Money in Historical Perspective 9780226742298

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A National A National Bureau Bureau of Economic Economic Research Research of Monograph

Money in Historical Perspective

Anna J. Anna J. Schwartz Schwartz

with an Introduction by by Michael D. Bordo and Milton Friedman

The University of of Chicago Press Chicago and London

ANNA J. SCHWARTZ is research associate emerita with the National Bureau of of Economic Research. MICHAEL D. BORDO is professor professor of of economics at the University of of South Carolina Carolina and a research associate at the National Bureau Bureau of of Economic Research. research fellow at the Hoover MILTON FRIEDMAN is a senior research Hoover Institution.

The University University of of Chicago Press, Chicago 60637 The University University of of Chicago Press, Ltd., London © © 1987 by The National Bureau of of Economic Research Research Published 1987 All rights reserved. Published Printed of America Printed in the United States of 5 4 3 2 96 95 94 93 92 91 90 89

Libnry Library of of Congress Congress Cataloging-in-Pub6eation Cataloging-in-Publication Data Data Schwartz, Anna Anna Jacobson. Money in historical perspective.

(A National Bureau Bureau of Research monograph) of Economic Research monograph) "These ' T h e s e articles were presented presented to Anna at a honor in New conference conference held in her honor New York City on October 6, 1987"-Pref. 1987"-—Pref. October "Publications "Publications of of Anna J. Schwartz"-P. Schwartz"—P. Bibliography: p. Includes index. 1. Money-United States-History. 1. Money—United States—History. 2. MoneyMoney— Great Great Britain-History. Britain—History. 3. Monetary Monetary policy-History. policy—History. 4. standard—History. I. Title. II. Series. 4. Gold standard-History. HG538.S354 1987 332.4'9 87-5973 HG538.S354 1987 332.4'9 87-5973 ISBN 0-226-74228-8

National Research National Bureau Bureau of of Economic Economic Research Omcers Officers Richard N. Rosett, chairman chairman George T. Conklin, Jr., vice-chairman vice-chairman Martin Feldstein, president president

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Contents Contents

Preface Preface

ix

Acknowledgments Acknowledgments

xi

Introduction Introduction by Michael D. Bordo and Milton Friedman I.

MONEY AND BANKING IN HISTORICAL PERSPECTIVE 1. The Beginning of of Competitive Banking in Phlladelphia, Philadelphia, 1782-1809 [1947] 2. Money and Business Cycles [1963] with Milton Milton Friedman Friedman with 3. Secular Price Change in Historical Perspective [1973]

II.

vii

xiii

33

24

78

4. Understanding 1929-1933 [1981]

110 110

of British Market Interest Rates, 5. A Century of 1874-1975 [1981]

152

MONETARY MONETARY POLICY

6. Why Money Matters [1969]

167

7. How Feasible Is a Flexible Monetary Policy? [1975] with Phillip Cagan with Phillip Cagan

183

viii

III. III.

Contents

of Money Substitutes 8. Has the Growth of Hindered Monetary Policy? [1975] with Phillip Cagan with Phillip Cagan

209

9. Clark Warburton: Pioneer Monetarist [1979] with Michael D. Bordo with Michael Bordo

234

10. The Importance of of Stable Money: Theory and Evidence [1983] with Michael D. Bordo with Michael Bordo

255

11. Real and Pseudo-Financial Pseudo-Financial Crises [1986]

271

12. Has Government Any Role in Money? [1986] with Milton Friedman with Milton Friedman

289

INTERNATIONAL MONETARY ARRANGEMENTS INTERNATIONAL MONETARY

Report 13. Reflections on the Gold Commission Report

[1982]

317

14. The Postwar Institutional Evolution of the Intemational International Monetary System (1983)

333

15. Alternative A1temative Monetary Regimes: The Gold Standard [1986]

364

16. Lessons of of the Gold Standard Era and the Bretton Woods System for the Prospects of an Intemational International Monetary System Constitution [1986]

391

Appendix: Publications of of Anna J. Schwartz

407

References

413

Index

429

Preface

It It is a pleasure to issue this collection of articles by Anna Jacobson

Schwartz. For more than five decades, Anna has contributed to our understanding of the economy. Her studies of monetary policy, banking, and the gold standard have added significantly to our knowledge of has of these these important important topics. topics. It It is is indeed indeed fortunate fortunate for for NBER NBER that that she she has been associated with with us us since since 1941. 1941. been associated These articles were presented to Anna at a conference held in her high honor honor in in New New York York City City on on October October 6, 6, 1987. 1987. They They maintain maintain the the high level of of scholarship scholarship all all Bureau Bureau publications hope to to achieve. achieve. In In one one publications hope level the important important respect, respect, however, however, some some of of these these articles articles depart depart from from the Bureau*s firm firm tradition tradition of of avoiding avoiding policy policy recommendations. recommendations. Other Other Bureau's NBER publications must must confine confine themselves themselves to to analyzing analyzing the the effects effects NBER publications of policies policies and and strictly strictly eschew eschew recommending recommending one one course course of of action action over over of another. Some Some of of the the papers in this this volume volume were were originally originally written written for for papers in another. other purposes purposes and and do do take take policy policy positions. positions. Rather Rather than than omit omit any any of of other these papers, papers, we we decided decided instead instead to to make make an an exception exception to to the the Bureau's Bureau's these rule. rule. II would would like like to to thank thank Michael Michael D. D. Bordo Bordo and and Milton Milton Friedman Friedman for for selecting these articles and for organizing the conference honoring Anna. not Anna. Without Without their their initiative initiative and and hard hard work, work, this this volume volume would would not have been been published. published. Mark Mark Fitz-Patrick Fitz-Patrick of of NBER NBER gave gave valuable valuable guidguidhave ance in in preparing preparing the the manuscript manuscript and and able able research research assistance assistance was ance was provided Ivan Marcotte. Marcotte. II would would also also like like to to thank thank the the Alex Alex C. C. provided by by Ivan Walker Educational Educational and and Charitable Charitable Foundation Foundation and and the the Earhart Earhart FounWalker Foundation for for their their generous generous financial financial support support of of the the conference conference and and the the dation publication. publication. Martin Feldstein ix

Acknowledgments

The author and the University of Chicago Press wish to thank the original publishers of the essays in this volume for permission to reprint them and to thank Michael Bordo, Phillip Cagan, and Milton Friedman for for permission permission to to reprint the-essays the essays that that they they coauthored. coauthored. Chapter Chapter 1. 1. "The "The Beginning Beginning of of Competitive Competitive Banking Banking in in Philadelphia, Philadelphia, 1782-1809," Journal of 417-431. 1782-1809," Journal of Political Economy Economy (October (October 1947): 1947): 417-431. Copyright Copyright 1947 1947 by byThe The University University of of Chicago. Chicago. Reprinted Reprinted by by permission permission of Press. of The The University University of of Chicago Chicago Press. and Chapter Chapter 2. 2. "Money "Money and and Business Business Cycles," Cycles," by by Milton Milton Friedman Friedman and Economics and Anna J. andStatistics Statistics(February (February1963): 1963): Anna J. Schwartz, Schwartz, Review of Economics supplement, of supplement, 32-64. 32-64. Copyright Copyright 1963 1963 by by the the President President and and Fellows Fellows of Harvard permission of PubHarvard College. College. Reprinted Reprinted by by permission of Elsevier Elsevier Science Science Publishers V. (North-Holland). lishers B. B. V. (North-Holland). Chapter JourChapter 3. 3. "Secular "Secular Price Price Change Change In In Historical Historical Perspective," Perspective," JourMoney, Credit, Banking (February nal nal of of Money, Credit, and and Banking (February 1973): 1973):part part11,243-269. II, 243-269. by permispermisCopyright Copyright 1973 1973 by by Ohio Ohio State State University University Press. Press. Reprinted Reprinted by sion of of the the Ohio Ohio State State University University Press. Press. All All rights rights reserved. reserved. sion Depression Chapter Chapter 4. 4. "Understanding "Understanding 1929-1933," 1929-1933," in in The The Great Great Depression Revisited, ed. Karl Karl Brunner Brunner (Boston: (Boston: Martinus Martinus Nijhoff), 5-48. CopyNijhoff), 5-48. CQPYRevisited, ed. right 1981 University of Governright 1981 by by University of Rochester Rochester Center Center for for Research Research in in Government Policy Policy and and Business. Business. Reprinted Reprinted by by permission permission of of Kluwer-Nijhoff Kluwer-Nijhoff ment Publishing. Publishing. Chapter Chapter 5. 5. "A "A Century Century of of British British Market Market Interest Interest Rates, Rates, 1874-1975" 1874-1975" The by permission The Henry Henry Thornton Thornton Lecture Lecture (January (January 1981). 1981). Reprinted Reprinted by permission of Finance. The City City University, University, Centre Centre for for Banking Banking and and International International Finance. of The Lloyds Bank Chapter Chapter 6. 6. "Why "Why Money Money Matters," Matters," Lloyds Bank Review Review (October (October 1969): 1-16. 1-16. Reprinted Reprinted by by permission permission of of Lloyds Bank Review. Review. 1969): Lloyds Bank xi

xii

Admowledgments Acknowledgments

Chapter Phillip Chapter 7. 7. "How "How Feasible Feasible Is Is aa Flexible Flexible Monetary Monetary Policy," Policy," by by Phillip Cagan Cagan and and Anna Anna J. J. Schwartz, Schwartz, in in Capitalism and Freedom: Problems and Prospects, ed. ed. R. R. T. T. Selden Selden (Charlottesville: (Charlottesville: University University of of Virginia Virginia Press). by The University of Virginia. Reprinted by Press). Copyright Copyright 1975 1975 by The University of Virginia. Reprinted by permission of the the University University of of Virginia Virginia Press. permission of Press. Chapter MonChapter 8. 8. "Has "Has the the Growth Growth of of Money Money Substitutes Substitutes Hindered Hindered Monetary Anna J. J. Schwartz, Journal of of etary Policy?" Policy?" by by Phillip Phillip Cagan Cagan and and Anna Schwartz, Journal Money, Credit, Banking (May (May 1975), 1975), 137-159. 137-159. Copyright Copyright 1975 1975 by by Money, Credit, and Banking Ohio by permission the Ohio Ohio State State University University Press. Press. Reprinted Reprinted by permission of of the Ohio State State University Press. All rights reserved. University Press. All rights reserved. Chapter Chapter 9. 9. "Clark "Clark Warburton: Warburton:Pioneer PioneerMonetarist," Monetarist,"bybyMichael MichaelD.D.Bordo Bordo and and Anna Anna J. J. Schwartz, Schwartz, Journal Journalof ofMonetary MonetaryEconomics Economics(January (January1979): 1979): 43-65. Copyright Copyright 1979 1979 by by North-Holland North-Holland Publishing Publishing Company. Company. Reprinted Reprinted 43-65. by permission of of Elsevier Elsevier Science Science Publishers Publishers B. B. V. V. (North-Holland). (North-Holland). by permission Chapter to. "The EviChapter 10. "The Importance Importance of of Stable Stable Money: Money: Theory Theory and and Eviand Anna Anna J. J. Schwartz, Schwartz, The TheCato CatoJournal Journal dence," by by Michael Michael D. D. Bordo Bordo and dence," 33 (May (May 1983): 1983): 63-82. 63-82. Copyright Copyright 1983 1983 by by the the Cato Cato Institute. Institute. Reprinted Reprinted by permission of The The Cato Cato Journal. by permission of Journal. Chapter Financial Crises Crises," in in Financial Crises Chapter 11. 11. "Real "Real and and Pseudo-Financial Pseudo-Financial Crises," and and the the World World Banking BankingSystem, System, ed. ed. Forrest Forrest Capie Capie and and Geoffrey Geoffrey E. E. ForWood York: Macmillan, Wood (New (New York: Macmillan, 1986), 1986), 1:11-31. 1:11-31. Copyright Copyright 1986 1986 by by Forrest Capie rest Capie and and Geoffrey Geoffrey E. E. Wood. Wood. Reprinted Reprinted by by permission permission of of Forrest Forrest Capie and and Geoffrey Geoffrey E. E. Wood. Capie Wood. Chapter Any Role by Milton Chapter 12. 12. "Has "Has Government Government Any Role in in Money?" Money?" by Milton Friedman and Anna Anna J. J. Schwartz, Schwartz, Journal Journalof ofMonetary MonetaryEconomics Economics(Jan(JanFriedman and uary 1986): 37-62. 37-62. Copyright Copyright 1986 1986 by by Elsevier Elsevier Science Science Publishers Publishers B. uary 1986): B. V. permission of PubV. (North-Holland). (North-Holland). Reprinted Reprinted by by permission of Elsevier Elsevier Science Science PubV. (North-Holland). lishers lishers B. B. V. (North-Holland). Chapter Report," Journal Journal Chapter 13. 13. "Reflections "Reflections on on the the Gold Gold Commission Commission Report," of Money, Credit, and Banking Banking (November 538-551. of Money, (November 1982): 1982): part part 1, 1, 538-551. Copyright by Ohio University Press. permisCopyright 1982 1982 by Ohio State State University Press. Reprinted Reprinted by by permission of of the Ohio State State University Press. All sion the Ohio University Press. All rights rights reserved. reserved. Chapter Chapter 14. 14. "Postwar "Postwar Institutional Institutional Evolution Evolution of of the the International International The International InternationalTransmission Transmissionofof Inflation, Monetary System," System," in in The Monetary Inflation, ed.ed. 14-45. Copyright Michael Michael R. R. Darby, Darby, James James R. R. Lothian, Lothian, et et al. al. 1983, 1983, 2: 2:14-45. Copyright 1983 by University of of Chicago. Chicago. Reprinted Reprinted by of the 1983 by the the University by permission permission of the University of Chicago Chicago Press. University of Press. Chapter Chapter 15. 15. "Alternative "Alternative Monetary Monetary Regimes: Regimes: The The Gold Gold Standard," Standard," in Alternative Monetary Monetary Regimes, Regimes, ed. Dougan, in Alternative ed. C. C. Campbell Campbell and and W. W. Dougan, by Johns University. Reprinted per1986. 1986. Copyright Copyright 1986 1986 by Johns Hopkins Hopkins University. Reprinted by by permission the Johns University Press. Press. mission of of the Johns Hopkins Hopkins University Chapter the Gold Bretton Chapter 16. 16. "Lessons "Lessons of of the Gold Standard Standard Era Era and and the the Bretton Woods the Prospects an International International Monetary Monetary System System Woods System System for for the Prospects of of an Constitution." meeting of EcoConstitution." Presented Presented at at the the July July 1986 1986 meeting of the the Western Western Economic Association, Association, San San Francisco. nomic Francisco.

Introduction Michael D. D. Bordo and Milton Friedman Michael Bordo and Milton Friedman

Background Our collaboration collaboration with Anna Jacobson Jacobson Schwartz Schwartz has has been been aa rare and Our with Anna rare and wonderful experience—spanning more three decades decades for for FriedFriedwonderful experience-spanning more than than three man, over over aa decade decade for for Bordo. man, Bordo. As an an economic economic historian historian and and monetary economist, Anna is dediAs monetary economist, Anna is dedicated to accuracy, precision, and thoroughness-qualities thoroughness—qualities present even in the the earliest earliest of of her her papers papers reprinted in this this volume, fascinating reprinted in volume, aa fascinating in account of of the the beginning beginning of of competitive competitive banking in Philadelphia banking in Philadelphia (Chap(Chapaccount ter 1). 1). That That dedication, dedication, repeatedly repeatedly demonstrated demonstrated during during the course of the course of ter our collaboration, collaboration, has has guaranteed guaranteed aa solid solid scholarly scholarly foundation foundation for for our our our joint publications. joint publications. As aa friend friend and and colleague, colleague, Anna Anna is is aa thoughtful, thoughtful, considerate, considerate, uniAs uniformly helpful, and warm human being with firm principles and wideranging tolerance—as demonstrated demonstrated by by the remarkable fact fact that we the remarkable that we ranging tolerance-as cannot recall any episode episode involving involving acrimony acrimony in in our our many many years of cannot recall any years of collaboration. Disagreement, frank criticism, criticism, discussion, discussion, strongly strongly held held collaboration. Disagreement, frank views, acrimony, personal pettiness, never. never. That That views, yes; yes; acrimony, personal recrimination, recrimination, pettiness, has been common experience experience of of the several persons of widely widely has been the the common the several persons of different temperaments and personalities who have been privileged to .different temperaments and personalities who have been privileged to collaborate with with her her closely closely at at one one time or another. another. collaborate time or Born Anna Jacobson Jacobson on on November November 11, 11,1915, in New City, Anna Anna 1915, in New York York City, Born Anna received from Barnard College in in 1934, 1934, an an M.A. M.A. and and Ph.D. Ph.D. received aa B.A. B.A. from Barnard College Michael Michael D. D. Bordo Bordo is is professor professor of of economics economics at at the the College Collegeof ofBusiness Business Administration, Administration, University of research associate the National Bureau of EcoUniversity of South South Carolina, Carolina, and and aa research associate of of the National Bureau of Economic Research. nomic Research. Milton Friedman is aa Senior Senior Research Research Fellow Fellow at at the Institution on on War, War, RevRevMilton Friedman is the Hoover Hoover Institution olution and and Peace, Stanford University. University. olution Peace, Stanford

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Michael D. Bordo and Milton Friedman

from Columbia University in 1936 1936 and 1964, 1964, respectively. Married to Isaac Schwartz in 1936, 1936, she did not let her marriage, or the loving care she and Isaac lavished on their four children, all now grown and living independently, interfere with the pursuit of a demanding professional professional career, devoted primarily to research, though with occasional forays forays into into teaching teaching (at (at Brooklyn Brooklyn College College 1952, 1952, Baruch Baruch College College 1959-60, 1959-60, Hunter Hunter College 1967-68, 1967-68, and and New York University University 1969-70). 1969-70). College New York A year year at at the the U.S. U.S. Department Department of of Agriculture Agriculture in in 1936 1936 was was followed followed A by by five years years at at Columbia Columbia University's University's Social Social Science Science Research Research CounCouncil, where where she she collaborated collaborated with with A. A. D. D. Gayer Gayer and and W. W. W. W. Rostow Rostow on on aa cil, study of of The The Growth Growth and and Fluctuation of the the British 1790study Fluctuation of British Economy, Economy, 17901850, published published in in 1953 1953 in in two two volumes volumes under under that that title. title. Although Although the the 1850, study has has become become something something of of aa classic classic in in British British economic economic history, history, study and was was republished republished in in aa second second edition edition in in 1975, 1975, Anna's Anna's later later work work led led and her to to revise revise her her views views on on the the role role of of monetary monetary forces forces in in British British ecoecoher nomic history, as as she she explains explains in in aa new new preface preface to to the the second second edition. edition. nomic history, Anna's interest interest in in and and profound profound understanding understanding of of British British institutions institutions Anna's and British British economic economic history history have have continued continued ever ever since. since. Two Two examples examples and are the the papers papers on on secular secular price change and and on on British British interest interest rates rates are price change that are are reprinted reprinted in in Chapters Chapters 33 and and 55 of of this this book. So also, also, on on aa larger larger that book. So scale, is is her her contribution contribution to to Monetary Trends in in the the United United States States and scale, Monetary Trends and the United United Kingdom, authored jointly with Friedman Friedman (1982). (1982). the Kingdom, authored jointly with In In 1941, 1941, Anna Anna joined the the National National Bureau Bureau of of Economic Economic Research Research and has has remained remained with with the the bureau bureau ever ever since, since, becoming an emeritus emeritus and becoming an research associate associate in in 1985. research 1985. In 1981-82, 1981-82, Anna performed performed a major public service when she served as as staff staff director director of of the the U.S. U.S. Gold Gold Commission, Commission, in in which which capacity capacity she she wrote volume volume 11 of of the the Report Report of of the the Gold Gold Commission. Commission. Once Once again, again, wrote her her scientific scientific and and personal personal qualities qualities stood stood her her in in good good stead.Despite stead.Despite the controversy controversy surrounding surrounding the the role role of of gold, gold, and and the the highly highly political political the nature of of the the commission, commission, Anna Anna was was able able to to work work effectively effectively and and conconnature genially with with all all the the members members of of the the commission commission to to gain gain their their respect respect genially and trust trust and and to to produce produce aa report will long serve serve as as an an invaluable invaluable and report that that wi11long source document document for for anyone anyone interested interested in in the the gold gold standard. standard. Her Her ininsource terest in in the the gold gold standard standard also also led led to an NBER conference that that she she terest to an NBER conference helped to to organize organize in in 1982, 1982, and and her her "Introduction" "Introduction" to to the the resulting resulting helped volume, A on the the Classical Classical Gold Gold Standard, Standard, 1921-1931 volume, A Retrospective Retrospective on 1921-1931 (1984). (1984). Anna has served at various times as a member of the Board of Editors of of the the American Economic Review, the the Journal of of Money, Credit, Credit, and Banking, and and the the Journal of of Monetary Economics. She She has has been Banking, been aa regular regular participant in in the the Carnegie Carnegie Rochester Rochester Conference Conference Series Series on Public Policy Policy and and is is aa founding founding member member of of the the Shadow Shadow Open Open Market Market Public

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Introduction

Committee. She is currently an Honorary Visiting Professor Professor at the City University, London Business School, and will be president of the Western Economic Association in 1987-88. 1987~88. Scholarly Work Anna's major scholarly contributions are contained in the impressive body of work that she has written in collaboration with others: the book jointly with book authored authored jointly with Gayer Gayer and and Rostow; Rostow; the the series series of of books books and and articles that that developed developed out out of of her her long long collaboration collaboration with with Friedman Friedman on on articles the National Bureau of of Economic Economic Research's Research's money money and and business business cycle cycle the National Bureau project; her her participation participation with with Michael Michael Darby, Darby, James James Lothian, Lothian, and and project; others on on aa bureau bureau study study of of the the international international transmission transmission of of inflation; inflation; others her collaboration collaboration with with Phillip Phillip Cagan Cagan on on two two articles articles on on monetary monetary policy; policy; her conand aa series series of of articles articles jointly authored with with Bordo. Bordo. (Appendix (Appendix 11 conand jointly authored tains aa complete complete bibliography bibliography of of her her writings.) writings.) tains Anna's Anna's contributions, contributions to to these these publications, publications, as as well well as as to to those those that that she has authored alone or jointly with still other collaborators, are in four particularly monetary four related related areas: areas: economic economic statistics, statistics, particularly monetary statistics; statistics; economic history, particularly monetary history; monetary theory and policy; policy; and and international international monetary monetary arrangements. arrangements.

Statistics Statistics The meticulous care she has expended on constructing basic statistical tical series series is is exemplified exemplified in in the the British British share share price price index index and and comcommodity price index developed in the Gayer-Rostow study; in the monthly estimates of currency United States to 1944, 1944, estimates of currency holdings holdings in in the the United States from from 1917 1917 to published jointly with Emma Oliver (1947); of (1947); in monthly estimates of gross by all gross dividends dividends and and interest interest payments payments by all corporations corporations in in the the United United States in in the the nineteenth nineteenth century century (1960); (1960); and, and, above above all, all, in in the the massive massive States collection of of monetary monetary and and economic economic statistics statistics for for the the United United States States collection and the the United United Kingdom Kingdom contained contained in in three three Friedman-Schwartz Friedman-Schwartz books books and (Monetary History of the the United United States States [1963], [1963], Monetary Monetary Statistics Statistics of (Monetary History of of the United United States States [1970], [1970], and and Monetary Trends in in the the United United States States the Monetary Trends and the the United United Kingdom Kingdom [1982]). [1982]). Most Most of of these these series series have have by by now now and become the the common common stock stock in in trade trade of of economists economists and and historians. historians. become Economic Economic History History A characteristic feature of Anna's work on economic history is its strong Never aa compiler strong quantitative quantitative base. base. Never compiler of of statistical statistical data data for for its its own sake, she has sought to test her interpretations of historical episodes sodes not not only only with with qualitative qualitative data data but but also, also, whenever whenever possible, possible, with with numerical data. data. The The interweaving interweaving of of descriptive descriptive history, history, economic economic analanalnumerical

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Michael D. Bordo and Milton Friedman

ysis, ysis, and and quantitative quantitative evidence evidence is is characteristic characteristic of of all all her her historical historical work, book on work, whether whether in in the the early early Gayer-Rostow-Schwartz Gayer-Rostow-Schwartz book on British British Monetary History, History, or history, history, the the later later Friedman-Schwartz Friedman-Schwartz Monetary or the the articles articles reprinted reprinted here here in in Part Part I. I. In In the the process, process, she she has has helped helped to to construct construct aa sound sound factual factual and and analytical analytical base base for for later later students students of of related related topics. topics. Monetary Monetary Policy Policy The The historical historical evidence evidence linking linking economic economic instability instability to to erratic erratic monmonetary product of etary growth, growth, in in tum turn largely largely aa product of discretionary discretionary monetary monetary manmanagement, agement, has has persuaded persuaded Anna Anna of of the the importance importance of of stable stable money money and and of the case case for for aa constant growth rule. rule. As she of the constant money money growth As aa consequence, consequence, she of has has devoted devoted much much attention attention in in the the past past two two decades decades to to the the study study of monetary policy in the the United United States States and and other other countries. countries. monetary policy in As As aa founding founding member member of of the the Shadow Shadow Open Open Market Market Committee, Committee, organized by Allan organized by Allan Meltzer Meltzer and and Karl Karl Brunner Brunner in in 1971, 1971, Anna Anna has has been been engaged engaged in in continuous continuous critical critical evaluation evaluation of of the the Federal Federal Reserve's Reserve's performance. This This aspect aspect of of her her work work is is reflected reflected in in Part Part II II of of this this book, book, which which reprints published over reprints seven seven articles articles published over aa seventeen-year seventeen-year span, span, dealing dealing basic issues with with aa variety variety of of basic issues of of monetary monetary policy. policy. International International Monetary Monetary Arrangements Arrangements Anna's Anna's interest interest in in international international monetary monetary arrangements arrangements began began with with her her collaboration collaboration with with Michael Michael Darby, Darby, James James Lothian, Lothian, and and others others on on study of of the the international international transmission transmission of of inflation, inflation, leading, leading, as as noted noted aa study earlier, earlier, to to her her organizing organizing with with Bordo Bordo aa conference conference on on the the Gold Gold Standard, Standard, and culminating culminating in in her her role role as as staff staff director director of of the the U.S. U.S. Gold Gold ComComand mission. Her Her contribution contribution to to the the Darby-Lothian Darby-Lothian study study assessing assessing postpostmission. war international international monetary monetary arrangements arrangements is is reprinted reprinted in in Part Part III III as as war Chapter 14. 14. Her Her reflections reflections on on the the Gold Gold Commission Commission Report Report are are sumsumChapter marized in in Chapter Chapter 13. 13. The The final two articles articles reprinted in Part Part III HI final two reprinted in marized provide aa wide-ranging wide-ranging survey survey of of the the historical historical development development of of the the gold provide gold 15), and and of of the the lessons lessons that that can can be drawn from from current current standard (Chapter (Chapter 15), be drawn standard policy from from past attempts at at constructing constructing international international monetary monetary conconpolicy past attempts stitutions (Chapter (Chapter 16). stitutions 16). Conclusion Conclusion

These brief comments These brief comments only only scratch scratch the the surface surface of of aa body body of of work, work, impressive impressive alike alike for for its its scope, scope, its its quality, quality, and and its its adherence adherence to to the the highest highest standards standards of of scholarly scholarly care care and and objectivity. objectivity. The The reader reader who who dips further further into into this this collection collection of of essays essays will will enjoy enjoy contact contact with with aa dips

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Introduction

subtle mind of wide learning and rare judgment. Unfortunately, he he or she will not be able to share our experience of close collaboration she will not be able to share our experience of close collaboration with with aa modest, modest, unassuming, unassuming, remarkable remarkable human human being. being. Michael D. Bordo Milton Milton Friedman Friedman

1

The The Beginning Beginning of of Competitive Banking in Philadelphia, 1782-1809 Two banks operating might, Two capital capital banks operating in in one one city city ... . . . might, to each perhaps, act perhaps, act in in opposition opposition to each other other and, and, of of course, destroy destroy each each other.-Pelatiah other.—Pelatiah Webster course, Webster (1786). (1786).

The banking in The founders founders of of commercial commercial banking in this this country country doubted doubted seriously seriously that several banks in espethat several banks in one one community community could could get get along along together, together, espemore intruded upon its cially bank could cially that that the the initial initial bank could survive survive if if one one more intruded upon its domain. They They reasoned that each each new new bank bank would would embarrass embarrass the the esdomain. reasoned that established institutions by drawing to build up tablished institutions by drawing on on their their specie specie reserves reserves to build up its own. own. A A corollary corollary of of this this argument argument for for monopolistic was its monopolistic banking banking was necessity reduce others. that newcomer must that each each newcomer must of. of necessity reduce the the profits profits of of the the others. But in in Philadelphia, Philadelphia, the the home of the the country's country's first first bank, it was was But home of bank, it demonstrated—as one one rival rival after after another another opened opened its its doors doors in in the the face face demonstrated-as of the opposition of of older older institutions-that institutions—that competition competition did did not not impede impede of the opposition Yet no sooner did did aa bank bank win win friendly recognition from their growth. their growth. Yet no sooner friendly recognition from In New New York its elders elders than than it it fell fell prey the same same fear fear of of newcomers. its prey to to the newcomers. In York and possibly also new and Baltimore Baltimore (and (and possibly also in in Boston); Boston),1 as as in in Philadelphia, Philadelphia, aa new institution was was looked looked upon as aa threat threat to to the the security security of of intrenched intrenched institution upon as banking interests. interests. Only Only after after considerable considerable experience experience did did the the banks banking banks learn how how to to minimize minimize the impact of of the immediate repercussions learn the impact the immediate repercussions of of the establishment of of another another bank, bank, and and also also how how to to conduct conduct themselves themselves the establishment in their their relations relations with with it. it. This This experience, experience, its its effects effects lightened lightened by in by an an expanding demand demand for for bank accommodations and and fortuitous fortuitous accretions accretions expanding bank accommodations to their their specie specie holdings, holdings, made the banks banks generally generally realize to made the realize that that aa comcompetitor's advent did did not eclipse. petitor's advent not necessarily necessarily mean mean their their eclipse.

1.1 1.1 In May May 1781, 1781, when the Continental Continental Congress Congress approved approved the the estabIn when the estabthe Bank North America, the lishment lishment of of the Bank of of North America, it it recommended recommended that, that, for for the duration of of the the war, no other other banking banking institution institution be chartered by by any duration war, no be chartered any state. There There was in the the charter charter granted granted the of state. was nothing, nothing, however, however, in the Bank Bank of 33

4

Anna J. Schwartz

North America North America in in March March 1782, 1782, to to suggest suggest that that it it had had been been accorded accorded an an exclusive exclusive right right to to banking banking in in Pennsylvania Pennsylvania either either during during or or after after the the war. war. Yet, Yet, for for aa decade decade after after the the war war ended, ended, the the bank bank was was able able to to preserve preserve its its monopolistic monopolistic position position in in both both Philadelphia Philadelphia and and the the state. state.22 Early in 1784 1784 the the Bank Bank of of North North America America was was faced faced with with the the prospect prospect of of aa rival. rival. The The first two two years years of of its its existence existence had had been extremely extremely and 141 profitable; it profitable; it paid paid 8! 8f percent percent on on its its shares shares in in 1782 1782 and 144 percent percent in in 1783. 1783.33 This This handsome handsome return return in in itself itself was was sufficient sufficient inducement inducement for for others to engage in banking, but there was another motive. The closed character character of of the the ownership ownership ofthe of the bank's stock stock and and its its board board membermembership gave rise to an opposition group among the merchants. Quaker businessmen businessmen in in Philadelphia Philadelphia were were excluded excluded from from bank proprietorship proprietorship and claimed that the directors' partiality to insiders prevented them from from obtaining obtaining bank bank loans. loans. Their demands evidently compelled the Bank of North America to issue issue more more shares. shares. Meeting Meeting on on January January 12, 12, 1784, 1784, stockholders stockholders agreed agreed to sell one thousand additional shares at $500 each (although the par value value of of the the original original shares shares was was $400) $400) and and to to treat treat the the new new and and the the old old shares as equal. 44 If we can judge by what Thomas Willing, the president of of the the bank, bank, wrote wrote William William Bingham, Bingham, his his son-in-law, son-in-law, before before the the stockstockholders' holders' meeting, meeting, the the subscription subscription was was intended intended only only for for outsiders outsiders durduring ing the the first first six six months: months: "".... . . you'll you'll be be excluded excluded as as well well as as myselffrom myself from st Aug. next . . . unless you get some any more shares before the 11st act for you in other person to But when when the the sale sale of of the the other person to act for you in the the Matter."s Matter."5 But new shares started, they were offered to stockholders as well as new shares started, they were offered to stockholders as well as to to the the general public. general public. proposed increase The The terms terms of of the the proposed increase in in the the bank's bank's capital capital did did not not cancel cancel plans, plans, announced announced nine nine days days after after the the stockholders' stockholders' meeting, meeting, for for aa new new institution, institution, to to be be known known as as the the Bank Bank of of Pennsylvania. Pennsylvania. Shares Shares were were priced priced at at 400 400 Spanish Spanish milled milled dollars. dollars. On On February February 5, 5, when when seven seven hundred been subscribed paid for, hundred shares shares had had been subscribed and and apparently apparently paid for,66 the the holdholders ers elected elected aa board of of directors, directors, composed composed mainly mainly of of Quaker Quaker merchants merchants whom whom the the opposition opposition press press satirically satirically dubbed dubbed "rigid "rigid Presbyterians," Presbyterians," "unshaken "unshaken Quakers," Quakers," and and "furious "furious Tories."7 Tories."7 On On February February 10 10 the the subscribers petition was scribers applied applied to to the the Assembly Assembly for for aa charter, charter, and and the the petition was favorably favorably received received by by the the committee committee to to which which the the matter matter was was referred. referred. of When When the the legislature legislature tabled tabled aa request request of of February February 26 26 by by the the Bank Bank of North America America to to be be heard heard in in opposition opposition to to the the new new charter, charter, and and two two days bring in days later later appointed appointed aa committee committee to to bring in aa bill, bill,88 the the bank bank hastily hastily called called aa stockholders' stockholders' meeting meeting for for March March 1. The passed aa resolution The meeting meeting passed resolution increasing increasing the the amount amount of of the the new new subscription subscription from from one one thousand thousand to to four four thousand thousand shares shares and and reducing reducing the five hundred the price price to to $400. $400. Those Those who who had had subscribed subscribed to to five hundred shares shares at at $500 per share $500 per share were were to to be be refunded refunded the the difference. difference. In In aa statement statement to to the the public-signed public—signed by by Willing; Willing; James James Wilson, Wilson, counsel; counsel; Thomas Thomas

5

The Beginning of Competitive Banking in in Philadelphia

FitzSimons and Gouverneur Morris, stockholders-the stockholders—the original advance in the price of the shares was defended. It It was claimed that the price was now now reduced reduced not not out out of of private considerations but but in in the the price was private considerations public interest, interest, since since aa new new bank bank would would injure injure commerce. commerce.99 public The bank's revised The bank's revised stock stock offer offer appeased appeased the the discontented discontented merchants merchants who planned forming who had had planned forming aa rival rival institution. institution. On On March March 16, 16, when when the the bill creating the the Bank Bank of of Pennsylvania Pennsylvania was was reached, reached, its its directors directors obbill creating obtained leave leave to to withdraw withdraw their their application application for for aa charter.lo charter.10 The The general general tained subscription to to the the Bank Bank of of North North America America was was so so well well received received that that subscription by the end end of of March March its its capital, capital, though though less less than than half half of of the the possible possible by the $2 million, million, had had more more than than doubled. doubled. One One hundred hundred and and thirty thirty new new stockstock$2 holders subscribed subscribed six six hundred hundred shares; shares; the the rest rest were were taken taken by old holders by old stockholders or or those those who who had had subscribed subscribed before March 1.11 l.11 before March stockholders The Bank of North America's anxiety about the scheme to establish another bank cannot be explained another bank cannot be explained simply simply in in terms terms of of the the supposed supposed effects profits, although effects that that sharing sharing the the market market would would have have on on its its profits, although that that apprehension was was undoubtedly at the the root root of of its its opposition. opposition. It It also also apprehension undoubtedly at feared for for its its specie specie holdings. holdings. Subscribers Subscribers to to the the proposed Bank of of feared proposed Bank Pennsylvania could could pay pay for for their their shares shares with specie in in general general circucircuPennsylvania with specie lation or or with with Bank Bank of of North North America America notes. notes. Most Most of of them them had had chosen chosen lation the latter. latter. As As its its notes notes were were at at once once presented presented for for redemption, redemption, the the Bank Bank the of North America was drained of gold and silver. William Seton, the of North America was drained of gold and silver. William Seton, the cashier of the proposed Bank of New York, who was visiting in Philcashier of the proposed Bank of New York, who was visiting in Philadelphia, wrote wrote to to Alexander Alexander Hamilton Hamilton on on March March 27: 27: "Gold "Gold and and silver silver adelphia, had been extracted in such amounts that discounting was stopped, and had been extracted in such amounts that discounting was stopped, and for this fortnight past not any business had been done at the bank this for this fortnight past not any business had been done at the bank this way.. . . Therefore, for the safety of the community at large, it became way.... Therefore, for the safety of the community at large, it became absolutely necessary necessary to to drop drop the the idea idea of of aa new new bank, and to to join hand bank, and join hand absolutely in hand hand to to relieve relieve the the old old bank from the the shock shock it it has has received."12 received."12 in bank from Hamilton, who had originally favored the incorporation of the Bank of Pennsylvania, Pennsylvania, now now saw saw the the competition competition in in aa different different light. light. He He wrote wrote of Gouverneur Morris: Morris: "I "I had had no no doubt doubt that that it it was was against against the the interests interests Gouverneur of the the proprietors; proprietors; but, on aa superficial superficial view, view, II perceived benefits to to of but, on perceived benefits the community, community, which, on aa more close inspection, inspection, II found found were were not not the which, on more close real."13 Robert Robert Morris, Morris, concluding concluding that there was not enough enough capital capital real."13 that there was not in the the country country to to support support several several banks, Jefferson on on April April 8, 8, in banks, wrote wrote Jefferson 1784: "The "The establishment establishment of of so so many many banks, instead of of aiding aiding credits credits 1784: banks, instead and facilitating facilitating operations, operations, will for some some time time to to come come have have aa contrary contrary and will for effect, and and it it is is not not without without great great difficulty difficulty that that they they will will each each collect collect effect, capital sufficient sufficient to to support support its its own own operations. operations. The The struggle struggle to to get get aa capital such capital capital places places these these institutions institutions in in aa degree degree of of opposition opposition to to each each such other injurious injurious to to them them all."14 all."14 other At the time Morris was writing, exports of specie exceeded imports, owing to to an an unfavorable unfavorable balance of trade trade and and the the payment of the the claims claims owing balance of payment of of English English creditors creditors for for debts debts contracted contracted before the war. war.15 The conconof before the IS The

6

Anna J. Schwartz

sequent tightening of the specie supply seemed to confirm his gloomy foreboding that the creation of a new bank would lead to disaster. But he he knew, as he he indicated two two years years later, later, that that the the flow of of specie specie from from this country would soon be reversed}6 reversed.16 When the balance of international tional payments payments shifted shifted in in our our favor, favor, gold gold and and silver silver were were bound bound to to become more generally available. Morris' argument against a new bank had had at at best best only only temporary temporary cogency. cogency. A real fallacy was his assumption that a new bank could obtain specie for for its its reserve reserve only only from from the the vaults vaults of of the the preexisting preexisting institution. institution. He He ignored the fact that only a fraction of the country's specie was held by by the the Bank Bank of of North America; that that if if aa rival rival drew drew on on its reserve, reserve, it it could hope that is holdings would be replenished by deposits of gold and and silver silver in in the the public's public's possession.i1 possession.17 Had the Bank of Pennsylvania's capital consisted entirely of Bank of of North North America America notes notes and and had had there there been been no no transfer transfer to to it it of of specie specie held by the public in strong boxes, the Bank of North America might IS But if indeed have suffered suffered by the redistribution of its holdings. holdings.18 if we assume that the credit supply would have been more rationally distributed when two banks instead of one were in operation, the community might have benefited benefited from the opening of a second bank even if it it added added no no specie specie to to the the amount amount already already in in vault vault and and the the total total credit credit supply remained unchanged. The The proposition proposition agrunst against competitive competitive banking generally, generally, as as stated stated by by Morris, boxes would Morris, seems seems indefensible. indefensible. Specie Specie kept kept in in strong strong boxes would have have found found its its way way to to the the new new bank, bank, presumably just as as it it did did to to the the older older bank bank when when it it increased increased its its capital. capital. If If enough enough capital capital could could not not be be scraped scraped together together for for two two banks, banks, as as Morris Morris asserted, asserted, it it is is difficult difficult to to understand understand I9 how how the the subscription subscription of of the the older older bank bank was was doubled. doubled.19 In In short, short, the the crux crux of of the the Bank Bank of of North North America's America's opposition opposition to to aa potential potential competitor competitor was was concern concern over over its its specie specie holdings, holdings, but, but, had had its its relations relations with with the the Bank Bank of of Pennsylvania Pennsylvania been been amicable, amicable, an an agreement agreement would have have been reached at at the the outset outset concerning concerning the the acceptance acceptance of of would been reached each each other's other's notes. notes. And And the the run run on on the the Bank Bank of of North North America America for for specie, specie, described described by by Seton, Seton, might might have have been been avoided. avoided.

1.2 During North America During the the decade decade 1784-93 1784-93 the the Bank Bank of of North America modified modified its its attitude. On On its its own own initiative initiative it it established established good good relations relations with with out-ofout-ofattitude. state banks banks and and submitted, submitted, willingly willingly or or unwillingly, unwillingly, to to the the authority authority of of state the Bank Bank of of the the United United States. States. And And when when the the legislature legislature chartered chartered aa the second bank bank in in 1793, 1793, the the Bank Bank of of North America discovered discovered that that its its second North America operations were were not not crippled. crippled. operations

7

The Beginning of Competitive Banking in in Philadelphia

At the same time that it was resisting local bank competition, it was encouraging the founding founding of banks banks outside Pennsylvania. To To help Boston merchants who proposed opening the Bank of of Massachusetts, Willing in January 1784 1784 described his experience in running his bank. In March, Seton went to Philadelphia bearing a letter of introduction from Hamilton Hamilton to FitzSimons, FitzSimons, requesting requesting his his advice advice concerning concerning the operaopera20 tion of of a bank. 20 Thus, Thus, while the management management of of the the Bank Bank of of North America looked looked upon another bank in Philadelphia as an interloper, it tolerated banks outside outside the the state, state, even even admitting admitting that they they might be useful: first, because to aa bank cause subscriptions subscriptions to bank in in Boston Boston or or New not likely likely New York York were were not to be paid for for in in Philadelphia Philadelphia bank bank notes notes that that would recoil on on the the issuer; issuer; second, the the banks banks would operate within within their own local local markets, withsecond, would operate their own markets, without out affecting affecting the the demand demand for for and and supply supply of of loans loans in in Philadelphia; Philadelphia; third, third, they would accommodate Bank Bank of of North America customers customers who had they would accommodate North America who had In contrast contrast to to its its payments or or collections collections to to make make in in their their vicinity.21 vicinity.21 In behavior toward newcomer in in Philadelphia, Philadelphia, the the Bank Bank of of North Amerbehavior toward aa newcomer North America's ica's relations with banks banks in in other other cities cities were exemplary. exemplary. The the Bank The smooth smooth course course of of the the organization organization of of the Bank of of the the United United States States in in 1791 1791 afforded afforded other other evidence evidence of of how harmoniously the the situsituation might might have have been been managed managed in in Philadelphia Philadelphia in in 1784. 1784. By By opening opening ation the the subscription subscription books for for the the national bank, the Bank Bank of of North North AmerAmerica surprised surprised the the skeptics skeptics who expected it it to to be antagonistic; Willing Willing ica who expected be antagonistic; was Philadelphians subscribed subscribed heavily; heavily; was one one of of the commissioners.22 commissioners.22 Philadelphians 23 some even even were disappointed, so so keen was the the demand demand for for shares. shares.23 some were disappointed, keen was There must been repercussions repercussions on on the specie holdings of the the Bank Bank There must have have been the specie holdings of of North America, but but when Willing was was chosen chosen to to head head the the national national of North America, when Willing 24 The bank, it became obvious that that aa modus modus vivendi vivendi would be found. found.24 The bank, it became obvious would be Bank ofthe of the United States opened opened on on December December 12,1791. 12, 1791. On On February February United States Bank 6, 1792, 1792, the the Bank Bank of of North America adopted adopted aa resolution resolution providing providing for for 6, North America daily exchange exchange of of notes notes with with it it and and on on March March 23 23 one one providing providing for for aa daily the appointment of aa committee committee of of three to consult consult with with aa three to the appointment monthly monthly of similar committee committee from from the the Bank Bank of of the the United States, "for "for the the purpose purpose United States, similar of communicating communicating freely freely upon upon the of both, as well well to prevent of the business business of both, as to prevent improper interference interference with with each each other other as as to to promote accommoimproper promote the the accommodation dation of of the the citizens."2s citizens."25 The The attitude attitude of of an an elder elder sister sister institution institution toward toward aa newcomer newcomer in in the the local local banking banking field was of of crucial crucial importance. importance. Its Its opposition opposition to the the proposed Bank of of Pennsylvania Pennsylvania in in 1784 1784 had caused aa crisis crisis in in the the Bank Bank proposed Bank had caused of of North North America's America's affairs. affairs. But, But, because because the the state state bank cooperated, cooperated, all went went smoothly smoothly when of the the United United States States was orall when the the first first Bank Bank of was or26 Yet ganized.26 it lost lost some some local local business business as as well as the the accounts accounts of of the the ganized. Yet it well as federal government, government, which which had been exceedingly exceedingly profitable. profitable. The The serserfederal had been vices the Bank of the States rendered rendered the business vices the Bank of the United United States the merchant merchant business

8

Anna J. Schwartz

order were acknowledged to be more important than any possible loss 27 its competition might entail. 27 Whether Bank of North America stockholders suffered suffered is proble12 matical. The bank paid 13V2 1316 percent in 1791, 1791, 12V2 1216 percent in 1792, 1792, 12 percent for the next six years, and never less than 99 percent as long 28 However, in as the first Bank of of the United States was in existence. 28 of July 1792, 1792, after after an exceedingly good year, the dividend committee of the Bank of North America recommended a payment at a lower rate than than the bank's bank's financial situation situation warranted. Taking Taking for for granted granted that that the competition of the new bank would lower profits, it warned that another another dividend dividend at at aa high high rate rate might might raise raise false false hopes hopes which which would would have to to be be dashed. dashed. But But the committee had an ulterior motive in in urging urging have the committee had an ulterior motive aa low low rate: rate: "Another "Another probable probable consequence consequence of of two two successive successive high high dividends deserves consideration; would it not be likely to induce others ers to to engage engage in in aa business business that that yielded yielded so so large large aa profit, and and if if the the Legislature of of the State had an advantageous advantageous offer offer made to them, them, would would Legislature the State had an made to they Preventing the the creation creation they not be be likely likely to to grant grant another another charter?"29 charter?" 29 Preventing of aa new new bank bank meant meant holding the legislature legislature as as well as the the commercial commercial of holding the well as elements elements in in the community community at at bay. At this this time time aa Treasury Treasury surplus surplus challenged challenged the the attention attention of of PennsylPennsylvania state state authorities. authorities. After After the the entire entire public debt had liquidated vania public debt had been been liquidated from from the proceeds of of sales sales of of public public lands lands and and paid-up back back taxes, taxes, aa tidy sum sum remained remained unappropriated. unappropriated. The The high high dividends dividends paid paid on on bank bank tidy stock attracted attracted notice in political quarters. Governor Governor Mifflin Mifflin on on August August stock notice in political quarters. 13, 1792, proposed proposed to subscribe, on on behalf of the the commonwealth, commonwealth, to 13,1792, to subscribe, behalf of to aa 30 On substantial quantity quantity of of Bank Bank of of North America stock. stock.30 On January January 29, North America 29, substantial 1793, the stockholders agreed agreed to admit the the state state on on terms terms to to be set by the stockholders to admit be set by 1793, committee to to be be appointed appointed to to confer confer with with the the governor.31 governor.31 Its Its offer offer aa committee seems to been aa $750,000 $750,000 SUbscription subscription at at the the rate of $400 $400 for for each each seems to have have been rate of share, half half to to be be borrowed borrowed from from the the bank.32 bank.32 share, The negotiations were unsuccessful. Merchants, perhaps because they were dissatisfied dissatisfied with their accommodation at the Bank of North America and the Bank of the United States, seized on the political circumstance circumstance of of the the state's state's search search for for an an investment investment for for its its surplus surplus to to 33 The state struck a bargain with the new institution, promote a bank.33 the Bank of of Pennsylvania, Pennsylvania, which it it incorporated incorporated for for twenty years on on March 30 30 and used thereafter thereafter as its fiscal agent. To the bank's authorized million the the governor ized capital capital of of $3 $3 million governor subscribed subscribed $1 $1 million million on on behalf behalf of the state, paying part with public stock of the federal government owned by the state at the value fixed by the legislature; part in specie; and the rest with the proceeds of 34 of a $250,000 $250,000 loan from the bank. 34 Possibly Possibly in in deference deference to to the the view that that aa competitor competitor would would impair impair the the profitability profitability ofthe of the Bank of North America, the Bank of Pennsylvania's charter charter stipulated stipulated that two two thousand shares shares at at $400 $400 each each should should be set set aside for for Bank Bank of of North stockholders, if if they they decided decided to to reaside North America America stockholders, re-

9

The Beginning of Competitive Banking in Philadelphia

linquish their charter within three months after after it was granted. The Bank of North America turned down this suggestion; evidently a year and aa half's half's profitable profitable operation operation alongside alongside the the Bank Bank of of the the United United States States and had changed changed its its views views on on competitive competitive banking.35 banking.35 It It had had no no cause cause to to had regret the the decision decision to to retain retain its its identity. identity. "It "It appears appears ... . . . that that estabestabregret lishment of of the the Bank Bank of of Pennsylvania Pennsylvania hath hath not not upon upon the the whole whole lessened lessened lishment the business, business, but but hath hath increased increased it it in in several several departments," departments," reported reported the committee appointed appointed by by the the directors directors of of the the Bank Bank of of North North America America aa committee to examine examine the the possibility possibility of of reducing reducing the the staff. staff.36 36 to There North America There is is no no evidence evidence that that the the Bank Bank of of North America and and the the Bank Bank of of Pennsylvania Pennsylvania did did not not get get on on well. well. The The Bank Bank of of the the United United States States also established established friendly friendly relations relations with with the the new new bank, bank, including including it it in in also the arrangement arrangement for for the the daily daily settlement settlement and and exchange exchange of of notes. notes. Ajoint A joint the committee of of the the three three banks, banks, meeting meeting on on March March 2, 2, 1797, 1797, adopted adopted the the committee rule that that "after "after March March 31, 31, all all bills bills made made payable payable at at sight sight or or on on demand demand rule must be be paid paid on on the the same same day day they they are are presented" presented" and and agreed agreed that that no no must bank would would discount discount aa note note from from which which the the qualifications qualifications "without "without bank defalcation" or or "without "without set-off" set-off" were were omitted. omitted. Joint Joint action action was was proprodefalcation" posed in in June June when when the the Bank Bank of of North North America America appointed appointed aa committee committee posed to meet meet with with committees committees which which the the Bank Bank of of the the United United States States and and the the to Bank of of Pennsylvania Pennsylvania might might appoint appoint "to "to attend attend to to the the bill bill depending depending Bank before the the House House of of Representatives Representatives of of the the United United States States for for levying levying before aa stamp stamp duty duty and and to to report report their their opinion opinion thereon." thereon." Committees Committees from from the three banks conferred again in May 1799 on "the prevailing distress the three banks conferred again in May 1799 on "the prevailing distress of the the mercantile mercantile interests interests of of this this city."37 city."37 of The older institutions probably could not risk harassing a rival with which the the state state was was identified; identified; moreover, moreover, they they were were no no doubt doubt learning learning which that mutual mutual trust trust was was aa sine sine qua qua non non of of aa successful successful banking banking community. community. that The regularization regularization of of interbank interbank relations relations was was aa prerequisite prerequisite to to the the exexThe pansion of of credit credit merchants merchants required required for for the the carrying carrying trade. trade. Mercantile Mercantile pansion houses combining combining importing importing and and exporting exporting mUltiplied multiplied as as the the NapoNapohouses leonic wars, wars, until until the the embargo embargo period, period, opened opened business business opportunities opportunities leonic for Americans. Americans. The The shipment shipment of of colonial colonial produce produce to to the the several several belligfor belligerent mother-countries-as mother-countries—as well well as as its its purchase purchase for for their their own own account account erent in the the French, French, Spanish, Spanish, and and Dutch Dutch colonies---engaged colonies—engaged the the energies energies of in of growing merchant merchant class. class. American American firms also imported imported European European aa growing firms also manufactures, especially especially British, British, and and the the manufactures manufactures and and produce produce of manufactures, of the East East Indies Indies and and China China for for re-export re-export to to the the West West Indies, Indies, the the Spanish Spanish the colonies in in South South America, America, and and Europe. Europe. They They got got the the British British products products colonies on longterm longterm credits credits but-in but—in order order to to purchase purchase ships ships and and domestic domestic proproon duce and and also also to to speculate speculate in in land land and and securities-had securities—had to to borrow borrow from from duce American banks. banks.38 38 American Without Without an an effective effective banking banking community, community, ambitious ambitious businessmen businessmen during during the the Napoleonic Napoleonic era era would would not not have have been been able able to to go go so so far far as as they did. did. Interbank Interbank claims claims were were inevitable; inevitable; and and the the merchant merchant business business they

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Anna J. Schwartz Schwartz

order could not thrive unless banks trusted one another. City banks, not only in Philadelphia but also in other coastal cities where merchants organized banks to further further their business interests, had to accept and adapt themselves to competitive banking. Their compliance was reluctant. Despite the experience afforded afforded by the formation of the Bank of the United States and the Bank of Pennsylvania, "Civis" noted in the Aurora the prothe Aurora General General Advertiser Advertiser on on December December 21, 21, 1801: 1801: "On "On the propriety of establishing a banking house there exist various sentiments; without without at at present present hazarding hazarding an an opinion opinion upon upon it, it, II can can venture venture to to say, say, that the banks now in this city will not approve the establishment. From presumably proceed proceed the From this this quarter quarter there there will will presumably the greatest greatest opposition." opposition."

