English Monetary Theories and Debates in the Age of Classical Economics

3.4.1. TheRestrictionAct

Finally we would like to recall some English monetary debates, which we find particularly enlightening, in that they anticipate various contemporary discussions between monetarists and Keynesians, for instance, that on the efficacy and utility of discretionary monetary policies, that on the endogeneity of the money supply and that on the causes of inflation.

In 1797, facing the consequences of a serious financial crisis, the British government passed a Restriction Act that suspended the convertibility of sterling and gave life to a monetary system which was in open conflict with the orthodox monetary doctrines. Immediately there was a sort of revolt on the part of the most important laissez-faire economists, and a theoretical controversy started which showed no signs of exhaustion until 1821, when convertibility was re-established. After this the heated discussions recommenced, but took a new direction.

The climax of the controversy occurred around 1810, the year in which the Report of the Select Committee on the High Price of Gold Bullion was presented to Parliament. The famous ‘Bullion Committee’ had been formed in February 1810 to investigate the reasons for the depreciation of sterling that had occurred in the first ten years of the century. And, both in the formulation of the problem and in the political solutions suggested, it revealed a clear stance in favour of one of the contending parties—the bullionist—which was the position assumed by most orthodox economic observers of the period. The two most important exponents of the bullionist approach were Henry Thornton and David Ricardo. The former, undoubtedly the most acute monetary theorist of the period, we will discuss in section 3.4.3. Here we will discuss Ricardo’s ideas.

The existence of a persistent gold premium, i.e. a positive difference between the market price and the mint price of gold, was the crux of the problem.

At the basis of these beliefs, however, there was no accurate analysis of the specific economic factors underlying the observed monetary and foreign exchange phenomena: economic growth, foreign trade trends, crises, the war, etc. Instead, there was a rigid and abstract application of the theory of the price-specie-flow mechanism formulated by Hume in the eighteenth century. The exchange rate between two convertible currencies cannot diverge from the ratio between the gold parities except within strict limits. If the exchange rate of sterling with respect to the dollar fell, it would be in the interest of English importers and speculators to convert sterling into gold and send the ingots to America. This would arrest the depreciation of sterling. At the same time it would reduce the amount of sterling in circulation and decrease internal prices. Such a mechanism, however, could not work if sterling were inconvertible. In this case, in fact, it would be impossible to reduce the amount of sterling in circulation by means of its conversion into gold.

The bullionists analysed the relationship existing between an excess of issues and a high gold price in a similar way. If the currency was convertible, a difference between the market price and the mint price of gold would not be possible because, as soon as such a divergence arose, the merchants would find it profitable to go to the mint to change sterling into ingots and sell the gold on the market. In this way any excess in the amount of money in cir­culation would be automatically eliminated owing to its conversion into gold.

The bullionists considered the Restriction Act as illicit government interference into the affairs of the private sector. In fact, the Bank of England was a private institution, even if it had been given some legal monopolistic privileges. It should have been managed according to the principles of sound administration of a private firm. The convertibility of the banknotes which it issued would, in any case, oblige it to behave correctly. With the Restriction Act the government had changed the rules of the game in its own favour and loosened the administrative rigour of the bank, thus causing a great deal of damage to the private citizens. In fact, inconvertibility permitted the financing of an excess of State spending and generated sharp increases in aggregate demand in monetary terms thus triggering inflation.

The ‘Bullion Committee’, which, as already mentioned, was dominated by the bullionists, presented a report that was clearly in favour of the return to convertibility. However, ten years had to pass before the government decided to listen to its advice. The fact is that, in practice, things progressed in a rather different way from that envisaged by orthodox theory; and this is one of the most illuminating examples, in the history of economic thought, of how the political sensibility and the experience of merchants, bankers, and politicians can sometimes outweigh the doctrinal rigidity of theoretical economists.

From 1793 to 1815 England was involved in a series of wars with France which required the mobilization of all its political, military, and economic resources. Continual and heavy financing of the allies, besides maintaining the army, led to periodic draining of gold from the vaults of the Bank of England. Furthermore, the difficulties of the war and the Continental blockade made the export channels increasingly arduous and the supply of raw materials and wage goods more costly. Add to that an exceptional series of bad harvests, and it is easy to understand the real roots of the monetary problems debated by the economists.

