Political Economy of Money: Emerging Fiat Monetary Regime

POLITICAL ECONOMY OF MONEY

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POLITICAL ECONOMY OF MONEY Emerging Fiat Monetary Regime GEORGE MACESICH

PRAEGER

Westport, Connecticut London

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

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

9 8 7 6 5 4 3 2 1

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

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Contents Preface

ix

1.

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

1 1 9

2.

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

15 15 16 17

3.

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

31 31 35 36 38 45

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

47 47

4.

Contents

Vlll

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

54

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

61 61

6.

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

77 77 84

7.

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

89

8.

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

67

89 91 100 105 105 107 110 112

Selected Bibliography

121

Index

133

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

X

Preface

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

CHAPTER 1

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

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Political Economy of Money: Emerging Fiat Monetary Regime

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

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3

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

2.

3.

4. 5.

6.

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

4

Political Economy of Money: Emerging Fiat Monetary Regime

7.

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

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

The Issue of Money

5

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

6

Political Economy of Money: Emerging Fiat Monetary Regime

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

The Issue of Money

7

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

8

Political Economy of Money: Emerging Fiat Monetary Regime

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

The Issue of Money

9

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

10

Political Economy of Money: Emerging Fiat Monetary Regime

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

The Issue of Money

II

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

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Political Economy of Money: Emerging Fiat Monetary Regime

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

The Issue of Money

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

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CHAPTER 2

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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CHAPTER 3

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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3. See Frank D. Graham, Exchange, Prices and Production in Hyperinflation Germany 1920-25 (Princeton: Princeton University Press, 1930). 4. See George Macesich, The International Monetary Economy and the Third World (New York: Praeger Publishers, 1981), pp. 26-35. 5. The fact is that apparently little attention appears to have been paid by countries to the rules of the gold standard game in the pre- and post-World War I period though the evidence is far from conclusive. See, for instance, Arthur I. Bloomfield, Monetary Policy under the International Gold Standard: 1880-1914 (New York: Federal Reserve Bank of New York, 1959) and Ragnar Nurkse, International Currency Experience (Geneva: League of Nations, 1944). 6. See George Macesich, "Supply and Demand for Money in Canada," in David Meiselman, z<\., Varieties of Monetary Experience (Chicago: University of Chicago Press, 1970), pp. 249-296. 7. See George Macesich, Yugoslavia: The Theory and Practice of Development Planning (Charlottesville: University Press of Virginia, 1964). 8. See W. S. Vuchinich, "Interwar Yugoslavia," in Contemporary Yugoslavia, ed. W. S. Vuchinich (Berkeley: University of California Press, 1969). 9. See George Macesich, "Monetary Policy and International Interdependence in the Great Depression: The U.S. and Yugoslavia," Zbornik (Belgrade: Serbian Academy of Sciences and Arts, 1976), pp. 77-100.

CHAPTER 4

The Emerging Postwar Fiat Monetary Regime: Myth, Fact, and Fancy THE BRETTON WOODS REGIME Myth, fact, and fancy dominated postwar attempts to reconstruct the international monetary regime. Such major political and economic issues as exchange rates, international liquidity, and the adjustment process that plagued the interwar period were placed high on the agenda in international conferences. Basic questions concerning whether to demonetize gold and replace it with international reserve credit money, the distribution and creation of international liquidity, and relations between debtor and creditor countries and their respective responsibilities in the international adjustment process all came up for discussion, if not resolution, in the postwar period. The various solutions advanced always came encumbered with their heavy economic, political, and ideological baggage. This left the puzzling choice between real and spurious solutions. The net effect was that few monetary problems can ever have been so ingeniously contrived to maximize difficulty as that of the postwar monetary organization. A carefully cultivated view with roots in the interwar period and more myth than reality argues that the United States was not only able,

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it was also willing, to assume the postwar leadership role—in effect to become and act as stabilizer as some had urged in the interwar period.1 American policymakers, so it is argued, had learned an important lesson in the postwar period. The "failure" of American leadership and the country's withdrawal into isolation after World War I are viewed as major factors in the collapse of the economic system and of the peace. Some American policymakers thus believed that after World War II the United States could no longer isolate itself. As the strongest power in the postwar world, the United States would have to assume responsibility for establishing political and economic order. With the outbreak of the Cold War another dimension was added, and the case strengthened for the need of American leadership. Without American leadership economic weakness in Europe and Japan would lead to Communist political victories. In short, the strength of the American economy, the lessons of the interwar period, and the Cold War security incentives made American leadership necessary and palatable economically and politically at home and abroad—at least to some Americans, Europeans, and Japanese. Certainly the British supported and actively cultivated such a view if only because it would provide props to British imperial power. As in the interwar period, they were again to be sadly disillusioned, for again American and British views differed in important respects. Indeed, Keynes' report after the Bretton Woods conference to the British Parliament explaining the nature and scope of the new international monetary regime and its centerpiece the International Monetary Fund (IMF) argues that the domestic supply of money would no longer be regulated by gold flows and that the IMF proposals were the exact opposite of the gold standard.2 Keynes's view was not shared by the Americans. In fact, the U.S. Congress was being presented with the view that the dollar was "defined" in terms of gold and that the IMF would operate much like the gold standard.3 In Keynes's view, the new international order was "far removed from the old orthodoxy. If [IMF and the Bretton Woods agreements] do so in terms as inoffensive as possible to the former faith, need we complain?" All of this, he argued, serves to provide an international framework for the new ideas and new techniques associated with the domestic policy of full employment. American proposals, at least initially, did not envision such drastic departure from orthodoxy nor that the United States was to be the prin-

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cipal world stabilizer and, in fact, financially and economically underwrite the entire arrangement. Indeed, the initial American plan for an International Stabilization Fund, presented by Harry Dexter White, differed in these main points from the British plan for an International Clearing Union, presented by Lord Keynes. In the first instance, the Americans opposed creation of $26 billion in international liquidity that the British argued would be necessary to finance expansion of world trade and postwar recovery. Such provisions for an increase in international liquidity they viewed as an application of the deficit financing translated from the domestic to the international scene and hence not likely to serve as a means for stabilization. Instead of new international reserves, the Americans proposed that the Stabilization Fund could just as well operate with a much smaller amount of $5 billion in gold and national currencies. In the second instance, the Americans did not view with enthusiasm the proposal contained in the British plan for flexibility in exchange rates. They argued that exchange rates be fixed and changed only with the consent of 80 percent of the voting power. Finally, the Americans were not at all attracted to the British idea that pressure should be exerted on a creditor country to facilitate international adjustments. The Americans clearly expected to be the largest creditor in the postwar period and thus wished to limit American liability. One other plan that never made the Bretton Woods agenda was the "key currency" plan promoted by J. H. Williams of Harvard University and the Federal Reserve Bank of New York. It is worth noting, if only because what is strictly academic today might well be tomorrow's reality. The essence of Williams's proposal is that postwar stability really rested on the position of the American dollar and British pound. They are the key currencies in the sense that they play dominant roles in world trade, finance, and foreign exchange markets. According to Williams, internal monetary stability and cooperation between the United States and Great Britain is the critical issue and what happens to their currencies determines events in the rest of the world as well. If stability could be maintained in these two countries and in the dollar-pound exchange rate, stability in other countries would not present major difficulties. Europeans tended to opt for the gold standard and its advantage, which alternative systems do not possess—at least as practical worldwide systems. F. A. Hayek draws attention to at least three virtues of the

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gold standard that in view of postwar experience have considerable merit to many people.4 Although far from perfect, the gold standard did create an international currency without submitting national monetary policy to the decision of an international authority. It did make monetary policy by and large automatic and fairly predictable. It did secure changes in the basic money that tended to be in the right direction. Moreover, the "ruling superstitious prejudice in favor of gold" made the international gold standard possible. Indeed, this prejudice in favor of gold made an international money possible at a time when any other arrangements by international agreement and cooperation were unlikely. J. M. Keynes and other critics were quick to point out that the international gold standard does not provide the world with the appropriate quantity of money to ensure stable prices—though arrangements could be provided to compensate for this drawback.5 Second, and perhaps more important, Keynes argued that wages tend to rise beyond the limits set by the volume of money, but can only be prevented from doing so by the weapon of deliberately creating unemployment. This weapon, according to Keynes, after a good try, the world has decided to discard. To Keynes the primary aim of an international currency arrangement should be to prevent not only those evils that result from a chronic shortage of international money due to the drawing of gold into creditor countries, but also those that follow from countries failing to maintain stability of domestic efficiency costs and moving out of step with one another in their national wage policies without having at their disposal any means of orderly adjustment. In Keynes's view, a system providing orderly adjustment would allow countries to pursue different wage policies and so different prices are impossible under a strict gold standard. The error of the gold standard, according to Keynes, lay in submitting national wage policies to outside dictation. In his view it is wiser to regard stability (or otherwise) of internal prices as a matter of internal policy and politics. Some countries will be more successful than others in their pursuit of wage and price stability. Keynes went on to observe at the time as a portent of things to come in the postwar period that some people argue that a capitalistic country is doomed to failure because it will be found impossible in conditions of full employment to prevent a progressive increase in wages. According to this view, Keynes observed, severe slumps and recurrent periods of unemployment have been hitherto the

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only effective means of holding efficiency wages within a reasonably stable range. He went on to observe that whether this is so remains to be seen. The more conscious we are of this problem, he noted, the likelier shall we be to surmount it. Not everyone agrees with Keynes' interpretation of prewar experience. Hayek, for instance, in discussing lessons to be drawn from British prewar experience agues that it was unique and exceptional in that the problem of unemployment was largely a problem of a too-high level of real wages, and in which the much more crucial and general problem of flexibility of the wage structure could be neglected. As a result of Britain's return to gold in 1925 at the 1914 parity, he argues, a situation had been created in which it could be plausibly argued that all real wages in Britain had become too high for her to achieve the necessary volume of exports. He notes that it is doubtful whether the same has ever been true of any important country, and even whether it was entirely true of the Britain of the 1920s. It is also true, Hayek notes, that Britain then had the oldest, most firmly entrenched, and most comprehensive trade union movement in the world, which by its wage policy had succeeded in establishing a wage structure determined much more by considerations of justice, which meant little else than the preservation of traditional wage differentials, and which made those changes in relative wages demanded by an adaptation to changed conditions politically impossible.6 Not every country was willing to incorporate into the design of the postwar monetary regime an important lesson from British experience. This is the lesson on the role of changes in relative wage rates and prices, reallocating labor and resources between industries so as to facilitate continuous adaptation to changing economic and technological conditions to maintain and advance real income and wealth. The substitution of unions and other institutional arrangements for the market mechanism in setting wages and prices had become an established fact in many countries in the post-World War II period. The consequent wage and price rigidities, viewed by many economists at the time as irreversible, required policies to be adapted accordingly and had imparted severe inflationary bias to the world economy. Moreover, government macroeconomic policies designed to promote maximum employment and output serve in part to reinforce this inflationary bias. The end product of American and British consultations, meetings, conferences, and redrafts of the Keynes and White plans over the period 1941-1944 was the Bretton Woods conference, convened in July 1944,

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and the establishment of the International Monetary Fund. The operation of IMF was the key role of such reserve currencies as the dollar and pound, which shaped much of the postwar international monetary regime. Keynes's idea expressed in his General Theory provided the basis of postwar economic policy for the United States and other Western industrial nations. Basic to Keynesian doctrine is the use of government fiscal power to stimulate the economy when unemployment is high and restrain the economy when high employment and excessive demand begin to cause wage and price rises to reach an inflationary rate. In general, much of postwar economic policy has been postKeynesian in the sense that some, but not all, theorists and policy-makers in major Western countries have agreed in principle on Keynesian ideas of how to deal with unemployment and inflation. Since their triumph in the postwar period, Keynesian policies have not always come up to expectation. The theories and policies have been rigorously and increasingly challenged by many economists, most notably by Milton Friedman. A number of factors appear to have influenced the less than satisfactory outcome of both the theories and policies derived from these theories. The inflationary outburst in the mid-1960s appears to be traceable to the Cold War and its hot manifestations. Fiscal mismanagement by the federal government and the new Great Society programs added to the pressures. The United States is blamed for contributing to European inflation by forcing overvalued dollars on the Europeans, particularly in the form of investments. Into the decade of the 1970s, crop failures and soaring oil prices compounded world problems. When President Kennedy took office, the level of output was below capacity, and unemployment for the previous three years had been around 6 percent and was rising. New Frontier economists diagnosed the trouble as stemming from the Eisenhower administration's overrestrictive fiscal policy. In the previous two years, the federal budget had shown an approximate balance despite the 1958-1959 recession. The Kennedy administration set a "full employment" target of 4 percent unemployment and set out to stimulate the economy by increasing federal spending and sending the budget into deficit. Monetary policy was "easy" and interest rates were kept "low." These expansive measures were reinforced by the tax cut granted in 1964. Wage and

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price guidelines were pressed into service in an attempt to keep the economy on even keel. When the economic situation began to get out of hand in 1965, Keynesians urged fiscal measures in the form of tax increases. Owing to escalating Vietnam War and Great Society costs that were either underestimated or understated and his own unwillingness to take action for fear of inviting public criticism, President Johnson rejected the advice of this own economic advisors. Fiscal measures were not implemented. The resulting huge budget deficits served to escalate inflation. One can argue that Keynesian economics did not fail. Political leadership in fact mismanaged the economy and brought the country to the brink of disaster. Keynes always assumed that a capable and sophisticated political leadership would be at hand to administer and manage the affairs of nations. This does not always happen. Economic theory often gives way to "political reality." Affairs were not much better served by President Nixon's administration. In early 1969, a tax surcharge tardily voted by Congress together with administration efforts to counter inflation with a combination of tighter fiscal and monetary policies attempted to achieve a return to full employment and price stability. This is now the familiar policy of "gradualism," which failed to control inflation. This policy may have been more successful had not the dollar "weakened" in the summer of 1971. As a result, stricter measures were put in place. These measures included wage and price controls and were labeled the New Economic Policy (NEP). The net effect of NEP anti-inflation policies appears to have been the raising of interest rates by the Federal Reserve System. It was expected that monetarism would be tried by the Nixon administration. This did not happen. In fact, President Nixon's administration opted for the Keynesian concept of the "full employment budget." Accordingly, monetary and fiscal policy is to be used to stimulate the economy when unemployment rises above 4 percent and measures are taken to restrain the economy when the full employment goal is reached. Just how Keynesian the administration was becoming is suggested by the 1975 budget, when the administration was willing to consider a major program of public service employment if unemployment reached "serious" proportions. The issues of the deficit, inflation, and, most importantly, the expanding role of government are Keynesian ideas. In the immediate

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post-World War II years, these ideas permeated the leading industrial countries. They have also made it possible for the United States and its allies to carry out worldwide commitments undertaken as a consequence of the Cold War. Indeed, these resources provided the solvent for dissolution of old empires in the postwar years and the Soviet Union in 1990. These problems may or may not have been foreseen. The net effects were that the Bretton Woods regime by the mid-1960s began to show itself incapable of handling a very different world from that envisioned by its framers.7 Depending on one's viewpoint, it can be argued that the Bretton Woods regime, thanks in large measure to American participation and generosity, enabled the Europeans and Japan to recover from the devastation of the war and established a stable monetary regime as well as a more open trade and financial system that led to a period of unparalleled economic growth. This was not to last. Partly because the system had become dollarcentered, persistent deficits and piling up of short-term indebtedness of the United States as a reserve center slowly undermined the confidence of other countries in the ability of the United States to honor its commitment to redeem dollar holdings in gold. Indeed, by the early 1960s R. Triffin, in his various writings, noted that other countries derived from net American losses nearly 60 percent of their total reserve increases in 1958-1962.8 This was simply not a safe and rational way to regulate the increase in international reserves that are to serve as the ultimate basis, especially under conditions of convertibility for increases in national money supplies necessary to support growing levels of production and trade in an expanding world economy. QUANTITY THEORY, INCOME EXPENDITURE THEORY, AND THE BALANCING MECHANISM OF INTERNATIONAL TRADE Theoretical and empirical underpinnings supporting the post-World War II system are indeed wobbly. Postwar balance-of-payments problems are partly the result of the policy applications of the Keynesian view of international trade theory. Derived from the Keynesian income expenditure theory, the Keynesian view relegates the role of the stock of money to a secondary place in determining money income.9 It asserts that the stock of money and monetary policy aimed at its control is inca-

The Emerging Postwar Fiat Monetary Regime: Myth, Fact, and Fancy55 pable of significantly, or dependably, influencing the circular flow of income and thereby the balance of payments. One reason for this minor role is the conviction that monetary velocity behaves in an erratic and unpredictable manner whereas the investment multiplier is the more useful concept because of its relative stability. By way of contrast, preKeynesian theory attributed a central role to the stock of money and so to monetary policy in the balancing mechanism of international trade. In contained an explicit acceptance of the quantity theory of money, which argues, among other things, that monetary velocity does behave in a predictable manner. The previously received doctrine of the monetary theory of international trade and the belief that the monetary system operates in such a way that a country's balance of payments tends automatically toward a state of equilibrium were subjected to serious question with the publication of Keynes's General Theory. The pre-Keynesian textbook belief was that if one country had a surplus in its balance of payments, an inflow of gold into the surplus country would increase its stock of money and so bring about internal price rises. The domestic inflation, in turn, would increase imports and reduce exports and eventually restore balance-of-payments equilibrium. The effects on the deficit country would be symmetrically opposite. Prices would decline as a result of the gold outflow and the stock of money decreases, thereby making it a relatively cheaper place in which to buy goods. Exports would increase and imports decrease in the deficit country, thereby tending to equalize receipts and payments and work to restore equilibrium in its balance of payments. The simple view contained the principal mechanism for balance-ofpayments adjustments to restore equilibrium. It was modified so as to take into account changes in foreign balances, the similarity of foreign exchange shifts to gold movements, the existence of fractional reserve banking, the effect of interest rates in capital movements as well as other factors. Such a view of the balancing mechanism obtained considerable influence.10 An important theoretical foundation to this pre-Keynesian view is the acceptance of the quantity theory of money as a principal component in the balancing mechanism of international trade. It asserts that an increase or decrease in the quantity of money leads to an increase or decrease in the aggregate demand for goods and services. In effect, the quantity theory implies that the level of aggregate demand is de-

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termined by the supply of money and by velocity, the relation between the stock of money and the flow of income. It asserts that individuals aim at some desired relationship between their real cash balances and their income. It further asserts that this relationship is stable and dependable so that the effects of changes in the stock of money or income are largely predictable. The Keynesian view of the balancing mechanism of international trade that grew out of Keynes's General Theory relegates the monetary system and the stock of money to a secondary place. It emphasizes the savings-investment approach rather than the quantity theory approach because of the widely held belief that the propensity to consume part of one's income is the more stable and dependable propensity than the propensity to hold some definite amount of money in relation to one's income. Its international trade theory aspect is the assertion that an increase in a country's exports resulting from some external event will also increase imports even without relative price changes because changes in demand for exports affect the level of income and so the demand for all goods and services. In effect, movements of output and employment play a similar role in the Keynesian view that price movements play in the pre-Keynesian view of the balancing mechanism. Consider the theory of the balance of payments that grew out of the income expenditure theory. Let us suppose that Country A increases its imports from Country B so that a deficit occurs in A's balance of payments. The deficit may be met by an outflow of gold, by a movement of short-term balances, or by capital movements. But irrespective of the method of financing the deficit, the Keynesian view agues that a more or less automatic mechanism will be activated that will serve to offset at least part of the initial disturbance. Exports in B will expand, raising income and employment in its export industries. This development in turn will raise the demand for domestic goods in B so that the expansion will spread from the export industries to the entire economy. As a result of the expansion in B's income, its demand for goods produced by A will also increase so that a part or perhaps all of the initial rise in exports to A will be offset. In contrast with the pre-Keynesian view of the balancing mechanism, the Keynesian concept is relatively independent of money. Thus, the sequence of movements of output and employment that account for a large part of the adjustment mechanism will typically be largely independent of central bank action.11 The necessary income movements are

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direct consequences of changes in the demand for goods and services caused by this initial external disturbance. For example, in our previous illustration, if B's surplus were offset by a gold inflow, its central bank could prevent such inflows from increasing bank reserves and the money stock by the sale of securities. According to the Keynesian view, such an operation, if it is to be successful, requires investment or saving to be highly sensitive to changes in interest rates. Since this is usually not the case, so the argument goes, the adjustment would proceed as before. Thus, aside from this influence directly on capital movements the central banks's ability to affect the balance of payments through the circular flow of income is at best tenuous and uncertain.12 In effect, the question of observing the rules of the game so important in the preKeynesian monetary theory of international trade loses much of its importance in the Keynesian concept. Recent studies, however, cast doubt on the secondary role assigned to money in the Keynesian concept of the balancing mechanism of international trade. These studies indicate that income expenditure theorists are in error in arguing that the propensity to consume is more stable than monetary velocity and in supposing that changes in the stock of money influence spending only by means of altering market interest rates. In addition, Friedman and Becker accuse these theorists of incorrectly formulating the test of their theory.13 The correct test is not the stability of the consumption function and income. On this issue the test results produced by Friedman and Meiselman for the relatively closed American economy as well as by others for other countries indicate that the investment multiplier appears to be a poor predictor of consumption. In effect, the quantity of money has been the better predictor of consumption than autonomous expenditures.14 One important implication of these results is particularly significant for the Keynesian concept of the balancing mechanism of international trade. The evidence clearly indicates that a change in the quantity of money dependably affects the total spending and thereby the balance of payments. In addition, the changes in the stock of money may impinge in spending decisions independent of affecting observed market interest rates. Contrary to the assertions of the income expenditure theorists, the central bank and monetary policy are important components in the balancing mechanism of international trade theory. The pre-Keynesian emphasis on central bank policy to facilitate balance of payments equilibrium would appear to regain much of its lost importance.