1.3 When the Philadelphia Bank began operations as an unincorporated association in September 1803, 1803, the wisdom its predecessors had acquired in interbank relations was put to the test. Merchants who had gone into into business business for for themselves themselves after after the the start start of of the the Napoleonic Napoleonic gone wars, and and who who claimed claimed that that they they were were being being unfairly unfairly treated treated by by the the wars, banks, had had aa prominent prominent share share in in the the new new institution's institution's organization. organization. banks, Designed to to appeal appeal to to men men of of smaller smaller means means than than those those who who had had ininDesigned vested in in the the older older banks banks and and were were their their customers, customers, its its shares shares were were vested priced at at $100. $100. The The strength strength of of investors' investors' demands demands may may be be gauged gauged from from priced the ease ease with with which which the the new new bank bank accumulated accumulated capital. capital. By By December December the 39 31, 1803, 1803, $1 $1 million million was was fully fully paid paid in. in.39 31, To banks in To avoid avoid antagonizing antagonizing other other banks in the the city city the the Philadelphia Philadelphia Bank Bank received received and and paid paid out out their their notes notes along along with with its its own. own. Yet Yet the the other other 4O On banks refused refused to to reciprocate. reciprocate.40 On September September 21 21 the the board board of of directors directors banks of the the Philadelphia Philadelphia Bank Bank resolved: resolved: "That "That so so long long as as the the Banks Banks of of the the of United States, Pennsylvania, and North America continue to refuse United States, Pennsylvania, and North America continue to refuse the notes notes of of this this Bank, Bank, that that the the Cashier Cashier apply apply every every day day to to the the said said the Banks for for Specie Specie in in exchange exchange for for such such of of their their notes notes as as may may be be on on Banks hand in in this this Bank."41 Bank."41 This This retaliation retaliation brought brought to to heel heel all all except except the the hand Bank of of Pennsylvania, Pennsylvania, which which continued continued prey prey to to the the fears fears that that had had Bank exercised the the Bank Bank of of North North America America aa decade decade earlier. earlier. "Anti-Monop"Anti-Monopexercised oly" wrote: wrote: "That "That the the Pennsylvania Pennsylvania Bank Bank is is opposed opposed to to the the policy policy and and oly" prosperity of of Pennsylvania Pennsylvania is is obvious-for obvious—for though though they they have have refused refused prosperity the paper paper of of the the Philadelphia Philadelphia Bank, Bank, the the Banks Banks of of Boston, Boston, Hartford, Hartford, the New York, Baltimore, Baltimore, Delaware, Delaware, and and Alexandria Alexandria accept accept them-and them—and New York, their acceptance acceptance was was voluntary. voluntary. Jealousy Jealousy and and the the spirit spirit of of monopoly monopoly their of the the Pennsylvania Pennsylvania Bank Bank opposes opposes the the credit credit of of citizens citizens of of PhiladelPhiladelof phia."42 Before Before its its quarters quarters offered offered suitable suitable protection, protection, the the Philadelphia Philadelphia phia."42 Bank had had placed placed aa box box of of money money for for safekeeping safekeeping in in the the Bank Bank of of PennPennBank

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The Beginning of Competitive Banking in Philadelphia

sylvania. As a rebuke to the latter it now moved the box to the Bank Bank of the United States and ordered Bank of Pennsylvania notes to be presented for redemption immediately upon their receipt. In this atmosphere of uncertain acceptance by the local banking fraternity, the Philadelphia Bank applied to the legislature for a charter 43 on December 13. This action put the state in a dilemma: as a stock13.43 holder in the Bank of Pennsylvania, its interests presumably coincided with those of the private investors in the bank, but as arbiter of the public welfare, it had to consider the views of the promotors of the Philadelphia Bank. These conflicted with the ambitions of Bank of Pennsylvania stockholders. implicit in Pennsylvania stockholders. The The contradictions contradictions implicit in the the state's state's position were stated in a resolution read in the House at a later date: Whereas, Whereas, the the intimate intimate connexion connexion and and union union of of pecuniary pecuniary interests interests between government and between aa government and great great monied monied institutions, institutions, tends tends to to create create .an an influence, influence, partial partial to to the the latter latter and and highly highly injurious injurious to to the the former. former. It being being the the duty duty of of government government to to consult consult the the general general will will and and proIt provide for for the the good good of of all, all, embarrassments embarrassments must must frequently frequently be be thrown thrown vide in the the way way of of the the performance of this this duty, duty, when when the the government government is is in performance of coupled in interest with with institutions whose rights rights are are founded founded in coupled in interest institutions whose in monopoly, and and whose whose prosperity prosperity depends depends on on the the exclusion exclusion and monopoly, and suppression of of similar similar institutions. institutions. The The government government in in such such cases cases suppression becomes identified identified with with these these establishments, establishments, and and the the means means of of probecomes promoting and and extending extending commerce, commerce, manufactures manufactures and agriculture equally equally moting and agriculture over the the whole whole state state for for the the general general good good are are too too often often lost lost sight sight of of over 44 by this dangerous dangerous and and unnatural by this unnatural union. union. 44 In by In resolution resolution of of these these conflicting conflicting interests interests aa committee committee appointed appointed by the proposals to comthe Philadelphia Philadelphia Bank's Bank's stockholders stockholders made made various various proposals to compensate the state for the charter: to pay $15,000 outright for a ten-year charter charter or or $20,000 $20,000 for for aa fourteen-year fourteen-year charter. charter. For For aa fourteen-year fourteen-year charter it offered alternative terms: terms: The bank would agree to lend the if state state $100,000 $100,000 for for three three years, years, without without interest, interest, "on "on condition condition that that if the legislature should, at any time hereafter, impose a tax on banks, that be considered that the the interest interest so so remitted remitted should should be considered as as aa set set off off against against any tax which the legislature might be disposed to lay on this institution." Finally, it suggested that the legislature authorize a $500,000 SUbscription subscription to its stock, payable in Bank of Pennsylvania stock held by the state, at par, on the transfer of which the Philadelphia Bank 45 would pay by June 1804 $125,000 in specie as a premium. premium. 4s The The House House committee, committee, under under the the chairmanship chairmanship of of Adcock, Adcock, to to which which the petition was the Bank Bank of of Philadelphia's Philadelphia's petition was referred, referred, favored favored the the fourth fourth proposal because it not proposal because it contained contained the the largest largest spot-cash spot-cash offer offer and and did did not impair banking business. comimpair the the state's state's equity equity in in the the banking business. Although Although the the committee was unwilling mittee was unwilling to to express express an an opinion opinionregarding regardingthe theultimate ultimateeffects effects

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of the "multiplication of of Banks" on the general public interest, it ap46 proved the petition for incorporation. 46 On December 17, 17, the day after after Adcock's committee reported, six Bank of Pennsylvania directors (including Matthew Carey) appointed by the legislature sent a letter to both houses requesting that nothing be done about chartering a new bank until a memorial then being prepared was laid before them. They asserted that another bank in Philadelphia would "materially injure the property of the state in the Bank of Pennsylvania, and the interest of the community at large. We also believe there are no terms on which a charter could be granted, that would compensate the state for the injury it would sustain thereby."47 thereby."47 The memorial duly submitted by the Bank of Pennsylvania on December 29 29 stated: "Immense injuries must inevitably arise to the institution and the state, should the legislature incorporate the said bank."48 bank."48 The House had postponed a second reading of the Adcock report but, when the Bank of Pennsylvania submitted its protest, referred both the report and new committee, which Maclay both the report and it it to to aa new committee, for for which Maclay was was 49 Aware of the pressure the Bank of Pennsylvania was spokesman.49 bringing to to bear bear on revised its bringing on the the legislature, legislature, the the Philadelphia Philadelphia Bank Bank revised its so four proposals with a view to making them more attractive. 50 The reported on the incorThe Maclay Maclay committee committee reported on January January 20 20 against against the incorporation of of the Philadelphia Bank. It It argued that more banks would mean profits for reduce the value of the state's mean smaller smaller profits for all all and and hence hence reduce the value of the state's investment in the Bank of Pennsylvania. No premium which the Philadelphia this loss. adelphia Bank Bank might might pay pay for for aa charter charter could could offset offset this loss. The The comcommittee, furthermore, was skeptical of the bank's ability to live up to its proposals and valuation of its proposals and doubted doubted the the accuracy accuracy of of its its valuation of the the various various premiums: "Banks already chartered ... . . . are fully competent to the business of the state and ... . . . [their] protection, more especially ofthat of that one where the property of the state is lodged, is of more utility . . . than the chartering of of new ones."SI ones."51 Having disposed of the Philadelphia Bank's application, the Maclay committee indorsed a measure proposed by the Bank of of Pennsylvania. If the state would extend its charter for fourteen years beyond 1813 (the expiration date under the act of incorporation), the Bank of Penn52 During sylvania would pay the state $200,000 in specie or bank notes.52 this time (a) (a) no other bank (except the Bank of North America) should be chartered by the state; (b) (b) no incorporated association with more than ten members in Philadelphia or within the state of of Pennsylvania should be permitted to carry on banking or issue notes; (c) (c) stockholders unincorporated company; should be personally liable for the debts of of an unincorporated (d) (d) the Bank of Pennsylvania should not be subject to taxation. The House took no immediate action on the Maclay report. In the Senate a resolution was introduced on January 24 24 to discharge the committee committee appointed appointed December December 13 13 to to consider consider the the Philadelphia Philadelphia Bank's Bank's

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The Beginning of Competitive Banking in Philadelphia

petition. 53 S3 The chances for a charter looked slim. The stockholders of of the prethe Philadelphia Philadelphia Bank, Bank, however, however, again again memorialized memorialized the the House, House, prepaid-in capital senting senting three three rejoinders rejoinders to to the the Maclay Maclay report: report: (a) (a) the the paid-in capital proved was fully proved that that the the bank bank was fully capable capable of of carrying carrying out out any any proposals proposals it it had had made; made; (b) (b) as as its its specie specie holdings holdings equaled equaled its its circulation, circulation, the the bank bank was in aa sound sound condition; condition; (c) (c) the the bank's bank's proposals proposals had had been been misunmisunwas in derstood; it it was was ready ready to to pay pay into into the the state state treasury treasury $145,000, $145,000, $154,000, $154,000, derstood; $152,000, or or $400,667, $400,667, depending depending upon upon which which ofthe of the four four proposals was $152,000, proposals was accepted. The The stockholders stockholders had some additional additional bait to accepted. had some bait with with which which to tempt the the state: state: "As "As banks must necessarily increase with with our our growing growing tempt banks must necessarily increase population and and industry; industry; we we are are willing willing should should the the legislature legislature wish wish that that population at the the end end of of every every four four years years the the state state may may subscribe subscribe two two hundred hundred at thousand dollars dollars to to the the Philadelphia Philadelphia bank bank at at par, and dispose dispose of of the the par, and thousand same, for for the the sole sole emolument emolument of of the the commonwealth."54 commonwealth."54 same, On On January January 27 27 the the House, House, in in committee committee of of the the whole, whole, reported reported against against the bring in the Maclay Maclay resolution resolution and and recommended recommended that that aa committee committee bring in aa bill of of incorporation incorporation for for ten ten years years under the terms terms of of the the bank's bank's first first under the bill proposal. The The report report was was adopted adopted fifty to thirty-five, thirty-five, and and on on January January proposal. fifty to 55 31aa bill was introduced introduced and and read the first 31 bill was read the first time. time. 55 In by the In the the form form in in which which it it was was reported reported with with amendments amendments by the comcommittee ultimately adopted, bill required Philmittee of of the the whole whole and and ultimately adopted, the the bill required the the Philadelphia Bank Bank to to pay pay aa cash cash gratuity gratuity of of $135,000 $135,000 to to the the state state for for aa tentenadelphia year charter; privileged to year charter; the the state state was was privileged to subscribe subscribe $300,000 $300,000 by by paying paying that sum sum in in 66 percent percent stock stock of of the the United United States States (but (but if if the the bank should bank should that fail, the United States stock was to be retransferred to the state); the fail, the United States stock was to be retransferred to the state); the state had had the the right right to to subscribe subscribe an an additional additional $200,000 $200,000 at at par at the the end end par at state of four four years years and and aa like like sum sum at at the the end end of of eight eight years; years; and, and, whenever whenever of required by by the the governor, governor, the the bank was obligated obligated to to lend lend the the comcomrequired bank was monwealth $100,000 $100,000 at at 55 per per cent cent for for any any period not exceeding exceeding ten ten monwealth period not years. years. was reached When When the the second second reading reading of of the the bill bill was reached in in the the House, House, the the with an Bank Bank of of Pennsylvania Pennsylvania approached approached the the legislature legislature with an offer offer of of aa $100,000 be repaid percent stock $100,000 interest-free interest-free loan loan for for one one year, year, to to be repaid in in 66 percent stock of the the United United States, States, at at par, par, provided provided the the Philadelphia Philadelphia Bank Bank was was not not of granted aa charter charter before the next next session session of of the the Assembly. Assembly. PostponePostponebefore the granted ment was was urged to give give the the Assembly Assembly time time to to make make inquiries inquiries concerning concerning ment urged to the injury injury already already done done the the Bank Bank of of Pennsylvania, Pennsylvania, which which would would be be the aggravated by by the the incorporation incorporation of of aa new new bank, and to to permit the bank, and permit the aggravated representatives to to consult consult their their constituents. constituents.56 56 representatives The block the The Bank Bank of of Pennsylvania's Pennsylvania's efforts efforts to to block the bill bill in in the the House House were bill progressed progressed through were fruitless; fruitless; the the bill through its its second second reading reading uneventunevent57 fully finally passed fully and and was was finally passed by by aa vote vote of of forty-five forty-five to to thirty-five. thirty-five.57 The bill for The Senate Senate ordered ordered aa second second reading reading of of the the House House bill for February February 21. Residents Residents of of Lancaster Lancaster borough borough and and county county presented presented aa petition petition 21. expressing regret regret that that the the bill had passed the House: House: "Reflecting "Reflecting on on expressing bill had passed the

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the extensive interest which the state holds in the Bank of of Pennsylvania, baneful effects of an they cannot too seriously seriously consider consider the the probable baneful effects of an additional chartered Bank at this period, on the fiscal concerns of the state and on the banking system."58 system."58 The next day a petition by Lancaster residents favoring the chartering of the Philadelphia Bank was read. A letter from the Bank of Pennsylvania to the legislature confirmed firmed the the offer offer made madeten tendays daysearlier earlierof ofan aninterest-free interest-free loan loanfor for aayear year and, in addition, proposed another scheme to reward the state if the bill to incorporate the Philadelphia Bank was postponed. Though the Bank of Pennsylvania calculated the monetary value of its new offer offer to be $440,000,59 $440,000,59 the legislature was apparently no more pleased than it it had had been with the the offer offer embodied embodied in in the the bill chartering chartering the the PhilaPhiladelphia Bank; perhaps not so much, since the Bank of Pennsylvania 60 Despite attempts to amend the House bill, attached many conditions. 60 61 The the Senate passed it without change by a vote of thirteen to ten. 61 legislature thus supported an expanding and competitive banking system, which existing institutions perforce had to accept.

1.4 1.4 Once Once the the Philadelphia Philadelphia Bank Bank had had been been incorporated, incorporated, opposition opposition to to the creation creation of of rivals rivals steadily steadily dwindled. dwindled. Even Even while while it it lasted, lasted, the the exexisting new bank bank by obisting institutions institutions did did not not try try to to tie tie the the hands hands of of aa new by ob62 Committees appointed by each bank conferred structive tactics. 62 conferred upon subjects fixed the subjects of of common common interest; interest; e.g., e.g., they they fixed the values values at at which which foreign foreign coins by cooperative coins would would be be taken taken after after September September 1804. 1804. And And by cooperative action action the the banks banks made made possible possible the the multiple multiple expansion expansion of of credit credit on on aa given given specie specie base. base. The The argument argument that that additional additional competition competition would would diminish diminish profits profits was was once once again again advanced advanced in in 1807-8 1807-8 when when the the fourth fourth bank, bank, the the Farmers' Farmers' and Mechanics', Mechanics', appeared appeared on on the the scene. scene. Unlike the older older banks, banks, which which and Unlike the had by merchants predominantly, the had been been organized organized by merchants predominantly, the Farmers' Farmers' and and Mechanics' was founded Mechanics' Bank Bank was founded by by aa mixed mixed group-merchants, group—merchants, manumanu63 The facturers, The older older banks banks appealed appealed to to the the selfish selfish facturers, and and mechanics. mechanics.63 interest of of the the commonwealth commonwealth itself itself in in their their profits in the the hope hope that that it it interest profits in would new bank would deny deny the the new bank aa charter. charter. The The emptiness emptiness of of the the argument argument became obvious business expanded-there all. became obvious when when business expanded—there was was enough enough for for all. Thus Thus in in approving approving one one of of seven seven offers offers to to remunerate remunerate the the state, state, together together with with the the Farmers' Farmers' and and Mechanics' Mechanics' Bank's Bank's petition petition for for incorporation, incorporation, the banks remarked of the House House committee committee on on banks remarked in in 1808 1808 that that the the Bank Bank of Pennsylvania not injured Pennsylvania was was not injured by by the the Philadelphia Philadelphia Bank, Bank, nor nor was was either either of by the of them them affected affected by the operation operation of of the the Farmers' Farmers' and and Mechanics' Mechanics' Bank Bank 64 Moreover, as unincorporated association. business drawn as an an unincorporated association.64 Moreover, the the business drawn to to banks not reduce banks of of adjoining adjoining states states did did not reduce their their profits. profits.

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The Beginning of Competitive Banking in Philadelphia

The offer of monetary inducements for the granting of a charter, which began as a voluntary solicitation of the legislature, came to be looked upon as a necessary accompaniment of a petition for incorporation. The committee reported that, since the petitioners sought a charter for profit-making purposes, the state had a right to require a payment for the privileges it conferred. The The rationale rationale of of aa competitive competitive banking banking system system was was also also elaborated. elaborated. The have The banking banking system, system, being being once once introduced, introduced, (its) (its) evils, evils, if they they have any find their any real real existence, existence, will will probably probablyfind their most most effectual effectual remedy remedy in in the rivalship rivalship which which an an increase increase of of the the number number of of banks banks to to aa proper the proper extent is is calculated calculated to to create create..... . . . An An extravagant extravagant emission emission of of bank extent bank paper will will be be prevented prevented by by the the fear fear of of being being called called upon upon for for specie, specie, paper and partiality partiality in in the the distribution distribution of of loans, loans, destroyed destroyed by by the the anxiety anxiety and each will will feel feel to to secure secure to to itself itself the the best best customers. customers. And And if if (which (which each no former former experience experience seems seems to to warrant) warrant) there real ground ground to to no there was was real apprehend that that aa bank bank might, might, by by extending extending or or withholding withholding accomapprehend accommodations, acquire acquire aa power power over over the the conduct conduct and and independence independence of of modations, individuals, the the danger danger would, would, perhaps, perhaps, be be best best counteracted counteracted by by aa individuals, fair competition, competition, depriving depriving the the several several institutions institutions of of the the ability ability to to fair command custom, custom, and and obliging obliging them them to to merit merit and and attract attract it it by by their command their conduct.65 6.5 conduct. The The incorporation incorporation of of the the Farmers' Farmers' and and Mechanics' Mechanics' Bank Bank by by the the Act Act of of March March 16, 16, 1809, 1809, heralded heralded the the coming coming ofa of a decade decade of of unlimited unlimited increase increase banks. in in the the number number of of Pennsylvania Pennsylvania banks.

1.5 Between 1784 1784 and 1809 1809 Philadelphia banks moderated their resistance to competition. tance to competition. The The oldest oldest successfully successfully opposed opposed the the formation formation of first ten ten years years of of any any state-chartered state-chartered rival rival during during the the first of its its existence existence but but managed managed to to adjust adjust itself itself to to the the conditions conditions created created by by the the opening opening of of the the national national bank bank in in 1791 1791 and, and, two two years years later, later, of of aa bank bank in in which which the the state state was was the the largest largest stockholder. stockholder. It It discovered discovered that that it it could could prosper prosper despite, or perhaps with the help of, the newcomers. Opposition to the charter charter of of additional additional banks banks did did not, not, however, however, cease. cease. In In 1803-4 1803-4 it it was was led by the state-supported bank. But expanding trade proved too strong; by by 1809 1809 the the restrictive restrictive drive drive had had collapsed. collapsed. The privilege of banking was not to be confined to one or two large institutions. institutions. A A competitive competitive unit-banking unit-banking system system seemed seemed more more desirable desirable both both to to businessmen businessmen and and the the state. state. New New bank bank incorporation incorporation provided provided them them with with profitable profitable investment investment outlets. outlets. The The state, state, moreover, moreover, favored favored a unit-banking system because the grant of aa charter served as an opportunity Disopportunity to to secure secure aa payment payment for for the the valuable valuable right right conferred. conferred. Dis-

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Anna J. Schwartz

satisfaction satisfaction on the part of groups of of businessmen with the loan policies of existing institutions also encouraged the formation of rival banks. Increments to the country's specie supply, which the carrying trade yielded, reduced the tensions of of bank competition that Robert Morris 66 A new bank was a source of specie and Hamilton had pictured.66 deposits, which extended the basis of of loans for the whole system, not a threat. The issue of monopoly or competition in commercial banking became extinct.

Notes 1. I am not sure that, in Boston, the initial bank bank or banks actively opposed the addition of of members to the banking community. N. S. B. Gras comments: "From time to time other other banks were established established in Boston "From Boston (in addition to the Boston of the first Bank of the United States), but apparently they Boston branch branch of Bank of rarely or never doubtful never received received from the Old Massachusetts anything but a doubtful welcome and and hard hard terms" of Boston, Boston, welcome terms" (The Massachusetts Massachusetts First First National National Bank Bank of 1784-1934 [Cambridge: Harvard Harvard University Press, 1937], p. 37). I have not, 1784-1934 of the adjustment adjustment of of however, found any explicit references references to to the problems of the first first Boston or banks banks to See Edwin A. Stone, Stone, A Century the Boston bank bank or to newcomers. newcomers. See Edwin A. A Century of Boston Boston Banking (Boston: Rockwell Churchill, 1894), 1894), pp. pp. 8-12. 8-12. of Banking (Boston: Rockwell & Churchill, 2. James Wilson, Considerations Bank of North America America (PhiladelConsiderations on the Bank of North Pennsylvania Statutes, Laws Passed Passed 1781phia: Hall & Sellers, 1785), p. 4; Pennsylvania Statutes, Laws 178182, chap. ix. 3. Lawrence Lewis, Jr., A History History of Bank of North America America (Philadelof the the Bank of North phia: Lippincott, 1882), p. 152. 4. Bank of America stock was closely held in 1783 by wartime asof North America of Robert Morris—largely non-Quaker non-Quaker businessmen Robert Morris-largely businessmen related by marsociates of riage family—and non-Pennsylvanian riage to the Willing family-and non-Pennsylvanian capitalists. The directors were well-born and wealthy, with common religious, social, and business interests (R. (R. A. A. East, in the the American Era terests East, Business Business Enterprise Enterprise in American Revolutionary Revolutionary Era "It is notorious," Gou[New York: Columbia University Press, 1938], p. 290). "It verneur Morris, supporter, wrote, if the not been been verneur Morris, aa bank bank supporter, wrote, "that "that if the directors directors had had not under compulsion, they would not have extended extended the the subscription subscription beyond beyond the the under compUlsion, they would not have first four four hundred dollars" (Jared (Jared Sparks, Sparks, Life of Gouverneur Gouverneur Morris Morris first hundred thousand thousand dollars" Life of [Boston: Gray Gray & & Bowen, Bowen, 1832], 1832], III, III, 462). Gazette, January [Boston: 462). Pennsylvania Pennsylvania Gazette, January 21, 21, 1784, reported reported the the stockholders' stockholders' meeting on January 12, 1784. 1784, meeting on January 12, 1784. 5. Willing to Bingham, November November 29, 1783, "Provincial "Provincial Delegates," V, 17, in the Historical Society of of Pennsylvania. Pennsylvania. 6. Pennsylvania Journal, February 11, Pennsylvania Gazette, Gazette, January 21, 1784; Freeman's Freeman's Journal, 1784. 1784. New York Journal, Journal, March 18, 1784, by East East (op. cit., 7. Quoted Quoted from the New cit., p. 291, 291, n. 24). 8. Journal Journal of Assembly, VIII, 54, 123-24, 156-57. of the Assembly, Incorporation Incorporation was not at this time a statutory statutory requirement requirement for banks in Pennsylvania seek Pennsylvania. Why, then, did the promoters of of the Bank of of Pennsylvania conjecture that they sought to place the proposed new a charter? We may conjecture of North America with respect, institution on the same footing as the Bank Bank of

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The Beginning of of Competitive Banking in Philadelphia

for example, to its expectancy of of unlimited life and its capacity for suing and being sued and for holding and transmitting property. The strenuous efforts of of the Bank of of North America to defend its charter against revision by the unfriendly legislature of of 1784-86 and to regain it upon its repeal in September, 1785, indicate the value placed on legal incorporation. See Matthew Carey, Debates Debates and Assembly of and Proceedings Proceedings of of the General General Assembly of Pennsylvania, Memorials Praying Praying a Repeal Repeal or Suspension Suspension of of the Law Law Pennsylvania, on the Memorials Annulling Charter of of the Bank (Philadelphia: Seddon Seddon & & Pritchard, Pritchard, 1786), 1786), Annulling the Charter Bank (Philadelphia: passim. passim. Oscar Handlin and Mary F. Handlin have shown ("Origins of of the American Corporation," Journal Economic History, Journal of of Economic History, V, 1-23) 1-23) that, at its origin in Massachusetts, the the business business corporation corporation was was not not characterized characterized by by the the attriattriMassachusetts, butes it later later acquired: acquired: unique unique economic economic efficiency, efficiency, limited limited liability, liability, and and perperbutes it petual freedom from from state state interference. interference. They They argue argue that that the the corporation corporation was was petual freedom conceived as as an an agency agency of of government, government, designed designed to to serve serve aa social social function function for for conceived the state, state, and and therefore therefore was was used used in in the the organization organization of of business business activities activities the determined by by the the community, community, not not the the enterprising enterprising capitalist---e.g., capitalist—e.g., turnpikes, turnpikes, determined not trade; trade; banks, banks, not not land land speculations. speculations. The The applicability applicability of of this this interesting interesting not thesis to to the the use use of of the the corporate corporate form form in in Pennsylvania Pennsylvania requires requires special special study. study. thesis 9. Pennsylvania Pennsylvania Gazette, Gazette, March 3, 1784. 10. Assembly, VIII, 186. 10. Journal Journal of of the Assembly, 11. Directors' Minutes, March 1, 1792, "Bank of of North America Papers" in the Historical Society of of Pennsylvania. Alexander Hamilton Hamilton (New York: J. C. 12. J. C. Hamilton, ed., The Works of of Alexander Trow, 1850-51), 1,417. I, 417. 13. Hamilton to FitzSimons, March 21, 1784; to Morris, April 4, 1784, HamHamilton, ilton, I, 416, 418. The switch in Hamilton's views may be judged from a letter he wrote William Seton under date of of January 18, 1791, regarding a projected rival to to the the Bank Bank of of New York. "" 'Tis 'Tis impossible impossible but that three three great great banks banks rival New York. but that in one one city city must must raise raise such such aa mass mass of of artificial artificial credit credit as as must must endanger endanger everyone everyone in of them, them, and and do do harm harm in in every every view." view." He He was was sure sure that that the the combined combined force force of of of the Bank Bank of of New New York York and and the the Bank Bank of of the the United United States States branch branch would would "remove "remove the the excrescence excrescence which which has has just appeared." the just appeared." It seems strange that a man with Hamilton's aggressive business instincts should have assumed that businessmen would go to a new bank for additional credit for speculative purposes only. Such a view could more easily be ascribed to Jefferson. Jefferson. to 14. Jared Sparks, ed., The Diplomatic Diplomatic Correspondence Correspondence of of the American American Revolution Revolution (Boston: Nathan Hall and Gray & Bowen, 1830), XII, 485. 15. Pelatiah Webster, Political Political Essays Essays (Philadelphia: Joseph Crukshank, 1791), p. 267, n. 448. i6. 16. Carey, op. cit., cit., pp. 82 and 89. 17. Pelatiah Webster estimated the country's specie stock in 1780 to be $10 million. There were large accessions from 1780 until some time in 1783, due to expenditures by foreign troops, the French loans, and the profitable trade with the Spanish Islands. See Political Political Essays, Essays, p. 267 n. Brissot de Warville wrote of of Pennsylvania: "It was from their farms that the American and French armies were principally supplied during the last war; it was from their produce that came those millions of of dollars brought from the Havanna after the year 1780-millions 1780—millions which laid the foundation of of the Bank of peace" (New of North America, and supported the American army till the peace" (New Travels in the United United States States of of America Performed in 1788 1788 [London: [London: Jordan, Jordan, America Performed Travels 1792], p. p. 336). 336). See See also also W. W. G. G. Sumner, Sumner, The Financier Financier and and the Finances Finances of of the 1792], American (New York: York: Dodd, Dodd, Mead, Mead, 1892), 1892), I, I, 99-100. 99-100. American Revolution Revolution (New

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Anna J. Schwartz

When the bank was opened, the United States subscribed subscribed $254,000 in specie; other other stockholders, $70,000; but it is not clear how this amount amount was paid. transfer of Thomas Paine refers refers to a transfer of subscriptions from from the Pennsylvania Pennsylvania Bank of 1780--which 1780—which functioned functioned for a year and a half government of half apparently as a government purchasing agency agency rather rather than than as as aa bank—to Bank of of North North America. America. bank-to the the Bank purchasing Individual SUbscriptions subscriptions to to the latter institution institution may consisted of of bills bills of of the latter may have have consisted Individual exchange, drawn drawn on on the Ministers of of the States in in Europe Europe in in favor favor of of exchange, the Ministers the United United States the directors of of the the Pennsylvania Bank—not of of specie. specie. See See Carey, Carey, op. op. cit., cit., p. p. the directors Pennsylvania Bank-not 48; M. M. D. D. Conway, Conway, The The Writings Writings of of Thomas Thomas Paine Paine (New (New York: Putnam, 18941894York: Putnam, 48; 96), II, II, 153; 153; W M. Gouge, Gouge, A of Paper Paper Money and Banking 96), W. M. A Short Short History History of Money and Banking in in the United United States (Philadelphia: T. T. W. 1833). pp. pp. 34-35. 34-35. W. Ustick, Ustick, 1833). the States (Philadelphia: At the end of of 1793, the first dat~ date for which a figure exists, the Bank Bank of of North America held $462,000 in coin and specie. End-of-year End-of-year figures figures for 1794-1810 1794-1810 were considerably considerably lower, lower, ranging ranging from from $102,000 $102,000 to to $312,000. $312,000. See See "Bank "Bank of of were North America Papers." North America Papers." 18. The effect effect would, however, have been mitigated (if (if we take for granted that Bank of of North America America loans did not exhaust the demand) by the possibility of of further further expansion of of bank bank credit on the the given specie base. base. Erick sibility Bollmann (Paragraphs {Paragraphs on Banks Banks [Philadelphia: [Philadelphia: C. C. & A. A. Conrad, Conrad, 1811], 1811], p. 38) p. 38) BoUmann pointed out, out, on on the the other other hand, hand, that two banks banks doing doing the the same same amount amount of of that two pointed business formerly formerly done done by one might might require require larger larger specie specie holdings holdings than business by one than aa single bank: bank: "The "The most favorable situation situation of of aa bank therefore would would be be to be most favorable bank therefore to be single the only only one one in in the country and and to have for for customers customers aU all the merchants in in it, it, the the country to have the merchants because then then all all payments be made in checks checks on on the the same same bank bank and and the the payments would would be made in because call for for notes would be be extremely extremely limited limited..... . . . As As banks increase the custom banks increase the custom call notes would naturally divides, which tends, as as we have seen, seen, to to cause cause an an issue issue of of more more naturally divides, which tends, we have paper and and though though this operates both putting one one bank as often often in in pospospaper this operates both ways, ways, putting bank as session of of the the paper of the the other other banks banks as as its its own own is is held by them—yet it paper of held by them-yet it session admits of of fluctuation fluctuation and and prudence will require require to to be with aa greater greater prudence will be prepared prepared with admits quantity of of specie." specie." quantity 19. The new capital was doubtless only partly paid in specie. But Morris enlargement of of the bank's capital. did not decry the enlargement 20. Willing's letter, dated January 6, 1784, to "Messrs. Wm. Phillips, Isaac Smith,Jona. Russell,J. Smith, Jona. Mason, Thos. Russell, J. Lowell, S. Higginson of of Boston" ("Bank ("Bank of of North America Papers"). See Hamilton to FitzSimons, March 21, 21, 1784. Hamilton, 416. Hamilton, I, 416. president of 21. On April 14, 1794, for example, the president of the Bank of of North America Bank of America was requested requested to arrange with the Bank of New York a mutual credit of of $40,000 "for "for the accommodation accommodation of of the respective customers of of both banks in remitting moneys between between New York and Philadelphia" (Directors' Minutes, Bank of of North America). Bank 22. General Advertiser, June 24, 30, 1791. General Advertiser, 1791. Pelatiah Webster Webster was outraged outraged by promotion of Bank of Willing's promotion of a rival institution (To {To the the Stockholders Stockholders of of the Bank of North America America by a Citizen North Citizen of of Philadelphia Philadelphia [Philadelphia: Joseph Crukshank, 1791]), passim. passim. 23. Hamilton Hamilton had discussed discussed converting converting the Bank of of North North America into a National Bank Department, December national bank (Report {Report on a National Bank. . .. . . Treasury Treasury Department, December 13, 1790 [60th Cong., 1st sess., Senate Doc. 379]) as an alternative to forming forming the Bank of of the United States. The Bank Bank of of North America America showed no interest in Hamilton's suggestion. See Fisher Fisher Ames to Hamilton, July 31, 31, 1791, HamHamilton, ilton, V, 473. Bingham may have planted planted the proposals concerning conversion conversion of of the state into a national bank. See J. O. Wettereau, "Letters "Letters from Two Busi-

19

The Beginning of of Competitive Competitive Banking in Philadelphia

Alexander Hamilton on Federal Fiscal Policy, Nov. 1789," ness Men to Alexander Journal of Economic Economic and and Business Business History, History, III, 681-82. Bingham was Journal of uneasy of his of North if a uneasy lest the the price of his Bank of North America America shares decline if national L. Brown, "William "William Bingham, national bank entered the field. See M. L. Eighteenth Century of History History and and BiBiPennsylvania Magazine Magazine of Eighteenth Century Magnate," Magnate," Pennsylvania ography, LI, 405. 405. ography, 24. Only one-quarter one-quarter of of the private subscription ($8,000,000) to the stock of of the Bank Bank of of the United States had to be paid in specie; the rest was paid in stock of of the United States. To pay for its subscription subscription ($2,000,000), the United from the bank. States borrowed borrowed from An unsigned article ("On ("On Banks," Gazette Gazette of of the the United United States, States, March 10, 1792) repeated the orthodox bank competition. "A new bank orthodox fears respecting bank produces no new deposits of of specie. There is not a dollar more money added of specie and of of course to the circulation. A new bank divides the deposits of manifest that two banks with of credit. For it is manifest diminishes the advantages of small capitals will do less than one bank bank with both capitals. Besides the ordinary banking risks, each institution is in danger from the others." For the opposite view see Russell, Russell, "On "On Banking Banking Companies Companies in in the the United United States," States," American American view see Museum, XII (September 1792), 144-45. 144-45. (September 1792), Museum, XII of North America. 25. Directors' Minutes, Bank of 26. There is, nevertheless, some evidence that in the beginning interbank "Large relations were strained. Hamilton wrote Seton, August 17, 1792: "Large payments into the Bank of of North America on account account of of the State of of Pennsylvania subscriptions to canals, etc., and large calls upon the Bank Pennsylvania of of government, joined of the United States for the service of joined to liberal discounts, had produced aa considerable considerable balance balance in in favor favor of of the Bank of of discounts, had produced the Bank North it expedient expedient to of specie specie from from North America America which which rendered rendered it to draw draw aa sum sum of New York, not not to leave the Bank in in any any degree degree in in the the power power New York, to leave the National National Bank of of North once manifested mischievous of the the Bank Bank of North America, America, which which once manifested aa very very mischievous disposition, that that was afterwards repaid acts of of kindness and generosity" generosity" kindness and disposition, was afterwards repaid by by acts (Hamilton, V, (Hamilton, V, 521). 521). of North America's operations declined considerably considerably between 27. The Bank of of dividends was 1791 and \U1d 1792, according to year-end year-end reports. But the rate of of the bank's outstanding stock relatively unaffected. unaffected. In 1792 the par value of was only $742,800, compared with $946,800 difference $742,800, compared $946,800 seven years before. The difference represented stock stock bought in at one time or another. See Directors' Minutes, represented 1, 1792. March I,

1791 Discounts Circulation Deposits

2,557 1,000 1,000 1,293

($000's) ($OOO's)

1792 1,771 1,771 531 953

28. Lewis, op. op. cit., cit., p. 152. 29. Directors' Minutes, Bank Bank of of North America, July 2, 1792. 30. An Act of Laws Passed of April 10, 1792 (Pennsylvania (Pennsylvania Statutes: Statutes: Laws Passed 1791-92, 1791-92, chap. chap, lxxvi), empowered empowered the governor to apply certain moneys "in "in the proof shares in the Bank of of North America for the use of of this Commoncuring of wealth, provided provided the same may be obtainable at par." 1792-93, pp. 90-91; Stockholders' Minutes. 31. Senate Senate Journal Journal 1792-93, Senate Journal 1792-93, pp. 180-81; Anthony Morris (a director of of the 32. Senate Journal 1792-93, of North America, 1800-1808) made this proposal in a bill he read in the Bank of

20

Anna J. J. Schwartz

Senate after after moving to postpone the House bill incorporating incorporating the Bank of of Pennsylvania. foreign 33. While the older banks financed principally merchants engaged in foreign of the Bank of Pennsylvania Pennsylvania were described as chiefly chiefly Bank of trade, the customers of retail shopkeepers. See Henry Adams, The Writings Writings of of Albert Albert Gallatin Gallatin (Phil1879), I, SO. 80. Thomas Leiper, the tobacconist, was disadelphia: Lippincott, IS79), satisfied with with the the accommodation accommodation he he received received at at the the Bank of the the United United Bank of satisfied States and and transferred transferred his his business business to to the the Bank Bank of of Pennsylvania, Pennsylvania, of of which which States he became became aa director. director. Cf. Cf. aa speech speech by by James James Lloyd, Lloyd, United United States States Senator Senator he from Massachusetts, of Congress, Congress, XXII XXII (lIth (11th Cong., Cong., 3d 3d sess., sess., Senate), Senate), from Massachusetts, Annals Annals of 165. 165. Journal 1792-93, pp. 142, 156-57; Pennsylvania Statutes: Laws Laws 34. House House ':lournal1792-93, Pennsylvania Statutes: Passed 1792-93: Act of March 30, 1793, chap. chap, xxix, sec. xi; Senate Senate Journal Journal Passed 1792-93: Act of 1793-94, p. p. 44. 1793-94, of the Senate noted in IS09: 1809: "The object object of of the legislature legislature A select committee of in the establishment establishment of of this bank was to promote the regular, permanent permanent and successful operation operation of. of the ·finances finances of of the state, so as to be productive of of successful benefit to trade and industry in general" (Senate {Senate Journal 1809-10), p. 67. Henry benefit Journal 1809-10), "The apprehension apprehension that this (the surplus) would be Adams quotes Gallatin: "The squandered by by the the Legislature Legislature was was the the principal principal inducement inducement for for chartering chartering the the squandered of Pennsylvania" (The Life of Albert Albert Gallatin Gallatin [New York: Peter Smith, Bank of Life of 1943], p. 86). Gazette Gazette of of the the United United States States (March (March 9, 9, 1793) 1793) published the published the 1943], p. S6). following rhyme rhyme of of opposition: opposition: following "ANOTHER "ANOTHER BANK BANK "The "The State, in cash 'tis said abounds, of many thousand pounds; To th' amount of lies— Snug in the banks the treasure liesA sure defence should dangers rise; from public view, For while 'tis hid from It mocks the grasping, scheming crew; But cunning cunning now now exerts exerts its its springs, springs, But To give give the the dormant dormant eagles eagles wings; wings; To Hence aa new new banking banking plan plan is is form'd, form'd, Hence And soon soon the the bolted bolted vaults vaults are are storm'd, storm'd, And On paper paper plumes plumes they they mount mount the the air, air, On And fly-the fly—the Lord Lord alone alone knows knows where; where; And Meantime the the Sharks Sharks of of speculation, speculation, Meantime Laugh at at the the sages sages of of the the Nation!" Nation!" Laugh of North America, May 2S, 28, 1793; Senate Senate 35. Stockholders' Minutes, Bank of Journal 1809-10, Journal 1809-10, pp. 67-S0. 67-80. In Baltimore in 1795 a proposal to establish a new consolidation of of the bank was also coupled with a clause providing for the consolidation Bank of of Maryland Maryland with with the the new new institution, institution, if if both both parties consented. The The Bank parties consented. clause was was not not accepted, accepted, and and the the Bank Bank of of Baltimore Baltimore was was chartered chartered as as an an entirely entirely clause separate institution. institution. See See A. A. C. C. Bryan, Bryan, History History of of State State Banking Maryland Banking in Maryland separate (Baltimore: Johns Johns Hopkins Hopkins Press, Press, IS99), 1899), pp. 20-21. (Baltimore: pp. 20-21. 36. Directors' Minutes, June 2, 1794. Bank of of the the United United States States (Washington: (Washington: First Bank 37. J. T. Holdsworth, The First Government Printing Office, 1910), p. 41; 41; Directors' Minutes, Bank of of North Government America, March 2, June 26, 1797; May 16, 1799. 3S. Annals (Philadelphia: T. Dobson & Son, ISIS), 38. Adam Seybert, Statisiical Statistical Annals 1818), p. 60; "Minutes of of Evidence ... . . . respecting the Orders in Council," ParliaParliamentary Papers, Papers, 1808, X, No. 1I9, 119, 2, 3, 9, 15, 35, 4S, 48, 143; Alexander Baring mentary

21

The Beginning of of Competitive Banking in Philadelphia

Ashburton, An Inquiry into the Causes Causes and Consequences Consequences of of the Orders Orders in Council Council (2d ed.; London: J. M. Richardson, 1808), p. 62. House Journal Journal 1803-4, Biographies of 39. House 1803-4, p. 258; Stephen N. Winslow, Biographies of Successful Philadelphia Merchants Successful Philadelphia Merchants (Philadelphia: James K. Simon, 1864), Her Merchants Merchants (Philadelphia, pp. 167-69; Abraham Ritter, Philadelphia Philadelphia and Her Principles and 1860), pp. 49, 70; Observations Observations on the Principles and Operation Operation of of Banking Banking Philadelphia by Anti-Monopoly with Strictures Strictures on the Opposition Opposition to the Bank of of Philadelphia Anti-Monopoly (Philadelphia, 1804). 40. Joel Cook, The Philadelphia Philadelphia National National Bank: Bank: A Century's Century's Record, Record, 180318031903, by a Stockholder Stockholder (Philadelphia: W. H. Fell, 1903), p. 23. An analogous situation developed in New York. For fifteen years the Bank of of New York had no rival. When the Manhattan Company was incorporated, ostensibly to supply water to the City of of New York but in reality to carry on a banking business, the directors of the Bank of New York at aa special meeting meeting on August 22, 1799, resolved not to accept its notes. The resolution was rescinded on April 15, 1800. See H. W. Bank of W. Domett, A History History of of the Bank of New New York York (New York: G. P. Putnam's Sons, 1884), pp. 57-58. The Bank of of New York must have learned that an aggressor was no more immune to attack than its victim. 41. Cook, op. cit., cit., p. 30. 42. Observations Observations . .. . . , p. 15. Because street money rates declined as bank loans increased, the author claimed that usurers were among the most violent opponents of of the new bank. 43. In Baltimore the atmosphere was similarly hostile to the formation of the third city bank. The application of of the Union Bank for a charter from Maryland in 1804 was bitterly opposed by the Bank of of Maryland and the Bank of Baltimore. Baltimore. Bryan, Bryan, op. op. cit., cit., pp. pp. 23-24. 23-24. of 44. House House Journal Journal 1812-13, 1812-13, p. 193. The resolution, which was defeated, proposed either either to to sell sell the the state's state's stockholdings stockholdings in in incorporated incorporated banks, banks, the the proposed receipts to to be lent to to the the federal federal government, government, or or to to transfer transfer the the stock stock to to it it on on receipts be lent terms agreed agreed upon. upon. terms Journal 1803-4, 45. House House Journal 1803-4, pp. 67-68. 46. Ibid., pp. 66-67. 47. Ibid., pp. 83-84; Senate Journal 1803-4, Senate Journal 1803-4, pp. 52-53. 48. Ibid., p. 71. 49. William Maclay, who served as United States senator from Pennsylvania, Jeffersonian in outlook before the party came into existence. 1789-91, was Jeffersonian The Hamiltonian Hamiltonian system system was was exceedingly exceedingly distasteful distasteful to to him, him, but but his his efforts efforts to to The curb it it were were unsuccessful. unsuccessful. A A quotation quotation from from his diary, dated dated January January 1, 1, 1791, curb his diary, 1791, reveals his his views on banks. "This day day the the Bank Bank [of [of the United States] States] bill bill banks. "This the United reveals views on reported. It It is is totally totally in in vain vain to oppose this The only only useful part II can can act act to oppose this bill. bill. The useful part reported. is to to try try to to make make it it of of some some benefit benefit to to the public, which which reaps reaps none none from from the the is the public, existing banks" banks" (E. (E. S. S. Maclay, ed., The The Journal of Maclay [New York: & existing Maclay, ed., Journal of Maclay [New York: A. A. & C. Boni, Boni, 1927], 1927], p. p. 353). 353). C. 50. It added two supplements to each proposal: (a) (a) to permit the state to subscribe $300,000, $300,000, paying paying in in at at par par 66 percent percent stock stock of of the the United United States, States, then then subscribe selling at at aa discount; discount; (b) (b) to to lend lend the the state state not not over over $100,000, $100,000, whenever whenever required, required, selling for the the term term of of its its charter, charter, at at not not more more than than 55 percent percent interest. interest. It It advanced advanced the the for premium it it was prepared to give under under the fourth proposal proposal (for (for an an exchange exchange premium was prepared to give the fourth of $500,000 $500,000 of of Philadelphia Philadelphia Bank Bank stock stock for for Bank Bank of of Pennsylvania stock) from from of Pennsylvania stock) $125,000 to to $166,666.67 $166,666.67 and and guaranteed guaranteed to pay -Within within six six months months $100,000 $100,000 to pay $125,000 above the the par value ofthe of the Philadelphia stock the the state state would would thus thus acquire, acquire, par value Philadelphia Bank Bank stock above