In fact, it was the detailed attention to the real problems that characterized the theoretical approach of the anti-bullionists, from William Pitt (the younger), Chancellor of the Exchequer at the time of the Restriction Act, to Charles Bosanquet, Robert Torrens, and Robert Malthus. They maintained that the undervaluation of the exchange rate was due to excep­tional exogenous factors, such as financing of the allies, overseas military expenditure, the fall in exports, the increase in the value of imported com­modities, and the bad harvests. The maintenance of convertibility would probably permit the rebalancing of the balance of trade, but would produce more damaging effects than the illness it was supposed to cure; while the limit on the expansion of the money supply would force the government to limit the public debt, thus giving deflationary impulses to the economy. Moreover, further impulses of the same type would arise from difficulties with the balance of payments. In fact, the rebalancing of foreign accounts would require a reduction in the money supply and a decrease in incomes and internal prices. This would lead to drastic reductions in production and employment; phenomena which, in effect, often occurred in that period in the form of financial and productive crises. Could Great Britain, in the political conditions in which it found itself, allow itself the luxury of deflation?

In regard to the problem of inflation, the anti-bullionists adopted a clearly anti-monetarist viewpoint. The causal link in the equation of exchange, they argued, goes from prices to the money supply and not vice versa. The inflationary impulses come from the real economy, from bad harvests and imports, while the money supply adjusts passively to demand. They even maintained that it was impossible for the Bank of England, and the pro­vincial issuing banks, to issue more bank notes than were necessary to sus­tain the needs of commerce, provided they were restricted to discounting only ‘real bills’.

3.4.2. The Bank Charter Act

Immediately after the end of the Napoleonic era the English economy entered into a long phase of stagnation, which was characterized by a suc­cession of brief periods of expansion, culminating in ephemeral explosions of speculative euphoria, and long periods of crisis, with sharp decreases in employment, production, and prices.

There were two causes at the root of the first of these crises: the reduction of public spending connected to the end of the war and, perhaps more important, the monetary changes caused by the decision to return to con­vertibility. There had been a drastic cut in Bank of England issues during 1817-19, when preparations were being made for the return to gold; but the cuts were even more drastic in 1819-21, when the parliamentary decision was put into practice. Ricardo’s critics immediately attributed the respons­ibility of the crisis to his monetary theory; and Ricardo had difficulty in defending himself. He argued that the blame should be attributed to the drastic and rapid way in which the Bank had undertaken the return to convertibility, forgetting that he himself, in the preceding years, had stated in Parliament that the restoration of the Gold Standard would have to be extremely rapid. In any case, the 1825 crisis and, with the passing of time, all the other crises that followed served to convince a growing number of eco­nomists of one fact: that the simple maintenance of convertibility was not sufficient to maintain monetary stability.

The debate on this problem, which began immediately after the 1825 crisis and went on until the end of the 1840s, involved two schools of thought: the currency school, which linked itself to the bullionist tradition, and the banking school, which basically continued the anti-bullionist tradition, even though it accepted some of the arguments of the old bullionist views. The main exponents of the former were Thomas Joplin, Samuel Jones Lloyd (Lord Overstone), and Robert Torrens, who had passed over to the enemy after fighting in the ranks of the anti-bullionists in the second decade of the century. The main members of the banking school were Thomas Tooke, John Fullarton James William Gilbart, and, with a certain ambiguity, John Stuart Mill.

The currency school established the principle of ‘metallic fluctuation’, according to which the amount of money in circulation should oscillate as if it were entirely made up of gold. In other words, the quantity of banknotes would have to vary in the same measure as the gold reserves. It was argued that this rule could be infringed if the Bank of England reserved the right to adopt discretionary monetary policies.

Many economists of this school, headed by Overstone, had adopted a theory of the business cycle in which monetary permissiveness played an essential role. In expansion phases, they maintained, the Bank of England quickly adjusted the supply to the demand of money, so fuelling inflation, speculation, and euphoria. Then, when the crisis and panic arrived, the Bank, in order to protect its own reserves, was forced to take drastic measures, thus deepening the crisis.

The currency-school theorists proposed two fundamental measures to overcome these difficulties. The first, in part inspired by a proposal put forward by Ricardo in Plan for the Establishment of a National Bank, consisted of the division of the Bank of England into two departments: a banking department, with the credit function, and an issue department, with the sole task of issuing banknotes. In this way, it was thought, the oscillations in gold reserves could not be influenced by credit policies. This would have ensured perfect ‘metallic fluctuation’. The second measure imposed to the Bank to cover banknotes issues with bills only for a fixed amount. For the rest, issues had to be covered with gold reserves. In this way the reserve ratio would have changed automatically and anti-cyclically, increasing during years of prosperity, when the reserves increased, and decreasing when they decreased in the phases of crisis.