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As in the quantity theory statement of Milton Friedman, the essential assumption in the monetary approach is that there does exist an aggregate demand function for money that is a stable function of a relatively small number of aggregate economic variables. In this sense it makes the same assumptions as in the moderate Keynesian view. Like the classic quantity theory of money, the monetary approach assumes the longer-run view for the most part of a fully employed economy as the norm rather than the exception. A country's size is irrelevant to the monetary approach. A small country viewed as facing a parametric set of world prices and interest rates presents no theoretical difficulty in regarding demand and supply functions dependent on prices rather than prices themselves as parameters. Some observers believe that country size is important on the monetary side of analysis. For instance, a large country such as the United States whose national currency is internationally acceptable may, as a result of following an inflationary domestic credit policy, force an accumulation of its money in foreign hands and so lead to world inflation rather than loss in its international reserves. The postwar era is a good illustration of such a case. And, indeed, empirical studies of the determination and control of the world money supply under fixed exchange rates for the period 1961-1971 reach important general conclusions that the growth of the world money supply was influenced in an important and predictable way by the growth of the world reserve money, but even if there had been firm central control of the growth of world high-powered money, this would not have prevented national central banks from pursuing domestic credit expansion policies unconducive to world price stability.15 NOTES 1. See, for example, Joan E. Spero, The Politics of International Economic Relations (New York: St. Martin's Press, 1977). 2. See, for example, Keynes's speech before the House of Lords, May 23, 1944, reprinted in G. M. Meier, Problems of a World Monetary Order (Oxford: Oxford University Press, 1974), pp. 31-35. 3. Ibid., p. 30; and see R. N. Gardner, Sterling-Dollar Diplomacy (Oxford: Clarendon Press, 1956) for an account of the congressional debate before the United States accepted membership in the International Monetary Fund. 4. F. A. Hayek, "A Commodity Reserve Currency," Economic Journal 53 (June-September 1943).

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5. J. M. Keynes, "The Objective of International Price Stability," Economic Journal 53, June-September 1943. 6. F. A. Hayek, A Tiger by the Tail: The Keynesian Legacy of Inflation, Cato Paper No. 6, compiled with an introduction by S. R. Shenay (San Francisco: The Cato Institute, 1979), pp. 107-108. 7. See, for instance, R. Solomon, The International Monetary System, 1945-1976: An Insider's View (New York: Harper and Row, 1977). 8. Robert Triffin, The Evaluation of the International Monetary System: Reappraisal and Further Perspectives (Princeton: Princeton Studies in International Finance, No. 12, 1964). 9. See, for example, Lloyd A. Metzler, "The Theory of International Trade," in A Survey of Contemporary Economics, vol. 1, ed. Howard S. Ellis (Homewood, 111.: Richard D. Irwin, 1949), p. 212. For a useful summary see Harry G. Johnson, "Monetary Theory and Policy," American Economic Review, June 1962, pp. 335-385. 10. Metzler, "The Theory of International Trade," p. 212. 11. Ibid, p. 216. 12. Ibid, p. 212. 13. Milton Friedman and G. S. Becker, "A Statistical Illusion in Judging Keynesian Models," Journal of Political Economy, February 1957, pp. 65-75. 14. Milton Friedman and David Meiselman, "The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897-1958," in Stabilization Policies (Englewood Cliffs, N.J.: Prentice-Hall for the Commission on Money and Credit, 1963), pp. 185-268. See also George Macesich, "The Quantity Theory and the Income Expenditure Theory in an Open Economy: Canada 1926-1958," Canadian Journal of Economics and Political Science, August 1964, pp. 268-290. What these results indicate is that a simple version of the quantity-theory approach to income changes is more useful than a simple version of the income-expenditure theory. The results, however, are not so strikingly onesided in favor of the quantity theory as earlier studies indicated. The Canadian tests and those of several other countries are based on comparatively simple versions of the two theories so that results are, like all scientific judgements, subject to later modifications as additional data and other ways of organizing these data become available. 15. Harry G. Johnson, "Monetary Approach to the Balance of Payments: A Nontechnical Guide," in The Contemporary International Economy: A Reader, ed. John Adams (New York: St. Martin's Press, 1975) p. 205. The empirical study is M. Parkin, I. Richards, and G. Zis, "The Determination and Control of the World Money Supply under Fixed Exchange Rates 1961-1971," The Manchester School 43, September 1975, pp. 293-316.

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CHAPTER 5

The Post-Bretton Woods Regime: Attempts at Reform ATTEMPTS AT REFORM The postwar Bretton Woods regime came to an end on August 15, 1971 when President Nixon announced his New Economic Policy, whereby the dollar would no longer be convertible into gold and a 10 percent surcharge would be imposed on dutiable imports. The "unthinkable," which so often dogs monetary history, occurred. The history of the international monetary regime since that date has been to enthrone the fiat monetary regime while attempting to reimpose order as the world's monetary regime. There were, and indeed are, no shortages of proposals for international monetary reform. Every economist eager to take his place in the history of monetary thought rushed forward with his own proposals. In addition to various versions of the dusted-off White and Keynes plans, we also have a Triffin Plan, a Stamp Plan, a Machlup Plan, a Lutz Plan, a Bernstein Plan, a Harrod Plan, and others. Mainline American economists became apologists for persistent American payments deficits. Arguing that expanding world trade required enormous liquidity that could be satisfied only with dollars.

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To many economists, central bankers, and treasury officials it is obvious that the persistent American payments deficits and consequent loss of gold reserves in the 1960s and 1970s are simply the "mirror image" of those Western European and Japanese payments surpluses and growing national reserves during the 1960s and 1970s. As a result West Europeans and Japanese had been permitted to divert their own tax revenues to domestic improvements and social services while observers had begun to comment on the shabbiness of American cities. Between 1946 and 1958 the United States gave military grants of $16.6 billion to Western Europe and $6.1 billion to other countries; the first eight years of the Marshall Plan cost the American taxpayers $53 billion; the period of lend-lease assistance from July 1, 1940 to July 1, 1945 cost the American taxpayers a net of recouped assistance and payments of about $41 billion. America's Western European and Japanese partners insisted on every advantage they had gained since 1945—long after the justifications for American generosity had vanished. On the other hand, Ludwig Erhard of West Germany in his The Economics of Success argues that American negotiators have remained remarkably soft-hearted and soft-headed, regarding American expenditures for the defense of Western Europe. Matters are not helped by such ventures as President Johnson's Great Society and federal spending programs that undoubtedly appealed to many American voters. Federal budget deficits began to get out of hand. Foreign bankers began to lose confidence in American ability to manage the Bretton Woods regime. Clearly, a retrenchment was in order so as to end the chronic disequilibrium in American payments accounts. As countless currencies depreciated against the dollar in the 1960s, American industry suffered unnecessary unemployment while capital, technology, and jobs moved abroad, primarily to Western Europe and Japan. To be sure, American consumers benefitted from cheaper imports and relatively inexpensive foreign travel. The American dollar did reap "benefits" as well as "costs" in serving the functions of an international currency.1 Such a role enables the United States to acquire and run a larger cumulative deficit than otherwise since foreigners are willing to acquire and hold dollars. By creating "international money" in the form of dollars, Americans obtain claims on foreign resources much the same way as the gain from seigniorage of an earlier period, when the state treasury gained the difference between the circulating value of a coin and the cost of bullion and

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its minting. With a "cumulative" deficit in its balance of payments the United States can create internationally held dollars in a costless fashion and gain an increase in real national expenditures relative to national income. These arrangements also facilitated mobilization of resources to carry out American worldwide commitments made necessary by more than four decades of Cold War confrontation. The cost side is that the United States gives up a substantial degree of freedom in conducting expansionary monetary and fiscal policies for strictly domestic purposes. Evidently by 1971 President Nixon felt that costs exceeded benefits derived from the dollar's role as an international currency. Coincidentally, efforts toward detente began to make serious headway during the Nixon administration and the dollar's slippage as a world currency. The Smithsonian Agreement of December 1971, and a sort of crisis control rather than a reform as such, lasted little more than a year when massive currency controls used proliferation of currency rates. By March 1973 all major world currencies were floating. Management was left to the market and to central bankers who intervened to prevent extreme fluctuation. By 1972 a Committee on Reform of the International Monetary System and Related Issue, the Committee of Twenty, had been established within the IMF to develop a major reform of the international monetary regime. The Committee of Twenty consisted of ten industrial countries and ten developing countries. The charge of this committee was to come up with new means of managing the quantity of international reserves, developing new adjustment mechanisms, and establishing a generally accepted currency or currencies. There was general agreement of principles within the Committee of Twenty, which reported that exchange rates were to be more flexible (including floating in some circumstances); inconvertible balances, especially dollar balances, were to be returned to convertibility; the adjustment process was to be made more equitable; and cooperation was necessary to stem disequilibriating capital flows. Principles are one thing; practice is another. Very serious differences soon came to surface. There was little compromise. Disagreements arose over the nature of controls on surplus and deficit countries, over conditions of floating, over the role of the dollar and gold, over conditions for dollar convertibility, and each country pushed its own views to the limit.

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While the Committee of Twenty debated, international monetary regime received shocks that demolished existing systems of fixed exchange rates. Inflation fed by the large dollar outflow from the United States escalated to double digits in many countries. The issue was no longer inadequate international liquidity with which the committee was wrestling but one of excess liquidity. Different rates for national currencies undermined solutions to stable exchange rates. Indeed the emphasis was now on floating rates so as to shape up the domestic economy from international inflation. The second shock came from OPEC countries, which engineered a significant rise in oil prices. The net effect was to transfer an estimated $70 billion from oil-consuming to oil-exporting countries in 1974. This brought major new problems of recycling the surplus earnings of oil producers, which in 1974 amounted to $150 billion. And these were indicators that such surplus earnings would continue to constitute a problem. The recycling problem for the international monetary system, simply stated, is how to transfer earnings from oil-surplus to oil-deficit countries. The recycling has been accomplished, for the most part, through private banks that accepted deposits of oil-surplus countries and loaned these funds to oil-importing countries, through government-to-government direct investment and loans, and the participation of the IMF and World Bank by borrowing from oil producers and lending to oil-consuming countries. In any case, the sums in need of recycling grew so rapidly that they in effect amounted to continual shocks to the system. As a result, the committee capitulated, declaring that it was impossible to develop a comprehensive plan for monetary reform in view of the international economic situation. An interim committee was appointed to deal with more short-run problems such as oil-price increases and various recycling schemes. By 1975 and 1976 agreement of sorts was reached on the mechanism for cooperation (January 1976, Jamaica Meeting) but not on the management of floating currencies. No agreement on the dollar was reached nor on Special Drawing Rights (SDRs) nor indeed on gold as an international reserve asset. A movement was made toward demonetization of gold by the elimination of an official price of gold of the IMF, proposed disposal of one-third of the Fund's supply of gold, and removal of IMF's obligation to make and receive payments on gold. The net effect is that the nature and quantity of what is to serve as an inter-

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national reserve asset is outside the realm of international monetary management. With the reforms incomplete, the international monetary system continued to drift. Little wonder that international monetary problems are as fascinating as they are perplexing—combining, as they do, a rich mixture of technical economics, political repercussions, and even psychology of symbols and beliefs. The lessons from the postwar experience suggest that embittered, politically bargained agreements on the international monetary regime are untenable and surely give invitation to circumvent such agreements. The United States and Great Britain put forward the postwar international monetary regime so organized as to cope with many of the criterion problems. They reasoned that the determination of exchange rates, the provision of international liquidity, and the adjustment process are matters of political economy far too important to be left to the initiative of others. Accordingly, the Bretton Woods regime, dominated by British and American influence, served to usher into being the International Monetary Fund. It was to serve as a source of short-term international liquidity, thereby providing countries time for balance-of-payments adjustments without resort to competitive currency devaluation and disarray of the interval period. By the 1970s, however, the Bretton Woods regime was politically undermined and in a shambles, with its leadership weakened and its power challenged. Though the dominant political and economic power remained with the developed and industrialized countries led by the United States, such outsiders as the emerging countries challenged the right of industrialized countries to manage the system. They, too, wanted to participate in the management and share what they observed as the rewards of the international economic system. The advanced countries, for the most part, were just as determined to deny these outsiders access and share in the management. At the close of the 1970s the world counted up its toll of problems unsolved. Inflation and unemployment were both simultaneous, the task of recycling funds from rich to poor was already immense, currencies were floating, and interest rates were high enough to set the course for another decade of inadequate investment.2 Gold, which was supposed to be "demonetized" when the United States stopped converting dollars into gold in August 1971 while the IMF in January 1976 agreed to start selling its gold stock and central

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bankers agreed to freeze their holdings, made a robust comeback. The European monetary system required 25 percent of its gold reserves in European currency units (ECUS). The United States was selling gold to help cover its trade deficit while other countries added to their gold reserves. In 1970 gold made up 41 percent of the world's official international reserves while at the end of the decade demonetized gold accounted for 46 percent. Floating exchanges had not been adopted by all countries. In fact, at the close of the 1970s, of the 142 members of the IMF, 41 were pegged to the dollar, 14 to the French franc, and 3 to the British pound. The European monetary system embraced 8, and 38 were fixed on some other currency composite or set of indicators. Indeed, only 38 floated freely in theory and still fewer in fact. The major currencies at the time all floated more or less "dirtily" against the dollar. The Economist notes several reasons for such behavior.3 In the first place, it is argued that exchange rate movements do not correct trade imbalances. Their effects on inflation quickly erode the change in competitive advantages. This is not strictly correct, as witness the saving from surplus to deficit by strong currency in Japan and Germany in 1977-1979, or Great Britain's export boom in 1977, before the pound sterling rose too high. Second, in the very short run depreciation makes deficits worse, not better. While trade deficits are sliding down the front of the "J" curve, floating exchange markets may go on reacting, turning helpful adjustments into overadjustment. Third, exchange rate "uncertainty" makes trade and, still more, investment difficult, according to many businessmen. One among many other complaints is of complications about dealing in forward markets for currency. Fourth, the "weak" dollar, according to some, necessitates heavy intervention into the market. The SDRs, which promised to displace the dollar and so protect the international monetary regime from the vagaries of the American economy, did not live up to expectation. Indeed, some $13.5 billion in SDRs had been allocated by the end of the decade. They were made a little more attractive by a more generous interest rate formula. And, in fact, governments were discussing ways in which the world's overload of dollar reserve might be sterilized in a substitution account, supplying holders with SDR-denominated assets in exchange. Nevertheless, the dollar closed the decade as the principal component in the international monetary regime.