21 22

Anna Anna J. Schwartz Schwartz

if if the legislature should pass a law within one year relinquishing the stock. Moreover, it suggested suggested that the state have the right to appoint directors in House Journal Journal 1803-4, proportion proportion to its stockholdings. See House 1803-4, pp. 257-58; Senate Senate Journal 1803-4, Bank of Journal 1803-4, p. 273. (The state owned thirteen thirteen twenty-thirds of of Bank of Pennsylvania stock but had power twenty-fifths of Pennsylvania power to appoint only six twenty-fifths of the directors. When the Philadelphia Bank was finally incorporated, the state owned represented by three-elevenths three-thirteenths three-thirteenths of of its stock and was represented three-elevenths of of the directors.) 51. House House Journal Journal 1803-4, 1803-4, p. 252. 52. Ibid., Ibid., pp. 260-61. A bill embodying the measure proposed proposed by the Bank of Pennsylvania was printed, without of Pennsylvania without authority, to accompany accompany the Maclay distributed in handbills to members; see ibid., pp. 348-52. This report, and distributed minor scandal was, however, suppressed. suppressed. 53. Senate Senate Journal Journal 1803-4, 1803-4, p. 168. 54. House House Journal Journal 1803-4, 1803-4, pp. 285-87. 55. Ibid., Ibid., pp. 298-300, 304-5, 319. 56. Ibid., Ibid., p. 379; Senate Senate Journal Journal 1803-4, 1803-4, pp. 250-51. 57. House House Journal Journal 1803-4, 1803-4, pp. 387-88, 392, 396. 58. Senate Journal 1803-4, Senate Journal 1803-4, pp. 249, 257, 269-70. Ibid., pp. 272-74. The Bank Bank of Pennsylvania would give the state and 59. Ibid., of Pennsylvania profit of permit it to subscribe $200,000 at par. The state would make a profit permit of $120,000 by taking advantage of of its right to subscribe a further further sum of of $300,000, in exchange for 6 percent percent United States stock at par. At the end of of one year, if if the state wanted to sell the stock, the bank bank would purchase it at a 40 percent increase in price. At the end of of five years the state would also receive $120,000, the estimated estimated excess of of payments over par from from the sale of of $300,000 of of unsubscribed stock. subscribed 60. With one addition, the conditions were the same as those the Maclay further demanded demanded the committee had reported reported and indorsed. The bank now further return of of $200,000 of of the state's stock, at par, should the legislature grant another charter charter for for aa bank bank before 1827; see see ibid., before 1827; ibid., p. p. 274. 274. another 61. Ibid., Ibid., pp. 277-84, 287-89. bank which Stephen 62. The notes of of the private bank Stephen Girard founded founded in Philaof $1,200,000, MaY, 1812, with with a capital of$1 ,200,000, were were at first refused refused by by some delphia in May, banks, but but opposition opposition collapsed collapsed early early in in 1813. 1813. The The chartered chartered banks banks were were posposbanks, sibly indignant indignant that Girard had had ceased ceased paying out their as had been his his their notes, notes, as had been sibly that Girard paying out practice own were were printed. printed. Nonacceptance of his his notes notes had basis Nonacceptance of had aa basis practice until until his his own in law, as the the Act of March 19, 1810, 1810, prohibited prohibited the of bank notes by by Act of March 19, the issue issue of bank notes in law, as unincorporated Pennsylvania banks. banks. Government evidently did iniunincorporated Pennsylvania Government agents agents evidently did not not initially accept accept them, Girard's subscription, subscription, exceeding exceeding $5 $5 million, the but to to Girard's million, to to the tially them, but 1813, there the private bank be placed United States loan of 1813, there was was aa proviso proviso that that the private bank be placed United States loan of on the the same same footing footing as as chartered chartered banks a trustee trustee on banks in in Philadelphia. Philadelphia. David David Lenox, Lenox, a of Girard's Girard's bank, bank, who who was elected president of the the Philadelphia Bank in in JanJanof was elected president of Philadelphia Bank uary, 1813, 1813, is is said said to have been been instrumental instrumental in in arranging arranging to to have Girard's notes notes to have have Girard's uary, honored chartered bank. bank. See See Stephen Stephen Simpson, Simpson, Biography Biography of of Stephen Stephen honored by by the the chartered Girard (Philadelphia, (Philadelphia, 1832), 1832), p. 114; K. K. L. L. Brown, Brown, "Stephen "Stephen Girard's Girard's Bank," Bank," Girard p. 114; Pennsylvania of History and Biography, 36-42; Cook, op. Pennsylvania Magazine Magazine of History and Biography, LXVI, LXVI, 36-42; Cook, op. cit., pp. cit., pp. 55, 55, 58. 58. From then on banks were controlled controlled by and offered offered accommodation accommodation to 63. From General Advertiser, others besides merchants in foreign trade. See General Advertiser, February 11, 12, 12, 16, 16, 1807, 1807, and and February February 3, 3, 1808; 1808; James James Robinson, Philadephia 11, Robinson, The Philadephia Directory 1807. for 1807. Directory for

23

The Beginning of Competitive Banking in Philadelphia

64. House House Journal 1807-8, I,I, 194-95. 194-95. The The chairman chairman of of this this committee committee was was 64. Journal 1807-8, John Sergeant, whose legal talents in support support of of banks banks and and John Sergeant, whose legal talents were were early early enlisted enlisted in commercial interests. commercial interests. 65. Ibid., 65. Ibid., p. p. 197. 197. 66. C. C. J. J. Bullock, Bullock, J. J. H. H. Williams, Williams, and and R. R. S. S. 'lUcker, Tucker, "The 'The Balance Balance of of Trade 66. Trade of States," Review of Economic Statistics (1919), (1919), I,I, 215-17. 215-17. of the the United United States," Review of Economic Statistics

2

Money and Business Cycles Milton Friedman Friedman and and Anna Anna J. J. Schwartz Schwartz Milton

The be given this session session covers covers too too broad broad an an area area to to be given The subject subject assigned assigned for for this even paper. Accordingly, even aa fairly fairly cursory cursory treatment treatment in in aa single single paper. Accordingly, we we have have chosen to to concentrate concentrate on on the the part part of of it it that that relates relates to to monetary monetary factors factors in chosen in economic fluctuations. fluctuations. We We shall shall still stillfurthernarrow further narrowthe the scope scopeofthe of the paper paper economic by interpreting' interpreting'''monetary monetary factors'' of the by factors" to to mean mean the the role role of the stock stockof ofmoney money and of of changes changes in in the the stock-thereby stock—thereby casting casting the' the "credit" market as as one one and 'credit" market of the the supporting supporting players players rather rather than than aa star star performer-and performer—and by by intrepretintrepretof ing "economic "economic fluctuations" fluctuations" to to mean mean business business cycles, cycles, or or even even more more exexing actly, the the reference reference cycles cycles studied studied and and chronicled chronicled by by the the National National Bureau. Bureau. actly, The topic topic so so interpreted interpreted has has been been rather rather out out of of fashion fashion for for the the past past The few decades. decades. Before Before the the Great Great Depression, Depression, it it was was widely widely accepted accepted that that few the business cycle was was aa monetary monetary phenomenon, phenomenon, "a "a dance dance of of the the dollar," dollar," the business cycle as Irving Irving Fisher Fisher graphically graphically described described it it in in the the title title of of aa famous famous article.! article.1 as Different versions versions of of monetary monetary theories theories of of the the business business cycle cycle abounded, abounded, Different though some of these were really "credit" theories misnamed, since though some of these were really "credit" theories misnamed, since they gave gave little little role role to to changes changes in in the the money money stock stock except except as as an an incident incident they in the the alteration alteration of of credit credit conditions; conditions; and and there there was was nothing nothing like like agreeagreein ment on the details details of of anyone any one theory. theory. Yet Yet it true that that most most ment on the it is is probably probably true economists gave gave the the money money stock stock and and changes changes in in it it an an important, important, if economists if not aa central, central, role role in in whatever whatever particular particular theory theory of of the the cycle cycle they they were were not inclined to to accept. accept. That That emphasis emphasis was was greatly greatly strengthened strengthened by by the the inclined course of of economic economic events events in in the the twenties. twenties. The The high high degree degree of of economic economic course stability then then achieved achieved was was widely widely regarded regarded as as aa consequence consequence of of the the stability effectiveness of of the the monetary monetary policies policies followed followed by by the the only only recently recently effectiveness created Federal Federal Reserve Reserve System System and and hence as evidence evidence that monetary created hence as that monetary factors were were indeed indeed aa central central factor factor in in the the cycle. cycle. factors The The Great Great Depression Depression radically radically changed changed economic economic attitudes. attitudes. The The failure of of the the Federal Federal Reserve Reserve System System to to stem stem the the depression depression was was failure 24 24

25

Money and Business Cycles

widely widely interpreted-wrongly interpreted—wrongly as as we we have have elsewhere elsewhere argued argued22 and and elabelabbelow-to mean orate orate below—to mean that that monetary monetary factors factors were were not not critical, critical, that that "real" factors factors were were the key to economic fluctuations. fluctuations. InvestmentInvestment— "real" the key to economic which had had always always had had aa prominent place in in business cycle theoriestheories— which prominent place business cycle received new new emphasis emphasis as as aa result result of of the the Keynesian Keynesian revolution, revolution, so so received much so so that that Paul Paul Samuelson, Samuelson, in in the the best best selling selling textbook textbook in in the the councounmuch try, could could assert assert confidently, confidently, "All "All modern modern economists economists are are agreed agreed that that try, the important important factor factor in in causing causing income income and and employment employment to fluctuate is is the to fluctuate investment."3 Investment Investment was was the the motive motive force,its force, its effects effects spread spread investment."3 through time time and and amplified amplified by by the the "multiplier," "multiplier," and and itself itself partly partly or or through largely aa result result of of the the "accelerator." "accelerator." Money, Money, if if it it entered entered at at all, all, played played largely purely passive passive role. role. aa purely of interest been sparked by Recently, Recently, aa revival revival of interest in in money money has has been sparked less less by concern with with business business cycles cycles than than with with concern concern about about inflation. inflation. Easy Easy concern money policies were accompanied accompanied by by inflation; inflation; and and inflation inflation was was nomoney policies were nowhere stemmed stemmed without without aa more more or or less less deliberate deliberate limitation limitation of of growth growth where of the the money money stock. stock. But But once once interest interest was was aroused, aroused, it it naturally naturally exexof tended cycle as well as to inflation. inflation. In In the the United United States, States, indeed, indeed, tended to to the the cycle as well as to there has has been been something something of of aa repetition repetition of of the the 1920s. 1920s. A A high high degree degree there of economic economic stability stability has has been been accompanied accompanied by by aa large large measure measure of of talk talk of about an active monetary policy, and the monetary authorities have about an active monetary policy, and the monetary authorities have often been been given given credit credit for for playing an important important role role in in promoting promoting often playing an stability. As the experience of the twenties suggests, this fair-weather stability. As the experience of the twenties suggests, this fair-weather source of of support support for for the the importance importance of of money money is is aa weak weak reed. reed. source Examining present state of Examining the the present state of of our our understanding understanding about about the the role role of money business cycle, first present present some money in in the the business cycle, we we shall shall first some facts facts that that seem seem rereasonably reasonably well well established established about about the the cyclical cyclical behavior behavior of of money money and and related magnitudes magnitudes and and then then speculate speculate about about some some plausible interpretalated plausible interpretations of of these these facts. facts. The The facts facts we we present are drawn drawn largely largely from from our our own own tions present are unpublished work work done done under the auspices auspices of of the the National National Bureau Bureau of of unpublished under the Economic Research Research and and associated associated unpublished unpublished work work by Phillip Cagan. Cagan. Economic by Phillip

2.1 Some Some Facts Facts about about the the Cyclical Cyclical Behavior Behavior of of Money 2.1 Money the Money 2.1.1 Cyclical Pattern 2.1.1 Cyclical Pattern of of the Money Stock Stock The The outstanding outstanding cyclical cyclical fact fact about about the the stock stock of of money money is is that that it it has has tended to to rise rise during during both both cyclical cyclical expansions expansions and and cyclical cyclical contractions. contractions. tended This is is clear clear from from figure 2.1 which which plots (1) the the stock stock of of money money from from plots (1) This figure 2.1 1867 to to 1960, 1960, with with money money defined defined as as including including currency currency plus plus adjusted adjusted 1867 deposits in in commercial commercial banks (both demand demand and and time) held by the deposits banks (both time) held by the nonbanking public public (i.e., (i.e., excluding excluding both both balances balances of of the the federal federal govgovnonbanking ernment and and of of banks); and (2) (2) from from 1914 1914 on, on, aa narrower narrower total total which which ernment banks); and excludes time time deposits. deposits. From From 1867 1867 to to 1907, 1907, our our data data are are at at annual annual or or excludes

Currency Currency held held by by the the public, public, plus plus demand demand deposits deposits adjusted, adjusted, plus commercial bank time deposits

-

....... Currency held by the public, plus demand deposits adjusted Billions Billions of of dollars dollars

6~--~------------~~-------------r----------~ 5 4 3 2 ll

I I I I I I I I I I I I I I I I I I I I I I I I I I 1 I I I I

11861'68 1867'68

'10 '70

'12 '72 '14 '74

'16 '76 '78 '78 '80 '80 '82 '82 '84 '84 '86 '86

''88 118 '90 '90

'92 '98 '92 '94 '94 '96 '96 '98

~r-~----------'-----------'-------==~ 40 30

............-...................................

20

'02

'04

'06

'08

'10 12

'14

'16

'18

'20

'22

'24

'26

'28

......................................

,..........~ ...... ... ............

20 1929 '30

Figure 2.1

" ..,.1

Ratio scale

......, .. / '32 '32 '34 '34 '36 '36

'38 '38 '40 '40

'42 '42 '44 '44

'46 '46

'48 '48 '50 '50 '52 '52 '54 '54

'56 '60 '56 '58 '58 '60

Money stock including commercial bank time deposits, 18671960, and currency currency plus demand deposits adjusted, adjusted, 1914-60. Source: Friedman and Schwartz, A Monetary Monetary History History o/the of the United United States, States, 1867-1960 1867-1960 (Princeton, N.J.: Princeton University Press, for the National Bureau of of Economic Reseasonally search, 1963a), table A-1, A-I, cols. 7 and 8. These are seasonally adjusted figures, figures, dates as of of end of of month, 1867-1946; for adjusted currency plus demand deposits adjusted adjusted is an av1947-60, currency of daily figures, figures, and commercial bank time deposits, erage of last-Wednesday-of-month figfiga 2-month moving average of last-Wednesday-of-month ures, for a month centered at mid-month.

27

Money and Business Cycles

semiannual dates; dates; from 1907 on, monthly. The only major exceptions since 1867 1867 to to the the tendency tendency of of the the money money stock stock to to rise rise during during both both since cyclical expansions expansions and and cyclical cyclical contractions contractions occurred occurred in in the the years years cyclical listed in in the which gives gives also also the the percentage listed the following following tabulation, tabulation, which percentage dedecline during during each each exception. exception. cline Years of Exception ixception 1873-79 1873-79 1892-94 1907-08 1920-21 1920-21 1929-33 1937-38

Percentage Decline 4.9 4.9 5.8 5.8 3.7 3.7 5.1 5.1 35.2 2.4 2.4

In two minor World In addition, addition, there there were were two minor exceptions exceptions since since the the end end of of World War II, 1948-49 1948-49 1959-60

1.4 1.4 1.1

The years. The major major exceptions exceptions clearly clearly did did not not fall fall in in aa random random subset subset of of years. Each corresponds corresponds with with an an economic economic contraction contraction that that was was major major as Each as judged other indicators; indicators; in in the the period covered, there there was was no other judged by by other period covered, no other economic contraction contraction more more severe severe than any in in the the list; list; and and there there apeconomic than any appears to be considerable gap gap between the severity severity of of those those contraccontracpears to be aa considerable between the tions and and of of the the remainder, remainder, with with the the possible possible exception exception of of the the concontions traction of 1882-85 which might be regarded as a somewhat borderline traction of 1882-85 which might be regarded as a somewhat borderline case. case. For mild mild depression depression cycles, cycles, therefore, therefore, the the cycle cycle does does not not show show up For up as aa rise and aa fall. Figure 2.2 2.2 gives gives the the average average reference-cycle reference-cycle as rise and fall. Figure patterns for mild mild and and deep deep depression depression cycles cycles since since 1867, 1867, excluding excluding patterns for only war war cycles. cycles. (Patterns (Patterns are are given given separately separately for for the the period period before before only and after after 1907, 1907, because availability of of monthly monthly data data after after 1907 because the the availability 1907 and permits the construction construction of of aa more more detailed detailed pattern-a pattern—a nine-point nine-point permits the instead of of aa five-point pattern.) The The patterns patterns for for mild mild depression depression five-point pattern.) instead cycles rise almost in in aa straight straight line, line, though though there there is is some some indication indication cycles rise almost of aa slower slower rate rate of of growth growth from from mid-expansion mid-expansion to to mid-contraction mid-contraction of than during during the the rest rest of of the the cycle cycle (especially (especially in in the the nine-point nine-point pattern than pattern for monthly monthly data). data). In In its its cyclical cyclical behavior, behavior, the the money money stock stock is is like for like other series series with with aa sharp sharp upward upward trend-such trend—such as as population, the total total population, the other stock of of houses, houses, the the number number of of miles miles of of railroad railroad track track in in operation operation in in stock the pre-1914 pre-1914 period, the amount amount of of electrical electrical energy energy produced. produced. In In all all the period, the of these, these, the the cycle cycle shows shows up up not not in in an an absolute absolute rise and fall fall but of rise and but in in different rates rates of of rise. rise. different

28

Milton Friedman and Anna J. Schwartz -1867-1908 1867-1908 1908-1961 - - - 1908-1961

Reference Reference cycle relatives 110110—

--0..

r>--

|_

__

Wo (1 _

Y(T)]] 8) dd log log P(T) P(T) x d d log log Y(T) Y(T) M(T)J *. dd log Y(T) dd log M(T)

Solve Solve for for dd log log Y(T)/d Y(T)/d log log M(T) M(T) to to get get (8) (8)

d log Y(T) Y(T) d log M(T)

11 wo[8 11] , w0[b + (1 (1 -- 8) 8) TI]

where 11 T] is is the the elasticity elasticity of of the the measured measured price price level level with with respect respect to to where measured income, income, and and can can be be expected expected to to be be between between zero zero and and unity unity measured for cyclical cyclical fluctuations (i.e., both and output output can can be be expected expected for fluctuations (i.e., both prices prices and

63

Money and Business Cycles

to move in the same direction as money income). We may designate d log Y(T)/d Y{T)ld log log M(T) M(T) the the money money multiplier, multiplier, analogous analogous to to the the investment investment multiplier, be noted multiplier, though though it it should should be noted that that the the analogy analogy is is somewhat somewhat incomplete. The money multiplier gives the ratio of the percentage percentage 32 To change in income to the percentage change in the money stock. 32 get the number of dollars of income change per dollar change in the stock stock of of money, money, it it is is necessary necessary to to multiply multiply the the money money multiplier multiplier by by the the income velocity velocity of of money. money. income It It so so happens happens that that our our earlier earlier work work furnishes furnishes empirical empirical estimates estimates for for the United States of all the quantities entering into the right-hand side of of of equation equation 8. 8. Hence, Hence, we we can can construct construct an an estimate estimate of of the the elasticity elasticity of money income with respect to the money stock. These estimates are 33 as as follows: follows:33 Wo w0

= = 0.33 1.81 88 = 1.81 TI = = 0.20 0.20 TJ

Inserting these figures in equation 8 gives

(9)

| MM(D ^ ==1.1.84 EEstimate s t i m a dt elog 84 .

d log Y(D

d log M(T) This estimate is certainly remarkably close to the estimate, based on table 2.4, of the ratio of the variability of income to the variability of be recalled of money. money. It It will will be recalled that that we we there there found found this this ratio ratio to to be be almost almost of exactly 2.0. So far as we can see, these two numbers are estimates of 34 Yet, the the same same theoretical theoretical construct. construct.34 Yet, statistically, statistically, they they are are almost almost comcompletely independent. The estimate in equation 9 comes from the following Wo0 is based on the consumption lowing sources: sources: w is based on aa study study of of the consumption function function which used used no no data data on on money money whatsoever; whatsoever; 88 is is based on aa correlation correlation which based on inbetween bases of between average average cycle cycle bases of money money and and estimated estimated permanent permanent income; and and TJ r\ is is based based on on the the ratio ratio of of per per month month cyclical cyclical amplitudes amplitudes come; computed computed from from average average cycle cycle patterns patterns of of money money income income and and prices. prices. Hence, so far as we can see, no one of these items uses in any way the the intracyclical intracyclical movements movements of of money. money. Yet Yet the the estimate estimate of of 2.0 2.0 based based on table table 2.4 2.4 has has in in its its denominator denominator the the average average standard standard deviation deviation of on of sets, containing 3, 4, 5, or 6 years, of year-to-year percentage changes in the stock of money. The close agreement of two estimates, statistically so tically so independent, independent, certainly certainly strongly strongly suggests suggests that that the the theoretical theoretical 3s structure which produced them deserves further further exploration. 35 In such further further exploration it would be desirable to generalize this analysis in a number of respects. (1) (1) 1] ^ should not be treated as a numerical constant. One would expect it to be different different at different different stages of the cycle and under different different circumstances. Under conditions

64

Milton Friedman and Anna J. Schwartz

offull of full employment and inflation, it would be unity or close to it, whichwhich— given given that that 88 is greater greater than than unity-would unity—would make make the the money money multiplier aa maximum maximum of of lIwo, l/w0, or or with with our our estimate estimate of of wo, w0, 3. 3. At At the the other other extreme, extreme, ifthere if there were extensive unemployment, 1} t] might might be be close close to to zero zero (though (though it is by no means clear that this has been true in experience), which would would make make the the money money multiplier multiplier aa minimum minimum of of lIwo1}, l/w0r\, or or with with our our estimates, 1.67. More generally, 1} iq plays an important role not only in any any theory theory along along the the general general lines lines we we have have been been sketching sketching but but also also in in 36 It deserves much more systematic study income-expenditure theories. 36 than than it it has has received. received. (2) (2) The The demand demand equation equation 44 should should be be expanded expanded to to include include interest interest rates rates and and perhaps perhaps the the rate rate of of change change in in prices. prices. Though Though our our studies studies suggest suggest that that these these are are far far less less important important than than income income in affecting affecting the the demand demand for for money, money, interest interest rates rates do do have have aa statistically statistically significant significant effect effect and, and, since since they they have have aa fairly fairly regular regular cyclical cyclical pattern, pattern, should be included in a cyclical analysis. (3) The effect effect of expected trends trends in in prices prices and and income income should should be be allowed allowed for for explicitly explicitly and and not not simply neglected, as we have done. (4) For cycle analysis, the demand equations equations should should be be estimated estimated on on aa quarterly quarterly rather rather than than annual annual basis. basis. (5) In generalizing to a quarterly basis, it will no longer be satisfactory satisfactory to to suppose suppose that that actual actual and and desired desired money money balances balances are are always always equal. equal. It will be desirable to allow instead for a discrepancy between these two two totals, totals, which which the the holders holders of of balances balances seek seek to to eliminate eliminate at at aa rate rate depending on the size of the discrepancy. This will introduce past money balances into the estimated demand equation not only as a proxy for prior permanent incomes but also as a determinant of the discrepancies ancies in in the the process process of of being being corrected. corrected. In In addition, addition, it it will will permit permit lag lag patterns other than the simple exponential kind we have used. 2.3 2.3 A A Tentative Tentative Sketch Sketch of of the the Mechanism Mechanism Transmitting Transmitting Monetary Monetary Changes Changes However However consistent consistent may may be be the the relation relation between between monetary monetary change change and and economic economic change, change, and and however however strong strong the the evidence evidence for for the the autonautonomy omy of of the the monetary monetary changes, changes, we we shall shall not not be be persuaded persuaded that that the the monetary we monetary changes changes are are the the source source of of the the economic economic changes changes unless unless we can can specify specify in in some some detail detail the the mechanism mechanism that that connects connects the the one one with with the the other. other. Though Though our our knowledge knowledge is is at at the the moment moment too too meager meager to to enable enable us us to to do do this this at at all all precisely, precisely, it it may may be be worth worth sketching sketching very very broadly broadly some some of of the the possible lines lines of of connection, connection, first, in in order order to to provide provide aa plausible findings; second, plausible rationalization rationalization of of our our empirical empirical findings; second, to to show show that that aa monetary monetary theory theory of of cyclical cyclical fluctuations fluctuations can can accommodate accommodate aa wide wide variety findings about variety of of other other empirical empiricalfindings about cyclical cyclical regularities; regularities; and and third, third, to to stimulate stimulate others others to to elaborate elaborate the the theory theory and and render render it it more more specific. specific. Let Let us us start start by by defining defining an an Elysian Elysian state state of of moving moving equilibrium equilibrium in in which price level which real real income income per per capita, capita, the the stock stock of of money, money, and and the the price level

6S 65

Money and Business Cycles

are all changing at constant annual rates. The relation between these rates depends on whether real income is rising or falling, whether wealth is remaining constant as a ratio to income or is rising or falling relative to income, on the behavior of relative rates of return on different forms of wealth, and on the wealth elasticity of demand for money. To simplify, let us suppose that all interest rates in real terms of (i.e., adjusted adjusted for the rate of change in prices) and also the ratio of wealth to income are constant, so that the wealth elasticity of of demand for money can be approximated by the elasticity of demand for money with respect to permanent income. If If real income is rising at the rate of ayy per year, the stock of money demanded will then be rising at the rate of 8a hay per year, where 8 is the income elasticity of demand for money, and prices will be rising at the rate of ap aM -- 8a bayy,, where aP = aM aM aM is the rate of rise in the nominal stock of money per capita. For example, if income per capita is rising at 2 percent per year, the stock of of money at 4 percent a year, and 8 is 3/2, then prices would be rising 37 If 8 and ay were to be the same, and the stock at 1 percent a year.37 y of money were to rise at, say, 10 percent percent aa year, year, prices prices would would be be rising rising at the rate of 7 percent aa year; year; if if the stock stock of of money were were to be be declining declining at 10 percent a year, prices would be falling at the rate of 13 13 percent 38 a year. year.38 Let us now suppose that an unexpected rise to a new level occurs in the rate of change in the money stock, and it remains there indefinitely-a nitely—a single shock, as it were, displacing the time path of the money stock. In tracing the hypothetical effects effects of the higher rate of growth of the money stock, there will be some difference of difference in detail depending on the source of the increase-whether increase—whether from gold discoveries, or central bank open-market purchases, or government expenditures financed by fiat fiat money, or a rise in the deposit-currency ratio, or a rise in the deposit-reserve ratio. To be definite, therefore, let us suppose it comes from an increased rate of open-market purchases by a central bank. Although the initial sellers of the securities purchased by the central bank were willing sellers, this does not mean that they want to hold the proceeds in money indefinitely. The bank offered offered them a good price, so they sold; they added to their money balances as a temporary step in rearranging their portfolios. If the seller was a commercial bank, it now has larger reserves than it has regarded before as sufficient sufficient and will seek to expand its investments and its loans at a greater rate than before. If If the seller was not a commercial bank, he is not likely even temporarily to want to hold the proceeds in currency but will deposit them in a commercial bank, thereby, in our fractional reserve system, adding to the bank's reserves relative to its deposits. In either case, therefore, in our system, commercial banks become more liquid. In the second case, in addition, the nonbank seller has a higher ratio of of money in his portfolio than he has had hitherto.

66

Milton Friedman and Anna J. Schwartz

Both the nonbank seller and commercial banks will therefore seek to readjust readjust their portfolios, the only difference difference being that the commercial banks will in the process create more money, thereby transmitting the increase in high-powered money to the total money stock. The interposition of the commercial bank in the process means that the increase in the rate of growth of the money stock, which initially was less than in high-powered money, will for a time be greater. So we have here already a mechanism working for some overshooting. It seems plausible that both nonbank and bank holders of redundant tum first to securities comparable to those they have sold, balances will turn say, fixed-interest coupon, low-risk obligations. But as they seek to purchase these they will tend to bid up the prices of those issues. Hence they, and also other holders not involved in the initial central bank open-market transactions, will look farther afield: the banks, to their loans; the nonbank holders, to other categories of securities-highersecurities—higherrisk fixed-coupon obligations, equities, real property, and so forth. forth. As the process continues, the initial impacts are diffused diffused in several respects: first, the range of assets affected affected widens; second, potential creators of assets now more in demand are induced to react to the better terms on which they can be sold, including business enterprises wishing to engage in capital expansion, house builders or prospective homeowners, consumers who are potential purchasers of durable congoods-and so on and on; third, the initially redundant money sumer goods—and balances concentrated in the hands of those first affected affected by the openmarket purchases become spread throughout the economy. As the prices of financial financial assets are bid up, they become expensive relative to nonfinancial assets, so there is an incentive for individuals and enterprises to seek to bring their actual portfolios into accord with desired portfolios by acquiring nonfinancial assets. This, in tum, turn, tends to make existing nonfinancial assets expensive relative to newly constructed nonfinancial nonfinancial assets. At the same time, the general rise in the nonfinancial assets tends to raise wealth relative to inprice level of nonfinancial come, and to make the direct acquisition of current services cheaper relative to the purchase of sources of services. These effects effects raise demand curves for current productive services, both for producing new capital goods and for purchasing current services. The monetary stimulus is, in this way, spread from the financial markets to the markets for goods and services. Two points need emphasis at this stage. The first is that the terms "financial "financial markets," "assets," "investment," "rates of interest" and "portfolio" must, in order to be consistent with the existing empirical evidence, be interpreted much more broadly than they often are. It has fibeen common to restrict attention to a small class of marketable financial securities and the real capital it finances, to regard "the" rate

67

Money and Business Cycles

of interest as the market yield on such securities, and the "investment" "investment" which is affected affected by by changes changes in in the the rate rate of of interest interest as as solely solely or or mainly mainly which is the items classified classified as as "capital "capital formation" formation" in in national income accounts. accounts. the items national income Some of of the the empirical empirical results summarized earlier earlier are are inconsistent inconsistent with with Some results summarized 39 this view. To rationalize rationalize the the results, it is is necessary necessary to much To results, it to take take aa much this view. 39 broader regard the as containing containing aa much much broader view, view, to to regard the relevant relevant portfolios portfolios as wider range range of of assets, assets, including including not only government government and and private not only private fixedfixedwider interest and and equity equity securities securities traded on major major financial markets, but but interest traded on financial markets, also aa host host of of other other assets, assets, even even going going so so far far as as to include consumer consumer also to include durable goods, goods, consumer consumer inventories inventories of of clothing clothing and and the the like like and, and, maybe maybe durable also, such such human capital as as skills skills acquired acquired through and the the also, human capital through training, training, and like. Similarly, Similarly, it it is is necessary necessary to make "rate "rate of of interest" interest" an an equally equally like. to make broad covering explicit explicit or implicit rates specbroad construct, construct, covering or implicit rates on on the the whole whole spec40 trum of assets. assets.40 trum of The The second second point point is is to note how readily these tentative lines lines on on our our sketch accommodate accommodate some some of of the documented regularities of business business sketch the documented regularities of cycles. The The cyclical cyclical counterpart counterpart to our assumed assumed initial initial shock shock is is the the rise rise cycles. to our in the of growth growth of of the money stock stock that generally occurs occurs early early in the money that generally in in the rate rate of contraction. On On the basis of of the sketch so so far, far, we should expect expect it it to to contraction. the basis the sketch we should have its its first impact on on the the financial markets, and and there, there, first on bonds, bonds, have first impact financial markets, first on and only only later later on on equities, equities, and and only only still still later later on on actual actual flows of paypayand flows of ments for for real real resources. This is is of of course course the the actual actual pattern. The pattern. The ments resources. This financial markets tend to revive well before the trough. Historically, financial markets tend to revive well before the trough. Historically, railroad prices have have risen very early early in in the the process. process. Equity Equity marmarrailroad bond bond prices risen very kets start to recover later but still generally before the business trough. kets start to recover later but still generally before the business trough. Actual expenditures on on purchases of goods goods and and services services rise still later. later. Actual expenditures purchases of rise still The consistent tendency for orders to lead actual purchases would The consistent tendency for orders to lead actual purchases would of of course expected on theory, but but it it would follow simply simply from the course be be expected on this this theory, would follow from the mechanics of the the production Hence it it gives gives no no definite definite support support production process. process. Hence mechanics of to or any any other other theory. It is is simply simply aa stage stage in in the the way way any any impulse, impulse, to this this or theory. It however generated, will transmitted. The The tendency tendency for for the prices however generated, will be be transmitted. the prices of financial assets to to rise rise early early in in the is quite quite aa different different matter. matter. of financial assets the pattern pattern is If the initial impulse impulse were were generated generated by an autonomous autonomous increase increase in If the initial by an in spending on on final goods and and services, services, it it would plausible to to expect expect would be be plausible spending final goods the timing to to be the reverse of what what it it actually actually is. is. Of Of course, course, on on the the the timing be the reverse of theory sketched, the the precise timing will depend on on the the source source of of theory being being sketched, precise timing will depend the initial monetary impulse. However, However, under under the the banking banking structure structure of the initial monetary impulse. of the States and and other other financially developed countries, countries, whatever whatever the United United States financially developed the initial impulse, impulse, commercial commercial banks will play in transformtransformplayaa key key role role in the initial banks will ing it into an increased rate of growth in the money stock, and will ing it into an increased rate of growth in the money stock, and this this will impose a large measure of uniformity on the outcome. impose a large measure of uniformity on the outcome. One other feature of cyclical experience that our sketch may be able, to and that is worthy of special special note is the the behavior of the the to rationalize rationalize and that is worthy of note is behavior of deposit-currency ratio. ratio. The The initial initial monetary impulse is is concentrated concentrated deposit-currency monetary impulse

68

Milton Friedman and Anna J. Schwartz

among financial assets then diffused to the among holders holders of of financial assets and and is is then diffused to the rest rest of of the the community. But this means, as we have have noted, noted, that that the the redundant community. But this means, as we redundant of balances are balances are initially initially in in the the hands hands of of asset asset holders holders with with aa high high ratio ratio of deposits to currency. As balances are are diffused, diffused, they they deposits to currency. As the the redundant redundant balances spread to to more nearly aa representative group in in the the population. Conspread more nearly representative group population. Consistently with with this this sequence, sequence, the the ratio ratio of of deposits deposits to to currency currency starts starts to to sistently rise early in in contraction, contraction, not not very very far far removed removed in in time time from from the the trough trough rise early in the the rate of rise rise in in the money stock; stock; the deposit-currency ratio ratio conconthe money the deposit-currency in rate of tinues rise during during the the rest of contraction contraction and and early early expansion expansion but but tinues to to rise rest of then around mid-expansion, mid-expansion, and and falls. falls. The The turning turning point, point, then reaches reaches aa peak peak around on this sketch, reflects point at at which which the tide of of redundant redundant on this sketch, reflects the the point the net net tide balances has shifted from from the the financial community to the rest rest of of the the balances has shifted financial community to the community. community. To return to to our we had had reached reached the To return our sketch, sketch, we the stage stage at at which which the the demand for for the services of of factors factors of of production production was rising, which which demand the services was rising, means, of course, course, aa rise in money incomes. This This will will tend tend to to be partly rise in money incomes. be partly means, of reflected in in aa rise rise of of the of resources resources and and of of final goods; at at the the reflected the prices prices of final goods; same time, time, the of nonfinancial nonfinancial assets assets will already have have been been will already same the prices prices of rising as demand demand shifted shifted to from financial assets. These These price rises rising as to them them from financial assets. price rises themselves tend correct portfolios by making making the the real value of of monthemselves tend to to correct portfolios by real value monetary assets assets less less than otherwise would would be. The result is to reduce etary than they they otherwise be. The result is to reduce the relative redundancy of monetary assets, which sets the stage for aa the relative redundancy of monetary assets, which sets the stage for rise in the structure of interest rates in place of the prior decline. The rise in the structure of interest rates in place of the prior decline. The exact sequence of rises in prices, whether it affects first prices of final exact sequence of rises in prices, whether it affects first prices of final products, and and only only later later prices of factors and so so shifts shifts profit actors and profit margins— marginsproducts, prices off and so on—depends on the structure of the product and factor markets. markets. and so on-depends on the structure of the product and factor Like the the relation between new orders and and production, production, this this is is part of Like relation between new orders part of the transmission common to all theories and tells little or or the transmission mechanism mechanism common to all theories and tells little nothing about the generating impulse. impulse. This This does does not not mean it is is unimnothing about the generating mean it unimportant. On the contrary, it it may well determine determine the the sequence sequence of of events events portant. On the contrary, may well once the stage is is reached at which which income income is is rising, as well as the the time time once the stage reached at rising, as well as duration of of subsequent subsequent reactions. reactions. duration However, point for purposes is very different. However, the the important important point for our our purposes is very different. It It is that described will to overshoot overshoot the mark; is that the the process process we we have have described will tend tend to the mark; it will simply produce smooth movement movement to to the new path path conconit will not not simply produce aa smooth the new sistent with with the the new rate of of growth growth of of the the money money stock stock assumed assumed to to sistent new rate prevail. There There are are two classes of of reasons reasons embodied embodied in in our our analysis analysis that that prevail. two classes explain why why the the process process will overshoot. One, One, and and in in our our view more explain will overshoot. view the the more basic theoretically, has to do with the demand demand for for money. money. At At the the higher higher basic theoretically, has to do with the rate of of price that is is the new ultimate equilibrium, the the amount amount of price rise rise that the new ultimate equilibrium, of rate money demanded will less in in real it was was initially, initially, relative relative money demanded will be be less real terms terms than than it to and hence hence income. income. But But this this means means that, in the process of to wealth wealth and that, in the process of going from from the initial to to the the new equilibrium, prices prices must must rise rise at at aa faster faster going the initial new equilibrium, rate than their ultimate ultimate rate. Hence the the rate of price price rise rise must must overoverrate than their rate. Hence rate of

69

Money and Business Cycles

shoot. This effect effect is reinforced reinforced by that embodied in the subsection "Conclusions for Major Movements." In the initial stages of the process, holders overestimate cess, money money holders overestimate the the extent extent of of monetary monetary redundancy, redundancy, since they evaluate money stocks unduly low since they evaluate money stocks at at unduly low levels levels of of prices; prices; they they are are slow, slow, that that is, is, to to revise revise their their estimates estimates of of permanent permanent prices prices upward, upward, hence they they initially initially seek seek more more radical radical readjustments readjustments in in their their portfolios portfolios hence than will ultimately turn out out to required. (If (If this analysis is is applied applied than will ultimately tum to be be required. this analysis to aa cyclical cyclical process rather than than to to our our special special case case of of aa shift shift from from one one to process rather moving equilibrium equilibrium to to another, another, aa second second element element from from that that part part of of the the moving section would would also also enter enter to to produce overshooting—a slow slow revision revision of section produce overshooting-a of estimates of of permanent real income.) income.) The The second second class class of of reasons reasons for for estimates permanent real overshooting has has to to do do with with feedback feedback effects effects through through the the monetary monetary overshooting mechanism. Two Two ofthese of these have have already already been mentioned. First, First, the effect mechanism. been mentioned. the effect of the the initial initial assumed assumed shock shock is is to to cause cause aa greater greater rate rate of of rise rise in in highof highpowered money than than in in the the money money stock stock as as aa whole. whole. But But since since there there powered money is nothing about the the shock shock that that will will permanently alter the of money money is nothing about permanently alter the ratio ratio of to high-powered money, it follows that the money stock must for aa to high-powered money, it follows that the money stock must for time grow faster than ultimately in order to catch up. Second, there time grow faster than ultimately in order to catch up. Second, there is is reason for for the the deposit-currency deposit-currency ratio to rise rise in in the the initial initial stages stages of of the the reason ratio to process above its its long-run long-run equilibrium equilibrium level. level. In In addition addition to to these these two two process above classes of reasons for overshooting, which derive from the specifically classes of reasons for overshooting, which derive from the specifically monetary elements elements in in our our sketch, sketch, there there may may of of course course be those arising arising monetary be those from the other elements of the transmission mechanism common to from the other elements of the transmission mechanism common to almost any theory. almost any theory. The tendency to overshoot means that the dynamic process of transition from from one one equilibrium equilibrium path to another another involves involves aa cyclical cyclical adjustadjustsition path to ment process. Presumably, these adjustments will damped, ment process. Presumably, these cyclical cyclical adjustments will be be damped, though no merely verbal verbal exposition exposition can can suffice suffice to to assure assure that that the the parparthough no merely ticular mechanism mechanism described described will will have that property. Presumably also, also, ticular have that property. Presumably the extent of of overshooting overshooting will will not not be relative to the disthe extent be negligible negligible relative to the disturbance, though though again again no no merely merely verbal verbal exposition exposition can can suffice suffice to to assure assure turbance, that the the mechanism mechanism described described will will have have that that property. property. that The passage passage from from this analysis of of aa single single displacement displacement of of the rate the rate The this analysis of growth growth of of money money to to aa monetary monetary theory theory of of partly self-generating of partly self-generating cyclical fluctuations fluctuations is is direct direct and and has has in in large large part part been embodied in in cyclical been embodied the preceding statement. It It may may be worth noting, noting, however, however, that that it it would would the preceding statement. be worth be rather more more plausible plausible to to suppose suppose aa shock shock to to take take the the form form of of an an be rather unusually high high or or low low rate rate of of growth growth of of the the stock stock of of money money for for some some unusually time, with with aa reversion to aa previous previous level level rather rather than than aa shift shift to to aa perpertime, reversion to manently new new level. level. Such Such aa shock shock is is equivalent equivalent to two shocks shocks of of the the manently to two kind we we have have been considering—but shocks shocks in in opposite opposite directions. directions. kind been considering-but Hence the the shock shock itself itself gives gives rise rise to to aa cyclical cyclical movement movement in in addition addition to to Hence the cyclical cyclical adjustment adjustment to to each each shock shock separately. separately. The The fact fact that that in in the the the cycle there is never that complete complete adjustment adjustment to to the the existing existing state state of cycle there is never that of

70

Milton Friedman and Anna J. Sehw&rtz Schwartz

affairs affairs that is present in the assumed initial Elysian state of moving equilibrium is is of of no decisive importance. importance. It It merely merely means means that that one one state state equilibrium no decisive of incomplete incomplete adjustment adjustment succeeds succeeds another another and and that that successive successive widwidof enings and and narrowings narrowings of of discrepancies discrepancies between actual and and desired desired between actual enings portfolios replace replace the the introduction introduction of of aa discrepancy discrepancy and and the the correction correction portfolios of it. it. As As noted noted parenthetically parenthetically earlier, earlier, of of somewhat somewhat more more moment moment are are of the fluctuations fluctuations in in real real income income and and employment employment over over the the cycle, cycle, which which the introduce an an important important reason reason for for overshooting. overshooting. introduce The element in mechanism, as we have The central central element in the the transmission transmission mechanism, as we have outlined it, it, is is the the concept concept of of cyclical cyclical fluctuations fluctuations as as the the outcome outcome of of outlined balance sheet adjustments, adjustments, as as the the effects effects on on flows of adjustments adjustments bebalance sheet flows of between desired desired and and actual actual stocks. stocks. It It is is this this interconnection interconnection of of stocks stocks tween and flows that stretches stretches the the effect effect of of shocks shocks out out in in time, time, produces produces aa and flows that diffusion over over different economic categories, categories, and and gives gives rise rise to to cyclical cyclical diffusion different economic reaction mechanisms. mechanisms. The The stocks stocks serve serve as as buffers buffers or or shock shock absorbers absorbers reaction of initial initial changes changes in in rates of flow, expanding or or contracting contracting from from of rates of flow, by by expanding their "normal" "normal" or or "natural" "natural" or or "desired" "desired" state, state, and and then then slowly slowly alter alter their other flows as holders try to to regain regain that that state. state. other flows as holders try In In this this stock-flow stock-flow view, view, money money is is aa stock stock in in aa portfolio portfolio of of assets, assets, like like the the stocks stocks of of financial assets, assets, or or houses, houses, or or buildings, or or inveninventories, or or people, people, or or skills. skills. It It yields of services services as as these these other other tories, yields aa flow flow of assets do; do; it it is is also also subject subject to to increase increase or or decrease decrease through through inflows inflows and and assets outflows, also also as as the the other other assets assets are. are. It It is is because because our our thinking thinking has has outflows, increasingly moved moved in in this this direction direction that that it it has has become become natural to us us increasingly natural to to regard regard the the rate rate of of change change in in the the stock stock of of money money as as comparable comparable to to to income flows and to regard changes in the rate of change as a generating income flows and to regard changes in the rate of change as a generating force in in producing cyclical fluctuations fluctuations in in economic economic activity. activity. force producing cyclical 2.4 Summary 2.4 Summary

The statistical statistical evidence evidence on on the the role role of of money money in in business business cycles cycles The assembled in in the the first section demonstrates demonstrates beyond any reasonable reasonable assembled first section beyond any doubt that that the the stock stock of of money money displays displays aa systematic systematic cyclical cyclical behavior. behavior. doubt The rate change in in the the money stock regularly regularly reaches reaches aa peak before The rate of of change money stock peak before the reference reference peak and aa trough trough before before the the reference reference trough, trough, though though the peak and the lead lead is is rather rather variable. variable. The The amplitude amplitude of of the the cyclical cyclical movement movement in the in money is is closely closely correlated correlated with with the the amplitude amplitude of of the the cyclical cyclical movemovemoney ment in in general general business and is is about about half half as as large large as as the the amplitude amplitude of ment business and of cyclical movements movements in in money money income. income. The The most most important important single single decyclical determinant, from from the the supply supply side, side, of of the the cyclical cyclical pattern pattern of of money money is is the the terminant, cyclical pattern in the the division division of of the the public's money holdings holdings between between cyclical pattern in public's money currency and and deposits. deposits. The The stock stock of of money money is is much much more closely and and more closely currency systematically related to income income over over business business cycles cycles than is investinvestsystematically related to than is ment or or autonomous autonomous expenditures. expenditures. ment

71

Money and Business Cycles

In the second section we suggested plausible interpretations of of these facts, pointing out that the close relation tells nothing directly about whether of whether the the cyclical cyclical changes changes in in money money are are simply simply aa consequence consequence of the changes in income or are in large measure the source of of those changes. changes. For For major major movements movements in in income, income, we we concluded concluded that that there there is is an an extremely extremely strong strong case case for for the the proposition proposition that that sizable sizable changes changes in in the the rate rate of of change change in in the the money money stock stock are are aa necessary necessary and and sufficient sufficient condition for sizable changes in the rate of change in money income. For For minor minor movements, movements, we we concluded concluded that, that, while while the the evidence evidence was was far far less less strong, strong, it it is is plausible plausible to to suppose suppose that that changes changes in in the the stock stock of of money money played played an an important important independent independent role, role, though though certainly certainly the the evidence evidence for for these these minor minor movements movements does does not not rule rule out out other other interpretations. interpretations. In In the the subsection, subsection, "Conclusions "Conclusions for for Major Major Movements," Movements," we we formalized formalized one one element element of of aa theory theory designed designed to to account account for for the the observed observed tendency tendency of fluctuations in of cyclical cyclical fluctuations in income income to to be be wider wider in in amplitude amplitude than than cyclical cyclical fluctuations in money are. The theory, plus earlier empirical work, yielded yielded an an independent independent statistical statistical estimate estimate of of what what we we call call the the money money multiplier, or the ratio of the percentage change in income to the associated sociated percentage percentage change change in in the the stock stock of of money. money. The The independent independent estimate was 1.84; the directly observed ratio 2.0. This agreement does not reflect any of the two estimates. not reflect any common common statistical statistical origin origin of the two estimates. It It theretherefore suggests that further further elaboration of the theory might be well worthwhile. worthwhile. Finally, in the last section, we sketched in broad strokes the kind of of transmission transmission mechanism mechanism that that could could explain explain how how monetary monetary changes changes can can produce cyclical fluctuations in income, and that is consistent with our knowledge The final final picture that might knowledge of of economic economic interrelationships. interrelationships. The picture that might ultimately develop out of this sketch could be of a partly self-generating self-generating cyclical cyclical mechanism. mechanism. Disturbances Disturbances in in the the rate rate of of change change in in the the money money stock set in train a cyclical adjustment adjustment mechanism including a feedback feedback in the the rate rate of of change change in in money money itself. itself. Additional Additional disturbances disturbances from from time time to time would prevent the fluctuations from dying out. The mechanism emphasizes flows, with emphasizes the the reciprocal reciprocal adjustment adjustment of of stocks stocks to to flows, with money money playing a key role as a component of the stock of assets. We emphasize that that this this sketch sketch is is exceedingly exceedingly tentative tentative and, and, of of course, course, not not preclusive. preclusive. The The mechanism mechanism outlined outlined can can be be combined combined with with other other adjustment adjustment mechanisms. mechanisms.

