Money and Monetary Regimes : Struggle for Monetary Supremacy 9780313075070, 9780275972189

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Money and Monetary Regimes : Struggle for Monetary Supremacy
 9780313075070, 9780275972189

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Money and Monetary Regimes

Money and Monetary Regimes Struggle for Monetary Supremacy

George Macesich

Library of Congress Cataloging-in-Publication Data Macesich, George, 1927– Money and monetary regimes : struggle for monetary supremacy / by George Macesich. p. cm. Includes bibliographical references and index. ISBN 0–275–97218–6 (alk. paper) 1. Monetary policy. 2. Money. 3. Monetary policy—United States. 4. Money—United States. I. Title. HG230.3.M332 2002 332.4—dc21 2001021162 British Library Cataloguing in Publication Data is available. Copyright © 2002 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: 2001021162 ISBN: 0–275–97218–6 First published in 2002 Praeger Publishers, 88 Post Road West, Westport, CT 06881 An imprint of Greenwood Publishing Group, Inc. 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

For George M.P. Macesich







Chapter 1

Past and Present Monetary Regimes


Chapter 2

Struggle for Monetary Supremacy: Early American Experience


Contemporary Experience: Fiat Monetary Regime


Chapter 4

Moving to a Fiat Monetary Regime


Chapter 5

A Theoretical Framework


Chapter 6

Inflation and the Monetary Regime


Chapter 7

A Role for Fiscal Policy


Chapter 8

Rational Expectations and Monetary Policy


Chapter 9

Constraining the Struggle for Monetary Supremacy: Cooperation Theory


Chapter 3



Selected Bibliography








Second Bank of the United States Loans and Discounts, 1833, 1834


Money Stock, National Income, Velocity, and Prices in the United States, 1834–1860


Proximate Determinants of Money Stock in the United States, 1834–1860



Most Significant Single Determinant



Correlations between Variables in Nominal Terms (Annual)


Correlations between Variables in Nominal Terms (Quarterly)



Correlations between Synchronous Variables



Relations between Variables Holding Price Level Constant (Annual)








Relations between Variables Holding Price Level Constant (Quarterly)



Correlation between Variables in Real Terms



Simple Correlation Coefficients between Lagged Variables


Simple Correlation Coefficients between Lead Variables


Regression Equations of Lagged Variables (Parts a–d)




5.10 Regression Equations of First Differences of Lagged Variables (Parts a–d)




Prisoner’s Dilemma: A = Developed-Creditor Nations; B = Developing-Debtor Nations




Myth, fact, and fancy tend to dominate discussions of monetary affairs. 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. This book provides insight into monetary and political problems as they appear in past and ongoing struggles for monetary supremacy in the United States and elsewhere. In an earlier book, Political Economy of Money: Emerging Fiat Monetary Regimes, I discuss the resurgence of interest in monetary affairs and the ability of central banks to deal with what Milton Friedman terms the “current unprecedented fiat monetary system.” To date, central bankers and the performance of central banks in the fiat monetary system remains 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 (specie) 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 central bankers and monetary authorities in general look at in considering monetary policy? This study argues that given the unprecedented fiat monetary regime that is now emerging, valuable lessons are provided by past and present struggles for monetary supremacy. In effect, the issue is control over the stock of money. Such a struggle generates uncertainty and casts doubt on the participants, on the monetary regime, and on the ability of money to connect the separate act of sale from the act of purchase. In the process, society is demonetized and pushed into barter with all of the inefficiencies that a barter economy entails. The failure of a common currency as reflected in the rise of barter makes nonsense of government tax collection and so fosters and promotes corruption and thus undermines good government. An avenue of escape from the inefficiencies of barter is for people to turn to another currency to save and price. In effect, the government in question forfeits its sovereignty over the country’s monetary regime and the stock of money. It also loses an important source of tax revenue gathered through its ability to print money. And, indeed, it is tax collection that is an important expression of the power struggle over monetary supremacy and control over the stock of money. When a country is under a specie (gold/silver) standard monetary regime with fixed exchange rates, 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. If a country is not on a specie standard and fixed exchange rates as in a fiat monetary regime, the situation is different. Internal monetary changes can affect income, price levels, and exchange rates. Income and internal price levels are no longer rigidly linked to external events. If people opt for a currency substitute for their own country’s currency by adopting the U.S. dollar as their medium of exchange, for example, they may well be participating in an illegal activity which serves to undermine their government’s monetary sovereignty. In still other countries, currencies are legally tied to the U.S. dollar through the medium of a “currency board.” By its adoption of a



“currency board,” the country surrenders its monetary sovereignty. In the final analysis, however, the “single currency,” whether the U.S. dollar or the European euro, or the Japanese yen, remains a part of a fiat monetary regime that is being managed in a discretionary manner by mortals subject to human error. The countries of Europe attempting to build democratic market-oriented economies with the ruins of communism underscore the issues discussed in this study. In Russia, for instance, the monetary struggle for supremacy between the central authorities and local governments has cast doubt on the monetary regime based on the ruble. The net effect is to so demonetize the country’s economy that the central authorities are pushed to accept taxes in nonmonetary form. In the process, sound government has been undermined and the transition to a democratic market economy made all the more difficult. Thanks to the growth of a barter economy and its natural murkiness, corruption has also grown. To be sure, inflation in many of the former socialist economies serves to promote barter. Matters are made all the more difficult for the transition process by weak property-rights arrangements underscoring the general absence of a rule of law in these countries. As for the other eleven European countries that have joined the Economic and Monetary Union and opted for the “euro” as a common currency, some observers believe that the several members have “not surrendered their monetary sovereignty.” The several central banks, so the argument goes, already had political independence by law, so there was no “sovereign” involved even prior to the adoption of the euro. According to these observers, politicians in European Community countries turned over monetary policy to their central banks in order to avoid having money fall into the political arena. Perhaps so, but still the euro remains a work in progress. It is certainly a unique experiment in that it pushes and promotes a single currency and monetary union before political union is achieved. It is also true that the gold (specie) standard regime managed to function internationally without achieving world political union. The most serious obstacle to the operation and indeed survival of this “current unprecedented fiat monetary system” or regime is the member nation–states with competing and often conflicting agendas. In short, nationalism may simply overwhelm the monetary regime. We have ample historical data in support of such a possibility. Is it possible to modify existing nation–state institutions and policies so that each participant nation–state in the fiat monetary regime acts as



in a free market to promote an end that was no part of its intention, as though led by the Smithian invisible hand? For useful insight this study turns to the theory of cooperation. I am indebted to many colleagues with whom I have discussed one or another aspect of this book over the years. These include Phillip Cagan, Marshall R. Colberg, Walter Macesich, Jr., David Meiselman, Milton Friedman, Anna J. Schwartz, Wilson E. Schmidt, Earl J. Hamilton, and Harry Johnson. I am also grateful to Karen Wells for preparing this manuscript for publication.

1 Past and Present Monetary Regimes

VARIETY OF REGIMES Past and Present Monetary Regimes

Monetary regimes in the world have a colorful history. These regimes have ranged from stone money to the current fiat money regimes. The better known are the specie (gold and/or silver) regime, under which domestic currency was convertible into specie, and the fiat (paper) regime. The specie regime, more or less, dominated until 1971. The fiat paper regime has come to be the world’s principal regime since 1971. Other regimes included: bimetallic standard (gold and silver); unimetallic gold or silver; gold exchange standard; and post–World War II Bretton Woods. Over the years government policy priorities changed from the earlier focus on domestic currency convertibility to that of general (macro) domestic economic stability. These changes were prompted by economic (and indeed political) problems during the interwar years particularly during the Great Depression of the 1930s. Although the post–World War II Bretton Woods regime with its adjustable-peg exchange rate arrangement maintained an indirect link with gold, the convertibility into gold was abandoned. Henceforth the goals would be internal domestic economic stability and especially “Full” employment. The net effect has been to set off the Great Inflation of the 1960s and 1970s. The experience prompted many monetary authorities worldwide to again emphasize the goal of low inflation and some sort of rules based monetary regime. Indeed, by the 1990s a rules oriented monetary regime became increasingly popular as a means for


Money and Monetary Regimes

restoring and preserving the creditability of monetary authorities and central banks.

A SUMMARY OF THE EVIDENCE We now have evidence on the performance of the several monetary regimes. To judge from this evidence it does appear that economic performance in the United Kingdom and the United States (two of the world’s major economies) was better under the classical specie (gold and/or silver) standard regime than under the managed fiat standard.1 For example, both price levels and real economic activity were more stable in the pre-1914 period under the specie (gold) standard regime than they have been in any period since. Accounting for much of the characteristically poor performance of this period was the unfortunate coincidence of troubles that produced the collapse of the international monetary and financial framework, as well as the subsequent deflation, real output instability, and high unemployment. These results underscore the profound political, philosophical, economic, and social changes that have occurred in the world since the early years of the twentieth century. According to Michael Bordo, during the period 1834–1913, there was a slight downward trend in price levels on the average of 0.14 percent per year.2 The exceptions to this trend were the sharp rise in prices during the early to mid-1830s, when substantial capital imports into the United States occurred, and the price rises again from 1861 to 1866 during the American Civil War, when the United States was off the gold standard. The rapid price deflation from 1869 to 1890 was necessitated in the first instance by the American return to the gold standard in 1879. In the period since World War I, price stability has not been at all characteristic. In fact, in the United Kingdom, the United States, and elsewhere, price levels have been rising on the average. Short periods of price stability have occurred only during the 1920s under the Gold Exchange Standard, during the 1950s, and during the early 1960s under the Bretton Woods System. From 1914 to 1979, price levels in the United States registered an annual increase of 2.2 percent, and in the United Kingdom they averaged an annual increase of 3.81 percent. The overall record, then, indicates more long-term price stability during the gold standard regimes era than in the years since departure from that standard. The tendency for price levels to revert toward

Past and Present Monetary Regimes


long-run stable value under the gold standard regime ensured a measure of predictability with respect to the value of money. There could be short-term price rises or declines; however, inflation or deflation would not continue. Long-term price stability encouraged people to enter into contracts with the expectation that changes in prices for commodities and production factors would reflect real changes, not changes in the value of money brought about by inflation or deflation. One consequence of the departure from the gold standard regime and the lack of constraint in general prices was to generate confusion (e.g., between changes in price levels and changes in relative prices). This confusion increased the possibility for people to misjudge market signals and thereby to incur major economic losses. The evidence on real per capita income for both the United States and the United Kingdom suggests that it too was more stable under the gold standard regime than it has been in any period since World War I. For the United States, the mean absolute values of percentage deviation of real per capita income from trend was 6.64 percent from 1879 to 1913, and 8.97 percent from 1919 to 1979, excluding 1941–1945. For the United Kingdom the figures were 2.14 percent from 1870 to 1913, and 3.75 percent from 1919 to 1979, excluding 1939–1945. Moreover, in the United Kingdom there was a permanent break in trend in 1919, so that in the subsequent years real per capita income was almost always below trend. Unemployment, too, was on the average lower in both the United States and the United Kingdom in the pre-1914 period than in the post-World War I period. In the United States, the average unemployment rate for the period 1890–1919 was 6.78 percent, and for the period 1919–1979, excluding 1941–1945, it was 7.46 percent. In the United Kingdom, the average unemployment rate over the period 1888–1913 was 4.30 percent, and for the period 1919–1979, excluding the World War II years, 1939–1945, it was 6.24 percent. The evidence thus tends to support the view that the classical gold standard regime is associated with more economic stability than the managed fiat monetary regime by which it was replaced. The problem with the comparison is that it includes the interwar period when the international monetary and financial organization collapsed. The evidence presented by Bordo takes this into account. Accordingly, three time periods were compared: the pre-World War I gold standard regime period, the interwar period, and the post-World War II


Money and Monetary Regimes

period. The war years themselves were omitted for comparison. Overall, prices were more variable under the gold standard regime than in both post-gold standard regime periods. The least variability occurred in the post-World War II period. In the United States, the average annual percentage change in prices for the period 1879–1913 was 0.1 percent, and the coefficient of variation of annual percentage changes in the price level was 17.0. For the United Kingdom, during the period 1870–1913, prices drifted downward at an annual percentage change of –0.7 percent and a coefficient of variation of 14.9. For the United Kingdom and the period 1919–1938, the average annual percentage change in prices was –4.6 percent with a coefficient of variation of 3.8. The post-World War II years (1946–1979) for the United States showed an average annual percentage rise in the price level of 2.8 percent with a coefficient of variation of 1.3. During the same period for the United Kingdom, the average annual percentage rise in prices was 5.6 percent with a coefficient of variation of 1.2. The stability of real output is suggested by the coefficient of variation of year-to-year percentage changes in real per capita output. The evidence for the United States suggests a coefficient of variation of 3.5 for the period 1879–1913; 5.5 for the period 1919–1940; and 1.6 for the period 1946–1979. For the United Kingdom, this coefficient is 2.5 for the period 1870–1913; 4.9 for the period 1919–1938; and 1.4 for the period 1946–1979. In summary, real output was considerably less stable in both countries during the interwar years than during the post-World War II years when both higher rates of inflation and lower variability in output and unemployment were registered. This demonstrates the apparent policy preference away from long-term price stability toward full employment and suggests the reason behind the strong inflationary pressures in the postwar years. It is on the basis of such evidence that the public recognized that a specie like monetary regime no longer existed and began to arrange its affairs accordingly. The evidence also suggests that a fiat monetary regime based on a monetary rule for steady monetary growth could provide the benefits of the gold standard without its costs. A prerequisite for success, however, is a firm commitment from the government to maintain a monetary rule and to incorporate long-run stability as one of its goals. In any case, the international gold regime cannot now be restored. It requires a return to the set of economic, political, and philosophical beliefs upon which that regime was based, which is unlikely. It is

Past and Present Monetary Regimes


probably easier to deprive the government altogether of its monopoly over money, although the magnitude of such a task should not be minimized. Because the sensitive issue of national sovereignty is involved, as well as for other reasons, governments will not voluntarily abdicate their power over money. Constraints imposed on national monetary sovereignty by the rules of the international gold standard regime have been eroding since the collapse of the international monetary system. Fumbling attempts to reimpose monetary constraints through international monetary reform since World War I have only served the cause of discretionary intervention and imposed tasks on the monetary system which it has been unable to attain. Attempts to reimpose monetary constraint have not been successful because the contemporary world differs radically from 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 the 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, though the collapse and repudiation of the Soviet system in Europe may represent an important turning point and improvement in the area of individual and property rights. Nevertheless, the objective of full employment and various social safety-net programs imply intervention and regulation. And the only mechanism presently available for this is the national state and bureaucracy, including the central bank. As we know, the penchant for bureaucracies for discretionary authority as a means of self-preservation and expansion is very strong. Nowhere is this more conclusive than in the 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 necessarily call for granting unimportant discretionary authority to the state bureaucracy, although extension of intervention has also promoted discretionary authority. Few monetary problems have ever been so ingeniously contrived to maximize difficulty as that of granting discretionary authority to central banks. Such authority, when granted to central banks over domestic monetary policies—undertaken for various and often illusive goals— constitutes a formidable reinforcement of nationalism in the economic


Money and Monetary Regimes

sphere and creates an important source of instability. At the same time, the discretionary authority serves the central bank well whose preference function may indeed differ significantly from that of the general public. Central banks are an economic arm of the political interventionist position, while admirably serving their own bureaucratic goals and interests. Central banks are subject to political pressures, and their typical response, in the absence of explicit constraints, is to manipulate money and monetary policy as a matter of bureaucratic survival. They are, after all, creatures of the national state. Little wonder that the Federal Reserve System stubbornly refuses to disclose the criteria it uses to decide when to pump more money into the economy to drive interest rates down or when to draw money out of the economy to drive rates up. It is this lack of clarity that is an important criticism of the Federal Reserve. One suspects that the Federal Reserve System along with many other central bank staffs and some economists do not use growth in the money supply in monetary policy deliberations. They appear to prefer to rely on the Phillips’s curve or atheoretical relations.3 The evidence provided by Gerald D. Dwyer, Jr. and R.W. Hafer suggests that minimizing the role of money and its growth is ill-advised indeed. In fact, their evidence underscores that there is a positive and close relation between the price level and money relative to real income. This relation holds for long as well as short periods of time for many countries. They note that the average rise in this relationship during the early 1990s appears to be transitory and not at all unusual when viewed in a larger context. Indeed, the argument advanced by some economists that there is no information in monetary aggregates is simply incorrect.

THE GOLD STANDARD MONETARY REGIME IN RETROSPECT The gold standard monetary regime is a historic creature whose origin and early practice is lost in the mists of time. It is a regime in which a given weight of gold is supreme as money and into which all other forms of money including government fiduciary paper, bank notes, and deposits is convertible. Over the years the institutions and practices that characterize the gold standard regime have undergone many changes. 4

Past and Present Monetary Regimes


Typically the gold standard regime included a national money unit defined in terms of a specific weight of gold. The national currency’s international value was determined by comparing it with another country’s currency. The exchange rate between the currencies was a fixed rate because the gold weight of each currency did not vary. Thus the link between various currencies was gold at a fixed price. Whenever international demand and supply of a national currency did not balance, gold flows would result. Under the gold standard regime it is not only new gold output but the inflows and outflows of gold related to the movement in a country’s balance payments that influences the size of the domestic money supply. If a country’s money supply increases, eventually the general level of prices increases making the country’s exports less attractive to foreigners while making imports more attractive to domestic consumers. And conversely for a decrease in a country’s money supply. Thanks to the automatic nature of the adjustment process, the size and duration of international balances tended to be self-limiting. In effect, gold flows had the effect of equalizing price movements across countries. Holders of non-gold substitutes under a gold standard and regime were able to convert their holdings into gold. As the gold standard regime evolved, efforts were made to economize on the use of gold. In time gold coins became an even smaller part of a country’s money supply. Indeed, after 1914 many countries ceased to coin gold altogether. This was the end of free coinage of gold, circulation of gold coins, and the legal tender of status of gold coins. Gold now was concentrated into a country’s international reserve available for international payments. Although non-gold money remained convertible, it was converted into gold bars. Thereafter the gold standard regime came to be known as the gold-bullion standard regime. With the adoption of the Bretton Woods agreements and the dollar– gold exchange standard regime, convertibility in the United States was restricted to foreign official institutions. These institutions held dollars for the purpose of intervention into foreign exchange markets with the expectation that dollars so held could be converted into gold on demand. This arrangement was satisfactory as long as the United States stood ready to convert such dollars into gold. Growing U.S. deficits and outflow of dollars and reluctance of foreigners to hold these additional dollars cast in doubt the dollar–gold exchange standard. Threatened with a drain of all its gold, the United States closed the gold window in 1971 effectively ending all convertibility of the dollar into gold.


Money and Monetary Regimes

Various arrangements to restore the fixed exchange rates followed in the post-1971 period with mixed results. These included various readjustments of currency parities raising the dollar price of gold to $38; in effect a devaluation of the dollar by almost 8 percent even though the dollar remained inconvertible. The dollar price of gold was further increased to $42 in 1973. Nevertheless, dollars continued to flow abroad leading to another crisis in March 1973. Thereafter the dollar pegged exchange rates were abandoned by the major industrial countries. Gold by itself lost its central role in international monetary arrangements with the International Monetary Fund’s Articles of Agreement modified. The official price of gold was abandoned along with par values, gold convertibility, and maintenance of gold value obligations. Gold standard regime supporters make various claims for the regime. It is, so they argue, the metal which has intrinsic value and so it serves as a standard of value for all other goods. Moreover, it is a useful store of value since new production adds very little to the existing stock. Thus prices denominated in gold will be relatively stable from year to year. Even if the gold regime includes other forms of money, the convertibility into gold at a fixed price will constrain the government from excessive money issues. To these advantages may be added long-term price stability, since the rate of increase in the gold supply would vary automatically with the profitability of producing gold. And, indeed, a key advantage of a gold standard regime is its longterm price stability. This facilitates long-term contracts. Short-term price movements, however, are another matter. To judge from the study by Anna J. Schwartz, price movements before World War I were characterized by short-term variability and trends. 5 There are, moreover, the resource costs imposed on the economy in operating a gold standard regime. These include costs to mining gold and the alternative uses to which gold can be put. A fully operational gold standard would, indeed, be free of political intervention. Governments, however, did not readily accept the gold regime’s required discipline and intervened whenever political authorities thought it necessary and advantageous. Once the discipline of the gold standard was cast aside countries turned readily to political expediency and to a discretionary fiat money regime with managed exchange rates. Efforts to resurrect the gold standard regime met with little success. In fact, the failure of the U.S. Gold Commission in 1982 to support a role for gold underscores the lack of commitment to the monetary discipline envisioned by a gold

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standard regime. 6 No country, apparently, is willing to serve as a reserve currency country and thus allow its currency to be converted into gold on demand. And political authorities are simply unwilling to abandon discretionary monetary policies in favor of rules-oriented regimes. This is true whether the regime at issue is gold or a fiat money regime. It may well be that the various gold standard regimes before World War I were generally acceptable, thanks to the special role of Britain, London, and the pound sterling. This role was challenged by France and Germany even before 1914. It was only a question of time before Paris and Berlin became as important as London to world finance. The post-World War II role for gold ended with the inability of the United States to preserve dollar convertibility into gold.

STRUGGLE FOR SUPREMACY There is general agreement that no problem has encountered more diversity of interpretation in democracies than the theory of money, monetary policy, and the monetary regime. The debates seem endless but they boil down to the issue: how best to consider money, monetary policy, and the monetary regime against the widespread argument for a liberal, freely functioning trading world and for fully employed, prosperous member countries. Can a democratic market system based on self-interest be entrusted to an unconstrained bureaucracy and political elite? Can an enlightened elite of bureaucratic managers realistically be expected to suppress their individual interest for the general interest? Can they manage a monetary regime within a majoritarian democracy so as to anchor the long-term price level? Can a democracy and market economy survive if they fail? The facts are that the authority of the state and its bureaucratic apparatus including monetary authorities has increased, presumably to provide satisfactory solutions to these problems. This expansion has been expedient but inglorious, necessary but dangerous, useful but costly. Along with this expansion has been renewed concern over the moral and social values underpinning the democratic market system. This has promoted renewed discussion of various theses regarding the viability of market society.7 Professor J.R. Hicks tells us that in his search for a workable monetary regime, John Maynard Keynes found in the General Theory the


Money and Monetary Regimes

labor standard regime and its dependence on society’s sociopolitical processes.8 This, in turn, translated into, among other things, a “managed monetary standard regime” and justification for its discretionary management by central monetary authorities composed of an “enlightened elite.” Keynes, of course, was well aware of the precariousness of efforts to calculate the course of human affairs.9 Man constructs institutions and arrangements that give the illusion of rational foresight and stability. General breakdowns do occur from time to time for that is the course of human events. With breakdowns come shattered illusions. Thus it is, for instance, that with breakdowns employment and enterprise suffer because decision makers seek refuge for their reserves of wealth in money itself. The human institution of money which serves as a vehicle for man’s endless journey into an uncertain future can thus be a source of disturbance by serving as a refuge for wealth. Indeed, Keynes’ General Theory for the most part deals with circumstances and institutions, particularly the institutions of money which man has built in his attempts to make the uncertain certain. Long before Keynes, Georg Simmel in his Philosophy of Money underscores that an “unmanaged” or “free” monetary regime was cast in doubt.10 He identifies two likely sources of trouble for a free monetary order. One source is that since individuals do not receive income in kind but rather in money, they are exposed to the uncertainties originating in fluctuations in the purchasing power of money. The other is that the very success of a free monetary order encourages the development of socialist or collectivist ideas which serve to undermine the individualistic order based on free markets and money. The existence of a growing body of evidence on the vote-maximizing behavior of politicians and politically induced cycles in such key variables as inflation, unemployment, government transfers, taxes, and monetary growth suggests the critical nature of the problem in democracy. The appeal to a central authority that the problem produces was discussed long ago by that shrewd observer of American democracy, Alexis de Tocqueville. 11 As early as the nineteenth century he observed that democracy could falter as a consequence of citizens’ diminished interest in restraining central authority. He noted that since democratic man would not be able to count on his neighbors for support he had an incentive to increase the power of the central authority. He was in a

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sense predicting the rise of the protective welfare state of the twentieth century. As a matter of fact, American founders did not really expect people to become absorbed in politics and public affairs because they themselves experienced politics as unpleasant, intrusive, and undignified. Whatever the founders may have felt about civic duty, they clearly did not feel that politics answered to man’s higher nature. James Madison not only distrusted but dreaded “interested majorities.” Indeed, he followed David Hume in demonstrating that liberty is best safeguarded in an expansive political territory because here the diversity of interest and attitudes precludes unity of popular action. Their project, the federal Constitution, is an exercise in constructing a government out of defective human parts. They believe that the urge to tyrannize others was so strong that external restraints became absolutely indispensable. The image of man in their discourse appears less than free and rational because his will and intelligence may be at the service of his “passions,” forces beyond himself that make self-control impossible.12 In both Federalist and anti-Federalist political factions a vague egalitarianism also led to a fear of elitism, “the artful and ever active aristocracy,” usurping the power that belonged to an unalert and passive people, and Walter Lippman put it succinctly when he informed Americans that the powers of the Constitution bequeathed to future generations of Americans a government of checks and balances. This study underscores the aspect of a government of checks and balances as it is manifested in the ongoing struggle for monetary supremacy in democratic societies. The struggle is over the exercise of discretionary authority in monetary affairs by vote-maximizing bureaucracies and political elites. If monetary uncertainty is to be reduced and long-term price stability activated, constraints must be placed on the exercise of such authority. These issues are deeply imbedded in traditional American ideology and experience. They are as important today as in the past in both old and new democracies. The various “solutions” have come protected by strong political, economic, and ideological interests. In part, the difficulties seem to arise from economic circumstances, theory, and methodology of the interwar and post–World War II 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.


