sign in sign up
<<
Home , Currency, George Warde Norman, Thomas Tooke

RIVAL NOTIONS OF

Thomas M. Humphrey

Introduction Bullionist Controversy (1797-1821) The rise of ’s version of mone- did not begin with Friedman nor did tarism in the 1960s and early 1970s provoked an antimonetarism originate with Kaldor or Keynes’s antimonetarist backlash culminating in the late General Theory. Those doctrines clashed as early as Nicholas Kaldor’s The Scourge of Monetarism (1982). the Restriction period of the Napoleonic wars Friedman stressed the ideas of exogenous (i.e., when the suspended the converti- determined) money, money-to- bility of its notes into at a fixed price on de- causality, as a monetary phenomenon, and mand. The suspension of specie payments and the controllability of money through the high-powered resulting move to inconvertible paper was followed . He traced a chain of causation - by a rise in the paper price of commodities, ning from open operations to bank reserves gold bullion, and foreign currencies. A debate be- to the nominal of money and thence to aggre- tween strict bullionists, moderate bullionists, and an- gate spending, nominal income, and . tibullionists then arose over the question: Was there By contrast, Kaldor postulated the opposite notions inflation in England and if so what was its cause? of endogenous (i.e., demand-determined) money, reverse causality, and inflation as a cost-push or Strict Bullionists: the classical monetarists supply-shock phenomenon. He denied the possibility Led by , the strict bullionists argued of base control given the central bank’s responsi- that inflation did exist, that overissue of bility to guarantee bank liquidity and the financial by the Bank of England was the cause, and that the sector’s ability to engineer changes in the turnover premium on gold (the difference between the market velocity of money via the manufacture of money and official price of gold in terms of paper substitutes. Kaldor’s transmission mechanism runs money) together with the pound’s depreciation on from (and other factor costs) to prices to the foreign exchange constituted the proof. Price money and thence to bank reserves. Wages deter- numbers not then being in general use, the mine prices, prices influence demands, and loan bullionists used the gold premium and depreciated demands via their accommodation in the form of new to measure inflation. checking deposits created by commercial The bullionists arrived at their conclusions via the determine the money stock, with central banks following route: The Bank of England determines the passively supplying the necessary reserves. quantity of inconvertible paper money. The quan- Kaldor claimed his attack on monetarism was in tity of money via its impact on aggregate spending the tradition of Keynes’s General Theory. So much so determines domestic prices. Domestic prices, given that he labeled it “a Keynesian perspective on foreign prices, determine the exchange rate so as to money. ” In so doing, he contributed to the standard equalize worldwide the common-currency price of textbook tendency to treat the monetarist- . Finally, the exchange rate between incon- antimonetarist debate as a post-Keynesian develop- vertible paper and currencies deter- ment. This article shows that the debate long mines the paper premium on specie so as to equalize predates Keynes, that it is rooted in classical everywhere the gold price of goods. In short, causality monetary tradition, and that it traces back at least runs unidirectionally from money to prices to the ex- to the bullionist-antibullionist and currency school- change rate and the gold premium. It followed that banking school disputes in England in the nineteenth the depreciation of the exchange rate below gold century. More precisely, the following paragraphs parity (i.e., below the ratio of the respective mint demonstrate that the arguments of Friedman and prices of gold in each country) together with the Kaldor were fully anticipated by their classical premium on specie constituted evidence that prices predecessors. were higher and the quantity of money greater in

