Political Economy of Money: Emerging Fiat Monetary Regime

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POLITICAL ECONOMY OF MONEY

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POLITICAL ECONOMY OF MONEY Emerging Fiat Monetary Regime GEORGE MACESICH

PRAEGER

Westport, Connecticut London

Library of Congress Cataloging-in-Publication Data Macesich, George, 1927— Political economy of money : emerging fiat monetary regime / George Macesich. p. cm. Includes bibliographical references and index. ISBN 0-275-96572-4 (alk. paper) 1. Monetary policy. 2. Money. I. Title. HG230.3.M333 1999 332.4'6—dc21 99-17922 British Library Cataloguing in Publication Data is available. Copyright © 1999 by George Macesich All rights reserved. No portion of this book may be reproduced, by any process or technique, without the express written consent of the publisher. Library of Congress Catalog Card Number: 99-17922 ISBN: 0-275-96572-4 First published in 1999 Praeger Publishers, 88 Post Road West, Westport, CT 06881 An imprint of Greenwood Publishing Group, Inc. www.praeger.com Printed in the United States of America

The paper used in this book complies with the Permanent Paper Standard issued by the National Information Standards Organization (Z39.48-1984). 10

9 8 7 6 5 4 3 2 1

To the Memory of Walter Macesich, Sr. and Jr.


Contents Preface

ix

1.

The Issue of Money Growing Interest in Monetary Affairs Reform, the Monetary Regime, and Politics

1 1 9

2.

Fiat Money: Historical Perspective Political Issue and Manipulating Money The Early Years in Europe American Nineteenth-Century Monetary Experience

15 15 16 17

3.

Muddling Through to a Fiat Monetary Regime: The Interwar Years Breakdown War Debts Attempts to Restore the Role of Gold Monetary Collapse and Its Consequences The Interwar Years in Retrospect

31 31 35 36 38 45

The Emerging Postwar Fiat Monetary Regime: Myth, Fact, and Fancy The Bretton Woods Regime

47 47

4.

Contents

Vlll

Quantity Theory, Income Expenditure Theory, and the Balancing Mechanism of International Trade 5.

54

The Post-Bretton Woods Regime: Attempts at Reform Attempts at Reform The Postwar International Environment: The Cold War and Dissolution of the Old World Order

61 61

6.

The International Monetary Fund and Its Prospects What Role, If Any? Amending the IMF Charter?

77 77 84

7.

Echoes from the Past America as an Emerging Market: The Issue of Monetary Supremacy and Monetary Regimes Emerging Market Economies and Capital Flows Ongoing Role for Banks

89

8.

What Is to Be Done? The Basic Problem A Flexible Exchange Rate Solution? A New Bretton Woods and Return to Gold? Fundamental Differences on the Role of Money in Society

67

89 91 100 105 105 107 110 112

Selected Bibliography

121

Index

133

Preface There is a resurgence of interest in monetary and financial affairs world wide. Indeed, there is a call to find ways to adapt the international monetary architecture to the twenty-first century. To many observers it is far from clear that the International Monetary Fund (IMF) policies to help countries in their most recent difficulties will succeed. Various alternative measures are proposed ranging from capital controls to converting, for instance, Asia's burgeoning corporate debt into securities that could be sold in the marketplace, to replacing central banks with currency boards, to easing IMF measures such as high interest rates and slashing government budgets which were meant to restore investor confidence but which some analysts say have caused market panic instead. Many people agree and underscore the necessity for modifying the IMF with a view to accommodating Asia's private sector and stressing its long-term strengths including that of Latin America and Russia. Central banks, Asian and other governments promoted weak and irresponsible banks. These banks managed to devour their own good assets and became insolvent like the U.S. savings-and-loans in the 1980s. The central banks and governments vouched for these banks, enabling them to keep borrowing dollars from foreign banks. The transparency necessary for a properly functioning banking system in various regions in difficulty was simply not there. A global economy is not likely to work properly without monetary and financial institutions to facilitate trade and payments. Certainly, banks, for in-

X

Preface

stance, should be discouraged from "window dressing" and give the investing, depositing, and borrowing public more of the inside information management uses to run the bank. It is, after all, markets, not regulations or politics, that force the admission and correction of mistakes. The ability of central banks to deal with what Milton Friedman terms the "current unprecedented fiat monetary system" is surely an open question. Central bankers and the performance of central banks in the fiat monetary system remain to be tested. Indeed, Alan Greenspan, chairman of the Federal Reserve System, emphasizes that the current monetary regime is far from ideal. He notes that in a world in which historical regularities have been displaced by unanticipated change, especially in technologies, there does not appear to be a clear rule that can guide policy decisions about the money supply. As a result, policymaking, with no alternative, has turned more eclectic and discretionary. Greenspan lists and discards assorted policy rules, such as a gold standard, various fixed rules about growth of the monetary base, and rules anchored to output and prices. Moreover, price stability, though vital to maximizing economic growth, is hard to measure and getting harder. What, then, is the benchmark or guide or target that the Federal Reserve looks at in considering monetary policy? This study argues that given the unprecedented fiat money regime that is now emerging it would help if the Federal Reserve and world central banks became more transparent in the formulation and execution of monetary policy. It is unclear thus far for that the emerging fiat monetary regime will not go the way of all earlier paper standards. And Friedman underscores that the current challenge is to find a substitute for the convertibility into specie (gold or silver) that earlier constrained governments from resorting to inflation as a source of revenue. In effect, we must find a nominal anchor for the price level to replace the physical limit of a monetary commodity. Failure to do so will very likely force a return to a commodity standard such as a gold standard of one kind or another. The book is directed to the general economist, political scientist, and layperson. I am indebted to many colleagues with whom I have discussed one or another aspect of this book over the years. These include Marshall R. Colberg, Walter Macesich, Jr., Milton Friedman, and Anna J. Schwartz. I am grateful to Ann Chlapowski and Karen Wells for preparing this manuscript for publication.

CHAPTER 1

The Issue of Money GROWING INTEREST IN MONETARY AFFAIRS The resurgence of interest in monetary and financial affairs can be attributed in good part to the ease with which "money" slips into the political arena to become a singularly important political issue. Discretionary authority facilitates monetary manipulation for political ends, thereby increasing uncertainty and casting in doubt money, the monetary system, and, indeed, the monetary authority itself. This raises fundamental questions regarding public policy constraints on the monetary system as well as the ideas and economic philosophy underlying past, current, and future monetary regimes and policies. These issues are as important today to the "unprecedented fiat monetary standard" discussed by Milton Friedman as they were at the turn of the century when Irving Fisher (1867-1947) was prompted to write that the confusion into which discussion of the monetary affairs had been thrown can be found in the political controversies with which it had become entangled.1 In the modern world, monetary theory and policy in general are still enmeshed in political controversy, though perhaps more complex and involving more fundamental issues than in Fisher's time. As in Fisher's time, there appears to be a puzzling choice between real and spurious solutions. The various "solutions" have come protected by

2

Political Economy of Money: Emerging Fiat Monetary Regime

strong political, economic, and ideological interests. In part, the difficulties seem to arise from the economic circumstances, theory, and methodology of the interwar and postwar periods. Thus group interests and group ideologies remain involved in the discussion, with the Federal Reserve and other central banks joining the banking community and national governments with immense opinion-making resources in a long-standing involvement in these issues. Finally, some themes in the literature of monetary controversy may be interpreted as involving puzzles fundamentally vexing to the human mind, since they have provoked discussion over the centuries with no evident improvement in the general level of comprehension. Monetary problems are thus as fascinating as they are perplexing, combining as they do a rich mixture of technical economics, political repercussions, and even the psychology of symbols and beliefs. Essentially, the central issue in the disagreement is over defined versus undefined or discretionary policy systems. On this score the major opponents in the controversy in the past and in the present are Monetarists or Quantity Theorists and modern Keynesians as well as central bankers. Quantity Theorists urge a policy system based on rules and nondiscretionary intervention into the economy. The policy system's principal corollary is that only a slow and steady rate of increase in the money supply—one in line with real growth of the economy—can insure price stability.2 On the other side of the issue are people whose preference is administrative discretionary intervention to maintain aggregate demand in the economy. Modern Keynesians and central bankers contend that defined policy systems are inferior to administrative discretion. Central bankers view the conduct of monetary policy as an "art" not to be encumbered by explicit policy rules. If this is correct, the controversy is indeed ideologically driven and does involve money in political considerations. The modern Keynesian approach is, in effect, the economic branch of the political interventionist position whose defining principle is the extensive use of government power without definite guides or policy systems.3 It has important allies in central banks with whom it shares many banking school ideas. Its opponents, including Quantity Theorists (or Monetarists), are those seeking lawful policy systems and limitations on the undefined exercise of power by government.

The Issue of Money

3

At issue is the difficulty with undefined policy systems. If policies to be followed are uncertain, their consequences may indeed be disastrous. Such policy systems are indeed risky. And, indeed, the intellectual difficulty of the proponent of discretionary policy formation is a real one. Culbertson puts it well in underscoring that if the policy matters, then certain correct choices must be made, which implies that power must reside in those particular people who will make the correct decisions—but in a context in which the correct choices themselves are asserted to be incapable of being defined (since it is the basis of rejection of defined policy systems). 4 It is nothing less than putting forward an elite or priestly class that promises to accomplish the indefinable. Such a group readily becomes an important political element and money its instrument of power. In a well-defined policy system the role of money as an instrument of political power can be constrained. A theoretical and empirical underpinning for such an arrangement is summarized by Milton Friedman in his Counter Revolution in Monetary Theory, First Wincott Memorial Lecture (London: Institute of Economic Affairs, 1970). This is, in fact, a Quantity Theorist (Monetarist) view on the relationship between the money supply and the price level. We can summarize Friedman's view as he does in the following seven points: 1.

2.

3.

4. 5.

6.

There is a consistent, though not precise, relation between the rate of growth of the quantity of money and the rate of growth of nominal income. This relationship is not obvious to the naked eye largely because it takes time for changes in monetary growth to affect income, and how long it takes is itself variable. On the average, a change in the rate of monetary growth produces a change in the rate of growth of nominal income about six to nine months later. This is an average and does not hold in every individual case. The changed rate of growth in nominal income typically shows up first in output and hardly at all in prices. On the average, the effect on prices comes about six to nine months after the effect on income and output, as the total delay between change in monetary growth and a change in the rate of inflation averages something like twelve to eighteen months. Even after allowance for the delay in the effect of monetary growth, the relation is far from perfect. There is many a slip "twixt the monetary change and the income change."