Money and Monetary Regimes

And again, central to these issues is the perpetual disagreement over difused versus undifused or discretionary policy systems. On the one side, historically, are the monetarists or, more preferably quantity theorists, urging a policy system based on rules and nondiscretionary intervention into the economy. Its principal corollary is that a slow and steady rate of increase in the money supply—one in line with the real growth of the economy—can insure price stability. 13 On the other side of the issue are people whose preference is the administrative intervention to maintain aggregate demand in the economy. These include modern Keynesians and central bankers whose position is that defined policy systems are inferior to administrative discretion. In effect, the modern Keynesian position and that of central bankers does not involve a search for optimal decision rules for monetary (and fiscal) policy. Central bankers are more or less in accord since it is inconsistent with their view that the conduct of monetary policy is an “art” not to be encumbered by explicit policy rules. Essentially, the modern Keynesian approach is the economic branch of the political interventionist position whose defining principle is the extensive use of government power without definite guides or policy systems. It has important allies in central banks with whom it shares many banking school ideas. Its opponents, including monetarists (quantity theorists), are those seeking lawful policy systems and limitations on the undefined exercise of power by government. The difficulty with undefined policy systems is that they are in themselves uncertain and if followed could lead to very undesirable results. Discretionary policy formation requires that correct choices will be made and that the power to do so be granted to people who will make the correct decisions. Unfortunately, it is the very inability to make such choices in defined policy systems and for which such systems are rejected that we are now asked to vest discretionary authority with people who promise to accomplish the undefinable. The implication is that there is indeed an elite or priestly class that promises to accomplish the undefinable.14 Money, monetary policy, and the monetary regime, in effect, became the connecting link between two interacting systems: the economic and political. The manner in which they link is accomplished and its implications are a critical issue in the ongoing problem of macroeconomic stability. It is, moreover, central to the preservation of the market

Past and Present Monetary Regimes


system and political pluralism so basic to Western type economies. 15 It is fundamental to monetary reform. Thus, the fact that the Keynesian view takes the position that prices and wages are determined outside the system through sociopolitical processes has important implication. 16 These processes constitute, for the most part, an arbitrary exercise of power by bureaucracies and political elites. The power is arbitrary in the sense that its exercise is neither tempered by competitive market forces nor answerable to society as a whole. There is little to assure that under the circumstances the economy will respond appropriately to government manipulation of aggregate demand by monetary and fiscal policies. As a result, government must out of necessity participate in the formation of these prices and wages to assure a desired outcome. This will typically lead to price and wage controls creating or strengthening bureaucracies to administer them. Since wage and price controls inevitably fail, the system is increasingly driven into collective participatory planning where wages and prices are determined. One consequence is to enhance governmental and bureaucratic power and the interests of those whose preference is for the exercise of discretionary power. This will tend to be at the expense of arrangements whereby money and the monetary system are allowed to play a nondiscretionary and autonomous role within the constraints of a rules-based policy system. Such an outcome may indeed be desired by the bureaucracy and politicians. It is the recognition of such an outcome that prompts the extension of economic analysis to bureaucratic and political analysis. Thus, we have it from the theory of bureaucracy that we can expect central bankers not to take seriously theory and evidence that will constrain their activities. This has little to do with individual central bankers, many of whom are outstanding. At issue is the system itself and the incentives to which central bankers respond. Central bankers view their conduct of monetary policy as an “art” which leaves the policy system conveniently undefined and open to discretionary control. They will not voluntarily give up their discretionary authority for that of a monetary policy defined and constrained by the behavior of the money supply (or some other monetary aggregate) as urged by the monetarists. This is understandable. There is, after all, a problem of power and monetary supremacy. And power is the ability of its holder to exact compliance or obedience of other individuals to his will on whatever basis.


Money and Monetary Regimes

It is concern for its own power and prestige that prompts an agency such as a central bank to prefer discretionary policy systems. A policy defined and constrained by rules or performance criteria signals less power and prestige. For this reason, an agency prefers economic theories and models that support discretionary policy systems and shuns those that lead to defined optimal behavior of such instrumental variables as defined money supply functions. Scientific evidence that could lead to the imposition of explicit decision rules that would undermine its power is questioned, evaded, or ridiculed. With no “bottom line” or constraint the less likely it is that the agency can be demonstrated to have made serious errors. 17 Central banks as government agencies exercise discretionary policy. It is important to have an independent evaluation of their performance in terms of explicit criteria. Central banks are loath to accept this constraint, since they view the exercise of monetary policy as an “art” that cannot be defined or measured in terms of any single variable. Their preference is to discuss monetary policy in terms of unmeasured restraint, or else in terms of a set of nonequivalent measuring variables among which the interpreter is free to choose as he wishes. NOTES 1. See Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton: Princeton University Press for the National Bureau of Economic Research, 1963); 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); George Macesich, Monetary Policy and Politics: Rules versus Discretion (Westport, CT: Praeger, 1992); see also Anna J. Schwartz, “The U.S. Gold Commission and the Resurgence of Interest in a Return to the Gold Standard,” FSU Proceedings and Reports, Vol. 17, edited by George Macesich (Tallahassee: Florida State University/Center for Yugoslav American Studies, Research, and Exchanges, 1983). Dr. Schwartz was Executive Director of the U.S. Gold Commission. 2. Michael D. Bordo, “The Classical Gold Standard: Source Lessons for Today,” Monthly Review, Federal Reserve Bank of St. Louis (May 1981): 2–17; see also Michael Bordo and Hugh Rockoff, “The Gold Standard as a Good Housekeeping Seal of Approval,” Journal of Economic History, 56, no. 2 (June 1996) 389–428; Gary M. Waltron and Hugh Rockoff, History of the American Economy, 8th ed. (Orlando, FL: Harcourt Brace, 1998). 3. See Gerald D. Dwyer, Jr. and R.W. Hafer, “Are Money Growth and Inflation Still Related?” Economic Review, Federal Reserve Bank of Atlanta

Past and Present Monetary Regimes


(Second quarter, 1999): 32–43; see also Allan H. Melzer, “Monetarism: The Issues and the Outcome,” Atlantic Economic Journal (March 1998): 8–31. 4. For a discussion of the gold standard regime see Anna J. Schwartz, “Alternative Monetary Regimes: The Gold Standard,” Colin D. Campbell and William Dougan, eds., Alternative Monetary Regimes (Baltimore and London: The Johns Hopkins University Press, 1986), pp. 44–72; Report to the Congress of the Commission on the Role of Gold in the Domestic and International Monetary Systems, Vols. 1 and 2 (Washington, DC: The Secretary of the Treasury, March 4, 1982); Anna J. Schwartz, “Introduction,” A Retrospective on the Classical Gold Standard 1821–1931, Michael Bordo and Anna J. Schwartz, eds. (Chicago: University of Chicago Press, 1984); see also Milton Friedman, “Commodity-Reserve Currency,” Journal of Political Economy (June 1951): 203–32. 5. Anna J. Schwartz, “Alternative Monetary Regimes: The Gold Standard,” Colin D. Campbell and William Dougan, eds., Alternative Monetary Regimes (Baltimore and London: The John Hopkins University Press, 1986), p. 69. 6. Ibid., 71. 7. For a discussion of four conflicting theses about the market society see Albert Hirschman, “Rival Interpretations of Market Society: Civilization, Destructive, or Feeble?” Journal of Economic Literature (December, 1982): 1463–484. See also George Macesich, Money and Democracy (Westport, CT: Praeger, 1990), pp. 137–49. 8. John R. Hicks, “The Keynes Centenary: A Skeptical Follower,” The Economist (June 18, 1983): 17–19; John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace, and World, 1964). 9. G.L.S. Shackle, The Years of High Theory: Invention and Tradition in Economic Thought 1926–1939 (Cambridge: Cambridge University Press, 1983), pp. 149ff. 10. Georg Simmel, The Philosophy of Money. Translation by T. Bottomore and D. Frisby. Introduction by D. Frisby (London and Boston: Routledge and Kegan Paul, 1977, 1978). This study was first published in German in 1907. 11. Alexis de Tocqueville, Democracy in America (Garden City, NY: Doubleday, 1969). 12. For a discussion of these issues, see J.P. Diggins, The Lost Soul of American Politics: Virtue, Self-Interest and Foundations of Liberalism (New York: Basic Books, 1984) and Joyce Appleby, Capitalism and a New Social Order: The Republican Vision of the 1790s (New York: New York University Press, 1984). 13. Milton Friedman, “The Role of Monetary Policy” in The Optimum Quantity of Money and Other Essays, Milton Friedman, ed. (Chicago: Aldine, 1969), p. 99; see also George Macesich, Monetarism: Theory and Practice (New York: Praeger, 1983) as well as the bibliography cited in these studies. Friedman writes, “Personally, I do not like the term monetarism, I would


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prefer to talk simply about the quantity theory of money, but we can’t avoid usage that custom imposes on us,” in “Monetary Policy: Theory and Practice,” Journal of Money, Credit and Banking (February 1982): 101. 14. John M. Culbertson, Macroeconomic Theory and Stabilization Policy (New York: McGraw-Hill Book Company, 1968), p. 545. 15. See Assar Lindbeck, “Stabilization Policy with Endogenous Politicians” (Richard T. Ely Lecture), The American Economic Review (May, 1976): 1–19. 16. George Macesich, Monetarism, Theory and Policy (New York: Praeger, 1983), pp. 43–60. 17. For a discussion on these and related issues see John M. Cubertson, Macroeconomic Theory and Stabilization Policy (New York: McGraw-Hill, 1968), pp. 410–11; see also A. Downs, Inside Bureaucracy (Boston: Little Brown, 1967); Harry Johnson, “Problems of Efficiency in Monetary Management,” Journal of Political Economy (October 1968): 971–90; Keith Hebeson and John F. Chant, “Bureaucratic Theory and the Choice of Central Bank Goals: The Case of the Bank of Canada,” Journal of Money, Credit, and Banking (May 1973): 637–55; P. Selznik, “Foundation of the Theory of Organizations,” American Sociological Review 13 (1948), reprinted in F.E. Emery, ed., Systems Thinking (Harmondsworth: Penguin Books, 1969); O.F. Williamson, The Economics of Discretionary Behavior: Managerial Objectives in a Theory of the Firm (Chicago: Markham, 1964); Albert Bretton and Ronald Wintrobe, The Logic of Bureaucratic Conduct (Cambridge: Cambridge University Press, 1982); George Macesich, Money and Democracy (New York: Praeger, 1990).

2 Struggle for Monetary Supremacy: Early American Experience AN HISTORICAL PERSPECTIVE S tru ggl e for Mon etary Su premacy

The issues and problems that continue to dominate monetary affairs in the United States and elsewhere can best be examined by drawing on monetary history. This is especially true in the interaction of a given monetary regime and domestic events. Consider the important role in monetary policy given to the regional Federal Reserve Act of 1913. The Act of 1913 did not intend to concentrate monetary affairs in Washington. The Congress of 1913 tried to design a central bank that would not repeat the alleged mistakes of the First Bank of the United States (1791–1811) and the Second Bank of the United States (1816–1836). To this end the 1913 Congress tried to craft a central bank that would be insulated from political pressures but sensitive to regional concerns. As in the nineteenth century so in the twentieth century the 1913 Congress worried about the dominance of the national economy by New York banks and their presumed bias for foreign economic affairs. To this end they put in place a banking system that would remain independent of New York. They established twelve Federal Reserve districts, and chartered each federal bank separately. Each bank would be run by a mix of outside directors who would select a president and who decided on the discount rate. Indeed, it was not until 1935 that the Board of Governors in Washington was given any veto power over appointments made by local directors. It was, in fact, regional interests that were meant to be protected by the rule that each of the seven governors had to come from a different Federal Reserve District. Furthermore, the 1913 Congress attempted to protect regional interests by assigning the power to “rediscount” commercial bank loans to the various District Reserve Banks. Moreover, it was expected that the


Money and Monetary Regimes

discount rate would differ among the District Reserve Banks depending on local conditions. Congress continued to enhance the power of the regional banks at the expense of the central authorities in Washington well into the 1930s. In the early 1930s attempts were made by central authorities to add to their power at the expense of the District Reserve Banks. These attempts were thwarted by Senator Carter Glass and others. Indeed, in 1935 the Secretary of the Treasury and the Comptroller of the Currency were removed from both the Federal Reserve Board and the Open Market Committee. Senator Glass argued that when he was Secretary of Treasury he had too much influence on the Reserve Board and the Federal Reserve had to be safeguarded against future secretaries. The 1913 Congress went to considerable trouble to prevent dominance of the Federal Reserve by new banks and financiers. With the reforms of the 1930s Congress became increasingly concerned with the growing influence of Washington. By the 1990s concern about the dominance of monetary affairs by regional banks and authorities that Congress entrusted to serve to check and balance the central financial powers is indeed ironic. Conflict between the gold standard monetary regime requirements and domestic events is underscored in American experience in the post-World War I years. Thus, from 1923 to 1929 the Federal Reserve System offset inflows of gold by open-market purchases. Federal Reserve credit worked inversely with movements in the gold stock. France too did not allow gold inflows to effect its money stock and prices after returning to the gold standard regime in 1928. The Federal Reserve System again ignored gold standard regime requirements in 1929–1931 when gold inflows were not matched by an expansion of the U.S. money stock and indeed the money stock actually declined. In the years after 1934 both outflows and inflows of gold were not allowed to influence the money stock nor economic activity. When gold approached the minimum legal requirement, the minimum was lowered and eventually abolished. Henceforth, gold became a symbol rather than an effective constraint on domestic monetary authorities. In the Bretton Woods system years following World War II, no provision existed that required a country’s currency to be governed by its gold holdings as in the period before 1914, nor was there a requirement that a country had to undergo deflation or inflation to balance its external accounts. Domestic affairs henceforth became dominant in monetary policy formation and execution.

Struggle for Monetary Supremacy


THE TURBULENT 1830s AND 1840s It is, however, the turbulent 1830s and 1840s in the United States that perhaps best illustrate the struggle for monetary supremacy and the internal and external requirements of a specie (gold and silver) monetary regime. Consider briefly the main internal factors on the American domestic scene during these years. These factors arose for the most part from the struggle for monetary supremacy between the partisans of the Second Bank of the United States and the Federal Government. Though the internal disturbances may have been a manifestation of a disturbance more fundamental in nature such as the requirements of the specie monetary regime, they were undoubtedly important sources of short-term monetary uncertainty and in this way affected links between internal and external prices. 1 Early in the period the mint ratio of silver to gold changed from fifteen to one to sixteen to one affecting the condition of the gold supply in the United States. a. In 1833 the Second Bank of the United States lost its position as a key depository of federal funds. 2 This institution had been founded in 1816, with one of its functions to serve as banker to the Federal Government. Tax receipts, mainly from tariffs, were paid into the Second Bank through customs’ collectors in the form of bank notes of other banks. It was the consensus that the subsequent presentation or treat of presentation of these notes by the Second Bank for payment at the banks of issue constituted a continual check on overissue. Its loss of federal depository status thus initially ended its restraining influence over monetary expansion. The Federal Government, in turn, encouraged expansion by the newly selected depository banks.3 b. The Deposit Act, or Distribution of the Surplus Revenue Act passed in June 1836, called for the distribution of about $37 million to the several states on a per capita basis. The distribution was to be made in four equal installments on January 1837, April 1837, July 1837, and October 1837. The first two installments were transferred, the third was made payable in bank notes irrespective of quality, and the fourth was canceled. c. On July 11, 1836, the Treasury Department issued what is termed the “Specie Circular,” an order that agents for the sale of public lands should take in payment only specie, and should no longer receive the notes issued by banks. The Specie Circu-


Money and Monetary Regimes

lar was repealed in May 1838. The expected effect of the Deposit Act and the Specie Circular is that they ushered in a substantial shift in the “specie ballast” affecting bank reserves and ultimately the money supply. And, in addition, they increased domestic and foreign distrust in the ability of the United States to maintain the specie standard monetary regime. d. On May 10, 1837, the banks of New York City suspended specie payments, and they were shortly followed by banks in other parts of the country; resumption occurred from May through August 1838. The banks of Philadelphia suspended again on October 9, 1839 and did not resume effectively until March 1842; in this they were followed by others throughout the country. We should expect the initial effect to have been to prevent or postpone a contraction that would otherwise have occurred. e. During the period of suspension the new state bank depository arrangement for handling government funds was discredited. Following a period of political agitation a new arrangement for handling government funds was made. This arrangement was called the Independent Treasury System. The first use of the Independent Treasury System was short lived. The Act of July 4, 1840 was repealed on August 13, 1841. Thereafter and until 1846, bank notes were accepted by the Treasury and deposits of the Federal Government went to state banks on terms similar to those under which the transfer from the Second Bank had been made in 1833. We should expect that this operation had an expansionary effect on bank reserves and ultimately on the money supply. However, we should not expect the effect to be as pronounced as in the earlier period, since government deposits had become almost negligible.

INTERNAL FACTORS PROMOTING INSTABILITY IN EARLY AMERICAN MONETARY AFFAIRS I have suggested that internal factors discussed above can be linked to the struggle for monetary supremacy between the partisans of the Second Bank of the United States and the Federal Government and the requirements of the specie standard monetary regime. The partisans of the Second Bank attributed the expansion and subsequent contraction to the elimination by the Federal Government of the Second Bank both

Struggle for Monetary Supremacy


as a depository for federal funds and as a national institution. In effect, the partisans of the Second Bank argued that the Federal Government by its policies had at first promoted an autonomous increase in the money supply and later reversed itself and promoted an autonomous decrease in the money supply. Indeed, it is true that the Federal Government did at first encourage the new depository banks along with others to expand their operations. It is also true that the Federal Government shortly thereafter repudiated the new depository banks and the banking system in general by its issue of the Specie Circular. However, in the context of the external conditions and requirements of the specie standard monetary regime, which I have discussed elsewhere, the fact that banks expanded and later contracted their members, notes, and deposits was only partly the form taken by the expansion and subsequent contraction that would have occurred one way or another. Arithmetic aside, the economic significance of the internal factors in that they were important sources of short-term monetary uncertainty and this way affected the links between external and internal prices. For this reason consider these internal factors in more detail. The present examination of internal disturbances will take up briefly the Second Bank of the United States following 1833, Hard Currency Policy of the Federal Government, and the Deposit Act of 1836, in the order given.

Second Bank of the United States Contemporaries and more recent students of the subject attributed the expansion and subsequent contraction to the destruction of the Second Bank of the United States. It is not the purpose of this section to enter into a detailed analysis of this institution. This has been done elsewhere. The purpose, rather, is to examine briefly the claims by contemporaries and more recent students of the “favorable” effects wielded by the Second Bank on the country’s money supply over the period of this study. It is held by contemporaries and more recent students that the Second Bank had three distinctive methods with which to affect “favorably” the money supply:4 it was the depository of federal funds; it possessed numerous branches; and it exercised “proper restraint” in its dealings as a private bank. By skillfully employing these methods, it is held that the Second Bank was able to wield control over state banks and through


Money and Monetary Regimes

them ultimately on the money supply. The process of control was simplicity itself: the Second Bank merely presented the bank notes to the state banks for payment when they fell into its hands. Contemporaries emphasized that the stability of the country’s currency depended almost exclusively on this measure. 5 As to the effects of these operations, evidence is presented that state bank notes everywhere prior to 1834 had been either driven out of circulation or made redeemable in specie.6 However, all of this is consistent with the Second Bank leaving little or no effect on the money supply. That is to say, the views of contemporaries as well as those of more recent students are subject to several criticisms.7 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 a threat of a call for specie. However, the serious employment of this method 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 Second Bank’s position as a depository for federal funds. 8 In its position as a federal depository, state banks in all payments to the government had to satisfy the Second Bank that their 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 manner, the Second Bank could face a state bank with the alternative of operating on a specie-paying 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 Second Bank’s actions were on the money supply one must see what its effect was on international economic movements. The reason for this becomes clear when it is recalled that the United States was on the international specie standard monetary regime. In its effect on international economic movements, and thus on the money supply, the operations of the Second Bank seem to merit partic-

Struggle for Monetary Supremacy


ular attention only on two occasions over the period under review. The first is during the so-called “Bank War” in 1833–1834. The second is following the suspension of specie payments in 1837. The Bank War is particularly interesting. The actions of the Federal Government to deprive the Bank of federal deposits as well as its federal charter and the efforts of the Bank to dissuade the government from this course of action have seldom been paralleled in monetary history. Indeed, in many respects the course of events may be viewed as an early forerunner to the contests between central bankers and central governments in more recent history. With the appointment of new depository banks in 1833, the Second Bank lost its profitable monopoly and the Bank War began in earnest.9 The government deposits were not withdrawn at once. The deposits were allowed to run down in the normal course of government disbursement. The entire matter of deposits, however, soon fell into the political arena. Two secretaries of the treasury, Louis McLane and William Duane, were dropped by President Andrew Jackson before a more pliable secretary was obtained in the person of Roger B. Taney to implement the government’s policy. The Second Bank, in turn, began to curtail its operations in August 1833 with a view first to strengthening its position and second to forcing the return of government deposits and its re-chartering as a national institution. Table 2.1 presents evidence on the severity of the Second Bank’s contraction of loans and discounts. For the purpose of this study, the accumulation of specie by the Second Bank is even more significant. The sum was a little over $10 million at the beginning of August 1833. It was $15.5 million at the end of September 1834. It had never before reached within $4 million of that amount. The accumulation of specie by the Second Bank is highly relevant to international economic movements and thus to the money supply. In effect, the accumulation of specie was equivalent to a capital export. This means that the United States had to have a favorable balance, or less unfavorable one, in foreign trade sufficient to provide this specie. This in turn could be produced only by a lower price level in the United States relative to external price. The evidence seems consistent with this explanation. Thus there is a sharp drop in the United States commodity import surplus from 1833 to 1834 and an increase in specie imports along with a high ratio of import-to-export prices in the same period. The United States, however, was receiving capital imports during this period. It would seem that the above two positions are inconsistent.


Money and Monetary Regimes

Table 2.1 Second Bank of the United States Loans and Discounts, 1833, 1834 (in thousands of dollars)

They are not. It simply means that a larger specie supply was required to activate the adjustment mechanism of the specie standard monetary regime. By accumulating specie the Second Bank, in effect, offset part of the capital inflow and in this manner caused the money supply to decline, or rise relatively less than would otherwise have been the case. As one would expect the Second Bank’s contraction threw the country into an economic panic. For example, as early as November 1833, Nicholas Biddle had privately admitted that the Second Bank was “entirely beyond the reach of any mischief from the Treasury.”10 Relief committees traveled from one contestant to the other without obtaining the desired results. Indeed, the partisans of the Second Bank felt that the relief committees were rendering the Bank a valuable service by impressing the Federal Government with the bank’s importance. The panic was, however, short-lived and for the remainder of 1834 the economy was on the upswing. As a result of the so-called Bank War, the Second Bank of the United States was stripped of its monopoly powers. Quantitatively, moreover, the importance of the Second Bank decreased progressively over the period under review. For example, the ratio of loans and discounts of the Second Bank to total loans and discounts of all banks as well as the ratio of specie held by the Second Bank to total specie held by all banks declined steadily from 1834 to 1840. Furthermore, the Second Bank disclaimed any further “responsibility” for the conditions of the country’s currency. 11

Struggle for Monetary Supremacy


In conclusion, the Bank War showed that on occasion political circumstances independent of events in other sectors of the economy can be important in affecting a country’s money supply. Moreover, the Bank War is instructive for the light it sheds on the so-called “independence of a central bank.” This central bank, albeit a primitive one, saw its policies fail and its existence threatened when these policies were such that they opposed the policies of the central government.

The Hard Currency Policy and Deposit Act of 1836 With the destruction of the Second Bank of the United States as a source of power, the Federal Government undertook the first of a series of reforms whose object was to give the country a “hard currency.” The first of these reforms occurred on June 24, 1834 with passage of legislation changing the mint ratio from fifteen to one to sixteen to one. This legislation in effect overvalued gold vis-a-vis silver. In pressing for adoption of the new mint ratio, the government’s argument was that the new mint ratio would change the supply condition of gold in the United States. At the same time the government argued that the increased supply of gold currency would displace bank currency. Discussion prior to the adoption of the ratio of sixteen to one favored a single standard, and that silver. The reasons given for this preference were that contracts for many years had been based upon the silver dollar and that no exact adjustment of the bimetallic ratio could be maintained with any degree of permanence. Moreover, it was felt that the country could not get along without silver but could without gold by the use of sound bank currency. The Secretary of Treasury J. Ingham on May 4, 1830, in response to a resolution of the Senate on December 20, 1828, suggested that since it was desirable under his plan to have gold at a slight premium, the desirable exchange ratio would be 15.625 to 1. In May 1834 the banks in New York, under the lead of Albert Gallatin, then president of one of them, sent a memorial to Congress asking for the enactment of a law to coin gold at the rate of 23.76 grains of pure and 25.92 grains of standard metal to the dollar. This would have continued the fineness of coin at .916-2/3 (or 11/12) and since the silver dollar remained unchanged, would have resulted in a ratio of 15.625 to 1. They also asked that silver of the Latin American States and five franc pieces of France be made legal tender as well as Spanish dollars at their mint values. The silver coins of these countries had in fact become the chief elements in the specie circulation of the United States.