FEDERAL RESERVE BANK OF RICHMOND 3 England than would have been the case had con- Moderate Bullionists vertibility reigned. Here is a straightforward applica- Moderate bullionists, led by Henry Thornton, tion of the monetarist ideas of exogenous money, Thomas Malthus, and William Blake, modified the money-to-price causality, inflation as a monetary strict bullionists’ analysis in one respect: they argued phenomenon, and parity. On these that it applied to the long run but not necessarily to grounds the strict bullionists attributed depreciation the short. They held that in the short run real as well of the internal and external of the pound as monetary shocks could affect the exchange rate solely to the redundancy of money and reproached such that temporary depreciation did not neces- the Bank for having taken advantage of the suspen- sarily signify monetary overissue. In the long run, sion of to overissue the currency. however, real shocks were self-correcting and only The strict bullionists also enunciated the monetarist monetary disturbances remained. Their is notion of control of the money stock through the best exemplified by Blake’s distinction between the high-powered monetary base. With respect to base real and nominal exchanges. The real exchange or control, they argued that the Bank of England could, terms of , he said, registers the impact through its own note issue, regulate the note issue of nonmonetary disturbances-crop failures, unilateral of the country (non-London) banks as well as other transfers, trade embargoes and the like-to the privately issued means of payment (bills of exchange . By contrast, the nominal ex- and checking deposits). Two circumstances, they change reflects the relative purchasing powers of said, worked to ensure base controllability. First, foreign and domestic currencies as determined by country banks tended to hold in reserve Bank of their relative supplies. Both components contribute England notes (or balances with London agents to exchange rate movements in the short run. In the transferable into such notes) equal to a relatively fixed long run, however, the real exchange is self-correcting fraction of their own note liabilities. This estab- (i.e., returns to its natural equilibrium level) and lished a constant relationship between the Bank note only the nominal exchange can remain permanently base and the country note component of the money depressed. Therefore, persistent exchange deprecia- stock. Second, a fixed-exchange-rate regional balance tion is a sure sign of monetary overissue. On this of payments or specie-flow mechanism kept coun- point the moderate bullionists agreed with their strict try bank notes in line with the Bank’s own issues. bullionist colleagues. Country bank notes were fully convertible into Bank of England notes but did not circulate in London. Antibullionists: the classical nonmonetarists Should country banks overissue, the resulting rise Opposed to the bullionists were the antibullionist in local prices over London prices would lead to a defenders of the Bank of England. They denied that demand to convert into Bank of the Bank had overissued or that domestic monetary England notes to make cheaper purchases in Lon- policy had anything to do with the depreciating don. The ensuing drain on reserves would force exchange rate and rising price of gold. Such infla- country banks to contract their note issue, thus tionary symptoms they attributed to real rather than eliminating the excess. For these reasons, the quan- monetary causes. In so doing, they contributed two tity of country notes was tied by a rigid link to the key ideas that today appear in Kaldor’s work. volume of Bank notes and could only expand and First was their supply-shock or cost-push theory contract with the latter. The implication was clear: of inflation. They argued that crop failures and war- Bank of England notes drove the entire money stock. time disturbances to foreign trade had raised the price Country banks were exonerated as a source of of wheat and other staple foodstuffs that constituted inflation. the main component of workers’ budgets. These The strict bullionists displayed another monetarist price increases then passed through into money trait in prescribing rules rather than discretion in wages and thus raised the price of all goods pro- the conduct of . Their rule called duced by labor. Ricardo, however, convincingly for the Bank of England to contract its note issue replied that this explanation confused relative with upon the first sign of exchange depreciation or rise absolute prices. For without excessive money growth, in the price of gold. This rule derived from the a rise in the relative price of wheat that required famous Ricardian definition of excess according to which workers to spend more on that commodity would if the exchange was depreciated and gold was com- leave them with less to spend on other goods whose manding a premium the currency was by definition prices would accordingly fall. In that case the rise excessive and should be contracted. in wheat’s price would be offset by compensating falls