4


7.

In the short run, which may be as much as five or ten years, monetary changes primarily affect output; over decades, on the other hand, the rate of monetary growth affects primarily prices.

The Quantity Theorist (Monetarist) view as summarized in Friedman's Counter Revolution, in effect, questions the doctrine advanced by John Maynard Keynes that variations in government spending, taxes, and the national debt could stabilize both the price level and the real economy. This doctrine has come to be called the Keynesian Revolution. The battle between neo-Keynesian and Quantity Theorists has been waged for more than a half century. It has long since moved into the policy area. The critics of the quantity theory approach declare that in the instance of a cure for inflation the proposed quantity theory approach can work only by imposing excessive burdens and huge losses in real output and prolonged losses on the economy. Quantity Theorists respond that the burden must be borne because there is no other way to restore the economy to price stability or economic stability. The acceptance of monetary policy by modern Keynesians, for instance, does not mean that they accept the principal Quantity Theorist (Monetarist) tenet regarding the importance of the money. Indeed, along with central bankers they strongly oppose the measurement of monetary policy by the money supply, whatever its definition. They apparently prefer to use interest rates and other credit market conditions as measures of monetary policy. Such a view is, in effect, similar to the defunct views of the banking school that takes "sound credit conditions" as its guiding principle, rather than the money supply. Although many variants of the theory are possible, they typically take as a principal autonomous and explanatory variable some measure of credit conditions, amount of credit or bank credit, credit availability, credit terms, or interest rates. These measures are as important to central bankers today as they were more than two hundred years ago. No doubt modern Keynesians do not consider themselves heirs to the banking school tradition. Their strong rejection of the concept of the money supply, however, is similar to the banking school view. It is curiously intense and implacable.5 For instance, John K. Galbraith attributes the lack of "success" of monetarism in the United States and Great Britain to difficulties at three levels.6 There is, according to Galbraith, first, the difficulty as to what "money" is; there is, second, the problem that what a central bank elects

The Issue of Money

5

to call money cannot be controlled in either quantity or velocity; there is, third, the certainty that efforts at vigorous control will substitute for the problem of inflation the alternatives of high unemployment, recession or depression, and disaster for those industries that depend on borrowed money. In effect, monetarism, which places its sole confidence in stabilizing the growth of some "esoteric monetary aggregate" to the exclusion of other concerns, is a prescription for calamity. These critics are distressed that monetarism, which began with the slogan "Money matters" and manifested a healthy skepticism to early Keynesian view, has over the years blossomed into all-out opposition to such discretionary Keynesian stabilization policies as compensatory use of fiscal and monetary measures. So, too, it is upsetting to such critics to hear Quantity Theorist (Monetarist) charges that a discretionary and interventionist stabilization policy causes more problems than it cures. Critics charge that Quantity Theorists have never really provided a convincing theoretical foundation for their policy prescriptions. There is not, so the critics argue, a clear conceptual basis for a sharp distinction of "money" from its substitutes and for ignoring systematic and random variation in velocity. Apparently the theoretical and empirical evidence presented by Quantity Theorists (Monetarism) is insufficient.7 Monetarists, moreover, are charged by their critics with converting long-run equilibrium conditions into short-run policy recommendations. This "natural rate theory" argues that no permanent reduction of unemployment can be gained by accepting inflation. Anti-inflationary policies produce protracted social costs in lost output and unemployment. These costs are not fully addressed by Monetarists. This is not surprising, so the critics argue; given their free market ideology, they will not entertain wage or price controls or income policies as alternatives or complements to anti-inflationary restrictions. Milton Friedman identifies monetarism with quantity theory he freed of dependence on the assumption of automatic full employment, the focal point of Keynesian ridicule of traditional quantity theory. It is also in his University of Chicago monetary workshop during the 1950s, in which this writer had the privilege to participate as a graduate student, that studies on inflation and the role of money in inflation received considerable attention. Friedman's work changed professional thinking on matters pertaining to the role of money. Harry Johnson has described changes in monetary theory as owing much to Friedman's efforts that made monetary economics exciting and

6


concerned with crucial issues.8 Johnson argues that the Friedman analysis gave a central place to expectations about future price movements and to Fisher's distinction between real and money rates of interest—in contrast to Keynesian analysis which always started with the assumption of stable prices. As a consequence, Friedman steered theory and empirical research and monetary economics toward concepts and methods far more appropriate to the inflationary-cum-necessary development of recent years than Keynesian economics was capable of providing. It is, in fact, unfair to present Friedman as just another ideologue who lets his politics dominate his economics. To do so is to distort the actual situation. Indeed, Karl Brunner argues that many of Friedman's political or policy views were guided by a strong commitment to a relevant empirical use of economic analysis.9 Friedman's "politics" emerge to a major extent as a consequence of his economic analysis. Brunner points out that Friedman's analysis led him to a series of quite radical questions bearing on many of our social institutions, particularly on the view of stabilization policies. Thus the proposal for a monetary rule was not motivated by any "laissez-faire" preconception—but evolved from his appreciation of the unpredictable variability of monetary lags. Indeed, Keynesian emphasis on the basic instability of the private sector and the stabilizing function of a stable government sector is a central idea that Brunner correctly notes is turned on its head by Friedman on the basis of his work with Anna J. Schwartz on the Great Depression. Their argument is that it is essentially the stable private sector that operates as a shock absorber to the shock imposed by an erratic and unstable government sector. This inversion has generated a considerable amount of intellectual and political heat but little resolution. It is, moreover, erroneous to attribute to money and monetary policy an all-embracing power and thus make discretionary interventionism desirable. Milton Friedman is quite explicit on this issue when he writes that assigning monetary policy a larger role than it can perform and so preventing it from making the contribution that is capable of making, risks failure.10 And, indeed, as we have noted, Quantity Theorists (Monetarists) argue that monetary authority can control only nominal quantities and directly the quantity of its own liabilities.11 By manipulating the quantity of its own liabilities, it can fix the exchange rate, the price level, the nominal level of income, the nominal quantity of money; it can also in-

The Issue of Money

7

fluence directly the rate of inflation or deflation, the rate of growth of the nominal stock of money, and the rate of growth or decline in nominal national income. The monetary authority cannot, through control of the nominal quantities, fix the real quantities such as the real interest rate, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real national income, or the rate of growth of the real quantity of money. This does not mean, as Quantity Theorists are quick to point out, that monetary policy does not have important effects on real magnitudes. Indeed, when money gets out of order, important repercussions are felt throughout the economy. As this study underscores, monetary history provides ample evidence on this score. In spite of the empirical evidence advanced by Quantity Theorists supporting the limitations of monetary policy and the ideological neutrality of monetary theory, "money" is used, however erroneously, to promote goals of ideology and social philosophy. Given the optional and political determination of a country's monetary system, this is not surprising. Constraints imposed by the rules of the international gold and specie standard on national monetary sovereignty have been eroding since the interwar collapse of the international monetary system. Fumbling attempts to reimpose monetary constraints through international monetary reform in the period since World War I have served the cause of discretionary intervention and imposed tasks on the monetary system that it has been unable to obtain. Attempts to reimpose monetary constraints have not been successful, in good part because the contemporary world differs radically from that of the pre-World War I era. The revolutions of the nineteenth century were aimed at assuring political and economic liberty by breaking through the outworn controls of a preceding age of regulations. For the most part the revolutions of our time have been protests against the philosophy and institutions of the system of individualism based on natural rights. They have aimed at the opposite values of social control, and they have created myths and Utopias of individual liberty. The impersonal forces of the market on which classical (and neoclassical) economists relied to bring about a maximum of production and distribution of income, which, if not equitable, would at least be effective in maintaining high production, tend now to be displaced as political ideals by such objectives as full employment and various social safety-net programs.

8


Inevitably these objectives imply intervention and regulation. And the only mechanism presently available for such intervention and regulation is the national state and its bureaucracy, including the central bank. As we note in this study, the penchant by bureaucracies for discretionary authority as a means of self-preservation and expansion is well known. The evidence for this is to be found on every hand, moreover, and nowhere is it more conclusive than in expanded activities of central banks in domestic and international monetary affairs. Intervention and regulation, however, can take place within constrained policy systems. It does not call necessarily for the granting of important discretionary authority to the state bureaucracy, although extension of intervention has also promoted discretionary authority. Few monetary problems can ever have been so ingeniously contrived to maximize difficulty as that of granting discretionary authority to central banks. Such authority granted central banks over domestic monetary policies, and undertaken for various and often illusive goals, constitute a formidable reinforcement of nationalism in the economic sphere as well as create an important source of instability. At the same time, discretionary authority serves well the central bank whose preference function may well differ significantly from that of the public in general. They are indeed an economic arm of the political interventionist position, while admirably serving their own bureaucratic goals and interests. Central banks are, of course, subject to political pressures to which they typically respond, in the absence of explicit constraints, by manipulating money and monetary policy as a matter of bureaucratic survival. They are, after all, creatures of the nation state. Their independence is more myth than fact. Their alliance with political elements in government is understandable, as our theory of bureaucracy suggests. However, their attempt to carry out seriously the various goals assigned, e.g., low interest rates, price stability, economic growth, employment, and balance-of-payments equilibrium, through the exercise of discretionary policies is more likely to cast doubt on their own credibility and that of money and the monetary authority itself. This is in fact what has happened in the United States and elsewhere. Subsequent demands for monetary constraints and reform are thus understandable. Whatever may be thought of the wisdom or practicability of such intervention and use of discretionary authority by central banks, the fact must be recognized that the nineteenth-century integration of market processes has

The Issue of Money

9

been impaired by the emergence in every country of a greater measure of state intervention, particularly in monetary affairs. Indeed, Milton Friedman and Anna J. Schwartz report that "government intervention in the exchange markets since the 1930s has been more potent in disunifying the markets than improvements in transportation and communication have been in unifying them."12 Recognition of these drastic changes in the monetary system from a largely constrained specie standard to an unconstrained fiduciary standard by the public has been slow. Since the mid-1960s, however, a pronounced awareness of these changes is registered by lenders and borrowers. This, according to Friedman and Schwartz, is suggested by the close relation for the first time in a century between interest rates and the rate of price change. They note that Gibson has been replaced by the original Fisher. And lenders and borrowers apparently have been able to predict price changes more accurately and to adjust the terms of lending and borrowing accordingly.13 In fact, it is a recognition of the change in the monetary system from a largely specie standard to a fiduciary standard.14 REFORM, THE MONETARY REGIME, AND POLITICS Alarm and concern over the drastic changes in the monetary system has prompted all sorts of reform measures. They range from proposals to impose constraints on the monetary system within prescribed policy guidelines to calls for reinstituting interest rates and credit market conditions as guides to policy reminiscent of the banking school. Many are taken from the dustbins of history with little, if any, modification. Money and the monetary system, however, are not a junkyard of political and economic system parts. These institutions have evolved along with general economic ideas and political economy. Attempts to resurrect no longer existing bits and pieces of systems to shore up or reform the monetary system are an exercise in futility. The pre-Socratic philosopher Heraclitus sums it up well with his remark that we cannot step into the same river twice. In any case, we do not have to go to the past since a well-implemented and executed Quantity Theorist (Monetarist) rule will serve to constrain money and the monetary system within a defined non-discretionary and lawful policy system. Money and monetary theory is ideologically neutral. This does not mean that it must be the same in all