Notes 1. "The Business Cycle Largely a 'Dance of Journal of of the Dollar,' "" Journal of the American Association, December 1923, pp. 1024-1028. American Statistical Statistical Association,

72

Milton Friedman and Anna J. Schwartz

2. See our "A Monetary History of of the United States, 1867-1960," Princeton University Press for NBER, 1963a, Chapter Chapter 7. 3. Economics, Economics, 3d ed., 1955, p. 224. 4. See the discussion of of this problem in Milton Friedman, "The "The Lag in Effect Effect of Journal of Economy, October 1961, of Monetary Policy," Journal of Political Political Economy, 1961, pp. 453453454. 454. 5. See our forthcoming forthcoming "Trends "Trends and Cycles in the Stock of of Money in the United States, 1867-1960." 1867-1960." The patterns in figure 2.4 differ differ in construction construction from the reference reference patterns for the stock of of money in figure 2.2. The rate of of change series, being the percentage change from month to month, is already in a form that is independent of of units of of measure. In addition, the rate of of change in the money stock can be be zero zero or or negative negative as as well well as as positive, positive, and and hence hence its its average average value value for for aa can given cycle cycle can can hardly hardly serve serve as as aa base base for for computing computing reference reference cycle cycle relatives. relatives. given For these these reasons, reasons, the the basic basic data, data, instead instead of of being being expressed expressed as as relatives relatives to to For the average average for for aa cycle, cycle, are are expressed expressed as as deviations deviations from from the the average average for for aa the cycle (as (as in in A. A. F. F. Bums Burns and and W. W. C. C. Mitchell, Mitchell, Measuring Measuring Business Cycles, New New cycle Business Cycles, York, NBER, NBER, 1946, 1946, pp. pp. 137-138). 137-138). This This is is why why the the base base lines lines in in figure figure 2.4 2.4 are are York, labeled 00 instead instead of of 100 100 as as in in figure figure 2.2, 2.2, and and the the scale scale is is in in terms terms of of deviations deviations labeled rather than than of of relatives. relatives. rather Because of of a discontinuity in the underlying money figures in early 1933, we have estimated estimated stage IX for the 1927-33 cycle and stage I for the 193338 cycle from the average value for January, April, and May 1933, instead of of before the banking holiday for February, March, and April. Restricted deposits before counted in full in the recorded money stock. However, after after the holiday are counted unrestricted deposits in unlicensed banks are excluded excluded both restricted and unrestricted completely from the recorded money stock. That shift shift in treatment is the completely major factor behind the sharp decline in the recorded figures in March 1933 major (see our our "A "A Monetary Monetary History History of of the the United United States, States, 1867-1960," 1867-1960," Chapter Chapter 8, 8, (see section 1). 1). section 6. Though our money series starts in 1867, the first reference reference tum turn with which specific cycle tum turn is the peak in October October 1873. Hence we we have matched a specific reference trough of of December December 1867, peak of of June 1869, and do not match the reference of December December 1870. The absence of of a specific cycle tum turn to match with trough of December 1867 trough may simply result from the fact that our series does the December time—a possibility suggested by the long average not go far enough back in time-a lead at at troughs. troughs. For For the the other other two two reference reference turns, turns, we we conjecture conjecture that that the the lead annual data data for for successive successive Januarys-all Januarys—all we we have have for for that that period-may period—may conceal conceal annual by their their crudeness crudeness turns turns that that monthly monthly data data would would reveal. reveal. This This conjecture conjecture seems seems by especially plausible plausible because because of of the the unusual unusual brevity brevity of of the the expansion expansion phase, phase, especially only 18 18 months, months, followed followed by by aa contraction contraction of of equal equal length. length. only ' estimate . f s.d. d . == J'i,(X-X)2 h . teo h observation, b servatlOn, . 7Th at IS, 0of s. X, 7.. That is, / —,, were where x IS is the x, n 1 "Y n — 1 the mean, and n the number of of items in the group, in this example, 3. 2ir

21Tt, where t is time. Then m is the period of 8. 8. Let Let the the sine sine wave wave be be Asin Asin —t, m where t is time. Then m is the period of m the wave and A the amplitude, the wave fluctuating from +A to -A. the9.wave and be A the fluctuating - At . + 1, so Let p(t) the amplitude, continuousthe ratewave of growth from from year +A t to to year 9. Let p(i) be the continuous rate of growth from year t to year t + 1, so that that Xt+l =

Xtep(t),

73

Money and Business Cycles

where X log,Jf/+1 -- log..xl log^ XIt and X XI+l Th.en 10g..xt+l t+l are successive annual observations. Then = = p(t). P(f).

Note also that XI+l 1- XI) \ogeXt+l 1 -- log..xl lo&AT, == loge loge ((l1 + + * ' +XI ^ * ' V. log..xl+

But loge log MONSUP, = j=l j=l

BKDEDt BKDED,

Table period beginning beginning 1929, with personal Table 4.1, 4.1, covering covering the the shorter shorter period 1929, with personal income the income variable, and table 4.2, the longer income as as the income variable, and table 4.2, covering covering the longer period period beginning the income beginning 1919, 1919, with with bank bank debits debits to to deposit deposit accounts accounts as as the income value of variable, report probability of variable, report the the probability of obtaining obtaining aa value of F F greater greater than than that actually hypothesis is j)]. If If that actually obtained obtained if if the the null null hypothesis is valid valid [Prob [Prob (F (F > /)]. this probability that the the null this probability is is low, low, it it indicates indicates that null hypothesis hypothesis is is implausible implausible and the shorter reject exoexoand can can be be rejected. rejected. Over Over the shorter period, period, one one cannot cannot reject Table 4.1 1lIble 4.1

Reg. No. (I) (1)

(2) (3) (4) (5) (6) (7) (S) (8) (9) (10) (11) (11) (12) (13) (14) (15) (16)

Granger Causality Test Results, 1929-39

xX,t

Y, Yt

Prob (F>f) (F>f)

FStatistic

NOBS

Lags (min)

MONSUP PERINC MONSUP PERINe PERINC *MONSUP *PERINCS *MONSUP *MONSUP *PERINCS MONSUP2 PERINCN PERINCN MONSUP2 PERINCN PERINCN *MONSUP2 *PERINCS *MONSUP2 *PERINCS

PERINCN PERINCN MONS UP MONSUP PERINCN PERINCN MONSUP PERINeS PERINCS MONSUP PERINCS UP MONS MONSUP PERINCN PERINCN MONSUP2 PERINCN MONSUP2 PERINCS MONSUP2 PERINCS MONSUP2

0.SS51 0.8851 0.3767 0.8027 0.S027 0.3971 0.6334 0.6334 0.34SS 0.3488 0.7685 0.76S5 0.5034 0.9850 0.9S50 0.2501 0.2501 0.7807 0.7S07 0.0771 0.6130 0.650S 0.6508 0.8030 0.S030 0.2760

F(24,47) F(24,47) F(lS,65) F(18,65) F(lS,65) F(18,65) F(24,5S) F(24,58) F(24,5S) F(24,58) F(lS,76) F(18,76) F(lS,76) F(18,76) F(24,47) F(24 ,47) F(24,47) F(lS,65) F(18,65) F(lS,65) F(18,65) F(24,5S) F(24,58) F(24,5S) F(24,58) F(lS,76) F(18,76) F(lS,76) F(18,76)

lOS 108 108 lOS 114 114 108 lOS lOS 108 114 114 108 lOS 108 lOS 114 114 lOS 108 lOS 108 114 114

(24,24) (24,24) (lS,IS) (18,18) (lS,IS) (18,18) (24,24) (24,24) (lS,IS) (18,18) (lS,IS) (18,18) (24,24) (24,24) (lS,IS) (18,18) (lS,IS) (18,18) (24,24) (24,24) (lS,IS) (18,18) (lS,IS) (18,18)

Sources: MONSUP = from Friedman Friedman and Schwartz Schwartz 1970, table I, 1, col. 9. MONSUP2 Sources: = M22,, from = = M 2,, as above, adjusted adjusted for exclusion of of deposits in unlicensed banks, March 1933unlicensed bank bank deposits May 1935, by applying the ratio oflicensed of licensed and unlicensed bank to licensed licensed bank Schwartz 1963a, table 15, cols. 4, 2). PERINC = = Personal income, OBE (Friedman and Schwartz 1961, 2: 139. from Moore 1961, Note: All regressions include a constant Note: constant and linear trend, and regressions (5)-(S) (5)-(8) and (13)-(16) (13)—(16) (shown with asterisk), seasonal dummies also. Regressions are of of the form form m

L

.

L

X,t = = 2 aa)(,-i X ixt-i ++ 2 i=1

i=l

l3iY,-1 frr'-i ++ residual.

Table reports marginal significance significance level of of F-statistic pertinent pertinent for testing null hypothesis Pi = = 132 p2 = = .• .• .• = = 13. P/i = = 0, 0, which which is is the null hypothesis " FY fails fails to Granger-cause X." X." 131 the null hypothesis" to Granger-cause Wherefis pertinent F-statistic, the marginal significance W h e r e / i s the calculated calculated value of of the pertinent significance level is defined defined as as prob [F > 11 f] under the null hypothesis. prob [F under the null hypothesis. is

117 117

Understanding 1929-1933 1929-1933

Thble Table 4.2

Granger Causality Test Results, 1919-39 1919-39

xX,t

Y, Yt

(F > j) (F>f)

FStatistic

NOBS

Lags (min)

(1) (1) (2) (3) (4) (5) (6)

MONSUP BKDED MONSUP BKDED *MONSUp· *MONSUP *BKDEDS

BKDED MONSUP BKDED MONSUP MONS UP BKDEDS MONSUP

0.2685 0.0007 0.4401 0.4401 0.0008 0.2410 0.00003

F(36,131) F(36,131) F(24,167) F(24,167) F(18,185) F(18,185)

216 216 228 228 234 234

(36,36) (36,36) (24,24) (24,24) (18,18) (18,18)

(7) (8) (9) (10) (Il) (ID (12)

MONSUP2 BKDED MONSUP2 BKDED *MONSUP2 *BKDEDS

BKDED MONSUP2 BKDED MONSUP2 BKDEDS MONSUP2

0.7318 0.0031 0.0031 0.9634 0.0011 O.OOIl 0.7854 0.0002

F(36,131) F(36,131) F(24,167) F(24,167) F(18,185) F(18,185)

216 216 228 228 234 234

(36,36) (36,36) (24,24) (24,24) (18,18) (18,18)

Reg. No.

~

Source: Source: BKDED == Bank debits to deposit accounts, except interbank interbank accounts, 140 centers (excluding New York City), from U.S. Board ofGovemors of Governors of of the Federal Reserve Reserve System 1943, pp. 236-37. Note: Note: See note to table 4.1. Here, regressions (5)-(6) and (11)-(12) (11>—(12) (shown with asterisks) include seasonal dummies.

geneity in either direction, though the probability of exceeding the observedfis, observed/is, with one exception [(13), (14)], uniformly lower for those equations testing the influence of money on income than for those testing the reverse relation. For the longer period, the situation is very different: not one of six regressions yields any evidence that income had a significant significant influence influence on money-the money—the lowest of the probabilities associated with the observed f/ i iss 0.24, which means that in at least one time in four, chance alone would yield as strong an influence of income on money as that observed. In sharp contrast, every one of the six regressions testing the influence of money on income yields a far stronger relation than could be expected by chance if money really had no influence on income. The least-favorable least-favorable regression regression yields yields aa probability probability of of 0.003 0.003 for for the the computed computed /, which which means means that that aa relation relation this this strong strong would would occur occur by by chance chance less less f, than than 33 times times in in 1,000. So far as these results go, then, for the interwar years as a whole, they they clearly clearly support support unidirectional unidirectional causality causality running running from from money money to to income. The The reverse reverse hypothesis hypothesis that that Temin, Temin, Kindleberger, Kindleberger, and and AbraAbraincome. movitz appear appear to to embrace embrace receives receives no no support support at at all. all. For For the the shorter shorter movitz period, the the results results are are not not inconsistent inconsistent with with the the passage passage II quoted quoted above above period, from "Money "Money and and Business Business Cycles" Cycles"—mutual interdependence of of money money from -mutual interdependence and income, income, with with money money the the senior senior partner; partner; but but neither neither do do they they give give and it much much support. support. Perhaps Perhaps the the only only conclusion conclusion they they support support is is that that eight eight it

118 118

Anna Anna J. J. Schwartz Schwartz

years77 is is too too short short aa period period to to give give very very much much evidence evidence on on direction direction years of causation, causation, given given the the large large random random element element in in the the month-to-month month-to-month of movements of of both both money money and and personal personal income. income.88 movements 4.2 Measuring Measuring Monetary Monetary Stringency Stringency 4.2 Temin Temin has has revived revived the the Keynesian Keynesian view view that that the the importance importance of of money money can be be measured measured by by the the behavior behavior of of interest interest rates. rates. In In Keynesian Keynesian analanalcan yses, yses, the the measure measure of of monetary monetary stringency stringency is is aa rise rise in in interest interest rates. rates. The interest interest rate rate is is regarded regarded as as "the "the price price of of money." money." In In quantity quantity theory theory The analyses, the the price price of of money money is is lip, MP, the the inverse inverse of of the the price level. In In analyses, price level. the former former case, case, stringency stringency is is reflected reflected in in credit credit markets. markets. In In the the latter latter the case, money money is is an an asset, asset, actual actual and and desired desired holdings holdings of of which which are are case, adjusted through prices, so that stringency is reflected in a rise in the adjusted through prices, so that stringency is reflected in a rise in the reciprocal of of prices. prices. reciprocal Figure 4.1 4.1 plots plots the the reciprocal reciprocal of of the the U.S. U.S. wholesale wholesale price price index, index, Figure monthly, that every of monthly, 1919-39. 1919-39. It It is is of of some some interest interest that every monetary monetary event event of significance of significance during during these these two two decades decades is is mirrored mirrored in in the the movements movements of money. Moreover, Moreover, the the reaction reaction of of prices to each each monetary monetary the price of money. the price of prices to event is is either observed in in the the coincident coincident month month or or within within five months event either observed five months of the the event. event. The monetary events events in in the deep contraction contraction phases phases of The monetary the three three deep of the interwar period—1920-21, 1929-33, and 1937-38— are are marked marked of the interwar period-I920-21, 1929-33, and 1937-38by vertical lines lines on the figure identified by Table by vertical on the figure and and identified by {lumber ~umber above above it. it. Table 12 1.91 1.74 1.57 INVERSE 1.40 INVERSE OF INDEX OF INDEX

19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39

Fig. Fig. 4.1 4.1

Inverse 1.0). Inverse of of U.S. U.S. wholesale wholesale price price index, index, 1919-29 1919-29 (1926 (1926 = = 1.0). To identify identify the the numbered numbered monetary monetary events events on on the the figure, figure, see see To table Source: U.S. U.S. Bureau Bureau of of the the Census Census 1949, 1949, p. p. 344. 344. table 4.3. 4.3. Source:

119

U n d e r s t a n d i n g 1929-1933 1929-1933 Understanding

4.3 4.3 shows shows the the lag lag in in months months in in the the price price response response to to the the monetary monetary events listed. listed.99 events Figure 4.1 refutes the allegation that Temin makes that there is no evidence evidence of of monetary monetary stringency stringency in in 1930 1930 and and 1931 1931 before before Britain Britain abanabandoned gold. gold. II might might also also have have entered entered dates dates of of monetary monetary events events between between doned 1921 and and 1929 1929 but refrained from from doing doing so, so, because because during during this this period period 1921 but refrained the Reserve Reserve System System attempted attempted to to anticipate anticipate business movements, so so the business movements, the monetary monetary events events and and the the reaction reaction of of the the price of money money could could be be the price of regarded as as the the common common result result of of movements movements in in autonomous autonomous spending spending regarded or whatever whatever third third other other force force produces produces the the cycle. cycle. For For the the three three deep deep or contractions ofthe of the interwar interwar years, years, however, however, the the Federal Federal Reserve Reserve took took contractions policy steps steps that that cannot cannot be regarded as as necessary necessary consequences consequences of policy be regarded of contemporary changes changes in in business business activity. activity. The The restrictive restrictive actions actions were were contemporary followed, with with brief lags, by by sharp sharp declines declines in in the the quantity quantity of of money money followed, brief lags, and sharp sharp rises rises in in the the inverse inverse of of the the price price level. level. The The one one important important and expansive action-the action—the 1932 1932 open-market open-market purchases-was purchases—was followed followed three three expansive months later later by by an an end end to to large large monthly monthly declines declines in in the the quantity quantity of of months money, and and four four months months later later by by the the largest largest decline decline in in the the inverse inverse of money, of the price price level level during during the the whole whole 1929-33 1929-33 period. period. the Table 4.3 Table 4.3

Monetary Events Reftected Reflected in Inverse of U.S. Wholesale Price Index in Three Interwar Deep Cyclical Contractions

Cyclical Contraction Contraction 1920-21 1920-21

of Monetary Event Date of

I. 1. 2(a). 2(a). (b).

1929-33

3. 4. 5. 5. 6. 7. 8. 8. 9. 10. 11. II.

1937-38

12. 13. 14.

1/20 Rise in discount rate I120 6/20 Final rise in discount rate 6120 6/20 Peak in Mz M2 6120

8/29 10/29 10/30 3131 3/31 9/31 3/32 6/32 6132 1/33 I133 3/33

Rise in discount rate Stock market crash Stock Onset of of first banking crisis Onset of of second banking crisis Britain leaves gold Onset of of open-market open-market purchases Last of large monthly declines in Mz M2 Last of Final banking crisis Bank Holiday

Announcement of of final rise in Announcement reserve requirements requirements Mz2 3/37 Peak in M Effective date of of final rise in reserve 5/37 Effective requirements

Lag (in months) of Initial of of Response of liP IIP +5 +5 +1 +1 +1 +1 00 0 +1 +1 0 +4 +4 + +11 +1 +1 0

I137 1/37

a + 5 for date of of onset of of rapid rise in lIP. 1/P. ·+5

+4 +4 +2 +2 0* oa

120

Anna J. Schwartz

As we had particular use As it it happens, happens, we had never never before before made made this this particular use of of the the had earlier numbered monmoninverse inverse of of the the price price level, level, yet yet we we had earlier dated dated the the numbered etary etary events, events, so so this this comparison comparison is is fresh fresh and and unbiased unbiased evidence. evidence. Frankly, Frankly, we were how uniform uniform the was. we were surprised surprised at at how the connection connection was.

4.3 4.3 Decline Decline in in Spending Spending II now now turn turn to to the the detailed detailed profile profile of of the the 1929-33 1929-33 contraction contraction provided provided by different himself (1976) by different investigators. investigators. Temin Temin himself (1976) has has reviewed reviewed critically critically what he he terms earlier earlier versions versions of of what terms the the "spending "spending hypothesis," hypothesis," the the class class of of explanations explanations that that account account for for the the severity severity of of the the Great Great Contraction Contraction by the collapse collapse of of one one or or another another category category of of expenditure. expenditure. Temin Temin finds finds by the that not support that the the data data do do not support aa fall fall in in autonomous autonomous investment-the investment—the leading candidate candidate in in the the Keynesian Keynesian approach. approach. leading 10 the Temin reviews 10 the versions versions of of the the spending spending hypothesis hypothesis associated associated Temin reviews with the the names names of of Alvin Alvin Hansen, Hansen, R. R. A. A. Gordon, Gordon, Joseph Joseph Schumpeter, Schumpeter, with Thomas Wilson, Wilson, and and Keynes Keynes himself himself and and econometric econometric models of the the Thomas models of interwar period constructed by by Ben Ben Bolch Bolch and and John John Pilgrim, Pilgrim, Lawrence Lawrence interwar period constructed Klein, Jan Jan Tinbergen, Tinbergen, and and John John B. B. Kirkwood. Kirkwood. He He concludes concludes that that all all Klein, of versions are are unacceptable on untested of these these versions unacceptable because because they they rest rest on untested asassumptions. He He also also reviews the long-swing long-swing or or Kuznets Kuznets cycle cycle hypothhypothreviews the sumptions. esis. He He asserts asserts that that it it assumes assumes that that only only aa large large shock-presumably, shock—presumably, esis. World War War I-could I—could have have produced produced aa large large cycle cycle in in income. income. He He then then World dismisses it it because it cannot cannot explain explain why why the the World World War War II shock shock did did dismisses because it not generate generate aa downturn downturn until until aa decade decade later. later. He He leaves leaves open open the the posposnot sibility, but is half-hearted in offering offering it, it, that that the the stock stock market crash sibility, but is half-hearted in market crash and the fall in in construction construction might might have have been the channels channels through which and the fall been the through which mild downturn downturn was was converted converted into into aa severe severe one. one. aa mild both Kindleberger's In part, then, In part, then, Temin Temin provides provides aa critique critique of of both Kindleberger's and and Abramovitz's Abramovitz's approaches approaches to to 1929-33. 1929-33. His His own own version version ofthe of the spending spending hypothesis, hypothesis, however, however, turns turns out out to to be be equally equally vulnerable. vulnerable. According According to to him, him, two two unexplained unexplained developments developments in in 1930 1930 changed changed the the nature nature of of the the in downturn. minor one downturn. The The minor one was was aa decline decline of of approximately approximately $1 $1 billion billion in constant prices in American exports constant prices in American exports as as aa result result of of "the "the deepening deepening world world agricultural agricultural depression" depression" and and "European "European troubles troubles independent independent of United States of the the United United States. States. Events Events outside outside the the United States therefore therefore exerted exerted a deflationary impact within this country" (p. (p. 68). The unexplained development, The major major unexplained development, according according to to Temin, Temin, was was an an autonomous autonomous fall fall in in consumption consumption in in 1930 1930 (see (see table table 4.4). 4.4). He He specifically specifically rejects rejects an an explanation explanation of of the the fall fall in in consumption consumption as as reflecting reflecting the the effect effect on wealth of the the stock stock market crash, on on the ground that the wealth wealth market crash, the ground that the on wealth of effect was was too small. In In this this sense sense he regards the the fall fall as as autonomous autonomous he regards effect too small. and unexplained. unexplained. and Temin's Temin's conclusion conclusion that that there there was was such such aa fall fall in in consumption consumption is is based based nondurable nominal nominal consumption on on regressions regressions of of total total and and nondurable consumption spending spending

69.6 127.8 54.5 11.7

1921

1919 84.0 84.0 146.4 57.4 1.4 1.4

54.5 11.7

65.4 5.2

-17.1 -17.1 -12.7 -12.7 - 5.1 5.1 ++10.3 10.3

-16.7 -16.7 + 6.5

-23.9 -23.9 - 8.7 8.7

97.0 90.9 190.9 50.8 4.2

90.4 90.4 183.5 49.3 8.7 8.7

1930

24.3 49.3 8.7

22.0 50.6 3.2 1928

90.4 183.5 130.4 28.0 1.4 1.4

1930

103.1 203.6 139.6 36.9 1.5

1929

30.8 44.5 44.5 14.3 (9.2)

9.5 + 9.5

+

6.8 6.8 3.9 3.9 3.0 3.0 4.5 4.5

82.5 82.5 193.0 42.7 16.9 (10.1)

1936

90.4 203.2 143.1 24.5 - .7

-12.3 - 9.9 9.9 - 6.6 6.6 -24.1 -24.1 - 6.7 6.7

- 2.6 2.6 5.5 + 5.5

1937 1937

Change (in Percent or or Percent Percentage Percentage Points) Points)

84.7 192.9 43.9 19.0 19.0 (12.5)

1938

33.9 43.9 19.0 (12.5)

84.7 192.9 140.2 19.4 1.9 1.9

1938

. ++ + + (+ (+

+

+ (+ (+

-

2.7 2.7 0.1 0.1 2.8 2.8 2.1 2.1 2.4)

1.3 1.3 4.7 3.3) 3.3)

+ 10.1 10.1

- 6.3 6.3 - 5.1 5.1 - 2.0 2.0 - 20.8 + 371.4

Change (in Percent or or Percent Percentage Percentage Points) Points)

Sources: Sources: U.S. Bureau of of the Census 1975, series F-l, F-1, F-3, F-5, F-48, F-53, F-63, F-66, 0-86. D-86. Figures in parentheses are Darby's (1976) estimates estimates of unemployment unemployment rate. of

current prices (billion $) $) GNP, current constant (1958) prices Implicit price index (1958 == 100) Unemployment Unemployment rate

69.6 127.8

1921

91.5 140.0

1920

Change (in Percent or Percent Percentage Points)

Changes in Macroeconomic Variables in Three Periods

GNP, current current prices (billion $) $) constant (1958) prices Personal consumption consumption expenditures expenditures Gross private private domestic domestic investment investment Gross Net exports exports of of goods goods and and services services Net Government purchases purchases of of goods goods and and Government services Implicit price index (1958 == 100) Unemployment Unemployment rate

Table 4.4 4.4 Thble

122

Anna J. Schwartz

on nominal current disposable income and nominal wealth for the period 1919-41. 1919-41. Actual consumption expenditures were above the level predicted by these regressions for 1921 1921 and 1938 1938 but below the predicted level for 1930. 1930. Hence Temin concludes that 1930 1930 was unusual since consumption expenditures declined by more than would have been predicted from the associated decline in income and from the behavior of consumption expenditures in the other interwar major conl1 traction years. 11 traction years. differences in residuals from his Temin also compares yearly first differences regressions regressions for for 1921, 1921, 1930, 1930, and and 1938 1938 on on the the ground ground that that aa movement movement from aa high high positive positive to to aa low low positive residual indicates indicates aa deflationary deflationary from positive residual year-toeffect effect on on the the autonomous autonomous component component of of consumption. consumption. The The year-toyear changes changes in in residuals residuals based on the the regression regression were were $6.1 $6.1 billion billion in in year based on 1921, 1921, -- $1.43 $1.43 billion billion in in 1930, 1930, and and$1.81 $1.81billion billioninin1938. 1938.He Hethen thenaverages averages the changes changes in in residuals residuals for for 1921 1921 and and 1938, 1938, subtracts subtracts the the change change in the in residuals in in 1930, 1930, and and concludes: concludes: residuals On the assumption that the [average] overprediction of decline in consumption consumption shown shown for for 1921 1921 and and 1938 1938 is is the the norm norm for for this this function function in depression years, the predicted decline in consumption was $5 billion 72) billion too too low low in in 1930. 1930. (P. (P. 72) This price estimate This is is his his current current price estimate of of the the autonomous autonomous fall fall in in consumption consumption between 1929 1929 and 1930, 1930, two-thirds of the total fall. In constant prices, the the estimate estimate is is $3 $3 billion billion of of the the actual actual fall fall in in real real consumption consumption expenexpenditures of of $4.3 $4.3 billion. Thus, according according to to Temin, Temin, before before the the onset onset of ditures billion. Thus, of the of the October October 1930 1930 runs runs on on banks, banks, the the economy economy was was set set on on aa course course of deep contraction by the combined autonomous fall of $1 $1 billion in exports exports and and $3 $3 billion billion in in consumption consumption expenditures. expenditures. Questions Questions immediately immediately arise arise with with regard regard to to these these estimates. estimates. With With respect to exports, the obvious question is whether the decline in U.S. exports U.S. exports was was attributable attributable to to events events abroad abroad independent independent of of the the U.S. cyclical contraction. I shall deal with this question when I tum turn to explanations explanations stressing stressing international international factors. factors. Temin's estimate ofthe of the autonomous decline in consumption expenditures first place, ditures raises raises questions questions of of an an entirely entirely different different order. order. In In the the first place, the consumption consumption functions functions he he fits are so so crude crude by standards of of th,e the the fits are by standards present state present state of of the the art art that that it it is is hard hard to to take take them them seriously. seriously. Second, Second, his assertion assertion that that the the positive residuals he he observes observes for for 1921 1921 and and 1938 his positive residuals 1938 from from this this questionable questionable regression regression are are the the norm norm for for interwar interwar contractions contractions is strictly strictly an an obiter obiter dictum. dictum. He He gives gives no no basis basis for for regarding regarding 1921 1921 and and is 1938 1938 as as in in some some unspecified unspecified sense sense "normal" "normal" contraction contraction years. years. But But unless this this is is granted, granted, he he has has no no basis basis for for regarding regarding his his small small negative negative unless residual for for 1930 1930 as as abnormal. abnormal. residual Thomas Mayer (1978a) (1978a) in a recent paper has reestimated Temin's equations equations for for the the interwar interwar years years and and has has found found larger larger negative negative residuals residuals

ll3 123

Understanding 1929-1933

in other years of the period. Why did the negative residual in 1930 1930 cause a deep contraction but the larger negative residual in 1925, 1925, for example, not cause one? This is ad hoc economics without qualification. qualification. Gandolfi and Lothian (1977), (1977), in a review of Temin's book, fit a more sophisticated consumption function for the longer period 1899-1941. 1899-1941. They regressed the log of real per capita total consumption on the log of of real real per per capita capita permanent permanent income income and and the the log log of of transitory transitory income, income, defined as the difference difference between the logs of measured and permanent income. income. The The inclusion inclusion of of the the transitory transitory income income variable variable is is designed designed to to reduce the effect effect of purchase of durable goods, as opposed to their flow flow of of services, services, as as aa component component of of total total consumption consumption expenditures. expenditures. Since purchases purchases of of durable durable goods goods are are more more cyclical cyclical than than their their service service Since flows, flows, they they are are more more dependent dependent on on transitory transitory than than on on permanent permanent inincome. For For the the sake sake of of comparison comparison with with Temin's Temin's results, results, Gandolfi Gandolfi and and come. Lothian also also examined examined year-to-year year-to-year changes changes in in residuals residuals as as well well as as Lothian their levels. levels. They They found found 1930 1930 far far from from unique. unique. Of Of the the five severe concontheir five severe tractions other other than than 1930 1930 (1894, (1894, 1896, 1896, 1908, 1908, 1921, 1921, and and 1938), 1938), only only 1921 tractions 1921 had aa very very large large positive positive residual. residual. Overprediction Overprediction of of the the fall fall in in conconhad sumption expenditures, expenditures, then, then, is is hardly hardly aa normal normal feature feature of of deep deep conconsumption tractions. The The negative negative value value for for 1930 1930 is is not not abnormal abnormal by by comparison comparison tractions. with all all years, years, not not simply simply deep deep contraction contraction years. years. Of Of 41 41 changes changes in with in residuals, 14 14 are are positive, positive, 27 27 negative, negative, of of which which 15 15are arelarger largerthan than 1930. 1930. residuals, Of all all 41 41 changes, changes, 25 25 are are larger larger in in absolute absolute value, value, 15 15 smaller. smaller. Why Why is is Of it that that these these 15 15 did did not not produce produce aa violent violent reaction reaction in in economic economic activity, activity, it while the the 1930 1930 shift shift did? did? while Temin Temin combines combines his his hypothesis hypothesis that that there there was was an an autonomous autonomous decline decline in (nominal and real) spending relative to output with the hypothesis that that the the demand demand for for (nominal) (nominal) money money was was falling falling more more rapidly rapidly than than the the quantity of money during 1930 1930 and the first three quarters of 1931. 1931. The decline he regards regards as as aa movement movement along along decline in in the the quantity quantity of of money money itself itself he stable supply-of-money supply-of-money function function in in response response to to aa downward downward shift shift in in aa stable the the demand demand function. function. For For logical logical rigor, rigor, this this statement statement needs needs to to be be supsupplemented by a more precise specification specification of the arguments of the demand demand and and supply supply functions-changes functions—changes in in which which would would equate equate quantity quantity demanded with with quantity quantity supplied. supplied. demanded For the demand for nominal money, Temin would presumably include as arguments the price level (or, the inverse of the price level), real income, and interest rates. Assume, now, with Temin that for fixed values of the arguments, the nominal quantity of money demanded fell relative suprelative to to the the quantity quantity supplied. supplied. To To eliminate eliminate the the putative putative excess excess supply of money (that is, make money holders willing to hold it), prices would would have have to to rise-but rise—but they they fell, fell, which which exacerbated exacerbated the the excess excess supply; supply; real income income likewise likewise would would have have to to rise, rise, but but it it fell, fell, again again exacerbating exacerbating real the excess excess supply. supply. The The one one remaining remaining possibility possibility is is that that interest interest rates rates the would have have had had to to fall, fall, which which they they did. did. As As aa formal formal matter matter of of monetary monetary would

124 124

Schwartz Anna J. Schwartz

theory, then, Temin treats the whole process as an autonomous decline in liquidity preference reinforced reinforced by declines in prices and in real income produced by other (spending) equations in the system, and wholly countered by lower interest rates-in rates—in other words, a large-scale shift shift of flow flow demand from goods to securities, and of stock demand from from money to securities. But then, why no stock market boom? As Allan Meltzer (1976) points out, perhaps the temporary rally in the market in the spring of 1930 is consistent with Temin's construction; so also, of of course, is the decline in interest rates in 1930, but hardly anything else is. Indeed, put this way, the notion of a sharp decline decline in liquidity preference is hard to square with a severe contraction accompanied by of by increasing increasing industrial industrial bankruptcies bankruptcies and and unprecedented unprecedented failures failures of banks. banks. With With respect respect to to the the supply supply function, function, under under the the gold gold standard standard in in effect effect in 1930 1930 and and 1931, 1931, both both declining declining prices prices and and declining declining real real income income would would in be be expected expected to to produce produce aa gold gold inflow inflow (which (which they they did) did) and and thereby thereby increase the the nominal nominal quantity quantity of of money. money. Here Here too, too, therefore, therefore, Temin Temin increase must powerful force must treat treat the the decline decline in in interest interest rates rates as as aa sufficiently sufficiently powerful force reducing the the nominal nominal quantity quantity of money to to have have overcome overcome the the opposite opposite reducing of money influences of of the the other other two two variables. variables. And And apparently apparently he he does, does, since since influences he argues argues that that in in the the absence absence of of bank bank failures failures the the same same decline decline in in the the he quantity of of money money would would have have occurred occurred through through aa decline decline in in depositdepositquantity reserve ratios. ratios. reserve of Temin presents no independent evidence of such great sensitivity of either demand demand for for or or supply supply of of money money to to interest interest rates rates as as would would be be either required required for for his his explanation. explanation. The The general general conclusion conclusion of of most most studies studies is is that quantity of money supplied is largely insensitive to the interest rate rate (see (see Cagan Cagan 1965; 1965; Fand Fand 1967; 1967; Rasche Rasche 1972) 1972) and and that that the the quantity quantity of money money demanded demanded is is only only moderately moderately sensitive sensitive to to the the interest interest rate, rate, of displaying an an elasticity elasticity aa good good deal deal less less than than unity unity with with respect respect to to longdisplaying longterm rates. rates. term The The various various versions versions of of the the spending spending hypothesis-one hypothesis—one of of which which atattributes the the Great Great Contraction Contraction to to an an autonomous autonomous decline decline in in investment, investment, tributes another another to to an an autonomous autonomous decline decline in in housing, housing, aa third third to to an an autonomous autonomous decline in consumption consumption and and exports-cast exports—cast doubt doubt on the value value for for cycydecline in on the clical clical analysis analysis of of the the Keynesian Keynesian distinction distinction among among investment, investment, conconsumption, and and net net exports. exports. The The authors authors of of the the various various versions versions write write sumption, as propagated by by the as if if the the cycle cycle is is necessarily necessarily propagated the component component of of GNP GNP that that first reaches reaches aa peak peak or is most most volatile. volatile. Is Is this this more more than most first or that that is than the the most vulgar vulgar post post hoc-propter hoc-propter hoc hoc reasoning? reasoning? If If not, not, where where is is the the evidence? evidence? The particular particular category category of of expenditure expenditure that that first reaches aa peak may The first reaches peak may not be be the the trigger trigger of of the the downturn downturn but the first to respond respond to to aa common common not but the first to influence on all expenditures, expenditures, and similarly the the variability of housing housing influence on all and similarly variability of or investment investment or or of of exports exports is is not not an an indicator indicator of of causal causal dominance, dominance, or

125 125

Understanding Understanding 1929-1933 1929-1933

as Temin, for example, assumes in analyzing the German national product in constant prices, 1924-29 156). 1924-29 (p. 156). One other general comment needs to be made about Keynesian models. It It is difficult difficult to understand how the experience of 1929-33 1929-33 could have spawned the notion of the need for the replacement of the classical assumption of a price-adjustment price-adjustment by a quantity-adjustment quantity-adjustment system system of of movement movement toward toward equilibrium. equilibrium. One One key key aspect aspect of of the the concontraction was that the decline in nominal income was divided almost equally between a fall in quantities and in prices. Real income fell by more then one-third, implicit prices by more than one-quarter. Why quantities quantities changed changed as as they they did did in in response response to to price price changes changes should should be be the goal of analysis. A model in real terms to explain a contraction in which which price price declines declines were were so so prominent is is bound bound to to serve serve imperfectly imperfectly 12 the cause of historical understanding. 12 Finally, no decline-in-spending model has ever been able to explain the the detailed detailed development development of of the the contraction. contraction.

4.4 International International Explanations Explanations 4.4 The The main main problem with with Kindleberger's Kindleberger's account account of of the the world world in depression is is his his assumption assumption that, that, because because the the contraction contraction was was worldworlddepression wide wide in in scope scope once once it it got got under under way, way, it it therefore therefore did did not not originate originate in in the United United States. States. The The U.S. U.S. share share in in world world trade, trade, world world capital capital and and the financial markets, markets, and and the the world's world's stock stock of of gold gold has has been been sufficiently sufficiently financial large since since World World War War II to to give give the the United United States States the the capacity capacity to to initiate initiate large worldwide movements movements and and not not merely merely to to react react to to them. them. Of Of course, course, worldwide once having having initiated initiated aa worldwide worldwide disturbance, disturbance, it it would would in in tum turn be be once subject to to reflex reflex influences. influences. subject From From 1923 1923 on, on, the the Federal Federal Reserve Reserve sterilized sterilized much much of of the the gold gold inflow inflow into into the the United United States, States, preventing preventing the the kind kind of of expansionary expansionary effect effect on on the stock stock of of money money and and thence thence on on prices prices that that would would have have occurred occurred the under the the prewar prewar gold gold standard. standard. Instead, Instead, the the system system sought, sought, and and to to aa under large large measure measure achieved, achieved, stable stable economic economic growth growth with with falling falling wholesale wholesale prices. This This achievement achievement was was largely largely atthe at the expense expense of of economic economic stastaprices. bility in in Great Great Britain Britain and and the the peripheral peripheral countries countries tied tied to to sterling. sterling. bility Britain's return return to to gold gold in in 1925 Britain's 1925 at at aa parity parity that that overvalued overvalued sterling sterling would would have have caused caused less less difficulty difficulty for for Britain Britain if if prices prices in in the the United United States States had had risen instead instead of of falling falling thereafter. thereafter. risen Similarly, Similarly, any any problems of of agricultural agricultural depression depression in in the the peripheral peripheral countries before before 1929 1929 were were not not independent of U.S. U.S. policy. policy. For For the the countries independent of contraction itself, the the record record is is equally equally clear. clear. The The stock stock market market boom, boom, contraction itself, which is said to have drained funds from the rest of the world, and the stock States. The The downward downward movemovestock market market crash crash occurred occurred in in the the United United States. ment in in the the U.S. U.S. money money stock, stock, including including the the sequence sequence of of bank bank failures, failures, ment

126

Anna Anna J. Schwartz

was not the consequence of influences from abroad. The gold inflow into the United States (during the first two years of the contraction) to which reference will be made below is further further evidence that other countries were being forced to adapt to the U. S. monetary policies U.S. rather than the reverse. The decline in U.S. lending abroad and the protectionist Smoot-Hawley Tariff Tariff Act were clearly U.S. actions that 13 destabilized destabilized the world financial financial system. system.13 The United United States States was was no no pitiful, pitiful, helpless helpless giant giant on on whom whom the the rest rest of The of the the world world inflicted inflicted the Great Great Contraction. Contraction. It is is true true that that when the the pound pound and other other currencies currencies were were cut cut loose loose from from gold gold in in 1931, 1931, the the U.S. U.S. trade trade and balance was was adversely adversely affected affected and and speculative speculative pressure pressure on on the the dollar dollar balance developed. These These devaluations, devaluations, however, however, were were themselves themselves the the reflex reflex developed. consequences of of the the U.S. U.S. contraction, contraction, and and even even so, so, their their subsequent subsequent consequences effects were were not not crippling, crippling, given given the the size size of of the the U.S. economy. U.S. economy. effects is also also relevant relevant to to both both Temin' Temin'ss assumption assumption that that the the decline decline This point point is This in U.S. U.S. exports exports was independent of of U.S. actions and and to to Abramovitz's Abramovitz's in was independent U.S. actions analysis. Temin Temin never never alludes alludes to to the the monetary monetary standard standard of of fixed exfixed exanalysis. change change rates rates that enforced enforced aa worldwide worldwide decline decline in in income income and and prices prices after 1929.J4 1929.14 The The central central role role of of the the United United States States in in the the worldwide worldwide after 15 scope scope of of the the contraction contraction is is attested attested to to by by the the balance balance of of payments. payments.15 If the the decline decline in in income income in in the the rest rest of of the the world world was was being being transmitted transmitted If to the the United United States, States, we we should should have have observed observed aa balance-of-payments balance-of-payments to deficit in in the the United United States, States, leading leading to to aa gold gold outflow. outflow. However, However, the the deficit U.S. gold gold stock stock rose rose by by nearly nearly $200 $200 million million from from the the annual annual average average U.S. of 1929 1929 to to that of 1930. 1930. From From August August 1929 1929 to August 1931, 1931, the the gold gold of that of to August stock rose rose by by over over $600 $600 million. million. The The gold gold inflow inflow strongly strongly suggests suggests that that stock any decline decline in in U.S. exports to the rest rest of of the the world world was attributable was attributable any U.S. exports to the to the the effects effects on on the the rest rest of of the the world world of of contraction contraction here. here. to Likewise, Abramovitz, by assuming that there were forces making for for aa major major decline decline in in the the dollar dollar value value of of U.S. U.S. exports exports independently independently monetary actions, actions, is is able able to to conclude conclude that that there there was was aa significant significant of U.S. ofU .S. monetary constraint on on the the power power of of the the Federal Federal Reserve Reserve to to sustain sustain the the growth growth constraint of the the money money stock. stock. In In fact, fact, however, however, there there were were no no such such forces. forces. The The of gold inflows inflows contradict contradict the the assumption assumption that that the the initiating initiating force force was was aa gold serious decline decline in in the the dollar dollar value value of of our our export export market market independent independent serious of what what was happening in in the the United United States. States. The The other other exogenous exogenous factor factor of was happening for Abramovitz's Abramovitz's analysis-net analysis—net capital capital imports-is imports—is also also an an item item that that for was crucially crucially determined determined by by events events within within the the United United States. States. In In the the was 1930s the the decline decline in in U.S. U.S. capital capital exports exports may may have have been been exogenous exogenous in 1930s in the sense sense that that the the state state of of the the capital capital market market abroad abroad and and the the prospective prospective the yields on on investment investment in in various various foreign foreign countries countries discouraged discouraged capital capital yields exports. But But equally equally the the volume volume of of saving saving available available for for capital capital export export exports. relative to to the the volume volume of of investment investment demand demand at at home home were were important important relative endogenous elements. elements. Internal Internal developments developments in in the the United United States States enorenorendogenous mously affected affected U.S. U.S. capital capital exports. exports. mously

127

Understanding 1929-1933

Is the monetary approach to the balance of payments helpful in understanding 1929-33? The theory asserts that the active element in the balance-of-payments balance-of-payments adjustment adjustment process is the equalization of the quantity of money demanded with the quantity of money supplied. Flows of specie are interpreted as responses to changes in demand for or domestic supply of money in various countries. A reduction in the public's demand for goods and securities leads to reduced imports and expanded expanded exports exports on on the the goods goods side side and and to to higher higher interest interest rates rates and and capital imports on the securities side. The current account or the capital account account or or both both move move into into surplus. surplus. Although Although the the law law of of one one price price has has frequently been associated with the monetary approach, some adherdoents between the ents allow allow for for significant significant slippage slippage between the rate rate of of change change of of domestic prices and of world prices. Similarly, some adherents also accommodate commodate interest interest rate rate differentials differentials between between domestic domestic and and foreign foreign assets in their versions of the monetary approach. Are flows and Are the the gold gold flows and price price movements, movements, 1929-33, 1929-33, consistent consistent with with the monetary monetary approach approach to to the the balance balance of of payments? payments? As As already already noted, noted, the from $600 from August August 1929 1929 to to August August 1931, 1931, there there was was aa gold gold inflow inflow of of $600 million. An An increase increase in in the the demand demand for for money money in in the the United United States States million. relative relative to to other other countries, countries, or or aa decrease decrease in in the the supply supply of of money money in in the the United States States relative relative to to other other countries, countries, or or any any combination combination would would United be the monetary monetary approach approach to account for for the inflow. Such Such be required required by by the to account the inflow. change in in the the relative relative demand demand or or supply supply of of money money would would be be manimaniaa change fested in in aa decline decline in in U.S. U.S. wholesale wholesale prices prices relative relative to to those those in in the the rest rest fested of the the world-either world—either along along with with the the inflow inflow or or as as an an intermediate intermediate step step of in producing producing the the inflow. inflow. If If changes changes in in wholesale wholesale prices shown in in table table in prices shown 4.5 for for various various countries countries are are reliable, reliable, the the 1929-31 1929-31 decline decline in in U.S. U.S. prices prices 4.5 was steeper steeper than than in in France France and and Germany, Germany, but but not not in in the the other other countries. countries. was From the Britain cut cut the the pound pound loose loose from from gold gold in in September September 1931 From the time time Britain 1931 until July July 1932, 1932, the the United United States States had had aa gold gold outflow outflow of of $1 $1 billion, billion, until absorbed principally principally by by France, France, Belgium, Belgium, Switzerland, Switzerland, and and the the NethNethabsorbed erlands. The The outflow outflow would would be be interpreted interpreted as as aa relative relative increase increase in in the the erlands. demand for for or or decrease decrease in in the the supply supply of of money money in in those those countries. countries. The The demand data on on wholesale wholesale prices prices in in the the United United States States and and France France confirm confirm an an data only slightly slightly steeper steeper rate rate of of price price decline decline in in France France than than in in the the United United only States during during this this interval. interval. The The return return flow of gold gold to to the the United United States States flow of States until the climactic weeks before the Bank Holiday in March 1933 until the climactic weeks before the Bank Holiday in March 1933 rerestored the the U.S. U.S. gold gold stock stock so so that that it it was was only only $80 $80 million million lower lower than than stored at the cyclical peak peak in in business business in in 1929. 1929. Again, Again, aa relative relative increase increase in in at the cyclical the demand for money in the United States and a steeper rate of price the demand for money in the United States and a steeper rate of price decline in in the the United United States States than than abroad abroad would would be be consistent consistent with with the the decline inflow. This This seems seems to to be be the the case case from from September September 1932 1932 to to February February inflow. 1933. 1933. It does does not not seem seem to to me me that that the the discussion discussion of of the the international international setting setting It of of 1929-33 1929-33 as as set set forth forth in in A Monetary History requires requires modification. modification.

-11.9 -- 6.7 6.7 -16.2 -14.3 -ll.5 -11.5 -- 5.3 5.3

France -- 5.8 5.8 -22.3 -13.6 -- 3.0 3.0 + 53.7 +53.7 +16.8 + 16.8

Japan

U.K. -- 9.2 9.2 -14.9 -15.2 -- 1.5 1.5 + 16.0 +16.0 -- 7.6 7.6

Canada -11.8 -16.0 -16.9 -- 6.5 6.5 -- 3.1 3.1 -- 8.5 8.5

-11.6 -10.8 -12.3 -16.2 -- 4.6 4.6 -10.0

Germany

-12.3 -14.1 -16.2 -- 9.5 9.5 + 4.0 4.0 -ll.5 -11.5

Italy Italy

Sources: Sources: U.S.: U.S.: U.S. U.S. Bureau Bureau of of the the Census, Census, 1949, 1949, p.p. 344. 344. France: France: Librarie Librarie de de Recueil Recueil Sirey Sirey 1937, 1937, table table 11. 11. Japan, 1929-33, table table 10. 10. The The U.K. U.K. index index was was constructed constructed Japan, Canada, Canada, U.K., U.K., Germany, Germany, Italy: Italy: League League of of Nations Nations 1929-33, by the the Board Board of of Trade; Trade; the the Italian Italian index index is is labeled labeled "Bachi." "Bachi." by

-13.1 -12.2 -17.0 -13.0 + 6.5 -17.6

Mar. Mar. Sept. Sept. Sept. Sept. June Sept. Sept. Feb. Feb.

Aug. 1929 1929 Aug. 1929 Aug. 1929 Sept. 1930 1930 Sept. Sept. Sept. 1931 1931 June 1932 1932 Sept. 1932 1932 Sept.

1933 1930 1931 1932 1932 1933

U.S. U.S.

To To

Annual Rates of Change

Percentage Chllllles Changes in Wholesale Prices at Annual Rates ror for Various Countries, 1929-33 1929-33

From From

'Dlble Table 4.5 4.5

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Understanding 1929-1933

Countries within the British orbit along with Britain were depressed during the '20s while the rest of the world prospered, partly thanks to U.S. capital exports. When the U.S. capital flow declined in 1928 and virtually ceased in the succeeding years, the economic position of the formerly recipient countries deteriorated. The gold exchange standard made the international financial system vulnerable. Given the attachment to fixed exchange rates, there was no way for other countries to insulate themselves from the effects effects of U.S. contraction. Deflation Deflation in the United States forced an adjustment adjustment on the rest of the world reflected reflected partly in the gold inflows to the United States, partly in internal deflation necessary to reduce further flows. We tion necessary to avoid avoid or or reduce further gold gold flows. We exported exported deflation and depression to the rest of of the world. Even though deflation abroad then reacted unfavorably unfavorably on the United States, much leeway still remained for U.S. policy.

