Review of Keynesian Economics

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Review of Keynesian Economics

Volume 1 No. 3 2013

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Review of Keynesian Economics Volume 1, No. 3, Autumn 2013 The Evolution of Monetary and Financial Markets and Economic Development

Contents Articles Introduction: the role of central banks in economic development with an emphasis on the recent Argentinean experience Mercedes Marcó del Pont

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Developmental central banking: winning the future by updating a page from the past Gerald Epstein

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The nation-building purposes of early US central banks Jane Knodell

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A shackled revolution? The Bubble Act and financial regulation in eighteenth-century England William E. McColloch

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Economic crises and the development of the industrial state: the industrial intervention of the Bank of Italy and the Bank of England, 1918–1939 Valerio Cerretano

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Endogenous money and public foreign debt during the Argentinean Convertibility Juan Matías De Lucchi

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Is inflation targeting operative in an open economy setting? Esteban Pérez Caldentey and Matías Vernengo

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Book Reviews John King, The Microfoundations Delusion: Metaphor and Dogma in the History of Macroeconomics (Edward Elgar, Cheltenham, UK and Northampton, MA, USA 2012) 304 pp. Reviewed by Philip Pilkington Robert Skidelsky, Keynes: The Return of the Master (Public Affairs, New York, USA 2009, reprinted in 2010) 228 pp. Reviewed by Slim Thabet Claudio Sardoni, Unemployment, Recession and Effective Demand: The Contributions of Marx, Keynes and Kalecki (Edward Elgar, Cheltenham, UK and Northampton, MA, USA 2011) 192 pp. Reviewed by James Andrew Felkerson Robert M. Solow and Jean-Philippe Touffut (eds), What’s Right with Macroeconomics? (Edward Elgar, Cheltenham, UK and Northampton, MA, USA 2012) 240 pp. Reviewed by John King

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Introduction: the role of central banks in economic development with an emphasis on the recent Argentinean experience Mercedes Marcó del Pont President, Banco Central de la República Argentina (BCRA), Argentina

Almost all of the papers presented in this special issue were part of the annual conferences of the Banco Central de la República Argentina (BCRA) during the last couple of years, or are variations on the topics on which the authors presented during the Bank’s Annual Conference. They share a common theme, one that is relevant for the recent Argentinean experience, but that is also important for many developing countries, since it puts into question the role of central banks in the process of development. The papers suggest that central banks historically were not limited to fighting inflation and have, under certain circumstances, been relevant in promoting a broad process of development with price stability.1 Throughout the history of central banking both in advanced and developing countries, financing governments, managing exchange rates, and supporting the productive sectors by using direct methods of intervention have been among the most important tasks of central banking and, indeed, in many cases, were among the reasons for their existence. The conventional independent central bank concerned only with inflation is, in a sense, radically out of step with the history and practice of central banking throughout most of its history. The recent Argentinean experience, in fact, reflects this notion that central banks can be instruments of development. It is important to remember that during the Convertibility period (1991–2002) the BCRA was significantly limited in its ability to act as a lender of last resort, and that a process of liberalization, deregulation and privatization, together with the fixed exchange rate, resulted in unsustainable current account deficits and increasing external indebtedness which led to the default. After the crisis, and particularly after 2003, the economy grew at the highest rates in its recorded history, to a great extent as a result of the expansion of domestic demand. Even though the external conditions were favorable, it is important to note that other countries in South America had a more favorable shock to their terms of trade and still grew considerably less than Argentina. Further, the expansion of demand, and the reduction of unemployment rate from more than 22 percent to around 7 percent, went hand in hand with the maintenance of primary fiscal surpluses,2 and higher real wages that permitted a considerable improvement in income distribution. 1. On the historical evolution of central banks and a discussion of their different roles over time, see Epstein (2006) and Goodhart (2010). 2. Financial deficits were only recorded after the Global Financial Crisis (GFC) and the collapse of international trade impacted the Argentine economy. Note that these deficits were caused by the use of counter-cyclical policies, which have been recommended by several economists, contrasting with the austerity policies followed in other regions. Ocampo (2011), for example, has praised the Latin American countries for having broken new ground with their performance during the GFC with their counter-cyclical policies. © 2013 The Author