4 ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1988 in other relative prices leaving general prices below the expected rate of on the use of the unchanged. borrowed funds. In this case loan demands will be Second, the antibullionists enunciated the notion insatiable and the resulting rise in money and prices of an endogenous, demand-determined money stock. will be without limit. This came in the form of their , which Bullionists, especially Henry Thornton, advanced they employed to assert the impossibility of an ex- exactly this same argument against the antibullionists’ cess supply of money ever developing to spill over real bills doctrine. That doctrine, they said, suffers into the to put upward pressure from two basic flaws. First, it links the nominal on prices. The real bills doctrine states that money money stock with the nominal volume of bills, a can never be excessive if issued upon the discount variable that moves in step with prices and thus the of sound, short-term commercial bills drawn to money stock itself. In so doing it renders both finance real goods in the process of production and variables indeterminate. It thus ensures that any . It purports to match with inadvertant jump in money and prices will, by real output so that no inflation occurs. raising the nominal value of goods in the process of The antibullionists used this idea to defend the production and hence the nominal quantity of bills Bank of England against the charge that it had eligible for discount, lead to further increases in caused inflation through overissue. The Bank, they money and prices ad infinitum in a self-justifying said, was blameless since it had restricted its issues inflationary spiral. Second, it overlooks that the to real bills of exchange and so had merely re- demand for and volume of bills offered for dis- sponded to the real needs of trade. In other words, the Bank, by limiting its advances to commercial count depend not so much on real output to be paper representing actual output, had merely financed as on the perceived profitability of borrow- responded to a loan already in ing as indicated by the differential between the loan existence and had done nothing inflationary to create rate of and the expected on the that demand. use of the borrowed funds. In particular, it fails to The real bills doctrine was an early version of see that when the profit rate exceeds the loan rate Kaldor’s notion that a passive, demand-determined the demand for loans becomes insatiable and the real money stock cannot be overissued and so cannot bills criterion fails to limit the quantity of money in cause inflation. Antibullionists also anticipated Kaldor existence. in arguing that since no one would borrow at interest This last flaw, bullionists argued, rendered the real money not needed, the Bank could not force an ex- bills doctrine an especially dangerous policy guide cess issue on the market. Such excess, they said, under inconvertibility. To be sure, even under specie would be speedily extinguished as borrowers returned convertibility a central bank that set its loan rate too it to the Bank to pay off costly loans. In short, the low relative to the expected profit rate would find antibullionists held that the Bank could not cause itself inundated with a potentially unlimited supply inflation since it merely supplied money passively in of eligible bills clamoring for discount. But the response to a loan demand for it. Thus there could resulting rise in money and prices would, by be no excess issue to spill over into the commodity making home goods dearer than foreign ones, lead market in the form of an excess demand for goods to a trade deficit and a matching gold drain that would to bid up prices. force the bank to protect its metallic reserves by raising its loan rate thereby ending the inflation. No Critique of the Real Bills Doctrine such result was assured under paper currency Monetarists today criticize Kaldor’s notion of a regimes, however. For without the crucial check of transmission mechanism running unidirectionally convertibility, the profit rate-loan rate differential from wages to prices to money for ignoring the feed- could persist indefinitely and with it the self- back effect of money on prices. Adding this feed- reinforcing rise in money, prices, and commercial back loop produces a two-way interaction in which bills. This point was particularly telling during the prices and money can chase each other upward ad suspension period when usury ceilings constrained infinitum in a self-reinforcing inflationary spiral. the Bank of England’s lending rate to 5 percent at Monetarists argue that such a spiral is sure to result a time when the expected profit rate, buoyed by the if banks, in passively creating new money in response boom conditions of the Napoleonic wars, was well to loan demands for it, set the loan rate of interest in excess of that level.

