoutputand tempted torenege onitspromise andcreate a thebankwillbe are formulated andactedupon, realize thatoncetheirnew pricepredictions h uuaieefc ftefrgigdevel- foregoing the of effect cumulative The , thatasevere Schwartz 34 ndmntaiga uh the In demonstratingasmuch, Martin Luther King,Jr., Luther Martin is assassinated. 35 1967 be exploited. be remain to trade-offs inflation-unemployment such thatno permanent level equilibrium natural its to returns activity real inflation, actual adjuststo inflation ed says that,whenexpect- hypothesis. This concept posit thenaturalrate and Edmund Phelps Friedman Phillips curve, the into expectations inflation Incorporating 1968 1969 the moon. the walks on astronaut First 1970 0 5 10 15 20

U.S. UNEMPLOYMENT (%) 23 with inherited inflation. with inherited live to must learn society pursue and costlyto too is thendisinflation If so, itsnaturallevel. ly to slow- very returns activity fashion, real learning in mechanical error- adaptively expectations agents theirinflation form thatwhen ians argue rate hypothesis,Keynes- Responding thenatural to 24

U.S. INFLATION RATE (%) -20 -10 20 10 0 sicesdgoa optto,rapid techno- forces as increased nonmonetary globalcompetition, such to 1990s the of flation attributingthedisin- Steuart’s cost-pushtheory, Others echo disinflation istoocostly topursue. with inheritedinflationthantofightitbecause economists stillinsistthatitisbettertolive some Even today, views continue toabound. For mercantilist ishardly secure. though ruling, Stilltheclassicalwisdom, resources efficiently. can receive accuratemarket signalsandallocate price- level stable environment withinwhichbusinesspeople a providing as mission view primary now their bankers central many that is proof The contribute tosuchstability. rules Monetary uisite andare therefore harmful. non-negligible inflationratesviolatethisprereq- All of anefficiently functioningreal economy. Stability ofthevaluemoney isaprerequisite all thatremains isachangedrateofinflation. The outputeffect vanisheswhenpricesadjust; best affect outputandemployment temporarily. Money-stock changesat inflation ordeflation. ever-worsening to dosoproduce explosive, Attempts real variablesatdisequilibriumlevels. centralbankscannotpermanently peg exploit; are nolong-runinflation-outputtrade-offs to There ratherthancost-pushphenomena. etary Inflationanddeflationare mon- classical truths. experience have hard-won establishedcertain controversyThree centuriesofmonetary and 1970 rsnl hs rtsaei h rvrsseat. driver’s the in are truths these Presently Lucas oil-producing countries quadruple oil oil-producing countries prices leadingprices toan energy crisis Following Israeli-ArabWar, the and gaspumps. queuesatthe 921974 1972 conditions render costless. conditions disinflation fashion. credible insystematic, policy These markets clear, and conduct (3)theauthorities adaptively, flexibility that (2)price so prevails rather than rationally expectations inflation manent, vanish provided (1) their agents form and per- temporary trade-offs, Phillips curve heshows thatall expectations, rational of UsingJohn Muth’scostly disinflation. concept KeynesianRobert of Lucas scrutinizes fears 1973 abandoned: thegold standard. worldleaves WoodsBretton system fixed-exchange-rate The Great Inflation The Inflation Great 1975 of MITSAltair. the invention Roberts’s Ed with isborn puter The personal com- Conclusion (1968-1984) 5 me,o ok theclassicaltruthsintoendur- orlock, embed, work cutoutfor him. hehashis eclipsed andunfashionableideas, Ascuratorofthestock doctrinal historian. theclassicalwisdomfallsto and preserving Thetaskofcounteringtheseinfluences past. as thepresent onetostudythelessonsof that future generationsmay well beasreluctant and upon toreinterpret therecord radically, thatrevisionist scholarscanbecounted scene, Keynesian- monetarist controversy ispassingfrom the the with familiar economists of gener- ation current the that changes, leadership bank thatcentral tall order given thatmemoriesfade, Butthatisa sical truthswillnotbeforgotten. full employment andmaximizingreal growth. to pursuenonpriceobjectives suchasachieving policyshouldbefree monetary