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Higher growth, current account surpluses, and the accumulation of foreign exchange rate reserves, together with a tough renegotiation of the foreign debt, resulting in its reduction, in an improvement in the country’s external sustainability. The Central Bank played an important role in promoting the re-monetization of the economy in the aftermath of the crisis, providing liquidity for a banking sector that expanded the credit to the private sector. Further, the Central Bank provided support to the Treasury, by extending advances on fiscal revenue, and providing part of its foreign exchange reserves to pay the external commitments of the Treasury, holding bonds in exchange. Note that the advances to the government did not imply current account deficits, and were instrumental in allowing the economy to make a relatively large recovery from the 2009 effects of the GFC.3 It is important to emphasize that while external conditions were favorable, with the price of commodities increasing significantly, that does not mean that the economy grew as a result of good luck. In fact, inflows associated with the commodity boom put pressure on the real exchange rate and created difficulties for the process of re-industrialization, which are typical of the problems caused by the so-called Dutch Disease. Many of the positive developments in the last decade were possible because the BCRA recovered the ability to pursue an autonomous monetary policy. The process culminated with the change of the Organic Law that regulates the actions of the BCRA, moving away from a single mandate to preserve the value of money, to the pursuit of multiple mandates associated with financial stability, employment creation, and economic development with social equity. Among the concrete measures that came from the new policy stance of the BCRA is the extension of lines of credit to productive activity, requiring that banks lend at least 5 percent of their deposits on long-term investment projects at a fixed interest rate. In other words, the BCRA has been an integral part of an economic development strategy that prioritizes the creation of domestic jobs and the expansion of domestic markets associated with the structural transformation of the economy, while at the same time improving income distribution. This strategy has avoided the conventional wisdom obsession with inflation as the single goal of economic policy, and has steered clear of the austerity policies that have led to a slow recovery from the Global Financial Crisis in advanced economies. In that sense, the Argentinean success since the 2001–2002 crisis underscores the relevance of dismissing the orthodox canons on how to deal with the GFC. In particular it is important, given the recent crisis in advanced economies, which owes a great deal to the worsening income distribution of the last 3 decades that led to excessive private borrowing and a financial collapse, that policies that promote inclusive strategies of development would also promote financial stability.4 An important lesson that Argentina also highlights is the importance of better income distribution to push a healthy recovery. The rest of the introduction briefly describes the contributions to this special issue of the Review of Keynesian Economics (ROKE).

3. It is important to note that now even the International Monetary Fund suggests that fiscal austerity in the face of a recession is a mistake. See, for example, Blanchard and Leigh (2013), who find that stronger planned fiscal adjustment in advanced economies has been associated with lower output growth. 4. On the relation between financial instability and income inequality, see Galbraith (2012). © 2013 The Author

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THE CONTRIBUTIONS IN THIS ISSUE Gerald Epstein argues in his contribution that orthodoxy in central banking – that is, the idea that the most important priority goal for central banks would be to keep inflation in the low single digits – is, in general, neither optimal nor desirable. According to him, this orthodoxy is based on several false premises: namely, that moderate rates of inflation have high costs, that in this low-inflation environment economies naturally perform best, and, last but not least, that there are no viable alternatives to this inflationfocused monetary policy. He suggests that central banks can pursue several other goals, besides low and stable inflation rates, as the targets of their policies, including employment, real GDP growth, the rate of investment, and a stable and competitive exchange rate, since the latter might be related to employment creation and economic growth. Arguably, in some respects, by pursuing alternative goals central banks might actually make the task of maintaining stable prices easier, since in many cases inflationary pressures arise as the result of supply side constraints associated with the inelasticity of foodstuff or energy-related commodities, and by promoting the development of productive forces in those sectors the central bank might lift the constraints. Further, Epstein argues that this is exactly what central banks have done, to a great extent, throughout history. The three subsequent papers by Jane Knodell, William E. McColloch and Valerio Cerretano show particular historical circumstances in which unorthodox policies were essential for promoting economic development in a few developed economies, namely in the United States (US), the United Kingdom (UK), and Italy. Knodell argues that early US central banks, the First and Second Banks of the United States, were created to provide public finance support to the Treasury, not to deal with banking instability problems. As she argues, their functions as fiscal agents for the US government were front and center in their charters, which were mute as to these banks’ monetary stabilization purposes. Yet, as she demonstrates, the public finance and fiscal functions of the First and Second Banks inevitably positioned these institutions to play a regulatory role vis-à-vis the state-chartered banks and to take actions to protect and preserve the nation’s stock of specie, which represented both outside money for the domestic banking system and the means for maintaining the US government’s position as an international borrower.5 Her paper highlights the importance of central banks as fiscal agents of the government and how, historically, inflation was not the main preoccupation of central banking. McColloch contends that the adverse impact of financial regulation and state borrowing in eighteenth-century Britain, as defended by Temin and Voth (2013), has been greatly overstated. His paper briefly outlines the historical context in which the Bubble Act emerged after the infamous South Sea Bubble, before turning to analyse the existing diversity of perspectives on the Act’s lasting impact. McColloch argues that there is little evidence to support the view that the Bubble Act significantly restricted firms’ access to capital, and suggests accordingly that the crowding-out argument, theoretical 5. Note that Knodell (2004) has shown that countries without central banks in the nineteenth century actually grew faster than those with established monetary authorities. In addition, according to her, the US might have had the best of both worlds, with stability provided by the Bank of England, as part of the Gold Standard global monetary system, and a certain flexibility associated with Andrew Jackson’s veto of the federal rechartering of the Second Bank in July 1832. © 2013 The Author