10


countries or throughout history, though the evidence tends to support the view that "money does matter—that any interpretation of short-term movements in economic activity is likely to be seriously at fault if it neglects monetary changes and repercussions."15 Recent proposals for return to some form of the gold standard as a constraint on the domestic and international monetary system have not met with notable success.16 This is not surprising. What is often lacking in these proposals is an appreciation and understanding of the fact that the gold standard was more than a monetary standard. It cannot be understood, as it cannot be operated successfully, except as part of a socioeconomic, political, and philosophic system in which it was developed. This system no longer exists, for reasons we discussed above. There is, moreover, a tendency on the part of some gold advocates to idealize the gold standard and to overlook some of its more troublesome aspects. Thus, between 1815 and 1914, there were twelve major crises or panics in the United States that pushed up interest rates, created severe unemployment, and suspended specie payments (conversion of the dollar into gold) in addition to fourteen minor recessions.17 To be sure, between 1879 and 1965—a period when America was on some sort of gold standard (the dollar's final links with gold were not cut until 1971 during President Nixon's administration)—the consumer price index rose by an average of only 1.4 percent a year. On the other hand, the severe bouts of inflation were followed by deep deflation in which prices actually fell. For instance, in the 1921 world recession, when production actually fell for only a few months, there were 30 to 40 percent cuts in manufacturing wages in some countries in the period 1920-1922. An alternative proposal, pushed from theory to practice by F. A. Hayek a few years ago, is that the provision of money be left to an unregulated market.18 Hayek contends that with private provision of money, money users would receive a better product, and the problems of the business cycles would be ameliorated. Pre-1860 American monetary experience with multiple private currencies sheds light on the feasibility of Hayek's proposal. At the time, however, the ultimate constraint on the American monetary system was the specie or gold standard. Hayek's proposal on this score is not clear. Another reform proposal is to opt on the national level for a fiduciary monetary standard within a "monetary constitution." This is essentially a Monetarist proposal. It is suggested by Leland Yeager and

The Issue of Money

II

James Buchanan and incorporates a Friedman-type rule on the rate of monetary growth.19 On the international level, fully flexible exchange rates would replace the existing "dirty-float" system of exchange rates. One merit of these proposals for constraining the monetary system by a monetary constitution and rule is their implicit recognition that the nineteenth-century integration of market processes has been impaired over the past several decades by the emergence in every country of a greater measure of state intervention and particularly the discretionary nature of such intervention in the monetary sphere. The fact is that in every country there has been an increased degree of intervention since World War I, and in all, the instruments of intervention are primarily national. The flexibility of exchange rates could well deputize for the varying degrees of flexibility in internal price structures brought about by state intervention. Such a flexible system also takes into account varying political, economic, cultural, and, indeed, historical conditions of the world community of nations, thereby avoiding conflict over sensitive issues of national sovereignty. The ease with which money slips into the political arena is aptly demonstrated in recent Congressional attempts to have the Federal Reserve change its policies. Echoing banking school arguments, a call for reform by thirty-one Democratic senators, led by then Minority Leader Robert E. Byrd, introduced legislation in August 1982 that would direct the Federal Reserve Board to abandon the monetary policy it had pursued since October 1979.20 The measure, called the Balanced Monetary Policy Act of 1982 and subtitled "A Democratic Recovery Initiative," would direct the Federal Reserve to give up priority to meeting yearly targets for short-term interest rates instead of to controlling the money supply, the presumed focus of its then policy. According to Senator Byrd, the aim would be to return interest rates to their "historical levels" of roughly one to four percentage points above the inflation rate. Indeed, Byrd cites the October 1979 Federal Reserve decision—to focus on the money supply as its operational goal rather than controlling interest rates—as "one major cause" of the 1982 deep recession. Little chance for the passage of the Democratic bill was given at the time, owing to the month or so that remained before Congress adjourned for the election campaigns. Nevertheless, Senator Edward Kennedy (D-MA) indicated that the bill might at least serve as a shot across the Fed's bow, perhaps encouraging it to "abandon this academic, experimental monetary policy" it had been following since 1979.

12


Not to be outdone by the Democrats, the Republicans came forth with an alternative proposal, the Kemp-Lott bill (at the time Representatives Jack Kemp, R-NY, and Trent Lott, R-MS). As in the Democratic proposal, the Kemp-Lott bill would direct the Federal Reserve to abandon concentration on the money supply and move to a greater concentration in targeting interest rates. According to its sponsors, the Federal Reserve had already moved in this direction in July and August 1982, when it reduced the discount rate and took steps to cut the federal funds rate, i.e., the interest rate on overnight loans between banks. At the same time, the promoter of the Republican proposal would direct the Federal Reserve to include other factors in determining interest rate policy, including employment, economic growth, stable prices, and stable exchange rates. The priority, however, is to be given to price stability, and any threat to it would require the Federal Reserve to refrain from pushing interest rates. In effect, the bill is so phrased as to blunt criticism that it seeks lower interest rates and economic growth at the expense of increased inflation. In other words, the Kemp-Lott bill would direct the Fed to opt for price stability in the event of conflicts among stated goals of low interest rates, unemployment, growth, and exchange rates. In this sense the Republican bill does differ from the Democratic proposal. In both instances, however, the results are likely to be an increase in the exercise of discretionary authority by the Federal Reserve Board and away from consideration of nondiscretionary rules within a lawful policy system. If either proposal is seriously adopted by the Federal Reserve, the net effect is likely to be a repeat performance of the Fed's indifferent past record. NOTES 1. Irving Fisher (assisted by H. G. Brown), The Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crisis (New York: Macmillan Company, 1913), p. viii. 2. Milton Friedman, "The Role of Monetary Policy" in The Optimum Quantity of Money and Other Essays, ed. Milton Friedman (Chicago: Aldine, 1969), p. 99. 3. John M. Culbertson, Macroeconomic Theory and Stabilization Policy (New York: McGraw-Hill Book Company, 1968), p. 535. 4. Ibid., p. 535. 5. Ibid., p. 534.

The Issue of Money

13

6. John K. Galbraith, "Up for Monetarism and Other Wishful Thinking," The New Review of Books, August 13, 1981, pp. 27-32. 7. Milton Friedman writes, "I must say that personally I do not like the term, I would prefer to talk simply about the quantity theory of money, but we can't avoid usage that custom imposes on us." Milton Friedman, "Monetary Policy: Theory and Practice," Journal of Money, Credit, and Banking, February 1982, p. 101. This study uses both terms Quantity Theory and/or Monetarism. 8. Harry Johnson, "The Nobel Milton," The Economist, October 23, 1976, p. 95. 9. Karl Brunner, "The 1976 Nobel Prize in Economics," Science, November 5, 1976, p. 648. 10. Milton Friedman, "The Role of Monetary Policy," in The Optimum Quantity of Money and Other Essays, ed. Milton Friedman (Chicago: Aldine, 1969), p. 99. 11. Ibid., p. 99. 12. Milton Friedman and Anna J. Schwartz, Monetary Trends in the United States and United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867-1975 (Chicago: University of Chicago Press, 1982), p. 626. 13. Ibid., p. 631. 14. Ibid., p. 631. 15. Milton Friedman, "The Quantity Theory of Money—A Restatement," in Studies in the Quantity Theory of Money, ed. Milton Friedman (Chicago: University of Chicago Press, 1956), p. 3. 16. See Anna J. Schwartz, "The U.S. Gold Commission and the Resurgence of Interest in a Return to the Gold Standard," Proceedings and Reports, vol. 17, 1983 (Tallahassee: Center for Yugoslav-American Studies, Research and Exchanges, Florida State University, 1983). Dr. Schwartz was Executive Director of the U.S. Gold Commission. 17. The Economist, September 19, 1981, pp. 17-18. 18. F. A. Hayek, Denationalization of Money (London: Institute of Economic Affairs, 1976). 19. See, for example, Leland B. Yeager, ed., In Search of a Monetary Constitution (Cambridge: Harvard University Press, 1962); James Buchanan, "Predictability: The Criterion of Monetary Constitutions," ibid., pp. 155-183; Milton Friedman, "Should There Be an Independent Monetary Authority?" ibid., pp. 219-243. 20. "Democrats in Senate Seek Federal Policy Shift," Wall Street Journal, August 4, 1982, p. 3.


CHAPTER 2

Fiat Money: Historical Perspective POLITICAL ISSUE AND MANIPULATING MONEY Manipulation of money can be dangerous, as many countries have learned. Money does indeed matter. The advantages of getting it right are less apparent to the public than the embarrassments of getting it wrong. Little wonder that some politicians in Europe, Asia, Latin America, and elsewhere are willing to get out of the money management business and join monetary unions and/or currency boards. We now know that the manipulation and pegging in the 1980s of various Asian currencies to hard currencies were not as stable as they looked. They were politically managed. And the politicians doing so lacked the courage to protect their value when the financial sector misused the foreign currencies that flowed into their countries. Unwillingness to do so has led to sharp declines in Asian currencies in the 1990s, the impoverishment of entire populations, and the threat of political and social unrest. The 1960s and 1970s did, in fact, underscore that control of the money supply is a powerful policy lever. The operation of the Bretton Woods Regime set up in 1944 and its stable rates of national currencies linked to the U.S. dollar, which in turn was linked to gold, depended very much on American willingness to go along and provide the neces-

16


sary stability. Following the collapse in the early 1970s of the Bretton Woods gold exchange standard, all currencies became fiat currencies. They are by definition "managed." Governments decide, by the right of their own judgments, how much or how little to create.