considerations, withpricesdeterminedby real who arguethat, Andalways there are those opposite istrue. proof isawash as that thecountry withmoney whenthe rates interest low Japan’s cite they when even parrot Law’s ofinterest theory monetary Commentators depressed Japanese economy. policy ispowerless tostimulate thecurrently image ofliquiditytraps inholdingthatmonetary Stillothersevoke theSteuart-Keynes the like. unions,and labor of power costs,weakened care fallingcomputerandhealth- logical progress, An even morechallengeisto important The challengethenistoensure thattheclas- of achievingof stability. price theobjective to irrevocably ities commitment binding theauthor- withapre- maker discretion policy- forreplacing case tency inconsis- statethetime Prescott Finn Kydland and C. Edward The Volcker disinflation Classical views are prevalent 1980 (1978-1984) 1982 of money.of theory quantity the of skepticism post-Keynesian of thepeak sents Monetarism The of Scourge Nicholas Kaldor’s repre- Kaldor lee.Theupshotisthatittooearly to altered. andappointments guarantees revoked, minated, contractster- Mandatescanbechanged, time. that classicalpolicieswillreign supreme for all of theseproposed arrangements canassure however, thatnone trouble is, price stability.The averse centralbankers committedtothegoal of inflation- (4) theappointment ofconservative, and them from thepoliticalpressure toinflate, independence for centralbankers toinsulate (3)guaranteed gets for price-level behavior, ments andcentralbanksfixingquantitative tar- (2) formal contractsbetween elected govern- (1) congressional mandatesfor pricestability, Theseinclude variety ofpossiblearrangements. proponents oftheclassicalview propose a end, room for mercantilist policyalternatives.To this ing institutionalarrangements thatallow no 1987 U.S. Market Stock Crash of the 1989 elnWall Berlin Fall of the 1990 put inorbit. Hubble SpaceTelescope 1991 Persian GulfWar Central bankers worldwide give precedence to the goal stability. of tothe price giveprecedence bankers worldwide Central close to absolutestability. to close levelbrings theprice sion while disinflation expan- longest peacetime The U.S. enjoys its Popularity of Internet the Popularity the chiefinsightsofdoctrinalhistory. Thatisoneof pel mercantilists toprominence. kinds ofeconomicshocksthatoccasionally pro- ithasproved resistant tothe spans oftime, Over long shows ittobenothingifnotresilient. For history nence tobeconfronted anew. willreturn topromi- inshort, Classicism, lenge. an inevitable classicalresponse tothatchal- economic problem. growth ratherthaninflationtobethedominant perceives unemployment orsluggishreal lenge theclassicalview whenever thepublic thatview willchal- For betterorworse, bility. and must notbeboundtothegoal ofpricesta- the opposingview thatcentralbanksneednot there may always beamarket for Indeed, view. for theclassical declare apermanentvictory tl,theinherent cyclicalityofideassuggests Still, human completion. DNAnears at mappingandall sequencing Human Genome Project aimed are launched. are Central Bank and theEuropean Union Monetary The European and maintain desires to as an inflation-fighter The Fed hard worked to build credibility buildcredibility to policy rules help. policy rules that credibility; that credibility; 2000 0 5 10 15 20

U.S. UNEMPLOYMENT (%) 25 ENDNOTES 10. On Steuart’s statesman, see Eltis (1986) full-employment-at-any-cost counterparts 1. Additional famous policy debates pitting and Skinner (1981). of the Birmingham School, especially the mercantilists and classicals include (1) the 11. Law denied that the monetary expan- Attwood brothers, Thomas and Matthias, Swedish Bullionist controversy (1755-1765), sion was excessive on the grounds that were gravely concerned with it. (2) the English Bullionist-Antibullionist, much of it went to redeem outstanding 20. See Hume (1752, pp. 47-59); Ricardo or Bank Restriction, dispute (1797-1821), government bonds and equity claims to his (1951-73, I, pp. 363-4; III, pp. 88-89, 91,92; (3) the Bimetallism debate (1880-1896), trading firm. Since to him bonds and stocks IV, p. 233; V, p. 445); Thornton ([1802] 1939, and (4) the German