4.5 Understanding Understanding 1929-33 1929-33 4.5 For Temin, 1929-33 was characterized by the absence of two equilibrating wages and real-balance effect. librating factors: factors: aa decline decline in in real real wages and aa strong strong real-balance effect. Real wages in manufacturing, as the quotient of nominal wages divided by wholesale prices, both hourly weekly bases in by wholesale prices, were were higher higher on on both hourly and and weekly bases in 1930, 1931, 1931, and and 1932, 1932, and and also also on an hourly in 1933. 1933. Real wages 1930, on an hourly basis basis in Real wages nominal wages in manufacturing, as in manufacturing, as the the quotient quotient of of nominal wages divided divided by by conconsumer prices, were higher higher on on an an hourly hourly basis basis in in every every year year except except 1932 sumer prices, were 1932 but lower year on weekly basis. basis. From hourly wholesale but lower in in every every year on aa weekly From the the hourly wholesale price deflated series, series, Temin Temin concludes concludes that that the the marginal price deflated marginal physical physical proproductivity rose as ductivity of of labor labor rose as employment employment fell, fell, which which is is consistent consistent with with the the classical theory theory of of factor factor substitution: substitution: lowering lowering the the wage rate further further classical wage rate might have have avoided demight avoided unemployment. unemployment. The The weekly weekly consumer consumer price price deflated series series shows, shows, however, however, that this was was aa vain hope, since since lower lower flated that this vain hope, wages decreased decreased the the level level of of demand. demand. He He adds adds that that if if the the real hourly wages real hourly wage series deflated deflated by consumer prices prices is is more accurate than the wage series by consumer more accurate than the is wholesale price then no part of wholesale price deflated deflated series, series, then no part of the the classical classical theory theory is accurate. accurate. I do not believe, however, that we can gain an understanding of of 1929-33 by assigning a central role to real wages. Further, by dismissing the evidence of the hourly wholesale price deflated deflated series, Temin Temin fails fails to to see see aa link link between between it it and and the the aborted aborted recoveries recoveries that that Mitchell and Bums Burns (1936) noted in 1930, 1931, 1931, and 1932. The second equilibrating factor that Temin alleges was absent in 1929-33 1929-33 was was aa strong strong real-balance real-balance effect. effect. He He defines defines that that effect, effect, howhowever, as relating to the stock of money or the stock of money plus other financial Yet the the proper is assets. Yet proper measure measure of of the the real-balance real-balance effect effect is financial assets. the effect effect of of the the change change in in the indebtedness of of the government the the net net indebtedness the government

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sector-that sector—that is, the sum of noninterest- and interest-bearing government liabilities. The nominal value of currency plus government debt increased 27 62 27 percent from 1929 1929 to 1933; 1933; the real value increased 62 percent. This may be described as a strong increase in real balances, whatever the strength of the effect effect on spending for consumption. In Temin's account, an unexplained change in spending set the economy on its downward slide. No monetary change could stop the downward slide. An increase in the supply of money would not help, since the public had an excess supply of money. Things could get worse, as they did, when in September 1931 1931 the the Federal Federal Reserve Reserve for for the the first firsttime time since 1929 1929 in his view exerted a deflationary deflationary effect effect on the economy. Temin's analytical structure is a throwback to the Keynesian position of the quarter century after of after 1933. 1933. It It has no theoretical explanation of the price level. It It makes no distinction between nominal and real magnitudes.1t nitudes. It presumes that no evidence exists on the relation of monetary change to income change. It It ignores recent theoretical developments. The period 1929-33 1929-33 began as a cyclical contraction much like others, this time in response to the immoderate concern of the Federal Reserve Board about speculation in the stock market. Application of the theory of of stock stock values values as as affected affected by by expectations expectations of of the the growth growth of of earnings earnings of now suggests, as Irving Fisher believed, that marked overvaluation of stocks ecostocks was was not not general general (Sirkin (Sirkin 1975). 1975). Had Had high high employment employment and and economic growth growth continued, continued, prices prices in in the the stock stock market market could could have have been been nomic maintained. 1928 maintained. In In the the event, event, restriction restriction of of the the growth growth of of money money from from 1928 on produced peak in in business business and and some some months months later later the the stock stock market market on produced aa peak crash. A A temporary temporary increase increase in in the the money money stock stock in in October October 1929 1929 eased eased crash. the effect effect of of the the shock shock of of the the crash. crash. This This may may account account for for the the increase increase the in output output recorded recorded in in early early 1930 1930 as as aa lagged lagged effect effect of of monetary monetary growth. growth. in The economy was thus subjected to two sharp shocks: the initial restrictive money growth and then the collapse of stock prices. Still, what what followed followed suggests suggests an an adjustment adjustment that that moved moved the the economy economy toward toward equilibrium, but not for long. It It is not hard to explain why an unanticipated ipated decline decline in in aggregate aggregate demand demand will will lead lead employers employers to to hire hire fewer fewer workers at at each each real real wage wage rate rate as as perceived by them them and and will will lead lead workers perceived by workers to to refuse refuse offers offers of of work work at at lower lower nominal nominal wages wages on on the the basis basis workers of unchanged unchanged anticipations. anticipations. Along Along rational-expectations rational-expectations lines, lines, howhowof ever, in ever, employers employers and and workers workers will will in in time time revise revise their their anticipations anticipations in accordance with with the the change change in in opportunities. opportunities. If If the the Federal Federal Reserve Reserve accordance had maintained maintained the the initial initial moderate moderate rate rate of of decline decline in in the the money money stock, stock, had presumably the the economy economy after after aa time time would would have have adjusted adjusted to to this this conconpresumably dition. But But this this is is not not what what happened. happened. The The screw screw was was tightened tightened again again dition. and again, again, until 1932, and and unanticipated unanticipated change change in in each each case case required required and until 1932, new period period of of adjustment. adjustment. To To add add to to the the problem, problem, leading leading government government aa new officials and and industrialists industrialists exhorted exhorted employers employers to to maintain maintain wage wage rates rates officials

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Understanding 1929-1933

and share employment, which must have contributed to shorter average work weeks and higher layoffs. layoffs. Still, one must acknowledge the resilience of the economy after after the first first shocks in 1929 1929 and the first banking crisis at the end of 1930. 1930. In early 1931, 1931, some industries with relatively smaller price declines revived. Again, the adjustment adjustment was aborted by a second round of banking failures, subsequently compounded by the Federal Reserve's reaction to gold losses, in the autumn of 1931. 1931. The favorable shock in April 1932, the Federal finally began 1932, when when the Federal Reserve Reserve System System finally began an an open-market open-market purchase program in response to congressional pressure, produced a positive reaction to move upward and positive reaction in in the the economy. economy. Prices Prices began began to move upward and output increased. increased. The The adjustment adjustment was was short-lived. short-lived. The The purchase purchase prooutput program gram ended ended in in early early August, August, and and the the political political campaign campaign spawned spawned rumors rumors about the the condition condition of of banks banks the the Reconstruction Reconstruction Finance Finance Corporation Corporation about (RFC) (RFC) had had aided. aided. The The consequence consequence was was aa series series of of runs runs that that ended ended with the the shutdown shutdown of of all all banks banks as as the the new new administration administration took took office. office. with The The economy economy was was at at its its lowest lowest ebb. ebb. Yet Yet vigorous vigorous growth growth was was not not precluded during the expansion phase that followed. A far more satisfactory satisfactory explanation of 1929-33 1929-33 than Temin's is, therefore, that aa series negative shocks, therefore, that series of of negative shocks, monetary monetary in in origin, origin, reduced reduced real output output and and the the demand demand for for labor labor and and shifted shifted the the demand demand for for sereal securities curities to to short-term short-term instruments instruments and and high-grade, high-grade, long-term long-term securities. securities. Destroy aa banking banking system, system, and and the the real real economy economy will will grind grind to to aa halt. halt. Destroy There are are no no unexplained unexplained changes changes in in spending spending that that serve serve as as deus deus ex ex There machina. The The presence of equilibrating equilibrating forces forces is is attested attested to to by by the the machina. presence of interludes during during the the course course of of the the contraction contraction when when real real output output inininterludes creased. The The behavior behavior of of the economy was was determined determined by by public public polthe economy polcreased. icies. Different Different policies policies would would have have resulted resulted in in different different behavior. behavior. icies.

Appendix Dissents from from the Views Monetary History Dissents Views in a Monetary History Temin A Monetary Temin rejects rejects the the account account in in A Monetary History History of of the the wayan way an initial initial mild decline in the money stock from 1929 1929 to 1930, 1930, accompanying a decline decline in in Federal Federal Reserve Reserve credit credit outstanding, outstanding, was was converted converted into into aa sharp decline decline by by aa wave wave of of bank bank failures failures beginning beginning in in late late 1930. 1930. II shall shall sharp five items discuss discuss in in tum turn five items in in Temin's Temin's catalog catalog of of dissent: dissent: (1) (1) the the moneymoneystock identity, (2) the behavior of high-powered money, (3) the behavior of of interest interest rates, rates, (4) (4) the the price price of of deflation deflation and and the the behavior behavior of of real real money balances, balances, (5) (5) the the role role of of bank bank failures; failures; and and II will will comment comment finally finally money

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(6) on his and others' approaches to monetary policy during the contraction. 4.A.l 4.A.1 The Money-Stock Identity In A Monetary Monetary History, History,we weused usedan anidentity identitythat thatrelates relatesmoney moneybroadly broadly defined dedefined to to three three proximate proximate determinants: determinants: high-powered high-powered money, money, the the deposit-reserve ratio, and the deposit-currency ratio. The three proximate determinants determinants reflect, reflect, respectively, respectively, the the behavior behavior of of the the monetary monetary auauthorities (in (in the the United United States, States, the the Treasury Treasury and and the the Federal Federal Reserve Reserve thorities System), public. The System), the the commercial commercial banks, banks, and and the the public. The monetary monetary auauthorities provide provide high-powered high-powered money-the money—the sum sum of of reserves reserves and and curcurthorities rency-that rency—that the the banks banks and and public public divide divide between between themselves themselves in in light light of the the factors factors influencing influencing the the two two sets sets of of ratios. ratios. The The deposit-reserve deposit-reserve of of ratio ratio is is affected affected by by legal legal reserve reserve requirements, requirements, banks' banks' expectations expectations of currency movements movements into into and and out out of of their their vaults, vaults, and and interest interest rates. rates. currency The The deposit-currency deposit-currency ratio ratio is is affected affected by by interest interest rates, rates, income, income, and and the public's public's preference preference for for holding holding coin coin and and currency. currency. The The ratios ratios clearly clearly the reflect reflect demand demand factors factors that that interact interact with with the the supply supply of of high-powered high-powered money. The The argument argument of of A History, as as already already noted, noted, is is that that money. A Monetary Monetary History, the Federal Federal Reserve Reserve System System through through its its control control of of the the issue issue of of highthe highpowered money money can can offset offset any any undesired undesired change change by by the the other other actors actors powered in some some short short run, run, and and hence hence the the system system plays plays aa dominant dominant role role in in the the in control of of the the quantity quantity of of money. money. control Temin believes he has isolated a fatal error in A Monetary History, History, because because the the identity identity suggests suggests to to him him that that the the stock stock of of money money is is deterdetermined by supply factors alone, instead of being joined with a demand equation equation to to determine determine equilibrium equilibrium supply supply in in the the market market for for money. money. Temin writes: writes: Temin of Consider Consider the the stock stock of of bonds. bonds. The The size size of of the the stock stock is is the the product product of past fixed past decisions decisions about about corporate corporate and and government government finance. finance. It It is is fixed at at any any moment moment of of time time by by these these previous previous supply supply decisions. decisions. If If the the demand for for bonds bonds shifts, shifts, it it will will not not change change the the number number of of bonds bonds in demand in existence immediately; immediately; it it will will change change their their price. price. In In the the short short run, run, existence therefore, the the quantity quantity of of bonds bonds is is determined determined by by the the supply, supply, and and the the therefore, price is is determined determined by by the the demand. demand. In In the the longer longer run, run, the the price price will will price be aa function function of of both both the the supply supply and and demand demand working working through through aa be recursive relationship. relationship. Friedman Friedman and and Schwartz Schwartz employed employed the the shortshortrecursive run part part of of this this argument; argument; they they appear appear to to have have rejected rejected the the long-run long-run run part. (P. (P. 18) part. 18) According in the According to to Temin, Temin, we we treat treat changes changes in the demand demand for for money money as as affecting affecting only the price of money, meaning the interest rate, and not quantity, quantity, the the equilibrium equilibrium stock stock of of money. money. This This is is standard standard Keynesian Keynesian

133

Understanding 1929-1933

doctrine, in which the price of money is defined as the interest rate rather than the reciprocal of the price level. The problem with Temin's analysis, as with much Keynesian analysis, is the assumption that the price level is predetermined and the resulting failure to treat the price level as a variable that helps to equate nominal demand for money with the nominal supply of money or, alternatively, alternatively, to to enable enable any any level level of of real real balances demanded demanded to to be be attained for any level of nominal balances. Temin's failure to recognize the the importance importance of of the the distinction distinction between nominal nominal and and real real magnitudes magnitudes leads leads him him to to stress stress instead instead the the distinction distinction between between long long run run and and short short run, but but this run, this distinction distinction is is not not highly highly relevant relevant to to the the determination determination of of the stock Undoubtedly, different forces exert inthe stock of of money. money. Undoubtedly, different forces exert different different influences behavioral patterns patterns underlying deterfluences on on the the behavioral underlying the the proximate proximate determinants in the short and long run. But in both runs, it is the behavioral patterns underlying underlying the the proximate proximate determinants determinants that that determine determine the the size size of of the the nominal nominal quantity quantity of of money money outstanding. outstanding. The The demand demand forces forces emanating public that emanating from from the the public that affect affect the the nominal nominal quantity quantity of of money money are are those those that that have have to to do do with with the the forms forms among among which which they they choose choose to to distribute distribute their their nominal nominal (or (or real) real) assets-the assets—the fraction fraction they they choose choose to to bank deposits hold hold in in real real assets, assets, securities securities of of various various kinds, kinds, bank deposits of of various various kinds, kinds, and and high-powered high-powered money. money. These These demand demand forces forces interact interact with with the supply conditions of high-powered money, and of various forms of deposits deposits or or securities, securities, to to determine determine the the nominal nominal quantity quantity of of money. The quanThe demand demand for for real real money money balances balances interacts interacts with with the the nominal nominal quantity tity of of money money to to determine determine the the price price level. level. Of Of course, this is an oversimoversimplified statement. all plified statement. A A more more sophisticated sophisticated statement statement would would assert assert that that all of of these these variables variables are are determined determined simultaneously simultaneously and and that that some some of of the variables variables that that enter enter into into the the demand demand for for real real money money balances balances may may also also enter enter into into the the functions functions that that determine determine the the distribution distribution of of the the total total point balance balance sheet sheet among among various various forms forms of of assets. assets. But But the the important important point is fully fully brought brought out out by the simplified simplified picture: picture: to to leave leave price price expectations expectations is by the the picture picture in the short to leave major out out of of the in the short run run from from 1929 1929 on on is is to leave out out aa major picture-both for part ofthe part of the picture—both for monetary monetary analysis analysis and and for for income income analysis. analysis. As public adjusts between its balAs the the public adjusts discrepancies discrepancies between its actual actual real real money money balances and and desired desired real real money money balances, balances, nominal nominal income income is is altered altered and ances and the breakdown into prices prices and and output output is is determined. determined. the breakdown into "deTemin Temin alleges alleges that that the the supply supply of of money money in in our our specification specification is is "determined 19). termined by by forces forces independent independent of of income income and and interest interest rates" rates" (p. (p. 19). Yet Yet we we specifically specifically note note that that the the deposit deposit ratios ratios are are functions functions of of the the interest rate, rate, among among other other variables variables (contrary (contrary to to Temin's Temin's discussion, discussion, interest which which suggests suggests that that we we do do not not include include it) it) and and that that the the deposit-currency deposit-currency ratio is is aa function function also also of of income. income. He He is is right right that that we we regard regard banking banking ratio 20) panics and away away the the most most important important single single determinant" determinant" (p. (p. 20) panics as as "far "far and of the the ratios, ratios, not not only only in in the the early early 1930s, 1930s, but but also also during during other other panic of panic

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episodes. How do we know this? By studying the pattern of behavior in these ratios during panic episodes. The early 1930s do not stand alone. We have evidence on the behavior of the ratios in all the postCivil War panics in the United States. They tell a uniform story of a shift from deposits to currency by the public once the economy is engulfed in panic and of a belated attempt by banks to increase reserves relative to their deposits once the panic subsided. We have evidence also from Canadian experience in 1929-33. The percentage fall in Canadian nominal income over these years was about the same as in U.S. nominal income, yet the percentage fall in the Canadian stock of money was considerably smaller. The reason is that Canada was spared the ordeal of bank failures. There was no shift from deposits deposits to to currency currency in in Canada Canada comparable comparable to to that that in in the the United United States, States, and so there was no effect effect from this proximate determinant in producing aa decline money. There There was was no no decline decline in in the the "quality" "quality" decline in in the the stock stock of of money. of deposits deposits comparable comparable to to that that in in the the United United States States because because of of aa loss loss of of of confidence confidence in in banks, banks, and and hence hence there there was was less less of of aa decline decline in in the the demand for real money balances in Canada. That is why a smaller decline decline in in the the quantity quantity of of money money was was consistent consistent with with almost almost the the same same decline in in income income and and prices. prices. The The sharp sharp decline decline in in Canadian Canadian income income decline and and prices prices occurred occurred because because Canada Canada kept kept its its exchange exchange rate rate with with the the United States States fixed until September September 1931 1931 and and then then maintained maintained its its exexUnited fixed until change change rate rate at at aa new new level level involving involving aa smaller smaller depreciation depreciation than than that that undergone by the pound sterling. For Canada, it is entirely appropriate to to regard regard the the quantity quantity of of money money as as adapting adapting in in large large measure measure to to movemovement in in income income and and prices, prices, rather rather than than as as an an exogenous exogenous force. force. It It was was ment the tail. was the the dog. the tail. The The United United States States was dog. 4.A.2 4.A.2 The The Behavior Behavior of of High-Powered High-Powered Money Money The The decline decline in the the quantity quantity of of money money from from August August 1929 1929 to to October October 1930, before the first banking panic, did not result from any weakness of of the the private private economy. economy. The The decline decline was was entirely entirely the the result result of of aa decline decline in Federal Reserve credit outstanding. There were no problems with the the banking banking structure, structure, no no attempted attempted liquidation liquidation of of loans loans by by banks, banks, no no attempt by by depositors depositors to to shift shift from from deposits deposits to to currency currency that that contribcontribattempt uted uted to to reducing reducing the the quantity quantity of of money. money. In In fact, fact, the the banks banks were were reducing reducing reserves relative relative to to deposits, deposits, and and the the public public was was increasing increasing its its deposits deposits reserves relative Rerelative to to currency-enough currency—enough to to offset offset half half the the decline decline in in Federal Federal Reserve credit. credit. serve Temin counters counters that that aa decrease decrease in in bank bank discounts discounts at at the the Fed, Fed, in in Temin response of response to to the the decline decline in in market market interest interest rates, rates, and and not not any any failure failure of the Fed, Fed, was was responsible responsible for for the the decline decline in in Federal Federal Reserve Reserve credit credit the outstanding. Bank Bank borrowings borrowings declined declined from from aa peak peak of of $1,096 $1,096 million million outstanding.

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Understanding 1929-1933

in to $189 million by bank reserves in July July 1929 1929 to $189 million by September September 1930. 1930. Total Total bank reserves fell not allude to the the punitive punitive attitude fell about about $40 $40 million. million. Temin Temin does does not allude to attitude of the system toward member bank borrowing, bypasses the of the system toward member bank borrowing, hence hence bypasses the reason them to reason there there was was little little incentive incentive for for them to increase increase rediscounting, rediscounting, ratesabsent panic, when when the the Reserve Reserve Banks Banks lowered absent any any panic, lowered discount discount rates— "dramatically," to him he takes the absolute "dramatically," according according to him (p. (p. 21)-and 21)—and he takes the absolute amount amount of of discounting discounting to to be be "10w."16 "low."16 In the discount was not not reduced reduced uniformly In fact, fact, the discount rate rate was uniformly at at all all Reserve Reserve Banks. By mid-1930, New New York York had had reduced reduced its rate in Banks. By mid-1930, its rate in six six steps steps from from 66 to to 2.5 2.5 percent, percent, while while at at other other Reserve Reserve Banks Banks the the rate rate had had gone gone from from 55 to to 44 and and 3.5 3.5 percent. percent. By By the the end end of of 1930, 1930, the the New New York York rate rate stood stood at 22 percent, the rates at two other banks at 33 percent, and at at the the at percent, the rates at two other banks at percent, and remaining rate fell than the remaining nine nine at at 3.5 3.5 percent. percent. The The discount discount rate fell less less than the commercial paper paper rate even in in New New York; York; aa lot lot less, less, in in other other districts. districts. commercial rate even The between the the commercial rate and the discount discount rate The spread spread between commercial paper paper rate and the rate at New shade lower lower in in 1930 1930 than than in in 1929; 1929; at at other other Reserve Reserve at New York York was was aa shade Banks, much lower. under the runs by by the public, Banks, much lower. Of Of course, course, under the lash lash of of runs the public, the did increase increase their their borrowings-from borrowings—from $189 $189 million million in in SeptemSeptemthe banks banks did ber 1930 to to $338 $338 million in December. increase in in Reserve Reserve ber 1930 million in December. But But this this increase Bank credit credit outstanding outstanding was smaller than the increase increase in in the the public's public's Bank was smaller than the currency holdings. currency holdings. Temin's general Keynesian tendency tendency to to treat treat interest Temin's general Keynesian interest rates rates as as the the crucial variable leads him astray the role crucial monetary monetary variable leads him astray in in evaluating evaluating both both the role of responsibility. For he of the the Fed Fed and and our our views views about about its its responsibility. For example, example, he writes that the Federal Reserve "could writes that the Federal Reserve "could have have offset offset changes changes in in interest interest rates by changing the discount rate, and rates by changing the discount rate, and it it could could have have avoided avoided the the banking banking panics panics by changing changing its its procedures" (p. (p. 20). 20). That That is is not not our our view. We We put put major major emphasis, rate changes view. emphasis, not not on on discount discount rate changes or or on on "procedures," but on Federal Reserve control of high-powered money, or reserves, through through open-market or bank bank reserves, open-market operations. operations. view, the the Federal Federal Reserve From From our our view, the crucial crucial question question is is whether whether the Reserve was powerless powerless to to engage purchases to to restore the level was engage in in open-market open-market purchases restore the level of its credit outstanding, given that, until the first banking panic, the banks, for the discount banks, for whatever whatever reason, reason, were were not not willing willing to to come come to to the discount the system's behavior is window. window. Temin's Temin's discussion discussion of of the system's behavior is ambiguous, ambiguous, to to say say the the least: least: No one the Fed Fed has power to No one disputes disputes that that the has the the power to undertake undertake open-market open-market operations. And And most most people people agree these actions operations. agree that that these actions have have effects effects on very few on the the economy. economy. But But very few of of the the monetary monetary changes changes in in the the early early to undertake undertake open1930's 1930's were were the the results results of of conscious conscious decisions decisions to openmarket Friedman and that the the decline market operations. operations. Friedman and Schwartz Schwartz argued argued that decline in the stock was the the result in the stock of of money money in in 1930 1930 was result of of aa fall fall in in discounts discounts at at the response to market rates rates not not fully by the Fed Fed in in response to aa fall fall in in market fully duplicated duplicated by the discount rate, and that the the fall in the discount rate, and that fall in in 1931 1931 was was due due to to aa decline decline in

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Anna J. Schwartz Anna

the two deposit produced by the two deposit ratios ratios produced by the the banking banking crises. crises. These These events events are not the same as open-market purchases. (P. (P. 25) These events clearly are the opposite of open-market purchases, which would have increased Reserve credit outstanding and high-powered money. precisely the the kind money. They They are are precisely kind of of events events that that conventional conventional centralcentralbank wisdom would regard as requiring open-market purchases in order to to offset offset their their effects. effects. Temin Temin objects objects that that we we imply imply that that "all "all changes changes in the stock of of money of actions actions by the Federal Federal Rein the stock money were were the the results results of by the Reby the serve" serve" (p. (p. 25). 25). They They are are the the results results of of actions actions or or inactions inactions by the Federal Reserve. In 1930 1930 before the panic panic condition condition developed developed at at Federal Reserve. In before the the end of of the the Federal Federal Reserve could have readily reversed reversed the end the year, year, the Reserve could have readily the decline in in Federal Federal Reserve Reserve credit credit outstanding. outstanding. Temin Temin evades evades the the the decline central issue issue of of why did not do so. so. central why they they did not do Temin makes much of the fact that high-powered money on an annual average to increase he argues, average continued continued to increase except except in in 1930. 1930. Hence, Hence, he argues, there there was no on the the supply supply of of money. money. High-powered High-powered money money grew grew was no restraint restraint on after first banking because member after the the first banking crisis, crisis, not not because member bank bank reserves reserves were were expanding, but because the public's currency holdings began to climb preferences toward toward currency in in the the usual usual shift shift of of its its preferences currency as as an an aftermath aftermath of the crisis. By By August August 1931, 1931, the public's currency currency holdings holdings of the banking banking crisis. the public's had increased by $583 million million over over its its holdings holdings in in October October 1930, 1930, but but had increased by $583 high-powered was only only $558 $558 million higher. High-powered High-powered money million higher. money high-powered money money was growth, to meet the public's growth, barely barely adequate adequate to meet the public's growing growing distrust distrust of of bank bank deposits, had had contractionary contractionary effects effects on on the of the bankdeposits, the reserve reserve position position of the banking system-hardly system—hardly impressive impressive evidence evidence of of monetary monetary ease. ease. ing 4.A.3 The Behavior of Interest Rates According to Temin, the money hypothesis fails its most important test because there no evidence rates of monetary strintest because there is is no evidence in in interest interest rates of monetary stringency at the end of 1930 as the result of of bank failures. Temin has not examined but it true that that short-term examined the the data data for for earlier earlier panics, panics, but it is is true short-term rates rates in those episodes did rise during the weeks of of panic, and we do not observe a comparable rise during the weeks of the first banking crisis in the last quarter of 1930 or of the second banking crisis from March 1931.17 The failure of of short-term rates to rise, however, is not to June 1931.t' necessarily inconsistent with the presence of of monetary stringencystringency— both because prices rather both because monetary monetary stringency stringency might might be be reflected reflected in in prices rather than in interest rates and because other factors were simultaneously impinging impinging on on short-term short-term rates. rates. In In partiCUlar, particular, the the failure failure of of short-term short-term rates to rise may have reflected, first, declines in the 1920s in the supply of by both private borrowers of short-term short-term instruments instruments issued issued by both private borrowers and and the the government and, and, second, second, the special role of the the commercial commercial banks as government the special role of banks as

137

Understanding 1929-1933

demanders of these short-term instruments. There are two markets to consider, the commercial paper market and the market for short-term government securities. The commercial paper market today is a different different market from the IS In today's one that existed in the 1920s through the Great Contraction. 18 today's market, the finance companies are the dominant borrowers. In the 1920s, corporate enterprises in textiles, foodstuffs, foodstuffs, metals, and leather were the main borrowers. There was a dramatic decline in the market from 1924 to 1933, interrupted by a brief brief expansion from the stock market to April April 1930. million market crash crash to 1930. Outstandings Outstandings fell fell from from aa peak peak of$925 of $925million in October 1924 to a low of of $265 million in September 1929, largely because firms firms that that had had formerly borrowed in the commercial because formerly borrowed in the commercial paper paper market found it more advantageous to float float stocks and bonds. The stock market crash stock market crash and and the the reduction reduction in in commercial commercial paper paper rates rates relative relative to bank lending rates led to a rise in outstandings in April 1930 to $553 million. the volume volume declined to $358 million in million. Thereafter, Thereafter, the declined to $358 million in December December 1930 and and $275 $275 million million in in August 1930 August 1931. 1931. Currently, nonfinancial corporations are the main holders of commercial through the mercial paper. paper. In In the the 1920s 1920s through the Great Great Contraction, Contraction, the the banks banks were sole buyers of commercial commercial paper, paper, with country banks banks were virtually virtually the the sole buyers of with country the mainstay mainstay of of the member bank call date date of of Dethe the market. market. From From the the member bank call December 31, 31, 1930, 1930, through through the September 29, 29, 1931, 1931, call call date, date, member member the September cember bank of commercial commercial paper paper ranged ranged from from 102 102 to 141 percent percent of bank holdings holdings of to 141 of the ~eported reported total amount outstanding, outstanding, the excess over over the the reported reported the total amount the excess amount outstanding outstanding rising rising steadily steadily over over the interval covered. covered. The The examount the interval explanation for the excess is is that that the banks purchased from dealers dealers planation for the excess the banks purchased paper paper from other than than those those reporting reporting to the Federal Reserve Bank of New New York York other to the Federal Reserve Bank of and is is one one indication indication of of the strength of of member bank demand demand for for comcomand the strength member bank mercial paper. mercial paper. The chief chief advantage of commercial paper to member banks apart from its yield was its eligibility for rediscount at the Reserve Banks. This advantage gained in importance during a panic, so that, from the demand side, a panic, rather than putting pressure on commercial paper rates, to some extent relieved the pressure. Instead of selling commercial paper, banks increased borrowings using commercial paper as collateral to meet depositors' demand for currency. As we have seen, bills discounted rose in the last quarter of 1930 and again in June 1931, the culmination of the second banking panic. With limited supply and persistent demand, the failure of commercial paper rates to rise during the panic in no way contradicts the money hypothesis. of With respect to the government securities market, the reduction of the public debt, dating from 1919, continued through December 1930. This constituted an increase in the supply of loanable funds, thereby reducing the interest rate that would clear the market at any given price

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level. The increase in in the public debt was small through August 1931, so the the the influence on on the the supply of loanable funds and and hence on on the upward pressure on on interest rates from this source must likewise have been small (see table 4.A.1). As is true for later years also, also, we lack adequate data on the maturity maturity distribution of the the debt, 1929-31. Treasury bills-first bills—first issued in in DeDecember 1929-and 1929—and certificates of indebtedness had had a maturity of less than one year when issued; Treasury notes, of three to to five five years; and bonds, of more than five years. When purchased or held, held, however, however, the the remaining maturity might be quite different different from the original maturity. So the distribution of security holdings among the indicated categories is only a rough index of their distribution by by maturity. Of the reduced total of the public debt, through December 1930, less than 10 percent of member bank holdings were in less than one-year maturities when issued; four-fifths four-fifths were in in long-term bonds (see table 4.A.2). less than bills 4.A.2). Their Their holdings holdings amounted amounted to to less than one-quarter one-quarter of of the the bills and certificates outside the Federal Reserve from the October 1929 call call date through the the June 1930 call date, rose to to three-tenths at the the September 1930 call date when the first banking panic had not yet erupted, and and then then to to three-eighths three-eighths by by the the call call date date in in December December after after the the Bank Bank of United United States States had had been been suspended. suspended. In In 1931, 1931, the the composition composition of of of the member member bank bank holdings holdings of of government government securities securities shifted shifted toward toward the short-term when when issued, issued, probably probably reflecting reflecting aa shift shift in in the the composition composition short-term Thble Table 4.A.l 4.A.1

Situation as as of Situation of Day of: of: Last Day June 1929 June 1929 Aug. 1929 1929 Oct. 1929 1929 Dec. 1929 1929 Mar. 1930 1930 June 1930 1930 Sept. 1930 1930 Oct. 1930 1930 Nov. 1930 1930 Dec. 1930 1930 Mar. 1931 1931 June 1931 1931 Aug. 1931 1931 1931 Sept. 1931 Dec. 1931 1931

u.s. U.S. Federal Government Interest-bearing Debt Outstanding, Various Months, 1929-31 (in (in Millions of Dollars) Bonds

Treasury Notes

Certificates Certificates of of Indebtedness

12,124 12,126 12,1I5 12,115 12,1I0 12,110 12,1I2 12,112 12,112 12,1I3 12,113 12,1I3 12,113 12,1I3 12,113 12,1I3 12,113 12,709 13,531 13,536 14,336 14,298

2,254 2,781 2,649 2,513 2,570 2,390 2,345 2,345 2,343 2,342 1,129 621 621 644 644 644 644 795

1,640 1,620 1,658 1,306 1,385 1,264 1,264 1,247 1,247 1,247 1,192 2,228 1,924 1,883 1,545 1,860

Source: Source: U.S. Treasury Department 1929-31.

Treasury Bills

— —

100 56 156 120 223 230 128 128 214 445 445 523 524 576

Total 16,018 16,527 16,422 16,029 16,123 15,922 15,825 15,928 15,933 15,775 16,280 16,520 16,586 17,049 17,529

4,155 4,022 3,863

4,085 4,061 4,095 4,125

5,002 5,343 5,564 5,319

29 4 31

27 27 30 30 24 31

25 25 30 29 31

Total (I) (1)

6.7 6.4 8.2 8.9 18.0 16.9 16.4 12.8

3,288 3,340 3,343 3,271 3,771 4,039 4,279 4,199

524 463 463 418 485 332 332 403 371 371 441 441

899 899 901 914 914 679

10.8 10.8 9.1 6.4 6.4

Bills and Certificates Certificates (5)

273 259 259 334 334 369 369

Bonds (4) 3,005 2,992 3,094

Notes (3)

6.6 6.6 7.5 7.5 6.7 6.7 8.3

12.8 11.4 10.2 10.2 11.8

16.9 16.5 13.5

Notes (6)

75.4 75.6 76.9 78.9

80.5 80.5 82.2 81.6 79.3

72.3 74.4 74.4 80.1

Bonds (7)

of Total Member Member Percent of Bank Holdings in:

704 704 665 520

446 446 365 249

Bills and Certificates Certificates (2)

Member Member Bank Holdings (Millions of of Dollars)

31.9 33.7 33.7 34.1 31.8

26.3 26.5 26.5 26.9 27.4 27.4

26.3 26.3 25.0 24.9

Total Total (8)

42.2 44.5 54.2 33.7

23.4 23.4 22.6 30.7 30.7 37.6

28.8 28.8 24.0 21.0

Bills and Certificates Certificates (9)

30.1 67.8 60.5 60.5 57.9

21.9 21.0 19.4 22.9

32.6 32.6 26.5 22.6

Notes Notes (10)

of Total Holdings as Percent of Amounts Outside FR Banks

Chief Chief Kinds of of U.S. Government Direct Ob6gations Obligations Held by Member Banks, Member Bank CaU Call Dates, 1929-31 1929-31

30.3 30.5 30.5 30.5 30.5 30.1

27.5 27.9 27.9 27.4 27.4

24.8 24.8 25.7 25.7

Bonds (11) (ID

Sources, Sources, by columns: (I): (1): Sum of of cols. (2)-(4). (2)-{4). (2)-(4): U.S. Board of of Governors of of the Federal Reserve System System 1943, p. 77. (8): Holdings of of of the three kinds of of debt outstanding (ibid., pp. 332, 343, 375, 509-10); col. (I) (1) was the Federal Reserve Banks were deducted from the total of expressed as as aa percentage percentage of of the the difference. difference. (9)-(11): ( 9 M H ) ' Procedure Procedure similar similar to to that that for for col. col. (8), (8), except except that that no no breakdown breakdown of of Federal Federal Reserve Reserve expressed holdings was was available available except except at at Dec. Dec. 31; 31; the the percentage percentage distribution distribution of of the the three three kinds kinds of of debt debt was was assumed assumed the the same same at at other other dates dates in in each each holdings year as as on on the the following following Dec. Dec. 31. year 31.

1929 June Oct. Dec. 1930 Mar. Mar. June June Sept. Dec. 1931 1931 Mar. Mar. June June Sept. Dec.

Table 4.A.2 4.A.2 1Bble

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Anna J. Schwartz

of outstandings, but also reinforcing the growing concentration of bank demand on these issues, already manifested manifested in December 1930. Bank holdings of short-term governments were more than 50 percent of outstandings in September 1931, 1931, and 60 percent of outstanding mediumterm governments. Mayer (l978b) (1978ft) asks whether one would not expect "the demand for other assets to decline, and hence their yields to rise" (p. 140) when bank failures reduced the money supply. But the short-term assets for which we have yield information, primarily commercial paper and shortterm governments, are not those for which demand declined. The banks dominated these markets, and with good reason. After After the experience of two banking panics, the remaining banks chose to acquire assets with assured convertibility into cash sums at need and at short notice. Short-term governments did not experience the unremitting declines in rates that characterized the commercial paper market in 1930. Continuous monthly data are available only for the yields on three- to sixmonth Treasury notes and certificates certificates (see figure 4.A.1). 4.A.1). (There were only five issues of Treasury bills that year, so there are quotations only figure 4.A.l on new offerings.) offerings.) As the chart in figure 4.A.1 shows, small increases in yields occurred during three months in 1930-5 1930—5 basis basis points points in in April, April, 27 month the the Bank 27 in in September, September, and and 88 in in December, December, the the month Bank of of United United States failed. failed. States Given these conditions both the paper and Given these conditions in in both the commercial commercial paper and short-term short-term government markets until Britain cut loose from gold on September 21,1931, why did the commercial paper rate rise from 21, 1931, why did the commercial paper rate rise from 22 percent, percent, during during the week ending ending October October 3, 3, to to 4.13, 4.13, during during the ending November November the week the week week ending 14, which it uninterrupted decline to the 14, after after which it continued continued an an uninterrupted decline to the week week ending ending with Holiday—its low low point during the the contraction contraction of of 1.38 1.38 with the the Bank Bank Holiday-its point during percent? Why did the average rate on new issues of of Treasury Treasury bills, percent? Why did the average rate on new issues bills, which reached aa low low of of 0.485 0.485 percent in July July 1931, 1931, rise rise steadily steadily theretherepercent in which reached after to to 3.253 3.253 percent in December 1931? Outstandings Outstandings of of commercial commercial after percent in December 1931? paper continued to to decline decline to to the the end end of of the the year, outstanding year, but but outstanding paper continued Treasury bills somewhat. It It is is clear clear from from the of short-term short-term Treasury bills rose rose somewhat. the pattern pattern of rates of of private instruments that that the the rate rate rise rise followed followed the increase in rates private instruments the increase in the discount rate at New New York on October October 9, 9, from from 1.5 1.5 to 2.5 percent, percent, the discount rate at York on to 2.5 and on on October October 16, 16, to to 3.5 3.5 percent. percent. In In this this instance, instance, the the Federal Federal Reserve Reserve and led the In the discount rate rate reductions from November led the market. market. In the discount reductions from November 1929 1929 to May 1931, it it followed followed the market. In In the short-term government government to May 1931, the market. the short-term market, an added added factor factor contributing contributing to in interest interest rates market, an to the the rise rise in rates may may have been been the the increase increase in in Treasury Treasury notes. have notes. Bills discounted been rising July 1931, Bills discounted had had been rising from from July 1931, when when discounts discounts averaged $169 million, to $282 million in September. They then rose to $614 peaking at February 1932. 1932. $614 million million in in October, October, peaking at $848 $848 million million in in February

141

Understanding 1929-1933 PERCENT PERCENT PER YEAR PER YEAR ~~~~~~~~~nm""~~""TnnT~~~ I I M I I I I I I I I In i 11111 1111111 11111111 u 111 n i

7.900 7.900C 6.900 5.900

2.900 1.900

1929 1930 1931 1932 1929 1930 1931 1932 *NEGATIVE * NEGATIVE YIELDS, YIELDS, OCT.-NOV. OCT.-NOV. 1932 1932

Fig.4.A.l Fig. 4.A.1

1933 1933

Yields three- to to six-month treasury notes notes and Yields on on threesix-month treasury and certificates, certificates, 1919-33. Source: U.S. U.S. Board the Federal 1919-33. Source: Board of of Governors Governors of of the Federal Reserve 460. Reserve System System 1943, 1943, p. p. 460.

In to the the increase their indebtedness, banks lost In addition addition to increase in in their indebtedness, member member banks lost $74 million in between July $74 million in reserves reserves between July and and September September 1930 1930 and and aa further further $426 $426 million million between September September 1931 1931 and and February February 1932. Interest rate behavior is not, then, then, inconsistent with monetary monetary strinInterest rate behavior is not, inconsistent with stringency pattern of gency both both before before and and after after September September 1931. 1931. The The pattern of short-term short-term interest before September firm demand by interest rate rate declines declines before September 1931 1931 reflected reflected firm demand by commercial banks for for commercial commercial paper paper and and short-term commercial banks short-term government government securities securities and and aa generally generally declining declining supply supply of of these these instruments. instruments. When When the rates sharply 1931, the Federal Federal Reserve Reserve increased increased discount discount rates sharply in in October October 1931, it pulling them them up, up, whereas it led led market market rates, rates, pulling whereas its its earlier earlier discount discount rate rate reductions followed reductions followed market market rate rate declines. declines. Temin, however, is that short-term Temin, however, is right right in in arguing arguing that short-term interest interest rates rates are are the the ones ones to to examine examine because because they they most nearly resemble holding-period holding-period yields. yields to alyields. For For long-term long-term rates, rates, only only yields to maturity maturity are are available, available, al-

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Anna J. Schwartz

though investors make plans on the basis of holding-period yields. Temin therefore regards long-term rates as unsuitable for analysis because they are complicated for the years 1928-31 by the growing risk of default for some bonds and the rising price of risk. In A Monetary History, we noted that while both long- and shortterm interest rates had been declining before the first banking crisis, a widening spread the first first crisis, widening spread began began to to emerge, emerge, synchronous synchronous with with the crisis, between yields to maturity on lower-grade corporate bonds and on government bonds as yields on bonds rose rose sharply government bonds as yields on corporate corporate bonds sharply and and yields yields on government bonds continued to fall. Temin says "this suggestion will not stand up" (p. will not stand up" (p. 105) 105) because because bond bond prices prices began began to to fall fall well well before before the panic, and and only only the the prices of lower-grade lower-grade bonds bonds fell; fell; the the prices prices of the panic, prices of of high-grade corporate corporate and government bonds bonds stayed stayed roughly roughly constant. high-grade and government constant. The point of the value value of bank portfolios The point of Temin's Temin's insistence insistence that that the of bank portfolios of declined well before the bank panic of 1930 is that the price decline of bonds was not not aa result result of the liquidity liquidity scramble rather aa cause. bonds was of the scramble but but rather cause. He He argues that bonds were being moved from one quality class to another so movements in the Baa not show the change so that that movements in the Baa rate rate do do not show the change in in the the price price of of banks' portfolios. The price decline in any actual bond portfolio in the 1930s the result the decline the price the 1930s was was the result of of both both the decline in in the price of of aa given given quality class and the decline in the quality ratings of the bonds in the portfolio. fixed sample that Temin portfolio. The The yields yields on on the the fixed sample of of bonds bonds that Temin conconstructed for December and June dates 1928-31 rise continuously and far bonds. far exceed exceed the the yields yields on on Baa Baa bonds. No that bond 1929 No one one disputes disputes that bond prices prices were were depressed depressed in in 1928 1928 and and 1929 while the boom in equities was in full swing. Temin's assertion that yields on high-grade corporate and on government bonds thereafter thereafter were constant is hard to assess. Yields on high-grade corporate bonds fell through October fell from from December December 1929 1929 through October 1930, 1930, from from 4.67 4.67 to to 4.42. 4.42. At At the end of of 1930, 1930, during during the the months of panic, 4.52. They They the end months of panic, they they rose rose to to 4.52. then resumed aa decline decline to to 4.36 4.36 in in July July 1931. 1931. Yields Yields to to maturity maturity on on then resumed government bonds bonds fell fell from from 3.43 3.43 in in January January 1930 1930 to 3.19 in in November November to 3.19 government 1930, then to 3.30 3.30 in in February 1931, falling falling thereafter until June, 1930, then rose rose to February 1931, thereafter until June, when the yield yield was 3.13. These These small small changes changes are are consistent consistent with with when the was 3.13. monetary stringency stringency before the first banking panic—given the steady steady panic-given the inonetary before the first banking decline commodity prices, so that that real and decline in in commodity prices, so real rates rates rose rose appreciably; appreciably; and the movements and and subsequent subsequent declines declines at at the the end end of of 1930 1930 are are the upward upward movements consistent with with an an intensification intensification of of monetary monetary stringency stringency during during the the consistent panic. panic. In any event, the relative constancy of high-grade yields does not contradict the argument bonds was was induced contradict the argument that that the the sale sale of of low-grade low-grade bonds induced by a scramble for liquidity. Temin counters that banks were net sellers of the risk more quickly of bonds bonds in in 1931 1931 because because "they "they perceived perceived the risk more quickly or or because they were more more risk risk averse averse than than individuals. individuals. The The fact fact that that they they because they were

143

Understanding 1929-1933

sold while individuals bought is not evidence of a liquidity scramble" (p. 106 n.). This ignores the effect effect that dumping securities, for whatever motives, by some banks produced on the values ofthe of the investment portfolios of other banks. As for money and income, there is no reason to expect a one-way relation. The reflex influence of bond sales in setting off off other bond sales is the essence of a liquidity crisis that Temin fails to recognize. fails to recognize. 4.A.4 4.A.4 Price Price Deftation Deflation and and the the Behavior Behavior of of Real Real Balances Balances

Temin argues that the distinction between nominal interest rates and real interest rates can be neglected. To begin with, he doubts that anyone apart from professional professional economists makes such a distinction. Further, even if if the distinction were made, it would not salvage the monetary explanation. If If high real interest rates dominated all other explanations of 1929-33, he asks, why do we not observe a similar effect effect in 1920-21 with a greater deflation and the same institutional constraint that nominal interest rates cannot be negative? There were indeed high real rates in 1920-21, but their effect effect was not prolonged by banking panic effects effects on the money stock. The final major indication for Temin that monetary causes cannot account account for for the severity severity of the economic decline is that real balances did not decline. Because prices fell so rapidly, the stock of real money balances did not fall from 1929 to 1931; hence, in his view there could not have been any deflationary deflationary effect effect from the decrease in the nominal stock of money. He asks: Why . . . should the level of real expenditures and hence of employment have been lower in, say, 1931 1931 than in 1929 since the real stock of money was larger by all of the measures shown in Table 23? (P. 142) For Temin, there is no contradiction between his assertion that the demand (Le., (i.e., demand function) for nominal balances declined while real balances (Le., (i.e., quantity of real balances held) were constant or increased. Real Real money money balances balances are are aa statistical statistical construct construct that that he he exexincreased. amines merely merely because because quantity quantity theorists theorists consider consider it it important. important. If If he he amines thought it it represented represented the the basic basic monetary monetary total total demanded, demanded, he he would would thought have had had to to explain explain why why aa decline decline in in the the demand demand for for money money did did not not have produce aa rise rise in in prices, prices, for for aa fixed nominal stock, stock, to to produce produce aa decline decline produce fixed nominal in real real money money balances. balances. in If one regards real money balances as the basic monetary total demanded, there is no evidence that the demand function declined. Gandolfi and Lothian (1976) have shown that the function that predicts actual real real money money balances for 1900-1929 1900-1929 predicts actual real real money money actual balances for predicts actual

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Anna J. Schwartz

balances during the Great Contraction with no loss in predictive power. The demand for real money balances is conventionally defined as related positively to lated positively to real real income income and and negatively negatively to to the the rate rate of of interest. interest. Hence the movement of real balances over the cycle depends on the relative relative movements movements of of the the determinants. determinants. There There is is no no evidence evidence of of aa leftward leftward shift in the demand curve during the Great Contraction. The rise balances to 1931 rise in in real real money money balances to 1931 1931 and and similarly similarly the the decline decline from from 1931 to 1933 1933 were were due due to to changes changes in in the the determinants determinants of of the the demand. demand. There There to were were movements movements along along the the demand demand function, function, not not aa shift shift in in the the function, function, as Temin Temin would would have have it. it. as Gandolfi Gandolfi and and Lothian Lothian have have also also challenged challenged Temin's Temin's assumption assumption that that a fall in the nominal quantity of money accompanied by a corresponding corresponding fall unchanged, since fall in in prices prices should should leave leave real real output output unchanged, since real real balances balances remain constant. constant. In In this this case, case, Temin Temin fails fails to to note note aa distinction distinction between between remain anticipated unanticipated price anticipated and and unanticipated price change. change. Suppose Suppose output output depends depends on the the price of output output relative relative to to expected expected price price of of inputs. inputs. An An unanunanon price of ticipated prices, given ticipated fall fall in in all all prices, given imperfect imperfect information information on on input input prices, prices, will be perceived by producers as a relative fall in output prices. Temin ignores ignores aa growing growing literature literature on on the the supply supply effect effect of of unanticipated unanticipated price price changes on on real real output output change. change. Hence Hence his his assertion assertion that that the the behavior behavior changes of of real real balances balances is is inconsistent inconsistent with with aa monetary monetary explanation explanation of of the the contraction is is untenable. untenable. contraction 4.A.S 4.A.5 The The Role Role of of Bank Bank Failures Failures As indicated earlier, Temin' Temin'ss explanation of the role of bank failures failures is that they served as the channel through which the supply of money adjusted of adjusted to to the the falling falling demand. demand. He He alleges alleges that that the the banking panic panic of October 1930 1930 was induced by the decline decline in in agricultural agricultural income income and and in October was induced by the in the prices of relatively risky long-term securities presumably held by banks and, that the banks and, in in particular, particular, that the failure failure of of the the Bank Bank of of United United States States in in the the course course of of that that panic did did not not precipitate precipitate aa liquidity liquidity crisis. crisis. In In AA Monetary we devoted devoted aa section section to to the the question question of of the the origin origin Monetary History History we of of bank bank failures failures during during the the contraction. contraction. Did Did the the failures failures arise arise primarily primarily because of because of imprudent imprudent financial practices of of the the 1920s? 1920s? Or Or were were they they financial practices the product of developments of the early 1930s? Whatever may have been true of the initial bank failures in the first banking crisis, any ex ante deterioration in the quality of loans and investments in the later twenties or simply the acquisition of lowquality loans and investments in that period, even if no different different in quality than in earlier periods, was a minor factor in the subsequent bank failures. As we have seen, the banking system as a whole was in a position to meet the. the demands of depositors for currency only by a multiple contraction of deposits, hence of assets. Under such