Money and Monetary Regimes

Representative C.P. White of New York, a key member of the House Committee studying gold and silver, remembered the adoption of 15.625 to 1 and .900 as standard fineness. But one week before the passage of the act, Representative White reversed himself and reported a bill which favored a gold rather than a silver standard by fixing a ratio of about sixteen to one. Consequently, the new mint ratio made the United States a competitor for the worlds’ stock of gold.12 The change in the mint ratio was accompanied by a concentrated effort on the part of the federal and state governments to suppress the issue of small denomination notes. Small denomination banknotes had, for the most part, the dubious distinction of possessing for many years the highest rates of depreciation in terms of specie. Although as early as 1832 it was recommended that bank notes of ten dollars and under be prohibited, the measure was finally passed in 1835. 13 On April 6, 1835, the Treasury notified collecting and receiving agents of public revenue that after November 10, 1835 they were not to receive in payment banknotes of any denomination less than five dollars.14 Moreover, on March 3, 1836, the denomination of banknotes not receivable in payment to the government was increased, effective July 4, 1836, to ten dollars. To reinforce the measures against small denomination banknotes, it was provided that no bank would be appointed by the federal government as a depository which issued notes in denominations of less than ten dollars. Unfortunately, it is difficult to know how successful these measures were since there is no information available on the quantity of these notes outstanding. The Federal Government was not satisfied, however, with the course of monetary affairs. A particular source of dissatisfaction to the government was the course that events had taken in the southern and western sections of the United States. In this period these sections of the country were literally doing a “land-office” business. It was, however, a business in which the Federal Government felt that it and small purchasers were as a matter of course being victimized. In order to protect itself as well as the smaller purchasers, the government implemented the third of its series of reforms to achieve a “hard currency.” On July 11, 1836, the Treasury Department issued what is termed the “Specie Circular.” This circular was an order instructing agents for the sale of public lands to take in payment only specie and no longer receive notes issued by banks. 15 Almost simultaneously Congress authorized that the surplus in the Treasury above $5 million be distributed among the states in proportion

Struggle for Monetary Supremacy


to their populations. The distribution was to be made in quarterly installments beginning January 1, 1837. This was the Deposit Act or “distribution of the surplus reserve.” At the time of passage of this bill, the surplus in the Treasury amounted to approximately $41 million.16 Contemporary reports underscore the concern within the commercial community.17 Trade relations between the West and Atlantic were in chaos. Europe was alarmed and the Bank of England concerned at the quantity of specie in the United States. Accounts describe specie moving in every direction in literal fulfillment of the Deposit Act. If we take the views of contemporaries seriously we should expect to observe the following: first, that the West and Southwest gained specie at the expense of the East; second, that bank discounts and loans in both the West and Southwest as well as East declined or at least leveled off; and third, that other parts of the country received government deposits at the expense of the principal eastern, western, and southwestern states. The evidence available for the country as a whole on an annual basis does suggest that from 1836 to 1837 the West and Southwest gained specie at the expense of the East.18 Except for two regions, western Indiana and eastern Pennsylvania, evidence for this period on a less than annual basis is almost unobtainable. The discounts of the State Bank of Indiana indicate that following a rapid increase in 1835 they leveled off at $2.7 million between the middle and the end of the year 1836 while simultaneously, circulation declined and specie increased.19 Pennsylvania information indicates that following the rapid expansion in 1834–1836, discounts and notes leveled off in mid-1836 while specie thereafter slightly increased.20 The first three transfers were made to the states. The fourth scheduled for October 1837 was canceled. Indeed, by October 1837, there was no surplus to transfer. The Treasury obtained authority to issue one-year notes to meet current expenses. Although the Deposit Act of 1836 was considered by the government funds in the various states, the states interpreted the measure as a straightforward distribution of funds. For example, Virginia in 1883 brought its case to the Supreme Court for its share of the fourth transfer. In summary, let us briefly recapitulate the internal disturbances discussed above. In effect, the Federal Government was seeking to maintain the specie standard monetary regime. But the ability of the Government, as expressed in the Specie Circular and Deposit Act, to do so was uncertain. The approximate origin of the increase in distrust


Money and Monetary Regimes

in the ability of the Government to maintain the specie standard monetary regime was probably the operation of the Deposit Act itself. Public misgivings about the maintenance of the specie standard monetary regime soon became intensified when it became clear that not all of the government’s depository banks would be able to meet the provisions of the Deposit Act. The attempts by depository banks in particular and by all banks in general to increase their specie reserve coupled with the firm refusal of the government to repeal the Specie Circular merely increased the suspicion and made desirable an increase in the public’s specie/money ratio.

THE ARITHMETIC AND ECONOMICS OF THE STRUGGLE FOR MONETARY SUPREMACY In 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 the physical volume of trade in the period from 1834 to 1836 was coincident with the general external expansion. Coupled with external expansion was the substantial inflow into the United States of both short-term and long-term capital. Although capital inflow varied—partly because of the uncertainty created by the struggle for monetary supremacy—it did not cease completely with the difficulties of 1837 but continued into 1839.21 During the period of suspension, 1837–1838, the situation in the United States was different. Internal monetary changes affected internal price levels, which affected the exchange rate, so internal price levels were no longer rigidly linked to external price levels. Although the changes in the internal stock of money were determined initially by the requirements of external balance, the particular way that changes in the money stock were achieved reflected domestic monetary influences. We may summarize the pre-1860 American monetary experience with a method devised by Phillip Cagan for analyzing changes in the money stock.22 Cagan views the stock of money as having three proximate determinants within an identity relationship. These are (1) high-powered money (specie), (2) the currency/money ratio (specie/money), and (3) the reserve ratio of specie to bank notes and bank deposits in public hands. The reserve ratio referred to is not a legal requirement set by monetary authorities but the existing ratio of re-

Struggle for Monetary Supremacy


serves to deposits. Because all high-powered money must be either currency in public hands or reserves held by banks, these variables account completely for changes in high-powered money, with shifts in the composition of cash balances being between currency and deposits and with changes in bank-created deposit and notes outstanding. Cagan has formulated these relationships into the following: M=

H C/M + R/D − (C/M) (R/D)


where M is the supply of money, H is high-powered money, C is currency, R is reserves, and D is deposits. The variation in M due to changes in the determinants may be calculated by the following formula: d ln M d ln H M(1−R/D) d(−C/M) M(1−C/M) = + + d(1R/D) dt H dt H dt


100 d 1n M yields the Multiplying each component of right hand-side by dt effect expressed as a percentage. The results of the investigation summarized in Tables 2.2 and 2.3 indicate that over the entire period 1834–1860, the most notable roles were played by, first, changes in the reserve ratio; second, changes in the specie/money ratio; and third, changes in high-powered money. In the index presented in Table 2.4 where 1 indicates least significant, the variables score as follows: H = 1.88; C/M = 1.92; R/D = 2.23. These results give substance to the concern raised by classical and neoclassical writers over internal monetary and banking stability, even though the disturbances themselves are basically of external origin and ones to which banks were reacting. Such concern ostensibly prompted both the passage of the National Bank Act of 1863 and subsequent significant Federal Government intervention into the economy. Financing of the Civil War by the Federal Government, however, may well have had a greater weight attached to it than requirements of banking reforms or provision for a uniform currency for the country. In conclusion, it is interesting to note that contrary to the views of many contemporaries 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 as much as it


Money and Monetary Regimes

Table 2.2 Money Stock, National Income, Velocity, and Prices in the United States, 1834–1860 (in thousands of dollars)

otherwise would have. All of this, however, was played out against the background of fluctuating capital imports and a specie standard monetary regime with fixed exchange rates. Accordingly, it seems reasonable to conclude that the internal struggle for monetary supremacy was a surface manifestation of a deeper disturbance—the general worldwide expansion and subsequent con-

Table 2.3 Proximate Determinants of Money Stock in the United States, 1834–1860


Money and Monetary Regimes

Table 2.4 Most Significant Single Determinant

traction 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 of the United States 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 forces in motion which within themselves were important.

Struggle for Monetary Supremacy


NOTES 1. See George Macesich, “Sources of Monetary Disturbances in the United States, 1834–1845,” Journal of Economic History (September, 1960): 407– 34. 2. At no time, however, was the Second Bank a sole depository for the government. At various outlying points, the Treasury and collectors of revenue had no choice but to use state banks. W.B. Smith, Economic Aspects of the Second Bank of the United States (Cambridge: Harvard University Press, 1953), p. 64. 3. Reports of the Secretary of Treasury of the United States (Washington: Blair, 1837), III, p. 369. 4. Ibid. 5. H.R. 460, 22nd Congress, 1st Session, p. 363, ed. H.O. Adams, Gallatin’s Writings (Philadelphia: Lippenkott, 1879), III, p. 336. 6. H.R. 358, 21st Congress, 1st Session, p. 18. 7. It should be pointed out here that if the Second Bank could affect the money supply by “skillfully” employing the above methods, it could just as well affect the money supply by “unskillfully” employing the same methods. 8. Total government deposits amounted to over $410 million during the entire period that the Second Bank held them. The importance of government deposits to the Second Bank may be seen from calculations made by Secretaries of Treasury Roger B. Taney and R.C.H. Catterall. Average government deposits estimated by Taney for every month from 1819 to 1833 amounted to over $6,717,253. Catterall computes the profits at 6 percent for the whole time that the Second Bank was a government depository. His computations indicate that the Second Bank was the gainer to the extent of $6,448,562.28. S.D. 16, 23d Congress, 1st Session, pp. 4–5, and R.C.H. Catterall, Second Bank of the United States (Chicago: University of Chicago Press, 1903), p. 475. 9. “The whole question of peace or war lies in the matter of Deposits [sic]. If they are withdrawn it is a declaration of war.” Biddle Papers (Washington, DC: Manuscript Division, Library of Congress, Biddle to Webster, April 10, 1833). 10. Biddle Papers, N. Biddle to VerpLanck, November 19, 1833. 11. As Biddle expressed it: “What is done at Tammany or at Washington is a matter of little importance to the Bank. The Bank is no longer responsible for the currency, and the people who now have charge of it are welcome to their experiments.” Biddle Papers, Biddle to Hamilton, February 1, 1834. 12. See J.L. Laughlin, History of Bimetallism in the United States (Chicago: University of Chicago Press, 1901) and Milton Friedman, Money Mischief: Episodes in Monetary History (New York: Harcourt, Brace, Jovanovich, 1992) especially Chaps. 3–7. 13. Reports of the Secretary of Treasury, III (1837), p. 678.


Money and Monetary Regimes

14. An act of Congress specified that the United States should not pay out bank notes of less than ten dollars after April 14, 1835 and less than twenty dollars after March 3, 1836. 15. Reports of the Secretary of the Treasury, III (1837), p. 764. In certain cases Virginia Script was acceptable. Moreover, indulgence was granted the small purchaser (320 acres) until December 15, 1836. 16. How in fact this large surplus accumulated in the Treasury may be seen from an examination of government receipts. These receipts show that proceeds from the sale of public lands were the largest item in the government income after custom receipts. The revenue from customs in 1834 was $16.2 million, $19.4 million in 1835, and $23.4 million in 1836. Annual receipts from government land sales averaged approximately $2.4 million in the ten-year period 1824–1833. From 1833 to 1834 land sales amounted to approximately $1 million. By 1835, however, receipts from land sales reached $14.8 million and in 1836 amounted to $24.9 million. In October 1835, total government deposits were approximately $18 million and in October 1836, $41 million. Reports of the Secretary of the Treasury, Vol. III (1829–1837). 17. New York Spectator, December 15, 1836. Open letter from N. Biddle to J.Q. Adams, November 11, 1836. See also E.G. Bourne, The History of the Surplus Revenue of 1837 (New York: G. P. Putnam and Sons, 1885). 18. Reports of the Secretary of the Treasury, Vol. III, and Comptroller of the Currency for 1876. 19. William F. Harding, “State Bank of Indiana,” Journal of Political Economy IV (1895): 1–36. 20. Anna J. Schwartz, “Pennsylvania Banking Statistics” (unpublished manuscript, National Bureau of Economic Research). 21. L.H. Jenks, The Migration of the British Capital to 1875 (New York: A. A. Knopf, 1927), Chaps. II–IV. 22. Phillip Cagan, Determinants and Effects of Changes in the Money Stock, 1875–1960 (New York: Columbia University Press, 1965).

3 Contemporary Experience: Fiat Monetary Regime


The current fiat monetary regime has its roots in the ongoing struggle for monetary supremacy in the years since World War I. There are domestic and foreign participants in this struggle all with their own agenda. They all agree that there is something wrong with this monetary regime but disagree on what that something is. This chapter reviews this struggle. Since 1971, when the Bretton Woods gold exchange standard regime came to an end, the world has been on a fiat monetary regime with various currencies managed according to the discretionary authority of their issuing countries.1 These currencies are variously “floated” or “fixed” to other currencies either rigidly or within “trading bands” or “crawling pegs.” Little agreement exists as to whether this or that currency is maintained at too high or at too low a level relative to other currencies. Many observers urge as a solution to the perceived global monetary disorder a single global currency where supply would adjust automatically to maintain a stable price level in internationally traded goods and services. In their view such an arrangement would eliminate currency risk and the various forces of currency arbitrage that have tempted market participants with sometimes disasterous consequences for the world economy.


Money and Monetary Regimes

Rightly or wrongly, the world is indebted to John Maynard Keynes for some of the major monetary developments in the post–World War II era. In his search for a workable monetary regime, Keynes found in the General Theory the labor standard and its dependence on society’s sociopolitical process.2 This, in turn, translated into, among other things, “a managed fiat monetary regime” and justification for its discretionary management by central monetary authorities. What sets Keynes apart from other monetary economists are his views on the conduct of monetary policy. Milton Friedman, for instance, writes that where he disagreed with the views Keynes expressed in Monetary Reform is with the appropriate method for achieving a stable price level. Keynes favored managed money and managed exchange rates—that is, discretionary control by monetary authorities.3 It is the exercise of discretionary policy by monetary authorities advocated by Keynes that underscores his differences with the “Quantity” theorists (monetarists) and Austrians. Setting aside the moentary role of gold as a “bararous relic” casts him in disagreement with the Austrians. His desire to place the execution of monetary policy at the discretion of public-spirited and competent civil servants set him in disagreement with Quantity theorists who argue for a growth rate rule for some definition of the money supply. Keynes may well be in our received monetary heritage. After all his work, Monetary Reform does draw on this heritage while at the same time adding to it. 4 It was also Keynes who told us in 1919 in his Economic Consequences of the Peace that there is no better means to overturn an existing social structure than to debauch the currency. 5 He also alleged that Lenin indeed espoused that the best way to overthrow the capitalist system was to debauch the currency. And, ironically, some can argue that it was also Keynes’ subsequent teaching that opened the floodgates of inflation in the post–World War II period even though he personally attempted to close these gates shortly before his death in 1946.6 Nevertheless, it is Keynes who made the revolt against the predominant nineteenth-century view of money respectable. Recall the nineteenth-century view of society’s responsibility to maintain trust and faith in money was supported by the bitter eighteenth-century experiences with paper currency excesses. Most classical economists and certainly the “Austrians” underscored society’s monetary responsibilities for preserving trust and faith in money. Indeed, the traditional view, in keeping with the spirit of the nineteenth-century tradition, is

Contemporary Experience


against the use of discretionary monetary policy for the purpsose of exploiting the presumed short-run nonneutrality of money in order to increase permanent employment and output by increasing the stock of money. Though an arbitrary increase in money, according to Georg Simmel, will not necessarily disrupt relative prices permanently, such manipulation sets into motion forces whose consequences for social stability are very serious indeed.7 Since no human power can guarantee against possible misuse of the money-issuing authority, to give such authority to government is to invite destruction of the social order. To avoid such temptation, it is best to tie paper money to a metal value established by law or the economy. 8 It is thanks to the “Austrian School” and through such members as Carl Menger, Georg Simmel, Ludwig von Mises, and Friedrich Hayek that useful insights are had into money and the monetary system as an integral part of the social structure. Their views differ significantly from both Keynesian and Quantity theorist (monetarist) views, though Friedman and some Quantity theorists come closer to the Austrians in their emphasis on “monetary rules” and a stable monetary order. According to the Austrian view, money and the monetary system is the unintended product of social evolution in much the same fashion as the legal system. Money is a social institution—a public good. It is not simply another durable good held in the form of “real balances” by utility-maximizing individual or profit-maximizing firms as Keynesian and Quantity theorist views hold. However useful the tools of demandand-supply applied to money as a private durable good, Keynesians and Quantity theorists miss the full consequences of monetary instability. In essence, the monetary system is an integral part of the social fabric whose threads include faith and trust, which makes possible the exercise of material choice and the development of human freedom. This is misunderstood by the very people who benefit from it. It is their misunderstanding of the social role of money as a critical element in the market mechanism and the needs for confidence in the stability of its purchasing power that came to dominate much of Keynesian and Quantity theorist monetary thought in the post–World War II period. This misunderstanding is the idealogical key to the use of discretionary monetary policies for monetary expansion as an unfailing means of increasing output and unemployment and reducing interest rates. Thus it is that during these years much of the criticism of the quantity–velocity formulation of the Quantity theory of money rests on challenging the basic assumptions underlying the theory, especially in


Money and Monetary Regimes

its rigid form. Neither velocity nor income nor transactions, it is argued, are stable. All are subject to rapid change even in very short periods of time. Velocity changes at times may be an even more important factor than the quantity of money in accounting for short-run changes in the level of prices. Another criticism deals with the passive nature of P, the level of prices. It is asserted that P, far from being passive, may in fact contribute to changes in other factors. For example, a rise in the level of prices may encourage people to dispose of their money for fear that its purchasing power will decline even further. Such disposals are registered in an increase in velocity. Moreover, under a specie (gold and silver) monetary regime a change in prices may affect the production of the monetary and the stock of money (M). A rising level of prices may increase the costs of producing specie and conversely for a falling level of prices. The net effect is that P is not necessarily passive and may even influence M—albeit after a considerable period of time. Milton Friedman’s reformulation of the Quantity theory of money freed it from dependence on the assumption of automatic full employment. The emphasis is on the role of money as an asset. He treats the demand for money as part of capital or wealth theory concerned with the composition of assets. On Friedman’s reformulation, it is important to distinguish between ultimate wealtholders, to whom money is one form in which they choose to hold their wealth, and enterprises to whom money is a producer’s goods, like machinery or inventories. Friedman identifies “monetarism” with the quantity theory of money, underscoring thereby that monetarism is not a new development.9 The principal tenet of “monetarism” as in the Quantity theory of money is that inflation is at all times and everywhere a monetary phenomenon. Its principal policy corollary is that only a slow and steady rate of increase in the money supply—one in line with the real growth of the economy—can ensure price level stability. It questions the doctrine advanced by Keynes that variations in government spending, taxes, and the national debt could stabilize both the price level and the real economy. The doctrine has come to be called “the Keynesian Revolution.” It is in this “Revolution” that Keynes, following Georg Friedrich Knapp, presents money and the monetary regime as a creation of the state and, as such, avoidable for manipulation by government consisting mostly of wise and well-educated people disinterestedly promoting

Contemporary Experience


the best interests of society.10 In essence, it is at best an elitist view of government so familiar to Great Britain at the turn of the century. David Laidler takes exception to Frankel’s argument that Keynes is the architect of a short-run monetary policy that seeks to exploit monetary illusion in order to trick people into taking actions which, if they could correctly foresee their consequence, they would not take. Such “trickery” is not the policy product of the 1930s when Keynes believed that undertaking an activist monetary policy to deal with unemployment would be what individual agents desired but were prevented from accomplishing on their own because of price and market mechanism failures. Keynes, in effect, thought he was dealing with the issue of involuntary unemployment. It was in the 1950s and 1960s that the idea of a stable inflation–unemployment trade-off generated a “money illusion” available for exploitation by policymakers.

COLLAPSE OF THE GOLD STANDARD MONETARY REGIME It may well be that Keynes became convinced very early on that Great Britain would have to rely on means other than monetary policy to stabilize internal prices and output. The Bank of England, the Cunliffee Committee, and their allies had won the struggle for monetary supremacy and the monetary regime that was put in place in Great Britain in the post–World War I period. It will be recalled that since 1924, Keynes had advocated public works in a supporting role to monetary policy as an anti-deflationary 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 the gold monetary regime at the pre-war par, and with the maintenance of the gold standard monetary regime at a fixed exchange—Keynes pushed for alternative solutions to Great Britain’s problems of prices and output. Monetary disturbances led to variations in output through price changes and their influence on the expectations of future prices. Keynes argued that the relation between current and future prices influences investment decisions the most. In a world of rapidly fluctuating prices, uncertainty by businessmen could be so great that the government could have to undertake the investment necessary for growth and economic stability. Keynes thus moved from reliance on


Money and Monetary Regimes

monetary policy to fiscal policy on the grounds that it was politically unrealistic to expect stable growth in the money supply. The struggle for monetary supremacy over the type of monetary regime that would be put in place in post–World War I Great Britain owes much to the country’s reluctance to come to terms with its diminished status on the world scene as well as with its persistence in pursuing a forlorn policy of first a return to gold at the pre-war par and then maintenance of the gold standard monetary regime at a fixed exchange rate. Confident that they knew best how to play the game, the British were reluctant to capitulate to the American dominance in international finance even if the latter were seriously willing to entertain such dominance. 11 British pride, prestige, and indeed the Empire were at stake. Neither the Bank of England nor a British government of any party would have been willing to accept responsibility for facilitating the smooth transfer of such power to the unexperienced and indifferent Americans. Nevertheless, the American role after 1918 was critical and required careful cultivation of the gold standard game if it was to be played with any hope of success. The distribution of gold reserves had changed dramatically. These reserves increased in the United States by $1.8 billion from $692 million in 1913 to more than $2.5 billion in 1921. By comparison, Great Britain’s reserves increased by $583 million in the same period. The situation for the major European industrial countries was less favorable. For example, France gained about $10 million in gold reserves during this period, and Germany lost about $18 million. The dollar’s supremacy on every European exchange, with free American coinage and no restrictions on either the import or export of gold, convinced many people that only the dollar was a real gold currency. Also, since the American resumption of specie payments in 1879, the price of gold had remained at around $20.67 per ounce. It is not surprising, therefore, that until 1925 the dollar served as an international standard against which all other currencies fluctuated. To the displeased London bankers, anxious to regain their 1914 position in world finance, the years of dollar supremacy were at the very best a trial. It was simply assumed that Great Britain would return to the gold standard of the prewar parity of the pound. This was an article of faith. In 1918, the Cunliffee Committee 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

Contemporary Experience


would be aided by further inflation in the United States. This was not to be. The British were appalled to find that the Federal Reserve Board was simply not following the accepted “rules of the game” of the gold standard. 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 (set aside) excess gold reserves. The Cunliffee Committee not only miscalculated the American reaction but also misjudged the internal British political response to the acceptance of internal deflation for the sake of specie resumption at prewar par. As events unfolded, the labor unrest that followed contributed to making existing problems for Britain even more difficult. The 1920s were indeed difficult with vast changes underway. Prior to World War I, Western Europe and particularly Great Britain had served as the center for a worldwide trading system financed largely through the London money market. This was no longer true. Europe no longer functioned as the world’s banker. Imports increased relative to exports to produce balance-of-payments difficulties for most European countries. Increased amounts of income for investments overseas went to pay for imports and left little income from which to advance capital loans to borrowing countries. At this point, the United States stepped in and replaced Europe as the world’s banker. Large American loans were readily extended to Germany during the 1920s. Now other countries also borrowed in the millions of dollars for reconstruction and development. Unfortunately for world trade and the international gold standard monetary regime, the United States did not qualify as a “sophisticated” world banker. American banks readily lent large sums; however, the economic policy of the United States placed major obstacles in the way of repayment of loans. In view of its status as a major creditor nation, the United States logically should have increased its imports to enable other countries to earn dollars to service their debt to the United States. One important way, of course, was to lower American tariffs. The United States did just the opposite; it increased tariffs in 1922 (the Fordney–McCumber tariff) and again in 1930 (the Smoot–Hawley tariff), thereby boosting protectionism to its highest levels in American history. Other countries temporarily paid the interest on their debts to the United States out of further loans rather than from increased productivity associated with foreign loans and shifts in world production.