hyperinflation debate shared money’s characteristic as a transac- pp. 253-56). (1922-1923). tions medium, he saw them as exerting 21. Thornton ([1811] 1939, p. 342). He 2. Because anti-quantity theory elements the same influence on spending. In his view, ([1802] 1939, pp. 244, 253-6) applies the also characterize the fixed-exchange-rate, money swapped for bonds and equities same criticism to the real bills doctrine small-open-economy case of the monetary leaves the total supply of financial purchas- which ties the issue of bank money (notes approach to the balance of payments, some ing power – money, bonds, and stocks – and checking deposits) to the nominal vol- observers may be tempted to equate mer- unchanged. Such monetary issue therefore ume of commercial paper that borrowers cantilism with that approach. In fact, howev- is noninflationary. He erred. Not being offer as collateral for bank loans. er, the two theories differ markedly. First, transactions media, bonds and stocks are far from perfect substitutes for money in 22. For classic accounts of the Currency the monetary approach applies the quantity School-Banking School debate, see Viner theory, rather than its opposite, to closed- spending. Monetizing them can be inflation- ary. See Niehans (1990, p. 51). (1937, Ch. 5), Fetter (1965, Ch. 6), Robbins economy and inconvertible-paper, floating- (1958, Ch. 5), and Mints (1945, Ch. 6). For exchange-rate regimes. By contrast, mercan- 12. See Murphy (1997) for an exhaustive recent interpretations, see O’Brien (1975, tilists, with few exceptions, tended to apply account of the rise and fall of Law’s system. pp. 153-59) and Schwartz (1987). the anti-quantity theory indiscriminately to 13. Thus a follower of Smith might attrib- all regimes. Second, the monetary approach 23. With the exception of John Wheatley, ute Scotland’s penury not to monetary defi- classicals held that national price levels could rejects the mercantilist money-stimulates- ciency and the absence of banks, but rather trade doctrine. deviate temporarily from their purchasing to lack of specialization and division of power parity, or long-run equilibrium, levels. 3. On Law’s monetary theory, see Murphy labor resulting from a small population. (1997, Chs. 6 and 8) and Hutchison (1988, 24. O’Brien (1975, p. 153) credits Joplin, 14. Cesarano (1998) argues that Hume Drummond, Page, Pennington, and McCul- pp. 134-40). On Steuart’s theory, see Eltis actually rejected the price-specie-flow (1986), Hutchison (1988, pp. 341-51), Meek loch with the simultaneous enunciation mechanism and its attendant relative price of the metallic principle. (1967), and Skinner (1981). effects for the monetary approach to the 4. Law’s fear of monetary shortage under balance of payments. By contrast, the stan- 25. Because these doctrines are consistent 26 a metallic standard is incompatible with dard view emphasized here holds that with those of the monetary approach to the monetary approach to the balance of neither Hume nor his classical followers the balance of payments, Skaggs (1999) payments. The latter sees a small open subscribed to the approach’s proposition interprets the Banking School as early antic- economy, like Scotland, taking its price level of instantaneous purchasing power parity, ipators of that approach. Even so, the as given from the closed world economy or law of one price. School hardly derived its conclusions from with money then flowing in through the the logic of the monetary approach. The 15. See Ricardo (1951-73, I, pp. 46, 61-3, conclusions may have been the same, but balance of payments to support that price 104-5, 126, 302-3, 307-8, 315). level such that no monetary shortage they were reached by a different route. occurs. Of these two propositions, Law 16. See Hume ([1752] 1955, pp. 37-8, 47-8). 26. On Tooke’s interest cost-push theory recognized the first but denied the second. 17. Classicals recognized still other sources and Knut Wicksell’s definitive critique of it, See Murphy (1997, Ch. 8). of short-run nonneutrality including sticky see Humphrey (1998, pp. 60-64). 