THE EARLY YEARS IN EUROPE The idea of manipulating money as a policy tool is old. Indeed, the first European experiment with paper bank notes occurred in Sweden from 1661 to 1664 when the Bank of Sweden issued notes based on a copper standard. When the copper was exported, however, issue of paper notes had to be discontinued. In England bank notes made their showing during the years of the Civil War and Commonwealth when many landowners and others transferred liquid cash to the custody of goldsmiths in London. The receipt evidence of money deposited with such goldsmiths became known as notes or bills, which were negotiable. Fiduciary money or currency, so-called because it rested entirely on trust and confidence and not in specie or deposit support, made its appearance in England during the reign of Charles II. It soon fell into disrepute when large quantities of royal paper exceeded anticipated revenues. The experience served to promote the belief that banking should be placed securely in private hands. As indeed it was with the grant of a charter for the Bank of England in May 1694. The distrust of the public for royal paper did not extend to that of the artfully engraved "bills" of the private Bank of England, which took upon itself the task of collecting from the royal revenues. The Bank thus cultivated the public's trust while its stock of gold and silver coin and bullion served as the country's reserve against all credit issues. And credit money in England became firmly established by the end of the seventeenth century. On the continent of Europe experiments with paper and credit money were not always successful. In fact, John Law's experiments in France with the idea that royal debts could be funded and excessive state expenditures paid by unregulated printing of paper currency without specie reserve ended in failure in 1720. This was the so-called "Mississippi Bubble." The experience served to convince many Europeans that the idea of paper money and indeed British monetary thought and practice on the subject left much to be desired.

Fiat Money: Historical Perspective

17

AMERICAN NINETEENTH-CENTURY MONETARY EXPERIENCE In America gold and silver were relatively scarce and barter common. In fact, during the American Revolutionary War, the Americans resorted to the issue of fiduciary money to pay for the war. Many veterans were paid off in land grants at the end of the war. The experience with a rapidly depreciating fiduciary currency and the political difficulties that went along with such depreciation prompted Americans to turn to gold and silver. Indeed, the American Constitution, while forbidding the separate states to issue their own currencies, did envision restricting the federal government to gold and silver or, in effect, specie. Such an arrangement was simply not feasible under the circumstances. Thus the First Bank of the United States, in existence 1791-1811, chartered to supply money, had on hand only about $2 million in specie, or probably less than half of the country's supply of gold and silver. The French revolutionary government's experiment with paper money or the assignats secured by lands confiscated from the French crown and church fared no better than the American. Indeed by 1795, the French government pushed for a return to a metallic standard. Throughout the turbulent Napoleonic period and thereafter the French public preferred specie to paper. In essence, French trust of their rulers is less than that of the British. Little wonder that French governments remain bullionist, constrained as they are by the preference of the French themselves. It is in American pre-Civil War experience that useful insights are obtained on various monetary arrangements.1 The monetary arrangements in place were based on gold and silver or specie. It was largely private and paper notes of hundreds of banks circulated in any American community. Some were "as good as specie"; some worth half their face value; some counterfeit. Indeed, the differences between "legitimate" paper issue was one of degree and not of kind. The existence of "bank-note detectors" suggests the nature of the "quality" problem with the circulating media.2 Undoubtedly, some counterfeiting went on—for why else counterfeit detectors? On the other hand, it was an easy matter to enter into legitimate banking during this period, so that legal "counterfeiting," which was preferable, made the illegal kind less widespread.3 The operations of "strictly private" bankers are not included in any official estimates of banking operations. They were not required to re-

18


port to any authority. In function the private bankers varied considerably and were usually somewhat different from chartered banks. They were not banks of issue, though they sometimes circumvented or openly violated laws against no issue. For example, the existence of "George Smith's money" is a case in point. These notes were issued by the Wisconsin Marine and Fire Insurance Company, which was controlled by George Smith. The company clearly had no right to issue circulating notes, but these notes were convertible into specie at all times with such absolute certainty that they passed at par everywhere, and for years constituted the best currency in the Northwest. The later development of private bankers in the deposit field can be partly attributed to the stricter regulations imposed on state banks by the various states. Moreover, counterfeit notes as well as those of broken banks, until discovered, added to the money supply and so tended to raise prices, imposing a self-administered tax on cash balances. The revenue, however, did not go to the government. It went to counterfeiters. Little wonder that the advantages of a uniform currency to the rapid development of industry and commerce in the United States were repeatedly underscored. Partly in response to the American public's demand for a uniform currency, and partly out of the Treasury's desperate need to meet war requirements, the federal government assumed its long-neglected Constitutional monetary powers, effected first in the Legal Tender Act of 1862 and then in the Sherman Act of 1863, establishing the National Bank System. They were exercised again in 1865, but less successfully, when Congress put a prohibitive tax on state bank notes in an effort to force state banks to shift to the national bank system. One result, of course, was to promote the use of deposits and checks by state banks and elsewhere. One can argue that the bank note problem was never the principal concern of reformers. For instance, while many state banks did make the shift to the National Bank System, a substantial and growing number did not, demonstrating that the bank note was not essential nor of great importance nor of great profit even when accounted to be of value as advertising.4 Difficulties in financing the war and concern over its unexpected duration were undoubtedly more important. The Treasury's standing policy in compliance with the Department of Treasury Act of 1846 of accepting payment in specie only, and its insistence that the first large war loan for which it arranged conform with its specie policy,


19

drained specie reserves. As a result, specie payments were suspended in December 1861. The Treasury thereafter insisted on payment in its own greenback notes authorized by the Legal Tender Act of 1862. Greenback notes, however, were not at first issued in a quantity adequate to handle large-scale sales of U.S. bonds. It was argued that issue of greenbacks should be restricted so as to limit bank reserves and further issues of bank notes. President Lincoln's Secretary of the Treasury, S. P. Chase, proposed a new, uniform currency backed by U.S. bonds to replace state bank notes. Congress would not even consider it. By 1863 matters were different. Victory appeared a long way off, and government expenditures were mounting. The ability of the Treasury to function under such conditions was seriously questioned. Chase's proposal for a unified national currency became attractive as a war measure. Even so, the bill was passed by only a narrow majority. The fact is that more of the provisions of the various banking legislation were really new. In one form or another they were already in practice in some states. American experience with private bank notes suggests also that poorer banks showed more interest in putting out notes and keeping them out. The better banks cultivated deposit business. From about 1850 on, deposits exceeded bank notes in public hands. One reason bank deposits received little interest in early reports is that the relationship between deposits and loans was hazy and often omitted from banking statistics. Bank notes, however, received considerable public attention. Public sentiment favored open banking with few of the restrictions of other businesses. Indeed, "free banking" was taken to mean, as pointed out by the Comptroller of New York in 1849, that anyone was freely permitted to embark in it, upon compliance with certain conditions. The early framers of American banking legislation insisted on differentiation of banks from corporations. In New York, for instance, attempts were made to designate "free banks" authorized as "associations" to differentiate them from corporations. The state constitution required to be valid any act of incorporation to be adopted by twothirds majority of all legislators—a majority that could not be obtained. The problem was avoided by substituting the world association for corporation. Subsequent New York court decisions cast doubt on the constitutionality of the distinction. A new state constitution defined corporation to include association.

20


Free banking in New York appeared to work well, as it did in the other northeastern states. Banks were free to issue notes in return for depositing bonds with the state as security for the notes. Apparently, established wealth and a generally conservative financial atmosphere accounted for its success. So too, in the South, banks in such centers as New Orleans were served. It was in the West and parts of the South, however, that the experiment went out of control, casting doubts on "free banking." Indeed, my own estimates suggest a respectable average reserve ratio for reporting banks of about 22 percent for the period 1834-1860. Even in the absence of required legal reserve requirements in some areas, it cannot be assumed that in practice banks maintained inadequate reserves. For instance, Clearing House banks in New York City maintained reserves of 20 percent against deposits in 1858, and raised this to 25 percent in 1862. As a matter of fact, from 1791 to 1811 the First Bank of the United States served to maintain the "quality" of bank notes, and from about 1820 to 1836 the Second Bank of the United States performed the same service; the Suffolk Bank of Boston did much the same for bank notes in New England almost up to the Civil War, while in the rest of the country currency conditions ranged from good to poor. Resentment and envy were created by the Bank of United States in its role as a depository of the Treasury and its self-assumed role of currency regulator. The bank kept pressure on the state banks' reserves, thus limiting their credit extension and expansion of the deposit and note liabilities. These feelings were reinforced by states' rights, fear of increasing federal power, and growing monopoly in the country's monetary arrangement. The stage was prepared for the struggle for monetary supremacy that has characterized a good deal of American monetary and financial history. One effect of this struggle was to generate considerable public uncertainty over money and the country's monetary system. Thus, the First Bank's charter was allowed to expire in 1811, and its offices became state banks. In 1814 a general suspension of specie occurred, and for the next five years American circulating bank notes (in terms of specie) left much to be desired. The Treasury found its operations made difficult, thanks to the varying rates of discount in the bank notes of state banks. These difficulties prompted another attempt at national banking. In 1816 the Second Bank of the United States was


21

chartered for twenty years. Once again the Bank collided with local banks and states' rights politicians. As we noted, the Suffolk Bank in Boston, which some people recommend as a model for a private monetary arrangement, served New England well as a regulator of currency. Unlike the Bank of the United States, however, which performed its regulatory function as the creditor of local banks, the Suffolk Bank, like the Federal Reserve Banks, performed its regulatory role as their debtor. Nor did the Suffolk Bank have its constitutionality challenged as did the Bank of the United States in 1819 in the now-celebrated Supreme Court decision in McCulloch v. Maryland. Its constitutionality assured, which its detractors denied, freed from prohibitory taxation by states in which it had offices, the Second Bank of the United States enjoyed a brief period of prosperity—a period during which it managed to improve the country's currency circulation while at the same time alienating important sections of government on whose goodwill its survival depended. This is an early illustration of the illusory nature of central bank independence. President Jackson's administration, which began in 1829, ushered in a new phase in the continuing and growing struggle for monetary supremacy. Matters were complicated by the fact that the Second Bank of the United States was located in Philadelphia, whose dominant economic role was overtaken by New York. Moreover, New York was the source of the bulk of Federal Customs receipts. These receipts went to Philadelphia for deposit, with the Second Bank providing considerable irritation to New York merchants and underscoring again the issues of states' rights. The issue was soon brought to national attention when Martin Van Buren, an influential New Yorker, became advisor to President Jackson. Since the Bank's charter was to expire in 1836, the New Yorkers set about getting the deposit of federal funds moved to New York City. This was not difficult to do in view of the political temper of the times. To be sure, the Bank's opponents on Wall Street kept their own counsel; the agrarian and states' rights interests and President Jackson were cultivated to their side. They won. In 1832 President Jackson vetoed the new charter passed by Congress. A few months later Jackson was reelected with a sizable majority. Anticipating the Bank's demise in 1836, Jackson began transferring government deposits to selected state banks. Thereafter came the Specie Circular of 1836, and the Deposit Act, which called for distribution of the federal surplus among the several