145

Understanding 1929-1933 1929-1933

circumstances, any runs on banks for whatever reason became to some by some extent extent self-justifying, self-justifying, whatever whatever the the quality quality of of assets assets held held by banks. banks. Banks Banks had had to to dump dump their their assets assets on on the the market market which which inevitably inevitably forced forced aa decline decline in in the the market market value value of of those those assets assets and and hence hence of of the the remaining assets assets they they held. held. The The impairment impairment in in the the market market value value of remaining of assets held held by in their their bond bond portfolios, portfolios, was was the the assets by banks, banks, particularly particularly in most important important source source of of impairment impairment of of capital capital leading leading to to bank bank susmost suspensions, rather than than the the default of specific specific loans or of of specific specific bond bond pensions, rather default of loans or issues. (P. (P. 355) issues. 355) So banks that first So even even if if we we were were to to concede concede that that all all the the banks that failed failed in in the the first banking panic beginning October 1930 were bad banks that deserved to to fail, fail, this this series series of of failures failures would would have have provoked provoked difficulties difficulties for for other other good banks, the market value of whose assets would have been affected affected by the by the by the dumping dumping of of assets assets by the failing failing banks. banks. Such Such failures failures could could well well have promoted panic among all depositors. In a panic the public is mired mired in in doubts doubts that that institutions institutions are are as as sound sound as as they they are are said said to to be. be. II believe believe that that the the concession concession to to Temin Temin about about the the first first banking banking crisis crisis is not supported by the evidence, however. Good banks went down in that panic. His that panic. His allegation allegation that that the the Bank Bank of of United United States States failed failed because because of fraudulent fraudulent practices of its officers officers will not be sustained by an impartial examination bank. The partial examination of of the the record record of of the the bank. The charge charge of of fraud fraud tells tells you something about the temper of the times, not the facts of the case. Moreover, Moreover, the the panic panic of of October October 1930 1930 does does not not stand stand alone alone in in the the U.S. monetary history if if we look back this time, not forward to the succeeding banking crises succeeding banking crises from from 1931 1931 to to 1933. 1933.Cagan Cagan (1965) (1965) noted noted in in his his study, to which Temin does not refer, that panics in U.S. monetary history appeared in the early stages of cyclical contraction and therefore therefore themselves could not have been the major cause of the contractions. He panics made He concluded concluded that that panics made ordinary ordinary business business contractions contractions severe severe when they led to a substantial decline in the rate of monetary growth and by itself, itself, and and with with and not not otherwise. otherwise. "Substantial "Substantial decline decline in in this this rate, rate, by no panic, could and has produced severe business contraction" (p. (p. 267). 4.A.6 Policy 4.A.6 Monetary Monetary Policy I tum finally to the issue of monetary policy during the Great Conturn finally traction. In A Monetary History we argued that alternative policies were available that the Federal Reserve System could have pursued and and that that would would have have made made the the contraction contraction less less severe. severe. Temin Temin refuses refuses to be be drawn drawn into into aa discussion discussion of of alternative alternative policies. policies. "The "The question question to policy would posed" posed" in in his his book book "is "is not not whether whether some some alternative alternative policy would have have worked, but rather what what happened happened to to make make such such aa corrective corrective policy policy worked, but rather desirable" desirable" (p. (p. 7). 7). Nevertheless, Nevertheless, he he has has himself himself referred referred to to alternative alternative policies, himself conducted conducted aa counterfactual counterfactual "thought "thought experiment," experiment," as as policies, himself

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he labeled our section on alternative policies. It It is counterfactual counterfactual for of Temin to state that, had there been no bank failures, the quantity of money would have been reduced to the same extent by a rise in the reserve-deposit ratio rather than the rise in the currency-deposit ratio that actually occurred. And this counterfactual counterfactual assertion is refuted refuted by Cagan's study. Temin assumes that the reserve-deposit ratio would have risen as a result of the decline in interest rates in the absence of bank failures. Cagan finds little interest elasticity in this ratio and concludes that the larger part of the change in the ratio was related to panics. A lagged reaction to a panic on the part of banks was to raise the ratio of their reserves to their deposit liabilities. But But to to tum turn to to the the main main question: question: We We do do have have some some evidence evidence for for 1930-31 on what alternative policies would have accomplished. We know that when the Federal Reserve System finally finally undertook openmarket purchases of $1 $1 billion between April and August 1932, the money money stock stock grew grew at at aa 1.75 1.75 percent percent annual annual rate rate of of rise rise from from September September 1932 until until January January 1933 1933 compared compared with with the the preceding preceding 14 14percent percentannual annual 1932 in rate rate of of decline. decline. We We know know that that industrial industrial production production rose rose 14 14 percent percent in the second half half of 1932 after after sharp earlier declines and that commodity prices in prices rose rose in in the the second second and and third third quarters quarters of of 1932 1932 after after declining declining in the two two preceding preceding years. years. Temin Temin counters counters that that we we merely merely assume assume that that the the the change change in in the the quantity quantity of of money money changes changes the the level level of of income income and and do not not disprove disprove the the possibility of reverse reverse causation. causation. Can Can he he really really mean mean do possibility of that the the Federal Federal Reserve Reserve undertook undertook the the open-market open-market purchases purchases in in 1932 that 1932 as aa passive passive response response to to an an increased increased demand demand for for money money that that was was aa as result of of rising rising output output and and prices prices that that lagged lagged the the change change in in monetary monetary result policy? There There is is evidence evidence also also on on what what alternative alternative policies policies would would have have policy? 1924 accomplished accomplished if if we we tum turn to to the the system's system's open-market open-market purchases purchases in in 1924 and 1927. 1927. The The omission omission of of discussion discussion of of these these policy policy measures measures in in Temand Temin's book book reflects reflects his his assumption assumption that that money money is is passive. passive. Supply Supply simply simply in's adjusts to to the the demand. demand. This This is is aa real-bills real-bills vision vision with with aa vengeance. vengeance. adjusts A Monetary Monetary History History we acIn In A we found found aa contrast contrast between between the the policy policy actions of the Federal Reserve in 1924 and 1927 on the one hand and 1930-33 1930-33 on on the the other. other. Elmus Elmus Wicker Wicker (1966) (1966) denies denies such such aa contrast, contrast, arguing that international considerations accounted for the open-market purchases purchases in in the the '20s '20s and and that that international international considerations considerations were were ununimportant in 1930-33. In his view, the Federal Reserve never accepted domestic domestic economic economic stability stability as as aa goal goal of of monetary monetary policy. policy. Brunner Brunner and and Meltzer (1%8) (1968) also deny the contrast, arguing that in all three contractions, tractions, if if market market rates, rates, particularly particularly short-term short-term rates, rates, fell, fell, policy policy was was regarded as as expansive, expansive, and and if if market market rates rates rose, rose, policy policy was was regarded regarded regarded as contractionary. contractionary. In In the the earlier earlier contractions, contractions, gold gold inflows inflows and and aa decline decline as in the the demand demand for for currency currency and and bank bank loans loans produced produced aa decline decline in in in interest rates rates accompanied accompanied by by an an increase increase in in high-powered high-powered money. money. As As interest

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Understanding 1929-1933

a result, money supply rose and the economy recovered. In 1929-30, 1929-30, gold inflows and declines in the demand for currency and bank loans also produced a decline in interest rates, but high-powered money and the money supply fell. Hence the economy continued to deteriorate. of the members of of But, as Brunner and Meltzer document, nearly all of the Open Market Committee regarded monetary policy as easy. We regard Wicker's view as untenable. If If the Federal Reserve did not accept domestic economic stability as a goal of monetary policy, why did the system allocate resources to improving the data on economic activity, why did the staff staff prepare detailed studies on the state of the domestic economy in preparation for open-market committee meetings, why did the system claim credit for domestic prosperity when it occurred? There is without doubt some merit to the Brunner-Meltzer analysis, yet it cannot be accepted as a complete description of of the situation. After After all, the governor and the chief chief economists on the staff staff of of the the New York Federal Federal Reserve Reserve Bank all all recognized recognized that the decline decline in interest rates was not equivalent to monetary ease; they urged, and with some some support support from from others others in in and and outside outside the the system, system, extensive extensive open-market purchases at various times in 1930, 1930, 1931, 1931, and 1932 1932 and were not not dissuaded dissuaded from from doing doing so so by the decline decline in in interest interest rates. And these were were the the people people who, who, so so long long as as Benjamin Benjamin Strong Strong was these was alive, alive, effectively effectively dominated dominated Federal Federal Reserve Reserve policy. policy. Hence, Hence, we continue continue to to believe Strong lived lived or or had been succeeded succeeded by by someone someone believe that that had had Strong had he he been of similar similar views views and and equal equal personal personal force, force, the the same same monetary growth of monetary growth policies in 1924 1924 and and 1927 1927 would followed in in 1930, would have have been been followed 1930, policies followed followed in hence the the decline decline in in high-powered high-powered money money either either would would not hence not have have ococcurred or or would have been been promptly reversed, and and the economy would would would have promptly reversed, the economy curred have been spared its its prolonged ordeal. have been spared prolonged ordeal.

Notes 1. the business-cycle 1. In In their their study study of of production production during during the business-cycle contraction contraction of of 1929192933, W. C. C. Mitchell F. Bums noted: 33, W. Mitchell and and A. A. F. Burns (1936) (1936) noted:

The was interrupted by three revivals. Of Of The long long decline decline was interrupted by three partial partial and and abortive abortive revivals. these, the first, first, in months of mainly these, the in the the early early months of 1930, 1930, was was brief brief and and restricted restricted mainly to automobiles, automobiles, steel, steel, and and heavy construction. The The second, second, in in the to heavy construction. the first first half half of 1931, 1931, had scope, lasted lasted longer, longer, and and went further. It It was was especially especially of had wider wider scope, went further. pronounced in in the the textile, rubber tire, tire, shoe, shoe, and and leather leather industries. industries. The pronounced textile, rubber The revival in the summer and and autumn autumn of of 1932 1932 was was fairly fairly general, general, as as isis indicated indicated revival in the summer by the preceding discussion of of the the "double "double bottom" in the by the preceding discussion bottom" in the terminal terminal trough trough of this this cycle. cycle. In In some some industries industries one one of of these abortive revivals revivals lasted lasted long of these abortive long enough and and went far enough enough to an "extra" "extra" specific specific cycle cycle during during the the enough went far to produce produce an depression. (P. (P. 18) depression. 18)

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2. Haberler Haberler (1976, pp. 22-23) notes that the Majority Majority Report of of the Gold Delegation of of the Financial Committee of of the League of of Nations in 1932 also maladjustments caused by the war, but Gustav attributed the depression to maladjustments Cassel in a Memorandum Memorandum of of Dissent disputed the importance of of maladjustments maladjustments phenomena—the undervaluation undervaluation of of the French and stressed instead monetary phenomena-the overvaluation of of the pound, the cessation of of U.S. capital exports, franc, the overvaluation Maladjustments were also the explanation of of the and the U.S. depression. Maladjustments advanced in later studies issued by the Royal Institute of of Great Depression advanced International Affairs Affairs (Arndt (Arndt 1944) 1944) and and the the United United Nations Economic CommisCommisInternational Nations Economic sion for for Europe Europe (Svenillson (Svenillson 1954). 1954). sion 3. Abramovitz, in private correspondence with me, has called to my attention attention qualifications qualifications to this statement statement in his paper. He notes that since the "smallcountry" model in that paper was designed to apply to long swings, it was inappropriate for use within a single business-cycle contraction and, in any of a event, could not apply in full force to the United States. On the basis of subsequent paper paper (1977), (1977), in which he analyzed models of of a "large country" country" subsequent efforts by the Federal Reserve to and a "small country," Abramovitz believes efforts sustain the growth of of the U.S. money money supply supply in in 1930-31, 1930-31, unaccompanied unaccompanied by by the U.S. sustain the growth similar actions actions by by leading leading European European countries, countries, would would not not have have been been adequate adequate similar to prevent prevent the the massive massive decline decline in in income income that that in in fact fact occurred. occurred. to interpretation ofinterest of interest 4. See the appendix for a demonstration that Temin's interpretation 1931 is conrate movements as showing no monetary stringency in 1930 and 1931 of and demand for the relevant moneytradicted by evidence on the supply of market instruments during that period. 5. Christopher Christopher Sims (1972) introduced a sophisticated sophisticated alternative test of of Granger causality between a pair of of variables by running two regressions, with dependent variable and both leading and lagged values of of the other as each as dependent independent variables. independent 6. George Garvy (1959, pp. 71-73) has shown that bank debits to deposit accounts at these centers is a good proxy for nominal income. Peter Lindert of (1981) objects to this conclusion since Garvy (p. 87) also reports a lack of perfect conformity of of cyclical movements in debits with interwar NBER NBER refperfect conformity erence dates (debits lag the turns in January 1920 and July 1921 and skip turns in October October 1926 1926 and and November November 1927). 1927). Nonetheless, Moore (1961, (1961, vol. vol. 1, 1, chap. chap. Nonetheless, Moore in of coincident im.licators indicators for that period. Gordon 5) includes debits in his list of (1981), using quarterly GNP estimates, obtained results similar to and Wilcox (1981), those in in table table 4.2. 4.2. those 7. Eight years because of of the need to include lagged values. 8. One other approach to determine unidirectional relationship that some investigators have reported reported involves cross-correlations of of the innovations in and Y processes processes derived derived from from Box-Jenkins Box-Jenkins procedures. Christopher Christopher Sims X and (1977a) (1977#) has criticized that approach as biased "for "for any null hypothesis except of no relation between the series." The defect defect in testing the null hypothesis of "JC causes v," he points out, in a formulation formulation whether "x (1)y (l)y == a(L)y a(L)y + + b(L)c(L)x b(L)c(L)x + + v, v,

"with "with a, b, and c, as polynomials in positive powers of of the lag operator, L, L, and v uncorrelated uncorrelated with past values of of yy or x," JC," is as follows: follows:

The null hypothesis "x "JC does not cause yy"" is represented represented by b(L) b(L) == O. 0. Whether Whether or not a, b, and c are linear in the problem's parameters, maximum likelihood will be, for stationary x, y, y, asymptotically equivalent equivalent to choosing

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Understanding 1929-1933

a, b, b, and and cc to to minimize minimize the the sum sum of of squares squares of of vv in in the the sample sample period. period. With With a, anyfixed c, an an asymptotically asymptotically valid valid test test ofthe of the null null hypothesis hypothesis can can be be obtained obtained any fixed c, by estimating estimating aa and and bb jointly by maximum maximum likelihood likelihood or or nonlinear nonlinear least least jointly by by squares, then then applying applying standard standard test test statistics. statistics. Though Though this this is is not not aa difficult difficult squares, procedure, [the [the criticized criticized author] author] instead instead chooses chooses cc as as aa filter which makes makes procedure, filter which c(L)x serially serially uncorrelated, uncorrected, and and chooses chooses aa as as aa filter which makes makes a(L)y c(L)x IDter which a(L)y serially uncorrelated, uncorrected, then then holding holding aaand andcfixed, cfixed,estimates estimatesb.b.But Butthis thisamounts amounts serially to testing the significance significance of of bb by estimating the regression (1) (1) with with bb to testing the by first first estimating the regression set to to zero, zero, then then testing testing for for the the contribution contribution of of bb to to the the regression regression by by exexset amining correlations correlations between the residuals residuals of of this this first-stage equation and and first-stage equation amining between the the omitted omitted variables variables of of the the form form c(L)x. c(L)x. Anyone Anyone versed versed in in the the theory theory ofleastof leastthe squares regression regression will will recognize recognize this this as as involving involving aa bias bias in in favor favor of of the the null squares null hypothesis, except except in in the the special special case case when when the the omitted omitted variables variables are are unhypothesis, uncorrected with with the the included included variables. variables. (P. (P. 24) correlated 24) 9. 9. Contrary Contrary to to Temin Temin (1981), (1981), the the monetary monetary events events listed listed in in the the tabulation tabulation are, in are, in in the the main, main, not not "changes "changes in in the the quantity quantity of of money" money" or or "changes "changes in [market] interest interest rates." rates." They They are are events, events, like like aa change change in in the the Federal Federal Reserve Reserve [market] discount rate rate or or an an episode episode of of bank bank runs runs or or Britain's Britain's departure departure from from gold gold or or discount the 1932 1932 open-market open-market purchase purchase program, program, that that are are newsworthy newsworthy and and attract attract the attention. They They have have immediate immediate announcement announcement effects. effects. Moreover, Moreover, aa quick quick adadattention. justment of prices prices does does not not preclude preclude aa long long distributed distributed lag lag adjustment. adjustment. A A partial partial justment of adjustment that that shows shows up up quickly quickly is is not not equivalent equivalent to to the the full full adjustment adjustment of of adjustment prices. prices. 10. journal article 10. In In aa journal article that that postdates postdates Temin's Temin's review, review, Barber Barber (1978) (1978) traces traces the origins that he the origins of of the the Great Great Depression Depression to to demographic demographic factors factors that he links links to to aa decline in in the the residential residential construction construction market market in in the the United United States States and and to to "a "a decline markedly unfavourable unfavourable influence influence on on the the capital capital spending spending plans plans of of business business firms firms markedly throughout the the developed developed world" world" (p. (p. 453). throughout 453). Annual Annual growth growth in in standardized standardized nonfarm nonfarm households households declined declined from from 33 percent percent per year year to to under under 22 percent percent per per year year from from 1924 1924 to to 1932. 1932. This This is is supposed supposed to to per have triggered triggered the the decline decline in in U.S. U.S. residential residential construction. construction. Yet Yet the the annual annual have growth in in standardized standardized nonfarm nonfarm households from the the early early 1950s 1950s to to 1970 1970 was was growth households from lower than than growth growth of of households households in in any any year year from from 1924 1924 to to 1932. 1932. Barber Barberattempts attempts lower to rationalize this this inconsistency inconsistency by by citing citing the the availability availability of of mortgage mortgage finance to rationalize finance since World World War War II. II. In In that that case, case, the the demand demand for for housing housing is is not not dependent dependent on on since demographic factors factors exclusively. exclusively. demographic War Similarly, Similarly, aa rapid rapid decline decline in in the the rate rate of of population population growth growth after after World World War II in in developed developed countries, countries, which which was was accompanied accompanied by by aa lower lower rate rate of of laborlaborforce force growth growth in in the the United United States States and and Germany, Germany, need need not not have have had had the the conconsequence he he assumes assumes on on capital capital spending. spending. What What evidence evidence is is there there that that firms firms sequence throughout the the world world were were aware aware of of this this demographic demographic trend? trend? throughout Essentially, Essentially, Barber Barber fails fails to to establish establish aa connection connection between between his his empirical empirical evidence evidence on on the the decline decline in in population population and and disequilibrium disequilibrium in in the the steady-state steady-state growth Disgrowth model model he he presents presents and and aa model model that that would would explain explain recessions. recessions. Disequilibrium in in aa steady-state steady-state sense sense does does not not explain explain why the peak peak in in capital capital equilibrium why the spending occurred occurred in in 1929 1929 rather rather than than 1928 1928 or or 1930. spending 1930. 11. tries to 11. Temin Temin tries to determine determine (1976, (1976, p. p. 64) 64) from from the the components components of of real real GNP GNP whether 1930 1930 was was aa more more depressed depressed year year than than 1921 1921 or or 1938. 1938. Table Table 4.4, 4.4, based based whether on Commerce Commerce annual annual estimates estimates of of GNP GNP in in current current and and 1958 1958 prices, prices, the the GNP GNP on implicit price price deflator, deflator, and and the the unemployment unemployment rate, rate, is is an an alternative alternative to to Temin's Temin's implicit table which which shows shows percentage percentage changes changes in in Kendrick's Kendrick's annual annual GNP GNP estimates estimates table

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in 1929 prices, the consumption consumption and investment investment expenditures components of of GNP, and merchandise exports deflated deflated by wholesale prices. For the Comof GNP are available only since 1929. The merce estimates, the components of of table 4.4, following Temin, relates the changes in the year following following first part of of the peak year. The the peak in 1920, 1929, and 1937, to the magnitudes of half of of the table relates the changes in the year following those peaks bottom half to the the year year preceding preceding the the peaks peaks on on the the ground ground that that the the 1929 1929 magnitudes magnitudes were were to not typical typical of of the the interwar interwar years. years. One One may may ask ask whether whether 1920 1920 or or 1937 1937 was was any any not more typical. typical. In In any any event, event, such such comparisons comparisons between between consecutive consecutive or or nearly nearly more consecutive annual annual figures figures are are subject subject to to substantial substantial error error because because of of possible possible consecutive differences in in patterns within the the base base year year and and the the comparison comparison year. year. For For differences patterns within example, aa cyclical cyclical peak peak in in December December preceded preceded by by aa rapid rapid rise rise during during the the year year example, might be be accompanied accompanied by by aa zero zero year-to-year year-to-year change, change, despite despite aa severe severe recession. recession. might whatever such comparisons may be worth, the real income decline was For whatever somewhat somewhat greater in 1930 than in 1921, 1921, the rise in unemployment unemployment was smaller, of these respects, 1938 was and the price decline was much smaller. In all of much the mildest of of the three contraction years. Over a two-year span, the results show show the the 1930 1930 change change to to be be even even milder milder relative relative to to 1921. 1921. Of Of course, course, results 1930 was was aa contraction contraction year year from from beginning beginning to to end, end, whereas whereas in in 1921 1921 aa trough trough 1930 was reached reached in in July, July, and and in in 1938, 1938, in in June. June. In In addition, addition, Temin's Temin's use use of of gross gross was merchandise exports exports as as if if that that were were an an independent independent component component of of GNP GNP is is merchandise misleading. The The variable variable normally normally examined examined in in the the national national income income accounts accounts misleading. is net net export export of of goods goods and and services. services. The The change change in in the the variable variable from from 1929 1929 to to is 1930 is is one-third one-third the the magnitude magnitude of of the the change change Temin Temin reports reports for for gross gross mermer1930 chandise exports. exports. chandise What sets 1930 apart from both 1921 and 1938 is that a banking panic that changed the monetary character character of of the contraction contraction occurred occurred in the last quarter quarter of the year. In 1921 1921 there were many bank suspensions-triple suspensions—triple the number in of of 505 banks with deposits of of $172 million. In 1930, there were 1920, for a total of 1,350 bank suspensions, with deposits of of $837 million. In 1938, post-FDIC, 1,350 suspensions are are negligible, negligible, 54 54 banks banks with with $10 $10 million million in in deposits. deposits. Despite Despite the the suspensions increase in in bank bank suspensions suspensions in in 1921, 1921, there there were were no no runs runs on on banks. banks. That That is is increase what distinguishes distinguishes 1930 1930 from from 1921-there 1921-there was was panic panic in in 1930 1930 but but not not in in 1921. what 1921. Bank suspensions suspensions in in 1921 1921 were were perceived perceived by by the the public public as as special special problems problems of of Bank agricultural and and rural rural areas areas but but not not as as affecting affecting confidence confidence in in banks banks generally. generally. agricultural 12. On the role of of real wages, see section 4.5 of of this paper. Smoot-Hawley tariff tariff level even higher than 13. The fall in prices made the Smoot-Hawley it otherwise would have been since specific duties are automatically raised with a declining price level (Haberler 1976, p. 34, n. 65). Meltzer (1976, pp. 45960) assigns a large role to the Smoot-Hawley Smoot-Hawley tariff tariff and subsequent subsequent tariff tariff retaliation by by many many countries countries in in exacerbating exacerbating the the 1929-33 1929-33 contraction. contraction. The The effect effect taliation of the the tariffs tariffs was was to to impede impede the the price-specie price-specie flow flow mechanism mechanism and and the the adjustment adjustment of of the the U.S. U.S. and and the the world world economy. economy. Absent Absent the the tariff, tariff, U.S. U.S. prices prices would would have have of fallen relative relative to to those those abroad abroad and and led led to to an an increase increase in in foreign foreign demand demand and and fallen net exports. exports. net The protectionist protectionist policy that influential influential British economists in 1930 advised government to adopt played a role there parallel to that of of the the British government Smoot-Hawley tariff tariff in the United States. In his memoir about the "golden *'golden Smoot-Hawley of the great British economists, Colin Clark (1977) discusses a "might"mightage" of have-been": It is now unmistakably clear that what Britain, being still a power strong enough to give a lead to the world, should have done in 1930-31, irrespective

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Understanding 1929-1933 1929-1933

of of whether or not other countries so acted, would have been to have preserved Free Trade, accompanied by an expansionist demand policy, and allowing the exchange rate to move freely in response to market pressures. It is now universally agreed that the exchange rate had been overvalued on the return return to to the the Gold Gold Standard Standard in in 1925, 1925, and and aa reduction reduction would, would, in in any any case case the have been been required. required. (Though (Though he he had had protested protested strongly strongly against against the the overvalovervalhave uation in in 1925, 1925, Keynes Keynes himself himself was was not not recommending recommending devaluation devaluation in in 19301930uation 31—the only only prominent prominent men men to to recommend recommend the the policy policy were were R. R. G. G. Hawtrey, Hawtrey, 31-the the Treasury's Treasury's economic economic adviser, adviser, and and Ernest Ernest Bevin.) Bevin.) Once Once the the exchange exchange rate rate the had been been freed, freed, aa strongly strongly expansionist expansionist policy policy would would have have been been possible. possible. had The preservation preservation of of free free trade trade would would have have allowed allowed the the benefits benefits of of this this exexThe pansion to to flow flow to to other other countries countries and and also, also, aa matter matter of of equal equal importance, importance, pansion would have have set set the the right right example, example, and and spread spread economic economic expansion expansion more more would widely over over the world. (P. (P. 90) 90) the world. widely Clark's "might-have-been" applied a fortiori to the case of the United States. 14. In A Monetary Monetary History, History, we noted that since China was on a silver standard, it was hardly affected affected internally, 1929-31, by the worldwide economic economic contraction. Choudri and Kochin (1977) provide similar evidence for Spain for those years. Spain then had flexible exchange rates and a reasonably stable monetary policy. policy. monetary 15. Allan Meltzer (1976) traces the start of of the contraction to "economic "economic policies in the United States and other countries operating under the rules of the interwar gold standard" (p. (p. 457). In his view, a relative decline in prices in the the United United States, States, as as in in 1928-29, 1928-29, under under the the price-specie price-specie flow flow mechanism mechanism in can induce induce aa recession recession abroad. abroad. He He attempts attempts to to account account for for subsequent subsequent U.S. U.S. can price change change by by relating relating anticipated anticipated price price change change at at the the start start of of the the year year to to the the price average rate rate of of monetary monetary growth growth in in the the preceding preceding three three years years relative relative to to the the average rate of of monetary monetary expansion expansion in in the the most most recent recent year, year, with with acceleration acceleration from from rate the maintained maintained average average having having much much the the larger larger effect effect under under the the gold gold standard. standard. the He regards regards his his predicted predicted rates rates of of U.S. U.S. price price change change for for 1930-31 1930-31 and and 1933 1933 as as He not substantially substantially different different from from actual actual price price change. change. For For 1932, 1932, when when the the preprenot dicted rate rate was was only only half half the the actual actual rate rate of of price price decline, decline, he he concludes concludes the the dicted decline cannot cannot be be explained explained by by the the price-specie price-specie flow flow mechanism mechanism and and the the exexdecline pected response response to to monetary monetary contraction. contraction. pected 16. The percentage of of eligible paper offered for rediscount rejected by the Reserve Banks of New York, Dallas, Philadelphia, and St. Louis (of those reporting such figures) was higher in 1930 than in 1929, possible evidence that acceptability standards were higher despite the decline in discount rates. Of course, member banks had the option of borrowing against their 15-day promissory notes secured by government obligations. See Beckhart, Smith, and Brown (1932). 17. Minor increases in yields on short- and long-term governments and on municipals are reported for December 1930 and March-April 1931. Brunner and Meltzer (1968) interpret the persistent decline in short-term interest rates despite currency drains and bank failures as the result of of adventitious factors offsetting offsetting the effects on short-term market rates that would otherwise have have been been observed. observed. They They cite cite an an inflow inflow of of gold-mostly gold—mostly from from South South otherwise America and and Japan-in Japan—in the the last last quarter quarter of of 1930 1930 (p. (p. 343). America 343). 18. On the change in the character of of the commercial paper market since the 1920s, see Selden (1963). The commercial paper market during the 1920s is discussed in Beckhart (1932).

5

A Century of British Market Market Interest Interest Rates, Rates, 1874-1975 1874-1975

5.1 Introduction Henry Thornton left a spare account-best account—best described by the Latin phrase, phrase, multum in parvo, much much in in little-of little—of his his thoughts thoughts about about the the British monetary system during the Napoleonic era. That spare account is the elements is an an incredibly incredibly rich rich source source both both of of the elements of of monetary monetary theory theory Anyone and of instruction on the proper conduct of monetary policy. Any one of work could of aa dozen dozen different different insights insights recorded recorded in in Thornton's Thornton's work could serve serve as the the subject subject of of this this lecture. lecture. He He understood: understood: as the fallacy of the real-bills doctrine, the distinction first-round and monthe distinction between between the the first-round and ultimate ultimate effects effects of of monetary change, the lag in effect effect of monetary change, the problem market participants faced in distinguishing relative from general general price price changes, changes, the distinction between internal and external gold drains, the the role role of of the factors factors influencing influencing the the foreign foreign exchanges exchanges including including the purchasing power parity, how how to to bring bring inflation inflation under under control, control, the relation of the Bank of England to other English banks, types of effects effects of monetary disturbances on interest rates, the distinction between the market rate and the natural rate of interest and real rates rates of and between between nominal nominal and and real of interest. interest. of From this impressive list of ideas, I have chosen as my point of departure nominal and departure what what Henry Henry Thornton Thornton had had to to say say about about nominal and real real interest rates. I shall then tum turn to a review of the behavior of market interest with some interest rates rates in in Britain Britain in in the the century century from from 1874 1874 to to 1975, 1975, with some reference also to the differences differences between the British and American 152

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record. The historical material is drawn from a study, now nearing completion, of monetary trends in the United States and the United Kingdom, on which I have collaborated with Professor Professor Milton Friedman. Henry Thornton Thornton was was among among the the first to call call attention attention to to the the disHenry first to distinction tinction between the the nominal nominal and and real real rate rate of of interest. interest. He He explained explained the difference difference by by the the anticipated anticipated rate rate of of inflation. inflation. On On this this view, view, when when the inflation inflation comes comes to to be be anticipated, anticipated, lenders lenders demand demand and and borrowers borrowers are are willing to pay higher interest rates to compensate for the expected decline decline in in the the purchasing purchasing power power of of the the principal principal of of and and interest interest on on the the loan. The The nominal nominal interest interest rate rate is is then then aa sum sum of of the the real real rate rate of of interest interest loan. and and the the expected expected percentage change change in in the the price level. level. The The Usury Usury Laws in in force force when when Thornton Thornton lived lived made made the the permitted maximum Laws permitted maximum interest interest rate rate in in Britain Britain 5%. 5%. To To describe describe the the price price anticipations anticipations effect effect on interest interest rates, rates, Thornton Thornton had had to to cite cite aa case case other other than than an an English English on one. He He wrote: wrote: one.

Accordingly, in in countries countries in in which which the the currency currency was was in in aa rapid rapid Accordingly, course course of of depreciation, depreciation, supposing supposing that that there there were were no no usury usury laws, laws, the current current rate rate of of interest interest was was often often .. .. .. proportionably proportionably augaugthe mented. mented. Thus, Thus, for for example, example, at at Petersburgh, Petersburgh, at at this this time time [1811], [1811], the the current interest interest was was 20 20 or or 25 25 per per cent, cent, which conceived to to be be current which he he conceived partly partly compensation compensation for for an an expected expected increase increase of of the the depreciation depreciation of the currency. Much Much later later in in the the nineteenth nineteenth century, century, Irving Irving Fisher Fisher expressed expressed the the same idea, idea, which which he he subsequently subsequently elaborated elaborated in in mathematical mathematical form. form. same The The question question II propose propose to examine examine is is the extent extent to to which which Thornton's Thornton's and later later Irving Irving Fisher's Fisher's views views are are confirmed confirmed by by the the empirical empirical behavior behavior and of of interest interest rates rates in in Britain Britain during during the the century century from from 1874 1874 to to 1975. 1975.1I shall shall first report report on on the the behavior of average average nominal nominal yields on three catefirst behavior of yields on three categories of of assets: assets: short-term short-term nominal nominal assets, assets, long-term long-term nominal nominal assets, assets, gories and physical physical assets, assets, specifically, specifically, the the short-term short-term rate rate on on three-month three-month and bankers' bills; the the long-term long-term rate rate on on consols; consols; and and aa proxy yield yield on on physical assets, assets, namely, namely, the the rate rate of of change change of of nominal nominal income. income. II shall shall physical of then then discuss discuss the the behavior behavior of of average average real real yields yields on on these these categories categories of assets. Finally, Finally, II shall shall discuss discuss the the relation relation between between nominal nominal interest interest assets. rates rates and and the the rate rate of of price price change. change. In In the the study study from from which which this this evidence evidence is is drawn, drawn, we we express express the the data data as an average over a business expansion from cyclical trough to cyclical clical peak peak or or aa business business contraction contraction from from cyclical cyclical peak peak to to cyclical cyclical trough, sometimes referred referred to as half-cycles. In all, there are thirtyfive five such such half-cycles half-cycles for for Britain Britain during during the the period period we we cover. cover. II shall shall also report report the the averages averages over over peacetime peacetime half-cycles half-cycles and and over over various various also subperiods. subperiods.

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5.2 Average Nominal Yields Over the century the several average nominal yields display a relation consistent consistent with with expectations. expectations. The The short-term short-term yield yield averaged averaged 3.5%, 3.5%, the the long-term yield 4.2%, the difference difference of 77 basis points presumably reflecting of reflecting aa liquidity liquidity premium premium which which studies studies of of the the term term structure structure of interest rates rates have have shown shown to to exist. exist. interest The The proxy proxy for for the the nominal nominal yield yield on on physical physical assets assets is is nearly nearly identical identical with the nominal yield on long-term assets, as if if arbitrage operated to equate equate the the yields yields over over the the century. century. The The equality equality does does not, not, however, however, hold for for subperiods, subperiods, and and the the difference difference between between nominal nominal yields yields on on hold nominal nominal assets assets and and on on physical physical assets assets turns turns out out to to be be aa sensitive sensitive index index of economic economic conditions. conditions. of A A comparison comparison of of nominal nominal yields yields in in the the United United States States with with those those in in Britain over the period as a whole shows US yields to be about onehalf point higher. half of of one one percentage percentage point higher. However, However, the the yields yields for for the the two two countries are are not not directly directly comparable comparable because because of of changes changes in in the the exexcountries change change rate. rate. The The price price of of the the pound pound in in dollars dollars at at the the end end of of our our period period was lower lower than than at at the the beginning, beginning, the the rate rate of of decline decline averaging averaging 0.9% 0.9% per per was year. year. Hence, Hence, aa hypothetical hypothetical long-lived long-lived Englishman Englishman who who had had purchased purchased US assets· assets at at the the beginning beginning of of the the period, period, held them throughout throughout the the US held them period, and and converted converted them them back back to to pounds pounds at at the the end end of of the the period period period, would have have earned earned in in pounds pounds 0.9 0.9 percentage percentage points points more than the the would more than nominal US US yields. yields. Alternatively, Alternatively, an an American American who who did did the the same same with with nominal British assets assets would would have have earned earned in in dollars dollars 0.9 0.9 percentage points less less British percentage points the nominal nominal British British yields. yields. The The difference difference between between the the yields yields in in the the the two countries countries in in comparable comparable terms terms is is therefore therefore roughly roughly 1.4 1.4 percentage percentage two points rather rather than than one-half one-half of of one one percentage percentage point. point. This This difference difference is is points consistent with with the the net net outflow outflow of of capital capital from from Britain Britain to to the the United United consistent States for for much much of of the the period, period, offset offset not not by by aa private private return returnflow States flow induced induced by interest interest rate rate differentials differentials but but by by UK UK government government repatriation repatriation of by of capital during during World World Wars Wars II and and II. II. capital 5.3 5.3 Ex-Post Ex-Post Real Real Yields Yields We We calculate calculate the the ex-post ex-post real real yield yield by by subtracting subtracting the the rate rate of of change change of prices from the nominal yield for all three categories of assets. Henry Thornton's exThornton's description description of of the the relationship relationship between between nominal nominal and and expost real yields yields is is apt: apt: post real

. . . if, if, for for example, example, aa man borrowed of of the the Bank Bank £1000 £1000 in in 1800, 1800, and and ... man borrowed paid it it back back in in 1810, 1810, having having obtained obtained it it by by means means of of successive successive loans loans paid through that that period, period, he he paid paid back back that that which which had had become become worth worth less less through by 20 20 or or 30 30 per per cent cent than than it it was was worth worth when when he he first first received received it. it. He He by would have have paid paid an an interest interest of of £50 £50 per per annum annum for for the the use use of of this this would

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money; but if money; but if from from this this interest interest were were deducted deducted the the £20 £20 or or £30 £30 per per annum, which he he had the fall in the the value value of money, he annum, which had gained gained by by the fall in of money, he would find that that he he had had borrowed would find borrowed at at 22 or or 33 per per cent, cent, and and not not at at 55 per per cent, as as he appeared to to do. do. cent, he appeared The The relation relation among among the the ex-post real real yields yields on on our our three three categories categories of the century the same relation among of assets assets over over the century we we cover cover is is the same as as the the relation among the yields. However, between the United States However, as as between the United States and and Britain, Britain, the nominal nominal yields. the No further the real real yields yields are are directly directly comparable. comparable. No further adjustment adjustment for for exexchange change rate rate changes changes is is required required because because all all yields yields are, are, as as it it were, were, expressed expressed in in the the prices, prices, and and hence hence exchange exchange rate, rate, of of aa given given base base date, date, in 1929. in this this study, study, 1929. The real yield, yield, that that is is the the average The real the excess excess of of the the nominal nominal yield yield over over the average rate of of inflation, inflation, averaged averaged about about H% \\% for for Britain, Britain, about about 3% 3% for for the the United reason the yield exceeded the UK UK yield yield more United States. States. The The reason the US US yield exceeded the more for nominal yields yields is rose on the average for real real than than for for nominal is that that British British prices prices rose on the average more rapidly rapidly than prices, aa difference that was was reflected reflected in in more than American American prices, difference that the average the exchange the average behavior behavior of of the exchange rate. rate. 5.4 Yields in Peace-Time Cyclical Phases When the averages, When war-time war-time phases phases are are excluded excluded from from the averages, it it is is no no longer longer true that that the proxy measure measure ofthe yield on true the proxy of the yield on physical physical assets assets approximates approximates the yield on on long-term long-term nominal nominal assets. assets. It is is decidedly decidedly lower lower than than yields yields on nominal assets. on either either shortshort- or or long-term long-term nominal assets. The The excluded excluded war-time war-time phases phases are are inflationary inflationary phases, when when yields yields on on physical physical assets assets have have tended yields on nominal assets. tended to to be be higher higher than than yields on nominal assets. In In addition, addition, govgovernmental rates on in ernmental policy policy of of holding holding down down interest interest rates on nominal nominal assets assets in World War II also contributed to the change in the differential return World War II also contributed to the change in the differential return on physical assets on nominal nominal and and physical assets in in war war and and nonwar nonwar phases. phases. The yields between peace-time and The assets assets that that differ differ most most in in real real yields between peace-time and all all phases, however, nominal, not physical, assets. phases, however, are are nominal, not physical, assets. The The proxy proxy for for the the nominal phases than nominal return return on on physical physical assets assets is is higher higher for for all phases than for for peacepeacetime phases by by only than the rate of time phases only aa trifle trifle less less than the differential differential rate of inflation, inflation, so real return return on physical assets all so that that the the real on physical assets is is only only slightly slightly lower lower for for all phases phases only. phases than than for for peace-time peace-time phases only. By By contrast, contrast, the the nominal nominal return return on the same phases as on nominal nominal assets assets is is about about the same for for all all phases as for for peace-time peace-time phases, so the real real return return is phases, so that that the is appreciably appreciably less less for for all all phases. phases. The The war-time periods highlight aa point point to to which which II shall revert in war-time periods highlight shall revert in discussing discussing other namely yields yields on other periods, periods, namely on nominal nominal assets assets for for the the most most part part behave behave as if if price price changes changes were unanticipated. as were unanticipated. We between nominal nominal yields yields on nominal assets We distinguish distinguish between on nominal assets and and nomnominal yields on physical assets. inal yields on physical assets. There There is is no no comparable comparable explicit explicit distincdistinction in but he tion in Henry Henry Thornton's Thornton's writings, writings, but he does does make make the the distinction distinction

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implicitly. The man who borrowed £1000 in 1800 used the proceeds, he tells us, "by investing his money either in land or in successive commercial undertakings . . . and then finally finally selling his land or his commodities in the year 1810." At the sale, the man "would find the produce amount[ed] amount [ed] to £200 or £300 above the £1000 which he had borrowed," that is by the extent of the price rise over the decade, as estimated by Thornton. The point of the distinction is that nominal yields on nominal assets are contracted in advance, reflecting anticipated price changes, but not unanticipated price changes. The borrower of the £1000 knew in advance that he would have to pay £50 a year in interest. The ex-post real yield on the loan reflected reflected in full the unanticipated price change. The real yield on the £1000 loan made at 5% was only 2 or 3% because of unanticipated inflation. For physical assets, on the other hand, neither the nominal nor the real yield, as measured, is contracted in advance. The investor in land or in successive commercial undertakings did not know in advance what either the nominal or real yield would be at the time of sale. What is clear from Thornton's example is the reflection reflection in the sale price of of the estimated rate of of price rise in Britain from 1800 to 1810. There is, as it were, a measure of automatic indexing of yields on physical assets. Reflecting this difference difference in the characteristics of nominal assets and physical assets, nominal yields on nominal assets are consistently less variable than the real yields on nominal assets, whereas the reverse is true for yields on physical assets. The real yield on physical assets tends to be less variable than the nominal yield.

5.5 S.S

Yields during Sub-Periods Sub-Periods Yields during

We subdivide the century we cover into sub-periods, by separating the pre-World before 1896, when prices the pre-World War War II period period into into the the period period before 1896, when prices were generally falling, and the subsequent period, when prices were generally rising, separating out the war periods, and treating the interwarperiod terwar period as one unit, because of the paucity of of phase observations, even though the the behavior behavior of varied greatly even though of prices prices varied greatly during during the the nearly nearly two two decades covered. covered. On On the average, however, interwar period period was was decades the average, however, the the interwar certainly postwar period period requires requires no no certainly aa period period of of falling falling prices. prices. The The postwar subdivision. It It clearly is a period of generally rising prices. We therefore We therefore have have two two periods periods of of generally generally falling falling prices prices (before (before 1896, 1896, and interwar), two war-time periods of rising prices, and two peacetime post-World War War 11). time periods periods of of rising rising prices prices (1896-1914, (1896-1914, post-World II). Using Using the division division into into periods, we can can supplement supplement the the conclusions conclusions for for the the the periods, we period period as as aa whole whole with with respect respect to, to, first, first, the the differences differences between between Britain Britain and the United States; States; second, second, the effect of of price experience on on the the and the United the effect price experience

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differential differential between the yields on nominal and on physical assets. We confine the comparisons for the subperiods to the short rate and the proxy yield on physical assets, omitting long rates. 5.6 US-UK Differential Differential Yields 5.6 US-UK Yields If If the the differential differential of of the the short short rate rate as as between between the the United United States States and and Britain Britain is is examined examined over over the the six six subperiods, subperiods, it it shows shows aa steady steady decline decline from period to to period, period, with particularly sharp prefrom period with aa particularly sharp decline decline from from the the pre1896 to the 1896 1896 to to World World War War II period. period. In In the the pre-18% pre-1896 period, the period, the 18% to the short rate rate was was 2.5 2.5 percentage percentage points points higher in the the United United States States than than short higher in in Britain. Britain. In In the the post-World War II II period, the short short rate rate was was 1.5 1.5 in post-World War period, the percentage points points lower lower in in the the United United States States than in Britain. Britain. percentage than in Different Different factors factors played played aa role role in in different different sub-periods sub-periods in in contributing contributing to yield. The in to the the decline decline in in the the differential differential yield. The most most interesting interesting episode episode in the decline decline of of the the differential differential occurred occurred in in the the pre-1896 pre-1896 period, period, when when the the differential differential averaged averaged one one percentage higher than than in in the the subthe percentage point point higher subsequent period to World World War War I. I. A substantial increase increase in in the the degree degree of A substantial of sequent period to financial sophistication sophistication in in the the United United States States relative relative to to that that in in Britain Britain financial as between between the two pre-World pre-World War War II periods periods could could have have produced produced aa as the two decline in in the market rate rate of of interest interest on on nominal assets like like commercial commercial decline the market nominal assets paper that was in active active US US financial However, aa paper that was traded traded in financial markets. markets. However, detailed examination of the US-UK differential year by year contradetailed examination of the US-UK differential year by year contradicts this interpretation. There was no gradual reduction in the differdicts this interpretation. There was no gradual reduction in the differential such as might be expected from a gradual growth in financial ential such as might be expected from a gradual growth in financial sophistication. The The differential differential rather shows an an abrupt abrupt drop drop from from one one sophistication. rather shows level from from 1874 1874 though though 1896, 1896, to another level level from from 1897 1897 to to 1914, 1914, with with to another level sizable year-to-year year-to-year fluctuations about those those levels. levels. The The extreme extreme values values sizable fluctuations about for 1893 1893 and and 1896 1896 suggest suggest an an explanation explanation for for the the drop drop in in level. level. The The for extreme value in 1893 1893 reflects the banking banking panic panic of of that that year year in in the the reflects the extreme value in United States, States, which led after after July July to to aa restriction of cash cash payments payments United which led restriction of by and to to aa market market premium on currency, currency, which equivalent by banks banks and premium on which was was equivalent to aa depreciation depreciation ofthe of the US US dollar dollar vis-a.-vis vis-a-vis the British pound. pound. The The 1896 the British 18% to extreme value value of of the the US-UK US-UK differential differential reflects reflects the the capital capital flight extreme flight of of that year year produced produced by by William Jennings Bryan's for presthat William Jennings Bryan's nomination nomination for president, exacerbating exacerbating fears fears that that the United States States would abandon the the ident, the United would abandon gold standard. standard. In In both both cases, cases, fear fear of of devaluation devaluation was deterrent to to the the gold was aa deterrent flow of of British British short-term short-term capital capital to to the market except except at at aa subflow the US US market substantial premium. The election election of of William William McKinley McKinley in in 1896 1896 changed changed stantial premium. The the outlook. It made US adherence to the gold standard secure for the the the outlook. It made US adherence to the gold standard secure for time being and the subsequent flood of gold from South Africa, Alaska, time being and the subsequent flood of gold from South Africa, Alaska, and Colorado Colorado removed removed all all doubts. doubts. and The fear that the United States would abandon the gold standard was equivalent to to aa fear fear that the United States would inflate at at aa faster faster was equivalent that the United States would inflate

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rate than Britain or deflate at a slower rate. The fear of inflation inflation also of animated the opponents of free silver, the endemic political issue of the pre-1896 period. The paradoxical effect effect was to produce deflationdeflation— or more rapid deflation deflation than would otherwise have occurred. The paradox shows up to the full in interest rates. Before 1896, US prices were falling at a 1 percentage percentage point point per per year yearfaster faster rate rate than than ininBritain. Britain. That That %a alone should have produced an appreciation of the US dollar by 11% year and a 1 percentage percentagepoint pointlower lowerinterest interestrate. rate.But Butthe thefear fearof ofinflation inflation more than countered the fact of deflation; kept the currency in danger of being devalued; and made interest rates in the United States 1 perpercentage point higher relative to those in Britain than they were after after the the fear fear was was resolved. resolved. The contrast between fact and belief belief continued after after 1896. In In the subsequent eighteen years, prices rose in the United States by something over 1 percentage point more per year than in Britain. The fact of have produced of inflation inflation by by itself itself should should have produced aa depreciation depreciation of of the the US US dollar and a 1 percentage percentagepoint pointhigher higherinterest interestrate rateininthe theUnited UnitedStates. States. But the altered the elimination But the altered attitudes attitudes and and the elimination of of the the silver silver issue issue meant meant that the exchange value of the dollar was never threatened and US interest rates, while higher than in Britain, were 1 percentage point less so than they were before 1896. The facts would have justified justified a 2 percentage point point rise rise in the differential percentage in the differential US-UK US-UK rate rate on on nominal nominal assets assets from before to after after 1896. The beliefs about inflation inflation produced a 1 percentage point percentage point decline! decline! There was aa further percentage point point decline decline inin the the differential differential on on There was further 11 percentage nominal assets in the United States over that in Britain from the average of of the two pre-World War II periods to the interwar period. That decline is matched by a decline of 1 percentage point in the differential differential real yield on physical assets over the corresponding period, which may be regarded as largely accounting for the decline in the differential differential on nominal nominal assets. assets. The final decline of 2 percentage points in the US-UK differential differential from the interwar to the postwar period corresponds to the 2.4 percentage point decline in the rate of price rise in the United States relative to that in Britain. This differential differential rate of price decline was reflected reflected in the depreciation of the British pound relative to the US dollar. dollar. To summarize: the decline in the US-UK differential differential for the nominal short rate from before to after after 1896 reflects the resolution of fears that the United States would inflate and the US dollar would be devalued; the further pre-World War period reflects the further decline decline from from pre-World War II to to the the interwar interwar period reflects a decline in the real yield on physical capital in the United States relative to the further to that that in in Britain; Britain; and and the further decline decline from from the the interwar interwar period period to to

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the post-World War II period reflects greater inflation inflation in Britain than in the United States and an accompanying depreciation of the pound. S.7 5.7 Differential Differential Yields Yields on Nominal Nominal vs. Physical Physical Assets