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It was in the emerging world economies, however, that even more serious troubles were probably avoided. Blasted by chill winds blowing from OPEC, which compounded their deficit problems, these countries turned for relief to the industrial countries. Thanks to these countries and their successful reaction to the OPEC price shocks, the world avoided the dire prediction by countries, banks, and the international business community of financial collapse and default. The problem of recycling of petrodollars was eased by assistance from the industrial countries. This assistance rose from a net $6.8 billion in 1970 to $19.9 in 1978. Part came in OPEC aid, $6 billion in its peak years of 1977. Part went through special oil funds raised and lent on by the IMF. International banking boomed as a result of recycling. By the end of the 1970s "offshore" landing through such Euromarket centers as London and the Caribbean amounted to $60 billion. Indeed, the Euromarket centers expanded to a gross $1,000 billion by the end of the decade. Most major banks had established an international network of branches, subsidiaries, and affiliates. In fact, one-third of their loans and profits were abroad. To help stave off future crises, the IMF in early 1980 came forth with a "new" idea for a reserve asset backed by gold. Thanks to American action freezing Iranian assets in November 1979, international financial officials pushed for the creation of a new reserve asset that could not be blocked or depreciated by any single government. With the dollar surpluses of oil-rich countries amounting to about $100 billion in 1980, world concern increased that so many dollars loose in world money markets could wreck the entire international monetary and financial organization. In addition to reluctance on the part of some developed industrial countries for a gold-backed substitution account, the emerging countries were also opposed to using gold for any new scheme. Sales of IMF gold generate resources to assist development of these countries and any way to use gold for another purpose is viewed by those emerging countries as depriving them of such resources. THE POSTWAR INTERNATIONAL ENVIRONMENT: THE COLD WAR AND DISSOLUTION OF THE OLD WORLD ORDER The professional military had little, if anything, to do with the phenenomenon of the "Cold War" (a term first used by Walter Lippman in 1947 in a study entitled Cold War, which is usually understood as the

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postwar confrontation of the United States and the Soviet Union). How is it that the United States became involved after shunning all foreign entanglements and alliances during the interwar period and quickly demobilizing after World War II? Did it do so to "save the British Empire" and the fraternal organization of English-speaking peoples, as some argue and many hoped it would do? Did America, a former colony itself, consciously set out to make the world "safe for old empire"? Was it, after all, some conspiracy designed to accept world leadership, as others argue? Or, is it really a tragedy of errors that is responsible for the confrontation? Whatever the original reasons, they have long since passed into the mists of time. After the revision the counter-revision. The purpose is to focus on a number of salient features on the road to the Cold War so as to better understand the profound changes in the post-World War II sociopolitical and economic environment. At the time the United States and the Soviet Union were the most powerful countries in the world. It is their confrontation that provided the solvent for the dissolution of the old world order and indeed for the dissolution of the Soviet Union itself. In the closing years of the twentieth century only the United States remains the world's most powerful country. It is difficult to date precisely the Cold War's outbreak, since there was not a formal declaration of war. Conflict of interests between the United States and the Soviet Union surfaced at the Yalta Conference in February 1945. These tensions became pronounced upon the death of President Roosevelt and the succession of Harry S. Truman in April 1945. The American monopoly of the atomic bomb, successfully detonated in July 1945 and used against Japan in August 1945 to end the Pacific War, together with the then unsuccessful Potsdam Conference in July-August 1945 seemed to increase tensions. The Soviet Union under Stalin took the occasion to consolidate Communist gains in East Europe. By 1947, Hungary, Poland, Bulgaria, Romania, and (in 1948) Czechoslovakia were under strong Soviet influence. Yugoslavia broke with the Soviet Union in 1948 and embarked on its path of development and ultimate dissolution in 1991. The Greek civil war and an attempted Communist takeover in December 1947, together with Soviet attempts to dominate the western sectors of Berlin and incorporate the entire city into the German Democratic Republic (formally established in October 7, 1949), set off an alarm in the United States, prompting vigorous reaction. American re-

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ply to alleged Soviet threats had already taken forum as early as 1947 in the Truman Doctrine and the Marshall Plan. In retrospect it is difficult to say whether the position taken by the Soviet Union under Stalin in Europe was aggressive or defensive in those early years. Perhaps fear of the American monopoly of the atomic bomb and an American president's demonstrated willingness to use it propelled the Soviet Union into defensive reaction, including the consolidation of a perimeter of defense. Moreover, the Soviets have always felt that the United States continued to regard the emergence of the Soviet Union in 1917 as "an illegitimate child of history." On the other hand, it could also be that the truth is just as likely to be neither in the "revisionist" Stalin forced into isolation by the behavior of his wartime allies, as argued by some people during the heat of Vietnam, nor in the "prerevisionist" dictator driven to expanding Communist power to the limit by creation of puppet regimes. It is possible, for example, that Stalin created the Soviet empire as a by-product of the victorious war against Nazi Germany.4 It could be that he would have preferred, and indeed even attempted, to do so by means other than military conquest in order to avoid confrontation. The reason he could not do so is to be found in the Soviet system that bred him and tied his hands and that he felt compelled to perpetuate by his execrable methods. It was, accordingly, the Soviet system that was the "true cause" of the Cold War. The practices by which Stalin reached his objectives were devious. They might have been less so had his treatment by the Western allies been more straightforward. But the ineptitude of the diplomacy of the declining power of Great Britain and the inexperienced and, indeed, unwilling America often meant that those countries were weak and divided when they should have been firm, and firm only when it was too late.5 The American view, as seen by Dean Acheson from the State Department, underscores the difficulties at the time in getting a correct reading of Soviet intentions.6 In particular, the State Department, according to Acheson, ran into sterile argument between the planning staff and Soviet experts. The letter challenged the belief that Acheson shared with the State Department planners that the Soviets gave top priority to world domination in their scheme of things. The Soviet experts countered that Acheson and the planning staff attributed more of a Trotskyite than Leninist view to Stalin and that he placed the survival of the

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regime and "communism in one country" far ahead of world revolution. Acheson goes on to argue that he and the Department did not dissent from this but that difference to him was more theoretical than real in devising courses necessary to eliminate the weak spots that so tempted the Soviets to probe American and allied resolution. And while it may well be true, as later academic criticism concluded, that America overreacted to Stalin, which in turn caused him to overreact to policies of the United States, the various critics, argues Acheson, were not called upon to analyze a situation in which the United States had not taken action that it did take.7 Sir Winston Churchill served for many years as a persuasive negotiator between disparate interests on both sides of the Atlantic and there was no other European of comparable stature who could have replaced him in the esteem of the American people. He sounded the tocsin in a famous speech on March 5, 1946 in Fulton, Missouri, warning of an implacable threat that lay behind a Communist "iron curtain."8 Its tone and impact is ominous and warning. He argued that the United Nations be equipped with an international force. Perhaps even more important, he pleaded for a continuance of intimate military association and joint defense arrangements between the United States and Great Britain. This fraternal association of the English-speaking peoples would, he suggested, play its part in steadying and stabilizing the peace. He argued that, in effect, prevention is a better cure. He argued that no one really knows what the Soviet Union and its friends were likely to do in the future or where the limits to their ambitions lay but the situation in Europe is clear. In effect, it is not the liberated Europe for which the allies fought to build up, nor is it one that contains the essentials of permanent peace. Reaction was immediate. Robert Feis writes that President Truman, though denying it, read a mimeographed copy of the first draft of the speech and, according to Churchill, thought it quite admirable and would do nothing but good though it would make a stir.9 Apparently the president and Secretary of State Byrnes, in denying knowledge of the contents of the speech, did not wish to have it viewed that American foreign policy was now in the hands of the veteran anti-Bolshevik Churchill. They no doubt shared Churchill's sentiments given the United States was already firmly opposing Communist subversion and demands in Iran, Turkey, Greece, and elsewhere.

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The reaction from Moscow did not conceal the fury of Stalin and his supporters. In substance, their view was that Churchill was nothing less than a warmonger calling for war against the Soviet Union. Furthermore, they said, Churchill is not alone. He has friends not only in Great Britain but also in the United States. Though President Truman remained aloof and the Labor government leaders of Great Britain neither applauded nor rebuked Churchill, events between the Soviet Union and Iran over Azerbaijan and oil resources confirmed Churchill's dire analysis. The president soon began to speak and act as though in accordance with Churchill's prescription. Soviet proposals to Iran for a joint company to develop the oil resources of the five northern provinces, with the Soviet government to have 51 percent of the stock, as a condition for the withdrawal of Soviet troops from Iran provoked concern in Washington and London. Truman is reported to have said to A. Harriman, the newly appointed Ambassador to London, that the United States and the Soviet Union might soon be at war over Iran. The subsequent satisfactory resolution to the crisis over Iran apparently confirmed to President Truman that the Soviet Union did indeed intend by subterfuge and subversion to extend Soviet rule or influence not only over northern Iran but down to the Persian Gulf and into the Eastern Mediterranean. It was clear to him that the Soviet Union would also back down from going to war but would, at the same time, grab whatever it could without war. He concluded that if firmly resisted and faced, the Soviet Union would back down, very much in agreement with Churchill's dicta. On the face of it, Soviet aspirations may have been blocked by Truman's firm stand. Still, it could also be correct to argue that the Soviet Union really had no interest in the oil project except to create a political uproar that would serve to prevent American and British oil concessions near the Soviet frontier.10 At the same time the affair focused Iranian attention on the vast British oil venture in southern Iran that later, thanks to the stupidity of the Anglo-Iranian Oil Company, Mosadeq, and others, led to British-Iranian confrontation and to the American government decision to become seriously involved in Iran. More than thirty years later many Americans and Iranians would deeply regret and resent the decision and its consequences. American public and congressional support for such a wide-ranging global commitment on the part of the United States required consid-

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erable cultivation. In his book Present at the Creation, Dean Acheson suggests that it was a simple task to obtain such support. Not the least source of the problem was the special ties between the United States and Great Britain. To be sure, such special relations have existed and, in fact, do exist. There is, after all, a common language and a common history between Great Britain and the United States—though a common language can, and often does, lead to misunderstanding and it certainly does not assure affection, as Acheson quite correctly argues. And indeed, before Pearl Harbor many in the United States had no desire whatsoever to again become involved in a fraternal struggle in Europe—in fact, some condemned the whole misadventure as Britain's "imperialist" war. Acheson's argument that the commonality of British and American interests is long-standing British support for the Monroe Doctrine against the Holy Alliance and Britain's ultimate support for the Union during the American Civil War while Napoleon III of France occupied Mexico is but a case in point. Writing about a special relationship, in his view, can only increase suspicion among America's allies of secret plans and purposes, which they did not share and would not approve, and would only give proof to some Americans that the State Department was a tool of a foreign power. Such an attitude did not endear Acheson to many nor did it serve him well before the many congressional committees. Moreover, Acheson did not suffer fools lightly—though suffer them he did. A case in point is the senator from Wisconsin, Joseph McCarthy, whose name is given to a phenomenon broader than his own participation in it, the hysteria growing out of fear of Communist subversion that followed both world wars. The result was a national disaster of the first magnitude. Damage inflicted from the various charges and countercharges during 1950-1953 engulfed universities, government's foreign and civil services, and indeed the private sector. Congressional assaults on the executive branch approximated those in 1919-1923 under Attorney General A. Mitchell Palmer. It also brought with it a new definition of American foreign policy. This is contained in the now well-known document NSC-68 (National Security Council paper 68), which became national policy on April 25, 1950. The document was promptly classified. This is unfortunate since a clear statement of U.S. foreign policy would have avoided many subsequent misunderstandings on the part of both friends and adversaries.

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We have it from Acheson that the purpose of the document was to so bludgeon the mass mind of the top government that not only could the President make a decision but that decision could be carried out. Even so, it is doubtful if anything like what happened in the few years could have been done had not the Communists been stupid enough to have instigated the attack against South Korea and opened the "hate America campaigns."11 The conflicting aims and purposes of the United States and the Soviet Union are stated in the document, the United States placing priority on an environment in which societies could exist and flourish and the Soviet Union on world domination. The Soviet threat was pictured by Acheson as similar to that which Islam posed centuries earlier with combination of ideological zeal and fighting power. Then, as now, it had taken the combined Germanic power in the east, the Austrian military frontier in the Southeast, and Francoist power in Spain to meet it. This time U.S. energy and power would be added since the drama was being played on a world stage. As for the capabilities and resources for meeting such a threat NSC-68 recommended specific measures for a large and immediate improvement of military forces and weapons, and of economic and moral factors that underlay America's and its allies's ability to influence the conduct of other societies.12 Although no specific cost estimates are available, Acheson estimated it roughly to be about $50 billion per year for defense expenditure as compared to the $14 billion defense ceiling at that time. Postwar Keynesian policies designated to keep the economy up to full draft would serve to mobilize the resources necessary. What started as a conflict over postwar Europe soon spread to Asia following the Communist victory in China in 1949, thereby giving the Cold War its global dimension. Matters were not helped when in June 1950 the Korean War broke out and the Chinese intervened in October 1950, serving to confirm to many people in the United States that the country was confronted with a worldwide Communist conspiracy. The fact is that apparently the Chinese and Soviets were not acting in consort. China reacted on the fear that its territory was threatened by the American advance to the Yalu River in October 1950. Japan, as a consequence, was strengthened and organized as a bastion against China in 1951 and Okinawa retained by the Americans as a military base. The period 1949-1962 witnessed the Cold War in its full fury. It spilled over into the Middle East with the Baghdad Pact of 1955, the

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Eisenhower Doctrine in 1957, and American intervention in Lebanon in 1958. Uprisings in Poland and Hungary in 1956 were viewed as threatening to the Soviet Union as was unrest in Latin America to the United States. Finally, the Cuban missile crisis in 1962 forced both the Soviet Union and the United States to check the drift toward a third world war. Both concluded that they had far more to lose than to gain by continual conflict, and tension eased to the point that a nuclear test treaty was signed in 1963. The tragedy of the Cold War was compounded when its focus shifted to Southeast Asia, where the United States has been increasingly involved since at least 1954. Some Americans came to believe in the so-called "domino theory" that China and its brand of Maoist communism was the real threat to American and world security—especially after its acquisition of nuclear potential in 1964. In support of their case such believers also pointed to the growing Sino-Soviet conflict and quieter Soviet rhetoric in post-Khrushchev days as evidence of greater moderation in Soviet policy. Increasingly, Americans became involved in support of various dubious client states and governments in Southeast Asia. The disastrous American venture ultimately peaked in Vietnam when under President Johnson (1963-1968) more than 540,000 American troops were involved in an Asian land war. The futility of the entire American misadventure became increasingly evident when Vietnamese resistance could not be broken without resort to nuclear weapons, which would very likely draw the Chinese openly into war, broadening the scale of conflict to a worldwide conflagration. The economic strain on the American economy, becoming increasingly evident throughout the 1960s, convinced most people that it was time to cut America's losses and call an end, letting the dominoes fall where they would. This became an election issue in 1968. President Nixon succeeded Johnson in 1969 and American withdrawal began in earnest in 1973. These overtures on the part of President Nixon produced further results with visits to Peking and Moscow. These meetings ushered in a new era and, according to some observers, presaged an end to the Cold War. Among its many victims the Cold War can count the Bretton Woods monetary system and the International Monetary Fund, which narrowly missed destruction. Gone, too, are the days when Great Britain and some of the former leading powers could draw up a constitution for world monetary order. Monetary power is now widely dispersed,

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although the United States remains the major player. It remains to be seen whether those responsible for the affairs of nations have the political will and skill to establish a new international monetary system and to manage the system within the new rules, institutions, and procedures. NOTES 1. See, for example, Gerald M. Meier, Problems of World Monetary Order (Oxford: Oxford University Press, 1974), pp. 104-105. 2. See The Economist, December 8, 1979. 3. Ibid. 4. See, for example, Vojtech Mastny, Russia's Road to the Cold War: Diplomacy, Warfare and the Politics of Communism 1941-1945 (New York: Columbia University Press, 1979). See also Thomas G. Paterson, ed., The Origins of the Cold War, 2d ed. (Lexington: D. C. Heath, 1974) for a presentation of several different views in the Cold War and a useful bibliography. 5. For a discussion of Britain's sociopolitical and economic situation in the immediate postwar period and John Maynard Keynes's summary see David Dilks, ed., The Diaries of Sir Alexander Cadogan, 1938-1945 (New York: G. P. Putnam's Sons, 1971), p. 786. 6. See Dean Acheson, Present at the Creation (New York: W. W. Norton and Company, 1969). 7. See, for instance, Marshall D. Shulman, Beyond the Cold War (New Haven: Yale University Press, 1966) and Louis J. Halle, The Cold War as History (New York: Harper & Row, 1967). The literature of this period is listed and analyzed by Hans J. Morgenthall in "Arguing about the Cold War," Encounter, May 1967, pp. 37 ff. 8. Winston Churchill, Sinews of Peace: Post-War Speeches (Boston: Houghton Mifflin, 1960), p. 94. 9. Herbert Feis, From Trust to Terror: The Outset of the Cold War, 1945-1950 (New York: W. W. Norton and Company, 1970), pp. 78-80. 10. Ibid, p. 87. 11. Acheson, p. 374. 12. Ibid., p. 376.

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CHAPTER 6

The International Monetary Fund and Its Prospects WHAT ROLE, IF ANY? Spelling out the role, if any, of the IMF in the world's emerging fiat monetary regime is indeed a priority item. Many analysts argue that a valid reason for the IMF to exist is to act as lender of last resort. In effect, the IMF would step in only when a mismatch between short-term liabilities and long-run value of assets might threaten the world's monetary regime. A case in point, observers note, is the IMF's backing for the Argentine banking system during the 1995 crisis in which interest rates rapidly increased (briefly) while the country held fast its peso link to the dollar. In short, these observers underscore the lender-of-last-resort role for the IMF. Its critics argue that the IMF has allowed itself to be pushed into missions that are beyond its original mandate. Recall that the IMF was founded at the end of World War II solely to help defend the Bretton Woods system of fixed exchange rates. Its role was to act only as needed to adjust temporary payment imbalances that threatened the overall fixed-rate systems. As we discussed elsewhere in this study, the United States closed the gold window in 1971 and the dollar left the gold standard. In effect, the Bretton Woods agreement collapsed. The IMF continues to live on

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in search of new reasons for its existence. It is testimony to the power of a bureaucracy to live on long after reasons for its existence have passed. So powerful is the IMF bureaucracy that in 1998 it deployed a capital base of some $190 billion with requests for even more resources. What is it that the IMF hopes to do with the resources at its disposal? To judge from recent evidence, many of these resources have been used to reorganize and often subsidize significant aspects of the economies of many countries, including lending to weaker governments at below market rates albeit with conditions attached, and to "fine-tune" exchange rates not according to some Bretton Woods system but according to some criterion or criteria best known to the IMF's bureaucracy. The net result of the IMF's micromanagement is to undermine its own Articles of Agreement, which call for it to maintain orderly exchange arrangements among members and to avoid competitive exchange depreciation. Indeed, the IMF's backing of competitive devaluation in Asia in 1997, only to be followed by putting together bailouts totaling some $120 billion for the Asian countries, is but a case in point. Who decides who is to be bailed out and under what conditions is left to the IMF itself. Whatever it is the IMF and its bureaucracy think they are doing, it is clear that the scope and size of bailouts have grown. Not long ago the IMF bailout dealt with creditors holding sovereign debt, as in the Mexico crisis.1 With the rapid growth of the global economy, the IMF has found a new role for itself in bailing out loans in which both lender and borrower are in the private sector. Such action simply encourages overly risky lending, which will lead to new bankruptcies and, of course, bigger bailouts. The sad fact is that the IMF's bailouts have increased in 1997-1998 to $140 billion for Thailand, South Korea, Indonesia, and Russia. Of course, big international banks like IMF bailouts, because they are the chief beneficiaries of relief for investors in stricken highrisk markets. The same is true for other major exporters, including American farmers, who hope bailout money will prop up prices and demand abroad for U.S. farm exports. Many of the crises with which the IMF is engaged are, unfortunately, due to its own policy errors.2 International lenders loaned overgenerously in Thailand, Indonesia, and other Asian countries on the assumption that if they got into serious trouble the IMF would bail them out. This is the so-called "moral hazard" created by incentive to lend

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loosely. Whatever impression one might draw from the dreary sameness of IMF bailout efforts, all countries are different. Instability, structural deformity, and negative growth nonetheless seem to be characteristics shared by most recipients of bailouts. In the case of Russia, it has suffered more than eight decades of police state management of all aspects of human life. No country can make a successful transition from such a disaster in a few short years. Russia has indeed come a long way since the old Communist system collapsed of its own weight in 1991. It now has at least the trappings of market democracy—private banks, a stock market, and private enterprise. But all these trappings are in theory rather than in practice. What Russia really needs is to put these trappings into practice. This includes a proper tax system; banking laws that lay the foundation for a proper banking system; privatization on a serious scale including genuine legal protections of domestic and foreign direct investment and shareholder rights. The IMF bailouts were enough to obligate Russia to carry out Western-designed programs but not enough to do the job.3 Total Western assistance to Russia has been a fraction of what West Germany has spent on East Germany since unification. If the IMF money seemed indispensable to some, the steep price for it is now becoming apparent. Little wonder that the IMF is accused by its critics of lurching from one bad policy idea to another with very little comprehension of the severity of the problems in many of its member countries. In 1997, Thailand was advised by the IMF to promote a limited devaluation and raise taxes. By 1998 the country's per capita income had fallen to $1,800 from $3,000 in 1996. In 1998 Thailand found itself in the fifth IMF revision program; all the previous four missed their mark. Similarly, South Korea during its 1997 crisis received a massive bailout by the United States, the IMF, and international banks. The Korean approach included interest rate rises and devaluation as well as IMF forecasts that everything would be put right. The end result was that Korea's economy shrank to $280 billion in 1998 from $485 billion in 1985. Again, the IMF revised its forecast for the country's growth down to minus 4 percent in July 1998 from plus 2.5 percent in January 1998. In fairness to the IMF's efforts, not all recipient countries completed their prescribed programs. A case in point is Venezuela, which failed to fully implement the medium-term program supported by the

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IMF in 1996.4 The program included not only measures to stabilize and deregulate the economy; but also structural reforms to deal with fundamental issues necessary to lay the basis for sustained economic growth. Indeed, by late 1996 economic policy became constrained by political factors and structural reforms lagged, while the absence of an institutional mechanism to save the oil windfall, which had been recommended by the IMF, contributed to large increases in public expenditures. In short, Venezuela's policies deviated significantly from that recommended by the IMF. The example of Venezuela underscores the inability of the IMF to impose policies on reluctant governments. Countries do indeed differ. A country and its government must undertake needed reforms without badgering from the outside by the IMF or others if reforms are to achieve their objectives. In fact, IMF supporters argue that it is the only global institution capable of playing the role of lender of last resort for countries experiencing sudden liquidity shocks. During the period 1997-1998, the IMF distributed such a large volume of money to Asia and Russia that by fall 1998 it had only about $20 billion to $25 billion of surplus liquidity left. Should falling commodity prices and abrupt changes in capital flows threaten such important countries as Brazil, Mexico, or South Africa, the IMF would be hard pressed to help them through a temporary crisis. Worse still, people in countries that have come under the sway of the IMF despise it, and they see it as an agent of the United States. If there is a role for the IMF, as its supporters argue, it may well be to offer technical advice to member countries. It has considerable experience upon which to draw for such advice. Whatever political judgment is to be made should be made by the requesting government and not by the IMF. Political support for the IMF is eroding in good part because of its pressure on countries to adopt policies that they find unacceptable. Critics of the IMF argue that the institution should be totally reformed or abolished altogether. What the world needs is a stable monetary regime that would prevent currency meltdowns.5 In Jack Kemp's view the greatest threat to worldwide economic stability is the international monetary arrangement of floating currencies in which no currency is linked to a stable anchor and all countries are being encouraged to use currency devaluation as an economic policy instrument during times of economic duress.