22


states. The distribution was to be made in 1837 in four installments. Only the first installment was paid in full, and within a year of the Van Buren administration the Treasury was in deficit more than $5 million. The New Yorkers, however, did not get their "big bank." Instead, the opponents of banking pushed through the Independent Treasury System. Under this system the banks were denied all federal deposits, the Treasury was required to hold all its funds in its own vaults in gold and silver, and all payments to and by the Treasury were required to be made in coin only. It is held by contemporaries and more recent students that the Second Bank of the United States (1816-1836) represented an early central bank that had three distinctive methods with which to exercise its discretionary authority and thus affect "favorably" the money supply:5 it was the depository of federal funds; it possessed numerous branches; it exercised "proper restraint" in its dealings as a private bank. By skillfully employing these methods, it is held, the Bank was able to wield control over state banks and through them over the money supply (defined as specie held by the public plus bank deposits and bank notes held by the public). The process of control was simplicity itself: the Bank merely presented the bank notes of the state banks for payment when they fell into its hands. Contemporaries emphasized that the health of the country's currency depended almost exclusively on this measure.6 As to the effects of these operations, evidence is presented that prior to 1834 state bank notes had been either driven out of circulation or made redeemable in specie. Thus, Bray Hammond, after defending the Second Bank, condemns President Jackson and his followers for their actions in eliminating the Bank. He judges it a costly blunder that was subsequently repudiated in the administrations of Abraham Lincoln, Woodrow Wilson, and Franklin Roosevelt. This is indeed a harsh and serious indictment of the Jacksonians. It is all the more serious since it is not at all clear that the Second Bank and its president, Nicholas Biddle, possessed the control over the money supply that Hammond and others attributed to them. In the first instance Hammond's argument in defense of discretionary monetary control exercised by the Second Bank is overdrawn. He argues that Biddle's conduct of the Bank was skillful and very careful.7 Biddle, he notes, was well aware of the delicacy and complexity of the American economy and acted accordingly.


23

It should be pointed out, however, that if the Second Bank could affect the money supply and the economy by "skillfully" employing the methods at its disposal, it could just as well affect the money supply and the economy by "unskillfully" employing the same methods. It does little for the defense of discretionary controls to argue that such controls will always, or even often, be employed "skillfully." And indeed there is little comfort to be found in the ability of "skillful" employment of discretionary controls even by so August a figure as Nicholas Biddle. Indeed, Hammond attributes Biddle's fall to four things: judgment, temper, calculation, and his predilection for easy money and the long-term capital market.8 Furthermore, even the methods available to the Second Bank for controlling the money supply are subject to several criticisms. In the first instance, the possession of numerous branches might simply have resulted in the circulation of the notes of the Second Bank instead of the notes of state banks. This does not mean that the availability of a relatively uniform currency might not have been economically advantageous. It does mean, however, that the possession of numerous branches is consistent with little or no effect on the total money supply. In the second instance, the exercise of "proper restraint" in its dealings as a private bank is asserted as a method for keeping state banks in debt to the Second Bank. By keeping state banks in debt, it is said, the Second Bank restricted their operations with threat of a call for specie. The serious employment to this method, however, would almost certainly have resulted in making the Second Bank a smaller institution. Indeed, if it made no loans and issued no notes it would simply go out of business. The real method of control over state banks seems to have stemmed from the Bank's position as a depository for federal funds, which amounted to more than $410 million during the entire period that the Second Bank held them. In its position as a federal depository, a state bank in all payments to the government had to satisfy the Bank of the United States that its notes were equivalent to specie before the government would receive them, and if the government refused them, a source of extensive circulation was closed. In this matter, the Bank could face a state bank with the alternative of operating on a speciepaying basis or having its business severely restricted and the credit of its notes destroyed. However, in order to see what the real effects of the Bank's actions were on the money supply, one must see what its effect was on interna-

24


tional economic movements. The reason for this becomes obvious when one recalls that the United States was on the international specie standard with fixed exchange rates. Under these circumstances a country's first monetary duty is to obey the well-known rules for the operation of that standard. There is little room indeed for a central bank—albeit a primitive one such as the Second Bank—to exercise discretionary authority and to pursue an independent course of action. Under a specie standard the exchange rates are fixed within specie points, with the result that the internal price level and income in the United States are at first determined by the external events. Thus the internal price level must be of a value relative to the external price level, such that payments, including capital flows balance. Consequently, the internal money supply is determined by external conditions, but its composition may be affected by internal monetary circumstances. A special explanation for domestic disturbances can arise only if internal prices move differently from external prices. Domestic conditions can affect the internal price level and incomes appreciably only insofar as they affect conditions of external balance. For example, suppose internal monetary (bank credit) expansion threatens suspension of specie payments. A price level sufficiently low relative to the external price level must occur so that a surplus will arise that finances the capital outflow. If the country is not on a specie standard and fixed exchange rates, the situation is different. Internal monetary changes affect income, price levels, and exchange rates. Income and internal price levels are no longer rigidly linked to external events. The primacy of external events on internal income and price levels is important because much of the monetary upheaval in the United States during the nineteenth century may have been simply manifestations of disturbances more fundamental in nature. Erratic capital flows into and out of the United States, which characterized important periods of the nineteenth century, are cases in point. The increase in capital inflows required an increase in the stock of money in the United States. The only question was how. An expansion of bank note issues and deposit credit would not be a reason for an increase in the money supply; it would be only one form of a rise that would have occurred in one way or another. And, of course, the opposite would occur for periods of world deflation and cessation of capital imports.


25

Consider, for instance, the sharp decline in the United States from 1839 to 1843.9 External prices also declined, and the required internal price fall in the United States was further intensified by the cessation of the capital inflow of earlier years and by some repatriation of foreign investment. This contraction had important effects on the banking structure of the United States, namely the destruction of the Second Bank in 1841 (then under Pennsylvania charter), a 25 percent decrease in the number of banks from 1840 to 1843, and about a 30 percent decrease in the stock of money. The collapse of the banking system was one of the forms by which an adjustment, forced by other circumstances, worked itself out. The price decline abroad, cessation of the large capital inflow of earlier years, repudiation of obligations, suspension of specie payments by some banks, and distrust both at home and abroad in the maintenance of the specie standard by the United States made a sizable decline in prices the only alternative to the abandonment of the specie standard and depreciation of the dollar relative to other currencies. Given the maintenance of the specie standard, such an adjustment was unavoidable; if it had not occurred partly through the banking collapse, it would have done so in some other way, for example, by the export of specie. Along with the rest of the country, the less developed areas such as the southern states of Alabama, Mississippi, Florida, Arkansas, Louisiana, Georgia, and the Carolinas contributed their share to readjustment by banking collapses and repudiation of both domestic and international debt. Reactions to these various necessary adjustments took many forms, including those already discussed. On the national level, Andrew Jackson's "hard currency" schemes and the Specie Circular of 1836 are perhaps the best illustrations of reaction against adjustments generated by external factors that required an expansion of the money stock in the United States.10 On the local levels, prohibition against banking in some states is characteristic of the extreme form reaction took to the necessary contraction in the money supply, which was partly manifested in the banking collapse of the later 1830s and early 1840s. Singularly harsh, these attempts are but examples of efforts to tighten the country's monetary straightjacket and to force its monetary radicals to dance to the tune of the specie standard. The amount of confusion and mischief spread by some historians and others who fail to grasp the realities of the specie standard game is best illustrated in the commotion over the Second Bank of the United

26


States. Arthur M. Schlesinger, Jr., for example, argues that the Second Bank was a menace to representative government, and its alleged destruction at the hands of Andrew Jackson fully justified.11 This eliminated, presumably, the concentration of power over loans and currency circulation from the hands of a relatively small group of men. Thus Professor Schlesinger would have us believe a dangerous obstacle to American economic expansion was removed. Bray Hammond, on the other hand, as noted, defends the Bank in a harsh and serious indictment of the Jacksonians. Much of the confusion arises out of the methods ostensibly available to the Second Bank for controlling the money supply. Some of the contemporary reviews attributed the direct "cause" of the rise in prices in 1834-1836 and subsequent difficulties to the operations of "speculators." Friends of the federal administration and supporters of the Second Bank of the United States freely exchanged acrimonious charges, each blaming the other for the country's economic plight. Others simply blamed all three, speculators as well as the two contestants for monetary supremacy. All groups agreed that something was "wrong" with the money system of the country, but, of course, disagreed what that "something" was. For example, the federal government emphasized "monopoly" in banking, and sought to eliminate such "monopoly" by the removal of government deposits from the Second Bank of the United States and by the elimination of the Bank as a national institution. In addition, government sought to institute a "hard currency" in the place of existing "bank rags," i.e., bank notes. The supporters of the Second Bank of the United States, on the other hand, argued that the new method of handling government deposits was the cause of the surplus that accumulated in the Treasury by 1836. The distribution of this surplus in 1837, they argued, precipitated the crisis of that year and the difficulties that followed. As a solution to the country's economic plight, they called for a recharter of the Second Bank, or a similar institution, the return of government deposits, and a "well-regulated" bank currency. The term well-regulated was usually interpreted to mean according to the "needs of trade." For almost a decade the struggle for monetary supremacy continued. And, of course, so did the uncertainty about the ultimate outcome. In respect to the struggle for monetary supremacy, it is worth emphasizing the contrast between the arithmetic and economics of the situation. The rapid rise in the internal stock of money, prices, and physical


27

volume of trade in the period 1834-1836 was coincident with the general external expansion. Coupled with the external expansion was the substantial inflow into the United States of both short-term and longterm capital. Although the capital inflow varied, owing partly to the uncertainty created by the struggle for monetary supremacy, it did not cease completely with the difficulties of 1837 but continued into 1839.12 Under these external conditions, internal adjustments were required on the part of the United States. The only question is how. If, for example, banks expand or contract their deposits and notes in circulation, this is not, under the assumed conditions, the reason the money supply rises or falls—it is only the form that is taken by a rise or fall that would have occurred one way or another. This is the difference between the arithmetic and the economics of a situation. Thus the withdrawal of government deposits from the Second Bank and the use of state banks as depositories for government funds may well have increased money, prices, and surplus in the Treasury, but only because external circumstances in the period required an internal expansion. As was indicated, this does not mean that internal disturbances cannot affect the money supply and prices; they can, but only insofar as they affect the conditions of external balance. It could be, for example, that the internal monetary expansion, coupled with the distribution of the surplus, threatened suspension. This, in turn, would have promoted a capital outflow that would be deflationary. During the period of suspension, 1837-1838, the situation in the United States was different. Internal monetary changes affected the internal price level, and through it the exchange rate, so the price level was no longer rigidly linked to external price levels. Although to a first approximation the changes in the internal stock of money were determined by the requirements of external balance, the particular way in which changes in the stock of money were achieved reflected domestic monetary influences. In conclusion, it is interesting to note that contrary to the views of contemporaries and those of more recent students, the monetary damage done by the initial struggle for monetary supremacy, and the uncertainty generated by making a large specie stock desirable, rather than producing too rapid a rise in the money supply, kept the money supply from rising too much as it otherwise would have. All of this, however, was played out against a background of fluctuating capital inflows and a specie standard with fixed exchange rates.