If in in each each subperiod subperiod arbitrage arbitrage had had worked worked as as well well as as it it did did for for the the If period period as as aa whole, whole, the the yields yields on on nominal nominal and and physical assets assets would would be be equal or differ differ by a constant reflecting the average preference for physical ical versus versus nominal nominal assets assets or or the the reverse, reverse. For For peace-time periods, periods, howhowever, as I indicated earlier, the equality did not hold, so arbitrage clearly did did not work as as well well in in each each subperiod subperiod as as in in the period as as aa whole. whole. In the two periods of falling prices, the yield on nominal assets was decidedly decidedly higher higher for for both both countries countries than than our our proxy proxy for for the the yield yield on on physical assets. Deflation Deflation was not anticipated. Lenders did well. Borrowers rowers did did poorly. Since Since in in the the main, main, entrepreneurs entrepreneurs borrow in in nominal nominal terms to acquire physical assets, rentiers rentiers did well, entrepreneurs badly, which would seem to support the widely believed generalization that a period of unanticipated deflation is adverse to enterprise and growth. growth. That That generalization generalization is is belied, belied, however, however, for for the the pre-1896 period of of falling falling prices in both Britain and the United States, since real output grew at the the rate rate of of 2.2% 2.2% and and 3.3% 3.3% per per year year in in each each country, country, respectively. respectively. With the exception of Britain from 1897 to World War I, during periods periods of of inflation inflation our our proxy proxy for for the the yield yield on on physical assets assets was was higher higher than the the yield yield on on nominal nominal assets. assets. Apparently Apparently inflation inflation too too was was not not than anticipated. anticipated. Entrepreneurs Entrepreneurs did did well, rentiers rentiers did did poorly; poorly; capital capital was was transferred from from savers savers to to borrowers, borrowers, which which would would seem seem to to support support transferred the the widely widely believed believed generalization generalization that that unanticipated unanticipated inflation inflation is is fafavorable to enterprise and growth. Yet generalization is is also also belied belied vorable to enterprise and growth. Yet that that generalization for the 1897-World War War II period of rising rising prices in both Britain and and for the 1897-World period of prices in both Britain the United United States, States, since since real real growth growth was was greater greater during during the the pre-1896 pre-1896 the period offalling of falling prices than than during during the the post-1896 period of of rising prices. prices. But the public perception at the time was clearly the reverse. Alfred Marshall Marshall referred referred to to this this phenomenon in in 1886, 1886, when when he he wrote, wrote, "I "I think think there is is much much less less difference difference than than is is generally generally supposed supposed between between the the there net net benefits of of rising and and falling falling prices." prices." Henry Thornton was aware that holders of physical assets appeared to to do do better than than holders holders of of nominal nominal assets assets during during an an inflation. inflation. He He observed: observed: It It was true, that men did not generally perceive, that, during a fall

in the price of money [the value of money], they borrowed at this advantageous rate rate of of interest; interest; they they felt, felt, however, however, the the advantage advantage of advantageous of being borrowers. The temptation temptation to to borrow borrow operated operated on on their their minds, being borrowers. The minds,

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as their as he he believed, believed, in in the the following following manner: manner: .. .. .. they they balanced balanced their books year, and, and, on on estimating estimating the the value value of of those those commodities commodities books once once aa year, in that in which which they they had had invested invested their their borrowed borrowed money, money, they they found found that value value to to be be continually continually increasing, increasing, so so that that there there was was an an apparent apparent profit over over and and above above the the natural natural and and ordinary ordinary profit profit on on mercantile mercantile profit transactions. transactions. One One way way to to examine examine the the effect effect of of the the rate rate of of price price change change on on the the difference to difference between between the the yields yields on on nominal nominal and and physical physical assets assets is is to array the the subperiods subperiods by by the the rate rate of of price price change, change, disregarding disregarding both both array chronology and and country. country. If If the the price price change change had had been been fully fully anticianticichronology pated, and and the the real yield had had been been independent independent of of the the rate of price pated, real yield rate of price change, the the nominal nominal yields yields on on nominal nominal assets assets would would rise rise as as the the rate change, rate of price price change change increased, increased, and and the the real real yields yields on on physical physical assets assets of would stay stay constant. constant. In In fact, fact, the the nominal nominal yields yields fluctuated about aa would fluctuated about roughly constant constant level, level, so so that that the the effect effect of of inflation inflation produced sharp produced aa sharp roughly decline in in the the real real yield yield on on nominal nominal assets assets as as the the rate rate of of price price change change decline increased. The The hypothetical hypothetical pattern pattern of of yields yields for for aa fully fully anticipated anticipated increased. inflation came came close close to to being being realized realized for for physical physical assets. assets. Their Their nominflation nominal yield yield rose rose with with inflation inflation and and their their real real yield yield fluctuated about aa inal fluctuated about more or or less less constant constant level. level. However, However, this this pattern pattern does does not not reflect reflect more anticipations so much as the physical character of the assets anticipations so much as the physical character of the assets and and their real real yields. their yields. For fix rates For nominal nominal assets, assets, investors investors fix rates in in nominal nominal terms terms and and contract contract for aa period period ahead; ahead; prescience prescience is is therefore therefore required required if if these these rates rates are for are to reflect reflect future future price price behavior. behavior. For For physical physical assets, assets, investors investors may may fix to fix no rates, rates, and and certainly certainly not not in in nominal nominal terms, terms, and and generally generally make make no no no contracts about about either either real real or or nominal nominal yields yields for for aa period ahead. The period ahead. The contracts yield is is generated generated out out of of the the economic economic activity activity in in which which the the asset asset is is yield employed. It It requires requires no no prescience prescience forthe for the nominal nominal yield yield on on physical physical employed. assets to to reflect reflect current current price price behavior, behavior, only only that that the the physical physical asset asset assets participate along with with other other assets assets in in the the nominal nominal income income and and spending spending participate along flows. flows. The The excess excess of of the the yield yield on on physical physical assets assets over over that that on on nominal nominal assets assets is is sharply sharply negative negative for for deflation, deflation, sharply sharply positive positive for for inflation. inflation. If If inflainflations were were fully fully anticipated, anticipated, the the differences differences between between yields yields on on physical physical tions and nominal nominal assets assets might might be be expected expected to to be be roughly roughly aa constant, constant, reand reflecting any anypreference preferenceamong amongasset assetholders holdersfor forone onecategory categoryor orother other flecting of assets. assets. For For peacetime peacetime periods, periods, there there is is no no indication indication of of such such conof constancy. If If inflation inflation were were wholly wholly unanticipated, unanticipated, and and there there were were no no prefprefstancy. erence for for one one or or the the other other category category of of assets, assets, ex-post, ex-post, the the nominal nominal erence yield on on physical physical assets assets would would reflect reflect the the actual actual rate rate of of inflation, inflation, whereas whereas yield the ex-ante ex-ante nominal nominal yield yield on on nominal nominal assets assets would would not. not. This This seems seems to the to describe the the facts, facts, with with some some indication indication that that there there was was aa 11 percentage percentage describe point preference preference for for physical physical over over nominal nominal assets, assets, that that is is aa willingness willingness point

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to accept that much less in yield in order to hold a physical rather than aa nominal nominal asset. asset. This description of the pattern that would be produced by wholly unanticipated inflations does not apply accurately to both US war-time episodes especially World World War for Britain. There appears appears to to be episodes and and especially War II for Britain. There be rough constancy in in these three episodes episodes in in the excess of of the on rough constancy these three the excess the yield yield on physical assets over over that on nominal assets, as as if if they corresponded physical assets that on nominal assets, they corresponded to anticipated anticipated inflations. inflations. But interpreting these episodes in in this to But interpreting these episodes this way way implies aa very great preference—about percentage points-for points—for nomnomimplies very great preference-about 88 percentage inal assets assets during during war-time periods over over physical assets—which seems seems inal war-time periods physical assets-which most implausible. Possibly Possibly the the war-time war-time estimates estimates are are an an aberration aberration most implausible. rather than an indication indication of of correct correct anticipation anticipation of of war-time inflation. rather than an war-time inflation. These with the These results results are are inconsistent inconsistent with the hypothesis hypothesis that that the the ex-ante ex-ante nominal yields yields on nominal on nominal nominal assets assets incorporate incorporate correctly correctly anticipated anticipated rates rates of inflation-which inflation—which merely confirms what what has has long long been that of merely confirms been known, known, that the public has in fact fact been able over over long long periods, at least, least, until until the public has not not in been able periods, at possibly very recently, recently, to correct anticipations anticipations of of inflation. inflation. We possibly very to make make correct We can, however, however, examine examine the observations within within the the subperiods subperiods to can, the observations to dedetermine whether there there is is evidence evidence of of aa gradual gradual recognition recognition of of and and adadtermine whether justment inflation or or deflation. deflation. justment to to inflation 5.8 between Yields Yields on 5.8 Relations Relations between on Nominal Nominal and and Physical Physical Assets Assets Our Our proxy proxy for for the the real real return return on on physical physical assets assets varied in in the the six six subperiods, 2.6 to 2.2% per subperiods, ranging ranging for for Britain Britain from from --2.6 to + +2.2% per year, but the the variation was far less less than for the the ex-post ex-post real real yield yield on on nominal assets, variation was far than for nominal assets, which from -- 10.8 10.8 to +4.8% per year. year. Moreover, one extreme extreme which ranged ranged from to + 4.8% per Moreover, one item accounts accounts for for most of the the British for our our proxy for the real item most of British range range for proxy for the real return on physical assets. Omitting Omitting World leaves five observareturn on physical assets. World War War II leaves five observations, ranging from 1.3 1.3 to to 2.2% 2.2% per per year. year. No comparable tions, ranging from No remotely remotely comparable reduction in in the range can can be be achieved achieved for for the real yield on nominal nominal reduction the range the real yield on assets most discrepant observation. assets by by omitting omitting the the most discrepant observation. We can can adopt adopt Irving Irving Fisher's Fisher's view view that that the the ex-post real return return on on physical assets can can be be taken roughly constant constant on on the average physical assets taken to to be be roughly the average over time-though time—though at at aa higher higher level level in in the States than in Britain. Britain. over the United United States than in Then the the wide variation among among sUbperiods subperiods in in the difference between between Then wide variation the difference the on nominal nominal and and physical physical assets assets reflects the failure failure the returns returns on reflects primarily primarily the of nominal yields on on nominal nominal assets assets to to adjust adjust to actual rate rate of of nominal yields to the the actual of inflation. As As aa result, result, ex-post ex-post real returns on on nominal assets vary widely. inflation. real returns nominal assets vary widely. The implication implication of of rough rough constancy constancy of of real real returns on physical assets The returns on physical assets is that the variation variation in in ex-post ex-post real on nominal assets reflects reflects is that the real returns returns on nominal assets primarily unanticipated changes changes in in inflation. inflation. primarily unanticipated In In Irving Irving Fisher's Fisher's analysis, analysis, nominal yields adjust adjust not not to to the actual actual rate of inflation inflation but anticipated rate of inflation, inflation, which which in in tum turn rate of but to to the the anticipated rate of

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adjusts to actual inflation after after a considerable lag. In line with his analysis, we would expect to find that, shortly after after a change from, from, say, falling to rising prices, the yield on physical assets would exceed substantially the yield on nominal assets, reflecting the incorporation in the yield on nominal assets of the lagged anticipations of falling prices. As prices continued to rise, the differential differential would decline and approach the equilibrium difference, reflecting (inversely) any general preference for physical over nominal assets (or conversely). For the pre-World War I period, there is evidence of a response by of nominal yields to price anticipations. During the pre-1896 period of falling prices, the nominal short-term yield fell as if it were adjusting adjusting to anticipations of deflation. During the subsequent period of rising prices, the nominal short-term yield rose as if it were adjusting to anticipations of inflation. This pattern is not visible in the US data. Since the British financial financial market before 1914 was more sophisticated than the US market, it is not implausible that yields were more responsive to anticipations of price change in Britain. The only other subperiod that shows evidence of a response by nominal yields to price anticipations is the post-World War II period. The nominal short-term yield rises steadily throughout the period; the ex-post real yield on nominal assets rises sharply in the early part of of the period and then fluctuates about a more or less constant trend; and our proxy for the real yield on physical assets shows no steady trend.

5.9 Nominal Yields and and Rates Rates of of Change Change of of Prices Prices 5.9 Nominal Yields These results led us to to examine These results led us examine more more closely closely the the relation relation between between of nominal nominal yields on on short-term short-term nominal nominal assets assets and and the the rate rate of change of prices. A chart reveals an apparent connection for two widely separated separated periods: the period before World War I, and the period after after 1970. One feature of the relationship is the much wider variability of price change than of the rate of interest. This may reflect greater measurement ment error error in in the the series series on on price price change change than than in in the the series series on on interest interest rates, but more plausible plausible explanation explanation is is economic: economic: the the wider wider variation variation rates, but aa more in prices reflects the existence of monetary and other disturbances that were were random random and and could could not not be be readily readily anticipated. anticipated. In In the the relatively relatively stable decades before World War I, in Britain, it was possible to identify identify the tides through the much smaller waves; in the post-1970 decade, variability was great, great, but attributable attributable to to policy, not not change change... If the short-term rate rate and and the rate of of price change are are correlated correlated for for If the short-term the rate price change phases phases of of our our individual individual sub-periods, sub-periods, the the only only significant significant correlation correlation is is for the post-World War II period. The indication that there may have been of been aa change change in in the the relation relation between between interest interest rates rates and and the the rate rate of change of of prices in the the 1970s 1970s made made it it desirable desirable to to exploit exploit data data for for shorter shorter change prices in time time units units than cyclical cyclical phases. We We plotted beginning beginning in 1915 1915 monthly monthly

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averages of the rate of change-averaged change—averaged over six-month intervals to reduce extreme variability-ofthe variability—of the cost-of-living cost-of-living index, which the retail price index superseded in 1956, against the monthly three-month bankers' bill series. There is evident a lack of any short-term systematic relation between interest rates and the recorded rate of price change, and much wider short-period fluctuations in price change than in interest rates. There is a drastic reduction in the variability of recorded price change in Britain after after the mid-1950s, presumably reflecting the comprehensive statistical revision of the price index in 1956. It It may well be that a large part of the recorded fluctuations in prices before this date consisted of measurement error. Hence, the possibility cannot be ruled out that the statistical noise in the recorded price series drowns of out a systematic relation between interest rates and the "true" rate of price change. The UK monthly results from 1956 to the early 1970s rather argue against this conclusion. Despite the lesser amplitude of price fluctuations, this period, like earlier periods, shows essentially no relation between the rate on three-month bankers' bills and the rate of price change. The monthly figures also reveal that the rate on three-month bankers' bills was often often sticky, calling into question the extent to which the rate was truly market determined. The problem is by no means limited to the commercial bill market. Other short-term rates are also sticky. With the introduction of Competition and Credit Control in May 1971, 1971, the three-month bankers' bill rate for some years exhibited a reduction in rigidity. In the past few years, that is less evident. One further further feature of the relation deserves mention. The current rate on three-month bankers' bills since 1965 has been more highly correlated with the six-month price change average six months in the future than with the current six-month average. Interest rates apparently are forecasting price change over the next half half year. This would suggest that lenders and borrowers have become better able to protect themselves against price changes than they were earlier in the postwar period. The explanation may be that market participants have belatedly recognized the drastic change in the character of the monetary system from a largely specie standard to a fiduciary fiduciary standard. The change altered the information relevant to predicting the future course of prices. There is less short-term but more long-term variability in rates of inflation flation and much higher levels of inflation than had been experienced in peace-time over the past century. As a result, market participants have a greater incentive to seek to allow for future price movements. In Britain, the indication that interest rates and price change move symmetrically has lasted for a brief brief period only. The apparent shift shift may prove temporary. Whether it does, or whether it is carried farther, farther,

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may well depend on whether future rates of inflation remain as high and and as as variable variable as in in the past decade (or (or even higher and more variable) variable) or whether whether rates rates of of inflation inflation return return to to earlier earlier peacetime levels. or peacetime levels.

5.10 Conclusion Conclusion 5.10 Two Two themes themes of of this this lecture-the lecture—the relation relation between yields yields on on nominal nominal of and and on on physical physical assets, assets, and and the the relation relation between between rates rates of of change change of prices and interest interest rates in Britain Britain over over the the past century—examine prices and rates in past century-examine empirically an an idea idea that that Henry Henry Thornton Thornton presented presented in in his his speech speech on on 77 empirically May 1811, 1811, in in the the debate debate in in the the House House of of Commons Commons on on the the Report Report of May of the Bullion Bullion Committee. Committee. He He observed observed that that nominal rates were were the nominal interest interest rates relatively high high when when prices prices were were rising rising because lenders and and borrowers borrowers relatively because lenders anticipated price movements and and allowed allowed for for them them in in the the interest interest rates rates anticipated price movements they charged charged or or paid. paid. they The empirical empirical evidence evidence suggests suggests that that for for much much of of the the past past century century The an effect effect in in this this direction direction has has been been very very much much damped. damped. In In recent recent years, years, an however, nominal interest rates rates have have begun to track track the the rate rate of of price price however, nominal interest begun to change more closely than than at at any any earlier earlier time time in century from 1874. change more closely in the the century from 1874. Nominal rates rates of of interest interest have have become more variable variable than than real real rates rates Nominal become more of interest, interest, as as Irving Irving Fisher Fisher believed believed them them to to be, and nominal returns of be, and nominal returns on nominal nominal assets become as as nominal on physon assets have have become as variable variable as nominal returns returns on physical assets. assets. The The shift shift to to aa fiduciary monetary standard standard in in the the postwar postwar ical fiduciary monetary period and the the increased increased long-term long-term variability variability of of prices prices that that ensued ensued period and have driven lenders and borrowers to seek to predict price changes have driven lenders and borrowers to seek to predict price changes more accurately, accurately, and and to to adjust adjust the the terms terms of of lending lending and and borrowing borrowing more accordingly. accordingly.

6 6

Why Why Money Money Matters Matters

August this year marks the tenth anniversary of the publication of of the celebrated Radcliffe Radcliffe Report, which enshrined what had come to be conventional wisdom during the preceding quarter of a century, namely, that monetary policy is unimportant. According to the Radcliffe Radcliffe Committee, the Bank of England can exercise no effective effective control of of the money supply. However, this is of no consequence since the money supply does not playa play a critical role in the economy. What really matters financial institutions institutions and of of firms (para. 397) is "the liquidity position offinancial firms and people desiring to spend on real resources." Since the 1950s, the testing of hypotheses against the facts has increasingly characterized both government and academic economic Report were not accompanied studies. Yet, the views expressed in the Report by any analysis of the actual behavior of the supply of money or the Radcliffe Redemand for money in the United Kingdom. Indeed, the Radcliffe port does not contain any series at all on the quantity of money. At the time, there was little empirical research on the influence of money that could provide the basis for challenging the Committee's conclusions. Today, the situation is very different. Extensive historical and statistical investigations have been conducted into the role of money in the United States. These investigations give no support to the views expressed in the Radcliffe Report. In the United Kingdom, too, as in the United States, the evidence is that the quantity of money has a significant significant influence on the level of economic activity. The next four sections of this article summarize studies bearing on some of the issues posed by the Radcliffe Report: Can the central bank control the quantity of money? Is there a direct relationship between changes in the quantity of money and changes in income? What is the link link between between monetary change change and and income income change? change? What is is the the link link 167

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between monetary change and financial markets? Most of this relates final section to to the the United United States, States, but but in in aa final section some some preliminary preliminary results results are are 1880. presented presented of of aa study study of of British British monetary monetary experience experience since since 1880. 6.1 6.1 Can Can the the Central Central Bank Bank Control Control the the Quantity Quantity of of Money? Money?

For the the United United States, States, the the answer answer to to this this question question is is clearly clearly "yes." "yes." For Commercial public and Commercial banks, banks, the the public and the the central central bank bank all all affect affect the the quanquantity of of money money available available to to be be held, held, but but the the central central bank bank can can dominate dominate tity the the other other two. two. Three Three factors factors largely largely determine determine the the supply supply of of money: money: (1) (1) "High-powered "High-powered money" money" (sometimes (sometimes called called the the monetary monetary base) base)

is is provided provided in in amounts amounts determined determined by by the the central central bank, bank, to to serve serve as as "required" "required" and and "excess" "excess" reserves reserves of of the the commercial commercial banks banks and as as coin coin and and currency currency holdings of the the public. public. "Required" "Required" and holdings of reserves relate relate to to the the legal legal minima minima that that the the banks banks have have to to maintain maintain reserves against demand demand and and time time deposits, deposits, while while "excess" "excess" reserves reserves are are against the amount amount by by which which actual actual reserves reserves exceed exceed required. required. the (2) (2) The The ratio ratio of of deposits deposits to to reserves reserves is is determined determined by by the the banks banks in in light light of of their their legal legal (or (or customary) customary) reserve reserve requirements, requirements, expecexpecflows and fitations tations of of currency currency flows and interest interest rates. rates. Given Given existing existing financial conditions, conditions, an an increase increase in in reserves reserves will will induce induce banks banks to to nancial acquire earning earning assets, assets, thus thus increasing increasing their their deposits deposits and and restorrestoracquire ing the the desired desired ratio ratio of of deposits deposits to to reserves. reserves. ing (3) (3) The The ratio ratio of of deposits deposits to to currency currency is is determined determined by by the the public public in in light light of of interest interest rates, rates, income income and and its its preferences preferences for for holding holding coin coin and and currency. currency. In In the the United United States, States, growth growth in in high-powered high-powered money money has has dominated dominated the the long-term long-term growth growth of of the the quantity quantity of of money, money, the the deposit deposit ratios ratios playplaying ing aa more more important important role role in in cyclical cyclical changes changes in in the the money money stock. stock. But, But, of even behavior does even then, then, their their behavior does not not negate negate the the central central bank's bank's control control of the the quantity quantity of of money money over over short short periods periods because because it it can can take take action, action, if if it it wishes, wishes, to to offset offset the the behavior behavior of of the the ratios. ratios. An An examination examination of of the the circumstances circumstances surrounding surrounding the the major major changes changes in in the the quantity quantity of of money money in in the the United United States States over over the the past past century century reinforces reinforces this this evidence evidence of of the the close close correlation correlation between between high-powered high-powered money money and and the the quantity quantity of of money money over over short short periods. periods. These These major major of changes changes in in the the quantity quantity of of money money have have been been largely largely independent independent of contemporary changes changes in in business business conditions conditions and, and, since since 1914, 1914, have have contemporary clearly clearly been been the the result result of of decisions decisions by by the the Federal Federal Reserve Reserve System. System. highSome that central Some economists economists have have argued argued that central bank bank control control of of highpowered of powered money money does does not not confer confer control control over over the the total total quantity quantity of money. of money. They They regard regard an an open-market open-market purchase purchase of of aa certain certain class class of securities by by the the central central bank bank as as having having its its full full effect effect when when some some holders holders securities of of the the securities securities are are induced induced to to sell sell them. them. But But this this is is only only the the initial initial

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reaction of the sellers. They sold the securities not to add to their money holdings but as a step toward rearranging their portfolios in light of changed opportunities. The money they receive is a "temporary abode" of the proceeds from the sale, pending the purchase of other items. Money is serving its usual function of separating the act of sale from the act of purchase. Evidence shows that, by this process, the change of change in in high-powered high-powered money will be be translated translated by the the reactions reactions of banks and the the public into aa prompt and predictable predictable change change in in the quanbanks and public into prompt and the quantity of of money. money. 6.1.1 6.1.1 The central bank's ability to control the quantity of of money does not, of of course, mean that changes in it are necessarily the immediate objective of monetary policy. The bank may have other objectives, e.g., maintenance of fixed exchange rates or of fixed prices of Treasury securities. In such cases, the quantity of money must be whatever is consistent consistent with with these these alternative alternative objectives. objectives. In In the United United States, States, curcurrent policy, for example, aims at keeping certain short-term interest rates rates within aa range range specified specified every every three weeks at at the Federal Federal Open Open Market Committee meeting. The Committee instructs the manager of of the the trading desk desk at at the Federal Reserve Reserve Bank of of New York York to to conduct conduct open-market operations operations that keep specified specified interest interest rates rates within within open-market that will will keep the the indicated indicated range. If If this this produces produces too rapid aa growth growth of of bank bank credit, credit, the manager is instructed to allow rates to rise above the range. If If it produces too slow slow aa growth, growth, he is is instructed instructed to allow allow them to to fall fall below below the range. However, when the Treasury is attempting to issue coupon securities, securities, maintaining prices prices of of Treasury Treasury securities securities within aa fairly fairly narnarrow range may take precedence over maintaining specified limits on the rate of growth of bank credit. In that event, current policy operates flow of reserves and, hence, the growth rate of to raise the flow of the quantity of of money money above above the desired desired rate rate in in the the absence absence of of Treasury Treasury financing. As a result, there are periodic reactions by the Federal Reserve System to the cumulative effects effects of special regard on its part for the Treasury. These periodic reactions involve contraction of the flow of of reserves money-as during the last three quarters and of the rate of growth of money—as of 1966, and since the end of 1968. On balance, while the Federal Reserve can control the quantity of of money if if it chooses to do so, over the past decade control has been exercised fitfully. Most exercised at at best fitfully. Most of of the time time the growth growth rate rate has has been been inadvertent, a side effect effect rather than the direct objective of of monetary policy. Much the same conclusion apparently applies to Britain. The Bank of of England England can can control control the the quantity quantity of of money money if if it it chooses chooses to do do so. so. However, it it has, in general, general, at at least least until recently, chosen chosen to supply However, has, in until recently, to supply

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whatever quantity of money is necessary to stabilize the prices of the public debt at those interest rates it considers desirable. An empirical analysis of what determines Britain's money stock, corresponding to that for the U.S. money stock, does not yet exist. One reason is probably the difficulty difficulty of assembling detailed data for all commercial banks even yearly, let alone at more frequent frequent intervals. Yet, an analysis analysis is Yet, such such an is clearly clearly needed needed to to supplement supplement the the theoretical theoretical analyses that that have have demonstrated demonstrated the the shortcomings shortcomings of of the the assertion assertion in analyses in Radcliffe Report Report that England cannot the the Radcliffe that the the Bank Bank of of England cannot control control the the quanquantity of of money. money. tity 6.2 Changes in Quantity of Money and in Income

Two dramatic episodes in the United States have recently focused focused of public public attention attention on on the the relation relation between between changes changes in in the the quantity quantity of money and subsequent subsequent changes changes in in incomes, incomes, which which are, are, of of course, course, the the money and prices. combination combination of of movements movements in in output output and and in in prices. One April 1966 1966 to to January January 1967 1967 monetary monetary One episode episode was was in in 1966. 1966. From From April policy was contractionary: the quantity of money was not permitted to to grow, grow, following following aa year year in in which which it it had had expanded expanded at at the the rate rate of of 66 percent. Over the same nine months, fiscal policy was highly expansionary: sionary: the the federal federal government's government's (high-employment) (high-employment) budget! budget1 shifted shifted from balance to an $11 $11 billions deficit at an annual rate, the deficit then remaining remaining above above that that level level for for the the rest rest of of 1967. 1967. Yet, Yet, during during the the nine nine months from October October 1966 1966 to to July 1967 there there was was aa sharp sharp slowdown slowdown months from July 1967 in in both both production production and and prices. prices. Production, Production, which which had had risen risen 9.6 9.6 percent percent the preceding preceding year, year, actually actually fell fell 2.6 2.6 percent percent at at an an annual annual rate, rate, while while the consumer prices, which consumer prices, which were were up up 3.7 3.7 percent percent in in the the preceding preceding year, year, continued to rise, but at the lower annual rate of 2.4 percent. This episode, episode, like like many many historical historical predecessors, predecessors, suggests suggests that that within within aa few few quarters after after the the onset onset of of aa reduction reduction in in the the monetary monetary growth growth rate, rate, quarters output output will will contract contract and and the the rate rate of of price price rise rise diminish, diminish, despite despite aa highly highly expansionary fiscal policy. The second episode began at the end of 1968, when the growth rate of the quantity of money, which had been at the annual rate of 6.8 percent during the preceding 23 23 months, was reduced to roughly 3 percent at an annual rate. In 1968, while monetary policy was highly expansionary, fiscal policy turned highly contractionary: the federal government's government's (high-employment) (high-employment) budget, budget, seasonally seasonally adjusted, adjusted, shifted shifted from $16 $16 billions billions deficit deficit at at an an annual annual rate rate in in the the second second quarter quarter to to aa from small small surplus surplus at at the the end end of of the the year, year, with with the the size size of of the the surplus surplus estiestimated to to rise rise by by $5 $5 billions billions in in the the first half of of 1969. 1969. Economists Economists who who mated first half disregard the disregard the quantity quantity of of money money anticipated anticipated aa reduction reduction in in output output and and prices after after the the middle middle of of 1968. 1968. None None having having occurred, occurred, they they then then foreforeprices

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cast a slow-down in the first half of 1969 1969 and an improvement in economic activity in the second half. In contrast, economists who who stress the importance of changes in the quantity of money anticipated no contraction of economic activity in 1968 1968 or or the the first first half half of of 1969 1969and and forecast, if anything, a slow-down of economic activity in the second half half of 1969. 1969. At mid-year, the forecast of the former group of economists had not been confirmed. This episode, again like many historical predecessors, suggests that the effects effects of a high monetary growth rate will of persist for several quarters after after it is reversed in raising the level of output and the rate of price rise, despite a highly contractionary fiscal policy. 6.2.1 6.2.1

Apart findings supsupApart from from these these dramatic dramatic episodes, episodes, many many systematic systematic findings port a close association between changes in the quantity of money and those money income. the United United States, the correlation those in in money income. For For the States, the correlation between between year-to-year changes in in the quantity of of money and those those in in income income for year-to-year changes the quantity money and for the the 94 94 years years from from 1870 1870 to to 1963 1963 is is quite quite close. close. The The corresponding corresponding result result for the the United Kingdom for for the the year-to-year changes for for United Kingdom year-to-year percentage percentage changes for 77 years, is, 77 years years between between 1881 1881 and and 1967, 1967, omitting omitting war war years, is, in in fact, fact, slightly slightly better. Quarter-to-quarter changes changes in in the money stock stock are are most most better.22 Quarter-to-quarter the U.S. U.S. money closely associated associated with changes in in income income when they precede precede the the latter latter closely with changes when they by quarters. In In principle, association might might be considerably by two two quarters. principle, this this association be considerably misleading: the the changes changes in in money and in in consumption consumption might commisleading: money and might be be common consequences consequences of of associated associated changes changes in in "autonomous" "autonomous" investment investment mon is, determined determined indepenindepenexpenditure, investment investment expenditure, expenditure, that that is, expenditure, dently of current current business activity. In In practice, this possibility turns business activity. practice, this possibility turns dently of out not not to to be true. A A number number of of statistical statistical studies studies indicate indicate that that money money out be true. has an influence influence of of its its own own and and not as aa disguised disguised reflection not merely merely as reflection of of has an such expenditures, expenditures, whose whose influence influence is is generally generally less less strong strong and and less less such consistent than than that that of of money. money. consistent

6.2.2 6.2.2 A by the the Federal Federal Reserve Reserve Bank Bank of of St. St. Louis Louis has has further further A recent recent study study by documented the close association between changes in money and in income. fiscal actions and income. A A statistical statistical test test of of the the relative relative power power of of fiscal actions and monetary actions to predict quarterly changes in gross national product product from the first quarter of 1952 1952 through through the the second second quarter quarter of of 1968 1968yielded yielded results which indicated that the response of economic activity to monetary with that etary actions, actions, compared compared with that of of fiscal fiscal actions, actions, is is larger, larger, more more fiscal action tested included federal predictable and faster. Measures offiscal government (high-employment) receipts and expenditures and the differences between them. The The conclusion conclusion of of the the study study regarding regarding fiscal ferences between them. fiscal fiscal influence actions was that" either the the commonly actions was that "either commonly used used measures measures of offiscal influence

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do not correctly indicate the degree and direction of such influence, or there was no measurable net fiscal influence on total spending in the test period." Measures of monetary action tested included the monetary base and the quantity of money narrowly defined to include coin and currency and current accounts held by the public, and defined more broadly to include also commercial bank deposit (time) accounts. The conclusion regarding monetary actions was that there was a strong relationship between economic activity and measures of monetary action. Another set of studies has examined a different different aspect of the relation between money and economic activity. These studies compare the cyclical patterns of the rate of change in the quantity of money and of of general economic activity. Over the past century in the United States, peaks and troughs in the money series precede the corresponding peaks and troughs marking some twenty-odd cycles in economic activity, on the average by 17 months at peaks and by 13 13 months at troughs with, of course, much variability from cycle to cycle. A different different comparison that may be more revealing for periods with sharp trends is between dates when the level level of the monetary growth rate changes (shifting from from a high level to a lower level or from a low to a higher level) and peaks and troughs in general business activity. For this comparison, the money series leads, on the average by 7.5 months at peaks and 4.5 months at troughs, again, of course, with much variability. Similar comparisons have been made for countries other than the United States. These have not not been been as as extensive extensive as as those those for for the the United United States States but but the the results results have been much the same. A third comparison that gives about the same result as the second is between turning points in the rate of change in money and those in the rate of change in income. These comparisons are, by themselves, not conclusive about the direction of effect. What is described above as the peak of the money series peak of deseries leading leading the the subsequent subsequent peak of the the cycle cycle could could equally equally be be described as the peak of the money series lagging lagging behind the preceding trough of the cycle. Alternatively, both the money series and economic activity could be the common result of still a third variable, but with money reacting more rapidly. These and similar possibilities have, however, been extensively explored. There is much statistical evidence suggesting that they do not, in fact, account for the observed results, and that these are more readily explained as reflecting the independent influence of monetary changes. To summarize, cyclical studies indicate that changes in the monetary growth rate are a necessary and sufficient sufficient condition for changes in the growth of income over periods covering the different different phases of the business cycle. Short-term changes in monetary growth appear to have a major impact on changes in output and only a mild impact on changes

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Why Money Matters

in prices. This is the opposite of the relation found for longer periods. Longer-period money incomes produced by by aa changed Longer-period changes changes in in money incomes produced changed secsecular mainly in ular rate rate of of monetary monetary growth growth are are reflected reflected mainly in different different price price behavior rather than than in in different of growth growth of of output. output. behavior rather different rates rates of 6.3 Change 6.3 The The Link Link between between Monetary Monetary Change Change and and Income Income Change A A change change in in the the monetary monetary growth growth rate rate creates creates aa discrepancy discrepancy between between the money balances balances the the community holds and money balbalthe actual actual money community holds and the the money ances it it wants wants to to hold. hold. The The actions actions the the community community takes to ances takes to to try try to eliminate this this discrepancy discrepancy create create the the link link between between monetary monetary change change eliminate and income income change. change. To To explore explore the the implications implications of of this, this, it it is is first and first necnecessary to to discuss discuss the the way decide how to hold. hold. essary way people people decide how much much money money to

6.3.1 6.3.1 What ultimately What ultimately matters matters to to holders holders of of money money is is the the real real quantity quantity rather than than the the nominal nominal quantity quantity of of money money they they hold. hold. For For the comcommunity whole, the be expressed in munity as as aa whole, the real real quantity quantity of of money money can can be expressed in terms of of the the number number of of weeks weeks of of output output to to which which it it is is equal. equal. The The terms reciprocal measure of money is reciprocal of of this this measure of the the real real quantity quantity of of money is income income velocity, i.e., i.e., the the ratio ratio of of annual annual income income to to the the quantity quantity of of money. money. The The velocity, calculation of of velocity velocity is is made made at at those those prices prices prevailing at the the date date to to calculation prevailing at which the the calculation calculation refers. refers. These These prices are the the bridge the which prices are bridge between between the nominal and and the the real real quantity quantity of of money. Another way way of of expressing expressing nominal money. Another the real real quantity quantity of of money money is is to to deflate deflate the the nominal nominal quantity quantity by by an an the appropriate index index of of prices. appropriate prices. It has has been shown shown that that the real real quantity quantity of of money money the the community community wants by two wants to to hold hold is is determined determined by two main main variables: variables: real real income income and and the yield yield on on assets assets alternative alternative to to money. money. The The demand demand for for money money inthe increases as real real income income rises, rises, because rise in in real real income income makes makes creases as because the the rise possible larger wealth-holding wealth-holding and and money money is is one one form form in in which which to to hold hold possible larger wealth; rise, because wealth; and and it it falls falls as as interest interest rates rates rise, because aa rise rise in in interest interest rates rates makes money money aa less less attractive attractive asset asset to hold relative relative to to other other assets. assets. makes to hold There There is, is, then, then, some some fairly fairly definite definite real real quantity quantity of of money money that that people people wish to hold any given given circumstances. circumstances. Suppose Suppose that that the the nominal nominal wish to hold under under any quantity quantity of of money money that that people people hold hold happens happens to to correspond correspond at at current current prices to a real quantity larger than that which they want. They will, then, then, seek seek to to dispose dispose of of what what they they regard regard as as excess excess money money balances. balances. They They will will try try to to spend, spend, lend lend and and give give in in gifts gifts more more than than they they are are curcurrently receiving. receiving. But rently But one one man man can can reduce reduce his his nominal nominal money money balances balances only by persuading someone someone else else to to increase increase his. his. The The community community cancanonly by persuading not spend will not spend more more than than it it receives. receives. The The attempt attempt to to do do so, so, however, however, will raise the volume of of expenditures expenditures and and receipts, receipts, leading leading to to aa bidding-up bidding-up of prices and, no change of prices and, perhaps, perhaps, an an increase increase in in output. output. With With no change in in the the

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Anna J. Schwartz

nominal quantity of money, the initial excess of money balances will be eliminated, either by a reduction in the real quantity available to hold as a result of the price rise, or by an increase in the real quantity desired as a result of the increase in output. In the opposite situation, if nominal balances happen to correspond to a smaller real quantity of money than people would like to hold, they will try to spend, lend and give in gifts less than they are receiving. As a group, they cannot do so. But their attempt will, in the process, lower expenditures and receipts, driving down prices or output. Even though there is no change in the nominal quantity of money, the initial deficiency in the amount of money balances will be eliminated, either by an increase in the real quantity available to hold as a result of the price fall, or by a decline in the real quantity desired as a result of the reduction of output. It It is clear from all this that, in principle, changes in income can be produced either by changes in the real balances that people wish to hold or by changes in the nominal balances available for them to hold. The evidence suggests that, in practice, changes in the demand for money (desired real balances) occur slowly or are the result of earlier changes in supply, whereas changes in the supply of nominal balances can occur and frequently frequently have occurred independently of any changes in in demand. demand.

6.3.2 To To describe describe the the link link between between monetary monetary change change and and income income change change does not mean that we know the process of adjustment adjustment in detail. The prevailing orthodoxy prevailing orthodoxy presumes presumes that that aa change change in in the the nominal nominal quantity quantity of money must have its impact first on the bond market, an increase in in money money raising raising the the price price of of bonds bonds and and hence hence lowering lowering interest interest rates, rates, while aa decrease decrease lowers lowers the the price price of of bonds bonds and and hence hence raises raises interest interest while rates. These These interest interest rate rate changes changes are are assumed assumed to to reconcile reconcile actual actual rates. and desired desired money money balances. balances. The The sequence sequence of of events events is is then then traced traced and from financial to from financial to non-financial non-financial markets. markets. The The change change in in nominal nominal interinterest rates rates is is treated treated as as leading leading to to aa change change in in investment investment expendituresexpenditures— est aa qualification qualification is is often often added: added: insofar insofar as as investment investment expenditures expenditures are are responsive to to interest interest rate rate changes-and changes—and the the multiplier multiplier effect effect of of inresponsive investment vestment expenditures expenditures on on income income as as ultimately ultimately leading leading to to further further expenditures on consumer goods and capital goods. The prevailing view takes it for granted that changes in the nominal of quantity of money are equivalent to changes in the real quantity of money, so that price changes resulting from monetary change play no part in reconciling the demand for money with the change in supply. Only changes in interest rates produce the reconciliation. The more responsive responsive the the quantity quantity of of money money demanded demanded to to aa given given change change in in inin-

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Why Money Matters

terest rates, the less interest rates will have to change to achieve the reconciliation. Similarly, according to the prevailing view, the interest rate is the only link between monetary change and real income. The less responsive is investment to a given change in interest rates, the less will any given change in interest rates affect affect real income. If, If, therefore, the demand for money is highly responsive to interest rate changes, while investment expenditure is unresponsive, most of the change in supply of of money will be absorbed by a corresponding change in amount demanded, with little effect effect on real income or prices. This was the view adopted by the Radcliffe Report. By implication, changes in the quantity of of money are important only insofar insofar as they lead to changes in interest rates that influence decisions to hold money or other liquid assets. Changes in market interest rates on the liquid part of total wealth relative to the real rates of return on capital in the illiquid other part of total wealth are deemed to be the channel through which changes in spending are transmitted. Hence, interest rates are viewed as essentially the only market variable that reconciles the structure of assets supplied with the structure demanded. Yet, no evidence exists showing that this approach is valid. The correlations between the level of or rates of change in interest rates, on the one hand, and rates of change in nominal income, prices, and output, on the other, are considerably worse than those between rates of change in the quantity of of money and these magnitudes. 6.3.3 6.3.3 The alternative monetary analysis that has been replacing the Radcliffe view is based on evidence that a change in the quantity of money is followed by changes in both prices and output. The price changes are one channel of adjustment adjustment of the real quantity of money to the change the nominal nominal quantity. change in in the quantity. Interest Interest rate rate changes changes and and real real output output changes are are other other channels. channels. When actual and and desired desired money balances changes When actual money balances are in disequilibrium, flows of be affected are in disequilibrium, flows of every every conceivable conceivable sort sort may may be affected financial and non-financial assets in the process of altering stocks of financial to restore equilibrium. to restore equilibrium. On particular mechanical On this this alternative alternative view, view, the the particular mechanical sequence sequence from from money to bonds to interest rates to investment expenditures and, thence, to income is one, but only one, possible channel of transmission of of monetary change to income change. There is no reason to suppose that it balit is is exclusive. exclusive. A A discrepancy discrepancy between between actual actual and and desired desired money money balances may also be eliminated by initial spending effects effects on all manner of may affect of goods goods and and services. services. Such Such aa discrepancy discrepancy may affect expenditures expenditures on on durable and non-durable consumer goods, investment in education, in financial assets of of the wide variety variety available, available, including not only only bonds financial assets the wide including not bonds but also equities, mortgages, life insurance, and so on, and in durable

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Anna J. Schwartz

producers' goods. The effects effects are then further further diffused diffused as demand shifts for current output of goods and services and new sources of productive services. The precise sequence of transmission may well vary from time to time because it depends on the initial points of impact of the change in money. However, the consistency of the relation between monetary and income changes argues that the initial effects effects are dominated by the the more monetary changes inated by more general general diffused diffused effects effects that that monetary changes set set off. off. To this account relation between between changes To complete complete this account of of the the relation changes in in money money and in money income, some discussion is required of the link between changes money and changes in in money and the the division division of of the the change change in in incomes incomes between between price and output. The most widely held view of what determines this division probably that division is is probably that it it depends depends on on the the level level of of utilization utilization of of capacity. capacity. Wben When there is much unemployment of men and machines, an income change will be by increased prices will will change will be absorbed absorbed primarily primarily by increased output, output, and and prices rise little. When there is high employment and high utilization of capacity, moderate and prices will pacity, the the output output change change will will be be moderate and prices will absorb absorb the the findings indicate that past price rest of the income change. Some recent findings experience is at least as important as the rate of capacity utilization in influencing the rate of current price rise. A 5 percent rate of monetary growth mean aa more rate of price rise rise and growth tends tends to to mean more rapid rapid rate of price and aa lower lower rate rate of output growth if prices have been rising at 5 percent per year in the immediate prices have have been expeimmediate past past than than if if prices been stable. stable. But But past past price price experience is itself itself related to earlier monetary growth rates. Hence, this explanation explanation implicitly implicitly makes makes the the current current division division of of aa change change in in money money income between prices and and output output aa function function of of the the earlier earlier history history of income between prices of monetary change. However, the precise extent of of the monetary change. However, the precise extent the influence influence of of cacapacity and that that of of earlier earlier price experience is is still still under pacity utilization utilization and price experience under ininthe forces forces determining of vestigation. Indeed, this issue vestigation. Indeed, this issue of of the determining the the division division of change in in income income between between prices prices and and output output is is perhaps perhaps the the major major aa change gap in in our our present knowledge of of monetary and effects. effects. gap present knowledge monetary relations relations and 6.4 Markets 6.4 The The Link Link Between Between Monetary Monetary Change Change and and Financial Financial Markets Monetary policy is often examined in relation to its effects effects on credit rather quantity of money. The rather than than on on the the quantity of money. The chief chief function function of of the the central central bank, on this view, is regarded as the control of commercial bank assets in form of of loans terms of of credit credit in in the the form loans and and investments, investments, the the terms in the the loan loan of market and the yields on a few widely traded securities. The effect effect of monetary the quantity money is monetary policy policy on on the quantity of of money is not not given given special special considconsideration. eration. Yet, there are many reasons for believing that the concentration on credit bank actions provides an credit aspects aspects of of central central bank actions provides an unreliable unreliable indication indication of the thrust of monetary policy. The importance attached to asset

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Why Money Matters

targets of central bank operations reflects the view that the "first" "first" round of circulation associated with asset creation by the banking system needs special attention. Spending consequences of such a first round are assumed to exhaust the monetary effects effects of changes in assets. Loans to the private sector are deemed to playa play a crucial role because it it is is taken taken for for granted granted that that the the transactions transactions velocity velocity of of such such funds funds is markedly higher higher than than that that of of swaps swaps of of bank bank deposits deposits for for Treasury Treasury bills bills markedly or or other other securities securities held held by by the the public. Alternatively, Alternatively, stress stress on on bank bank loans as as the the main main channel channel through through which which banks affect spending spending someloans banks affect sometimes rests rests on on the the assumption assumption that that the the market market for for credit credit is is fragmented, fragmented, times so that that borrowers borrowers denied denied bank bank loans loans perforce perforce must must abandon abandon or or postpostso pone they wish wish to pone investment investment plans plans they to finance. finance. It is conceivable conceivable that that the the first round round may may exhaust exhaust the the monetary monetary effects effects It is ofthe of the change in assets. This would be the case if a change in the supply of of money money associated associated with with asset asset creation creation just equalled equalled aa change change in in the the demand for money. However, if a change in supply produces a discrepancy crepancy between the the public's public's actual actual and and desired desired money money holdings, holdings, there there will be be future future effects effects in in subsequent subsequent rounds rounds of of circulation, circulation, which which will will will escape escape the the notice notice of of aa central central bank whose whose targets targets are are restricted restricted to to bank bank assets. assets. In any any event, event, the the link link between changes in in reserves reserves over over short short periods periods In between changes and the the volume volume of of particular earning earning assets assets is quite loose. loose. The The distridistribution of of earning earning assets assets among among liquid liquid assets, assets, other other investments investments and and bution loans loans is, is, in in the the first instance, instance, subject subject to to the the banks' banks' control. control. Similarly, Similarly, the link link between between changes changes in in reserves reserves over over short short periods periods and and changes changes the in interest interest rates rates and and credit credit conditions conditions is is quite quite loose. loose. Interest Interest rates rates and and in credit conditions conditions are are the the outcome outcome of of the the interaction interaction of of demand demand and and credit supply in in markets markets in in which which the the central central bank may not not participate or, if supply bank may participate or, if it does, does, may may not not be be dominant. dominant. Bank Bank assets assets in in the the form form of of loans loans and and it investments are are aa minor minor fraction fraction of of the the total total outstanding outstanding volume volume of investments of credit. It It has has been been shown shown that, that, in in the the United United States, States, central central bank bank action, action, credit. measured by by the the rate rate of of change accounts only only in part for for change in in money, money, accounts in part measured the pattern of interest interest rates rates with with respect respect to to the the peaks and troughs troughs in the pattern of peaks and in general business, and explains explains only only about about aa quarter quarter of of the the cyclical cyclical general business, and variation in in the the movements movements of of interest interest rates. rates. Clearly, Clearly, central central banks banks variation exert an important influence on credit conditions, but it is far from exert an important influence on credit conditions, but it is far from being controlling. being controlling. Moreover, changes changes in in the the volume volume of of particular types of of credit credit or or of Moreover, particular types of total of total bank bank credit, credit, in in credit credit conditions, conditions, in in the the level level of of or or the the rate rate of change in in interest interest rates rates provide basis for for interpreting interpreting the the stance stance change provide aa poor poor basis of of monetary monetary policy. policy. However However money money is is defined, defined, the the evidence evidence is is clear clear that it it changes changes at very different different rates rates than than do do particular types of of bank bank that at very particular types credit or or total total bank bank credit. credit. There There is is no no unambiguous measure of of credit credit credit unambiguous measure conditions. They They can can be be described described only only qualitatively qualitatively in in degrees degrees of of ease ease conditions.