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Many years ago Milton Friedman, among other economists, argued the case for flexible exchange rates. He provided an alternative of flexible exchange rates to the fixed exchange rate regime encapsulated in the Bretton Woods system. In doing so he provided stimulus for ongoing academic discussion of options available to the world. And indeed, even the IMF later opted for "flexible exchange rates" arguing that fixed exchange rates had been completely discredited by experience. It is not surprising that Friedman concludes that since the IMF was established at Bretton Woods to oversee a system of fixed exchange rates that now no longer exists, the institution has lost its function and should be abolished.6 In his opinion its activities have caused much harm. Attempts on its part to recreate itself as a junior world bank simply underscore the immortality of bureaucratic organizations.7 The IMF's mistakes may well have created a backlash against globalization in the post-Cold War years. The Asian and Russian crises in the closing years of the 1990s and IMF attempts at fixing problems could deal a historic setback to the advance of Western-type market economies. A case in point is Malaysia, which in September 1998 effectively cut itself off from global financial markets by imposing controls on international capital flows. The country had benefitted considerably for more than a decade by encouraging such flows. Decline of its currency and stock market was blamed on international capital movements prompting the country to impose controls. Another Asian star performer in the past, Hong Kong began a vigorous effort in August 1998 to bolster the Hong Kong Stock Exchange by using billions of dollars worth of funds to buy shares. This prompted Milton Friedman to warn that the Hong Kong government's huge intervention in the stock market means that "all bets are off as to whether the city can keep its currency pegged at 7.8 to the U.S. dollar.8 Instead of supporting the currency, Friedman argues, the government's purchasing of shares undermined the credibility of its currency system, adding that the government should immediately announce that it made a mistake and sell off whatever stocks it purchased. Once the government starts tinkering with the stock market for the purpose of frustrating so-called currency manipulation it does indeed cast doubt on its adherence to traditional laissez-faire policies. Citing such attempts, Standard and Poor's Rating Services promptly downgraded Hong Kong's credit rating. By early September 1998 the Hong Kong Monetary Authority had spent an estimated 15 billion U.S. dol-

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lars on stocks to deter currency speculators for what it calls unfair attacks on the Hong Kong dollar. Under its currency-board arrangement, when speculators sell the Hong Kong dollar, local interest rates are automatically increased. Higher interest rates ultimately attract investors to buy Hong Kong dollars supporting the currency. On the other hand, increasing interest rates also depress the economy and stock prices. Friedman argues that the government's involvement in the stock market was totally unnecessary and counterproductive to the defense of the Hong Kong dollar. If the government allows the currency board to function properly, the automatic rise in interest rates would be sufficient to keep the currency free from speculative assaults. Moreover, Friedman states that such manipulation of the currency and stock market by the government casts in doubt the viability of the so-called "one country, two systems" operating in China. Indeed, he predicted earlier that the notion of one country and two systems would not last. Attempts to jump-start or protect economies very often make matters worse. The aim should be to get money into a country, not keep it out, however tempting that may be as a means for avoiding currency turmoil. Controls may work in the short run as nations can hoard funds that investors cannot change into dollars and other hard currency. Eventually such controls break down thanks in part to the ingenuity of people. To keep them effective, even greater controls and greater government intrusion into economic activity will be the end result. In general, controls are unmanageable and very susceptible to graft and corruption. Nevertheless, controls on short-term currency flows continue to be popular particularly since the currency turmoil of 1997-1998. Some observers point to the apparent success of the Chinese model, which welcomes foreign investment in factories and business but imposes strict controls on currency trading. Indeed, they note that countries whose currencies have not been freely convertible have done best. Chile's successful attempts to discourage the inflow of volatile shortterm money is tempered by the caution of its economists that controls should be used only as a preventive measure by countries that already have in place solid fiscal, monetary, and exchange-rate policies. Joseph Stiglitz, chief economist at the World Bank, argues that controls should be considered provided they can be designed to discourage short-term investment such as bank loans or short-term currency trades without disrupting foreign investment in factories and infrastructure.9 In fact, his staff of economists at the World Bank are

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examining the experiences of such countries as Chile, Columbia, Thailand, and the Czech Republic that have experimented with such controls. Paul Krugman, for his part, argues that such controls should disrupt ordinary business such as foreign travel as little as possible, clearly be temporary, be accompanied by a highly competitive exchange rate, and be used as an aid to reform and not an alternative.10 Thus far the backlash against globalization appears to be restricted to the markets for money. It may be that government interventions in the money and capital markets are all efforts to correct the excesses of a decade-long experiment in which money was free to flow worldwide. Throughout much of the post-World War II era many countries maintained controls on capital and money markets. Thus far the growth of controls has not spread to that of imports and exports of goods and services. In any case, the IMF had hoped to make the case for a new global financial system that involves even greater openness in capital and money markets, and a more prominent role for itself may well have been overtaken by events. One result of the reimposition of controls is that it has prompted a global redefinition of risk and a reassessment of how that risk should be valued. Until the reassessment is completed, world money and capital markets will almost surely remain highly volatile. Most analysts now agree that the world is a riskier place where the IMF could not and the G-7 industrial countries would not play the role of lender of resort on a global scale. It is important to put the recent attractiveness of controls on money and capital in perspective. Economists have long argued the benefits of free trade in goods and services. The idea that governments permit free international flow of money and capital is of relatively recent vintage. Indeed the principal intellectual founders of the IMF, J. M. Keynes and Harry Dexter White, feared capital and money flows would become an independent and disruptive force that would interfere with trade. In fact, Keynes argued that control of capital movements—both inward and outward—should be a permanent feature of the system. For years controls were, as Keynes had hoped, more or less permanent.

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AMENDING THE IMF CHARTER? Before the onset of the difficulties in 1997-1998 the IMF and its supporters argued that there would be benefits to amending the institution's charter to make the free flow of capital one of its major goals. The existing charter allows member countries to impose controls at their discretion. The proposed amendment could push for fewer restrictions on capital flows and give the IMF power to regulate this use. I have discussed elsewhere the changing nature of money and capital markets.11 The globalization of money and capital markets has indeed made their management very difficult both domestically as well as internationally. In fact, the various and ongoing changes in global markets complicate the tasks of monetary authorities, central banks, and international institutions in judging and lending with systemic risk and financial crisis as events in 1997-1998 underscore. One of the more vexing problems raised in attempts to regulate money and capital markets is their computerization and whether this will fragmentize or centralize them. Undoubtedly, large and important traders will play for even larger stakes, making it very difficult for the small trader to participate. The big players will not stop at attempts to predict markets. They will want to control them. If you are a big enough player in a market for your own moves to influence the market, then you can predict your own next move. Given past experience, the success rate in cornering markets is not notable. More likely, computer programming will lead to diversities in trading strategies in good part because no single program will remain dominant. It is also likely that these developments will bring in more traders and increase the market's liquidity. Such increases may reduce transaction costs and thereby improve the functioning of the market. As a result, the ability of markets to generate the resources needed for economic growth will increase. Traders do add value, if only because they reduce individuals' transaction costs and minimize by diversification their risk in investing in securities. In the process, traders will also benefit the markets as a whole. Various theoretical developments about efficient portfolios and their application are made possible by the development of sophisticated computers. Improved financial data enable traders to develop programs of lesser or greater complexity. Some analysts and traders may have become overconfident in their ability to predict the market.

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Outperforming the market is only one among other goals that investors may demand of their fund managers and brokers. Risk may be another important goal. On this score, scattered evidence does suggest that brokers and fund managers may do better than investors in identifying and managing risk. The standard definition of the services that an investor can expect of fund managers includes determining the appropriate level of risk, running a portfolio that achieves it, and minimizing tax and transaction costs. In doing so, fund managers and brokers will also improve the workings of the worlds' capital markets. One can also hope that in the long term, money managers will perform well in allocating capital to its most productive uses. To this end, efficient markets require active managers to seek information and put it into prices. In the process, they may deliver to their clients after-transaction costs less than market return. In support of this view that only higher risks will bring higher returns is the theory encapsulated in the so-called capital-asset pricing model. This model undergirds the investment strategies of many managers. Accordingly, prices do include discounts for certain kinds of risks, which alone explains consistently higher returns by some investors. In effect, the more volatile a portfolio of securities, the lower its price for a given expected return. For all practical purposes, current prices reflect all information about a security. Past developments have already been discounted. Only unpredictable news, which is, of course, unpredictable, can change prices—thus the efficient market theory and the view that even price change is unaffected by its predecessor and that the system has no memory. In sum, we are in a random walk down the market. Not everyone agrees with the efficient market theory and its closely associated capital-asset pricing model. Critics argue that no market is perfectly efficient in handling information. They hold that there are indeed inefficiencies to exploit even in such markets. The activities of traders exploiting an inefficiency cause it to disappear. A case in point is that new inefficiencies may continue to appear owing to the continuing development of new financial resources. Obviously, it takes time for traders to learn how to price new instruments. Of course, the fast learners beat the slow ones. In effect, new markets are inefficient markets in their view. To this may be added the so-called noise-traders, who deliberately elect not to maximize their expected return. An illustration of such a trader is a central bank purchasing its currency's currency in order to support a price and not a profit.

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Moreover, traders tend to be a varied group. They tend to reason and interpret differently the information they do receive. In short, they may have different attitudes to risk as well as different time horizons. Traders may receive the same information but react differently. No all are irrational, but some will be proven wrong. As a result, a market may misprice assets not because of information flow problems but simply because of different ways of reacting to information. Such expectations have prompted brokerage firms to employ a considerable number of mathematicians to search for market anomalies as well as predictabilities of markets. These efforts have produced a computer product for nonlinear statistics that seem to work, but do not explain why they work. It is more or less "data mining." Most economists and statisticians are not enthusiastic about such an approach. In their view, theories must start from how people behave and predict the effects, not begin with possibly spurious patterns in the data and induce their causes. It may be that the computer approach and data mining are not a complete waste of time and effort. For instance, in the 1960s a number of fund managers and brokers were convinced that the stock market is not a random walk. It tends to trend in one direction for a considerable length of time. After all, bull markets and bear markets not only exist, but do persist. Something may be causing the market to have memory. The arrival of fast computers capable of handling large quantities of data encourages search for that something. For assistance in their search they turned to fractal theory. In effect, these analysts considered that financial markets would prove to fractal. A fractal object is one that occupies more than a certain number of dimensions but does not fill the next number. Fractal theory in financial markets, as interpreted by some analysts, implies that each day's price depends to some extent on yesterday's, so the market is not a random walk. In essence, the market may show self-similarity at different scales. A random process can reveal a pattern after all. Some analysts turn to chaos theory for assistance. This theory puts forward the idea that simple systems in which there are few causes can still show noisy and apparently random behavior. Both fractal theory and chaos theory suggest that randomness and order can coexist in any given market. Though fractal theory and chaos theory may have something to say about financial markets it is difficult, if not impossible, to use them.

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Both theories may be useful in describing rather than predicting financial markets. The skeptics underscore their view with the observation that the rules employed by market traders change too fast. Nonetheless, there are optimists who argue that both theories may be useful. For instance, evidence does suggest that each market tends to stay in a pocket of predictability for some time before moving on. That is, predictability may be possible if one does not attempt to predict during rapid changes in the market. In effect, if one is encountering rapidly changing conditions in a market, it may be advisable to stand aside and wait for more settled conditions. Many of the successful market traders will readily agree that it is easy to lose money when a market reverses itself. These traders also lay no claim to an ability to outperform everyone in the market. They judge success by how consistently they are right. Finally, such traders seldom adhere to any one theory, though each may have a favorite insight in their search for consistent market patterns. Clearly, however, there is no assurance that any trader can know what the market will do tomorrow. Neither chaos theory nor fractal theory nor anything else will solve that problem for the trader. Whatever pattern in the past has proved a reliable guide to current patterns in the market will tend to be taken as better than a simple roll of the dice. A computer program may be useful to search out such patterns, along with detailed data showing every trade for several years in a desired market. It is also helpful, given past experience, if such a program incorporates some ideas from nonlinear statistical theory. Of course, computer theories, neural networks, technologies, and related ideas are only aids and not substitutes for individual thinking. Our brief discussion suggests the complex nature of the problems confronting attempts by market regulators to influence money and capital markets. These complexities serve to underscore the need for more open markets if the world is to benefit from globalization. Whether the IMF is the institution to carry out such liberalization within the world's emerging fiat monetary regime is another matter. Clearly, the IMF supporters have not completely convinced the American Congress, who insist that major industrial partners in the IMF agree to seek changes requiring borrowing countries to comply with trade obligations and eliminate crony capitalism within their own economies.

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NOTES 1. George Macesich, World Banking and Finance: Cooperation versus Conflict (New York: Praeger Publishers, 1984). 2. See, for instance, George Melloan, "Fear of the Unknown Is the IMF's Secret Weapon," Wall Street Journal, July 21, 1998, A15. 3. See Susan Eisenhower, "Strains from Russia's Crisis Put Federation at Risk," International Herald Tribune, September 2, 1998, p. 6. 4. See Claudio M. Loser, "Venezuela Failed to Complete IMF Plan," Wall Street Journal, August 28, 1998, p. Al 1. 5. See, for instance, Jack Kemp, "Who Needs the IMF?" Wall Street Journal, April 3, 1998, p. A19. 6. See Milton and Rose D. Friedman, Two Lucky People: Memoirs (Chicago: University of Chicago Press, 1998), pp. 219-221. 7. Ibid., p. 220. 8. See Erik Guyot, "Hong Kong's Stock Purchases Harm Currency, Friedman Sags," Wall Street Journal, September 3, 1998, p. A19. 9. See David Wessel and Bob Davis, "Currency Controls Gain a Hearing as Crisis in Asia Takes Its Toll," Wall Street Journal, September 4, 1998, pp. A1-A2. 10. Ibid., p. A2. 11. George Macesich, Transformation and Emerging Markets (Westport, Conn.: Praeger Publishers, 1996).

CHAPTER 7

Echoes from the Past AMERICA AS AN EMERGING MARKET: THE ISSUE OF MONETARY SUPREMACY AND MONETARY REGIMES It is not surprising that the International Monetary Fund (IMF) is not able to cope with crisis in a world of fiat monetary regimes. Such a world was not envisioned by the designers of the IMF, as we have discussed. Its search for a role in a new age has met with limited success. In the view of many observers its policies have produced disastrous results in emerging countries. Its supporters argue that the IMF is really the only world institution capable of dealing with problems cast up by fiat monetary regimes particularly as these regimes operate in emerging countries and on a global scale. In fact, it may be that the IMF and its activities are simply irrelevant. In many respects the IMF's problems and prospects are similar to those I discuss in this study of the Second Bank of the United States and ts dealings with American State banks and capital flows in the nineteenth century when the United States was an emerging market economy. It is useful to draw on these experiences from the nineteenth century for the insights they provide for the twentieth century and beyond. The IMF's attempts to impose its monetary will in a world of fiat monetary regimes will fare no better than the Second Bank's attempts to do so in the United States under a specie regime with fixed exchange rates.

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In both instances their activities are little more than froth on the surface of more fundamental disturbances. And in both instances a good deal of the disturbances can be attributed to the monetary regimes in place and their operation. Thus, there is an unexpected and contemporary resonance to American historical experience in the 1830s and 1840s. These too were years of considerable monetary, economic, and political turmoil. For many years the money supply of the country consisted of specie, paper money, and foreign coins. When the charter of the First Bank of the United States had expired in 1811, numerous state banks had been founded—their numbers increasing from 90 to 250 within six years. The bank notes of these various state banks circulated at a discount in terms of specie sometimes as much as 80 percent. Problems were further compounded by the War of 1812, which was financed by public loans and Treasury notes. The American Congress failed to increase taxes to pay for the war and, as usual, resorted to the inflationary route to meet these obligations. The politicization of the money supply and monetary affairs during the 1830s and 1840s played out against the constraints imposed by the international specie standard with fixed exchange rates and the inflow and outflow of capital into the United States. Much has been made of the strictly American domestic struggle for monetary supremacy by President Andrew Jackson and the Democratic Party and the supporters of the Second Bank of the United States. As I discuss, much of the turmoil associated with the domestic struggle for monetary supremacy was really froth on the surface of more fundamental disturbances originating in significant capital inflows and outflows. These flows into and out of the United States were erratic. Given that the country was on the specie standard with fixed exchange rates, an increase in capital flows requires an increase in the stock of money and conversely for a capital outflow. The fact that in the U.S. banks, bank note issues and deposits all increased during periods of capital inflows and decreased during periods of capital outflows is only a form of a rise (or decline) in the money supply that would have occurred in one way or another. The monetary uncertainty generated by the struggle for monetary supremacy in the United States by making a larger specie stock desirable, rather than producing too rapid a rise in the money supply, kept the money supply from rising too much as it otherwise would have.