Money and Monetary Regimes

The entire foreign trade and debt issue was further complicated by American insistence upon repayment of war debts. High tariffs, however, meant that the United States did not welcome payment of war debts in goods. Moreover, there was not enough gold outside the United States for payment of debts. Allied insistence that Germany pay war reparations rested in part on 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 debts accumulated. Between 1924 and 1929 all seemed to go quite well. Germany was able to make reparation payments and the allies were able to make war debt payments according to schedule. However, the entire arrangement was wobbly and illusory. The fact was that American private investors were making large dollar loans to Germany. The Germans, in turn, were using the dollars to pay reparations, and the allies were using the dollars to pay war debts. In short, it appeared as though the United States was paying itself. Given the magnitude involved, this was not the case, but it was used by those in favor of cancellation of debts to support their case. This international financial crisis was brought to a sudden end by the Great Depression of 1929 when American loans to Germany ceased. German industry had been reconstructed and strengthened, but democratic government in Germany had been undermined partly over the reparations issue. International relations among wartime allies had become embittered. In effect, attempts to collect war debts and to make reparations payments proved to be a colossal failure. It was an experiment that was not to be repeated in the post–World War II period. If the international gold standard monetary regime had operated properly, the “flow of gold” or its 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 adjustments to the international value of the British pound without the agonizing deflation that kept Britain in a straitjacket between 1924 and 1931. The fact is, however, that both on price policy and on tariffs policy, the United States focused primarily on domestic requirements and in the process undermined the requirements of the international gold

Contemporary Experience


standard monetary regime. Stable domestic prices rather than fixed exchange rates was the goal pursued by the Federal Reserve System, thereby casting in doubt the viability of the international gold standard monetary regime. The early victims of the wobbly world financial and economic structure were the countries producing foodstuffs and raw materials. In order to meet their balance of payments deficits, they threw wave after wave of products on world markets for whatever they could get. They cut down on imports wherever possible and pushed their exports in crumbling world markets. As the prices for their products declined, the real burden of their debts increased significantly. 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 because they had re-lent large sums borrowed for the short term from London. Moreover, the German situation 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 reichmarks of short-term credit owed to foreign creditors, mostly to London. Suspension of payments by Germany meant that British credits were frozen and could not be collected. Many foreigners, including the central banks of countries operating on a gold exchange standard monetary regime, held large short-term deposits in London. These depositors became alarmed and withdrew heavily from Britain. The Bank of England lost more than $200 million 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 monetary regime. Many countries quickly followed. For the time being only France and the United States, of the large nations, and Switzerland, Belgium, and the Netherlands, of the smaller nations, remained on gold. France and the United States held most of the world’s gold surplus reserves. Indeed, 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


Money and Monetary Regimes

deflationary burden on the rest of the world. In fact, French commentators and the public congratulated themselves for remaining “true” to the international gold standard monetary regime. 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 ever higher tariffs. 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 monetary regime in 1934. Belgium went off the gold standard monetary regime in 1935, followed by France, Switzerland, and the Netherlands in 1936. The international financial and monetary structure, which had been erected over the course of a century prior to 1914 and so painfully “restored” following World War I, collapsed within a decade after its restoration. With it perished worldwide economic solidarity and confidence in international solutions to economic problems. From that point onward, problems would be “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 from January 1929 to June 1933, the volume of world trade declined. Charles Kindleberger has aptly stated that “for the world economy to be stabilized, there has to be a stabilizer, one stabilizer.”12 Great Britain was unable to do it between the two world wars and the United States apparently could not or would not.

THE AMERICAN RESPONSE For the reasons why Americans could not, or would not, act as stabilizer for the world economy, attention should be turned to the Federal Reserve’s policies aimed at pursuing domestic objectives of stability. The Federal Reserve’s problems during the 1920s and 1930s are discussed at some length by Friedman and Anna Schwartz in their classic study of American monetary history. 13 Friedman and Schwartz

Contemporary Experience


note that the Federal Reserve’s errors began when it failed to tighten money in 1919 and 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 for 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 monetary regime called for tight money. During the mid-1920s, the American money supply grew at more or less a regular rate, and the economy performed well. However, near the end of the 1920s, monetary errors came with increasing frequency. It was at this point that Federal Reserve authorities made perhaps 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 squabbles between the Federal Reserve Board and its New York bank inhibited effective measures to discourage speculation. Had Federal Reserve authorities exercised their ample powers, they could have cut short the tragic process of monetary deflation and banking collapse. They also could have protected 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 ideas underlying American monetary policy, it was almost certain the Federal Reserve system would run into disaster sooner or later. Except for Governor B. Strong of the Federal Reserve Bank of New York in the years 1923–1927, little attention had been paid to the money stock by those 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 ideas and policy that the Federal Reserve system followed in committing its worst mistakes. Orthodox monetary theorists were mesmerized by the gold standard monetary regime, 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, orthodox theorists urged


Money and Monetary Regimes

the Federal Reserve system to tighten money in order to eliminate speculative activity. Some authors have argued that in the process of protecting the domestic economy from exaggerated dangers, policymakers may have blundered into economic disasters. I would argue that the United States was simply an unwilling stabilizer for the world economy. President Franklin D. 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.

NOTES 1. See Milton Friedman, Money Mischief: Episodes in Monetary History (New York: Harcourt, Brace, Jovanovich, 1992), especially Chap. 10. See also George Macesich, Political Economy of Money: Emerging Fiat Monetary Regime (Westport, CT: Praeger, 1999). 2. John R. Hicks, “The Keynes Centenary: A Skeptical Follower,” The Economist (June 18, 1983): 17–19. 3. Milton Friedman, “A Monetarist Reflects: The Keynes Centenary,” The Economist (June 4, 1983): 19. 4. John Maynard Keynes, Monetary Reform (London: Harcourt Brace, 1924). 5. John Maynard Keynes, The Economic Consequences of the Peace (London: Macmillan, 1920). 6. F.A. Hayek, “The Keynes Centenary: The Austrian Critique,” The Economist (June 11, 1983): 39. 7. See Georg Simmel, The Philosophy of Money (translation by T. Bottomore and D. Frisby; Introduction by D. Frisby) (London and Boston: Routledge and Kegan Paul, 1978). See also George Macesich, Money and Democracy (New York: Praeger, 1990). 8. S. Herbert Frankel, Two Philosophies of Money: The Conflict of Trust and Authority (New York: St. Martin’s, 1977), p. 92. 9. “I would say that personally, I do not like the term monetarism, writes Friedman, “I would prefer to talk simply about the Quantity Theory of money, but we can’t avoid the usages that custom imposes on us.” Milton Friedman, “Monetary Policy: Theory and Practice,” Journal of Money, Credit and Banking (February 1982): 101. 10. S. Herbert Frankel, Two Philosophies of Money: The Conflict of Trust and Authority (New York: St. Martin’s, 1977). See also review of Frankel’s

Contemporary Experience


study by David Laidler, in Journal of Economic Literature (June 1979): 570–72. 11. Apparently, little attention appears to have been paid to the rules of the gold standard monetary regime in the pre- and post-World War I period, though the evidence is far from conclusive. See Leland B. Yeager, International Monetary Relations: Theory, History, and Policy (New York: Harper & Row, 1966). 12. Charles Kindleberger, Wall Street Journal (October 23, 1979); Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton: Princeton University Press, 1963). 13. Milton Friedman and Anna J. Schwartz, A Monetary History in the United States, 1867–1960. National Bureau of Economic Research. Studies in Business Cycles, No. 12 (Princeton, NJ: Princeton University Press, 1963).

4 Moving to a Fiat Monetary Regime

THE ISSUE Moving to a Fiat Monetary Regime

It can be argued that the fiction of the “automaticity” of the pre-1914 gold standard monetary regime was resorted to by central bankers in order to keep at bay politicians seeking to interfere with the formulation and execution of monetary policy by central bankers. Of course, the wisdom of such a subterfuge leaves much to be desired. After all, the power is the power to tax. In representative democracies such power is typically vested in the people or their representatives. It is certainly not a special preserve for central bankers. It is better that monetary policy be formulated and executed in the sunshine so that money will behave in a predictable fashion devoid of mystery. The desires by central bankers to mystify money and to differentiate their product is understandable. Such desires, however, do not necessarily serve to create and perpetuate a stable monetary and financial framework, which the world has so desperately needed, especially in the interwar period and in the period since World War II as well. Failure of the British central bankers to let their public in on the deflationary policy scheme for the post–World War I period resulted in badly misjudging the internal British political situation and public acceptance of such a policy. This was subsequently compounded by misjudging American willingness to set aside domestic policy priorities in favor of playing according to the rules of the international gold monetary regime.


Money and Monetary Regimes

For all practical purposes, the Bank of England had been trying to invent magical monetary schemes that might somehow hold together the decaying British empire, even though its peoples were no longer willing to provide the resources for doing so. Turning to the United States to underwrite the British Empire was simply to misunderstand how full Americans were with Wilsonian ideals of self-determination for all nations and people. Such ideals are ill-suited for the perpetration of imperial power. John Maynard Keynes correctly judged these schemes as politically unacceptable and impracticable. Those already noted that as early as the mid-1920s, Keynes moved from reliance on monetary policy to reliance on fiscal policy on the grounds that it was politically unrealistic to expect a stable growth in the money supply. This is not too far from the beliefs of Milton Friedman and the Quantity theorists (monetarists) except that they express little confidence in the role that political authorities play in providing monetary stability and prefer that both monetary and fiscal authorities obey a fixed rule.

KEYNES’ EFFORTS Always pragmatic, Keynes adapted his monetary and economic ideas to fit the times. As a monetary economist, Keynes was looking for a monetary standard or regime that could be workable. In the Treatise on Money (1930), he was critical of the restored international gold monetary regime in the post–World War I era. His criticism was directed toward attempts to make the gold standard monetary regime work as it had been reinstituted. He was, however, seeking to make it work.1 By the 1930s and into World War II, he was still searching for a reformed monetary regime that would be workable as we know from his work in the creation of the International Monetary Fund. Where in relation to Keynes’ search for a reformed monetary regime stands his General Theory of 1936? Certainly the years when the book was being written were years of monetary upheaval. The monetary crisis was indeed due to an inadequacy in the supply of base money, consisting of gold, as many economists during and since the crisis have argued. This is certainly consistent with what Keynes was to call a rise in liquidity preference. In effect, there was not enough base money for the banking system to be able to come to the rescue. Subsequent devaluation of the pound sterling and dollar in 1931 and 1933, respec-

Moving to a Fiat Monetary Regime


tively, removed the monetary constraint against expansion, John R. Hicks argues. How far would be safe to allow such an expansion to go? This was the point, argues Hicks, where the revolution in Keynes’ own thinking occurred. It was here that he had to pass from consideration of the monetary regime to consideration of the real economy and which Hicks feels Keynes was on less secure grounds. Hicks argues that it is indeed true that long before Keynes wrote the General Theory he had been turning that way. His Treatise (1930) had been narrowly money; it was concerned with price levels and with their variations, not with output and unemployment. But even before he finished the Treatise, notes Hicks, Keynes was claiming he knew how to “conquer unemployment.” That the prescription Keynes was offering in his 1928 pamphlets would have involved a devaluation of sterling is, Hicks argues, a consequence he would not have refused. Keynes was, of course, aware that focusing on unemployment could be a dangerous target. Given the need between 1928 to 1935 to conquer unemployment, he was quite willing to do so. Keynes defined “full unemployment” as the maximum that could be reached by expansionary measures even though some residue of unemployment would still be out of reach to such measures. Hicks calls unemployment curable along lines as “Keynesian unemployment.” In working out this theory, Keynes was assisted by assuming that the level of money wages is in practice rather rigid. This was not an assumption which he accepted for benefit of the General Theory. It is, in fact, a belief that goes back at least to 1925 and his attack on the British return to the international gold standard monetary regime at the old parity. And, indeed, Hicks argues that it was in relation to the then existing level of money wages that Keynes was claiming that the British pound sterling, after April 1925, was overvalued. There is in fact little doubt in the minds of many observers that during the 1920s and 1930s, the wage level in Britain was becoming more “sticky” in money terms. Hicks goes on to argue, however, that when one considers the great variations, both upward and downward that occurred in 1918–1921 to have laid such stress upon rigidity, when rigidity had set in so recently does seem peculiar. 2 To be sure the tasks for economists and economics become much easier if we assume that wages are not only constant but rigid. It must be supposed that in conditions of “Keynesian unemployment” the wage level, as Hicks points out, must be rigid so it is unaffected by changes


Money and Monetary Regimes

in other variables. Thus, it is, argues Hicks, “the Keynes model is not just formally expressed in wage units; it is on a labour standard—a labour standard expresses the value of money in terms of labour, just as the gold standard expressed it in terms of gold.”3 Under the gold standard monetary regime, central banks stood ready to exchange money for as long as their gold resources lasted. Under normal conditions and with care such conversions could continue without endangering the standard. The trouble with the labor standard, of course, is that it has no reserves. There is no bank, no authority, which can guarantee the convertibility of money and labor. It is for this reason, argues Hicks, that it is only a pseudostandard. For it is the labor standard that is the “major weakness of the Keynes theory and of the policies that had been based on it.” 4 If indeed the monetary system adjusted itself to the level of money wages as envisioned in the General Theory, then sociopolitical forces gain in power relative to the economic forces. Among these forces are included, of course, labor unions. Others, as Hicks underscores, include the behavior of prices of the goods on which wages are spent. Since it is real wages in which labor unions and their members are interested, we have in the making of a vicious circle of rising prices and wages all too familiar in the post–World War II period. For all practical purposes we have in place a fiat monetary regime without constraints. In effect, we have no anchor for the long-term price level. In his search for a workable monetary regime, Keynes founded in the General Theory, according to Hicks, the labor standard and its dependence on society’s sociopolitical processes. Because of other things, this translated into a “managed monetary standard” and justification for its discretionary management by central monetary authorities composed of an “enlightened elite.” Keynes’ efforts were translated into a fiat monetary regime and yielded readily to discretionary monetary manipulation by authorities. The consequent monetary uncertainty generated by such manipulation has had the effect on balance of casting doubt on the credibility of these authorities, their policies, and ultimately on the fiat monetary regime itself. In the process, the long-term price level has lost its anchor. These are only the more obvious unintended consequences of Keynes’ efforts. The unintended consequences of Keynes’ search for a workable monetary regime are but another illustration of the struggle over monetary regimes in history and the unintended effects of human actions and decision which have had perverse effects. The best intentional

Moving to a Fiat Monetary Regime


changes do at time lead, via unintended consequences, to undesirable results. Keynes’ efforts are no exception. Indeed, the idea that the unintended effects of human actions and decisions often have unforeseen consequences came into currency in the eighteenth century at about the same time that another idea confidently supported the belief that institutional changes can be so engineered as to bring about a perfect society. 5 The idea of the perfectability of the social order arose primarily in the course of the French Enlightenment, while that of the unintended consequences was a principal contribution of the contemporary Scottish moralists. The idea of a perfectable society is deeply imbedded in critiques of social and economic order. By the beginning of the nineteenth century, the idea served to launch strong criticism of capitalism and the social and economic order it represented. In the twentieth century, the idea also served Keynes in his search for a workable monetary regime. In fact, Keynes’ flexibility and fine tuning propensities are certainly consistent with ideas flowing from the French Enlightenment. His propensities, writes Friedman, “were in accord with his leftist political philosophy, his conception of society run by an able corps of publicspirited intellectuals entitled to power that they could be counted on to exercise for the masses. They may also have been related to an excessive confidence or his ability to shape public opinion.” 6 His flexibility and attribution to others of his own capacity to change his views by changing circumstances also led to serious misreading of matters removed from economic policy.7 An example of Keynes’ flexibility and misreading of events is provided by F.A. Hayek when he writes, “I am convinced that he owed his extraordinary influence in this field [economics], to which he [Keynes] gave only a small part of his energy, to an almost unique combination of other gifts.” He had gained the ear of the “advanced” members much earlier and greatly contributed to a trend very much in conflict with his own classical liberal beginnings. The time when he had become an idol of the leftist intellectuals was in fact when in 1933 he had shocked many of his earlier admirers by an essay on “National Self-Sufficiency” in the New Statesman and Nation (reprinted with equal enthusiasm by the Yale Review, the Communist Science and Society, and the National Socialist Schmollers Jahrbuch). 8 In the essay in question, Hayek quotes Keynes: “The decadent international but individualistic capitalism, in the hands of which we found ourselves after the war is not a success. It is not intelligent, it is not


Money and Monetary Regimes

beautiful, it is not just, it is not virtuous—and it does not deliver the goods. In short, we dislike it and are beginning to despise it.” And, writes Hayek, Keynes later, in the same mood, states in the preface to the German translation of the General Theory that “he [Keynes] frankly recommended his policy proposals as being more easily adapted to the conditions of a totalitarian state than those in which production is guided by free competition.”9 Criticism of capitalism’s shortcomings is a view that Keynes shared with other contemporaries. Keynes, of course, was also a man with a very sharp sense of theory, and policy. In Chapter 24 of “Concluding Notes on the Social Philosophy Towards Which the General Theory Leads” of his General Theory, he writes that “the authoritarian state systems of today seem to solve the problem of unemployment at the expense of efficiency and freedom. But it may be possible by a right analysis of the freedom to cure the disease whilst preserving efficiency and freedom.”10 Keynes, the liberal economist, was certainly well aware of the advantages and value of individualism and the capitalist market system. Thus, he writes, “Whilst, therefore the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest would seem . . . both the only practicable means of avoiding the destruction of existing economic forms in their entirety and the condition of the successful functioning of individual initiative.”11 In effect, Keynes felt the shortcomings of the capitalist market oriented individualist system could be overcome with appropriate policies of government intervention, while at the same time preserving the system’s efficiency and freedom. On this point, Keynes is consistent with the eighteenth-century view that social engineering via appropriate government policies can improve society’s lot. And, indeed, Keynes is also consistent with the “self-destruction thesis” of capitalism discussed by Albert Hirschman and many other writers past and present including conservatives and Marxists. 12 Fred Hirsch in developing a version of the “self-destruction thesis” argues that capitalism depletes or erodes the moral foundation needed for its functioning.13 Keynesian bureaucratic elite assume an increasingly important role in managing the system. They must be motivated by the “general interest” rather than “selfinterest.” The system, however, is based on self-interest and provides no clear way of generating the proper “general interest.” To the extent

Moving to a Fiat Monetary Regime


that such a motivation does exist, it is a residue of previous value systems that are likely to erode. Keynes and others avoid the problems of implementation arising as a consequence of potential conflict between “general interest” and “self-interest” by arguing in favor of an enlightened elite of bureaucratic managers who would carry out the required program. The net result is that collective objectives are superimposed on an individualistic calculus. Though Great Britain may have favored the paternalism of Keynes’ elite democracy, America does not. According to Hirsch’s analysis, the capitalist market undermines the moral values that on its own supports. These supports have been inherited from preceding socioeconomic regimes, such as feudalism. The social morality which serves to buttress the market draws on an earlier morality which has eroded over time and by the very operation of the market itself. The greater inability and anonymity of an industrial market-oriented capitalist society has increasingly directed individual behavior to individual advantage, habits, and instincts at the expense of communal attitudes and objectives. The consequent weakening of traditional values has made the capitalist market-oriented economy increasingly more difficult to manage. Such social virtues as truth, acceptance, restraint, obligation, argues Hirsch, are needed for the functioning of an individualistic, contractual economy. 14 To a good measure, continues Hirsch, these virtues are based on religious belief which the individualistic, rationalistic orientation of a capitalist market economy undermines.15 Religious belief, however, is not what earlier writers of the seventeenth and eighteenth centuries had taken as characteristic of man. They were more realistic in viewing “self-interest” rather than “love and charity” as the basis for a well-ordered society. 16 Moreover, that the market would generate rather than erode such desired moral values as trust, truth, and other prerequisites required in a contractual society. It was expected that contract would replace custom, the traditional and ancient by the modern as a result of the pervasive influence and driving force of the market. It could be, as Albert Hirschman tells us, that to credit the market and capitalism with extraordinary powers of expansion, penetration, and disintegration “may in fact have been an adroit idealogical maneuver for intimating that it was headed for disaster.” 17 Hirschman goes on to argue that the simplest model for the self-destruction of capitalism is one that presents the idea that the successful


Money and Monetary Regimes

attainment of wealth will undermine the process of wealth generation. Accordingly, the advance of capitalism requires “first capitalists save and lead a frugal life so that accumulation can proceed apace. However, at some ill-defined point, increases in wealth resulting from successful accumulation will tend to enervate the spirit of frugality. Demands will be made for la dolce vita, that is for instance, rather than delayed gratification and when that happens capitalist progress will grind to an end.”18 Indeed, the idea that the rise and decline of capitalism occurs as a consequence of at first a successful attainment of wealth and of subsequently a deterioration in the wealth-creating process is a familiar eighteenth-century theme found in such writers as John Wesley Montesquieu and Adam Smith.19 More modern versions of the theme are found in Max Weber’s essay on The Protestant Ethic, as well as in essays by Herbert Marcuse and Daniel Bell. The basic flow in the idea, according to Hirschman, is that it focuses on the generation and the decline in personal savings while overlooking the more strategic variables, such as corporate savings, technical innovation, entrepreneurial skills, as well as cultural and institutional factors. A more sophisticated version of the self-destruction hypothesis is put forward by Joseph Schumpeter. 20 Accordingly, capitalism generates a critical frame of mind which, after destroying the moral authority of many institutions, turns upon itself and destroys the supporting values so necessary to a viable bourgeois society. And it is the intellectuals who spearheaded the attack on capitalism. This overlooks, however, the system’s strength at mounting a vigorous defense and counterattack. On this score, capitalism has managed its forces very well indeed (e.g., counter-cyclical policies, unemployment, and social security legislation) in turning aside system-threatening attacks on the part of intellectuals and others. Hirschman argues that Schumpeter’s thesis may be made more appealing if it can be demonstrated that the ideological currents unleashed by capitalism inadvertently erode the moral foundations of capitalism. 21 That is, if it can be shown that somehow capitalism is much more dependent on the previous system’s social and ideological foundations than realized by the emerging bourgeoisie and their ideologies, their demolition work will have the incidental result of weakening the foundations on which they themselves are sitting. This idea was developed by a very different group of European intellectuals who had also

Moving to a Fiat Monetary Regime


come to the United States during the 1930s: the Frankfurt School of Critical Theory which, while working in the Marxist tradition, paid considerable attention to ideology as a crucial factor in historical development. 22 Essentially, the idea is that a self-interest-oriented capitalist society depletes its moral legacy. Reason in such a society serves merely as a means for achieving arbitrary ends while leaving little to say about shaping human ends. The previous interactions between reason and revelation has been eroded by the progress of utilitarian philosophy and a self-interest-oriented capitalist society. In effect, the formalization of reason has served to undermine such cherished ideas as humanity and freedom which have served to hold society together. These values, moreover, have been inherited from previous social and ideological regimes. It is interesting that Hirschman argues that capitalist society has been saved from its self-destructive proclivities by Keynesianism, planning, and welfare state reforms. Certainly the 1920s, 1940s, and the late 1960s and 1970s were years of troubles. What is surprising is the failure to link these somber ideas about self-destruction that arose in the more difficult and somber moments of our century, but there was a failure to connect them with earlier more hopeful expectations of a market society bringing forth its own moral foundation, via the generation of douceur—probity and trust. One reason for this lack of contact is the low profile of the doux-commerce thesis after its period of self-confidence in the preceding century. Another is the transfiguration of that thesis into one in which it was to recognize. 23 The Industrial Revolution and its upheaval had much to do with casting into doubt the doux (soft, gentle) nature of the thesis. Except in international trade where expanding trade and contacts were expected to produce mutual material and cultural gains, domestic expansion of trade and industry was widely viewed as bringing about chaos, disintegration of communities, and a general breakdown in social and moral values. Thus, the force which was released in the center of capitalism came to be viewed as wild, blind, relentless, and unbridled. 24 Others continued to push forth the view that, on the contrary, society was indeed held together by the network of mutual obligations and relations arising out of the market. 25 It is not simply as a result of self-interested, market transitions but the division of labor that holds society together. And it is primarily the unintended consequences of


Money and Monetary Regimes

people’s actions and commitments in the wake of market transactions that play the critical role. In effect, a comprehensive system of rights and duties is created by the division of labor which serves to tie members of society together. There is in their view, as Hirschman underscores, a certain ambivalence on law; in fact a “solidarity” society emerges from the division of labor. The view appears to be “caught between the older view that interest-oriented action provides a basis for social integration and the more contemporary critique of market society as . . . corrosive of social cohesion.”26 There is to be sure an advantage to such ambivalence and the idea that under favorable conditions social bonds can be attached to economic transactions. It is to the work of Georg Simmel and our earlier discussion that we must turn to for the important role that money, credit, competition, and the market play in society. Competition and the market play significant roles in providing empathy and promoting strong social bonds in society. To Simmel, competition in society is always in favor of a third party. Each of the competitors tries to come as close as possible to the interests of the third party. Modern competition is for Simmel a fight of all against all and at the same time, a fight for all. It provides a vast network for the formation of third-party interests. And indeed, if we take it that the third party to competition among producers is the consumer and that everyone is a consumer, society as a whole is well served by it. As we have discussed earlier, Simmel’s views on money and credit stressed their importance in the functioning of the economy. In good measure, it results in their promotion of trust in social relations. This feature of the market along with competition serves to make social integration a reality. It provides in good part the bonds that for earlier societies were supplied by custom and religion. NOTES 1. John R. Hicks, “The Keynes Centenary: A Skeptical Follower,” The Economist (June 18, 1983): 17–19. 2. Ibid., 17. 3. Ibid., 18. 4. Ibid. 5. See Albert Hirschman, “Rival Interpretations of Market Society: Civilizing, Destructive, or Feeble?” Journal of Economic Literature (December, 1982): 1463–84.