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Anna J. Schwartz

or tightness, and the determination of what credit conditions are "appropriate" is equally amorphous. Since interest rates tend to move within a relatively limited range, a common fallacy is to assume that the top ofthe proof of tightness, and the bottom of the range of the range is proof proof proof of ease. Yet, tightness and ease are relative, not absolute, terms. A high interest rate when demand is strong may not be restrictive, while the same rate with weak demand may be highly restrictive. 6.4.1 6.4.1 Recent studies have shown that, while interest rates are initially lowered by increasing the quantity of money, this action produces income price effects income and and price effects which which will will offset offset the the reduction reduction within within several several months. Conversely for decreases in the quantity of money. That is why we observe rising interest rates during business expansions as a delayed consequence of a higher monetary growth rate and falling interest interest rates rates during during business business contractions contractions as as aa delayed delayed consequence consequence of aa lower lower monetary monetary growth growth rate. rate. The The initial initial effects effects on on interest interest rates rates of of of higher higher or or lower lower monetary monetary growth growth rates rates are are temporary: temporary: they they are are swamped by the effects effects of the ensuing increase or decrease in demand for for credit credit and and the the effects effects of of price price anticipations. anticipations. To To the the extent extent that that of lenders and borrowers anticipate changes in the purchasing power of money, be lower money, bond bond prices prices will will tend tend to to be lower and and nominal nominal yields yields higher higher when prices in general are rising than when prices in general are falling, since since the the decline decline (or (or the the rise) rise) in in the the real real value value of of the the principal principal is is aa deduction from from (or (or addition addition to) to) the the nominal nominal interest interest paid. paid. Hence, Hence, cencendeduction tral banks banks will will be be misled misled if if they they regard regard the the level level of of or or change change in in interest interest tral rates as as an an indication indication of of whether whether their their own own actions actions are are expansionary expansionary rates or contractionary. contractionary. or Though Though interest interest rates rates have have some some influence influence on on the the demand demand for for and and supply of money, and though there are undoubtedly some influences influences running of running from from prices prices and and output output to to changes changes in in the the nominal nominal quantity quantity of money, the weight of the evidence supports the proposition that the rate rate of of growth growth of of the the quantity quantity of of money money is is aa relatively relatively unambiguous unambiguous indicator of of monetary monetary conditions. conditions. A A sustained sustained rise rise in in the the rate rate of of growth growth indicator of of money money means means the the central central bank bank is is creating creating aa monetary monetary expansion expansion on on its own own or or acquiescing acquiescing in in monetary monetary expansion expansion set set in in motion motion by by the the its other determinants. determinants. Likewise, Likewise, aa sustained sustained decline decline in in the the rate rate of of growth growth other of money money means means the the central central bank bank is is creating creating aa monetary monetary contraction contraction of on its its own own or or acquiescing acquiescing in in monetary monetary contraction contraction set set in in motion motion by by the the on other determinants. determinants. other In post-war years one target of Bank of England operations has been the clearing banks' advances to the private sector. The object has been to to control control private private sector sector borrowing borrowing by by restricting restricting to to aa given given percentage percentage

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Why Money Matters

figure figure the increase, over some stated period, in the banks' advances, in order to hold down the demand for imports and domestic spending, both of which are assumed to be strongly associated with private borrowing. Recently, control of private advances has been exercised also as a means of curbing the quantity of money. Even if the banks hit the target-or, target—or, to use a more exact metaphor, get under the ceiling-control ceiling—control of poor way of advances advances would would still still be be aa poor way to to control control the the money money supply. supply. The links between advances and the money supply are too loose. To curb rate of curb the the rate of growth growth of of the the money money supply, supply, the the essential essential requisite requisite is is control of of the the monetary monetary base. This can can best best be be done done by Bank of of England England control base. This by Bank actions affecting affecting the the flow of reserves to the the banks. banks. actions flow of reserves to 6.5 6.5 British British Monetary Monetary Experience Experience Reasonably accurate annual data on the quantity of money in the United Kingdom United Kingdom are are available available for for 1880-1967. 1880-1967. Comparable Comparable annual annual data data for money income, prices and real income are available for an even longer period. An is longer period. An analysis analysis of of long-period long-period movements movements in in these these series series is now under way at the National Bureau of Economic Research in New York, but at which they York, but at this this stage stage only only the the basic basic data data in in the the form form in in which they are being being studied, studied, not not the results, can can be be presented. But, even even are the final final results, presented. But, from from this this elementary elementary material, material, it it can can be be seen seen that that the the evidence evidence for for the the United Kingdom is is broadly broadly consistent consistent with with that that for for the the United United States States United Kingdom on on the the relation relation between between monetary monetary changes changes and and changes changes in in other other ecoeconomic magnitudes. magnitudes. nomic For For aa study study oflong-period of long-period movements, movements, it it is is desirable desirable to to remove remove from from the data, so far as possible, the effects of effects of shorter-term movements of business cycles. A standard chronology of British business cycles dating from the mid-nineteenth century until the second world war has recently been extended basis, it possible to recently been extended into into the the 196Os. 1960s. On On this this basis, it is is possible to convert the the annual annual data data for for the the United Kingdom into into average average values values convert United Kingdom of phases of business cycles, of aa series series over over the the successive successive phases of business cycles, the the expansion expansion phase running from a cycle trough to a cycle peak, and a contraction phase running running from phase from aa cycle cycle peak peak to to aa cycle cycle trough. trough. The The initial initial phase phase covered by the money series is is the the contraction contraction running running from from aa peak in covered by the money series peak in 1883 to to aa trough trough in in 1886; 1886; for for the the other other series, series, it it is is the the proceeding proceeding 1883 1873 to toaa trough trough in in 1879. 1879.The The average average contraction running from aa peak peak in in 1873 contraction running from values for for incomes, incomes, prices prices and and the the stock stock of of money money are are shown shown in in figure values figure 6.1 plotted in the the middle middle of of each each phase. phase. 6.1 plotted in From the chart it will be seen that there is clearly a striking similarity between the course of the lines for the quantity of money and for money find income (the correlation is .972). It It is, perhaps, not surprising to find the prices and the quantity of money curves moving so closely together

180

Anna J. Schwartz Incomes, Prices and Stock of Money in U.K. 1876-1965

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of money in the United Kingdom, Incomes, prices, and stock of 1876-1965.

(the correlation correlation is is .976). .976). What What may surprising is is that, that, despite despite the the (the may be be surprising differences relation bebedifferences in in long-period long-period trends, trends, there there is is an an appreciable appreciable relation tween the the levels levels of of money and real real income income (the (the correlation correlation is is .970). money and .970). tween In In addition addition to to the the absolute absolute levels levels of of these these series, series, it it is is helpful helpful to to examine their their rates of change, change, as as shown shown in in figure 6.2. Rates Rates of of change change examine rates of figure 6.2. are notoriously erratic. Yet, Yet, there there is is scarcely scarcely aa movement movement of of any any size size are notoriously erratic. in the the money stock line line that does not not have its counterpart counterpart in in that of in money stock that does have its that of money income income (the (the correlation correlation is is .742). .742). The The similarity similarity between between the two money the two series does does not not reflect reflect any any spurious spurious correlation correlation arising arising from from reliance reliance series on common data, and and occurs occurs despite despite independent independent errors measureon common data, errors of of measurement in in the the data data underlying series. As As in in figure 6.1, the corment underlying the the two two series. figure 6.1, the cor-

181

Why Money Matters Rates of Change in Incomes, Prices and Stock of Money in U.K. 15r ^ 1880-1962

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relation of the rates of change in money and in prices (.798) is somewhat closer closer than that between the rates rates of of change change in in money money and and in in money money income. The two war-time peaks in the rate of change in money are reflected reflected in in the the rate rate of of change change in in prices. Real Real income income possibly possibly reproreproduces the first war-time peak in a muted form but not that of the second world world war. war. Omitting Omitting the the war war periods, periods, the the correlation correlation between money money stock and real income growth rates (.362) is not nearly so good as that between monetary monetary and and price change. change. The close close connection connection between between movements movements in in Britain's Britain's stock stock of of money money The and figures is and in in money money income income recorded recorded in in the figures is an an economic economic phenomphenomenon that that must must be be explained explained in in economic economic terms. terms. It It is is aa relation relation that that enon has has persisted persisted for for as as long long aa period as as there there are are data data to to examine, examine, for for cyclical as as well well as as longer-term longer-term movements. movements. Study Study of of the the data data for for the the cyclical United United States States has has revealed that that monetary monetary influences influences operate operate in in subtle subtle ways and and with with long long lags, lags, but but with and understandable understandable ways with highly highly regular regular and patterns. There There is is no no reason reason to to believe that that British British monetary monetary experience experience is an an exception exception to to this this conclusion. conclusion. is

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Anna J. Schwartz

Notes 1. Because actual tax receipts 1. Because actual current current tax receipts and and certain certain government government expenditures expenditures (such the level (such as as unemployment unemployment compensation) compensation) reflect reflect the level of of economic economic activity activity at tax and govat current current tax and expenditure expenditure rates, rates, the the measure measure of of "high-employment" "high-employment" government receipts and expenditures expenditures has been devised devised to effect of of the the ernment receipts and has been to reflect reflect the the effect budget independently of of the influence of of current current economic economic activity. activity. budget independently the reverse reverse influence This measure shows the the federal federal government's government's receipts receipts and and expenditures expenditures that that This measure shows would occur if if the economy were were at at high employment, aa situation situation in in which, which, would occur the economy high employment, but for for frictions, frictions, all all looking looking for for jobs at the the going going wage wage rate rate would would be able to to but jobs at be able obtain employment-in employment—in the the United United States, States, considered considered to to be be when when 96 96 or or 97 97 obtain percent of the labor force force is is employed. employed. percent of the labor 2. figures are U.S. and the U.K. 2. The The actual actual figures are .70 .70 for for the the U.S. and .77 .77 for for the U.K.

7

How Feasible Is a Flexible Monetary Policy? Phillip Cagan Cagan and and Anna Anna Jacobson Jacobson Schwartz Schwartz Phillip

7.1 7.1 Flexibility Flexibility and and the the Lag Lag in in Monetary Monetary Policy Policy

The of The position position now now 'held held by by monetary monetary policy policy as as the the main main tool tool of short-run stabilization stabilization has has yet yet to to be be reconciled reconciled with with the the accumulating accumulating short-run evidence evidence of of aa substantial substantial lag lag in in its its effects effects on on economic economic activity. activity. A lag complicates complicates the the execution execution of of policy, policy, since since it it means means that that actions actions lag take take effect effect well well after after they they are are initiated. initiated. Hence Hence aa policy policy of of stabilizing stabilizing short-run fluctuations in the economy implies the ability to forecast forecast the the course course of of economic economic activity activity and and the the subsequent subsequent effects effects of of policy policy actions. Twenty-five of Twenty-five years years ago ago Milton Milton Friedman Friedman pointed to to the the problems problems of a flexible flexible short-run stabilization policy.! policy.1 Adapting the argument specifically to flexible flexible monetary policy, he later wrote: "We seldom in fact know which way the economic wind is blowing until several months after after the event, yet to be effective, we need to know which way the wind is going to be blowing when the measures we take now will be effective, effective, itself itself a variable date that may be a half half year or year or two years from now."2 now."2 He concluded that countercyclical monetary policy in the United States was more often a destabilizing rather than a stabilizing influence and proposed as a policy rule a constant rate of of increase in the money stock. In recent years research on monetary policy has begun to explore the the problems problems faced faced by by stabilization stabilization programs programs with with short-run short-run objecobjectives. 33 In this paper we bring together the results of studies that provide evidence evidence of of the the lag lag in in monetary monetary effects. effects. The The lag lag patterns patterns indicate indicate that that a change in the money stock in the current quarter induces a change in in GNP GNP not not only only in in that that quarter quarter but but also also in in many many succeeding succeeding quarters. quarters. Thus, according according to to these these patterns, patterns, the the value value of of GNP GNP in in any any quarter quarter is is Thus, 183

184

Phillip Cagan and Anna J. Schwartz

a sum of the effects produced by money stock changes in a string of preceding quarters. Generally speaking, given the limitations of present forecasting capabilities, the longer the lag the more impracticable a policy of shortrun stabilization becomes. The flexibility flexibility allowed by the short inside lag of monetary policy-the policy—the lag between the provision of reserves to the banks by the Federal Reserve System and the change in the money stock-can stock—can be negated by a long outside lag-the lag—the lag between the change in the money stock and its effects. The studies we review suggest that the problem posed by imperfect imperfect forecasting techniques combined with long lags persists and, as Friedman pointed out, seriously limits the feasibility of flexible monetary of flexible monetary policy. policy. We begin by distinguishing the short-run monetary policy actions at issue issue here here from from the the day-to-day day-to-day and and week-to-week week-to-week flexibility also also adadvocated by the proponents of flexibility. flexibility. Possible conflicts are noted between the objective of of stabilizing stabilizing economic economic activity activity by by short-run short-run flexible flexiblemonetary monetarypolicy policyand andthe theobjective objectiveofofmoderating moderatingtransient transientmoney money market market disturbances disturbances by by aa policy policy of of stabilizing stabilizing interest interest rates rates (section (section 7.2). We We then compare some estimates of lags after after World War II with those those for for the the 1920s 1920s for for evidence evidence of of possible possible changes changes in in the the lag. lag. We were unable to establish that such changes had occurred. Our main focus is on four versions of of distributed distributed lag lag patterns patterns in in regression models models relating GNP to the behavior of the money stock in past quarters. All the lags cover many quarters (section 7.3). We predict GNP quarterly from M\ Mi data for 1921 1921 to 1970, based on each lag pattern, and select peaks and and troughs troughs in in the the estimated estimated GNP GNP series. series. The The timing timing of of these these turns compared with actual peaks and troughs in GNP or NBER reference dates suggests that the lag pattern itself itself is not fixed (section 7.4). For each of these lag patterns, we calculate the hypothetical required course of monetary growth in order to achieve a specified increase in GNP above its previous level. If the attempt were made to attain the target within a few quarters, it would require a complex path of monetary growth with the attendant possibility that the attempted policy itself, if not right on target, would become a source of instability. Neither the pattern estimated by the most sophisticated methods nor by simpler methods is favorable to a flexible flexible monetary policy (section 7.5). The effects effects on GNP of seasonal or other periodic movements in monetary growth are briefly discussed in section 7.6. Section 7.7 summarizes our findings. 7.2 7.2 Kinds Kinds of of Flexibility Flexibility flexible monetary Proponents Proponents of of aa flexible monetary policy policy often often have have several several objecobjectives tives in in mind, mind, not not all all of of which which are are beset beset by by aa lag lag problem. problem. Indeed, Indeed, aa

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How Feasible Is aa Flexibility Monetary Policy?

lag in monetary effects effects on economic activity means that day-to-day variations in monetary growth may be smoothed over by the lag and have no long-run importance for economic activity and prices. Consequently, such day-to-day variations can be made in pursuit of a transient with economic goals. sient objective objective without without interfering interfering with economic stabilization stabilization goals. In appraising appraising the of monetary monetary policy, policy, therefore, we should should In the flexibility flexibility of therefore, we distinguish three three different different objectives objectives of of monetary according to to distinguish monetary policy policy according the time time span span over which they apply. Spans Spans from from aa day up to to two or the over which they apply. day up two or three may be transient; the the short short run run covers covers spans spans from from three weeks weeks may be termed termed transient; month to to three three or or four four quarters, quarters, and and the the long long run run from from one one to to several several aa month years or longer. longer. years or On a day-to-day basis, open-market operations may be used to offset offset transient variations in the expansion multiplier of the banking system. Such variations originate within monetary system system and and affect affect the the Such variations originate within the the monetary growth rate of the money stock. stock. A major part part of of the day-to-day activity activity growth rate of the money A major the day-to-day of Federal Federal Reserve Reserve open-market open-market operations operations is is devoted devoted to to offsetting offsetting such such of variations and and is is believed believed to desirable to to control control the the stock stock of of money money variations to be be desirable in the short run. run. It It can can be be debated debated whether day-to-day variations in whether day-to-day variations in in the short monetary growth are are of of consequence, consequence, and and therefore therefore whether whether it it is is worthworthmonetary growth while trying trying to them, but in any any event event such such policy policy actions actions to to while to moderate moderate them, but in offset transient markets, typically undertaken offset transient movements movements in in financial financial markets, typically undertaken by Federal Federal Reserve, Reserve, have little import import for for economic economic stabilization. stabilization. by have little For high level level of For the the long long run, run, policy policy seeks seeks aa high of employment employment and and reareasonable may be sonable price price stability. stability. There There may be disagreement disagreement at at any any particular particular time on on the the combination combination of of employment employment and and price price change change it it is is desirable desirable time to achieve. But, given the the long-run long-run goal, goal, it be consistent consistent to try try to to achieve. But, given it will will be with aa particular average rate rate of of monetary growth. So So far far as as the monetary growth. the longlongwith particular average run goal is concerned, concerned, the would not be run goal is the monetary monetary growth growth rate rate would not have have to to be adjusted except perhaps infrequently for changes in the growth trend adjusted except perhaps infrequently for changes in the growth trend of monetary monetary velocity. velocity. The The transient transient and and long-run long-run objectives objectives of of monetary monetary of policy entail entail no no problem problem with lags. It It is short-run objectives objectives which which is the the short-run policy with lags. face aa problem. problem. face flexible monetary policy argue that all three time Proponents of a flexible horizons should be the concern of monetary policy, but they put particular emphasis on on the the need need for for short-run short-run flexibility. The purpose purpose is is ticular emphasis flexibility. The to cyclical fluctuations economic activity activity and and financial to moderate moderate cyclical fluctuations in in economic financial disturbances which which last last longer longer than than aa few few weeks. weeks. These These two two objectives objectives disturbances are partly since moderating moderating fluctuations in financial markets are partly related, related, since fluctuations in financial markets may help help to to stabilize stabilize economic economic activity. activity. This This is is true true of of shifts shifts in in prefprefmay erences by public as as between between money balances and and other other financial erences by the the public money balances financial assets. These These shifts lead to changes in interest rates can affect affect assets. shifts lead to changes in interest rates that that can aggregate demand, demand, and and an an accommodating accommodating monetary would in aggregate monetary policy policy would in this case keep both interest interest rates rates and and aggregate aggregate demand demand on on aa stable stable this case keep both course. The The problem problem is is that that changes changes in in interest interest rates can also also reflect reflect course. rates can

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PhilHp Phillip Cagan and Anna J. Schwartz

shifts in the demand for capital goods, and if interest rates are stabilized under these circumstances, an accommodating monetary policy will destabilize aggregate activity by feeding an inflation when interest rates rise or deepening a depression when they fall. 44 Unfortunately, there is often often no clear indication of the reason for changes in interest rates at the moment they occur. To avoid the possibility of interfering with the more important long-run objective of stabilizing aggregate demand, therefore, a policy of moderating changes in interest rates has to reverse itself itself within a short time period so as not to veer away from the appropriate long-run rate of monetary growth. Discussions of monetary policy have long noted this conflict conflict between the stabilization of interest rates and of aggregate demand. But the conflict is often obscured by the altogether different different question of using interest rates and general financial conditions as input data for forecasting economic activity and as indicators of whether the long-run goals are being achieved. A long-run goal for employment and prices implies some appropriate behavior of monetary growth and interest rates as well as other economic variables, and any group of these variables can in principle serve as indicators. In this way interest rates a"a apd financial conditions may certainly be relevant to policy-making, but their function as indicators does not mean that they should be stabilized as targets-that targets—that is, as the objective of policy. The proper role offinancial financial conditions in forecasting forecasting economic activity and as indicators of policy is a technical question which we put aside here. The financial markets The frequent frequent changes changes that that occur occur in in financial markets nevertheless nevertheless invite short-run variations in policy both to moderate the financial disturbances and to counteract the change in economic activity which those disturbances appear to indicate is underway (assuming the two objectives are consistent). Here the flexibility flexibility of policy can come into sharp conflict with the lag in its effect. Suppose that money has been growing at a rate which was thought appropriate to achieve the desired growth in aggregate demand for several years ahead. Then some new information information (financial or other) becomes available indicating that aggregate demand will be lower-though lower—though not permanently so-than so—than the long-run goal in the next several quarters. Should monetary policy attempt to correct the shortfall? The answer depends in part upon how quickly policy actions can be expected to affect affect aggregate demand. A change in money balances sets in motion a chain of adjustments adjustments which ultimately produces a change in aggregate expenditures, but the adjustments are spread over a considerable period of time. Hardly anyone expects policy to have its major effect effect on aggregate expenditures within a couple of months. But suppose it has some partial effect effect within a few quarters. The question can then be reformulated reformulated to bring out the problem: Should monetary growth be sharply adjusted adjusted to produce the

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How Feasible Is a Flexibility Monetary Policy?

desired effect effect in a few quarters with the intention of of reversing it later to avoid interfering interfering with the long-run goal? Whether such short-run flexibility in monetary policy accomplishes its purpose is a lively issue, because the Federal Reserve makes large and frequent frequent changes in the rate at which it supplies reserves to the banking system, apparently for all the reasons cited above. Present monetary policy works to offset offset transient fluctuations in the utilization of reserves by banks and to moderate other sources of disturbance to flexibility cited financial financial markets as they occur; this is the first kind of flexibility above. Monetary policy also pursues the second kind of flexibility to of flexibility achieve stability over the short run: it is clear from the reports of of the Open Market Committee that short-run operations are based on forecasts of economic activity for several quarters ahead with a view to altering the outcome in line with employment and price-level objecfinancial markets. tives, not to mention stability of of financial To what extent, then, can short-run variations in policy be successful successful in stabilizing economic activity and prices and, despite the lag in its flexible policy effect, effect, not be a source of instability? If the net effect effect of a flexible is to increase instability in the economy at large, it cannot be justified. We shall first examine the accumulated evidence on the lag, and then the implications for policy.

7.3 Evidence on the Monetary Lag 7.3.1 Step Dates The first statistical evidence on the lag was presented some years ago by Clark Warburton and then by Friedman and Anna J. Schwartz. 55 Warburton's measure of the lag, based on turning points in the deviations of monetary growth from its trend, is subject to considerable error because of difficulties difficulties in determining the trend. Friedman and Schwartz measured the lag from steps in the rate of change of money to corresponding business cycle turns. 66 The step method treats the monetary lag as discrete; that is, after after a delay, the impact of the change in monetary growth on activity is assumed to be concentrated at one point in time. The lags based on these steps since 1921 1921 are shown in table 7.1 for cyclical turns in general business activity, as given by the National Bureau chronology, and in GNP. The starting date is the earliest for which quarterly GNP is available. General business activity is the most relevant single benchmark for monetary effects. While GNP gives somewhat different different results, it is also relevant because most of the statistical GNP.?7 statistical lag lag patterns patterns to to be be examined examined were were estimated estimated for for GNP.

Lead (< - )) or or Lag Lag (+) ( + ) of of Steps Steps in in Monetary Monetary Growth Growth Rate" Rate8 Compared with Corresponding Cyclical Thms Turns in Business Activity and GNP, 1921-1970 (Quarten) (Quarters)

lllble Table 7.1

Date and Direction of of Step Thm Tbrn in Monetary Monetary Growth Ratea3 1921 IV 1922 IV 1924 1I 1925 III 1926 IV 1928 1I 1932 II 1936 II 1938 II 1945 III 1949 III 1952 IV 1954 1I 1955 III 1957 IV 1959 II 1960 II 1962 1I 1962 III 1966 1I 1966 IV 1969 II 1969 IV

up down up down up down up down up down up down up down up down up down up down up down up

Median 1920-38 1945-70

Reference Reference Cyclesb5 (1) (1)

+1 +1 -2 -2 -2 -2 -4 -4 -4 -4 -6 -6 -3 -3 -4 -4 0 +2 4-2 -I -1 -2 -2 -2 -2 -8 -8 -2 -2 -4 -4 -3 -3 none none none none -2 -2 -4 -4 -3 -3 -2 -2

GNP*: GNPC (2)

0 -5 -5 -2 -2 -5 -5 -6 -6 -6 -6 -3 -3 -5 -5 0 +1 +1 -1 -1 -2 -2 -I -1 -8 -8 -1 -1 -4 -4 -3 -3 none none -3 -3 -1 -1 -1 -1 -4 -4 -5 -5 -IV2 -V/2

Sources: Sources: Monetary step turns, Friedman and Schwartz (unpublished (unpublished manuscript), giving dates for MI Mi through 1969 IV, as in Edward Edward Gramlich, "The "The Usefulness Usefulness of of Monetary Monetary and Fiscal Policy as Discretionary Stabilization Journal of Money, Credit, Stabilization Tools," Journal of Money, Credit, and and Banking Banking 3 (May 1971): 506-32. Reference Reference dates, Geoffrey Geoffrey H. Moore, ed., Business Business Cycle Cycle Indicators (Princeton, N.J.: Princeton Indicators Princeton University Press for NBER, 1961), 1:671, and Solomon Fabricant, "Recent "Recent Economic Changes and the Agenda of of Business-Cycle Business-Cycle Research," Report 8, Research," National National Bureau Bureau Report 8, Supplement Supplement (May (May 1971):26, 1971):26, table table 2. 2. GNP GNP before before 1929, and Lawrence 1929, Harold Harold Barger Barger and Lawrence Klein Klein (unpublished (unpublished worksheets; worksheets; thereafter, thereafter, DepartDepartment ment of of Commerce). Commerce). a aNarrow Narrow money supply, MI. M\. b bSkipped Skipped reference reference turns are 1945 IV (trough) and 1948 IV (peak). c cNominal Nominal GNP through 1962 trough, real GNP thereafter. thereafter.

189 189

How Feasible Is aa Flexibility Monetary Policy?

The lags in column 1 of table 7.1 for business activity have an interquartile range of 1IV2 Y2 to 4 quarters and an overall median of of 2. 7.3.2 7.3.2 The The Step Step Dates Dates before before and and after after World World War War II II It It is is interesting interesting that that the the medians medians shown shown for for the the two two subperiods subperiods sugsuggest that that the the lags lags after after World World War War II II are are somewhat somewhat shorter shorter than than before. before. gest The The growth growth of of various various money money substitutes substitutes since since World World War War II II (partic(particularly savings savings and and loan loan deposits, deposits, time time certificates certificates of of deposit, deposit, Treasury Treasury ularly bills, bills, and and commercial commercial paper) paper) is is often often taken taken to to imply imply just the the opposite. opposite. John G. G. Gurley Gurley and and Edward Edward Shaw, Shaw, writing writing of of developments developments in in the the John 1950s, 1950s, touched touched off off aa voluminous voluminous literature literature on on the the dangers dangers of of money money substitutes to to the the efficacy efficacy of of monetary monetary policy. policy.88 Their Their argument argument was was substitutes that that the the growth growth of of substitutes substitutes makes makes the the demand demand for for money money balances balances more responsive to changes in interest rates, with the result that changes in the money stock take longer to affect affect aggregate expenditures. Supposedly a very elastic demand for money balances readily absorbs changes in the money stock through movements along the demand curve, thus delaying the effect effect on aggregate expenditures. Whatever the merits of the argument, the interest elasticity does not appear to have increased. We have estimated the short-run interest elasticity of of money money demand demand separately separately for for the the 1920s 1920s and and 1953-65, 1953-65, using using the the same same functional form to facilitate comparison, and find no evidence of an increase. increase. It It seems seems to to be be roughly roughly the the same same or or possibly possibly lower lower now. now. Although the growth of money substitutes contributed to the long-run decline decline in in money money demand demand which which is is reflected reflected in in the the postwar postwar rise rise in in monetary velocity, apparently it did not increase the interest elasticity of of the the remaining remaining balances. balances.99

7.3.3 Distributed Distributed Lags Lags 7.3.3 The The reduction reduction in in the the average average length length of of the the lag lag after after World World War War II, II, however, has has not not been been great great enough enough to to counter counter aa basic basic difficulty difficulty conconhowever, fronting aa flexible monetary policy. policy. The The difficulty difficulty pertains pertains to to our our imfronting flexible monetary imperfect knowledge knowledge of of the the lag lag in in monetary monetary effects on economic economic activity. activity. effects on perfect The lag lag varies varies considerably considerably over over time, time, owing owing in in part to errors errors in in the the The part to data as as well well as as the the existence existence of of other other cyclical cyclical developments developments that that reinreindata force or or offset offset the the monetary monetary effects. effects. The The variation variation is is also also aa reflection reflection force of the the diverse diverse channels channels through through which which monetary monetary effects effects are are produced, produced, of which means means that that the the resulting resulting changes changes in in aggregate aggregate expenditures expenditures occur occur which after delays delays of of different different durations. durations. Hence, Hence, depending depending on on the the particular particular after channels of of response response characterizing characterizing aa cyclical cyclical episode, episode, the the average average channels duration of of the the lag lag is is likely likely to to vary vary from from one one period period to to the the next. next. duration Even without changes from period to period, the various channels through which which monetary monetary effects effects are are produced produced have have different different lag lag times. times. through The differences differences mean mean that that the the total total effects effects of of aa monetary monetary step step are are The

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Phillip Cagan and Anna J. Schwartz

distributed over time. Numerous studies have estimated the average time distribution of the lag by relating GNP to the behavior of the money stock in past quarters, taking account in some cases of other influences on GNP. GNP. The regression coefficients coefficients of past monetary changes can be interpreted as forming the weights of a distributed lag. The regression which estimates these weights has the advantage of utilizing every observation of the time series within the period examined, instead of ignoring all observations except those around the step turns. But it also has the disadvantage, which is not true of the step dates, of assuming a fixed lag distribution over the period covered and of treating every observation as equally important in estimating monetary etIects.1O effects.10 Estimates Estimates of of aa distributed distributed lag lag were were presented presented by by Friedman Friedman and and David David I. I. Meiselman in their 1963 study,1l study,11 and their general approach was followed in subsequent work by the research staff staff of the Federal Reserve 12 The widely discussed St. Louis equation is a Bank of St. Louis. 12 relation between changes in GNP and lagged changes in the money stock, holding constant a variable representing fiscal policy (namely, changes in high-employment federal expenditures). Various versions of the lag pattern have been estimated, depending upon the period covered and the number of terms in the lag. All versions of the St. Louis lag pattern have the same general form. 13 form.13 The weights are the largest for the current and most recent past quarters, gradually declining thereafter, and becoming negative after after the fourth quarter if lag terms are included for such earlier quarters. Overshooting at the beginning is indicated when initial terms produce more than final total than the the final total effect. effect. Negative Negative weights weights at at the the end end provide provide aa partial partial offset. Such a lag pattern is theoretically appealing. It means that monetary changes induce a movement in the ratio of money to GNP initially away from its starting level because of the delayed etIect effect on GNP, but that that the the ratio ratio eventually eventually moves moves back back toward toward aa long-run long-run equilibrium equilibrium level. At At some some point, point, therefore, therefore, the the rate rate of of change change in in GNP GNP will will have have level. to to exceed exceed the the rate rate of of change change in in the the money money stock stock for for aa while while in in order order that the the ratio ratio of of money money to to GNP GNP can can move move back back toward toward its its starting starting level. level. that Hence Hence we we observe observe overshooting overshooting in in which which the the rate rate of of change change of of GNP GNP 14 goes past past its its new new equilibrium equilibrium for for aa while. while.14 goes We seWe reestimated reestimated various various versions versions of of the the St. St. Louis Louis equation equation and and seIS Its lag pattern is presented in column 2 lected one as representative.15 of A along of table table 7.2 7.2 as as St. St. Louis Louis A along with with others others to to be be discussed discussed shortly. shortly. The shape of the lag pattern remains largely the same for a smaller or larger As larger number number of of lag lag terms terms included included in in the the regression regression equation. equation. As usually presented, the St. Louis equation expresses the variables in dollar dollar amounts, amounts, but but here here we we used used percentage percentage changes. changes. The The percentage percentage form makes the result more applicable to a variety of time periods among among which which the the dollar dollar levels levels of of the the variables variables differ differ considerably. considerably.

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How Feasible Is a Flexibility Monetary Policy?

Table 7.2 1ltble

of the Distributed Lag 01 of Monetary Elreets Effects Estimates 01

St. Louis Lag Period (Quarters)

Steps (1)

0 1 2 3 4 5 6 7 8 9 10 11 12 Average length of of lag" lag*

2.6

FRB-MIT-Penn FRB-MIT-Penn

A (2)

B (3)

Silber (4)

.52 .62 .47 .22 -.03 -.03 -.21 -.21 -.26 -.26 -.22 -.22 -.10 -.10

0 .96 .63 .26 -.06 -.06 -.26 -.26 -.31 -.31 -.22 -.22

.32 .75 .68 .32 -.12 -.12 -.46 -.46 -.49 -.49 -.01 -.01

1.2

1.6

1.5

A (5)

.17 .12 .25 .10 .21 .00 .12 .02 .02

2.8

B B (6)

.13 .05 .16 .03 .10 .00 .05 .03 .03 .11 .11 .11 .11

6.1

Note: Note: No entry is shown in col. 1 since the step lag is not distributed. Cols. 2-4 2 - 4 give regression coefficients regression coefficients of of a regression of of GNP on the monetary monetary variable. Cols. 5-6 5 - 6 give coefficients coefficients based based on a simulation. Coefficients Coefficients have been adjusted adjusted to sum to unity (see n. 25 below). Details of of estimation estimation of of cols. 2-6 2 - 6 are as follows: (Col. 2) Percentage change in GNP regressed on percentage change in MJo Mi, 1954 I to 1971 II. The fitting used an Almon polynomial lag, 4th degree, with zero end-point end-point constraint constraint at the tailend. (Col. 3) Same as col. 2, except except that the monetary variable for the concurrent concurrent quarter quarter was omitted. omitted. monetary base as compiled compiled and published (Col. 4) Change in GNP regressed on change in monetary of St. Louis, 1953 I to 1969 I. I. See William L. Silber, "The "The St. by Federal Reserve Bank of ReLouis Equation: 'Democratic' and 'Republican' Versions and Other Experiments," Review 0/ of Economics Economics and and Statistics Simulation of of view Statistics 53 (Nov. 1971): 372-75. (Cols. 5 and 6) Simulation "Monetary Policy and Consumption: Consumption: model (see note 24 below). Franco Modigliani, "Monetary Effects in the Linkages via Interest Rate and Wealth Effects the FMP Model," in Federal Reserve Bank of of Boston, Boston, Consumer Consumer Spending and Monetary Policy: The Linkages (Boston, 1971), 1971), Spending and Monetary Policy: Linkages (Boston, Bank pp. 9-84: 9-84: figures figures kindly kindly supplied supplied by by the the author. author. Col. Col. 5 5 is is aa simulation simulation of of aa decreasll decrease in in pp. simulation of of an increase. demand deposits, and col. 6, a simulation a aFor For col. I, 1, mean of of entries in table 7.1, col. 1. For cols. 2-6, 2 - 6 , weighted averages, each a sum of products of of the lag period (through pllriod period 3 only for cols. 2-4, 2 - 4 , and full period 5-6) times the coefficients, coefficients, divided by the sum of of the coefficients coefficients included. included. for cols. 5-6)

mean

The patterns represent partial The other other lag lag patterns represent various various attempts, attempts, with with only only partial success, to to overcome overcome aa problem of feedback feedback for for which which the the St. St. Louis Louis success, problem of equation problem is bias produced by equation has has been been criticized. criticized. This This problem is the the bias produced by economic influences influences on on the the money money supply. supply. An An increase increase in in GNP, GNP, for for economic example, example, may may induce induce banks banks to to expand expand loans loans by by reducing reducing excess excess reserve reserve ratios or or increasing increasing borrowings borrowings from from Federal Federal Reserve Reserve Banks. Banks. There There ratios an are bank-generated expansion are limits limits to to how how far far this this bank-generated expansion can can go go without without an increase in in nonborrowed reserves, but but it it may may produce produce some some concurrent concurrent increase nonborrowed reserves,

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Phillip Cagan and Anna J. Schwartz

correlation between changes in GNP and in the money supply which is not due to monetary effects effects on GNP. GNP. The lag weight at time zero may be spuriously enlarged by this feedback and make the average lag in monetary effects effects appear shorter than it is. A drastic method for avoiding concurrent feedback is arbitrarily to assume assume that that the the concurrent concurrent coefficient coefficient is is zero zero and and to to impose impose that that conconstraint on the estimated pattern. The lag pattern shown in column 3 of of table table 7.2 7.2 as as St. St. Louis Louis B B was was derived derived by by this this method. method. It It has has aa slightly slightly longer average lag, as expected, but two obvious drawbacks. The method forces forces any any concurrent concurrent monetary monetary effects effects to to be be zero zero as as well, well, which which makes makes the average average lag lag appear appear longer longer than than it it probably probably is. is. At At the the same same time time the the the method method does does not not avoid avoid the the effect effect of of feedback feedback in in the the remaining remaining lag lag terms. 16 16 One One method method of of dealing dealing with with feedback feedback is is to to use use the the monetary monetary base base (that is, bank reserves plus currency held by the public) in place ofthe of the money money supply. supply. The The effects effects of of GNP GNP on on the the expansion expansion multiplier multiplier of of the the banking system are thereby omitted. As an alternative to the equation using the money supply, a version of the St. Louis equation using the 17 The latter approach was then monetary base was also presented.17 adopted adopted by by staff staff members members of of the the Board Board of of Governors Governors and and of of the the Federal Federal 18 Column 4 of table 7.2 Reserve Bank of New York. 18 7.2 gives a later version version by by William William L. L. Silber Silber which which is is preferable preferable for for our our purposes purposes because because he he 19 We have included more terms at the far end of the lag distribution. 19 assumed in assumed that that his his estimates estimates can can be be treated treated as as pertaining pertaining to to changes changes in the money money stock. stock. the The Silber equation has the disadvantage that it incorporates the lag time to the time from from the the monetary monetary base base to the money money stock stock as as well well as as from from money money to GNP. Yet the average length of of his lag pattern does not exceed most of of the the others, others, perhaps perhaps because because the the inside inside lag lag of of the the banking banking system system is is short. If If we we were were to to go go further further and and exclude exclude member-bank member-bank borrowing borrowing short. as as well well from from the the monetary monetary variable, variable, on on the the grounds grounds that that such such borrowing borrowing is endogenous and not offset offset by Federal Reserve open-market operations, tions, the the appropriate appropriate monetary monetary variable variable is is nonborrowed nonborrowed reserved. reserved. Richard G. G. Davis Davis has has shown shown that that the the inside inside lag lag (from (from aa change change in Richard in nonborrowed reserves reserves to to aa change change in in demand demand deposits) deposits) then then appears appears nonborrowed to be be longer, longer, and and Michael Michael J. J. Hamburger, Hamburger, that that the the total total inside inside and and outside outside to 2o We lag is is longer. longer.20 We have have not not included included such such lag lag distributions distributions in in order order to to lag maintain the the comparability comparability of of the the different different lag lag patterns patterns analyzed analyzed here. here. maintain The longer longer lag lag implied implied by by models models based based on on nonborrowed nonborrowed reserves reserves would would The increase the the difficulty difficulty of of conducting conducting aa stabilizing stabilizing monetary monetary policy. policy. increase Although Although Silber's Silber's use use of of the the monetary monetary base base avoids avoids feedback feedback from from GNP to bank reserve ratios and currency holdings, it incorporates any feedback feedback from from GNP GNP to to the the monetary monetary base base due due to to aa systematic systematic Federal Federal Reserve response to economic and financial developments (as do the

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How Feasible Is aa Flexibility Monetary Policy?

other well as those using reserves). For other equations equations as as well as those using nonborrowed nonborrowed reserves). For example, example, if if the the Federal Federal Reserve Reserve moderated moderated movements movements in in interest interest rates rates which fluctuations in base would which accompany accompany fluctuations in GNP, GNP, the the monetary monetary base would tend tend to display a positive covariation with GNP. A special econometric technique devised by Christopher A. Sims shows, however, that feedback on on the the money stock stock is is not not strong strong enough enough to account account for for the lag relationship between money money and and GNP, indeed does does not appear to relationship between GNP, and and indeed not appear to 21 Sim's be very important important if if we we disregard disregard the the concurrent concurrent quarter. quarter.21 Sim's techtechnique that quarter nique does does not not deal deal with with feedback feedback in in that quarter and and so so does does not not rule rule out an important immediate feedback from GNP to money. If it is important, raising the of important, however, however, it it has has the the effect effect of of raising the estimated estimated weight weight of the term in the lag making the the average the concurrent concurrent term in the lag distribution distribution and and of of making average lag Hence the lag appear appear shorter shorter than than it it is. is. Hence the St. St. Louis Louis and and Silber Silber patterns patterns may flexible monetary monetary may understate the the lag lag and and therefore the the difficulties difficulties of offlexible policy. (The not appear policy. (The St. St. Louis Louis B B pattern pattern in in table table 7.2 7.2 does does not appear to to be be an an adequate to this this feedback problem, possibly possibly because adequate solution solution to feedback problem, because of of serial serial correlation correlation in in the the variables.) variables.) Another problem recently Another estimation estimation problem recently discussed discussed by by Levis Levis Kochin Kochin arises policy control monetary growth to stabilize the econarises from from the the policy control of of monetary growth to stabilize the economy.22 monetary policy the effects omy.22 Insofar Insofar as as monetary policy succeeds succeeds in in offsetting offsetting the effects on on economic activity activity of of various disturbances, part of the the economic various nonmonetary nonmonetary disturbances, part of fluctuation in in monetary monetary growth growth will will not not correspond correspond with observed fluctuation with observed movements in GNP. GNP. In In the extreme case, case, if if monetary policy succeeded succeeded movements in the extreme monetary policy in removing all fluctuation fluctuation from from GNP, GNP, the the correlation correlation between between GNP GNP in removing all and money money would zero. If If the the stabilization stabilization policy policy is is partially partially but but and would be be zero. not completely successful, successful, the correlation will will be and if if the the not completely the correlation be negative, negative, and stabilization policy overcorrects for for nonmonetary disturbances, the the stabilization policy overcorrects nonmonetary disturbances, correlation will be positive. positive. Since Since we we observe observe aa positive positive correlation, correlation, correlation will be monetary policy policy in in practice overcorrects; that that is, is, less less fluctuation monetary practice overcorrects; fluctuation in in monetary growth growth would reduce the in GNP GNP growth. growth. But But monetary would reduce the fluctuation fluctuation in insofar as as monetary policy is is successful successful in in offsetting offsetting the effect on on GNP GNP insofar monetary policy the effect of some some nonmonetary nonmonetary disturbances, disturbances, the the observed observed relationship relationship between between of GNP and and money money does does not full effects effects of of money. money. Moreover, Moreover, GNP not portray portray the the full in that that case, case, it it is is not not at at all all clear clear how how the estimates of of the the lag lag distribution distribution in the estimates are affected. affected. are In the solution this estimation problem is to take take account In theory theory the solution to to this estimation problem is to account of nonmonetary variables variables which which monetary of all all the the effects effects on on GNP GNP of of nonmonetary monetary policy policy partially partially offsets. offsets. The The estimation estimation procedure procedure can can then allow allow for for the the interaction interaction between between monetary monetary growth growth and and other other variables. variables. The intention of of the the large large econometric econometric models models is is indeed indeed to to take take account account of of all all influences influences on on GNP. GNP. Columns Columns 55 and and 66 of of table table 7.2 7.2 present present the the lag lag pattern of of monetary effects effects implied implied by by the the FRB-MIT-Penn FRB-MIT-Penn econeconometric model. 23 23 This is a large-scale model which takes into account financial sysmany relationships, many relationships, including including feedback feedback from from GNP GNP to to the the financial sys-

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Phillip Cagan and Anna Sc:hwartz Anna J. Schwartz

tem and nonmonetary influences on GNP. GNR Despite simplifications to make the model manageable, it has the most elaboratefinancial financial sector of any econometric model so far constructed and represents the "state of the art" art" of model building as it exists today. Yet we are not alone in doubting seriously whether even this elaborate model deals adequately with feedback and with the more important problem just discussed of isolating the effects of stabilization policies. So far it has proved difficult to capture in an econometric model all all the the disturbances disturbances affecting GNP which monetary policy may try, in part successfully, to offset. We We regard the lag estimates produced by the FRB-MIT-Penn model-the model—the best of the attempts to allow for interactions-as interactions—as representative of large econometric models. 24 The esThe lag pattern of this model was derived by simulation. simulation.24 timates represent the effect of a hypothetical $1 $1 billion change in demand deposits on the level of GNP in 1967 I. I. A simulation for a decrease in demand deposits is shown as A A in table 7.2, and one for an increase increase as as B. B. Because Because monetary monetary policy policy will will produce produce changes changes in in GNP GNP before the full effects on the level occur, we expect the FRB-MIT-Penn the lag lag pattern pattern to to be be longer longer than than the the others. others. The The longer longer average average lag lag of of the pattern may may also also be be due due to to the the fixed channels of of monetary monetary effects effects it it pattern fixed channels prescribes. prescribes. Changes Changes in in monetary monetary policy policy in in the the model model have have the the effect effect of changing changing particular particular interest interest rates rates and and thereby thereby various various components components of of investment investment and and consumption. consumption. Insofar Insofar as as the the actual actual channels channels are are more more of diverse and and varying varying than than the the model model provides provides for, for, the the effects effects tend tend to to be diverse be understated and and very very likely likely tend tend to to be be faster faster in in coming coming than than it it predicts. understated predicts. 25 The lag patterns in table 7.2 have been adjusted to sum to unity. unity.25 Thus each weight gives the percentage of the total effect which occurs in each quarter. Although none of the estimation procedures imposed such such aa condition, condition, we we made made the the adjustment adjustment so so that that they they would would all all give give the same same long-run long-run relation relation between between GNP GNP and and the the money money stock. stock. (The (The the adjustment esadjustment also also converts converts the the FRB-MIT-Penn FRB-MIT-Penn patterns, patterns, which which were were estimated from variables in dollar terms, into a form applicable to variables percentage terms.) ables in in percentage terms.) The The condition condition is is theoretically theoretically appealing. appealing. For the the levels levels of of the the variables, variables, aa sum sum equal equal to to unity unity means means that that the the For rates ratio ratio of of money money to to GNP GNP eventually eventually returns returns to to its its initial initial level. level. For For rates of change change of of the the variables, variables, it it means means that that the the growth growth rates rates of of GNP GNP and of and 26 the the money money stock stock eventually eventually become become equal. equal.26 The The patterns patterns shown shown in in table table 7.2 7.2 represent represent the the best best of of recent recent research research 27 Each of the methods of estimation presents certain on monetary lags. lags.27 problems, problems, as as noted, noted, and and none none can can be be clearly clearly preferred. preferred. Hence Hence the the exact exact form of the pattern remains in doubt. All agree, however, in showing aa distributed distributed lag lag covering covering many many quarters. quarters. On On that that the the evidence evidence is is clear. clear. If monetary monetary policy policy is is to to take take account account of of lags, lags, it it will will have have to to reckon reckon If with the the results results of of studies studies such such as as these. these. with

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How Feasible Is aa Flexibility Monetary Policy?

7.4 Turning Points Implied by the Lag Patterns Whether the lag in monetary effects effects implied by these patterns is biased toward the long or the short side can be tested by the turning points in business activity derived from them. This test also indicates how consistently such fixed lag patterns fit the data over a long period, and particularly whether the variability of the leads in step turns can be explained by the configuration configuration of monetary growth surrounding the steps. We calculated the predicted levels of GNP from 1921 1921 to 1971 1971 estimated by each lag pattern. As noted earlier, we used the predicted level before 1960 and the level divided by the implicit price deflator for GNP thereafter, because of the difficulty difficulty of selecting turns in the undeflated undeflated level during the second half half of the 1960s. For the FRB-MITPenn pattern pertaining to levels, the logarithm of demand deposits was run through the lag pattern to derive an index of the level of GNP (in logarithms). Of course, this procedure gives only an approximation to a full simulation of the model. For the other patterns pertaining to rates of change, the quarterly rate of change of Ml Mx was run through the lag pattern to generate an estimated rate of change of GNP (with the constant term omitted). These rates of change of GNP were then used to derive an index of the level of GNP. Since the lag patterns are adjusted adjusted to sum to unity, the average rate of growth of this GNP index is the same as that of the money stock. The trend of the index and the trend of actual GNP differ differ by the trend in the ratio of GNP to the money stock. But these trend differences differences have little effect effect on the dates of turning points. We selected peaks and troughs in the estimated GNP indexes. The turns not corresponding to turns in actual GNP were disregarded. The selected turns turns were compared with with the actual peaks and troughs in selected were compared the actual peaks and troughs in National Bureau reference cycles (which sometimes differ differ from the turns in GNP).28 differences are presented in table 7.3, GNP).28 The timing differences together with the average of these differences differences compared with the average deviation for step cycle turns. The FRB-MIT-Penn model has the shortest leads or longest lags (because of its long pattern). It It fails to register many of the turns. The turning points of the other lag patterns, which are shorter than it is, are generally close to the turns in business activity. The differences differences in timing among the three lag patterns excluding FRB-MIT-Penn do not appear significant. (As we shall see below, however, the differences differences are important for policy purposes.) On this evidence, it is hard to choose among these three. The variability in their timing is about the same. The Silber pattern has the smallest average deviation because of its bullseye at the 1957 III peak, which the St. Louis patterns miss by well over a year. Otherwise it is not more accurate.

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Phillip Cagan and AnnaJ. Anna J. Schwartz

'Illble Table 7.3

Lead ( -—) )or orLag Lag(+) ( + )and andAverage AverageDeviation Deviationof ofEstimated EstimatedTurns Turns Compared with Actual Turns in Business Activity, 1921-70 1921-70 (Quarters)

Peaks and Troughs in Business Activity" Activity*

Steps

A

B

Silber

1921 III 1923 II 1924 III 1926 III 1927 IV 1929 III 1933 1I 1937 II 1938 II

+ 3.6 +3.6 +0.6 + 0.6 + 0.6 +0.6 -1.4 -1.4 -1.4 -1.4 -3.4 -3.4 -0.4 -0.4 -1.4 -1.4 +2.6 + 2.6

+2 +2 +1 +1 -1 -1 -2 -2 -1 -1 +1 +1 +1 +1 -1 -1 +1 +1

+2 +2 +1 +1 -1 -1 -2 -2 -2 -2 +2 +2 -1 -1 00 +1 +1

+2 +2 0 -1 -1 -2 -2 -2 -2 +22 + -1 -1 0 +1 +1

bb + 1.6 1.6 + 0.6 +0.6 +0.6 + 0.6 -5.4 -5.4 +0.6 + 0.6 -1.4 -1.4 -0.4 -0.4 -0.4 -0.4 + 1.6 1.6 + 0.6 +0.6 -1.4 -1.4

-4 -4 0 0 -1 -1 -6 -6 -1 -1 -3 -3 -1 -1 -1 -1 0 -1 -1 -3 -3

-3 -3 0 +1 +1 0 -7 -7 0 -2 -2 -1 -1 0 +1 +1 0 -2 -2

-3 -3 -1 -1 -1 -1 -1 -1 00 00 -3 -3 -1 -1 -1 -1 +1 +1 -1 -1 -2 -2

trough peak trough peak trough peak trough peak trough

1948 IV peak 1949 IV trough 1953 II peak 1954 III trough 1957 III peak 1958 II trough 1960 II peak 1961 I trough 1966 IV peak trough 1967 1I 1969 IV peak 1970 IV trough Average absolute deviation< deviation 0

St. Louis

1.5

1.5

1.3

1.2

FRBMITPenn b b

-2 b b +1 +1 +7 +7 +2 +2

b b b b b b b b b b

-1 -1 0 -2 -2 -3 -3 2.2

Note: Entries for step turns are the deviations from the average lead of Note: of 2.6 quarters (see table 7.2). GNP, estimated estimated from lag patterns, was deflated deflated for 1966-70 before before selecting of the estimates skip the turns. For FRB-MIT-Penn FRB-MIT-Penn esturns. Without deflation, most of selected from estimates based timated GNP, peaks were selected based on table 7.2, col. 5, troughs from estimates based on table 7.2, col. 6. from a "Peaks Peaks and troughs in National Bureau reference reference cycles (see source note to table 7.1) except except for 1966-67, which is not designated a reference reference cycle and is based on turns in real real GNP. GNP. The The 1945 1945 reference reference peak peak and and trough trough are are omitted. omitted. b bNo No matching tum. turn. c