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shortcomings aside, is largely inapplicable to eighteenth-century British economic development. Finally, McColloch argues emphatically that the savings-constrained vision of British capital markets significantly downplays the extent to which the Bank of England, founded as an institution to manage the public debt in the same vein as Knodell suggests for the US Banks, provided the entire financial system with liquidity in the eighteenth century. It is important to note the relevance of the topic for more recent discussions about the role of financial markets in the process of development. The paper suggests that financial regulation to control speculation is perfectly compatible with a significant expansion of liquidity and higher growth associated with the structural transformation of the economy. In the case under discussion, the structural transformation would be the Industrial Revolution in Britain. But the argument is essentially true of the financial regulations imposed in the US after the Great Depression, in particular the famous Glass–Steagall Act, and the widespread use of capital controls after World War II. In the last decade the discussion on capital controls, which have been adopted in Argentina as a macro-prudential tool, which together with foreign reserve accumulation provides a buffer against financial crises without necessarily becoming a restriction to economic growth or financial development, has again become relevant. The paper by Cerretano follows the historical approach of the previous ones, arguing that central banks in developed countries became involved with industry in the past, particularly during the inter-war period. Cerretano describes the cases of Italy and Britain where central banks provided long-term finance to ailing firms and banks, becoming important industrial players in their countries. His article explores the episode in a comparative setting, and concludes that intervention did not stem from a grand design of policy or from anti-market ideologies, but rather was piecemeal and a consequence of financial austerity. He also argues that intervention was the outcome of the over-expansion of the heavy industries more than the consequence of the weakness of financial systems. Likewise, Cerretano indicates that the Italian and British experiences also seem to point out that the direct management of ailing firms and banks proved more efficient and acceptable for central banks than the continuous provision of funds to economic groups whose managers were strangers to the central banks’ bureaucracy. The last two papers, by Juan Matías De Lucchi and by Esteban Pérez Caldentey and Matías Vernengo, move away from the more purely historical analysis of central banking and discuss the limitations of orthodox policies, in particular the currency board option adopted by Argentina in 1991, under the guise of the so-called Convertibility Plan, and the inflation-targeting approach adopted by several economies around the globe. In this sense, they complement the previous contributions by showing that current orthodox practices not only depart from the practical historical record on central banking, but also have dangerous consequences for the process of economic development. De Lucchi shows that the explanation of the endogeneity of money during the Argentinean currency board is compatible with the heterodox endogenous money approach. The Argentinean Convertibility was interpreted in the conventional view as a pure case of the Mundell–Fleming model with fixed exchange rate (MFFER). This approach points out that domestic money supply becomes endogenous because the Central Bank loses the ability to control the monetary aggregates. In the MFFER, money endogeneity is supplyled, and results from a balance of payment effect, in other words, from the rule that says that for every dollar inflow there will be a domestic issuance, and that monetary destruction will follow outflows. The heterodox approach, on the other hand, is demand-led, resulting