Moving to a Fiat Monetary Regime


6. Milton Friedman, “The Keynes Centenary: A Monetarist Reflects,” The Economist (June 4, 1982): 17. 7. Ibid., 18. 8. F.A. Hayek, “The Keynes Centenary: The Austrian Critique,” The Economist (June 11, 1983): 41. 9. Ibid., 41. 10. John Maynard Keynes, The General Theory of Employment, Interest and Money, First Harbinger, ed. (New York: Harcourt, Brace, & World, 1964), p. 381. 11. Ibid., 380. 12. See his discussion in Albert Hirschman, “Rival Interpretations of Market Society: Civilizing, Destructive, or Feeble,” Journal of Economic Literature (December 1982): 1466. 13. Fred Hirsch, Social Limits to Growth (Cambridge: Harvard University Press, 1976, second printing 1977) pp. 123–36. 14. Ibid., 141. 15. Ibid., 143. 16. Albert Hirschman, “Rival Interpretations of Market Society: Civilizing, Destructive, or Feeble?” Journal of Economic Literature (December 1982): 1467. 17. Ibid., 1468. 18. Ibid. 19. Ibid. 20. Joseph Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper, 1942). 21. Albert Hirschman, “Rival Interpretations of Market Society: : Civilizing, Destructive, or Feeble?” Journal of Economic Literature (December 1982): 1469. 22. Ibid. 23. Ibid., 1470. 24. Ibid. 25. See the views of Emile Durkeim discussed by Hirschman, Ibid., 1471. 26. Ibid.

5 A Theoretical Framework

MONETARY ANALYSIS ATheoreticalFramework

The issues involved in our discussion of money and monetary regimes can be illustrated by drawing on a theoretical framework set forth by Milton Friedman in “A Theoretical Framework for Monetary Analysis,” which is also one that most economists, including Quantity theorists (monetarists) and Keynesians, would accept. 1 It is ideologically neutral and thus useful in analyzing fluctuation in income and prices in a wide variety of institutional and sociopolitical arrangements. Assuming a closed economy and neglecting the fiscal role of government, Friedman’s framework cast into basic IS-LM apparatus can be described as follows:

Where: C = Consumption P = Price Level

C/P = f(Y/P,r)


I/P = g[i]


Y/P = C/P + I/P


Md = P1(P/Y,r)


Ms = h[i]


Md = Ms



Money and Monetary Regimes

Y = Income M d = Demand for Money M s = Supply of Money Friedman does not consider in dispute the demand-for-money equation, which is here written in a general version acceptable to most economists. At issue is the method of completing the system that has seven variables but only six equations in it. According to Friedman, the choice is either P = Po


which is the Keynesian income expenditure theory or (8) Y/P = y = yo as in the Quantity theory of money. Equation (7) represents the case of rigid prices. In this instance, the price level is determined outside the system, which again reduces the system to one of six equations in six unknowns. It assumes that prices are set or administered by the bargaining power of respective parties such as unions, oligopolies, and other institutional arrangements that restrict price flexibility. Views attributing inflation to one or another variety of cost–push causes are a manifestation of equation (7). A number of cost–push and administered price inflation theories are discussed in the literature. I call these theories “antitraditionalist” or cost–push theories. As discussed in the literature, Phillips curve contributions represent attempts, for the most part, to link real magnitudes and the rate of change in prices to their initial historically determined level. Equation (8) is a statement that the economy is operational at the full employment level of real income. That is, real income is determined outside the system by appending the Walrasian equations of general equilibrium to it and regarding them as independent of equations defining the aggregates. Again, the system is reduced to one of six equations determining six unknowns. Friedman notes that this is the essence of the so-called classical dichotomy. In effect, the division between consumption and investment and the “real” interest rate is also determined in a Walrasian “real” system, one that admits of growth. It is for this reason that Quantity theorists (monetarists) tend to concentrate on equations (4), (5), and (6). In their view, equations (1), (2), and (3) are a summarization of aggregation or subset of the Walrasian system.

A Theoretical Framework


This suggests one reason why Quantity theorists (monetarists) focus on increases in aggregate demand and specifically on increases in the stock of money as primary causes of inflation. These theories are known in the literature as “traditionalist” or “demand–pull” theories. Since changes in aggregate demand can be engineered also by fiscal policy manipulation, some advocates of demand-pull inflation may not share the Quantity theorist conviction on the important role of the stock money. Following Friedman, for the simple Quantity theory of money given that Y⁄P=Yo, equations (1), (2), and (3) become a self-sustained set of three equations in three unknowns: C/P, I/P, and r. Substituting equations (1) and (2) into (3), we have Yo − f(Yo,r) = g(r)


or a single equation that determines r. If we let ro be this value of r, from equation (5), this determines the value of M, say M o, which, using equation (6) converts (4) into Mo=P1(Yo,ro)


which now determines P. Equation (10), however, is simply the classical Quantity theory of money equation. This may be seen by multiplying and dividing the right side by Y o and replacing 1 (Y o, ro) /Yo by V which is its equivalent. Thus Mo=Py/V




For the Keynesian income expenditure theory, setting P = P o does not in general permit a sequential solution. The manner in which it is established is discussed above. By substituting equations (1) and (2) into (3) we have Y/Po − f(Y/Po,r) = g(r)


or one equation in two variables, Y and r. This is in fact John R. Hicks’ IS Curve in his IS-LM analysis. By substituting equations (4) and (5) into (6), we have h(r) = Po1(Y/Po,r)


a second equation in the same two variables, Y and r. It is Hicks’ LM Curve. The simultaneous solution of the two determines Y and r.


Money and Monetary Regimes

In keeping with the discussion, our simplified model (which Friedman points to as being faithful to Keynes) can be obtained by supposing that Y/P is not an argument in the right-hand side of equation (4) or that of absolute liquidity preference holds so that equation (4) takes the special form: MD = o if r > ro MD = if r < ro


In these cases, equations (4), (5), and (6) determine the interest rate, r = ro, as the simple Quantity theory of money equations (1), (2), and (3) do. Substituting the interest rate in equation (2) gives us investment, say I = Io, and in equation (1) makes consumption simply a function of income; so that real income must be determined by the requirement that it equate saving with investment. Moving along with Friedman, if we approximate the function f (Y/P, ro) by a linear form—say, C/P = Co + C1Y/P


and substitute in equation (3) and solve for Y/P, we have Y/P = Co + Io /1 − C1


which is the simple Keynesian multiplier equation with C o + I o equaling expenditure and 1o/1 – C 1 equaling the multiplier. The key differences between the Keynesian view and Quantity theorist view are: Keynesians argue that change in the quantity of money affects spending via interest rate effect or spending; the Quantity theorist view underscores wealth in portfolios and then on final spending. Neither the Quantity theory nor the Keynesian income expenditure theory model is satisfactory as a framework for short-run analysis. According to Friedman, this is so mainly because neither theory can explain: a. The short-run division of a change in nominal income between prices and output; b. The short-run adjustment of nominal income to change in autonomous variables, and; c. The transition between the short-run situation and a long-run equilibrium described essentially by the Quantity theory model. 2

A Theoretical Framework


A third way to determine the above system of equations is provided by Friedman in the monetary theory of national income.3 This method draws on Irving Fisher’s ideas on the nominal and real interest rates and Keynes’ view that the current long-term market rate of interest is expected to prevail over a long period. The Keynes and Fisher synthesis is then integrated into a Quantity theory model, together with the empirical assumptions that the real income elasticity of demand for money is unity, and that the difference between the anticipated real interest rate and the anticipated growth of real income is determined outside the system. In effect, this is the counterpart assumption to equations (7) and (8) of income expenditure theory and Quantity theory, respectively. The result is a monetary model in which current income is related to current and prior quantities of money. 4 This monetary model of nominal income, according to Friedman, corresponds to the broader framework implicit in much of the theoretical and empirical work that he and others have done in analyzing monetary experience in the short run and is consistent with many of the empirical findings produced in these studies. The Quantity theory of money is basically a theory of the demand for money. It is at its best when the demand for money is a stable function of a few key variables. For instance, its stability is important, because it ensures that, mutatis mutandis, inflationary pressures from a change in the supply of money are transmitted to the general level of prices.

RELATIVE STABILITY OF MONETARY VELOCITY AND THE INVESTMENT MULTIPLIER: EMPIRICAL EVIDENCE FOR CANADA How useful are the Quantity theory of money and Keynesian income expenditure theory in predicting economic events? This challenge is interpreted by some economists as an empirical issue resting entirely on the stability of monetary velocity on the one hand and the Keynesian multiplier (taken as the ratio of changes in income to changes in autonomous expenditures) on the other. A systematic comparison of the relative stability of velocity and the multiplier has been made for the United States from 1897 to 1958 by Friedman and David Meiselman. 5 To judge from the results, velocity is consistently more stable than the multiplier.


Money and Monetary Regimes

Method of Analysis This section extends the Friedman–Meiselman study and examines the relative stability of monetary velocity and the investment multiplier in Canada from 1926 to 1958. The derivation of the equations for the empirical testing of these two theories is presented by Friedman and Meiselman so that it is not necessary to repeat it here. I shall simply list the equations to be tested.6 (1) Y = z + V′M (2) Y = α + K′A (3) ∆Y = V′∆M (4) Y + K′∆A (5) C = α + KA, where K = K′−1 (6) C = α + VM (V does not have the simple relation with V′ as does K with K′) (7) C = α + VM + KA (8) C = α + VM + BP (9) C = α + KA + BP (10) C = α + BM + KA + BP Where: Y = Income, C + A M = Stock of Money V′ = Marginal Income Velocity A = Autonomous Expenditures K′ = Marginal Multiplier P = Index of Prices C = Induced Expenditures

Statistical Series Selection of statistical series to correspond to the variables under consideration is based principally but not exclusively on the criteria that the Canadian series should be comparable to the series used in the American tests. Statistical counterpart to income (Y) is personal dis-

A Theoretical Framework


posable income plus the residual error of estimate which is similar to the statistical discrepancy in the United States accounts. 7 Although the definitions of autonomous and induced expenditures are clear cut, their statistical counterparts are not unambiguous. For purposes of this study, I have selected personal disposable income plus the residual error of estimate minus consumer expenditure as an estimate of autonomous expenditures (A). Such a series corresponds to the series used in the American tests. Induced expenditures (C) are represented by consumption expenditures. Consumer prices (P) are measured by the implicit price index consumer expenditures. This choice is justified on the basis that tests for the stability of the multiplier in real terms amount essentially to an examination of the responses of consumers to changes in their incomes brought about by changes in autonomous expenditures. This same price index is also used for money–income relations. Consumer prices were used as deflators in the money–income relations and because the quantity theory tends to focus on household demand for money. M, the stock of money, is seasonally adjusted and consists of currency (notes and coins) in public hands plus notes, demand, and notice deposits of chartered banks in public hands. Alternative definitions of the money stock have not been tested. The definition employed corresponds to the American series.

EMPIRICAL RESULTS FOR CANADA The tests indicate clearly that income velocity for Canada is consistently more stable than the multiplier. This is so in each of the tests and during every period studied covering the wide range of experience from 1926 through 1958. The multiplier achieves its best performance during the period of the 1930s when a severe economic crisis gripped Canada. Although the multiplier performed during these hectic years better than in other years, its performance in absolute terms was poorer than that of velocity. These results are consistent with those obtained for the United States. They suggest that differences in institutions and dependence on external trade in the two countries were of minor importance in determining the outcome of the tests. Quarterly data reinforce results derived from annual data. The period of the business cycle selected does not subtract from the income velocity’s overall performance. It performs better than


Money and Monetary Regimes

the multiplier whether we conduct our analysis from peak to peak or from trough to trough of the cycle. Quarterly data in the period 1947–1958 permit testing for the existence of leads or lags in the variables. Again, the results heavily support the importance of the stock of money in determining the level of income. These results are summarized in Tables 5.7 and 5.8 (p. 77). Money is more highly correlated with consumption from one to four quarters later than with consumption in any earlier or later quarters. Autonomous expenditures are more highly correlated with consumption one quarter later than in the same or any later quarter. When first differences are considered, money is more highly correlated with consumption one or two quarters later than in the same quarter. The negative correlation of consumption and autonomous expenditures in the same quarter is consistent with the same puzzling result obtained in American tests. CANADIAN RESULTS IN DETAIL Relation between Synchronous Nominal Magnitudes The results summarized in Tables 5.1, 5.2, and 5.3 indicate that for all twenty-three selected subperiods covering the years 1926–1958 the stock of money is more highly correlated with consumption than is the level of autonomous expenditures. These results, moreover, are not simply consequences of common trends. Thus in the period after 1947, quarter-to-quarter changes in money are more highly correlated with quarter-to-quarter changes in consumption than are quarter-to-quarter changes in autonomous expenditures. As indicated by the relatively high correlation between consumption and autonomous expenditures in the subperiods 1926–1929 and 1933– 1938 some upward shift in the demand for money or decline in velocity in Canada did occur after 1929. The shift, however, was not as dramatic as the one that occurred in the United States since the correlation between money and consumption in Canada is consistently higher than between consumption and autonomous expenditures throughout the period. One reason for the differences between the countries may be attributed to the relative monetary stability that prevailed in Canada during these years. Unlike the United States, Canada was not burdened with a banking collapse. The greater stability of the consumption–money relationship is indicated by the correlation coefficient of .93 for the period 1926–1929 and

Table 5.1 Correlations between Variables in Nominal Terms (Annual) C or Y = + a0 + a1 (A or M)

Table 5.2 Correlations between Variables in Nominal Terms (Quarterly) C or Y = + a0 + a 1 (A or M)

A Theoretical Framework


Table 5.3 Correlations between Synchronous Variables

.97 for the trough-to-trough period 1933–1938. On the other hand, the correlation coefficients between consumption and autonomous expenditure are .88 and .72 for the two respective periods. If the disguised effects of money are removed by holding the quantity of money constant, the partial correlation coefficients between consumption and autonomous expenditure are –.86 for 1926–1929 and .78 for 1933–


Money and Monetary Regimes

1938. The corresponding partial correlation coefficients between consumption and money holding autonomous expenditures constant is .93 for 1926–1929 and .98 for 1933–1938. These results and those for other subperiods are summarized in Table 5.4. The correlations between money and consumption are higher in absolute value than between consumption and autonomous expenditures. For the period 1926–1958 the correlation is .97 between the annual values of the stock of money and consumption and .98 for the quarterly values after 1947. For any subperiod by itself, the lowest correlation between the annual values is .33 for the period 1926–1938. Results of first difference analysis of the quarterly values presented in Table 5.10 reinforce conclusions derived from the analysis of level values. The consistently low correlation coefficients obtained in the table may be attributed to the fact that errors in measurement for such short time periods as a quarter probably overwhelm any systematic factors present. In contradistinction, correlations between consumption and autonomous expenditures are generally low in absolute value. For the period 1926–1958 the correlation is .43 between the annual values of autonomous expenditures and consumption and .36 for the quarterly values after 1947. For any subperiod by itself the lowest correlation is .07 for the period 1926–1938 and the highest .88 for the period 1926–1929. For the period 1933–1938, which includes the hectic years in the Canadian economy, the correlation rises to .72 between autonomous expenditures and consumption. Aside from the period 1926–1929, the only other period in which the correlation rises is in the postwar trough to trough period 1954–1958 when it is .75. In every subperiod whether peak to peak or trough of the business cycle the correlation between the stock of money and consumption is higher than between autonomous expenditures and consumption. Friedman and Meiselman have noted in their analysis for the United States that a positive correlation between one of the alternative independent variables may reflect the influence of the other variable in disguise. Their results show that, except for the two subperiods containing the period 1929–1933, when the stock of money is held constant the partial correlation between autonomous expenditures and consumption is small throughout, and in many cases, negative. These results indicate that the relation between autonomous expenditures and consumption is essentially a disguised reflection of the effect of the stock of money.

Table 5.4 Relations between Variables Holding Price Level Constant (Annual) C or Y = a0 + (A or M) + a2 P

Table 5.5 Relations between Variables Holding Price Level Constant (Quarterly) C or Y = a0 + (A or M) + a2 P

A Theoretical Framework


Canadian results are consistent with those reported by Friedman and Meiselman for the United States. The partial correlations presented in Table 5.3 indicate that when the stock of money is held constant the partial correlation between autonomous expenditures and consumption is small and in some periods negative. In contrast, when autonomous expenditures are held constant the partial correlation between the stock of money and consumption is generally high and positive. The results summarized in Tables 5.1 and 5.2 for the relation between the stock of money and income are very nearly identical to those between the stock of money and consumption. There is consistently a higher correlation between money and income than between autonomous expenditures and consumption in every subperiod. Again the results are consistent with those found for the United States. Tables 5.1 and 5.2 present the regression equations for equation (5), C = α + KA. The computed values of the multiplier K are very erratic indeed. These results are consistent with those for the United States. The values for the subperiods covering peak to peak in the business cycles tend to be more stable than the values computed for subperiods covering trough to trough in the cycles. The constant term in the simple regression in each of the subperiods and for the entire period 1926–1958 is positive suggesting that the average propensity to consume has been higher than the marginal propensity to consume out of current disposable income. Aside from the period 1926–1929 and trough-to-trough period in 1933–1938, there is a continual increase in the constant term indicating the rising levels of average personal disposable income and upward drift of the shortperiod consumption function. Regression equations (1) zY = V′M and (6) C = α + VM, presented in Tables 5.1 and 5.2, indicate the stability of marginal income velocity and marginal consumption velocity. The changing values of the constant term indicate some disparity between marginal and average velocities. The high values for marginal velocities in 1926–1933 covering a contraction period in economic activity are symptomatic of the sensitivity of income to the monetary contraction that occurred during this period. Relatively high values of marginal velocities prevailed during the post-war period. Such values coincide with those for average velocity which fell during World War II and then increased during the post-war period.


Money and Monetary Regimes

Table 5.6 Correlation between Variables in Real Terms M Y − a0 + a1 + u P P

Relations Between Synchronous Real Variables Table 5.6 presents the relation between the stock of money and income when these two variables are deflated by our price index. For the period 1926–1958 the correlation is .93 and for the postwar quarterly values of real income and real money the correlation is .72. In the various subperiods the correlation ranges from .005 for the trough-totrough period 1946–1949 to .96 for the period 1926–1929. Since the division of variables expressed in money terms by the same price index

A Theoretical Framework


Table 5.7 Simple Correlation Coefficients between Lagged Variables (Quarterly Figures, 1/1947–4/1958)

introduces spurious correlation owing to common errors of measurement in the price index introduced into both sides of the equation, this method of deflation leaves something to be desired. The results of the analysis accordingly should be viewed with extreme caution. A more preferable procedure of deflation is to introduce a price index as an additional variable. The analytical results of the procedure are presented in Tables 5.4 and 5.5. These results show that in every period except 1926–1929 the real stock of money is more highly correlated with real consumption than is real autonomous expenditures. For the exception, 1926–1929, the correlation coefficient is .98 between real consumption and real autonomous expenditures and .94 for real stock of money and real consumption. Table 5.8 Simple Correlation Coefficients between Lead Variables (Quarterly Figures, 1/1947–4/1958)


Money and Monetary Regimes

The Canadian results are consistent with those for the United States and indicate the general stability in the demand for money whether in real terms or in nominal terms. So too do the Canadian results indicate the instability of the synchronous income–expenditure relationship in real terms.

Relations Between Lagged Variables Tables 5.9 and 5.10 present the results of multiple correlation equations computed for the purpose of examining in detail the effect of money or autonomous expenditures on the subsequent behavior of consumption. The tests are based on the values of consumption income and the values of money or autonomous expenditures in successively larger numbers of prior quarters. The results summarized in these tables support the strong and consistent relation between consumption and money and the weak relation between consumption and autonomous expenditures. Additional evidence on possible lagged effects is presented in Table 5.9, part d. Consumption is simultaneously correlated with prior values of both the stock of money and autonomous expenditures. Again the Table 5.9 Regression Equations of Lagged Variables (Quarterly Figures, 1/1947–4/1958) Part a

Table 5.9 Regression Equations of Lagged Variables (Quarterly Figures, 1/1947–4/1958) Part b

Table 5.9 Regression Equations of Lagged Variables (Quarterly Figures, 1/1947–4/1958) Part c

Table 5.9 Regression Equations of Lagged Variables (Quarterly Figures, 1/1947–4/1958) Part d

A Theoretical Framework


results strongly support the important role of the stock of money. Adding lagged values of autonomous expenditures to the analysis does not contradict results obtained from previous analysis. If anything, the results are reinforced. Results of first difference analysis presented in Table 5.10 tend to reinforce conclusions derived from the analysis of level values. The consistently low correlation coefficients obtained in the table may be attributed to the fact that errors in measurement for such short time periods as a quarter probably overwhelm any systematic factors present.

CONCLUSION The evidence summarized in this chapter on the relative stability of income velocity and the multiplier has important implications for monetary theory and policy. For example, the evidence casts doubt on the empirical assertions that the stock of money does not matter and that income velocity behaves in an erratic and unpredictable manner. Table 5.10 Regression Equations of First Differences of Lagged Variables (Quarterly figures, 1/1947–4/1958) Part a

Table 5.10 Regression Equations of First Differences of Lagged Variables (Quarterly figures, 1/1947–4/1958) Part b

Table 5.10 Regression Equations of First Differences of Lagged Variables (Quarterly figures, 1/1947–4/1958) Part c


Table 5.10 Regression Equations of First Differences of Lagged Variables (Quarterly figures, 1/1947–4/1958) Part d



Money and Monetary Regimes

Such assertions contributed in no small measure to the subordination of the stock of money and velocity in the economic analysis in the post-Depression years. What these results indicate is that the Quantity-theory approach to income changes is more useful than the income–expenditure theory approach. Stability of empirical relations in the Quantity-theory and instability of these relations in the income–expenditure theory over time is evidence on the empirical validity of the former approach to income changes. Since the Canadian tests are based on comparatively simple versions of the two theories the results are, like all scientific judgments, subject to later modifications as additional data and other ways of organizing these data become available.

NOTES 1. Milton Friedman, “A Theoretical Framework for Monetary Analysis,” Journal of Political Economy (April/May, 1970): 193–238; Milton Friedman, “A Monetary Theory of National Income,” Journal of Political Economy (April/May 1971): 323–37; see also George Macesich, Monetarism, Theory and Policy (New York: Praeger, 1983), pp. 43–60. 2. Milton Friedman, “A Theoretical Framework for Monetary Analysis,” Journal of Political Economy (April/May 1970): 193–238. 3. Milton Friedman, “A Monetary Theory of National Income,” Journal of Political Economy (April/May 1971): 323–337. 4. Ibid. 5. Milton Friedman and David Meiselman, “The Relative Stability of Monetary Velocity and Investment Multiplier in the United States, 1897– 1958,” in Stabilization Policies (Englewood Cliffs, NJ: Prentice-Hall for the Commission on Money and Credit, 1963), pp. 165–268. 6. Milton Friedman and David Meiselman, “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897– 1958,” op. cit., pp. 165–268. 7. All estimates except the money supply are taken from National Accounts Income and Expenditure, 1926–1956 for the period 1926–1956, and from the Canadian Statistical Review, 1959 Supplement (Ottawa, 1960) for annual and quarterly estimates for the period 1957–1958. Quarterly estimates for the period 1947–1952 are from National Accounts Income and Expenditure by Quarters 1947–1952 (Ottawa, 1953); for the period 1953–1955 quarterly estimates are from Canadian Statistical Review, 1955 Supplement; and for 1955–1958 they are from the Canadian Statistical Review, 1959 Supplement.

A Theoretical Framework


The money supply estimates are from an unpublished manuscript by George Macesich. The annual figures are centered means of end-of-month figures. Quarterly figures are centered means of end-of-month figures; the concept is the sum of currency, bank notes, and all chartered bank deposits in public hands. This chapter also draws on George Macesich’s, “The Quantity Theory and the Income Expenditure Theory in an Open Economy: Canada 1926– 1958,” Canadian Journal of Economics and Political Science (August 1964): 368–390.

6 Inflation and the Monetary Regime

INFLATION AND DEMOCRACY Inflation and the Monetary Regime

The managed fiat monetary regime in the form of a labor standard and its dependence in democracies on society’s sociopolitical processes has promoted bureaucracy and centralization beyond anything Keynes and his followers probably intended. Another consequence appears to be an upward trend of prices since World War II, which is facilitated by a growing preoccupation and sensitivity to any unemployment.1 This sensitivity is now in fact institutionalized in the United States in the Employment Act of 1946. The apparent declining effectiveness of policy restraints in democracies to postwar increases in the general level of prices has cast doubt on the monetary regime itself, permitting inflation to feed on its own strength. To be sure, if the inflation rate is constant and widely expected and if the economy adjusts completely, the principal disadvantage appears to be the inability to compensate holders of currency for the losses in purchasing power—due to inflation, which can be viewed as expropriation of resources such holders would otherwise command. The matter is more complicated when inflation is unanticipated. Since actual rates of inflation are too volatile to be anticipated with any degree of accuracy, the uncertainty of inflation rates imposes major costs in reduced efficiency of production and resource allocation and in suboptimal saving and investment.