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Contemporary and more recent students have made much of these dramatic surface events in the then emerging market economy of the United States. The political struggle between the Jacksonian Democrats and supporters of the Second Bank of the United States played out as the general worldwide expansion and subsequent contraction coupled with a substantial inflow and outflow of capital into the country. The necessary adjustments in the United States required by the specie standard monetary regime and fixed exchange rate brought about serious and prolonged domestic and international consequences, underscoring again the importance of monetary events. In particular, a number of American states with relatively weak financial institutions and wobbly banks refused to pay the interest owing on their bonds in 1840-1842. And the federal government disclaimed any responsibility for state debts. The American suspension and bankruptcies brought about by the necessary adjustments under the specie standard to a worldwide contraction and cessation of capital inflows shocked foreign investors who held doubtful American securities plus additional losses on their American banking, canal, and other investments. Needless to say, foreign investors took a dim view of American practices and soon expressed resentment against anything American. British bankers, in particular, who had encouraged excessive indebtedness were told that defaults should have been foreseen. The American government steadfastly refused to assume state debts. Foreign investors, on the other hand, held the United States collectively responsible for the shortcomings of its citizens. Anglo-American trade, for instance, declined by more than half from the 1830s. Indeed, an entire generation passed before British investors began to acquire American securities with any confidence. The idea of "moral hazard" was yet to arrive on the international financial scene. EMERGING MARKET ECONOMIES AND CAPITAL FLOWS History is strewn with financial and monetary breakdowns. Many came without warning and did great damage. Others could be predicted, as we have discussed. The principal lesson to investors and governments is to be careful. Complacency in finance invites disaster. This must be remembered when judging and encouraging flows of capital to emerging market countries.

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Optimism in the future of emerging markets may be correct. It may also be misplaced. Our discussion of America as an emerging market economy in the mid-nineteenth century is an illustration of the more distant past as the debt crisis of the 1970s and 1980s and world financial difficulties of the late 1990s are examples of more recent history. Economic euphoria soon turned to bitter disappointment. Little surprise that creditors collectively turned to save themselves and threatened the world's financial system with collapse. One way to avoid earlier experiences is to focus on improving the quality of foreign investment and not simply on the quantity of such investment, important though it is. This study applauds the reforms underway in many emerging market economies. Monetary and macroeconomic policies have worked to curb chronically high rates of inflation. Fiscal affairs that formerly were little more than a source of instability are now under better control through broadly based tax reforms and rethinking of the role of the state in these countries. These policies have now been reinforced in the emerging market countries by policies designed to open their economies to trade. Many of the emerging market countries have now, in some respects, more open economies than the industrial countries. They have privatized state-owned enterprises; deregulated industry, commerce, and domestic finance; and adopted convertible currencies. In fact, governments that once discouraged inward investors now go to the financial centers of industrial countries to advertise opportunities for foreign investment. Increasingly, moves away from heavy-handed state intervention toward more liberal economic policies in the emerging market countries have also increased their attentiveness to foreign investors. This also explains in part the change in the pattern of foreign investment flows from earlier periods. Thus, a far smaller share than in the past takes the form of bank lending; bond and equity finance are far more important than earlier, and the volume of foreign direct investment is much greater. These changes underscore the new opportunities created by financial liberalization, privatization, and better prospects of monetary and macroeconomic stability. They also serve to strengthen private sector links between the emerging market economies and the international capital markets as well as to encourage governments to hold steady on their reform course.

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All this supposes that domestic and international financial systems will continue to work as expected. History suggests that when the financial and monetary systems go wrong, the damage is widespread. While the opportunities for both emerging market countries and industrial countries have increased, so have the risks. Experience tells us that the transition from a tightly controlled domestic financial and monetary system to a substantially unregulated one has proven to be difficult. Even in the well-advanced industrial countries, such reform has been difficult. In many emerging market countries, including the former socialist countries, problems of financial reform are made all the more difficult by a large and growing stock of bad domestic debt. Problems become all the more formidable when integration with the outside world is attempted at the same time. In particular, there is greater vulnerability to various kinds of economic shock. Financial and monetary organization have demonstrated on more than one occasion in history being wrong rather than right. Experiences with such emerging markets as Latin America, Asia, Russia, and elsewhere may be enough to discourage the industrial countries' portfolio investors from all such markets. I have discussed elsewhere the new pattern of investment flows to emerging market countries.1 Capital flow is now directed to private firms rather than governments. The changing pattern of capital flows has also produced changes in risks and incentives for investors and recipients. The changing pattern of capital flows does not promise much for those countries not so favored. In particular, the world's poorest countries (e.g., sub-Sahara African countries) will likely receive a diminishing share of international capital. These countries have in the past received, and indeed relied on, growth and loans from industrial countries. This is in marked contrast to the experience of the Latin American region, where private capital flows have increased significantly. Reluctance on the part of private investors to view Africa with favor owes much to the regions' various governments and the sheer magnitude of problems. Not only are a number of the governments inept and corrupt, but the quality of the labor force and poor infrastructure preclude serious private investor consideration. Over time, however, this may well change in favor of African countries. Foreign investors will respond to sound investment incentives.

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In the 1990s, changes from bank finance to foreign direct investment and capital market finance are striking.2 In the mid-1980s, the share of private finance in developing countries fell to about 16 percent owing in part to the special circumstances of the debt crisis of the earlier years. By 1991, 30 percent of the developing countries' aggregate capital inflow came from the private sector. Even more significant, the private sector's share of bond finance increased from 4 percent in 1989 to 47 percent in 1992. By and large, the reasons for this transformation include, among others: privatization of state-owned firms; adoption of a broad range of probusiness policies, including deregulation; and lower tariffs and taxes. For instance, direct foreign investment has long been the largest component of the renewed flow of capital to emerging market countries. This component includes expenditures on acquisition of new firms, intrafirm loans, and retained earnings of foreign-owned firms. What distinguishes direct foreign investment from other components of investment is that management and other intangible assets are also included in the transfer. In short, such investment carries with it investor control. Not surprisingly, governments in developing countries in the past have attempted to avoid or minimize such investment. The situation has changed so that by 1991, Mexico, China, Malaysia, Argentina, and Thailand accounted for approximately $ 18 billion of the roughly $40 billion total for world direct foreign investment in developing countries. Much of this growth can be attributed to increased privatization in these emerging market economies. The very act of privatization further encouraged investors to invest in promising projects in these countries. During the same period portfolio flows of capital into emerging countries increased significantly. These flows now increasingly include investment in bonds, equities, and related securities. Reasons for such increases include, on the average, higher returns than in the industrial countries. Of course, returns on the securities in emerging markets are also riskier. In the early 1990s a number of emerging market economies enjoyed good ratings (investment grade) by the world's main credit rating agencies. Average ratings had improved considerably since the 1980s. Such ratings are important to all portfolio investors. For bond investors, who are promised a fixed rate of return with no participation in the firm, the value of such ratings is paramount. Industrial countries such as the

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United States have tight institutional rules for investors, particularly those involved in American pension funds. Portfolio investment also tends to flow along regional lines, which explains in part the heavy favor given Latin American countries whose credit ratings have improved. Many of the emerging market countries, moreover, have reduced financial restrictions formerly imposed on foreign investors. Countries such as Argentina, Brazil, Indonesia, and Peru allowed foreigners virtually open access to their stock market in the mid-1990s. Some countries, including Bangladesh, Chile, Mexico, and others, allowed foreign investors fairly free access to listed stocks, although sometimes with restrictions on separation. In still other countries (e.g., former socialist countries), stock markets now exist where none did before. Nevertheless, limited information and poor regulatory standards continue to plague these markets, reducing their attractiveness to many foreign investors. Certainly, emerging market countries have sharply exposed themselves to the volatility of international money and capital markets. These markets are turbulent as was demonstrated by events in 1997-1998. Prudent governments in emerging countries should take steps to insure some security from the turbulence that will surely follow once their economies are fully integrated into world capital and finance markets. After all, forecasting international capital flows is a hazardous business in the best of times, and many a forecaster has been surprised. There is one constant: Equity investors everywhere tend to prefer their own home markets regardless of the location of foreign markets. And, indeed, the maelstrom of 1997-1998 that first hit Asia and moved on to include other emerging market economies underscores our discussion. Problems are compounded by the hard-handed efforts on the part of authorities in some countries to intervene directly in their stock and currency markets. Nevertheless, important forces do suggest that emerging market countries are more likely to grow faster than industrial countries in the long term. The share of industrial countries in emerging markets is also likely to grow as a result. Moreover, investors from industrial countries are increasingly aware that returns in emerging markets tend to be weakly correlated with returns in their own stock markets. Cleverly utilized, such a combination would enable investors to strike a better balance between risk and return by moving into emerging markets and constructing a portfolio containing equities in both mar-

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kets. In essence, the evidence does suggest that opportunities in equities in emerging markets do exist. In the long term, likely returns or investment, as judged by global investors, will carry the greatest weight. On this score there is good evidence that since 1945 it is not the quantity of investment that counts but the quality. Emerging market countries do need the global market for capital. Many of the debt-ridden countries have not fared well in the global market in good part owing to self-inflicted wounds. It is hoped that circumstances will eventually improve in many of these countries. Still, problems are likely to continue as events of 1997-1998 underscore. In particular, the conduct of monetary, fiscal, and exchange rate policies in emerging market countries has increased in complexity as a consequence of the types of capital flowing into these countries. It would be unfortunate if in some future breakdown and crisis the blame is placed on free markets and political reforms. A case in point is the failure of monetary and financial reforms in a number of Latin American countries in the late 1970s and early 1980s. Even in the 1990s, and especially in 1997-1998, arguments continue among economists and politicians as to what exactly went wrong in many of the emerging market countries. There are important differences between the world of the 1990s and that of earlier periods. Nonetheless, policymakers should be alert to signals of possible trouble. It will be recalled that a member of the Latin American countries (e.g., Argentina, Chile, and Uruguay), in their reform efforts of their monetary, banking, and financial systems, reduced interest ceilings in domestic rates, allowing their banks greater freedom of action. Many of the controls on capital movements were also reduced in these countries. The net effect of the reforms in these countries was a sharp rise in their interest rates. These rises proved not to be temporary but sustained for much longer than expected. The consequent capital inflows promoted by these rises led to the appreciation of exchange rates in the reforming countries and a subsequent deterioration in their trade balances. One consequence of such trade balance deterioration was to encourage Argentina, Uruguay, and Chile to abandon their reform efforts in the early 1980s. One lesson of the 1970s and 1980s is that emerging market countries in the 1990s should be alert to the exchange rate implications of their reforms. It is much more difficult to impose effective controls on

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capital flows in an increasingly integrated global market operating with fiat monetary regimes as events in 1997-1998 underscore. Any rigorous controls that government may impose are simply swimming against the tide of global flows. Many of the controls at best are a nuisance and at worst redirect flows into often illicit channels. In any case, they deprive financial institutions from diversifying their holdings of assets in rentreducing ways. At the same time, controls serve to promote risk seeking and corruption. If, in fact, emerging market countries suffer from exchange rate problems because of the large capital inflows, economic theory suggests several courses of action, some more desirable than others. The first is, of course, to do nothing. If the exchange rate is fixed, let the rate float. If the capital inflow is of long duration, the exchange rate will have to change eventually. If it is of short duration and temporary, some action can be taken to prevent the exchange rate overshooting and thereby causing problems for exporters. The idea is not to stop the capital inflow, which permits a country to invest more than it saves. Another well-tried method to deal with rapid capital inflows is for a country to reduce interest rates. The domestic effects, however, may not be desirable. The same conditions that attracted the capital inflow and so promoted an expanding economy may now, by lowering interest rates, encourage domestic borrowing, thereby fueling the ongoing boom. Other methods available to emerging countries for controlling inflow and outflow of capital do not yield promising results. These may include sterilization of the capital inflow by selling government bonds. If carried out on a large scale, however, the government will have to raise its own interest rates to make the bonds attractive. This, in turn, will draw in more foreign capital. In due course, the government will have created another problem for itself in the form of an increase in the bill for debt service. Some observers suggest a combination of fiscal policy, partial sterilization by privatizing state-owned enterprises, and moderate appreciation of the exchange rate. In fact, such a combination of measures appeared in force in Latin American countries in the mid1990s. Whatever the advantages of such measures for preventing adverse consequences of capital flows for emerging market economies, not all of the emerging market countries are in a position of full control over their fiscal policy, public spending, and tax base. To this may be added

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the problem of sequencing policies in countries just embarking on economic reform. If a budget deficit is not brought under control, freeing capital flows may not only appreciate the country's exchange rate and so create difficulties for domestic and export industries, but may further enable the government to continue to borrow and prolong the budget deficit. Measures to curb the deficit, always politically unpopular, may be postponed and future fiscal problems made more difficult. In countries such as the former socialist countries of Europe, where price distortions are severe, liberalization of capital flows may result in simply moving new investment into existing or uneconomic projects. The net effect may be to reduce the country's output. Where domestic prices are so distorted and out of line with world market prices, any new investment will end up producing goods and services that are simply worth less than the resources used in their production. There are exceptions in severely distorted economies (e.g., the establishment of free trade zones, in which producers pay free trade prices for their materials and receive free trade prices for their products). Finally, an inadequate and unstable financial and banking system will make reform a useless exercise and private capital, whatever its source, powerless to promote a country's development. It is thus that most analysts give banking and financial reforms top priority for emerging market countries as well. These reforms have not always received the attention that they require. They have been forcefully brought forward by the financial and banking difficulties in the leading industrial countries (e.g., the United States, with its savingsand-loan problems, and Japan, with its huge amount of bad bank debts). They are underscored by the plight of the former socialist countries, where the assets of many state-owned banking systems are worthless. Nonetheless, these former socialist banks continue in many instances to extend credit to loss-making enterprises for fear of causing an economic collapse. Attempts to curb such practices have prevented other practices of enterprises borrowing from each other and leaving their bills unpaid. Still other countries have resorted to practices not much better than those in the former socialist countries. Their governments have manipulated the banking and financial system by suppressing the price mechanism in the allocation of credit in favor of projects and enterprises that they wished to promote. They have not put the savings of their people to good use by simply not allowing the domestic banking and financial system to channel these savings among competing uses.

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Domestic financial and banking systems properly operated serve to enhance a country's savings and effective investment. A proper system, moreover, promotes a country's transformation and merging into global markets. Governments should leave their people in no doubt about the direction of reform. In the case of banking and finance where new skills and institutions need to be created (e.g., former socialist countries), the paradigm of an entirely free market is not always the best solution. Some analysts would tightly restrict the number of a country's banks to restrict competition deliberately and ensure that banks could be profitable. In this way, banks would be given an incentive to be prudent in their lending and so avoid being eliminated and/or merged. No country has thus far come up with satisfactory answers to regulating banking and finance owing to the unique problems that they present. A case in point is that of deposit insurance. Most countries have in place some arrangement to protect depositors from bank failure. The reason is obvious. The fear of banking failure may spread and become a self-fulfilling prophecy. The net effect may be the destruction of the payments system that banks provide and a serious depression, well documented in the histories of countries such as the United States. At the same time, however, with deposit insurance, bank owners may have little to lose in continuing to operate in a risky manner even in the face of ever-increasing prospects of failure. There is little check on the temptation to lend to less credit-worthy borrowers at high interest rates, thus attracting the money a bank needs by paying depositors, in turn, higher interest rates. Moreover, if the bank was already on shaky financial grounds, its owners may see less rigid lending practices as a way to restore their fortunes. Something of this sort may be behind the savings-and-loan problem in the United States. Even competent and sophisticated bank supervision such as exists in the United States and Japan has not been able to control problems in banking. The problems in countries without such sophistication and competence appear overwhelming. The former socialist countries again provide a good example of the issues at hand. Many borrowers in these countries are doing so simply to pay wages and remain in operation. They are not borrowing in order to invest. Eventually the central authorities acquire the worthless assets of these banks, thereby increasing the size of their debt. The alternative to widespread default is, in effect, to monetize the debt by printing more money. The net result is high and persistent inflation.

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The ongoing transformation of international finance has implications not only for emerging market economies, but also for industrial countries as well as such international organizations as the IMF and World Bank. For instance, transformation processes may be facilitated by allowing emerging market countries easier access for their firms to markets and listing those firms on the exchanges of industrial countries. Facilitating tax treaties between these countries would also encourage equity investment by avoiding double taxation. In any case, private investors, both domestic and foreign, should be encouraged to be cautious in their selection of private firms in which to invest. This helps to channel resources to more efficient uses. ONGOING ROLE FOR BANKS As was the case under other monetary regimes so also is it under the current fiat monetary regime that banks in most countries continue to be big institutions for mobilizing savings. In some industrial countries, this role is being displaced by other institutions, including mutual funds. Banks continue to act as ultimate lenders of last resort, standing, as they do, between a systemic financial collapse and intervention of central banks. They continue to carry out the day-to-day operations of a country's payments system. They continue to ensure that the receiver of a payment is confident that he or she is getting "real" money. Because they are of value to society as a whole, banks will always remain viable entities in the economy. The franchise of banks in many countries continues to be broadened by technology and deregulation. Banks have come forth with such new products as securitized assets and derivation and have improved the efficiency with which they distribute old ones. For all those reasons, banks as institutions are likely to remain with us, though they have lost aspects of monopoly. Disintermediation in banking continues. Stocks indicate that since World War II in the United States, banks controlled more than half of the financial services industry. By the mid-1990s, their share was down to a quarter and continues to decline as consumers choose to put their resources in other places, including mutual funds. The business of banking will undoubtedly change to include more revenue from fee-based services, such as cash and information management, trading, and deriv-

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atives. No doubt profits will exist for those banks and their management, if it is capable of dealing with rapid change. In fact, since 1990 most large American banks have offered their own mutual funds. European banks have tended to focus on creating a large new market for life insurance and pension products to accommodate rich baby boomers entering middle age. Unlike their American counterparts, European banks can enter the insurance and securities businesses with few constraints. Few insurance or securities firms have the important advantage of name-brand recognition that established European banks possess. Moreover, strict legal restrictions exist that constrain American banks from marketing mutual fund deposits as insured. Mutual fund operations must be kept physically separate from other deposits in American banks. Moreover, such operations also require new skills not always available in a bank. Given the difficulties of developing new products and building new skills, a number of American banks have selected the purchase course. These banks have acquired mutual funds (e.g., Mellon Bank of Pittsburgh's purchase of the Dreyfus mutual fund). Changing technology, customers, and distribution systems have freed banks to reexamine the nature of their business. To some observers, the essence of a bank is its access to information from which it builds up its relations with customers. If so, anyone with access to such information (e.g., a telephone company) can be a bank. To survive, banks insist that they must be something more than a warehouse for insured loans. They must adapt and offer new products as demand changes—securities, financial management, and financial products that do not carry federal deposit insurance. This is the answer, American bankers argue, to the challenge of disintermediation. In effect, American banks must have more freedom to offer the same products as their competition. This may not be a complete answer to the disintermediation problem of American banks. For European banks, a tradition of universal banking has left them free to enter many sorts of businesses, including selling insurance and holding large stakes in industrial companies. The development of large banking and securities industries in Europe has occurred. Few European-run banks have been able to seriously challenge these large industries. Nevertheless, disintermediation is going on in Europe, albeit at a slower pace than in the United States. Fidelity, the strong competition of American banks, sells its mutual funds to many Europeans and in

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many of their countries. In France and Spain, a significant outflow of bank deposits into mutual funds has taken place. Some of the funds use banks' established names networks. The reason for such tactics is that in Germany, for instance, money market funds are not allowed. In the Netherlands, a mutual fund company, Robeco, sells its products through the branches of local banks. Owing to the difficulties in penetrating European markets, any retail branch within Europe, America, or another country would need to make substantial investment in branches and technology before it could compete with entrenched local competition. Local banks are perfectly willing to resort to political influence and pressure to keep out competition. These difficulties have encouraged banks with global ambitions to resort to acquisitions rather than organic growth when dealing with Europe. These factors have contributed to the relative absence of strong new bank competition and the adoption of new techniques such as securitization. Other reasons also come to mind, such as different laws and regulations as well as special local factors. As privatization proceeds in countries such as France, Spain, and Italy, a new class of shareholders may be unwilling to take low returns inherent in bank deposits. In some countries, moreover, the close relationship between banks and industries has turned into disaster. Given the nature of European banking, it is not surprising that European banks have lagged behind American and British experience. In both the United States and Great Britain, the barriers between commercial and investment banking are disappearing, while in Europe a long tradition in universal banking has ironically served as a barrier to innovation and development in capital markets. European banks have had all the protection that some American bankers seek. This has not been helpful. They have been protected, as have their inefficiencies. At the same time, the investment banking advantages of American institutions have increased. In financial innovation, specialization, and ability to provide low-cost financial services, American institutions are well ahead of their European competitors. For all their complaints about restrictions and poor position when compared to their competitors, such as mutual funds, banks possess a considerable advantage in the form of a subsidy: deposit insurance. Many people still prefer to hold deposits in banks in the knowledge that such deposits are insured and safe. This is, in effect, a federal government safety net for banks, without which banks would very likely disap-

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pear. Although protecting depositors, deposit insurance may have served to decrease banking discipline. For example, as a bank approaches insolvency and bankers have lost their capital its owners have little to lose by changing everything in a last desperate throw of the dice. Most countries, not surprisingly, have imposed higher capital standards and increased the insurance premiums banks must pay. NOTES 1. See George Macesich, Transformation and Emerging Markets (Westport, Conn.: Praeger Publishers, 1996). 2. Ibid., p. 95.