5. See Blaug (1996, p. 16). nominal interest rates, fixed nominal 27. Before he abandoned classicism, Keynes charges such as rents and taxes, fixed nomi- was one of its luminaries. Both his 1923 6. On Steuart’s cost-push theory, see nal incomes of wage earners and rentiers, Screpanti and Zamagni (1993, p. 53). A Tract on Monetary Reform and his 1930 confusion of relative- for absolute price A Treatise on Money are squarely in the clas- 7. Not all mercantilists were as sanguine changes, market size encouragement to sical tradition. He returned to the classical as Steuart on hoards. Indeed they were specialization and division of labor, and fold shortly before his death in 1946. somewhat ambivalent on the subject. deliberate efforts on the part of organized Hoards to them could be either desirable groups to maintain real incomes. See 28. Keynes applied this notion to a closed or undesirable. On the one hand, hoards, Humphrey (1993, pp. 251-63). economy. He was not referring to the by draining excess cash from circulation, case where, with foreign prices given and 18. Hume ([1752] 1955, pp. 39-40) admit- the exchange rate fixed, the real terms would tailor the remaining stock precisely ted that money might exhibit long-run to the needs of trade. On the other hand, of trade drives the price level in a small super-nonneutrality. Being unanticipated open economy. if output and so the needs of trade were (perhaps because agents formulate their expandable under the impact of a monetary expectations in a backward-looking way), 29. On the cost-push pricing theories stimulus, such hoards, by removing the a steady succession of money stock changes of Keynes and his followers, see Tavlas source of that stimulus, could unduly con- might perpetually frustrate the attempt (1981, pp. 324-330). strain real activity. Even so, such hoards of prices to catch up and therefore perma- 30. On the mercantilists’ policy goal of would see to it that no monetary excess nently affect the level of real output. full employment, see Grampp (1952). ever developed to spill over into the com- modity market to bid up prices. 19. Perhaps too cavalierly, classicals dis- 31. See Haberler (1941, pp. 242, 389, 403), missed or minimized the problem of unem- Pigou (1943, 1947), and Patinkin (1948, 1965). 8. See Screpanti and Zamagni (1993, p. 53). ployment. To them joblessness, while it 32. See Warburton (1966) for a collection 9. Steuart of course never resorted to certainly occurred from time to time, was of his relevant papers, many published such modern terminology. Nevertheless, necessarily short-lived and self-correcting between 1944 and 1953. the concepts were his. through automatic wage, price, and interest- rate reductions. Only their inflationist, 33. See Taylor (1997, pp. 278-9). Hume, David.“Of Money,” “Of the Balance Pigou, Arthur C.“Economic Progress in 34. Alternatively, an established reputation of Trade,” and “Of Interest,” (1752), in a Stable Environment,” Economica, vol. 14 as a zealous inflation fighter would do. Hume’s Writings on Economics, E. Rotwein, (August 1947), pp.180-90. ed. Madison, Wis.: University of Wisconsin Pigou, Arthur C.“The Classical Stationary 35. The time consistency case for rules Press, 1955. differs a bit from Friedman’s argument. He State,” Economic Journal, vol. 53 (December sees rules as overcoming the central bank’s Humphrey, Thomas M.“Historical Origins 1943), pp. 343-51. inability to predict the short-run impact of the Cost-Push Fallacy,” Federal Reserve Ricardo, David. The Works and Correspon- of its actions. By contrast, the time inconsis- Bank of Richmond Economic Quarterly, dence of David Ricardo, Vols. I and II, edited tency argument is that rules are good for vol. 84 (Summer 1998), pp. 53-74. by P.Sraffa with M. H. Dobb. Cambridge: commitment reasons even though central Humphrey, Thomas M. Money, Banking and Cambridge University Press, 1951-1973. bankers have full knowledge of the impact Inflation: Essays in the History of Monetary Robbins, Lionel. Robert Torrens and the of their moves. Thought. Aldershot, England: Edward Elgar Evolution of Classical Economics. London: Publishing Ltd., 1993. Macmillan, 1958. REFERENCES Hutchison, Terence W. 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