The 1844 Bank Charter Act (also known as the ‘Peel Act’, after the name of the Chancellor of the Exchequer who proclaimed it), fully adopting the currency-school view, divided the Bank of England into two departments, and established that the cover in bills of the liabilities of the issue department had to be £14 million.

Let us now consider the theories of the banking school. The exponents of this school accepted some of the currency school’s arguments, for example, the dogma of the superiority of the Gold Standard to an inconvertible paper money regime. However, they disagreed on nearly every other question of any theoretical importance, especially in regard to the definition of money, which they formulated in much less restrictive and more modern terms than their opponents, including in the stock of money, besides currency, deposits and bills of exchange. The banking school maintained that both the amounts of deposits and bills change with transactions; that the money supply is endogenous, and that the Bank of England is incapable of controlling it efficiently. Not only this, but they argued that even the circulation of banknotes is outside the control of the Bank. They supported this view by using the old ‘real-bills’ doctrine, now renamed the ‘doctrine of reflux’.

At this time the banking school had two new weapons with which to defend its own arguments: convertibility had been re-established and, from 1833, the 5 per cent limit for the discount rate had been abolished. Thus, at least in principle, an excess in the demand for credit for speculative purposes could be hindered by an increase in the discount rate. On the other hand, if an excess of issues had to be measured by the gold premium, as Ricardo and his followers had argued, then no excess of issues could exist in a convert­ibility regime. In fact, as soon as the paper money showed signs of being undervalued with respect to gold, it would have flowed back to the Bank to be converted. This would have arrested its depreciation and eliminated the excess of liquidity.

The theorists of the banking school were certainly right in maintaining that the overall money supply was very elastic and out of the control of the Bank. In fact, this was the main reason why the monetary strait-jacket constituted by the Bank Charter Act did not manage to obstruct to any significant degree the movements of the English economy. The adjustments of the money supply to the needs of capital accumulation occurred by variations in deposits and credit, despite the strictness of the rules the department of issues had to follow. Besides, there was always the possibility of suspending the Act in periods of serious crisis, as actually happened in 1847, 1857, and partially in 1866.

Finally, we should point out that, over time, the facts increasingly dem­onstrated the prevalently ideological nature of the Gold Standard doctrine, at least if it is understood as a theory of an automatic and neutral equilib­rating mechanism of foreign trade. During the 70 years after the passing of the Bank Act, the English economy was able to expand without great problems of external equilibrium, despite a permanent trade deficit; so that there were very few difficulties in the defence of the gold reserves of the Bank of England. But the external equilibrium was maintained thanks to the adoption of a shrewd policy in regard to the discount rate, a policy that was neither automatic nor neutral, and that tended to compel the less developed countries, and especially the producers of raw materials, to pay for the adjustments when necessary.

The economists of the banking school, well aware of the industrial and financial power of the English economy, argued that the serious problems for the gold reserves originated above all from exogenous and temporary commercial difficulties. These causes of the gold drain were considered ‘terminable’, that is, capable of stopping by themselves. All that was asked from the Bank of England, therefore, was to maintain a large gold reserve, around £15-18 million, so as to tackle the causes of tem­porary drains.

An important achievement of this debate concerns the understanding of the credit multiplier. It had become clear that the credit system based on the principle of fractional reserves generated significant multiplication effects of the central monetary impulses. Torrens, in particular, outlined the mech­anism of credit multiplication quite precisely. He maintained in any case, as did a few other members of the currency school, that the mechanism only created phenomena of amplification of the monetary impulses, but did not hinder the ability of the Bank to control the overall expansion of liquidity. Most of the members of the currency school did not follow Torrens on this point; but the main reason for the inability of the Bank of England to control the overall money supply, namely, the variability of the bank reserve ratios, was not yet well understood.

3.4.3. Henry Thornton

The economists mentioned in the preceding two sections are only a few out of the dozens and dozens who in Great Britain were concerned with mon­etary problems in this period. Moreover, the limitations we imposed on ourselves have prevented us from doing justice to the peculiarities of the individual contributions of the few we have mentioned. However, we must say something more precise about Henry Thornton, if for no other reason than that his theories created the roots of that great English monetary-theory tradition which, passing through Marshall and his school, was to culminate in the Keynesian revolution.