Money and Monetary Regimes

The political attractiveness of inflation cannot be denied. In democracies, the task of incurring unemployment for the sake of reducing inflation can resolve political pressures to expand expenditures without legislating higher tax rates. Large continuing budget deficits could be financed without inflationary policies, but in practice, they are partially monetized, thus producing inflation in part because of pressures to hold down interest rates. This results in additional incentives to politically weak governments for providing an automatic reallocation of government expenditures in real terms without explicit legislative action, since rising prices reduce the real value of monetary allocations for which no increase is mandated. Thus, the government by pressure groups and through inaction allows all other monetary allocations to decline in real terms without the necessity of explicitly legislating monetary cutbacks in any expenditures. Attempts to use manipulative monetary policy to achieve unattainable goals push the economy into the area of increasing inflationary pressures. It is an unattractive economic policy because the costs, for instance, of delaying a reduction of inflation are not compensated by lower overall costs of unemployment. It serves, moreover, to undermine the foundations on which the American democratic society rests. Much of our discussion is implicit in the work of Alexis de Tocqueville on democracy more than a century and a half ago. 2 He predicted that democracy might usher in the control of a vast bureaucracy taking its sustenance from a majoritarian tyranny. Unlike the critics of his time, de Tocqueville did not completely share their belief that democracy would bring mediocrity. In his view, the danger of democracy is the opportunity it gives to political and bureaucratic elites to multiply their power. Unlike the hierarchical societies of the past in which men had been tied to each other by the duty of obedience to superiors and of protection for inferiors, which produced aristocrats with the inclination to challenge overmighty government and the power to do so, democratic man by contrast cannot. The reason he cannot, argued de Tocqueville, is because democratic man is surrounded by equals to whom he felt no ties of duty; on the contrary, democratic society made every man a rival. According to de Tocqueville, two consequences flowed from this competitive individualism. The first was that the competition might absorb all energies, leaving none aside for political concerns. Second, democratic man would not be able to count on his neighbors for support; he would be forced to turn to the state. The first consequence

Inflation and the Monetary Regime


diminished the citizen’s interest in restraining central power; the second gave him a positive motive to increase it. By encouraging stronger government, equality could easily prove inimical to individual liberty. He was, in effect, predicting the rise of the protective welfare state as well as the reaction to it that is currently eroding its scope. A check to central government and authority is to be found in local institutions, which at least in the United States are natural bastions of democracy. This is not necessarily true elsewhere, particularly where local governments and institutions were traditionally dominated by aristocrats. It is perhaps for this reason that European democrats, for instance, favored the centralization of power and so hastened the development of powerful central government. The majoritarian tyranny that worried James Madison and that Thomas Jefferson feared would extinguish individual liberty has seeds in the managed labor standard of Keynes. The dependence of such a standard on society’s sociopolitical processes would certainly have troubled eighteenth-century Enlightenment thinkers like John Adams, Madison, and Montesquieu. Without constraints imposed on the discretionary manipulation of such a standard, the bureaucracy acting presumably in the name of the majority is free to act on its own. The worst fear of the framers of the Constitution is fulfilled—the spectacle of the greater number oppressing the lesser. It is this very spectacle, expressed now in economics and the expropriation of wealth through the manipulation of the monetary standard, in which the majority and minority are regarded as having mutually excluding interests, as indeed they were by the framers of the American Constitution, that European patterns of class conflict can erupt in democratic America. The manipulation of the monetary standard undermines the idea and sense of property concern to most Americans who see a connection between exertion and reward and thus support property as sacrosanct. It is this permeation of Lockean values which sustained Americans to assume that they had a “natural” right to acquire and dispose of property. It has meant that the majority need not be feared and that American society could be held together without the imposition of strong central government and its allied bureaucratic apparatus. Indeed, de Tocqueville argued that where property is protected and “equality of condition” prevails, arbitrary or despotic rule is less likely. This does not mean that tyranny is no longer an issue. It simply means, as de Tocqueville argued, that tyranny must be redefined as a social


Money and Monetary Regimes

phenomenon that results from the rise of mass democracy. It is the threat of society that absorbs the individual so that he experiences no conscious self apart from social existence. Authority moves from the individual to society as a whole with the result that the whole idea of individual natural rights, a heritage of the Enlightenment, evaporates. In its place arises the authority of society as opposed to that of the state. As the authority of society displaces the idea of individual rights—a process well understood by such transcendentalists as Henry David Thoreau—power becomes more centralized as the individual, fearing his isolation and self-doubts, identifies more and more with society and internalizes its rules. Imperceptively, the idea of a single authority directing all citizens steps naturally into their consciousness, as de Tocqueville puts it, without their giving the matter a thought. The net result is that man’s original political freedom, the contract of sovereignty in which he submits to the institutions of the state, has been overwhelmed by the dynamics of society. What John Locke and Montesquieu have provided in natural and historical rights with which man can resist the power of the state has in essence been taken over by social authority. The importance of maintaining the credibility of works in America cannot be minimized as de Tocqueville underscored. Most Americans take pride in their work and view it as their duty to their community. It serves as a means for gaining respect. Both classical and socialist thinkers have failed to see that in a liberal environment, a market society and democracy are compatible. To be sure, de Tocqueville stops short of romanticizing the entrepreneur and treating him as an Emersonian genius who defies all convention. He views Americans as possessing a practical intelligence that serves them well in understanding public affairs and the country’s interests. In America, he noted, one may not find great acts of self-sacrifice and duty as in Europe but small deeds that nonetheless do reflect public spiritedness. In the Old World, argued de Tocqueville, one hears of the beauty and dignity of virtue and the grandeur of sacrifice and duty; in the New World, of the value of character, of natural interest in every individual in the good of society, and of “honesty as the best policy” in all transactions. This new sense of virtue is not as the classical theorists would have it, nonetheless, it is more understandable and thus perhaps more realizable as de Tocqueville observed. It is moreover enlightened self-interest that yields “virtuous materialism” that most Americans can grasp. It is furthermore “wonderfully agreeable to human weakness” and thus

Inflation and the Monetary Regime


can command authority. Enlightened self-interest, he observed, cannot make a man virtuous “but its discipline shapes a lot of orderly, temperate, moderate, careful, and self-controlled citizens. If it does not lead the will directly to virtue, it establishes habits which unconsciously turn it that way.”3 As we have discussed, a monetary standard that does not lend itself to manipulation is a basic requirement if a democratic market society is to be well served. We leave it for our public-choice theory and accumulated experience that little trust can be given government, subject as it is to majority rule, to behave itself and exercise monetary restraint. In fact, the world has turned from the discipline of the gold standard monetary regime to one of discretionary fiat money with nonmanaged “flexible” exchange rates. Given the recent past poor record that the current monetary regime has produced in high and variable inflation and interest rates, low productivity growth and unstable exchange rates have prompted a call for monetary reform including a return to a gold standard monetary regime. There is, unfortunately, little ground for belief that contemporary popular democracies and their political authorities are willing to forego discretionary policies that a return to the gold standard or, for that matter, the establishment of a fiat monetary regime governed by a rule would require. Unless the underlying political economy can guarantee that inflation will not be a policy option, neither a well-designed gold standard regime nor a rule-based fiat monetary regime will be successful. A democratic market society, to function and survive, must have a predictable monetary policy capable of anchoring the long-term price level.

UNIONS AND INFLATION: WAGE–COST–PRICE SPIRAL Milton Friedman discusses the several stages through which professional views on the relation between inflation and unemployment have gone in the past several decades. In the first stage, a stable Phillips curve was accepted. In the second stage, notes Friedman, was the introduction of inflation expectations, as a variable shifting the shortrun Phillips curve, and the natural rate of unemployment, as determining the location of a long-run Phillips curve. And the third stage is the


Money and Monetary Regimes

apparent positive relation between inflation and unemployment. Friedman argues persuasively that this last stage is more than coincidental. The economics profession readily accepted the level of unemployment and the rate of inflation because, as Friedman notes, it appeared to fill a gap in Keynes’ theoretical structure. It seemed to provide the missing equation in that structure. Thanks to Keynesian acceptance of a rigid absolute wage level and a nearly rigid absolute price determined essentially outside Keynes’ model by institutional factors, changes in nominal aggregate demand registered almost entirely in output and hardly at all in prices. Keynes’ efforts also contributed to a recurring public issue in the perceived responsibility of unions and/or labor for inflation. The issue turns on the so-called wage–price or cost–price inflation.The reasoning underlying many of the inflation theories are based in the Keynesian tradition and may be summarized in the now familiar “wage–cost– price–spiral inflation.” Although there are many variations on the theme, their common thread is the assertion that the pricing mechanism is becoming progressively less sensitive. Whatever the alleged “cause” of inflation, the monetary preconditions must be satisfied so that the distinction among theories in the Keynesian tradition is between different mechanisms of inflation. Three variations on the theme, however, appear sufficiently important from a public policy viewpoint to warrant consideration. One is that union pressures for wage increase are the causal element in inflation. The second is that oligopolistic sectors administer prices and so are the causal element in inflation. The third incorporates elements of the first two and tangentially places the blame for inflation on the existence of both unions and oligopolistic industries. The first variation argues that unions are responsible for inflation in that they fail to recognize that wage increases that go beyond overall productivity gains are inconsistent with stable prices. Thus, the argument is that unions push up wages, which raises costs and prices. In order to avoid a logical fallacy, the more sophisticated argue that since the monetary authorities are committed to a policy of full employment, they will expand the money supply so as to make possible the sale of old output at the new price level. The second variation argues that prices are set in a different way in those sectors of the economy that are composed of many firms than they are in industries where there are a few major producers. Prices set by oligopolistic industries are “administered” so that they are excellent

Inflation and the Monetary Regime


conductors of inflationary pressure. They are relatively immune to traditional anti-inflationary policies in that their prices, having once reached a high level, are stickier in declining than those of competitive industries when demand declines. The third variation claims that unions and oligopolistic industries are primarily responsible for inflation. Unions, so the argument goes, lodge themselves in oligopolistic industries and share in the “spoils” derived from the product side. Thus, unions in such industries may take advantage of the inelastic or expanding demand conditions on the product market to obtain higher wages without fear that the entry of new firms will reduce union wage gains. According to this variation, the product market permitting the oligopolist will grant a higher wage rate as a means of avoiding a more costly strike. Moreover, in contradistinction to more traditional views, such unions need not be old craft unions; they may be the new industrial unions that economists have tended to treat as relatively powerless in setting excessive wages. It is for this reason, presumably, that the advent of new industrial unions, when coupled with oligopolistic industries, has changed the American economic system so greatly as to largely frustrate attempts to control inflation along traditional lines. In effect, the argument implicitly assumes that the pricing mechanism is becoming progressively less fluid or “automatic.” In place of traditional methods for coping with inflation, which some Keynesians consider largely ineffective or inappropriate, they advocate a “direct” assault on the problem of inflation—although such an assault may be dominant. First, government should resort to “moral suasion” to induce business and labor to exercise their power in a socially desirable (noninflationary) way. Second, government could increase the degree of competition in the marketplace by a more vigorous enforcement of antitrust legislation. Some people argue that since labor unions are monopolies, they should also be subject to antitrust legislation. Third, government can participate more actively in or control the price-and-wage setting process. Needless to say, these forms of control are not mutually exclusive. Eclectics view the discussion of whether inflation is “demand– pulled” or “cost–pushed” as analogous to “Which came first, the chicken or the egg?” They attempt to synthesize, in varying degrees of sophistication, the two views of inflation. Of the social syntheses available, we shall consider only two. One, which draws heavily from the Keynesian tradition, turns on the assertion that we cannot empiri-


Money and Monetary Regimes

cally isolate inflation by types. The other, which draws heavily from the monetarist tradition, asserts that we cannot conceptually isolate inflation by types. The synthesis that draws heavily from the Keynesian tradition asserts that it is impossible empirically to test for the existence of leads or lags from the cost or demand side, which is necessary if we are to classify inflation by types. For such a purpose, we need minute data on the cost and demand sides. Since such data presumably are not available, we cannot meaningfully classify inflation by types. Even if such data were available, they would shed little light on the “causes” of inflation. Prices and wages, according to their view, are not set in the traditional manner. They are set with reference to some markup over the cost of living. Accordingly, inflation is generated whenever labor and management attempt to get more than 100 percent of the selling price. This is an impossible situation. Yet, it is on the very impossibility of the situation that the continuing process of inflation depends. Thus, each party increases the part he tries to take by increasing wages or by increasing prices. Since together they cannot succeed in getting more than 100 percent of the selling price, wages and prices are continually raised, thereby generating a continuing process of inflation, though it may originate in the noncompetitive sector where market power is sufficient to raise prices and wages will “spill over” into the competitive sectors, thereby gaining momentum. This may occur, it is argued, either from the demand side or cost side or both. Since the prices of the products and services of the noncompetitive sector rise, there will be a change in the composition of demand. Consumers will switch their demand to the products and services produced by the competitive sectors so that prices rise in this sector. There is excess demand in the noncompetitive sector. The deficiency of demand will result in some unemployment in the noncompetitive sector. Owing to factor immobility, however, unemployment in this sector will not cause wages or prices to fall, so that unemployment persists. Attempts by the government to remove excess demand along traditional lines so as to check the overall price rise, while removing excess demand in the competitive sector, increases still further the unemployment in the noncompetitive sector. The same situation will prevail even if the spillover occurs from the cost side. Thus, the spillover will occur because wage or price rises in the noncompetitive sector are signals for labor and employers in the competitive sector to do the same in order to protect, if not increase,

Inflation and the Monetary Regime


their relative income shares. Accordingly, the government is confronted with the dilemma of either inflation or unemployment. The other view, which borrows heavily from the traditional position, argues that we cannot ever conceptually identify inflation by types, much less classify them empirically. In essence, this view turns on the proposition that while it is obvious that decreased conditions influence costs, it is equally obvious that one cannot separate out the portion of the cost increase attributable to increased demand. Traditional monetarists and Keynesians accordingly have erred in attempting to establish rigid links between types of inflation and public policy. The eclectic views essentially do not consider as practical the argument that the monetary authority, by refusing to expand the money supply, could “nip in the bud” an inflationary spiral. The bases for such an assertion are: first that velocity would increase, thereby frustrating the efforts of the monetary authority; and second, even if velocity could no longer increase, the monetary authority could overcome the strong institutional forces making for rigidity in the pricing system only at the expense of a possible serious depression. In order to control inflation, therefore, steps should be taken to remove institutional and other rigidities from within the American economic system. It is only then that the control of inflation along more traditional lines would have an effect. We may turn now to an appraisal of the above views of inflation by drawing both on economic theory and on recent experience. Theoretical and empirical evidence, though not completely inconsistent with alternative views, tends to support traditional monetarists’ views of inflation. The fundamental discovery of those de-emphasizing the traditional view of inflation is that prices and wages go up when somebody raises them. There is general agreement as to the facts. We take it to be true that most sellers would always like to raise their prices. We also take it to be true that sellers will never raise their prices without limit. What are the limits and circumstances under which sellers will raise their prices? It is precisely to the answering of this question that economists have directed their labors. The fruit of this labor has produced the consensus that the state of demand will set the limit and the circumstances under which sellers can raise or lower prices. The state of demand permitting, sellers can raise their prices without being penalized by a loss of sales and income and so they decide to “raise” prices. If, on the other hand, the state of


Money and Monetary Regimes

demand permits a rise in prices only at the expense of losing net income, sellers will not raise prices. Thus, there is no conflict between the view that prices rise because somebody raises them and the view that somebody decides to raise prices because the state of demand permits such a rise without losing sales and income. The views that de-emphasize the traditional approach to inflation do not provide an alternative theory of inflation that is independent of the state of demand. Although not new, the gained currency in the postwar period when a favorable state of demand was assured by the existence of a favorable state of demand permitted price increases without the loss of incomes, and so sellers decided to raise prices. In effect, the decision to raise prices is simply the form whereby a disequilibrium situation was brought into balance. In the absence of a favorable state of demand, however, such a decision may result in distortions in the relative price structure, or a one-time increase in the general level of prices coupled with a loss of sales and increased unemployment. There is nothing in the process whereby sellers decide to raise prices that will assure a favorable state of demand. It is essentially for this reason that these views have descriptive but not analytical validity. Consider the view that unions are responsible for inflation in that they push up wages. In support of this view, evidence is presented that unit labor costs (in many forms) have risen faster than average productivity. Needless to say, in a period of inflation, this observation is a truism. It does not help us to tell whether wages pushed up prices or demand pulled up wages. Albert Rees long ago pointed out that in the absence of favorable state of demand, unions can cause either shifts in the relative wage structure, or a one-time increase in the general level of wages together with increased unemployment. The flexibility of nonunion wages determines what will actually occur. On the other hand, if the state of demand is favorable, union wage increases can be followed by inflation and continued full employment. An important but unfortunately neglected point is that a necessary (but not sufficient) condition for unions to set off a “wage–price spiral” is that they need more power to raise wages: they must have increasing power to do so. This is a point argued by Friedman more than fortyyears ago and reported before the Industrial Research Association in 1959. In fact, there is little evidence that unions are becoming increasingly strong. Indeed, to judge from the size of union membership roles and recent unfavorable legislation, that power may be decreasing.

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The above limitations similarly restrict the usefulness of the eclectic view that inflation is triggered and generated whenever labor and management attempt to get more than 100 percent of the selling price. It too depends on the existence or assurances of a favorable state of demand. At the same time, each party must be increasing its power as a necessary condition for setting off the wage–price spiral. The positions that argue that union demands spill-over into competitive sectors and so cause wages and prices to rise in this sector also depend, contrary to many of their adherents, on the existence of a favorable state of demand. This state of demand occurs when union employers bid away more and better workers from other employers, and so lead these employers to raise wages in order to hold their employees. Again, there is no conflict between the view that wages and prices rise because somebody raises them and the view that somebody raises them because of a favorable state of demand for such a rise exists. If the state of demand is not favorable to such a rise, a very different story will unfold and we may just as well talk in terms of a “spill-in” effect (movement of labor from union to nonunion activities). If owing to higher wages, union employers curtailed employment, the movement in general wages will depend upon two conditions. First, if wages elsewhere are flexible downward, the union workers will spill into nonunion activity and so nonunion wages will tend to fall. The movement in the general level of wages, if any, will depend, as Rees pointed out, on the precise shapes of demand schedules of union and nonunion employers. Consider now the view that oligopolies and monopolies, by administering prices, cause inflation. As noted elsewhere, the assertion is that administrative prices are more rigid than competitive prices, and so they are excellent conductors of inflationary pressures. Many economists—Martin Bailey for instance—argue that administered prices are not as rigid as they seem. Inasfar as these prices are rigid, their role in inflation is misunderstood. According to this interpretation, administrative prices during a period when the state of demand is favorable do not rise as rapidly as competitive prices; so in effect, they may well be below levels that would clear the market thereby creating waiting lists and gray markets. When administered prices do rise, however, they are apt to do so in large jumps, thereby attracting widespread attention and charges that they are responsible for inflation.


Money and Monetary Regimes

The converse argument—that administered prices are rigid on the downward side and so respond more slowly to an unfavorable state of demand than competitive prices—also leaves much to be desired. In the first instance, the evidence used to support this assertion is far from conclusive. Thus, the usual American evidence cited is that after World War II, during periods (particularly 1957–1958) when the state of demand was unfavorable, output and unemployment declined but prices, as judged by price indexes, did not. An examination of the past record, however, suggests that this is not a unique experience. Of the seven (other than 1957–1958) recessions since 1920, in four of them the consumer price index rose in the early months. Furthermore, these price indexes, among other limitations, do not pick up price changes that take the form of special discounts or other informal price concessions, such as freight absorption or advertising allowances. The effect is an understatement of actual price changes, and so overstates the actual degree of rigidity. In the second instance, it should be noted that insofar as the administered price argument throws the blame for inflation on large corporations, available studies suggest little if any relation between concentration ratios and price rigidity. In the view of many economists, the sources of price rigidity is not the market sector of the economy but, ironically, the government sector. It is this sector that administers rigid prices through the medium of various regulatory agencies, price support programs, minimum wages, agricultural marketing programs, support of “fair trade,” and restrictions on both domestic and foreign trade. Such policies are largely inconsistent with attempts to remove monopoly elements from the economy. According to the view that incorporates unions on the factor side and oligopolies on the product market side, large wage increases, even by strategically placed unions, may lead either to (a) distortions of the wage structure if other wages lag, or (b) rising costs and upward pressure on prices if other wages rise equivalently, or a combination of the two. The net effect will be that the economy will move between episodes of price plateaus (accompanied by a stretching of the wage structure) succeeded by periods of rising prices. But this view, as with others that de-emphasize the traditional approach to inflation, contributes nothing essentially new to our understanding of inflation. The traditional view does not deny that unions may “distort” wages or that unions may share in monopoly spoils. As noted elsewhere, in the absence of a favorable state of demand this may

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be one of the effects of a union wage rise. As the above view claims, the precise proportion between wage-distorting and cost-inflationary forces depends upon the economic climate—in particular upon the level of national income. It simply reasserts the traditional view with its emphasis on the favorable state of demand. The interesting point about this view is the implicit assertion that new industrial unions and oligopolies have, apparently, sufficiently changed the economic structure so that the pricing system lacks fluidity. Little evidence other than casual empiricism is offered in support of the above view. Indeed, such evidence that we do have supports the opposite view—the pricing mechanism is not becoming progressively less sensitive. Some consider the distinction between demand–pull and cost–push inflation useless. One view asserts that we cannot empirically identify inflation by types. This view apparently turns on the question of the timing of demand–pull and cost–push types of inflation; that is, on the identification of the lead and lag series. If inflation is the demand–pull type, then presumably demand should lead the increase in costs. If it is cost–push, then costs should lead demand. To put the distinction between the two types of inflation in this manner is to hopelessly confuse the issue. One would be hard put indeed to identify the existence of leads and lags in the various relevant series. The consensus, however, seems to be that the essential difference between the two types of inflation is to be found not in the timing of the various series, but rather in their sensitivity to changes in demand. Thus, if the struggle to obtain more than 100 percent of the selling price is sensitive to sales losses and unemployment then it is very unlikely that the struggle will continue in the absence of a favorable state of demand. On the other hand, if in the face of an unfavorable state of demand the struggle is such that substantial losses in sales and unemployment are the consequences, it does make sense to talk in terms of types of inflation. Another view is that we cannot ever conceptually classify inflation by type. This view is interesting in that at times it is similar to the argument that raged in the latter part of the nineteenth century over the determination of value. The view states that we cannot identify that part of the price rise attributed to a cost increase and that part attributed to an increase in demand. The argument was settled, of course, when it occurred to economists that “each blade in a pair of scissors cuts.” The


Money and Monetary Regimes

analogy between the controversies breaks down because this view claims too much. Economists have long held that although each blade cuts, it makes sense to distinguish between the blades. Changes in the price level may occur with shifts in either the supply schedules or the demand schedules or both. To argue that we cannot conceptually identify which part of a price rise is attributed to costs and which to demand is to assert that we are always in a position whereby both schedules shift simultaneously and by about the same amount. It would not be difficult to conjure up cases in which either demand or supply is the dominant element in prices rising. Although arguments against traditional methods of controlling inflation take many forms, they do possess a common thread: we cannot expect high levels of employment and output and at the same time maintain stability in the general level of prices. This is now the familiar unemployment versus inflation dilemma. Owing to the lack of fluidity in the American pricing system we cannot, so the argument goes, attempt seriously to use traditional methods against inflation because their use would simply add to unemployment. Inflation, accordingly, is the necessary price we must pay for avoiding unemployment and, presumably, for maintaining high levels of output. This represents another aspect of inflation views drawing on the Keynesian tradition. It attempts to rationalize the relation of wage and price movements to aggregate demand and supply through the Phillips curve, which as we noted, argues a link between variations in employment and price changes. There are a number of reasons why the lack-of-pricing-fluidity argument falls short of providing an adequate explanation. In the first place, less than a third of the workers are organized into unions, and many of these are weak unions. As Rees and others have noted, even a strong union may temper its wage demands when confronted with the existence or possibility of unemployment. Furthermore, the idea of the spillover effect, whereby unions set a pattern for wage demands for non-unionized workers, is not independent of demand. In the second place, the commitment by government to shore up the employment wall is not a commitment in particular occupations. Individuals and organizations are still free to price themselves out of the market. Finally, the argument tacitly assumes the existence of a period when prices and wages were flexible, and then proceed to argue that the situation now has changed and prices and wages are no longer flexible—at least not

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on the downside. But we do not have studies that indicate that prices and wages were more flexible in the past than they are now. Indeed, such studies that are available do not support the contention that the pricing mechanism is becoming progressively less sensitive; however, they do suggest continuing fluidity. NOTES 1. See Phillip Cagan, Persistent Inflation: Historical and Policy Essays (New York: Columbia University Press, 1979). 2. Alexis de Tocqueville, Democracy in America (Garden City, N.Y.: Doubleday, 1969). 3. Ibid., pp. 525–528.