28


Accordingly and to a first approximation, it seems reasonable to conclude that the struggle for monetary supremacy was a surface manifestation of a deeper disturbance—the general worldwide expansion and subsequent contraction coupled with a substantial inflow of capital. The consequent adjustment to the external disturbance at first permitted the internal struggle to continue. For example, the capital inflow enabled the Second Bank to stand against the partisans of "hard currency." At the same time, the inflow of specie enabled the partisans of "hard currency" to press for the elimination of the Bank. However, the internal struggle set in motion forces that in themselves were important. American monetary experience underscores that monetary affairs are seldom left alone. Indeed, they readily become critical political issues of a very explosive nature. Proper institutional constraints are necessary. The international specie standard and fixed exchange rates seemed to keep the American experience within prescribed bounds. Even so, it did not always work well. NOTES 1. See for instance, George Macesich, "Sources of Monetary Disturbances in the U.S. 1834-45," Journal of Economic History, September 1960, pp. 407-434; T. D. Willet, "International Specie Flows and American Monetary Stability," Journal of Economic History, March 1968, pp. 28-50. 2. George Macesich, "Counterfeit Detectors and Pre-1860 Monetary Statistics," Journal of Southern History, May 1961, pp. 229-232. 3. See A. B. Hepburn, A History of Currency in the United States (New York: Macmillan Company, 1915). 4. Bray Hammond, "Banking before the Civil War," in Banking and Monetary Studies, ed. Deanne Carson (Homewood, 111.: R. D. Irwin, 1963), p. 14. 5. See, for example, R. C. H. Catterall, The Second Bank of the United States (Chicago: University of Chicago Press, 1903); and Bray Hammond, Banks and Politics in America (Princeton: Princeton University Press, 1957). The Second Bank operated after 1836 with a state of Pennsylvania charter. 6. H. O. Adams, Gallatin's Writings, 3 (Philadelphia: Lippincott, 1879), p. 336. 7. Hammond, Banks and Politics in America, p. 325. 8. Ibid., p. 534. 9. For a more detailed analysis, see Macesich, "Sources of Monetary Disturbances," pp. 467-434, and Macesich, "International Trade and U.S. Economic Development Revisited," Journal of Economic History, September 1961, pp. 384-385.


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10. See Harry N. Scheiber, "The Pet Banks in Jacksonian Politics and Finance, 1833-1841," Journal of Economic History, June 1963, pp. 196-214. 11. Arthur M. Schlesinger, Jr., Age of Jackson (Boston: Little, Brown and Company, 1945), pp. 115-131. 12. L. H. Jenks, The Migrations of British Capital to 1875 (New York: A. A. Knopf, 1927), Chapters 3-4.


CHAPTER 3

Muddling Through to a Fiat Monetary Regime: The Interwar Years BREAKDOWN Since World War I governments have steadily moved to destroy the popular notions that any individual has the right to convert paper fiat money into specie (gold and/or silver) for whatever purpose. During the war years convertibility was suspended owning to wartime requirements. Individual rights were secondary. Not only convertibility rights of individual citizens but also private holding of specie were more or less confiscated and placed in the vaults of central banks.1 The breakdown in international financial arrangements during World War I served to speed along the process toward a fiat monetary regime. Indeed, the war plans of the major powers called for an unlimited issue of paper notes. Nevertheless, their citizens remained trusting and essentially insensitive to the new situation into which they were thrust. Their expectations were that the war would be short if only because modern war was so expensive. The rashness of Austria-Hungary that precipitated hostilities soon placed Germany in the difficult position of coming to the aid of its hapless ally in need of constant financial, material, and military support.

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Both countries had suspended specie payments. Both were unable to obtain additional specie and commodities from abroad except through neutral Sweden and the Netherlands. By the end of 1914, the Reichsmark had depreciated 10 percent and the Austrian crown 16 percent on the Geneva exchange. By the end of 1915, the Reichsmark was down 20 percent, 34 percent by the end of 1916, and 50 percent by the middle of 1917. And by November 1918 and the war's end the Reichsmark stood at 40 percent of its 1914 value. More than a billion Reichsmarks in gold coin alone were withdrawn from circulation during the war years. German note issue increased from a prewar 2 billion Reichsmarks to 28.4 billion by November 1918. Wholesale prices registered 234 in November 1918 up from 105 in 1914 with a base of 100 for 1913. As the war continued more and more of the belligerents' gold stock found its way to neutral countries. The United States and Japan turned from prewar debtors into substantial creditors. Very soon the neutrals learned an obvious monetary lesson that the real value or purchasing power of a currency was not related in any way to its gold backing or "cover" but really to the quantity in circulation. The United States reluctantly found itself in a war it had hoped to avoid.2 Between January 1915 and March 1917 more than a billion dollars in gold entered the country. Most entered into the vaults of banks where it increased reserves and enabled credit expansion of several billion dollars. Inflation followed. Between 1914 and April 1917 wholesale prices increased by over 75 percent. Federal Reserve banks held more than $400 million in excess of required gold reserves. The potential for more price inflation prompted the authorities to freeze superfluous gold rather than allow it to expand note issue. The U.S. government had intended to concentrate gold in the Federal Reserve Banks. According to legislation put in place in 1917 Federal Reserve notes were to be issued for gold, and all member banks were required to keep their legal reserves in the form of deposits at the Reserve Banks. Gold circulation was discouraged and kept for settlement of international transactions. Indeed, it was considered unpatriotic to hold gold coin—a view first promoted by the Bank of England. In effect, the policy of the Federal Reserve and of the Treasury was to conserve gold and discourage its circulation during World War I and beyond. This is all the more surprising since the American gold stock

Muddling Through to a Fiat Monetary Regime: The Interwar Years

33

had risen to over $2 billion and 74 percent of the money supply in 1918 from $720 million and 28 percent of the money supply in 1916. The Bank of France had also been hoarding gold. It too called in gold coinage from circulation, insisted on payment in gold from its weaker allies, and only reluctantly paid in gold to its stronger allies. France too expected that war costs could be recovered by levying indemnities upon Germany and its allies. Given the experience of France after its defeats in 1815 and 1870 and the sums extracted from it, France considered it only reasonable and fair that the defeated do likewise. One consequence was that the primary method of financing the war had been advances by the Bank of France to the Finance Ministry. Accordingly, the Bank's note circulation increased from almost 7 billion francs in July 1914 to almost 30 billion francs in November 1918. Wholesale prices increased from 100 in 1914 to 300 in 1918. To their consternation the French felt duped by their government, which had called in their gold and sold them such vast amounts of paper securities. The Allies next turned to the German gold reserves as assets that were readily transferable now that the war was over. By November 30, 1918 the gold reserves of the Reichsbank contained the mark equivalent of more than £115 million according to the British Treasury. The amount of indemnities that Germany was to pay was announced by the Allied Reparations Commission on May 1, 1921. The amount was to be about 132 billion gold marks, or some $31.5 billion, clearly an impossible amount even for a prosperous pre-1914 Germany. Analysts quickly noted that the stipulation that reparations be paid in gold was unrealistic. In particular it was noted that more than onethird of the world's existing gold was already shipped to the United States and would not return. The French, however, insisted on gold payment with still vivid memories of the war indemnity they had paid in 1871. Concerned over the security of the reparations payments now owed to them, and the need to increase the value of French private gold hoards as well as to restore its prewar purchasing power against other commodities, France held firm to its demands. Very quickly the German mark began to depreciate. By the end of 1919 the mark had depreciated to 10 percent and the Austrian crown to 5 percent of their prewar gold parities on the Geneva exchange. As each new Allied pressure was applied to Germany, further depreciation occurred. From 1919 to the middle of 1922 Germany paid out an estimated 11 billion gold marks to meet international obligations. Of that

34


sum 1.25 billion marks were in gold, and the balance in varied types of securities. It was simply not enough to meet Allied demands. Efforts to revive the German economy failed. The fiscal measures taken failed to stop further depreciation of the mark. As its deterioration became progressive, the public expenditure of Germany continued to exceed its revenues. The Germans increasingly turned to the printing press. The government could pay for its expenditures simply by printing more currency and using it to make payments to those individuals and firms that were providing it with goods and services. In 1921 the German money supply began to grow rapidly and so did the price level.3 In 1923, the budgeting situation of the German government deteriorated even further. In early 1923 the French invaded the Ruhr because Germany failed to make its reparations payments. A general strike in the Ruhr then ensued to protest the French action, and the German government actively supported the workers by making payments to them. As a result, government expenditures climbed dramatically and the government printed currency at an even faster rate to finance this spending. The result of the explosion in the money supply was that the price level blasted off, leading to an inflation rate in 1923 that exceeded 1,000,000 percent. The German hyperinflation is certainly consistent with Milton Friedman's view that inflation is indeed a monetary phenomenon. It is, in fact, a controlled experiment. There was no third factor driving inflation and explosion in the German money supply. The invasion of the Ruhr and the printing of money to pay striking workers was an exogenous event. Obviously, the rise in German price level did not cause the French to invade as reverse causation would require. The German hyperinflation is also a good illustration of the political manipulation of the money supply. In effect, the German government actively supported the passive resistance to unpopular peace terms by printing money in order to pay the striking workers. The subsequent collapse of the German economy and society was predictable. For years the world would struggle to recover from the mistakes made at the Versailles Peace Conference in 1919. The European animosities and vindictiveness displayed at Versailles served to estrange many people, particularly Americans. A case in point are the German reparations and the debts of the Allies, which complicated the postwar recovery. The United States emphasized that it would not be a party to the German reparations settle-