Thornton was not an academic but a successful banker, who studied monetary theory for its direct implications for practical policy. He was also an influential Member of Parliament, as well as a fervent evangelist; and made an important contribution, along with Horner and Huskisson, to the drafting of the 1810 Bullion Report. Immediately after the 1797 Restriction Act he wrote a book which was full of profound insights and important theoretical innovations; a book that has been judged the greatest work on monetary theory of the nineteenth century: An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802).

Initially, Thornton was not against the Restriction Act, which he justified by the necessity of facing the problem of the drain of gold caused by panic and the war. He believed, however, that it should be an exceptional and temporary measure: the normal monetary system should be the Gold Standard. He was also one of the most rigorous theorists of the functioning of this system. He adopted Hume’s arguments on the price-specie-flow mechanism and on that basis developed the theory of the relationship existing between the depreciation of the exchange rate, the gold premium, and the excess of issues in a fiat money regime, a theory that was later to be upheld by Ricardo and his followers. We have discussed this in the previous section, and will not return to it here. We will just mention a development that Thornton brought to Hume’s theory: the argument that the internal deflation capable of correcting a balance-of-payments deficit would have operated, not only on price levels, but also on the level of income and, thus, directly on the level of demand for imports of consumer goods.

Thornton was not a committed deflationist like Ricardo. He believed, with the anti-bullionists, that a depreciation of the exchange rate and the emer­gence of a gold premium were not always caused by an excess of issues. In special cases they could originate from exogenous and temporary factors, such as a bad harvest, an explosion of panic, or a large transfer of gold to the allies. In these cases, he argued, a contraction in the issues could aggravate the problems rather than solve them. Particularly important are his ideas on the causes of internal drain, ideas in which some elements of the liquidity preference theory are foreshadowed. Individuals hold money, not only as a means of exchange, but also as a reserve of value, so that the quantity desired depends on the state of confidence.

A high state of confidence contributes to make men provide less amply against contingencies. At such a time, they trust, that if the demand upon them for a pay­ment, which is now doubtful and contingent, should actually be made, they shall be able to provide for it at the moment... When, on the contrary, a season of distrust arises prudence suggests that the loss of interest arising from a detention of notes for a few additional days should not be regarded. It is well known that guineas are hoarded in times of alarm, on this principle... In difficult times, however, the disposition to hoard, or rather to be largely provided with Bank of England notes, will, perhaps, prevail in no inconsiderable degree. (p. 46)

This phenomenon explains the variations in the velocity of circulation of the different monetary means. Thornton used a wide definition of money, including in it various means of exchange with different velocities of cir­culation, and also bills of exchange. He maintained that, in periods of crisis, not only the gold reserves of the Bank shrink but also the overall quantity of money and its velocity of circulation diminish. Therefore, the decision to reduce bank issues in order to check the drain would be a serious political error. It is important to note the remarkable implications of this argument for monetary policy. The liquidity preference theory, together with an understanding of the cyclical character of economic movements, led Thornton to attribute to the Bank of England, considered as an institution entrusted with public goals, a basic function as a lender of last resort.

Thornton was a bullionist above all in regard to the long-run effects of the movements of the monetary variables, and was inclined to believe—as we would say today—in the inefficacy of monetary policy in the long run. However, he did notice the possible real short-run effects of the Bank’s decisions. He argued that a credit expansion, by raising prices and profits, given the stickiness of wages, could stimulate production and increase the level of employment. He also argued that the decreases in real wages caused by inflation generate forced saving (‘defalcation of revenue’) and induce changes in the productive structure in favour of the accumulation of stocks of goods and means of production. Thornton thought that the Bank of England should follow a discretionary monetary policy, with the double aim of dampening the cyclical nature of economic growth, by intervening above all in periods of crisis, and of ensuring the stability of the exchange rate. The main intervention instrument should be the interest rate.

Thornton made an important theoretical contribution in regard to the theory of interest. He observed that the usury laws forced the Bank of England to expand credit without limit when the rate of profit was above the legal 5 per cent discount rate. Anticipating Wicksell in this, he brought to light the cumulative character of the inflationary effects of this process. He also pointed out the consequences of inflation on the reduction of the real value of the rate of interest. For example, he argued that, with a monetary interest rate fixed at 5 per cent, a 3 per cent inflation would reduce the real interest rate to 2 per cent. In countries where there were no usury laws, however, this phenomenon would have led to an increase in the nominal rate. The political implications of this reasoning are simple: only in the absence of usury laws could the Bank of England have an effective monetary-policy instrument in the interest rate.