FEDERAL RESERVE BANK OF RICHMOND 5 Currency School-Banking School Debate tracting to match inflows and outflows of gold. (1821-1845) Departure from this rule, the currency school argued, would permit persistent overissue of paper, forcing Monetarist and antimonetarist doctrines clashed an efflux of specie through the balance of payments, again in the three decades following the Bank of which in turn would endanger the , England’s restoration of the gold convertibility of its threaten gold convertibility, compel the need for notes in 1821. This time the debate focused on how sharp contraction, and thereby precipitate financial to protect the currency from overissue so as to secure panics. Such panics would be exacerbated if inter- the gold reserve and ensure the maintenance of con- nal gold drains coincided with external ones as vertibility. The protagonists in this dispute were moneyholders, alarmed by the possibility of suspen- known collectively as the currency school and the sion, sought to convert paper currency into gold. No banking school, but they were the intellectual heirs such consequences would ensue, however, if the of the bullionists and antibullionists. Leaders of the currency conformed to the metallic principle. currency school included such names as Samuel Jones Forced to behave like gold (regarded by the cur- Loyd (Lord Overstone), , and rency school as the stablest of monetary standards) Robert Torrens. Similarly, , John the currency would be spared those sharp procyclical Fullarton, James Wilson, and J.B. Gilbart led the fluctuations in quantity that constitute a prime source banking school. of economic disturbance. The currency school’s bullionist predecessors had The currency school scored a triumph when its assumed that a convertible currency needed no pro- ideas were enacted into law. The Bank Charter Act tection. If the currency were convertible, they rea- of 1844 embodied its prescription that, except for soned, any excess issue of notes which raised British a small fixed fiduciary issue, Bank notes were to prices relative to foreign prices would be converted be backed by an identical amount of gold while the into gold to make cheaper purchases abroad. The country bank note issue was frozen at its 1842 level. resulting loss of specie reserves would force the Bank In modern terminology, the Act effectively estab- immediately to contract its note issue thus quickly lished a marginal gold of 100 arresting the drain and restoring the money stock and percent behind note issues. With notes tied to gold prices to their preexisting equilibrium levels. Given in this fashion, their volume would start to shrink smooth and rapid adjustment (monetary self- as soon as specie drains signaled the earliest ap- correction) convertibility was its own safeguard. pearance of overissue. Monetary overexpansion A series of monetary crises in the 1820s and 1830s, would be corrected automatically before it could do however, convinced the currency school that adjust- much damage. ment was far from smooth and that convertibility per se was not a guaranteed safeguard to overissue. It Banking School was an inadequate safeguard because it allowed The rival banking school flatly rejected the cur- banks-commercial and central-too much discre- rency school’s prescription of mandatory 100 percent tion in the management of their note issue. Banks gold cover for notes. Indeed, the banking school could and did continue to issue notes even as gold denied the need for statutory note control of any kind, was flowing out, delaying contraction until the last arguing that a convertible note issue was automatically possible minute, and then contracting with a violence regulated by the needs of trade and required no fur- that sent shock waves throughout the . ther limitation. This conclusion stemmed directly from the real bills doctrine and law of reflux, which Currency School’s Prescription the banking school took from the antibullionists and What was needed, the currency school thought, applied to convertible currency regimes. was a law removing the note issue from the discre- The school’s real bills doctrine stated that money tion of bankers and placing it under strict regulation. could never be excessive if issued on loans made to To be effective, this law should require the banking finance real transactions in . Simi- system to contract its note issue one-for-one with larly the law of reflux asserted that overissue was outflows of gold so as to put a gradual and early stop impossible because any excess notes would be to specie drains. Such a law would embody the cur- returned instantaneously to the banks for conver- rency school’s principle of metallic fluctuation accord- sion into or for repayment of loans. Both doc- ing to which a mixed currency of paper and coin trines embodied the notions of a passive, demand- should be made to behave exactly as if it were determined and of reverse causality wholly metallic, automatically expanding and con- running from economic activity and prices to money