7 A Role for Fiscal Policy

THE RISE OF FISCAL POLICY A Role for Fiscal Policy

Economists usually define fiscal policy as the manipulation of government spending or taxes for the purpose of affecting aggregate demand. By fiscal policy multipliers, we mean ratios of the change in real gross national product to policy-induced changes. Fiscal policy emerged as a response to the practical and theoretical problems of the 1930s. Before that decade, the maximum of sound government finance had been the annual balanced budget. This rule was coupled with another—a sound money system—which meant a gold standard and a central banking system that confined itself to maintaining a supply of money sufficient for the legitimate needs of trade. The change from the old to the new fiscal policy came during the 1930s. In the early years of the Great Depression, the United States as well as other countries attempted to combat the Depression with cuts in government expenditures; by so doing, they may have made matters worse. Indeed, Franklin Delano Roosevelt campaigned in 1932 on promises to restore sound finance and a balanced budget in the orthodox tradition. Once in office, however, Roosevelt’s policies included significant expenditures for public works and employment relief. At about the same time, John Maynard Keynes proposed deficit spending—that is, spending from borrowed funds—as a means for economic recovery in Great Britain. In 1936, when Keynes published The General Theory of Employment, Interest, and Money, the foundation for the


Money and Monetary Regimes

modern theory of fiscal policy was laid. After several years of discussion and controversy, Keynes’s theories came to be incorporated into the main body of accepted economic theory. By the late 1930s, the debates on Keynes’ theories and the knowledge gained from reflection on New Deal policies pump-priming and compensatory spending established the outlines of fiscal policy as it is now known. Alvin E. Hansen of Harvard University, among others, led the way in working out the theories of fiscal policy. Other economists at the University of Chicago fought a rearguard action, especially against the extravagances of Keynes’ disciples who, like all disciples, went further than their master. During World War II, economists continued to discuss fiscal policy and its uses in postwar stabilization. Economists now agree, and so do leaders in political life, that there should be a fiscal policy for stability. As illustrated in the monetarist-Keynesian dispute, disagreement continues over the emphasis to be given fiscal and monetary policy and on their appropriate policy mix. The propositions of income theory are briefly stated elsewhere in this study. Rules of abstract fiscal policy need not be restated here; they are contained in most texts on principles of economics. In any case, the real problems of concrete fiscal policy revolve about other matters. How good a guide is abstract fiscal policy to concrete policy decisions that the U.S. Congress and parliaments of other countries have to make this year? Not good at all, is the monetarist answer. The gap between pure economic theory and usable policy recommendations exists everywhere and is by no means peculiar to fiscal policy. But this obvious reminder has to be given again, due to the over enthusiasm of some Keynesian economists for fiscal policy. Abstract fiscal policy reaches its most exuberant expression in the writings of Keynesian economist Abba P. Lerner of Florida State University. He calls it “functional finance,” and would have the government simply adjust the total of all spending so as to eliminate both unemployment and inflation. Just like that! Government expenditures and taxes and printed money would be manipulated so as to force businesses and consumers to spend the right amounts. Consider some fiscal policy proposals not of the abstract sort, but of the kind intended for concrete action by Congress. These proposals were at first called compensatory—the federal budget would compensate for the deficiency of aggregate demand after allowing for private consumption and investment. Federal expenditures were visualized as

A Role for Fiscal Policy


filling a large gap. It was not very long into the postwar era that economists began to see that the problem was one of stabilization rather than secular stagnation, that the task of successful economic forecasting was proving to be disappointingly hard, and that some reliance could be placed upon built-in or automatic stabilizers. One consequence was a search for a rule, which, when followed, would cause the volume of federal expenditures and taxes to behave in such a way as to stabilize the economy. To put fiscal policy on an automatic rule would provide it with greater acceptance, especially among monetarists. A case in point is the 1947 proposal by the Committee on Economic Development (CED) for fiscal policy by rule, when the rule would be fixed tax rates, not to be modified except as a response to a major change in national policy. Other examples of fixed policy rules include automatic flexibility and formula flexibility. The built-in stabilizers of the federal budget provide the automatic flexibility of tax revenues that fall and expenditures that rise when unemployment increases. The built-in stabilizers are not subject to recognition lags, let alone the administrative and operational ones. These automatic stabilizers are cushion shocks and act as a first line of defense. They must be supplemented by additional measures of fiscal policy. Formula flexibility, on the other hand, is a modification of the rule concept. Under this concept, for instance, Congress would change the income tax laws so that rates (or exemptions or both) would move up and down in accordance with our appropriate economic index. In 1949, economists from various shades of the political spectrum agreed that monetary policy in the United States and elsewhere was inoperative. It was not until 1951 (really 1953, at the end of the Korean War) in the United States, and later in other countries, that independent monetary policy began. Since that time, there has been little agreement on stability policy. Keynesians look to a strong fiscal policy with monetary policy as an adjunct. The monetarists place their reliance on a strong monetary policy accomplished by a rule-bound fiscal policy.

MONETARY AND FISCAL POLICY MIX How should monetary and fiscal policy be mixed? Milton Friedman discussed this issue at some length during the height of the Korean War in 1951.1 This was a period of military buildup in the United States, which pushed inflation into double digits.


Money and Monetary Regimes

Friedman argued that “monetary and fiscal measures are the only appropriate means of controlling inflation.” He ruled out any recourse to wage–price controls. According to Friedman, monetary and fiscal measures are substitutes within a wide range. A large budget surplus would be consistent with no or, for that matter, any degree of inflation. In his view, a balanced budget would require tighter money to prevent inflation, and a budget deficit would require still tighter money. It is possible, according to Friedman, that budget deficits may get so large that they will simply overwhelm monetary policy. In fact, it may be impossible to design monetary policy that will prevent inflation. Consequently, there may not be a single best mix of monetary and fiscal policy and degree of inflation. According to Friedman, a good mix would be a roughly balanced budget (balanced over the business cycle) together with whatever associated monetary policy would prevent inflation. Moreover, no policy very far from this combination is likely to be appropriate. As for high interest rates, Friedman in 1951 argued that while they curb investment expenditures, they also curb consumer expenditures, including spending on nondurable and durable goods. One reason, of course, is that high interest rates make saving more attractive. They also reduce the capital value of existing streams of wealth and thus reduce the ratio of wealth to income. In effect, high interest rates increase the desire on the part of people to add to their wealth. High interest rates in 1951 as today are not popular with many people for a variety of reasons. These reasons, however, are insufficient to overrule the requisite monetary policy to bring inflation under control. Thus it was that interest rates remained high in the early 1980s, at least in part because financial markets did not believe that inflation was under control. Indeed, some analysts argued at the time that financial markets believed that meant U.S. budget deficits slipped into Friedman’s worst-case scenario and became so large that they ultimately overwhelmed monetary policy. President Ronald Reagan’s economic program was originally thought to be what the financial markets ordered. This assumption proved to be premature. Again, the debate was over interest rates and deficits. The key issue, according to some observers, was that longterm interest rates at the time embodied in them the expectation of deficits three or four years out. Financial markets feared that deficits would either stifle a recovery or rekindle inflation later. At the time, conventional wisdom on Wall Street was that uncertainty over the then

A Role for Fiscal Policy


record-breaking deficits in excess of $100 billion Reagan proposed was a major reason—if not the only one—why interest rates were high. Lenders were demanding a high premium for their money because they did not know what economic conditions would prevail when they got paid back. Moreover, there was a feeling widely shared in the U.S. financial community that the Reagan administration was not paying attention to their views. Indeed, the Reagan administration argument that neither the Federal Reserve nor the government can do anything about the persistence of high interest rates was less than reassuring to the financial community. This pessimistic view was, in fact, written into investors’ expectations, and thus into high interest rates. There is a considerable distance between the political and financial worlds. One explanation for the gulf of misunderstanding between the two worlds is mutual suspicion. Wall Street looks upon the federal government as a “bloated monster loosed upon the land by vote-starved politicians.” Washington, on the other hand, tends to think of Wall Street “as a tiny cell of conspirators secretly manipulating the markets of America to exploit Main Street.” In fact, deficits do matter. The U.S. economy can tolerate deficits less readily than other countries because the U.S. economy is a comparatively low-saving economy. For example, in recent years in Japan, personal savings, as a percentage of disposable personal income, was four times as large as in the United States. In the Federal Republic of Germany, it was about three times as large. As the business sector is, in most countries, a net borrower, one must look at personal saving on the main source of surplus funds. In short, countries that save a lot (such as Germany, Japan, and indeed, Italy) experience less difficulty in financing a given level of deficit, expressed as a share of Gross Domestic Product, than countries with lower rates of saving (such as the United States). Although it is still a relatively low ratio to Gross National Product (GNP), the U.S. fiscal deficit accounts for a large share of available surplus funds and is of the same order of magnitude as total net outlays for new plant and equipment. When extra budgetary borrowing on behalf of other agencies is also taken into account, the current (mid1990s) borrowing requirements of the federal government are such as to leave little of the surplus saving available for private sector borrowing. Unless the projected levels of fiscal deficits over the remainder of the 1990s can be reduced, only a very large expansion of private saving


Money and Monetary Regimes

would prevent serious crowding out and upward pressure on interest rates. Moreover, if a recent National Bureau of Economic Research study for the United States is correct that there is a relatively fixed relationship between the total debt (both private and public) and GNP, the increase in public debt will imply a crowding out of private debt, with obvious implications for capital formation. In the United States, for example, total debt has averaged about 140 percent of GNP for several decades. In the 1960s, curiously, when the ratio of public debt to GNP in the United States was declining, the economy was growing at a lively pace. In the 1970s when that ratio was either stationary or increasing, the rate of growth slowed down. In essence, high fiscal deficits accompanied by tight monetary policies (as measured in terms of the rate of growth of the money supply) may not generate inflation, but nevertheless raise interest rates and thus bring about a reduction in private productive activities. This reduction itself will magnify the size of the deficit through its built-in negative effects on revenues and positive effects on public expenditures. Germany, Japan, and the United States are important examples of countries that have in the past pursued tight monetary policies in the face of sizable fiscal deficits. Suppose now that fiscal deficits are accompanied by an accommodating monetary policy. If the economy’s productive capacities are fully utilized, the increase in aggregate demand will bring about increases in prices and wages. In the short run, the increase in the money supply may bring about a decline in nominal interest rates as a result of the liquidity effect. Consumption will rise at the expense of saving as inflationary psychology prompts people to anticipate purchases. The demand for financial assets will fall, while that for real assets will rise, leading to a process of disintermediation in the capital market. Imports will expand, leading to a deterioration in the balance of payments. If exchange rates are fixed, there will be a loss in net foreign reserves that will tend to reduce the initial acceleration in the money supply growth. If exchange rates are flexible, the rate will depreciate, adding further to the domestic inflation rate. In short, high budgetary deficits accompanied by an accommodating monetary policy tend to aggravate inflation. As an alternative to borrowing from the central bank or the private sector, governments can and do borrow abroad. For industrial countries where domestic capital markets are well integrated with those abroad,

A Role for Fiscal Policy


the process is direct if not always simple. Indeed, the evidence indicates that the practice of foreign borrowing to finance budget deficits has become prevalent since the 1970s, along with the rapid expansion of international financial markets, as both industrial and developing markets incurred significantly larger deficits. In fact, during the latter part of the 1970s, estimates place foreign deficit finance as about one-sixth of industrial countries’ budget deficits and one-third of those of developing countries. Indeed, if borrowing by public enterprises could be accounted for, these percentages would no doubt be much higher. Moreover, the recent pool of international saving provided by OPEC countries unable to fully absorb their saving internally has become smaller. Though perhaps still sufficient to accommodate requirements of the smaller developing countries, the pool is inadequate to meet U.S. needs and other industrial countries. If interest rates in the United States drift upward, the country will no doubt attract many of these funds and thus contribute to financing the U.S. deficit. This will tend to aggravate the capital-needs situation in developing countries and elsewhere, who will thereby face much stronger competition and higher interest rates. The implications are ominous for developing countries. Deficits of large countries do indeed have implications for the rest of the world. Given the present and persistent size of fiscal deficits in many countries, authorities are severely restricted in their ability to use fiscal policy in a countercyclical fashion. To regain their freedom, countries are best advised to pursue policies that reduce budget deficits. This will enhance the chances that the negative effects of restrictive monetary policy will be removed and countries will be able to enjoy growth without inflation. Under these circumstances, perseverance and political courage are required in dealing with the fiscal problem.

FISCAL POLICY AND CROWDING OUT The monetarist view of fiscal policy is that pure fiscal expansion without monetary accommodation may influence national income in the short run. In the long run, however, such government expenditures will “crowd out” or replace some elements of private expenditure so that real income remains unchanged. If reduction in private expenditure is identical in magnitude to the increase in government expenditure, the long-run fiscal multiplier is zero and crowding out is said to be complete. When the fiscal multiplier is greater than


Money and Monetary Regimes

one, absence of crowding out is indicated. Crowding out is partial when the fiscal multiplier is between zero and one. In this instance, income rises by an amount less than the increase in government expenditure. Overcrowding is said to occur when the multiplier is negative. Private expenditures will fall by a greater magnitude than the rise in government expenditure. The analysis of crowding out, moreover, can be done in real or nominal terms. I discuss elsewhere the technical and analytical issues involved in crowding out in both terms.2 Suffice it here to note that one concept of crowding out does not imply the other; the distinction between them is important. Given expansionary fiscal operations on the part of government, various combinations of real and nominal crowding out are possible. Presumably, the process also works in reverse. That is, reducing government expenditures may have the effect of “crowding in” private expenditures. This may have the effect, among others, of replacing “nonproductive” government expenditures, thereby increasing the total output of goods and services in the economy. It is an implication that economists would accept. To judge from studies made several years ago, the results do indicate that crowding out does indeed occur. 3 It would seem that the question is no longer whether crowding out exists, but how much time it needs to occur. For instance, the Wharton Mark III model yielded a multiplier of minus three after thirty quarters, and the U.S. Department of Commerce model on the same period was minus twenty-three. This is far in excess of a crowding out effect as defined by a steady-state government spending multiplier of near zero. The performance of small monetarist models, such as that of the Federal Reserve Bank of St. Louis, suggests crowding out occurs in a much shorter period of time than in the earlier Keynesian-type models. Moreover, crowding out occurs in nominal rather than in just real terms. The reported results in the St. Louis model indicate that government spending, as measured by high-employment expenditures, exercises a relatively strong influence on GNP, assuming a constant change in the money supply in the current quarter and the next quarter, but it is offset approximately within a year’s time. All of this, of course, does not mean that government spending does not matter. Indeed, it matters very much, especially if government expenditures accelerate or decelerate rapidly. The reduced form results of the St. Louis model are all the more interesting since they do not

A Role for Fiscal Policy


follow from a structural model that constrains the channels of transmission from fiscal actions to economic activity. This is consistent with the monetarist view that government expenditures cover a wide range of activities. They may substitute or complement private sector expenditures for consumption and investment. The very diversity of these effects is apt to render limited any model that severely restricts the transmission channels of fiscal actions to income and/or interest rates. As such, the full impact of government expenditures on the private sector may well be missed. These and other simulation studies have served, and do indeed serve, as tools for policymakers who use them along with other information to make public policy. The size and variability of monetary and fiscal policy multipliers that they yield leave much to be desired. Indeed, Michael Evans, a leading builder of large econometric models, agrees that econometric models built around Keynesian demand theories are seriously flawed, primarily because they ignore supply-side factors.4 Moreover, failure to take into account recent data and changing economic structures (including legal and sociopolitical changes) limits the usefulness of these large econometric models for both simulation exercises and forecasting purposes. For instance, observers note that the parameters and multipliers of many models are typically based on people’s past reactions to government policies. As such, their utility for policy-simulation purposes has limited value to policy markets, though these models may still be useful for forecasting purposes. Forecasting, however, has its own shortcomings. No matter how sophisticated the econometric model used, it depends on the political and economic assumptions about government policies on which it rests. If these assumptions change, the model’s forecasts will very likely be erroneous. Furthermore, since we cannot attach probability statements to economic forecasts, the utility of these models is limited. What we can say is that if a forecaster could make the same forecast under the same conditions a very large number of times, he would be correct a certain percentage of the time—albeit within a certain range. This is not very useful, unfortunately, if we wish to forecast turning points in the GNP.5 The inability to forecast accurately has serious implications for stabilization policies, as we noted elsewhere. Together with variability of leads and lags in stabilization policies, erroneous forecasts have pushed some policy makers to reject short-run stabilization policies altogether in favor of a policy of rules.



Money and Monetary Regimes

The finding of a strong empirical relationship between several measures of money and economic activity suggests that monetary policy can play a singularly important role in stabilization policy. Indeed, failure to recognize these relationships can have serious consequences on economic activity. These relationships to economic activity, moreover, appear more certain than fiscal actions. Furthermore, the evidence provided in a number of Federal Reserve Board of St. Louis studies is consistent with other evidence that suggests that the money stock is an important indicator of the total thrust of stabilization actions, both monetary and fiscal. In the first instance, changes in the money stock principally reflect discretionary actions of the Federal Reserve System as it uses open market operations, discount rate changes, and reserve requirements. Second, the money stock reflects the joint actions of the Treasury and Federal Reserve System in financing newly created government debt. These actions are based, in the final analysis, on decisions regarding the monetization of new debt by Federal Reserve actions, and Treasury decisions regarding changes in its balances at Reserve banks. Thus, changes in government spending financed by monetary expansion are reflected in changes in the monetary base and in the money supply. As noted above, many economists argue that the major influence of fiscal actions results only if expenditures are financed by monetary expansion. In the United States, the Federal Reserve does not buy securities from the government. Its open market operations, along with other actions, serve to provide funds in the markets in which both the government and private individuals borrow. Moreover, it is not easy to reverse a stimulative stance in fiscal policy—a result in part of the institutional context in which fiscal tools are used. To be sure, some fiscal tools, such as automatic stabilizers, can be redirected very quickly. These programs expand and contract more or less automatically in response to changes in the pace at which the economy is expanding. Such programs include unemployment compensation, welfare programs, leasing subsidies, and, in the United States, the progressive nature of the federal tax structure. Some insight into how difficult it is to quickly change the posture of fiscal policy in either direction may be had by considering that all new programs in the United States require congressional approval. This approval must be in a form that provides for the actions sought by the administration. Bills are sometimes changed in committee or on the floor of Congress in ways that significantly redirect their thrusts. Much

A Role for Fiscal Policy


the same is true in tax legislation. Political realities often intervene to make either raising or lowering taxes a long, drawn-out process. The political give-and-take may very well result in less than an optimal tax system. Transfer payments, although they are outlays rather than taxes, are subject to the same forces that slow tax changes. Changes are likely to be a long time in coming, and temptation to embellish a proposed program is likely to be considerable. In fact, once recipients become accustomed to the payments, they and their political representatives will not be anxious to see them withdrawn when the need for stimulus passes. Discretionary changes in transfer payments thus tend to be one-way stabilization tools at best, for use when stimulus is needed. According to some observers, fiscal policy in many countries, particularly in such critical years as the 1960s and 1970s, has become a major destabilizing force.6 Indeed, many of title transfer programs and other benefits were introduced when their cost was low and their future fiscal consequences were ignored. In other cases, highly optimistic forecasts about important variables, such as growth, unemployment, and inflation, were made at the time the programs were introduced or expanded, mainly during the 1960s and early 1970s. Changed circumstances since those years has made it very difficult for many countries to keep their commitments and still pursue a sound fiscal policy.

INFLATION TAX Inflation is a method for raising revenue by a special kind of tax. This is a tax on the real money holdings, or, in the technical jargon of the economist, on the real cash balances of individuals. When a government is either too weak or is unwilling on grounds of political expediency to enact adequate tax programs and to administer them effectively, it resorts to inflation as a method of raising revenue. This tax is often appealing because it does not require detailed legislation and can be administered very simply. All that is required is to spend the newly created money. The resulting inflation automatically imposes a tax on the real money holdings or cash balances of individuals. The tax rate is the rate of depreciation in the real value of money, which is equal to the rate of rise in prices. The revenue (in real terms) is the product of this base and the rate. The money-issuing authorities “collect” all the revenue. When prices rise in greater proportion than the quantity of money (demand deposits, time deposits, and currency in


Money and Monetary Regimes

public bonds)—that is, when the real value of cash balances declines— part of the revenue goes to reduce the real value of the outstanding money supply. At the same time, inflation also reduces the real value of the principal and interest charges of debt fixed in money or nominal terms. Thus total revenue for a period of time is the sum of two factors: first, the real value of new money issued per period of time; and second, the reduction in outstanding monetary liabilities, equal to the decline per period of time in the real value of cash balances. It should be noted, however, that the money-issuing authorities do not set the tax directly. They set the rate at which they increase the money supply, and this rate through the willingness of individuals to hold and not spend the additional money supply. Institutions other than the government have money-issuing powers. Insofar as these institutions exercise these powers, they share in some of the revenue from tax, even though the initiating factor is government creation of money. However, in past inflations, these other institutions for the most part largely dissipated the revenue from their share of the tax. Banks, for example, largely dissipated their share by making loans at minimal rates of interest that did not take full account of the subsequent rise in prices. Thus the real rate of interest received was, on the average, below the real return that could be obtained on capital. The revenue dissipated went to the borrowers. The revenue received by the government consequently depends on the tax base, the tax rate, and the fraction of the revenue that goes either to institutions such as banks or to their borrowers. However, a higher tax rate will not yield a proportionately higher revenue because the tax base, or the level or real cash balances, will decline in response to a higher rate. As an increasing number of people begin to believe in the inevitableness of inflation, their money holdings will ultimately decline more than in proportion to the rise in tax rate, so that a higher rate will yield less revenue. It is at this point that inflation enters into a transition between “creeping” and “galloping” varieties. The productivity of taxation through inflation has been examined by Phillip Cagan. In his study of severe hyperinflation (galloping inflation), Cagan finds that the actual share of national income procured for different governments that used inflation as a means of taxation was 3 to about 15 percent, except for Imperial Russia, which had an unusually low percentage of 0.5.7 In almost all cases, the revenue collected by the inflationary tax was lower on the average than could have been col-

A Role for Fiscal Policy


lected by other means of taxation, given that the respective countries had a stable growth in the money supply. The recent rediscovery of issuing inflation-proof government debt promised savers that they will have a safe haven for their savings. The United States Treasury appears ready to issue index-linked debt (i.e., bonds whose interest payments and principal are tied to inflation). 8 In America, the practice was already known in 1780 when the state of Massachusetts issued bonds which promised that payments of both interest and principal would not be fixed in money terms, but would depend on the price of “five bushels of corn, sixty-eight pounds and four-seventh parts of a pound of bee, ten pounds of sheep’s wool, and sixteen pounds of sole leather.” 9 The reason for such a venture was that inflation was high and hard to predict, given that there was a war, making lenders wary of ordinary bonds.

A BALANCED BUDGET AMENDMENT Attempts to address the issue of federal deficits which stem from unbalanced budgets—budgets that spend more than they take in through taxation—is a recurring theme in American politics, especially since the World War II. The questions asked are familiar though. Should the federal budget be balanced by law, as many state and local budgets are? Should the United States adopt a constitutional amendment requiring a balanced federal budget? Just such questions were asked in 1982 when President Reagan pushed forward to Congress proposals for a balanced budget amendment to the Constitution. Although the balanced budget proposal did not pass Congress, it did generate considerable support. In fact, support for the proposal is such as to make it an ongoing issue before Congress and elsewhere. Does the proposal for a balanced budget amendment make any sense? Clearly, the continuing federal budget deficits since the 1960s have done little to reduce unemployment, and may, in fact, have simply complicated the problem of economic stability and growth of the American economy. Proponents of a constitutional amendment argue that balanced budgets would serve to stabilize the economy by removing the instability of government action. Such an amendment, moreover, would serve to cut federal programs, many of which are expensive and wasteful. Proponents note that spending is harder to cut than many people imagine. Attempts to cut spending


Money and Monetary Regimes

in the early 1980s simply raised deficits, in good part because of the deep recession in the 1980s. Income transfers automatically increased to help the unemployed, who paid less tax because they earned less wages and income. Apparently, runaway government spending cannot be controlled through tax cuts. The proponents thus turned to a constitutional amendment as the only serious route to legally force expenditures down to the level of tax receipts. To be sure, the political motives behind the balanced budget amendment are not always clear. Some people see it as a way to reduce social programs; others as a means to reducing defense expenditures, and so on. Still others favor a budget amendment rather than a constitutional correction with unforeseen consequences, including greater government restrictions of one kind or other on individual rights. The fact is that simple as a balanced budget amendment looks (i.e., expenditures equal revenues), the devil is in the details. Would the government resort to expansion via crediture expenditures as it did in the 1980s and as it did through tax expenditures in the 1970s? Or would the government’s influence on allocation and distribution through taxing spending, transfers, tax expendittfres, and so forth be reduced in unpredictable and unexpected ways? The fact of the matter is that debt is a major government revenue source. Government borrowing, and tax collection, goes by many names. It includes deficits, deficit spending, deficit finance, taxes—including taxes through inflation—and bond financing. The impact on the economy of such activities by government are many and diverse. Attempts to constrain such activities through a balanced budget amendment, while laudable, to many people is no easy chore. It simply is not easy to amend the American Constitution; three-fourths of the states must ratify an amendment once it passes through Congress. NOTES 1. See, for example, Milton Friedman, ed., Essays in Positive Economics (Chicago: University of Chicago Press, 1953). See also Herbert Stein, Fiscal Revolution in America (Chicago: University of Chicago Press, 1969). 2. See George Macesich, Monetarism, Theory and Policy (New York: Praeger, 1983), pp. 168–183. 3. For example, see Gary Fromm and Lawrence R. Klein, “A Comparison of Eleven Econometric Models of the United States,” American Economic Review (May 1973): 385–93; Lawrence R. Klein, “Commentary on the State

A Role for Fiscal Policy


of the Monetarist Debate,” Review, Federal Reserve Bank of St. Louis (September 1973): 9–12; K.M. Carlson, “Monetary and Fiscal Actions in Macroeconomic Models,” Review, Federal Reserve Bank of St. Louis (January 1974): 8–18; R.W. Hafer, “The Role of Fiscal Policy in the St. Louis Equation,” Review, Federal Reserve Bank of St. Louis (January 1982): 17–22. 4. Michael Evans, “Bankruptcy of Keynesian Econometric Models,” Challenge (January/February 1980): 13–19. 5. See, for instance, Victor Arnowitz, “On the Accuracy and Properties of Recent Macroeconomic Forecasts,” American Economic Review (May 1976): 313–19. 6. See, for instance, J. de Larosier, “Coexistence Official Deficits: High Tax Burdens in Consequence of Pressures for Public Spending,” IMF Survey (March 22, 1982): 82. 7. These occurred in Austria, October 1921 to August 1922; in Germany, August 1922 to July 1923; in Greece, November 1943 to August 1944; in Hungary, March 1923 to February 1924; again in Hungary, August 1945 to February 1946; in Poland, January 1923 to November 1923; and in Imperial Russia, December 1921 to January 1924. See Phillip Cagan, “The Monetary Dynamics of Hyper Inflation,” in Milton Friedman, ed, Studies in the Quality Theory of Money (Chicago: University of Chicago Press, 1956), pp. 25–117. See also Milton Friedman, “Government Revenue from Inflation,” Journal of Political Economy (July/August 1971): 852–54 especially. 8. See “Of Beef, Bushes, and Bonds,” The Economist (May 25, 1996): 84. 9. Ibid.