35

ment nor would it ask for any enemy territory. On the other hand, the United States would not consider cancellation of war debts and loans it had advanced to the Allies. WAR DEBTS It is the war debts issue that severely strained relations between the United States and its former allies and among the allies themselves. The size and distribution of these debts indicates that the majority were owed to the United States, about $5 billion, and a little less than $5 billion to Great Britain. Any forgiveness of war debts would have placed the United States and Great Britain as major losers. All others, including France, would have gained. Little wonder that the United States and Great Britain did not look favorably on debt forgiveness. The reluctance of debtor allies to come forth with their obligations to creditors rested on receipts of reparations payments from Germany. If Germany could not or would not pay neither would France, Italy, and many other debtor countries. When Germany asked for a moratorium in its payments in 1921, the world's monetary and financial regime was cast in doubt. The economic policy of the United States, moreover, placed major obstacles in the way of repayment of loans.4 In view of its position as a major creditor nation, the United States should logically have increased its imports in order to enable other countries to earn dollars so as to service their debt to the United States. One important way, of course, is to lower American import tariffs. The United States did just the opposite; it increased tariffs in 1922 (Fordney-McCumber Tariff) and again in 1930 (Smoot-Hawley Tariff), thereby boosting protectionism to its highest levels in American history. The entire foreign trade and debt issue was further complicated by American insistence upon repayment of war debts for reasons noted above. High tariffs, however, meant that the United States did not welcome payment of war debts in goods. Moreover, there was not gold outside the United States for payment of debts. And as noted, Allied insistence that Germany pay reparations rested in part in their desire to use the proceeds to pay war debts to the United States. Improved arrangements known as the Dawes Plan (1924) and the Young Plan (1929) facilitated debt financing. The United States made concessions to its allies by lowering the rate of interest at which the war

36


debts accumulated. Between 1924 and 1929 all seemed to go quite well. Germany was able to make reparations payments and the allies to make war debt payments according to schedule. However, the entire debt arrangement was wobbly and indeed illusory. The fact is that American private investors were making large dollar loans to Germany. The Germans, in turn, used the dollars to pay reparations, and the allies used the dollars to pay war debts. In short, it appeared as though the United States was paying itself. Given the magnitudes involved, this was not correct, but it was used by those in favor of cancellation of debts to support their case. This international financial circus was brought to a sudden end by the Great Depression in 1929 when American loans to Germany ceased. German industry, however, had been reconstructed and strengthened, but democratic government in Germany had been undermined partly over the reparations issue. International relations among wartime allies as well as between Germany and its allies had become embittered. In effect, attempts to collect war debts and to make reparations payments proved to be one colossal failure. It was an experiment that was not to be repeated in the post-World War II period.

ATTEMPTS TO RESTORE THE ROLE OF GOLD An attempt was made to move from the fiat monetary regime back to gold owing in part to the serious problems between Great Britain and France regarding the settlement of wartime gold transfers and postwar dollar balances. The idea was to reconstruct the monetary regime in the form of the prewar "automatic" gold standard. As we have noted elsewhere in this study, the regime is simple enough to state. As prices in one country rose, its balance of trade would become unfavorable. The country would then be exposed to a gold drain. As the gold flowed out of the country its money supply would contract. The consequent pressures on the price level would be sufficient to restore the old equilibrium. And the converse would take place in the country receiving gold inflows. As a result, the international gold monetary regime would promote general stabilization and suitable adjustment of price levels in various countries and thus a national distribution of the monetary gold stock of the world. And all this would take place automatically with no need for its management.


37

Though the idea is simple enough to state, to put it into practice was an entirely different matter. If the international gold standard regime were to operate properly, the "flow of gold" or equivalent into the United States should have raised domestic American prices. Higher American prices would have made American goods and services more expensive relative to foreign goods and services, thereby increasing imports relative to exports in the United States. At the same time a rise in American domestic prices would have permitted adjustment in the international value of the British pound without the agonizing deflation that kept Great Britain in a monetary straightjacket between 1924 and 1931. The fact is, however, on price policy as on tariffs policy the United States undermined the "rules" of the gold standard regime. Stable domestic prices rather than stable international exchange rates was the goal pursued by the Federal Reserve System, thereby jeopardizing attempts to return to a gold standard regime. American failure to raise prices promoted the necessary shifts in world production. To the displeased London bankers anxious to regain their pre-1914 position in world finance, the years of dollar supremacy and the belief by many people that only the dollar was a real gold currency were at the very best a trial. It was simply assumed that Great Britain would return to the gold standard at the prewar parity of the pound. This was an article of faith. The Cunliffee Committee in 1918 estimated that the transition to normal monetary conditions would take some ten years. For such a restoration a difficult postwar deflation in Great Britain was to be accepted. It was also expected that the process of adjustment would be aided by further inflation in the United States. As we noted, this was not to be. The British were appalled to find that the Federal Reserve Board was simply not following accepted "rules of the game" of the gold standard game.5 The Americans did not expand to accommodate the British and the rest of the world. They simply calculated the requirements for internal domestic balance inflated accordingly and sterilized excess gold reserves. The Cunliffee Committee not only miscalculated American reaction but also misjudged internal British political events as to the acceptance of internal deflation for the sake of specie resumption at prewar par. The labor unrest that followed contributed in time to the disintegration of the British Empire. It will be recalled that J. M. Keynes since about 1924 advocated public works in a supporting role to monetary policy as an anti-defla-

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tionary device. From the behavior of the Bank of England and its determination to accept and enforce whatever price fluctuations were consistent, first with the return to gold at the prewar par and then with the maintenance of the gold standard at a fixed rate, Keynes became convinced that Great Britain would have to rely on means other than monetary policy to stabilize internal prices and output. Monetary disturbances led to variations in output through price changes and their influence on expectations of future prices. Keynes argued that the relation between current and future price influences investment decisions most. In a world of rapidly fluctuating prices, uncertainty on the part of businessmen would be so great that the government would have to undertake the investment necessary for growth and economic stability. Keynes thus moved from reliance on monetary policy to fiscal policy on grounds that it was politically unrealistic to expect a stable growth in the money supply. MONETARY COLLAPSE AND ITS CONSEQUENCES World money markets collapsed in May 1931, when the largest bank in Austria, the Credit-Anstalt, collapsed, a victim of the default on loans made to the depressed economies of Europe. From Vienna to Berlin to London and New York the catastrophe spread, German banks were sensitive to the Austrian money market owing to the fact that they had re-lent large sums borrowed on short term from London. The German situation, moreover, was already precarious because of the cutoff of American loans in 1929. During the early months of 1931, all foreign payments by Germans were suspended, with 10 billion Reichsmarks of short-term credit owed to foreign creditors, mostly London. Suspension of payments by Germany meant that British credits were frozen and could not be collected. Many foreigners, including central banks of countries operating on a gold exchange standard, held large short-term deposits in London. These depositors became alarmed and withdrew heavily from England. The Bank of England lost more than $200 in gold within two months after the German "freeze" in July. Indeed, between Wednesday and Saturday in the third week of September, $43 million in gold was lost. On September 20, 1931, the Bank of England suspended gold payments and Great Britain went off the gold standard.

Muddling Through to a Fiat Monetary Regime: The Interwar

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Many countries quickly followed Great Britain off the gold standard. Only France and the United States among the large nations and Switzerland, Belgium, and the Netherlands among the smaller nations remained on gold for the time being. France and the United States held most of the world gold surplus reserves. Indeed, the French gold reserves had been rising rapidly, from 5.9 billion (predevaluation) francs in June 1928 to 36.6 billion in June 1929, 43.9 billion in June 1930, 56.3 billion in June 1931, and 81.2 billion in June 1932. The French were not particularly disturbed that their actions in acquiring these gold reserves placed an additional deflationary burden on the rest of the world. In fact, the French commentators and public congratulated themselves for remaining "true" to the gold standard. Of course, one consequence was that as the prices of products of these countries began to fall relative to French and American products their export industries suffered, ushering in attempts to rescue their industries by creating even higher tariffs. But even France and the United States could not escape for long. By the end of June 1932 the United States lost nearly $2 billion in gold. Foreign withdrawals plus increasing domestic demand for gold caused by shrinking credit led to a gold crisis. More than 5,000 banks failed in the United States between 1930 and 1932. Following a temporary closing of all banks in March 1933, the United States suspended gold payments and for all practical purposes departed the gold standard in 1934. Belgium went off the gold standard in 1935, followed by France, Switzerland, and the Netherlands in 1936. The international financial and monetary structure erected over the course of a century prior to 1914 and so painfully "restored" following World War I collapsed within a decade or so after its restoration. With it perished worldwide economic solidarity and confidence in international solutions to economic problems. Beggar-thy-neighbor policies in the form of protective tariffs, import quotas, and exchange controls became the rule. Nationalistic solutions simply aggravated the depression, and month by month between January 1929 and June 1933, the volume of trade declined. As to why Americans could not or would not act as the Bank of England did in the gold standard regime years before 1914, we turn to the Federal Reserve's mistakes, blunders, and "ineptitude" in the 1920s and 1930s, which are discussed at some length by Milton Friedman and Anna J. Schwartz in A Monetary History of the United States, 1867-1960. The Federal Reserve's errors began when it failed to

40


tighten money in 1919. They were compounded when tight money was applied too late, too much, and far too long in 1920. To be sure, the American monetary authorities had an explanation of each. In 1919, monetary policy was still subordinate to Treasury needs. In 1920, when the gold reserve was under pressure, the rules of orthodox central banking and the gold standard called for tight money. During the middle twenties, the American money supply grew at a more or less regular rate, and the economy performed well. Toward the end of the twenties, however, monetary errors came with increasing frequency. It was at this point that Federal Reserve authorities made their biggest mistake by following a policy that was too easy to break the speculative boom and too tight to promote growth. This mistake was compounded by an exaggerated view of the importance of the stock market. Indeed, much more can be said about how the internecine squabble between the Federal Reserve Board and its New York bank inhibited effective measures to discourage speculation. Had the Federal Reserve authorities exercised their ample powers they could have cut short the tragic process of monetary deflation and banking collapse. They could have prevented the stock of money from contracting thereby avoiding the successive liquidity crises. As the Depression wore on more serious mistakes were made. Open-market purchases were entirely inadequate to turn the tide of deflation. Even worse, the monetary authorities, in order to protect the gold stock, made the unbelievable mistake of tightening money at the depth of the trough in October 1931 by raising the rediscount rate and by open-market sales. Given the premises and philosophy underlying American monetary policy, the Federal Reserve System had sooner or late to run into disaster. Except for Governor B. Strong of the Federal Reserve Bank of New York from 1923 to 1927, little attention was paid to the money stock by those who were formulating and executing monetary policy. The fact is that the overwhelming majority of the most respected and influential economists of the day believed wholeheartedly in the philosophy and policy that the Federal Reserve System followed in committing its worst mistakes. Orthodox monetary theorists were mesmerized by the gold standard, haunted by an almost pathological fear of inflation, shocked by amateur stock market speculation, and led astray by the "real bills" doctrine. When the bull market entered its most intense phase in 1927,