6 ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1988 rather than vice versa as in the currency school’s view. idle hoards (i.e., buffer of specie reserves) and According to the reverse causality hypothesis, could not affect the volume of money in circulation. changes in the level of prices and production induce Falling solely on the hoards, gold drains would find corresponding shifts in the demand for bank loans their monetary effects neutralized (sterilized) by the which the banks accommodate via variations in the implied fall in reserve-note and reserve- ratios. note issue. In this way prices help determine the note To ensure that these hoards would be sufficient to component of the money stock, the expansion of accommodate gold drains, the banking school recom- which is the result, not the cause, of price inflation. mended that the Bank of England hold larger metallic As for the itself, the banking school reserves. With regard to the currency school’s attributed its determination to factor incomes or costs prescription that discretionary policy be replaced by (wages, interest, rents, etc.) thus establishing the a fixed rule, the banking school rejected it on the essentials of a cost-push theory of inflation. The im- grounds that rigid rules would prevent the banking portance of the cost-push idea to the banking school system from responding to the needs of trade and cannot be overestimated: it even led Thomas Tooke would hamper the central bank’s power to deal with to argue that high-interest-rate tight-money policies financial crises. Finally, the banking school asserted were inflationary since they raised the interest com- the impossibility of controlling the entire stock of ponent of business costs. money and money substitutes through the bank note component alone since limitation of notes would Antimonetarist Ideas simply induce the public to use money substitutes The concepts of cost inflation, reverse causality (deposits and bills of exchange) instead. In other and passive money are the hallmarks of an extreme words, the total circulation is like a balloon; when antimonetarist view of the monetary transmission squeezed at one end, it expands at the other. More mechanism to which the banking school adhered. Its generally, the banking school questioned the efficacy list of antimonetarist ideas also included the proposi- of base control in a financial system that could tions (1) that international gold movements are generate an endless supply of money substitutes. absorbed by and released from idle hoards and have The currency school, however, rejected this no effect on the volume of money in circulation, criticism on the grounds that the volume of deposits (2) that an efflux of specie stems from real shocks and bills was rigidly constrained by the volume of to the balance of payments and not from domestic notes and therefore could be controlled through notes price inflation, (3) that changes in the stock of money alone. In short, the total circulation was like an in- tend to be offset by compensating changes in the verted pyramid resting on a bank note base, with stock of money substitutes leaving the total circula- variations in the base inducing equiproportional vari- tion unchanged, and (4) that discretion is superior ations in the superstructure of money substitutes. In to rules in the conduct of monetary policy. counting deposits as part of the superstructure, the In its critique of the monetarist doctrines of the currency school excluded them from its concept of currency school, which contended that note overissue money. It did so on the grounds that deposits, unlike is the root cause of domestic inflation and specie notes and coin, were not generally acceptable in final drains, the banking school argued as follows: payments during financial crises. Overissue is impossible since the stock of notes is determined by the needs of trade and cannot exceed Subsequent Developments demand. Therefore, no excess supply of money In retrospect, the currency school erred in failing exists to spill over into the goods market to bid up to define deposits as money to be regulated like prices. In any case, causality runs from real activity notes. This failure enabled the Bank of England to and prices to money rather than vice versa. Finally, exercise discretionary control over a large and grow- specie drains stem from real rather than monetary ing part of the money stock, contrary to the inten- disturbances and occur independently of domestic tions of the school. The school also erred in not price level movements. recognizing the need for a lender of last resort to avert These arguments severed all but one of the links liquidity panics and domestic specie drains. With in the currency school’s monetary transmission respect to specie drains, the currency school re- mechanism running from money to prices to the trade fused to distinguish between domestic (internal) and balance, thence to specie flows and their impact on foreign (external) ones. As far as policy was con- the high-powered monetary base and finally back cerned, both drains were to be handled the same way, again to money. The final link was broken when the namely by monetary contraction. By the time Walter banking school asserted that gold flows come from Bagehot wrote his celebrated Lombard Street in 1873,

FEDERAL RESERVE BANK OF RICHMOND 7 however, it was widely recognized that the two drains ties failed to perceive this inflationary sequence and required different treatment and that the surest way did nothing to stop it. On the contrary, they saw their to arrest an internal drain was through a policy of duty as passively supplying on demand the growing liberal lending. Such drains were caused by panic- sums of money required to mediate real transactions induced demands for high-powered money (gold and at skyrocketing prices. They simply refused to Bank notes) and could be terminated by the central believe that issuing money on loan against genuine bank’s announced readiness to satiate those demands. commercial bills could have an inflationary effect. The currency school nevertheless remained op- After the debacle of the 1920s, bank- posed to such a policy, fearing it would place too ing school doctrines reappeared in