8 Rational Expectations and Monetary Policy


For more than a quarter century after World War II, discretionary monetary and fiscal policies have had a mixed record in reducing cyclical fluctuations that were indeed mild by historical standards. By the 1970s these discretionary policies oscillated between attempts to combat inflation and attempts to combat unemployment, with poor timing, and for the most part, indifferent and perverse results. In effect, the turbulent 1970s were dominated by discretionary policies and seemingly uncontrollable inflation, recessions, sharp declines in real wages, unemployment, energy problems, as well as various raw material shortages. They stand in marked contrast to the comparatively prosperous early postwar years, which appeared to justify the optimism of Keynesians and their reform liberal allies. The “stagflationary” disappointments of the 1970s—the high rates of unemployment, inflation, and interest; the depressed stock market; and the slowdowns in productivity and growth and capital formation—discredited Keynesianism and its intellectually reformed liberalism and ushered in a political and ideological counterrevolution spearheaded by monetarism (Quantity theory) and neoliberalism in the form of “Reaganomics” in the United States and “Thatcherism” in Great Britain.


Money and Monetary Regimes

Just as Keynesian theory inspired the revolution, so the synthesis of Keynesian and neo-classical doctrines that became orthodox in the 1950s and 1960s sustained the counterrevolution. I have discussed elsewhere the important intellectual role of Milton Friedman, Quantity theorists (Monetarists), and the Chicago School in bringing the counterrevolution. This has compelled a debate on the growth of government power and intervention in economic and political affairs. Though opinions differ, evidence does suggest that, in general, monetary authority can control nominal quantities and directly the quantity of its own liabilities. By manipulating the quantity of its own liabilities, it can fix the exchange rate, the price levels, the nominal level of material income, and the nominal quantity of money; it also has a direct influence on 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 material income. Again, though opinions differ, the bulk tends to tilt on the side that the monetary authority cannot, through control of nominal quantities, fix 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 material income, or the rate of growth of real quantity of money. Economists are quick to point out, however, that this does not mean that monetary policy does not have important effects in these real magnitudes. Indeed, when money gets out of order, important repercussions are felt throughout the economy. Monetary history provides evidence on this point. The debate continues as strong as ever over the monetary regime and effectiveness of monetary policy as a means for influencing economic activity. Keynesians over the years have argued that money and monetary policy have little or no impact on income and employment, particularly during severe economic depressions. Moreover, government taxation and spending—in effect, fiscal policy—are most effective when dealing with problems of inflation and unemployment. Quantity theorists (monetarists) stress the importance of money. They argue that a rule that requires the monetary authority to cause the nominal stock of money to increase by an annual fixed percentage would effectively reduce fluctuations in prices, real output, and employment. More recently, the new classical economists argue that adjustment in nominal variables, such as nominal income and prices, is complete and expectations are rational in the short run. They differ from Quantity

Rational Expectations and Monetary Policy


theorists and Keynesian views on this point. The importance of this difference is that to Quantity theorists and Keynesians a government’s demand management policies exercised through monetary policy and fiscal policy can be an effective means for stabilizing the economy. Anticipated government demand management policies, according to the new classicals, will leave no effect. There are no trade-offs, for instance, between employment and inflation even in the short run. The effect of anticipated demand management policies of government is only inflation. On the other hand, such policies can be used to solve the problem of inflation without undue loss of real output. This chapter focuses on the issues raised by Quantity theorists, Keynesians, and new classicals over the monetary regime and monetary policy as a means for influencing economic activity.1 THE PROBLEM The problem confronted by policymakers is whose advice to rely upon in formulating and executing monetary policy. Should they rely upon that of the now discredited Keynesians and their all but total disregard of expectations, rational or otherwise? Should it be the advice of the mainline monetarists who have used rational expectations to undermine the one-time firm belief in the stability of the Keynesian Phillips-curve trade-off, but find unacceptable the new classical view of rational expectations and its insistence that a freely anticipated money supply policy is ineffective? In short, should it be the advice of the Keynesians that the cure for inflation and stability is not to be found in monetary policy only; should it be the monetarist view of monetary policy that only a slow and gradual growth in the money supply within a rules-orientated policy system; or should it be a quick and clean break to end inflationary monetary growth as the new classical school argues? CRITICISM OF STANDARD MACROMODEL EXPECTATIONS The new classical macroeconomic models are not short on advice. Unfortunately, these models are not as simple and straightforward as the older macromodels whereby a given change in some policy variable will produce an x percent rise in GNP with y percent rise in prices. The new models say all of this too but add that it all depends upon the “state of expectations.” But how is a policy maker to gauge the “state of


Money and Monetary Regimes

expectations” and measure it quantitatively? Since such measures are notoriously unreliable, how does the policy maker select from alternative policies? To be sure, most practitioners have attempted to deal with expectations if not always successfully. Most are also aware that expectations affect all the parameters of the macroeconomic system. Many econometric model builders, for instance, consider themselves as working on the frontiers of new economic knowledge. Indeed, they insist that since the 1940s when the present generation of large econometric models (e.g., Wharton Models) was first being developed, expectations played a key role in the formulation of model structure. Accordingly, the most important use of expectations occurs in model development through the use of sample survey information. These model builders strongly deny that their forecasts and policy analysis have failed to keep pace with the role of expectations in economic theory. In their view when expected values are wanted in their econometric models they go to the source and measure these expectations by tabulating answers to questions posed to economic factors in sample surveys. Their models use indexes of consumer sentiment, expected purchases, expected income, and expected prices as measures of expectations by the public at large. Detractors point out, however, that expectations have no known measurable weight or duration so that the whole concept and influence upon the course of the economy remains very subjective and vague. Even in sophisticated markets, so the argument goes, expectations shift constantly and analytical evaluations are sharply divergent. Even given government policy, it is difficult to judge and assign weight to foreign events, political upheavals, and natural disasters. There is no “one number” to summarize expectations or indeed their meaning. Moreover, there remains the suspicion that people answer questions about expectations very lightly indeed. In addition, answers themselves may well be sensitive to the wording of the question. These are among the more obvious questions raised about the validity of expectation surveys. And, indeed, in the case of consumption in the United States, the findings from the Michigan Survey Research Center are used to approximate expectations about the future levels of household income. In the case of investment, stock market prices are used to gauge expectations about future business profitability. In both cases, the effort to incorporate expectations into the analysis explicitly led to little or no improvement in the ability to model the behavior of business firms and

Rational Expectations and Monetary Policy


households. Despite questions raised about these expectation surveys, examination of the Michigan Survey Center studies shows them to be reasonable and useful. The Center is correct in promoting and studying the formation of expectations and improving the methodology of such surveys. In addition to survey data, expectations can be measured in other ways. For instance, econometric equations that infer expectations from the behavior of measurable data such as interest rates or wage changes are used in some studies. In other studies broad historical analyses are used. Perhaps most important in terms of their use are expectations formed from past experience. This is in the nature of the learning process itself which may be slow, thanks to the difficulties of extracting accurate information from limited and very brief data. This may also be an advantage since it allows experience to accumulate before any precipitous action is undertaken. Another important source of information on expectations are prices and quantities transacted in markets where actions reflect expectations. Thus the expectation of inflation must affect interest rates. Given a theory of how expectations affect interest rates, it is possible to estimate expectations from observed interest rates. Of course, there must always be a theory between the observed facts such as nominal interest rates and the implied expectations. As useful as it is to have better data surveys and on a regular basis of the expectations of households and firms, such efforts will not likely resolve the existing controversies and uncertainties regarding the role of expectations as viewed by new classical economists.2 It is not the answers given by households and firms to questions asked in surveys that are relevant for economics, but the way in which views of the future affect supply and demand decisions of households and firms. Private agents take account of expected future developments, but do not necessarily take into explicit account magnitudes of variables to prevail in the future when they make their supply and demand decisions. Consequently, there are really no records as such to which one can turn for answers to questions asked in surveys and, of course, nothing to induce conformance between actual and reported expectations; it is doubtful that additional data, however carefully gathered, will do much to resolve the issue of expectations. The point is that expectational theories suggest that agents act as if they formed explicit expectations according to some criterion as ratio-


Money and Monetary Regimes

nale. These theories, however, do not imply that such agents are explicitly aware of their expectational magnitudes anymore than traditional economic theory implies that firms are explicitly aware of their marginal revenue and marginal cost functions at any given moment of time. Thus, there is nothing inconsistent about the argument that assigns expectations a primary role and yet argues that agents are not necessarily able to provide accurate answers to questions regarding their expectations. This is also correct even if the argument asserts that expectations are formed rationally and thus without systematic errors. A useful illustration of why expectations about the future affect decisions made today is provided by Friedman’s analysis of the determinants of how much of a household’s current income it wishes to save for the future. Thus, the more a household earns the more it will it tend to spend. Friedman’s point, however, is that current expenditures for the household depend not only on current income but also on expected future income. If a household expects to earn more in the future it will also tend to spend more today. Life expectancy, anticipated future earnings, and indeed expected future tax payments will tend to influence a household’s decisions about how much to spend now and how much to save. The above is similar for a firm when it considers and makes its investment decisions. For instance, a firm will weigh the present cost of a piece of machinery against the additional profits it expects such equipment to generate over its productive lifetime. As a result, forecasts about the future demand for the firm’s product(s) and the price at which the product(s) will sell are an essential element in a rational investment decision. As with the household, the firm will have expectations about the future which will influence its investment decision. Such factors as future tax policy, government regulation, and a host of other assorted factors will influence expectations regarding the future.

STATUS OF STANDARD MODELS What then is the status of the current standard macroeconomic and macroeconometric models? Can they be renovated so as to take into account the new developments in expectations. The answer, according to the new classical views, is no. The deficiencies in the standard models cannot be remedied by simply adding a few extra equations or a few variables as their sponsors argue. They are basically flawed

Rational Expectations and Monetary Policy


because of the manner in which the expectations foundations are constructed in these models. This is certainly at odds with the views held and advanced by the proponents of standard large scale econometric models as noted above (e.g., Wharton model, Klein–Goldberger model [1948], including FMP, Brookings, DRI, Chase, and UCLA models of the American economy). Their critics brush aside such remonstrations. They insist that these models simply do not accurately depict the way in which agents form expectations or the way in which their supplies and demands will respond to various policy measures. As a result they are not very useful for conditional forecasting; that is, forecasting conditional upon various assumptions regarding governmental policy. Any important change in policy will lead to changes in agents’ supply-demand behavior that will not be taken into account by the equations of the model. Consequently, information about the effects of policy changes derived from large-scale econometric models will be innaccurate. These prediction errors, moreover, will not be random. Indeed, the models’ forecasts will be systematically incorrect. If these large models are used for prediction, it is assumed that the policy to be followed is not significantly different from the one in force when the model was designed and estimated. If significant changes in the direction and emphasis of, say, monetary and fiscal policy does occur, the foregoing justification is inapplicable. It is after all nonsense to argue that we can accurately predict the effects of major policy changes with a tool which assumes no important change has taken place.3 In summary, the existing large-scale econometric models which are in turn based on standard macroeconomic models cannot accurately predict the effects of major policy changes. According to the critics, replacement models must take into explicit account expectations and should incorporate the hypothesis that expectations of private agents are rational. Expectations cannot be manipulated independent of reality. Statements about what people reply to in survey studies or about what policy makers hope will happen all dressed up as in the form of predictions are unlikely to have a serious effect on expectations, particularly if other information is available to agents acting in their own self-interest.

EXPECTATIONS: ADAPTIVE OR RATIONAL? It is useful to consider briefly how expectations are formed. This appears to be the key issue in the role of expectations in economics.


Money and Monetary Regimes

The traditional and standard macroeconomic model proceeds on the assumption that agents form expectations of future events according to a given simple rule. Thus the value of a variable, say x, which agents expect to observe in the coming period is simply a weighted average of the values of x which have been observed during the previous periods. Both the values of the (ai) and the order of the weighted sum (n) are either based on statistical procedures or arbitrarily selected by the model’s constructors. The general class of these expectation modulus is called “autoregressive” (AR) since the expected future values of x are based simply on the past values of x. To be sure AR models are an improvement over static models. As a class of expectations models, however, they are generally too restrictive. These models assume that whatever information an agent may have about future values of x it is restricted to its past values. Moreover, AR models may at times not make full use of available information. For instance, an agent may have information about the future course of other variables which are known to be systematically related to x. In such cases AR models can be interpreted as assuming that agents do not make full use of potentially valuable information. AR models of expectation formulation are widely used in economic analyses and policy. Their attractiveness to economists and others is their obvious mathematical simplicity and their agreeable assumption, to many economists at least, that agents form their expectations from relatively simple and stable forecasting schemes. Future rates of inflation, for instance, are supposed to be forecast by simple extrapolations of the behavior of inflation in the recent past. That is, agents form their expectations in an “adaptive” manner. Unfortunately, “adaptive expectations” schemes are plagued by a number of shortcomings. Agents, for one, are not as naive about how inflation, unemployment, and output are determined. They do not ignore the interactions of a modern economy in such issues as the money supply, inflation, employment, and output. As a result “adaptive expectations” schemes typically produce economic forecasts which are persistently erroneous. Moreover, agents who act in their own best interests would simply not form expectations adaptively. Such agents would use all the information they have available in the most efficient manner. And indeed this observation led John Muth as early as 1961 to propose the alternative hypothesis or “rational expectations.”

Rational Expectations and Monetary Policy


In essence, the “rational expectations” hypothesis as formulated by Muth argues that agents do indeed use all the information they have available in the most efficient manner. Such information would include not only past behavior of the economic variable being forecast, but also the past behavior of other economic variables which interact with that variable as well as any other information agents have about what they think might happen in the future. This does not mean, of course, that rational expectations are never wrong nor that forecasting errors can be avoided. The uncertain nature of a real world would quickly repudiate any such claims. It does mean that systematic mistakes can be avoided. For this reason they are superior to adaptive expectations which do lead to systematic errors because not all available information is used. Thus it is that in coming to grips with inflation in the 1970s the late 1960s versions of the large traditional econometric models based largely on adaptive expectations grossly underestimated what actually happened to rates of inflation, unemployment, and output. For instance, these models predicted that a sustained rate of unemployment of 4 percent would be consistent with an annual rate of inflation of 4 percent. The evidence, however, indicates that in each of the years from 1970 to 1973 and before the OPEC crisis both unemployment and inflation were significantly higher than the amounts suggested by the traditional large macroeconometric models. Nor indeed were these models stable. Thus, addition of new data in the 1970s did nothing to maintain user confidence in these models. In fact the estimates produced were significantly different from actual values. This suggested that the structure of the economy had changed so that the initial specification of the models were no longer appropriate. Nor indeed were such complicated ad hoc “add factors” much help in improving the performance of the models. These models, unfortunately, had serious consequences for public policy. They had the effect of creating an illusion that inflation was somehow an integral part of the economic structure. In these adaptive expectations models, inflation projections are little more than extrapolations of previous inflation trends with allowance for the effects of changes in unemployment rates, capacity utilization, and other shortterm market conditions. In effect, if monetary policy and fiscal policy were to have any effect on inflation they would be required to be restrictive for a very long time since the lower inflation rates would need to pass through the parameters of the adaptive expectations


Money and Monetary Regimes

process and so to significantly alter the momentum in the inflation process. Policy makers were erroneously advised by the users of such models that halting inflation would place unbearable costs on society in terms of unemployment and output losses. As a result, monetary and fiscal policies in most industrialized countries had an inflationary bias. They were, moreover, misguided into believing that “income policies” including wage and price controls could be used to bring down inflation rates by breaking the psychology of inflation. Such “stop and go” policies simply have not worked as a means for controlling inflation. Rational expectations hypothesis, however, is not just another way of modeling how agents forecast the future. Indeed if this were the case the hypothesis could be added to the existing macromodels in place of the adaptive expectations hypothesis. According to Robert Lucas in his now well-known criticism of standard macroeconomics, rational expectations is a far more serious challenge. Economists must simply, according to Lucas, reconsider the entire way in which economic models are formulated. His discussion focuses on agents’ decision rules that express their economic behavior in terms of those factors on which their behavior depends. Lucas’s analysis attempts to show that changes in the general economic environment within which agents carry out their on-going affairs, say in changes in the money supply, would result in changes in the entire form of these decision rules. In essence, changes in the “rules of game” in which agents participate will impact upon the economic behavior of agents. Since behavior does depend upon the “rules of the game,” economists must significantly change the way economic models are formulated and used to assess the effects of alternative government policies when these rules change. In effect, Lucas’s contribution may be summed up by the observation that if expectations are rational, then the parameters of standard macroeconomic models will not be invariant to policy change. Thus, even though standard models might serve as a useful summary of the way things have been in the past, they may provide useful projections about the path the economy would take if policy maintains its historical course. They are of little use in assessing the likely course of the economy if policy were changed. Choosing economic policies, based on comparisons of stimulations from standard models, is in effect a misleading venture. Thomas Sargent, Neil Wallace, Robert Barro, and others have also joined in raising doubts about the usefulness of standard macroeconomic models. Moreover, the rational expectations hypothe-

Rational Expectations and Monetary Policy


sis does not assume that agents are possessed of perfect foresight as some critics argue. It simply states that there is no sound theoretical reason for restricting an agent’s information sets to historical values of the “own” series as in the adaptive expectations hypothesis. The rational expectations hypothesis leaves the choice of agent’s information sets to the modeler subject to the condition that ex ante agents possess the same information about the structure of the model as does the modeler. The net effect is to severely constrain the options open to the modeler. Such constraints do not allow the modeler free rein to assume any level of detail about the structure of the overall model without violating the assumed expectations process. For instance, a modeler cannot assume circumstances, conditions, and information not available to the economic agent. An example will illustrate the issue. Thus a modeler cannot construct a model for a market for commodity X which depends not only on the price for X but also on consumer incomes and prices for complimentary goods while requiring that agents in the model (producers of X) forecast future prices by extrapolating only the recent price of X. In short, the modeler makes only one choice for the structure of the model which is chosen by the modeler and also represents the information set available to agents with the model. The issue may be illustrated with yet another example. Patterns of human behavior depend very much on the “rules of the game.” Change in the “rules of the game” would also change the pattern of human behavior as a result. If the entire tax system were to change, for example, rational expectations hypothesis implies that the very way people plan their spending and saving would change. Current spending can still depend upon current income. Its precise relationship, however, would in general be quite different after the change in tax rates. Past behavior of agents will not be a reliable guide to future behavior because the “rules of the game” have now changed. In a changing economic environment wherein the “rules of the game” are also changing historically based patterns of behavior may indeed be a poor guide for the construction of stable macroeconomic models. Unlike actions taken against inanimate subjects, human subjects are capable and indeed react to actions taken by policymakers. The fact that agents do look forward in making their decisions has important implications for the way policymakers think of and attempt to design suitable macroeconomic policy. If expectation decisions are taken seriously, it becomes necessary for government policy to be accurately and easily predictable.


Money and Monetary Regimes

The best way to achieve this is for the government to follow well-understood policy rules. Thanks to its large size relative to individual agents, government does have a special responsibility to be clear, predictable, and consistent. It is absolutely essential for private decisionmaking for the government to follow a widely understood and predictable rule. The primary objective of good economic policy may well be predictability since agents do make decisions that are forward-looking. A rational expectations hypothesis suggests that predictability in government policy is essential since it facilitates the making of forecasts by private agents. Good private agent forecasts are mutually advantageous for the effective and productive operation of the economy. The implications for the conduct of monetary policy are straightforward. Given that monetary aggregates are viewed by agents as important sources of swings in aggregate demand, monetary policy is an important factor influencing expectations. For this reason monetary policy should be based on policy rules that are publicly announced and adhered to. Such an arrangement will assure that monetary authorities act in a clear predictable and consistent manner. On this fundamental and important issue of rules versus discretionary authority, the new classical school and the rational expectations hypothesis are in agreement with the old style monetarists. 4

NOTES 1. George Macesich, Monetary Policy and Rational Expectations (New York: Praeger, 1987). 2. See, for instance, L.R. Klein, Economic Fluctuations in the United States, 1921–1941 (New York: John Wiley, 1950). 3. See, for instance, the views on rational expectations expressed in S. Fischer, ed., Rational Expectations and Economic Policy (Chicago: University of Chicago, for N.B.E.R., 1980) and Journal of Money, Credit, and Banking 12, no. 4, part 2 (November 1980). See also Robert E. Lucas, Jr. and Thomas J. Sargent, eds., Rational Expectations and Econometric Practice (Minneapolis: University of Minnesota Press, 1981). 4. For a useful discussion of these and related issues see Bennett T. McCallum, “Topics Concerning the Formulation, Estimation, and Use of Macroeconomic Models with Rational Expectations.” American Statistical Association. 1979 Proceedings of the Business and Economic Statistics Section, pp. 65–72.

9 Constraining the Struggle for Monetary Supremacy: Cooperation Theory

THE ISSUE Constraining the Struggle for Monetary Supremacy

The operation and indeed survival of the unprecedented fiat monetary regime depends on its nation-state participants. Historically, governments of nation states do attempt to secure various domestic goals by unsustainable inflationary policies. Governments pursuing accommodating monetary and fiscal policies should be on notice that they cannot count on being supported by other countries. Clearly, they would have to be tougher in allowing, for instance, cost–push or wage–price spiral inflation to have its normal effects on causing unemployment and less-than-capacity operation of their economies. It would be equally clear to employers and unions that they could not count on the government to support their inflationary actions by inflationary monetary and fiscal policy. How are countries persuaded to behave consistently and predictably and not attempt to achieve temporary domestic or international advantages at the expense of another country? Is it possible to modify existing institutions and policies so that each participant acts as in a free market to promote an end that was no part of their intention as if led by the Smithian invisible hand? For suggested insights we turn to cooperation theory.1

COOPERATION THEORY Can a worldwide managed fiat monetary regime operate without the benefit of conscious action by planners and governments in an area


Money and Monetary Regimes

where independent egoistic nations and domestic special interests face each other in a state of near anarchy? Can these diverse domestic and international monetary interests evolve reliable cooperative strategies so as to provide an anchor to the long-term price level? Can cooperation emerge in a world of diverse domestic monetary interests and sovereign states? In short, can cooperation evolve out of noncooperation? Specifically, how can cooperation get started at all? Can cooperation strategies survive better than their rivals? Which cooperative strategies will do best, and how will they come to predominate? As it turns out, our cooperation theory can help us in gauging the utility of such monetary reform proposals as a monetary growth rule in promoting cooperation, and indeed, the likely success of the reform itself and the viability of a managed fiat monetary regime. Many of the problems facing these nations and domestic monetary interests take the form of an iterated “prisoner’s dilemma.”2 In the prisoner’s dilemma game two individuals (or nations) can either cooperate or defect. The payoff to a player is in terms of the effect the action will have. No matter what the other does, the selfish choice of defection yields a higher payoff than cooperation. If both defect, however, both do worse than if they cooperated. For purposes of illustration let us assume “A” (developed-creditor nations) and “B” (developing-debtor nations) in Figure 9.1 agree to trade. Both are satisfied as to the amounts they will be receiving. Assume further that for some reason the exchange is to take place in secret. Both argue to place money in a designated location. Let us assume that neither A nor B will ever meet again nor have further dealings.

Figure 9.1 Prisoner’s Dilemma: A = Developed-Creditor Nations; B = Developing-Debtor Nations (the game is defined by: T > R > P > S and R > (S + T)/2

Constraining the Struggle for Monetary Supremacy


Now if both A and B carry out their agreement both stand to gain. It is also obvious that if neither A nor B carried out the agreement, neither would have what it wanted. It is equally obvious that if only one carried out its end of the bargain—say A—B would receive something for nothing since they will never again meet nor have further dealings. There is this incentive for both A and B to leave nothing. As a result neither A nor B get what they initially wanted. Does the logic present cooperation? That is the “prisoner’s dilemma.” The iterated prisoner’s dilemma can be made more quantitative and in that form studies by the methods of game theory and computer simulation. In order to do this we build a “payoff matrix” presenting hypothetical values for the various alternatives such as in Figure 9.1. In this matrix, mutual cooperation by A and B yields to both parties three points. Mutual defection yields to both zero points. If A cooperates but B does not, B gets five points because it is better to get something for nothing. The number 3 is called the “reward for cooperation” R. The number 1 is called the “punishment” or P. The number 5 is T for “termination,” and zero is 5, the “sucker’s payoff.” The conditions necessary for the matrix to represent a prisoner’s dilemma are the following: T>R>S