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from a bank credit effect. The central bank had some flexibility in the creation of reserves, according to private banks’ credit demands, but it still had a dollar shortage problem, which in the absence of current account surpluses could only be compensated by borrowing in international markets. In other words, De Lucchi correctly suggests that, given the structural external constraint, the BCRA operated as a lender of last resort to an unsustainable expansion of public foreign indebtedness. It is important to note that it is this unsustainable pattern of behavior that the new Organic Law has superseded, emphasizing the importance of credit creation in domestic currency. Finally, Pérez Caldentey and Vernengo argue that the justification for inflation targeting rests on three core propositions, none of which can be sustained after close scrutiny. The first proposition is called ‘lean against the wind’, which refers to the fact that the monetary authority contracts (expands) aggregate demand below capacity when the actual rate of inflation is above (below) target. The second one is ‘the divine coincidence’, which means that stabilizing the rate of inflation around its target is tantamount to stabilizing output around its full employment level. The third proposition is that of stability. This means that the inflation target is part of an equilibrium configuration which generates convergence following any small disturbance to its initial conditions. These propositions are derived from a closed economy setting which is not representative of the countries that actually have adopted inflation targeting frameworks, and the authors suggest that even if one uses the conventional logic, an open environment setting shatters the validity of the three propositions mentioned above. Currently there are 27 countries, 9 of which are classified as industrialized and 18 as developing, that have explicitly implemented a fully-fledged inflation-targeting regime. These countries are open economies and are concerned with the evolution of the external sector and the exchange rate as proven by their interventions in the foreign exchange markets. The trade-offs faced by central banks in open economies are significantly more complex than those suggested by the inflation-targeting model, and reliance on this regime should be taken with extreme caution, given the unreliability of its empirical results. It is often the case that orthodoxy in matters of policy becomes controversial in periods of crises. The Great Depression was one such situation, and the current Global Financial Crisis seems to fit the bill too. The experiences discussed in the papers gathered here shows that unorthodox solutions have from time to time allowed the world economy to avoid the suffering that comes with monetary policies that are only concerned with inflation and fiscal rectitude. As Keynes famously argued, worldly wisdom suggests that ‘it is better for reputation to fail conventionally than to succeed unconventionally,’ but there is more than reputation to central banking.

REFERENCES Blanchard, O. and D. Leigh (2013), ‘Growth Forecast Errors and Fiscal Multipliers,’ IMF Working Paper No 13/1. Epstein, G. (2006), ‘Central Banks as Agents of Economic Development,’ UNU-WIDER, Research Paper No 2006/54. Galbraith, J.K. (2012), Inequality and Instability: A Study of the World Economy Just Before the Great Crisis, New York: OUP. Goodhart, C. (2010), ‘The Changing Role of Central Banks,’ Bank of International Settlements, Working Paper No 326.

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Knodell, J. (2004), ‘Central Banking in Early Industrialization,’ in M. Lavoie and M. Seccareccia (eds), Central Banking in the Modern World: Alternative Perspectives, Cheltenham: Edward Elgar, pp. 262–281. Ocampo, J.A. (2011), ‘Macroeconomy for Development: Countercyclical Policies and Production Sector Transformation,’ CEPAL Review, 104, 7–35. Temin, P. and H.-J. Voth (2013), Prometheus Shackled: Goldsmith Banks and England’s Financial Revolution After 1700, Oxford: OUP.

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Developmental central banking: winning the future by updating a page from the past Gerald Epstein Professor and Co-Director PERI, University of Massachusetts, USA

The ongoing Great Financial Crisis that began in 2007–2008 has dramatically called into question the previously dominant neoliberal approach to macroeconomic and financial policy. Unfortunately, these lessons are being learned in a highly uneven manner – and in some important circles, not at all. In light of this struggle to adopt developmentally friendly financial structures, it is critical that the history and practices of these policies, as well as their costs and benefits, be well understood. There is much rich history of developmental finance and central banking to draw from and many lessons to be found there. In this paper, we survey some of this history, focusing on the late twentieth century, including a discussion of policies undertaken following the Great Financial Crisis. The major lesson we draw is that developmental roles of central banks and related financial institutions have been the dominant approach in many periods since the mid twentieth century at least, and that the neoliberal approach to these policies is much more the exception than the rule. The way forward out of this crisis is to recognize the current policies for what they are – experiments in more developmental policy – and to build on them for the longer run, rather than see them as exceptional aberrations that should be abandoned at the first opportunity. Keywords: developmental central banking, inflation targeting, employment targeting, monetary policy JEL codes: E58, N10, O23