renovated form much discretionary power in the hands of the cen- as part of the Keynesian revolution. Keynes in his tral bank. These shortcomings in no way invalidated General Theory (1936) stressed the banking school’s the currency school’s contention that convertibility notion of money entering idle hoards (liquidity traps) is an inadequate safeguard to overissue and therefore rather than active circulation. He also stressed the must be reinforced by positive regulation. Nor did school’s ideas (1) of variable velocity absorbing the they undermine its monetary theory of inflation, impact of money-stock changes leaving spending and which was superior to any explantion its critics had prices unaffected, (2) of real rather than monetary to offer. causes of cyclical depressions, and (3) of prices deter- As for the banking school, it rightly stressed the mined by autonomous factor costs. And in the im- importance of checking deposits in the payments mediate postwar period, Keynesians developed the mechanism. But it was wrong in insisting that the notion of cost-push inflation emanating from grow- real bills doctrine, which tied note issues to loans ing union bargaining strength, business made for productive purposes, would prevent infla- power, supply , and other institutional tionary money growth. The currency school trium- forces that produce autonomous increases in labor phantly exposed this flaw by pointing out that rising and other factor costs. Only the banking school ideas prices would require an ever-growing volume of loans of unlimited money substitutes and the futility of base just to finance the same level of real transactions. In control were missing. And these were provided in this way inflation would justify the monetary expan- the famous report of the British Radcliffe Com- sion necessary to sustain it and the real bills criterion mittee (1959). Representing the apogee of post- would fail to limit the quantity of money in existence. Keynesian skepticism of the relevancy of the quan- Also, by the 1890s Knut Wicksell had rigorously tity theory, the Radcliffe Report concluded that demonstrated the same point made by Henry Thorn- attempts to control inflation by limiting the stock of ton in 1802, namely that an insatiable demand for a narrowly defined monetary aggregate would merely loans results when the loan rate of interest is below induce spenders to turn to money substitutes instead. the expected rate of profit on capital. In such cases Velocity would rise to offset monetary restriction, the real bills criterion provides no bar to overissue. Despite this criticism the real bills doctrine sur- The Debate Goes On vived in banking tradition to be incorporated as a key Today currency school doctrines survive in Fried- concept in the Federal Reserve Act of 1913. And man’s work just as banking school doctrines appear during the German hyperinflation of 1922-23 the doc- in Kaldor’s writings. When Friedman argues that rules trine formed the basis of the Reichsbank’s policy of are preferable to discretion, that inflation is largely issuing astronomical sums of money to satisfy the or solely the result of excessive monetary growth, needs of trade at ever-rising prices. Oblivious to the that monetary shocks are a primary cause of cyclical Thornton-Wicksell demonstration that the real bills swings, and that the entire stock of money and money test provides no check to overissue when lenders peg substitutes can be governed by control of the high- loan rates below the going profit rate, the Reichsbank powered monetary base, he echoes currency school insisted on pegging its discount rate at 12 percent opinion. (later raised to 90 percent) at a time when the going Likewise, Kaldor echoes the doctrines of the bank- market rate of interest was well in excess of 7000 ing school. The school’s cost-push theory informs percent per annum. This huge differential of course his view of inflation. Inflation, he argues, stems made it extremely profitable for commercial banks mainly from increasing militancy of trade unions and to rediscount bills with the Reichsbank and to loan the resulting rise in unit labor costs caused by money out the proceeds, thereby producing additional wages advancing faster than labor-hour produc- inflationary expansion of the money supply and fur- tivity. The banking school’s notion of passive money ther upward pressure on interest rates. The authori- appears in his statement that money is a demand-

8 ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1988 determined variable that comes into existence as ing school, he argues that restriction of the monetary banks accommodate loan demands and central banks base induces offsetting rises in the stock of money acting as lenders of last resort permissively supply substitutes thereby thwarting base control. the necessary reserves. The school’s law of reflux In short, Kaldor emerges as the intellectual heir surfaces in his declaration that because money is of the banking school and the antibullionists just as demand-determined its supply can never exceed Friedman is the heir of the currency school and the demand; any oversupply is extinguished automatically bullionists. It follows that the debate between the as borrowers return it to the banks to pay off costly monetarists and antimonetarists is not of post- loans. Finally, the banking school notion of a poten- Keynesian origin. Rather it has its roots in policy tially unlimited supply of money substitutes underlies controversies going back to the era of classical his belief in the futility of base control. Like the bank- monetary thought.

FEDERAL RESERVE BANK OF RICHMOND