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CHAPTER 8

What Is to Be Done? THE BASIC PROBLEM The basic problem with a fiat monetary regime is the ease with which it lends itself to political manipulation. Political and economic wisdom is seldom the characteristic of such manipulation. All too often it is subject to human error and the vagaries of sociopolitical forces. Since 1971, when the Bretton Woods gold exchange standard came to an end, the world has been on a fiat monetary regime with various fiat currencies managed according to the discretionary authority of their issuing countries. These currencies are variously "floated" or "fixed" to other currencies either rigidly or within "trading bands" or "crawling pegs." Little agreement exists as to whether this or that currency is maintained at too high or at too low a level relative to other currencies. Little wonder that many observers urge as a solution to the global monetary disorder a single global currency whose supply would adjust automatically to maintain a stable price level in internationally traded goods and services. In their view such an arrangement would eliminate currency risk and the various forces of currency arbitrage that have tempted market participants with sometimes disastrous consequences for the world economy. The appeal and record of a single currency in the pre- and post-World War I years of the gold and specie regimes is discussed

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elsewhere in this study. Appeal of a single currency drives Europe to adopt the "Euro" as a single European currency. People elsewhere have opted for a single currency by adopting the U.S. dollar as their medium of exchange even in instances where parallel currencies are illegal. And in still other countries currencies are tied to the U.S. dollar through the medium of a "currency board." In the final analysis, however, the "single currency," whether the U.S. dollar or the European Euro, remains a part of a fiat monetary regime that is being managed in a discretionary manner by mortals subject to human error. Thus the ideas underpinning a single world money are not new. Indeed, The Economist suggests rethinking its possibility and merits.1 Whether a country would be better off sharing a currency is to set cost against benefit. Here the critical factors are openness to trade and freedom of movement of factors of production. A small open country has more to gain from the convenience provided by a single currency. However, if labor, for instance, is reluctant to migrate, the need for the foreign exchange rate to act as a shock absorber is underscored. Consideration of these factors has led many observers to conclude that even the European countries in their drive to the Euro do not in fact constitute an "optimal currency area" and so are less than ideally suited for sharing a single currency. And the world as a whole and its numerous national states is not even close to an optimal currency area. What is to be done? Many observers whose grasp of history leaves much to be desired present solutions that have been tried in the past and found wanting. Still others firmly grip current solutions and institutions with little regard for economic theory and reality. Fixed exchange rates will not work thanks in good part to the contemporary operation of the fiat monetary regime by nation states. Pegged but adjustable exchange rates will not work owing to their inability to withstand the operation of integrated world capital markets. Currency boards may work if a country is willing to give up its sovereignty. Thus far few countries are willing to do so and live without a central bank. A currency union does have a central bank. Its success, however, depends very much on the willingness of independent nation states to integrate seriously into such a union. The European Union and the Euro are a work in progress as much political as economic. Flexible (or floating) exchange rates as discussed in this study are another solution that, among other reasons, has the appeal that they may well operate successfully within a world of fiat monetary regimes oper-

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ated by independent nation states and in a world that is very distant indeed from an optimal currency area. It is a solution long advocated by Milton Friedman.2 It is also a solution that allows markets to work and so promote global prosperity. A FLEXIBLE EXCHANGE RATE SOLUTION? A flexible exchange rate solution is appropriate to the basic fiat monetary problem that arises from the fact that in a world of many sovereign governments few are willing to forgo money creation. For purposes of illustration consider two countries, A and B. If the government of either country A or country B, for example, lowers or raises expenditures, borrowing the difference from its own banks or from the central banks, both countries may suffer inflationary consequences, while only the agile government gets what it buys with money. If one of the countries uses budgetary policy in a conscious and responsible way to combat inflation, it may find itself continually raising taxes and cutting its budget, while the other country, which is causing the inflation by lowering taxes and in general increasing its expenditures, is deriving the benefits. The monetary system and banking system, in effect, constitute a pool of purchasing power available to the governments of the countries considered. An understanding must be reached on how the several countries will share the available purchasing power. In essence, such an understanding must result in an arrangement capable of coordinating monetary and fiscal policy to the satisfaction of the participating countries. At the same time, the operation of such a monetary regime must not prevent participating countries from achieving what they view as important domestic goals. If it did frustrate such goals, secession from the monetary regime and world trade would likely occur by those counties who believed themselves so abused. This may take the form of capital and trade controls of one form or another, which is tantamount to secession from an open world economy. Indeed, the balance between these requirements is delicate. It is particularly difficult to achieve in the presence in the world of nationalist aspirations by culturally, linguistically, and economically disparate nation-states. A flexible exchange rate arrangement is especially suitable in a world consisting of culturally, linguistically, and economically disparate nation-states. It would permit each country to develop its economy within the confines of its territory according to its own appraisal of pos-

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sibilities. Flexible exchange rates provide an "automatic" trade-balancing mechanism, thereby eliminating the necessity for exchange and trade controls. At the same time, the individual nations are freed from having to coordinate monetary and fiscal policies and economic development programs with other nations. Encroachment into the delicate area of national sovereignty is minimized. As a consequence, the chance for world prosperity is enhanced. A system of flexible exchange rates would also help compensate for the "stickiness" of wages and prices brought about by different stages of economic development among nation-states in the world economy. By promoting what would partially deputize for competitive price flexibility, flexible exchange rates would increase the effectiveness of the price mechanism and thus contribute to legitimate world economic integration. Such an arrangement provides a means for combining interdependence among countries through trade with the greatest possible amount of internal monetary and fiscal independence. No country would be able to impose its policy mistakes on others, nor would it have their mistakes imposed on itself. Each country would be free to pursue policies for internal stability according to its own appraisal of possibilities. If all countries succeeded in their internal policies, reasonably stable exchange rates would prevail. Effective intercountry coordination would be achieved without the risks of formal, but ineffective, coordination. On the other hand, critics of a system of flexible exchange rates argue that an exchange rate left to find its own level will not necessarily trace out an optimum path through time. However, an optimum is very difficult to define since its criteria hinge on medium-term and long-term expectations, which can never be guaranteed. Nevertheless, there is no necessity that the market per se will yield a reasonably satisfactory rate. Moreover, in small, undiversified, and less-developed countries a lack of sophisticated individuals with a heterogeneous outlook and sufficient capital may impair the working of a competitive market in foreign exchange. Another criticism is that exchange rate adjustments will not necessarily insulate the level of domestic activity while correcting an internal balance. Exchange rate adjustments are particularly desirable when price levels have moved out of line. The exchange rate correction will restore the terms of trade to their original position and leave the volume and balance of trade and seal income in each country at their original

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levels. The units of measurement will simply be changed. This is no longer true where the sources of disturbance are structural changes, different rates of full employment growth, and cyclical income fluctuations. Repercussions on domestic employment and output can be reduced, but they apparently cannot be eliminated by flexible exchange rates. The case for flexible exchange rates gathers strength in world markets in which labor immobility caused by cultural differences exists and a weak and indifferent central government is indifferent or incapable of easing depressed or less-developed regional adjustments. It may be just such a case that recent writers have in mind when they argue that if a common market is divided into national regions, and if within each there is factor mobility and between factors there is immobility, then each region can have a separate currency which fluctuates relative to all other currencies.3 In this case, the national region as an economic unit and currency domain coincide. Moreover, the stabilization argument for flexible exchange rates is valid when based on regional currency areas. We have it from Milton Friedman and others, including John Maynard Keynes, that when the issue before a country is a fixed exchange rate, independent monetary policy, and free capital movement, any two are viable but not all three.4 The country must choose. Attempts by countries to have all three has driven such countries into financial crises, most recently illustrated by the Asian experience in 1997-1998. And of course, earlier in Great Britain in 1967, Chile in the early 1980s, Mexico in 1995, and the list can be expanded. For a country with a major trading partner with a good and credible monetary policy, a truly fixed exchange rate with that country may work well. The idea that a country can evade external discipline and required adjustments simply by adopting a fixed exchange rate, however, is an illusion. A balance-of-payments deficit will ultimately lead to a decline in the quantity of money and so to other internal adjustments. A pegged exchange rate as distinct from a truly fixed exchange rate may allow a country to temporarily avoid adjustment to a balance-ofpayments deficit. The country's central bank could draw down its international reserves or borrow from abroad to finance the deficit. Usually, such an operation is taken in the belief that the deficit is of short duration. As usual, hope springs eternal. Minor problems viewed as temporary have a tendency to become major problems and of long duration. The necessary exchange rate adjustment now becomes a major issue for

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the country. Unsustainable policies cannot be kept in place forever by pegged exchange rates. Sooner or later required adjustments to ongoing deficits will take place with predicable consequences. A NEW BRETTON WOODS AND RETURN TO GOLD? Repeated calls for monetary reform thrust into the forefront the restoration of a fixed exchange rate system so as to provide a stable monetary foundation for international trade. The usual call, as underscored in this study, is also for a monetary regime anchored by a dollar convertible into gold.5 These calls repeatedly stress the dissatisfaction with the existing fiat monetary regime. Critics of the fiat monetary regime note in particular that this regime fails to deal properly with the problem of defining a monetary standard for measurement. There is the question of the global unit of account for signaling value across borders. Capital flows are in jeopardy thanks in good measure to the absence of a sound monetary regime. It is little wonder that some emerging countries, in the view of critics, are opting to withdraw from the global economy and abandon the free market rather than be victimized by monetary chaos. The crisis in the closing years of the twentieth century is largely the result of a world fiat monetary regime that has broken down. The way to put matters right, in the view of these critics, is to adopt a global gold standard. Unlike the failed Bretton Woods regime, which was a gold exchange standard whereby only the United States was required to convert the dollar into gold at a fixed rate and only foreign central banks were allowed the privilege of redemption, their proposal is for a return to the classic international gold standard. In effect, countries would once again be required to maintain convertibility into gold of their currencies and permit every individual the right to redeem their cash balances into gold. These proposals are straightforward. Under the gold standard (or specie standard) as noted elsewhere in this study, a country is committed to keeping the price of gold fixed and is willing to convert its money into gold at a fixed price. In such a regime, the country's monetary authorities must maintain gold reserves sufficient for the volume of sales that may be necessary from time to time to peg the price of gold successfully. Such authorities would be required to sell gold whenever the price of gold tended to rise. If the monetary authorities were to pursue a

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discretionary policy that resulted in inflation, the prices of all goods and services, including gold, would rise. In such an event, the rise in the price of gold would necessitate gold sales by the monetary authorities, which could eventually deplete the country's gold reserve. As a result, the monetary authorities of a country on a gold standard cannot carry out a serious discretionary monetary policy. The advantage of a gold standard is its tendency toward a predictable long-run value of a gold standard country's money. In effect, the country's monetary authorities assure that its money and gold are perfect substitutes. The aggregate price level in such a country is thus inversely related to the value of gold relative to other goods and services. If gold falls in value because the price level has risen, there is a disincentive to mine more of it. If there are exogenous shocks, such as discoveries of new gold, unpredictable swings in the value of money can occur. A number of examples are readily available from monetary history, e.g., the California and Alaska gold discoveries in the nineteenth century. A study by Anna J. Schwartz compares the performance of the economy under the historical gold standard with the experience of the United States and the United Kingdom following World War II.6 The study suggests that during the era of the gold standard, substantially lower rates of inflation were registered than in the period following World War II. There was also greater variability of real per capita increase in income. Schwartz also notes that a shift to a true gold standard would be a shift to a monetary regime that would find few supporters. Moreover, even if the United States, for instance, adopted a gold standard monetary regime, it is not certain that prices would be more predictable than under alternative regimes (Schwartz discusses why in the aforementioned study). The gold standard monetary regime was abandoned when conversion of domestic money into gold ceased. In the post-World War II period, fixed exchange rates under the Bretton Woods system evolved into adjustable pegged exchange rates. When confidence in American gold-dollar convertibility and in its role as the dominant reserve currency eroded in the 1970s, the Bretton Woods system, in effect, collapsed. Gold ceased to play a monetary role. Thereafter, the world embarked on a discretionary fiat monetary regime with "managed flexible rates." The results have not been satis-

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factory. Indeed, in many countries the results have been high and variable inflation and interest rates, low productivity growth, and unstable exchange rates, prompting discussion of returning to the gold standard and fixed exchange rates as a way of improving performance.7 Any discussions of a return to a gold standard must confront the reluctance of countries to give up discretionary authority over monetary affairs. This is also a problem for a fiat money regime governed by a rule for the growth of the money supply.8 The failure, moreover, of the U.S. Gold Commission in 1982 to endorse a larger role for gold in contemporary monetary affairs puts to rest its serious consideration.9 Nevertheless, the gold standard regime continues its appeal for many people. FUNDAMENTAL DIFFERENCES ON THE ROLE OF MONEY IN SOCIETY Moreover, there are fundamental differences among adherents and reformers of the existing fiat monetary regime on the very role of money in society. Indeed, for a proper perspective on money in society it is useful to reach back to John Locke. Consider briefly Locke's views on money. As we know, his purpose in economics was to clear up what he considered confusion about the interest rate and the price level.10 To this end he found it useful to present a general theory of value that provided a basis for a theory not only of money as a medium of exchange but also of interest, rents, and capital values.11 Accordingly, his discussion of money can be considered in three parts: origins of money; the requirements and functions of a money commodity; the determinants of the value of money. The first two are important in setting out his philosophy and attitude toward money while the third is his quantity theory of money. Money has its origin, in Locke's view, in man's desire to exchange his surplus of perishable commodities for more durable commodities, which would be preserved for long periods of time without deterioration. Although any durable commodity would suffice, gold and silver are particularly suitable because of their indestructibility, durability, and ability to maintain their value. Over time these metals acquired a store of value and people began accepting them in exchange for other commodities thereby establishing them as an exchange medium. The net effect has been for the two functions to reinforce each other thanks

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to the suitability of the two metals as a store of value, which made them acceptable to people in exchange, and their ready acceptance in exchange for commodities, which made them more reliable as stores of value. Thus by placing an imaginary value on otherwise worthless commodities, man, according to Locke, acquired a very useful instrument for bridging the past, present, and future. In effect, money came about through an implicit contract that enabled people to overcome the difficulties inherent in the state of nature. Such an origin of money well serves Locke's contract theory of the origins of society. According to Locke and to many other people before him, the money commodity must be durable, divisible, universally acceptable, and scarce in order for it to function properly as money. On this score gold and silver are the most suitable money commodities as a ready comparison will illustrate. Lead, for instance, is too abundant and too prone to rapid changes in price to be a money commodity. For political reasons Locke excludes paper money, which, he argues, is readily manipulated, and he views token money as little better than fraud. Although no ordinary metallist, Locke is certainly a "hard currency" proponent to whom President Andrew Jackson and his followers in the nineteenth century and the monetary regime reformers ever since could turn for inspiration and theoretical guidance, as indeed they do. It is in Locke's determinants of the value of money that a version of the quantity theory of money can be found. Accordingly, the demand for money as a medium of exchange will be stable, not be subject to the same forces as other commodities. In effect, the velocity of money is stable, so the value of money is determined by the quantity available. Since the value of money is the inverse of the general level of prices for goods and services, an increase in the quantity of money increases the price level and vice versa. Unlike earlier "quantity theorists," Locke's theory focused on the function of money as a medium of exchange and not simply as an empirical explanation of an existing inflation or deflation based on supply-and-demand analysis. All that is necessary to make Locke's "quantity theory" recognizable today is simply to interpret the money side of the equation as a flow rather than a stock. There is a rate of turnover or velocity of circulation of money that also plays a part in determining the value of money. There is much to suggest that Locke did indeed recognize this aspect of his theory.