41

orthodox theorists urged the Federal Reserve System to tighten money in order to eliminate speculative activity. It is possible that the Federal Reserve System's mistakes are indeed as some authors argue. In the process of protecting the economy from exaggerated dangers, policymakers may have blundered into economic disaster. I would argue that the United States was simply unwilling to assume Great Britain's pre-1914 monetary role. President Roosevelt, for example, was not particularly keen on supporting any of the proposals of the World Economic Conference for a worldwide recovery plan. Politically, economically, and perhaps psychologically Americans were not prepared to take on the burden of stabilizer for the rest of the world. The climate of opinion has changed. The pursuit of fixed exchange rates and the gold standard, in part instrumental in past disasters, has given way to a more sophisticated version of international monetary theory. Theorists concentrating on international trade are more likely to consider the stock of money as a more significant factor than hitherto. To them, the forces determining the long-run rate of growth of real income are largely independent of the long-run rate of growth in the stock of money so long as both proceed fairly smoothly; however, marked instability of money is accompanied by instability of economic growth. Friedman and Schwartz describe it well when they say that money is "rather clearly the senior partner in longer-run movements and in major cyclical movements, and an equal partner in shorter-run and milder movements." America's neighbor Canada also came in for hard times.6 By 1931 the external situation as reflected in a deficit in the Canadian balance of payments took a turn for the worse. In order to keep the exchange rate fixed, a further contraction of money, prices, and income was necessary. Although the chartered banks lost gold and external assets in attempting to support the dollar, these efforts proved inadequate. Rather than continue the internal contraction required to preserve external balance, Canada departed formally from the gold standard in October 1931 and the exchange rate depreciated significantly in terms of the U.S. dollar. That the exchange depreciation alone failed to eliminate Canadian difficulties is indicated by the decline in economic activity that continued until March 1933, when a trough was reached. During this subperiod the stock of money declined by about 8 percent and prices by approximately 10 percent.

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The one particularly bright spot in Canadian experience during the period was that, contrary to the experience of the United States, the Candian banking system did not collapse under the economic adjustment of the period. The chartered banks continued to contract their operations despite government attempts in November 1932 to have them do otherwise by forcing the banks to borrow, under the provision of the Finance Act, $35 billion in Dominion notes at a cost of 3 percent. The measure did not achieve the desired results because the banks proceeded to reduce their indebtedness to the government. Its effects on the stock of money appear negligible. However, within a month of the attempts by the government to force chartered banks to expand, the premium on U.S. funds increased from 11 percent to 19 percent, reflecting a further depreciation of the Canadian dollar. The depreciation may be attributed in part to the uncertainty generated by the government's expansionary policy that replaced the policy of contraction. By such a reversal of policy the government in effect promoted expectations of price rises, and so of further exchange losses, thereby confirming public suspicion of its inability to maintain fixed exchange rates and to observe rules of the game for their preservation. The year 1934 brought an improvement in Canadian economic affairs. As a result of the depreciation, exports, which had started to recover in 1933, advanced markedly in 1934. Following the World Economic Conference, the government in 1934 attempted once more to increase the stock of money by expanding bank cash by some $53 million through the issue of Dominion notes but this time without gold backing. The government's justification for this measure was that the conference had changed the rules of the gold standard game. Canada, in this view, was safe in expanding without worrying about exchange rate depreciation as had occurred in 1932. In effect, Canada was now free to pursue an independent monetary policy. Internal monetary changes affected the price level and through it the exchange rate. The subsequent expansion was interrupted in 1938 when Canada again experienced a decline in its exports. The difficulties originated in the short but severe recession that developed in the United States in 1937; expansion in the American economy did not resume until the latter part of 1938, but Canada was fortunate in having other foreign markets for support.


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The declaration of war in September 1939 found the Canadian economy with a great deal of unused capacity. Employment was still below its 1929 peak and over 11 percent of the labor force was unemployed. As a result of the increased tempo of government expenditures, that gross national product with the first full year of the war rose to $6.7 billion, or by nearly 20 percent in terms of current prices. At the very outset the government adopted an expansionist monetary policy and the stock of money increased. The government's justification was that in view of the existing conditions of unused capacity in the country, such a policy could be continued without fear of inflation. Power to control foreign exchange and thereby forcing trade for war purposes was vested in the government's Foreign Exchange Control Board in September 1939. It marked the first time that government restriction had been placed on foreign transactions by private Canadian citizens. The stated objectives were to maintain exchange stability, conserve American dollars for the war effort, and prevent capital outflows. When the United Kingdom imposed exchange control in September 1939 in order to protect its dollar reserves and exchange rate, the multilateral exchange system that had existed in the prewar period broke down. Canada could no longer, as it had done in the 1930s, convert sterling earned from a recurring net credit with the United Kingdom into dollars in order to meet the recurring deficit with the United States. These measures, together with increased exports to the United States and attempts to increase American investment in Canada, did not prevent a serious deterioration in the country's dollar reserves in 1941. Following the Hyde Park Agreement in April 1941 and the integration of the Canadian and American economies for war production, a rapid expansion of Canadian reserves of dollars and gold occurred. By the end of 1945 Canadian holdings of American dollars and gold rose to $1.5 billion. The largely agricultural Balkan and Danubian countries of Europe, many of them formed as a result of the defunct Versailles Treaties ending World War I, including Yugoslavia, had fallen into desperate financial and economic straits as a result of the worldwide depression and financial crisis of the early 1930s. They needed manufactured goods, and Germany needed food and raw materials. Moreover, the Balkan and Danubian countries constituted a relatively secure source of food and raw materials in wartime. For the primary products, Germany paid high prices in terms of the local currencies. Payment was made, however, in

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"blocked marks," that is, marks that could be spent only in Germany. The Nazi war economy absorbed large quantities of imports and built up large debts to the Balkan and Danubian countries. Some crops were grown on special order under long-term contracts at guaranteed prices, thus reducing the agrarian countries to economic colonies of the imperialist Nazi system. To their chagrin, the Balkan and Danubian countries discovered that Germany had little to export of the things they wanted. Having been ensnared in the Nazi trap, they dared not protest too vigorously lest the Nazis repudiate their debts and discontinue buying the crops for which there was no alternative market. It is ironic that these poor agrarian countries, which were constant debtors and in need of capital, would have supplied large credits to Germany, thus occupying a position during the 1930s similar to that of the United States during the 1920s. Militarily and politically the agrarian countries were intimidated by the burgeoning Nazi war machine, which soon became the most powerful in the world. Such shabby treatment would have backfired in the long run and led to disruption of bilateral arrangements or to the absorption of the agrarian states into the Nazi political orbit. This was not to be. By the time the Balkan and Danubian countries realized how short their end of the deal with Germany would be, World War II broke out. A case in point is Yugoslavia.7 As a small developing country Yugoslavia's attempts to cope with the difficulties stemming from the Great Depression were limited. The government introduced a number of measures designed to reduce agricultural difficulties including a moratorium on present debt in 1932 and cancellation in 1936. This did little to resolve the country's fundamental difficulties that had their origins abroad. German reparations payments, for example, played an important role in the Yugoslav economy between 1919 and 1931.8 In this period reparations amounted to more than a half billion gold marks, or about 15 percent of Yugoslavia's tax receipts. The Germans delivered to Yugoslavia large quantities of railway equipment and machinery including industrial installations. The cessation of these reparations had singularly serious repercussions in the country's economy. Under the circumstances of the world situation Yugoslavia could do little to help itself. In spite of the expansion of the economy that had occurred during the 1920s, the country entered the Great Depression as primarily an agricultural and raw material producer highly sensitive to


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external forces and pressures. As in the United States in the 1830s, so in Yugoslavia in the 1930s external events dominated.9 The sharp decline in the United States in 1839-1843, for example, was produced by a cessation of capital imports and intensified by a decline in the external prices created by a worldwide depression. So in Yugoslavia in the 1930s a cessation of war reparations from Germany combined with an external decline brought about a sharp internal decline in Yugoslavia's economy. THE INTERWAR YEARS IN RETROSPECT The interwar period produced a coincidence of troubles that generated worldwide uncertainty, hostility, and suspicion, casting in doubt the ability of the principal world economic powers to preserve and maintain the international monetary regime and its associated monetary and financial framework. These circumstances served to further strengthen the drive to a fiat monetary regime. From the viewpoint of economic policy, control over the stock of money is indeed critical. Walter Bagehot has described it well, saying money will not control itself. So, too, did Friedman, Schwartz, and others in arguing that instability of money is accompanied by instability of economic growth. The fiction of "automaticity" of the pre-1914 gold standard was resorted to by central bankers to keep at bay politicians seeking to interfere with the formulation and execution of monetary policy by central bankers. The wisdom of such subterfuge leaves much to be desired. Fiat money received additional force in the idea that the power to print money is the power to tax. In representative democracies such power is typically vested in the people and their representatives. It is certainly not a special preserve for central bankers. Better that monetary policy is formulated and executed in the sunshine so that money behaves in a predictable fashion devoid of mystery even if that money is now fiat money. NOTES 1. See William Wisely, A Tool of Power: The Political History of Money (New York: John Wiley and Sons, 1977), p. 60. 2. For a detailed discussion of these and subsequent events see Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (Princeton: Princeton University Press, 1963).

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3. See Frank D. Graham, Exchange, Prices and Production in Hyperinflation Germany 1920-25 (Princeton: Princeton University Press, 1930). 4. See George Macesich, The International Monetary Economy and the Third World (New York: Praeger Publishers, 1981), pp. 26-35. 5. The fact is that apparently little attention appears to have been paid by countries to the rules of the gold standard game in the pre- and post-World War I period though the evidence is far from conclusive. See, for instance, Arthur I. Bloomfield, Monetary Policy under the International Gold Standard: 1880-1914 (New York: Federal Reserve Bank of New York, 1959) and Ragnar Nurkse, International Currency Experience (Geneva: League of Nations, 1944). 6. See George Macesich, "Supply and Demand for Money in Canada," in David Meiselman, z

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