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INTRODUCTION

The ongoing Great Financial Crisis that began in 2007–2008 has dramatically called into question the previously dominant neo-liberal approach to macroeconomic and financial policy. Unfortunately, these lessons are being learned in a highly uneven manner – and in some important circles, not at all. Whereas, at the start of the crisis, both national governments and international institutions such as the IMF adopted expansionary fiscal policies and overthrew long-standing opposition to taboo policies such as capital controls, 5 years on, many of these institutions have returned to their almost instinctive affinity for austerity and aversion to appropriate financial regulation (see, for example, Cynamon et al. 2013; Gallagher and Ocampo 2013; Grabel 2013; Palley 2013). Still, some of the lessons learned from the need for alternatives to orthodoxy in macroeconomic and financial policy have stuck. When one surveys the landscape in the aftermath of the crisis, one is struck by the large amount of experimentation that is taking place with respect to monetary and financial policy. As with Shakespeare’s Malvolio, much of this new policy has been ‘thrust’ upon the central banks as they attempt to cope with the enormous challenges they confront in defending their © 2013 The Author

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economies from the onset and aftermath of the economic tsunami barreling down upon them, but experiment they have nonetheless. Of course, many of these central banks had hoped that the economic crisis would resolve quickly, and that they could simply return to their previous neo-liberal ‘inflation targeting’ frameworks which focused on achieving low inflation rates to the exclusion of employment, economic growth, or financial stability. But the reality of the economic meltdown would simply not cooperate. Instead, many of these central banks have had to implement more and more unorthodox policies. Early on after the crisis, even prominent economists from the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) were calling into question the dominant neoliberal approach to central banking, and in particular Inflation Targeting (IT). Olivier Blanchard, chief economist of the IMF, made a presentation at the ‘IMF Macro Conference’ in 2011: ‘Before the crisis, mainstream economists and policymakers had converged on a beautiful construction for monetary policy. To caricature just a bit: we had convinced ourselves that there was one target, inflation. There was one instrument, the policy rate. And that was basically enough to get things done. If there is one lesson to be drawn from this crisis, it is that this construction wasn’t right, that beauty is not synonymous with truth. The fact is that there are many targets and there are many instruments. How you map the instruments onto the targets and how you use these instruments best is a very complicated problem. This is the problem we have to solve’ (Blanchard 2011, p. 1). Despite the calls for a significant rethink in Central Bank Policy, and the fact that the practice of central banking, at least by the major central banks in the rich countries (in the US, Japan, UK and Europe), has been radically transformed by necessity, the idea of the ‘best practice of central banking’ has not seemingly changed much, if at all. The measures that have been taken since the crisis and the calls for a central banking ‘re-think’ have been seen by the dominant players in academia and the policy world primarily as a temporary, emergency deviation from standard practice, to be resurrected at the first available opportunity. In the developing world, at the same time, some central banks (for example, the Central Bank of Brazil) that had already been pursuing more heterodox – even developmental – approaches to monetary and financial policy, found that not only did they face new challenges from the crisis, but that there was more policy space available (at least temporarily) to pursue non-neoliberal approaches. And other central banks in developing countries, notably Banco Central De La Republica Argentina, have taken the opportunity to try to expand the developmental roles of the central bank. And when the IMF attempted to reverse course and limit the new policy space that had been opened up, key developing countries fought back to preserve their newfound space for a variety of tools of developmental finance and central banking. This has been especially true in the area of capital controls (or capital management techniques). Ilene Grabel calls this economic and political dance, specifically at the IMF, ‘productive incoherence’ (Grabel 2013, p. 563): the recognition by the powers that be that the crisis requires changes in policies and institutions, but the strong resistance to making the fundamental changes really required to adequately restructure policy and the economy. This dynamic has certain parallels with the fights over central bank and macroeconomic policies in the 1920s and 1930s following the instability after World War I and the response to the Great Depression of the 1930s. Financial orthodoxy in Europe and elsewhere pushed to restore the Gold Standard at prewar rates, while Keynes and others © 2013 The Author