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The quantity theory of money set forth by John Locke is now a shared monetary heritage for which philosophers as distant as Law, Hume, and Aristotle are called in evidence. Its more recent advocates include Irving Fisher and Milton Friedman. Its basic proposition is that inflation results from too much money chasing too few goods. In fact, Milton Friedman identifies "monetarism" (as noted earlier) with the quantity theory, underscoring thereby that monetarism is not a new development.12 The principal tenet of "monetarism," as in the quantity theory of money, is that inflation is at all times and everywhere a monetary phenomenon. Its principal policy corollary is that only a slow and steady rate of increase in the money supply—one in line with the real growth of the economy—can ensure price stability. It questions the doctrine advanced by John Maynard Keynes that variations in government spending, taxes, and the national debt could stabilize both the price level and the real economy. This doctrine has come to be called "the Keynesian Revolution." Much of the criticism of the quantity-velocity formulation of the quantity theory rests on challenging the basic assumptions underlying the theory, especially in its rigid form. Neither velocity nor income nor transactions, it is argued, are stable. All are subject to rapid change even in very short periods of time. Velocity changes at times may be an even more important factor than the quantity of money in accounting for short-run changes in the level of prices. Another criticism deals with the passive nature of P, the level of prices. It is asserted that P, far from being passive, may in fact contribute to changes in the other factors. For example, a rise in the level of price may encourage people to dispose of their money for fear that its purchasing power will decline even further. Such disposals are registered in an increase in velocity. Moreover, under a specie (gold and silver) standard, a change in prices may affect the production of the monetary metal and the stock of money (M). A rising level of prices may increase the costs of producing specie, and conversely for a falling level of prices. The net effect is that P is not necessarily passive and may even influence M—albeit after a considerable period of time. Milton Friedman's reformulation of the quantity theory of money freed it from dependence on the assumption of automatic full employment. The emphasis is on the role of money as an asset. He treats the demand for money as part of capital or wealth theory concerned with

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the composition of assets. On Friedman's reformulation, it is important to distinguish between ultimate wealthholders, to whom money is one form in which they choose to hold their wealth, and enterprises to whom money is a producer's goods, like machinery or inventories. It is thanks to the "Austrian School" and through such members as Carl Menger, Georg Simmel (actually a sociologist), Ludwig Mises, and Friedrich Hayek that useful insights are had into money and the monetary system as an integral part of the social structure. Their views differ significantly from both Keynesian and quantity theorist (monetarist) views, though Milton Friedman and some quantity theorists come closer to the Austrians in their emphasis on "monetary rules" and a stable monetary order. According to the Austrian view, money and the monetary system is the unintended product of social evolution in much the same fashion as the legal system. Money is a social institution—a public good. It is not simply another durable good held in the form of "real balances" by utility-maximizing individuals or profit-maximizing firms, as Keynesian and quantity theorist views hold. However useful the tools of demandand-supply analysis applied to money as a private durable good, Keynesians and quantity theorists miss the full consequences of monetary instability. In essence, the monetary system is an integral part of the social fabric whose threads include faith and trust, which makes possible the exercise of rational choice and the development of human freedom. This is misunderstood by the very people who benefit from it. It is this misunderstanding of the social role of money as a critical element in the market mechanism and the need for confidence in the stability of its purchasing power that came to dominate much of Keynesian and quantity theorist monetary thought in the post-Wold War II period. This misunderstanding is the ideological key to the use of discretionary monetary policies for monetary expansion as an unfailing means of increasing output and employment and reducing interest rates. Herbert Frankel writes that Keynes, following Georg Friedrich Knapp, presents money and the monetary regime as a creation of the state and, as such, available for manipulation by government consisting mostly of wise and well-educated people disinterestedly promoting the best interests of society.13 The fact that such an arrangement curtails individual choice and decision did not disturb Keynes, who saw little reason to believe that those choices and decisions benefit society. In

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essence, it is at best an elitist view of government so familiar to Great Britain at the turn of the century. David Laidler takes exception to Frankel's argument that Keynes is the architect of a short-run monetary policy that seeks to exploit monetary illusion in order to trick people into taking actions which, if they could correctly foresee their consequences, they would not take. Such "trickery" is not the policy product of the 1930s when Keynes believed that undertaking an activist monetary policy to deal with unemployment would be what individual agents desired but were prevented from accomplishing on their own because of price and market mechanism failures. Keynes, in effect, thought he was dealing with the issue of involuntary unemployment. It was in the 1950s and 1960s that the idea of a stable inflation-unemployment trade-off generated a "money illusion" available for exploitation by policymakers. According to Frankel, it is Keynes who made the revolt against the predominant nineteenth-century view of money respectable. Recall the nineteenth-century view of society's responsibility to maintain trust and faith in money was supported by the bitter eighteenth-century experiences with currency excesses. Most classical economists and certainly the "Austrians" underscored society's monetary responsibilities for preserving trust and faith in money. Indeed, the traditional view, in keeping with the spirit of the nineteenth-century tradition, is against the use of discretionary monetary policy for the purpose of exploiting the presumed short-run nonneutrality of money in order to increase permanent employment and output by increasing the stock of money. Though an arbitrary increase in money, according to Simmel, will not necessarily disrupt relative prices permanently, such manipulation sets into motion forces whose consequences for social stability are very serious indeed.14 Since no human power can guarantee against possible misuse of the money-issuing authority, to give such authority to government is to invite destruction of the social order. To avoid such temptation, it is best to tie paper money to a metal value established by law or the economy.15 Of course, Keynes, too, was essentially a monetary economist. His writings are an integral part of our received monetary heritage. Certainly his work Monetary Reform, draws on this heritage while at the same time adding to it.16 It was also Keynes who told us in 1919 in his Economic Consequences of the Peace that there is no better means to overturn an existing social structure than to debauch the currency.17 He

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also alleged that Lenin indeed espoused that the best way to overthrow the capitalist system was to debauch the currency. And, ironically, some can argue that it was also Keynes's subsequent teaching that opened the floodgates of inflation in the post-World War II period even though he personally attempted to close these gates shortly before his death in 1946.18 Keynes clearly shared a monetary heritage common to Simmel, the Austrians, and the quantity theorists (monetarists). What sets him apart, of course, is his views on the conduct of monetary policy. Friedman, for instance, writes that where he disagreed with the views Keynes expressed in Monetary Reform is with the appropriate method for achieving a stable price level. Keynes favored managed money and managed exchange rates—that is, discretionary control by monetary authorities.19 It appears that it is the exercise of discretionary policy by monetary authorities advocated by Keynes that underscores his differences with the quantity theorists (monetarists) and Austrians. Setting aside the monetary role of gold as a "barbarous relic" casts him in disagreement with the Austrians. His desire to place the execution of monetary policy at the discretion of public-spirited and competent civil servants set him in disagreement with quantity theorists (monetarists) who argue for a growth rate rule for some definition of the money supply. But some of these differences cast Keynes out of our received monetary heritage. Indeed, Professor J. R. Hicks tells us that in his search for a workable monetary standard, Keynes found in the General Theory, the labor standard and its dependence on society's sociopolitical processes.20 This, in turn, translated into, among other things, a "managed fiat monetary standard" and justification for its discretionary management by central monetary authorities. Keynes, of course, was well aware of the precariousness of efforts to calculate the course of human affairs. Man constructs institutions and arrangements that give the illusion of rational foresight and stability. General breakdowns do occur from time to time for that is the course of human events. With breakdowns come shattered illusions. Thus it is, for instance, that with breakdowns employment and enterprise suffer because decision makers seek refuge for their reserves of wealth in money itself. The human institution of money, which serves as a vehicle for man's endless journey into an uncertain future, can thus be a source of disturbance by serving as a refuge for wealth. Indeed, Keynes's General

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Theory for the most part deals with the circumstances and institutions and particularly the institutions of money that man has built in his attempts to make the uncertain certain. Long before Keynes, Georg Simmel in his Philosophy of Money underscores that an "unmanaged" or "free" monetary order was cast in doubt. He identifies two likely sources of trouble for a free monetary order. One source is that since individuals do not receive income in kind but rather in money, they are exposed to the uncertainties originating in fluctuations in the purchasing power of money. The other is that the very success of a free monetary order encourages the development of socialist or collectivist ideas that serve to undermine the individualistic order based on free markets and money. The existence of a growing body of evidence on the vote-maximizing behavior of politicians and politically induced cycles in such key variables as inflation, unemployment, government transfers, taxes, and monetary growth suggests the critical nature of the problem in a democracy. Constraints must be placed on the exercise of discretionary authority by vote-maximizing bureaucracies and political elites if democracy is to thrive and prosper. Satisfactory resolution to these issues is basic to reducing monetary uncertainty and stabilizing the long-term price level. NOTES 1. The Economist, September 26, 1998, Vol. 348, No. 8087, p. 80. 2. See, for instance, Milton Friedman, "Markets to the Rescue," Wall Street Journal, October 13, 1998, p. A22. 3. See Robert A. Mundell, "A Theory of Optimal Currency Areas," American Economic Review, September 1961, pp. 657-664; and Ronald I. McKinnon, "Optimum Currency Areas," American Economic Review, September 1963, pp. 717-725. 4. Milton Friedman, "Markets to the Rescue," Wall Street Journal, October 13, 1998, p. A22. 5. See, for instance, Judy Shelton, "Time for a New Bretton Woods," Wall Street Journal, October 15, 1998, p. A22. 6. See Anna J. Schwartz, "Alternative Monetary Regimes: The Gold Standard," in Alternative Monetary Regime's, ed. Colin D. Campbell and William R. Dougan (Baltimore and London: The Johns Hopkins University Press, 1986), pp. 44-72. Anna J. Schwartz, "Introduction," in A Retrospective of the Classical Standard, 1821-1931, ed. Michael D. Bordo and Anna J. Schwartz (Chicago: University of Chicago Press, 1984), pp. 1-20.

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7. Anna J. Schwartz, "Alternative Monetary Regimes: The Gold Standard," op. cit., pp. 69-70. 8. Ibid., p. 71. 9. Ibid., p. 71. 10. See, for instance, Karen Iversen Vaughn, John Locke: Economist and Social Scientist (Chicago: University of Chicago Press, 1980). 11. Ibid., p. 31. 12. "I would say that personally, I do not like the term 'Monetarism,'" writes Friedman, "I would prefer to talk simply about the Quantity Theory of money, but we can't avoid the usages that custom imposes on U.S." Milton Friedman, "Monetary Policy: Theory and Practice," Journal of Money, Credit and Banking, February 1982, p. 101. 13. S. Herbert Frankel, Two Philosophies of Money: The Conflict of Trust and Authority (New York: St. Martin's Press, 1977). See also review of Frankel's study by David Laidler in Journal of Economic Literature, June 1979, pp. 570-72. 14. See Georg Simmel, The Philosophy of Money (Translation by T. Bottomore and D. Frisby, with Introduction by D. Frisby) (London and Boston: Routledge and Kegan Paul, 1977, 1978). See also George Macesich, Money and Democracy (New York: Praeger Publishers, 1990). 15. Frankel, Two Philosophies of Money: The Conflict of Trust and Authority, p. 92. 16. John Maynard Keynes, Monetary Reform (London: Harcourt Brace and Co., 1924). 17. John Maynard Keynes, The Economic Consequences of the Peace (London: Macmillan, 1920). 18. F. A. Hayek, "The Keynes Centenary: The Austrian Critique," The Economist, June 11, 1983, p. 39. 19. Milton Friedman, "A Monetarist Reflects: The Keynes Centenary," The Economist, June 4, 1983, p. 19. 20. J. R. Hicks, "The Keynes Centenary: A Skeptical Follower," The Economist, June 18, 1983, pp. 17-19.

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Selected Bibliography Alpert, Paul. Twentieth-Century Economic History of Europe. New York: Henry Schuman, 1951. Angell, James W. "Appropriate Monetary Policies and Operations in the United States Today." Review of Economics and Statistics 42 (August 1960): 247-252. Arndt, H. W. The Economic Lessons of the Nineteen-Thirties. London: Frank Cass, 1963. Arnold, Roger A. "Hayek and Institutional Evolution." The Journal of Libertarian Studies 4, no. 4 (Fall 1980): 341-352. Attiyeh, Richard. "Rules versus Discretion: A Comment." Journal of Political Economy 73 (April 1965): 170-172. Auerback, Robert D. Money, Banking, and Financial Markets. New York: Macmillan, 1982. Beck, Nathaniel. "Presidential Influence on the Federal Reserve in the 1970s." American Journal of Political Science (August 1982): 415-445. Bloomfield, Arthur L. Monetary Policy under the International Gold Standard: 1880-1914. New York: Federal Reserve Bank of New York, 1959. Bonn, Moritz J. The Crumbling of Empire: The Disintegration of World Economy. London: Allen & Unwin, 1938.

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Bordo, M. D. "The Classical Gold Standard: Source Lessons for Today." Federal Reserve Bank of St. Louis, Monthly Review (May 1981): 2-17. Brennan, H. Geoffrey, and James M. Buchanan. Monopoly in Money and Inflation: The Case of a Constitution to Discipline Government. London: Institute of Economic Affairs, 1981. Bronfenbrenner, Martin. "Statistical Tests of Rival Monetary Rules." Journal of Political Economy 69 (February 1961): 1-14. Cagan, Phillip. Determinants and Effects of Changes in the Money Stock, 1875-1960. New York: National Bureau of Economic Research, 1965. Catterall, R. C. H. The Second Bank of the United States. Chicago: University of Chicago Press, 1903. Clapham, John H. "Europe after the Great Wars, 1816 and 1820." Economic Journal (December 1920): 423-435. Day, John P. Introduction to World Economic History since the Great War. London: Macmillan, 1939. Dewey, D. R. The Second United States Bank. Washington, D.C.: U.S. Government Printing Office, 1910. Downs, Anthony. Inside Bureaucracy. Boston: Little, Brown and Company, 1967. Fisher, Irving. Stabilizing the Dollar. New York: Macmillan, 1920. Friedman, Milton. "A Monetary and Fiscal Framework for Economic Stability." American Economic Review 38 (June 1948): 245-264. . "Commodity Reserve Currency." Journal of Political Economy 59 (June 1951): 203-232. . "Price, Income, and Monetary Changes in Three Wartime Periods." American Economic Review, Papers and Proceedings (May 1952): 612-625. . "The Quantity Theory of Money—A Restatement." In Studies in the Quantity Theory of Money, edited by Milton Friedman. Chicago: University of Chicago Press, 1956. . A Program for Monetary Stability. The Millar Lectures, no. 3. New York: Fordham University Press, 1960. . "The Lag in Effect of Monetary Policy." Journal of Political Economy 69 (October 1961): 447-66. . "Should There Be an Independent Monetary Authority?" In In Search of a Monetary Constitution, edited by L. B. Yeager, Cambridge, Mass.: Harvard University Press, 1962.

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. "The Role of Monetary Policy." American Economic Review, 58 (March 1968): 1-17. . The Optimum Quantity of Money and Other Essays. Chicago: Aldine, 1969. . The Quantity Theory of Money and Other Essays. Chicago: Aldine, 1969. . "Monetary Policy: Theory and Practice." Journal of Money, Credit, and Banking (February 1982): 108, 124. . "The Keynes Centenary: A Monetarist Reflects." The Economist (June 4, 1983): 17-18. . Money Mischief: Episodes in Monetary History. New York and San Diego: Harcourt Brace Jovanovich, 1992. Paperback. , ed. Studies in the Quantity Theory of Money. Chicago: University of Chicago Press, 1956. Friedman, Milton, and Rose D. Friedman. Two Lucky People: Memoirs. Chicago: University of Chicago Press, 1998. Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. National Bureau of Economic Research. Studies in Business Cycles. No. 12. Princeton: Princeton University Press, 1963. . Monetary Trends in the United States and United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867-1975. Chicago: University of Chicago Press, 1982. Galbraith, J. K. The Great Crash. Boston: Houghton Mifflin, 1972. Goldfeld, Stephen M. "New Monetary Control Procedures." Journal of Money, Credit and Banking (February 1982): 148-155. Gordon, George J. Public Administration in America. 2d ed. New York: St. Martin's Press, 1982. Gramley, Lyle E. "Guidelines for Monetary Policy: The Case against Simple Rules." Readings in Money, National Income, and Stabilization Policy, edited by W. L. Smith and R. L. Teigen, rev., ed. (Homewood, 111.: Irwin, 1970): 488-493. Gregory, Theodore E. "Rationalization and Technological Unemployment." Economic Journal (December 1930): 441-467. . "The Economic Significance of Gold Maldistribution." Manchester School of Economics and Social Studies 2 (1931): 77-85. . Gold, Unemployment, and Capitalism. London: P. S. King, 1933. . The Gold Standard and Its Future. 3d ed. New York: Dutton, 1935.

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Guillebaud, Claude W. The Economic Recovery of Germany from 1933 to the Incorporation of Austria in March, 1938. London: Macmillan, 1939. Hammond, Bray. Banks and Politics in America. Princeton: Princeton University Press, 1957. Hart, Albert G. "The Chicago Plan for Banking Reform." Review of Economic Studies 2 (1935): 104-116. . "The Role of Monetary Policy." American Economic Review (March 1968): 1-17. Havrilesky, Thomas M. "The Economist's Corner: The Politicization of Monetary Policy." The Bankers Magazine (Spring 1975): 101-104. Havrilesky, Thomas M., and John T. Boorman, eds. Current Issues in Monetary Theory and Policy. 2d ed. Arlington Heights, 111.: AHM Publishing Company, 1980. Hayek, Friedrich A. Studies in Philosophy, Politics, and Economics. Chicago: University of Chicago Press, 1967. . Denationalization of Money. London: Institute for Economic Affairs, 1976. . "The Keynes Centenary: The Austrian Critique." The Economist (June 11, 1983): 41. Hearn, Daniel S. Federal Reserve Policy Reappraised, 1951-1959. New York: Columbia University Press, 1963. Hicks, John R. "The Keynes Centenary: A Skeptical Follower." The Economist (June 18, 1983): 17-19. Hirsch, Fred. Social Limits to Growth. Cambridge, Mass.: Harvard University Press, 1976. Hirschman, Albert. "Rival Interpretations of Market Society: Civilizing, Destructive, or Feeble?" Journal of Economic Literature (December 1982): 1463-1484. Hoover, Calvin B. Memories of Capitalism, Communism, and Nazism. Durham, N.C.: Duke University Press, 1965. Hoskins, W. Lee. "Defending Zero Inflation: All for Naught," Federal Reserve Bank of Minneapolis. Quarterly Review (Spring 1991): 16-20. Hutchinson, Keith. The Decline and Fall of British Capitalism. New York: Scribner's, 1950. "Is the Federal Reserve's Monetary Control Policy Misdirected?" Journal of Money, Credit, and Banking (February 1982): 119-147.

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Jenks, L. H. The Migrations of British Capital to 1875. New York: A. A. Knopf, 1927. Johnson, E., ed. The Collected Writings John Maynard Keynes. Vol. 17, Activities 1920-1922: Treaty Revision and Reconstruction. Vol. 18, Activities 1922-1932: The End of Reparations. New York and London: Macmillan and Cambridge University Press, 1977, 1978, respectively, for the Royal Economic Society. Kahn, Alfred E. Great Britain in the World Economy. New York: Columbia University Press, 1946. Keynes, John M. "The Economics of War in Germany." Economic Journal (September 1914): 442-452. . "War and the Financial System, August 14, 1914." Economic Journal (September 1914): 460-486. . "The City of London and the Bank of England, August 1914." Quarterly Journal of Economics (November 1914): 48-71. . The Economic Consequences of the Peace. London: Macmillan, 1920. . A Revision of the Treaty. London: Macmillan, 1922. . The Economic Consequences of Mr. Churchill. London: Leonard and Virginia Woolf, 1925. . The End of Laissez-Faire. London: Leonard and Virginia Woolf, 1927. . "The French Stabilization Law." Economic Journal (September 1928): 490-494. . "The German Transfer Problem." Economic Journal (March 1929): 107. . Essays in Persuasion. New York: Harcourt, Brace, 1932. . The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace & World, 1964. Keynes, John M., and H. D. Henderson. Can Lloyd George Do It? An Examination of the Liberal Pledge. London: Nation and Athenaeum, 1919. Keynes, Milo, ed. Essays on John Maynard Keynes. New York: Cambridge University Press, 1975. Kindleberger, Charles. The World in Depression, 1929-1939. Berkeley: University of California Press, 1973. Klein, Benjamin. "The Competitive Supply of Money." Journal of Money, Credit, and Banking (November 1974).

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Kydland, Finn, and Edward Prescott. "Rules Rather than Discretion: The Inconsistency of Optimal Plans." Journal of Political Economy 3 (1977). . "Rules v. Discretion." The Economist (March 2, 1991): 71-72. League of Nations. The Network of World Trade. Geneva: League of Nations, annually 1932-1944. Lerner, Abba P. "Milton Friedman's 'A Program for Monetary Stability': A Review." Journal of the American Statistical Association 57 (March 1962): 211-220. Reprinted in Monetary Policy: The Argument from Keynes' Treatise to Friedman, edited by William Hamovitch. Boston: Heath, 1966. Macesich, George. "The Source of Monetary Disturbances in the United States, 1834-1845." Journal of Economic History (September 1960): 407-434. . "International Trade and U.S. Economic Development Revisited." Journal of Economic History (September 1961): 384-385. . "The Quantity Theory and the Revenue Expenditure Theory in an Open Economy: Canada 1926-1958." Canadian Journal of Economics and Political Science (August 1964): 368-390. . "International Trade and United States Economic Development Revisited." Reprinted in Stanley Cohen and Forest Hill, eds. American Economic History. Philadelphia: Lippincott, 1966. . "Central Banking, Monetary Policy, and Economic Activity." U.S. Congress. House. Subcommittee on Domestic Finance of the Committee on Banking and Currency. Compendium on Monetary Policy Guidelines and Federal Reserve Structure. 90th Cong., 2d Sess. Washington, D.C.: U.S. Government Printing Office, December 1968. . "Stock and the Federal Reserve System." U.S. Congress. House. Subcommittee on Domestic Finance of the Committee on Banking and Currency. Compendium on Monetary Policy Guidelines and Federal Reserve Structure. 90th Cong., 2d sess. Washington, D.C.: U.S. Government Printing Office, December 1968. . Geldpolitik in einem gemeinsametz europaischen markt (Money in a European common market). Baden-Baden: Nomos Verlagsgesellschaft, 1972. . "Monetary Policy in the Common Market Countries: Rules versus Discretion." Weltwirtschaftliches Archives 198 (1972): 20-52.

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127

. "Monetary Policy and International Interdependence in the Great Depression: The U.S. and Yugoslavia." Zbornik. Belgrade: Serbian Academy of Sciences and Arts, 1976. . The International Monetary Economy and the Third World. New York: Praeger, 1981. . Monetarism: Theory and Policy. New York: Praeger, 1983. . Economic Nationalism and Stability. New York: Praeger, 1985. . Monetary Policy and Politics: Rules Versus Discretion. Westport, Conn, and London: Praeger, 1992. . The United States Economic in the Changing Global Economy: Policy Implications and Issues. Westport, Conn.: Praeger, 1997. Macesich, George, and F. A. Close. "Comparative Stability of Monetary Velocity and the Investment Multiplier for Austria and Yugoslavia." Florida State University Slavic Papers. Vol. 3. Tallahassee: Florida State University, 1969. Macesich, George, and Hui-Liang Tsai. Money in Economic Systems. New York: Praeger, 1982. Mayer, Thomas. "The Lag in Effect of Monetary Policy: Some Criticisms." Western Economic Journal 5 (September 1967): 324-342. . Statement. Compendium: 46-72. "Stock and the Federal Reserve System." U.S. Congress. House. Subcommittee on Domestic Finance of the Committee on Banking and Currency. Compendium on Monetary Policy Guidelines and Federal Reserve Structure. 90th Cong., 2d sess. Washington, D.C.: U.S. Government Printing Office, December 1968. McCloskey, Donald N., and J. Richard Zecher. "How the International Gold Standard Worked 1880-1913." In The Monetary Approach to the Balance of Payments, edited by Jacob A. Frankel and Harry G. Johnson. Toronto: University of Toronto Press, 1976. Meiselman, David, ed. Varieties of Monetary Experience. Chicago: University of Chicago Press, 1970. Meltzer, Allen H. Introduction. Compendium: 488-491. "Stock and the Federal Reserve System." U.S. Congress. House. Subcommittee on Domestic Finance of the Committee on Banking and Currency. Compendium on Monetary Policy Guidelines and Federal Reserve Structure. 90th Cong., 2d sess. Washington, D.C.: U.S. Government Printing Office, December 1968.

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Mints, Lloyd W. Monetary Policy for a Competitive Society. New York: McGraw-Hill, 1950. . "Monetary Policy and Stabilization." American Economic Review, Papers and Proceedings 41 (May 1951): 188-193. Modigliani, Franco. "Some Empirical Tests of Monetary Management and of Rules versus Discretion." Journal of Political Economy 72 (June 1964): 211-245. Moggridge, Donald, ed. Collected Writings [Keynes]. Activities, 1940-1943: External War Finance [Keynes]. New York: Cambridge University Press, 1979. Morrell, S. O. "In Search of a New Monetary Order: An Open Discussion on Aspects of a Freely Competitive Monetary Arrangement." Institute Scholar 1, no. 1 (1980): 1-2. New Monetary Control Procedures. Federal Reserve Staff Study. Vols. 1 and 2. Washington, D.C.: Board of Governors of the Federal Reserve System, February 1982. Niles' Weekly Register 34: 154. Nordhaus, William. "Creeping Economic Constitutionalism." New York Times (December 27, 1981). North, D.C. The Economic Growth of the United States, 1790-1860. Englewood Cliffs, N.J.: Prentice-Hall, 1961. Nurkse, Ragnar. International Currency Experience. Geneva: League of Nations, 1944. Ohlin, Bertil. International and Interregional Trade. Cambridge, Mass.: Harvard University Press, 1935. Okun, Arthur M. The Political Economy of Prosperity. Washington, D.C: Brookings Institute, 1970. Pierce, James L. "The Myth of Congressional Supervision of Monetary Policy." Journal of Monetary Economics (April 1978). Reprinted in Thomas M. Havrilesky and John T. Boorman, eds. Current Issues in Monetary Theory and Policy. 2d ed. Arlington Heights, 111.: AHM Publishing Company, 1980. Pigou. Arthur C. Aspects of British Economic History, 1918-1925. New York: Macmillan, 1947. Roskill, Stephen. Hankey: Man of Secrets, 1919-1931. Vol. 2. Annapolis: U.S. Naval Institute Press, 1972. S.D. 16. 23d Cong., 1st sess. Samuelson, Paul A. "Reflections on Central Banking." National Banking Review I (September 1963): 15-28.

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Scheiber, Harry N. "The Pet Banks in Jacksonian Politics and Finance, 1833-1841." Journal of Economic History (June 1963): 196-214. Schlesinger, Arthur M., Jr. Age of Jackson. Boston: Little, Brown and Company, 1945. Schneider, Erich. "Automatism or Discretion in Monetary Policy." Banca Nationale del Lavoro Quarterly Review 23 (June 1970): 3-19. Schotta, Charles, Jr. "The Performance of Alternative Monetary Rules in Canada, 1927-1961." National Banking Review 1 (December 1963): 221-227. Schumpeter, Joseph. Capitalism, Socialism, and Democracy. New York: Harper, 1942. Schwartz, Anna J. "Short-Term Targets of Three Central Banks." In Targets and Indicators of Monetary Policy, edited by Karl Brummer. San Francisco: Chandler, 1969. . "A Review of Explanations of 1929-1933." In FSU Proceedings and Reports, edited by George Macesich. Vols. 12-13. Tallahassee: Florida State University, 1978-1979. . "Empirical Findings of the Study of Monetary Trends in the United States and United Kingdom." FSU Proceedings and Reports, edited by George Macesich. Vol. 15. Tallahassee: Florida State University/Center for Yugoslav-American Studies, Research, and Exchanges, 1981. . "The U.S. Gold Commission and the Resurgence of Interest in a Return to the Gold Standard." FSU Proceedings and Reports, edited by George Macesich. Vol. 17. Tallahassee: Florida State University/Center for Yugoslav-American Studies, Research, and Exchanges, 1983. Simmel, Georg. The Philosophy of Money. Translated by T. Bottomore and D. Frisby. Introduction by D. Frisby. London: Routledge & Kegan Paul, 1978. Simons, Henry C. "A Positive Program for Laissez-Faire: Some Proposals for a Liberal Economic Policy." Public Policy Pamphlet. No. 15, edited by H. D. Gideonse. Chicago: University of Chicago Press, 1934. . "Rules versus Authorities in Monetary Policy." Journal of Political Economy 44 (February 1936): 1-30. . "The Requisites of Free Competition." American Economic Review, Supplement 26 (March 1936): 69.

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. Economic Policy for a Free Society. Chicago: University of Chicago Press, 1948. Smith, Lawrence. "England's Return to the Gold Standard in 1925." Journal of Economic and Business History (February 1932): 228-258. Smith, W. B. Economic Aspects of the Second Bank of the United States. Cambridge, Mass.: Harvard University Press, 1953. Snyder, Carl. "The Problem of Monetary and Economic Stability." Quarterly Journal of Economics 49 (February 1935): 198. . Capitalism the Creator: The Economic Foundations of Modern Industrial Society. New York: Macmillan, 1940. Spencer, R. "Inflation, Unemployment, and Hayek." Federal Reserve Board of St. Louis Bulletin (May 1975): 10. Stein, Herbert. "Pre-Revolutionary Fiscal Policy: The Regime of Herbert Hoover." In The Fiscal Revolution in America. Chicago: University of Chicago Press, 1969. . "An Empirical Analysis of the Debate over Rules versus Discretion with Special Reference to the Monetary Management of the German Bundesbank from 1958 to 1970. Ph.D. diss., Florida State University, March 1973. Svennilson, Ingvar. Growth and Stagnation in the European Economy. Geneva: United Nations Economic Commission for Europe, 1954. Tanner, J. Ernest, and Vittorio Bonomo. "Gold, Capital Flows, and Long Swings in American Business Activity." Journal of Political Economy (January/February 1968): 44-52. Temin, Peter. The Jacksonian Economy. New York: Norton, 1969. Thornton, A. P. The Imperial Idea and Its Enemies: A Study in British Power. New York: Auden Books, 1968. Tobin, James. "The Monetary Interpretation of History." American Economic Review (June 1965): 464-485. Triffin, Robert. The Evaluation of the International Monetary System: Historical Reappraisal and Historical Perspectives. Princeton: Princeton University Press, 1965. Tucker, Donald P. "Bronfenbrenner on Monetary Rules: A Comment." Journal of Political Economy 71 (April 1963): 173-179. U.S. Congress. House. Committee on Banking and Currency. Compendium on Monetary Policy Guidelines and Federal Reserve Structure. Pursuant to H. R. 11. Subcommittee on Domestic Finance of

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Index Acheson, Dean, 72-73 Asian currencies, sharp decline in, 15 Atomic bomb, 68 Austrian School, 115-17 Bagehot, Walter, 45 Baghdad Pact, 73 Bailouts, 78-80 Balance of payments, 55-57 Balkan and Danubian countries, 43-44 Bank failure, 99 Banking, 100-103; free, 19-20 Bank notes: deposits and, 19; early, 16 Bank of England, 16 Barter, 17 Becker, G. S., 57 Biddle, Nicholas, 22-23 Bretton Woods Regime, 15-16,

47-54; end of, 61, 77, 105 Brokers, 85-86 Brunner, Karl, 6 Buchanan, James, 11 Budget deficits, 62 Bureaucracies, 8 Byrd, Robert E., 11 Canada, 41-43 Capital-asset pricing model, 85 Capital flows, 24, 27; emerging market economies and, 91-100 Central banks, 2; expanded activities of, 8; supporting a price, 85 Chaos theory, 86-87 Chase, S. P., 19 China, 74 Churchill, Winston, 70-71 Cold War, 54; and the dissolution

134 of the old world order, 67-75; "iron curtain" speech, 70; outbreak of, 48; worldwide communist conspiracy, 73 Committee of Twenty, 63-64 Constitution, and specie, 17 Convertibility, 31 Counterfeiting, 17-18 Counter Revolution in Monetary Theory (Friedman), 3-4 Credit, 4, 16 Crony capitalism, 87 Culbertson, John M., 3 Cunliffee Committee, 37 Currencies: debauched, 116-17; "hard," 25-26, 28; politically managed, 15; quantity in circulation, 32; single global, 105; and trust, 16; uniform, 18-19; "wellregulated," 26 Currency unions, 106 Debt forgiveness, 35 Deflation, 37 Democracies, and taxes, 45 Deposits: and bank notes, 19; insurance, 99; reserves against, 20 Domino theory, 74 Economic Consequences of the Peace (Keynes), 116 Eisenhower Doctrine, 74 Emerging market economies, and capital flows, 91-100 Employment, 50-51 Euro, 106 European currency units

Index (ECUs), 66 Exchange rates, 24, 97-98; fixed, 49, 58; flexible, 63, 81, 107-10; floating, 66; pegged, 15,109,111 Federal Reserve. 37; mistakes of, 39-41; raising of interest rates by, 53 Fiat money, 106; historical perspective on, 15-28; and the International Monetary Fund, 89; the interwar years, 31—45; political manipulation of, 105; postwar, 47-58 Fiduciary standard, 9 First Bank of the United States, 17, 20-21 Fisher, Irving, 1, 9 Fixed exchange rates, 49, 58 Flexible exchange rates, 63, 81, 107-10 Floating exchanges, 66 Fractal theory, 86-87 Frankel, Herbert, 115-16 Free banking, 19-20 Friedman, Milton, 1, 39, 41, 45, 57, 117; economic analysis of, 6; on exchange rates, 81-82, 109; on government intervention, 9; on inflation, 34; on money supply and price level, 3-4; and quantity theory, 5-6, 114-15 Fund managers, 85-86 Galbraith, John K., 4-5 General Theory (Keynes), 52, 55-56, 117-118 Germany: and the Balkan and

135

Index Danubian Countries, 44; hyperinflation in, 34; reparations payments, 33-36 Gold, 65; discovery of, 111; inflow of, 57; outflow of, 56; reparations payments in, 33-34; reserves of, 32-33, 39,54 Gold standard, 10, 105; "automatic," 36-37; and the IMF, 48; and the quantity of money, 50; return to, 110-12 "Gradualism," 53 Great Depression, 36, 44-45 Greenback notes, 19 Hammond, Bray, 22-23, 26 "Hard currency," 25-26, 28 Hayek, F. A., 10,49,51 Heraclitus, 9 Hong Kong, 81-82 Hyde Park Agreement, 43 Hyperinflation, 34 Ideology, 2, 7 Income, and monetary growth, 3 Income Expenditure Theory, 54-57 Inflation, 5; and budget deficits, 53; and default, 99; domestic, 55; and employment, 51-52; hyperinflation, 34; mid1960s, 52; world, 58; during World War I, 32 Interest rates, 96 International Monetary Fund (IMF), 67, 77-87; bailout efforts of, 78; and the Bretton Woods regime, 65;

charter of, 84-87; Committee of Twenty, 63-64; and fiat money regimes, 89; and the gold standard, 48, 67; as lender of last resort, 77 "International money," 62-63 International trade, 55-57 Interventionism, 6 Iran, 71 Jackson, Andrew, 21-22, 25-26, 90, 113 Johnson, Harry, 5-6 Johnson, Lyndon B., 53, 74 Kemp, Jack, 12,80 Kennedy, Edward, 11 Kennedy, John F., 52 Keynesian approach, 2, 4-6, 53-57 Keynes, John Maynard, 4, 49, 83, 115-18; and the Bretton Woods Conference, 48; on employment, 50-52; on exchange rates, 109; on investment decisions, 38; and public works, 37-38 Knapp, Georg Friedrich, 115 Krugman, Paul, 83 Laidler, David, 116 Law, John,16 Lender of last resort, 77 Lend-lease assistance, 62 Lincoln, Abraham, 19 Locke, John, 112-14 Lott, Trent, 12 Marshall Plan, 62 McCarthy, Joseph, 72

136 McCulloch v. Maryland, 21 Meiselman, David, 57 "Mississippi Bubble," 16 Monetarism, and inflation, 5 Monetary affairs, and political controversy, 1-12 Monetary collapse, 38-45 A Monetary History of the United States (Friedman and Schwartz), 39 Monetary Reform (Keynes), 116-17 Monetary supremacy, 27-28 Monetary theory, 2-7, 9-11, 54-58 Money: public uncertainty over, 20; quantity theory of, 2-7, 9-11,54-58, 112-14; role of, 112-18 Money supply: political manipulation of, 34; and price level, 3-4 Moral hazard, 91 Mutual funds, 101-2 National Bank System, 18 New Economic Policy (NEP), 53,61 Nixon, Richard M., 53, 61, 63 Noise traders, 85 Nonlinear statistical theory, 87 NSC-68, 72-73 OPEC countries, 64, 67 Paper money, 16-17; convertibility of, 31; counterfeiting of, 17-18 Pegging, 15, 109, 111 Petrodollars, 67

Index Philosophy of Money (Simmel), 118 Political controversy, 1-12 Potsdam Conference, 68 Present at the Creation (Acheson), 72 Private bankers, 17-18 Private sector, as shock absorber, 6 Public works, 37 Quantity Theory (Monetarist), 2-7,9-11,54-58,112-15 Reform, 7, 92; and interest rates, 96; and the monetary regime, 9-12; post-Bretton Woods, 61-75; problems of, 93 Reparations, 33-36 Reserves, against deposits, 20 Risk management, 85 Roosevelt, Franklin Delano, 68 Russia, 79 Schwartz, Anna J., 6, 39, 41, 45; on government intervention, 9 Second Bank of the United States, 20-28, 89-91 Simmel, Georg, 115-16, 118 South Korea, 79 Soviet Union, 68-71; SinoSoviet conflict, 74; and world domination, 73 Special Drawing Rights (SDRs), 64,66 Specie, 9-10, 17; suspension of, 20 Specie standard, and exchange rates, 24

Index Stabilization policies, 6 Stalin, 69-71 State banks, control over, 23 Stiglitz, Joseph, 82 Suffolk Bank of Boston, 20-21 Tariffs, 35, 39 Taxes: and democracies, 45; reform, 92; surcharge, 53 Thailand, 79 Theory: chaos, 86-87; fractal, 86-87; nonlinear statistical, 87; quantity, 2-7, 9-11, 54-58, 112-15 Traders, 84-87 Triffin, R., 54 Truman, Harry S, 68, 70-71 Unemployment, 116 Unions, 51 United States: gold stock of, 32-33; and repayment of loans, 35; role of, 47-54 Van Buren, Martin, 21-22 Venezuela, 79-80 Versailles Peace Conference, 34,43 Vietnam, 74 Wage and price guidelines, 52-53 Wages, 50-51 War debts, 35-36 "Well regulated" currency, 26 White, Harry Dexter, 83 Williams, J. H., 49 World Bank, 82-83 World Economic Conference, 41-42

137 World inflation, 58 Yalta Conference, 68 Yeager, Leland, 10 Yugoslavia, 43-45, 68

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About the Author GEORGE MACESICH is Professor of Economics at Florida State University. He is the author of several books, including The United States in the Changing Global Economy: Policy Implications and Issues (Praeger, 1997) and World Economy at the Crossroads (Praeger, 1997).