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warned of the grave consequences and the need for an alternative macroeconomic apparatus that would provide more government guidance and coordination of investment and where central banks would focus more on facilitating aggregate demand and employment, behind a wall of capital controls, rather than protecting a country’s gold stock and price level. This was a vision of macroeconomic policy and the institutions that carried it out – central banks and fiscal authorities – playing a much stronger developmental role, as against the laissez-faire vision of dominant financial economic elites. (See Pérez Caldentey and Vernengo 2013; Kindleberger 1986). It took the calamities of World War II to implement this more developmental vision as we discuss in more detail below, but the roots of this vision were contained in theoretical and polemical discussions and experimentation in many countries in the 1920s and 1930s. The developmentalist vision of central banking became the norm, both in the developed and the developing world, and there were numerous notable successes, including remarkably successful newly industrializing countries such as South Korea, Taiwan, Brazil, India, and China. By the 1980s, however, the tide had turned again. Despite these successes, the rise of neoliberalism and the Washington Consensus in development policy embodied by much of IMF and World Bank policy, the turn against developmental central banking and in favor of ‘inflation targeting’ and ‘inflation targeting lite’ became dominant (Epstein and Yeldan 2009). As this ‘dialectical history’ following major crises shows, when economic reality rears its ugly head, developmental finance of various types becomes a compelling set of tools to confront these difficult macroeconomic challenges. But the political forces behind neoliberalism stand waiting in the wings to snatch away those tools as soon as possible and reinstate the strictures of neoliberal policy as quickly as they safely can, and sometimes even before. In light of this struggle to adopt developmentally friendly financial structures, it is critical that the history and practices of these policies, as well as their costs and benefits, be well understood. There is much rich history of developmental finance and central banking to draw from and many lessons to be found there. In this paper, we survey some of this history, focusing on the late twentieth century, including a discussion of policies undertaken following the Great Financial Crisis. The major lesson we draw is that developmental roles of central banks and related financial institutions have been the dominant approach in many periods since the mid twentieth century at least, and that the neoliberal approach to these policies is much more the exception than the rule. The way forward out of this crisis is to recognize the current policies for what they are – experiments in more developmental policy – and to build on them for the longer run, rather than see them as exceptional aberrations that should be abandoned at the first opportunity. The rest of this paper is organized as follows: Section 2 introduces the concepts of developmental central banking, contrasting it with neoliberal thinking on the appropriate structure of central bank policy. Section 3 gives a brief survey of the use of developmental central banking by central banks in ‘developing’ countries with a very brief reference to ‘developed’ economies’ experiences. Section 4 gives two case studies in recent developmental central banking: the Central Bank of Argentina and the Bank of Bangladesh, two banks that have recently explicitly adopted developmental roles. Section 5 draws some lessons from the case studies in Section 4. Section 6 introduces some additional important considerations: the important role of capital management techniques to create policy space, as well as discussing some other possible targets of developmental central bank policy. The final section summarizes and concludes. © 2013 The Author

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CENTRAL BANKS AS AGENTS OF ECONOMIC DEVELOPMENT1

Prior to the Great Financial Crisis of 2007–2008, the neoliberal approach to central banking had become the dominant approach to central bank policy in much of the world. The major tenets of this approach include the following recipe: (1) central bank independence; (2) a focus on inflation fighting (including adopting formal ‘inflation targeting’) to the virtual exclusion of all other goals; and (3) the use of indirect methods of monetary policy, such as short-term interest rates as the exclusive tool of monetary policy, as opposed to more direct tools such as credit allocation techniques (Bernanke et. al. 1999). It is not an exaggeration to argue that this neoliberal approach to central banking was a major contributor to the outbreak of the crisis. By rationalizing financial liberalization, turning a blind eye to asset bubbles (such as the real estate bubbles that precipitated the crisis) while rejecting the central banking tools such as credit controls that could have limited them, and by contributing to an environment where broad-based investment and employment generation in the real sector were not a priority, the neoliberal approach to central banking was a critical part of the entire neoliberal ideological and macroeconomic apparatus that set the stage for the greatest economic crisis in more than 75 years. More specifically, the principles of neoliberal central banking have the following far-reaching implications. Central bank independence implies, first and foremost, that the central bank should not be subject to pressure from the government to finance government activities (deficits). The focus on goods inflation means that the central bank should not be concerned with other goals such as promoting full employment, supporting industrial policy or allocating credit to sectors of special social need, such as housing or limiting asset bubbles. Neither should the central bank attempt to manage exchange rates through monetary policy, and certainly not through using controls on capital flows. The pursuit of indirect tools of monetary policy means that the central bank should not use credit allocation techniques such as subsidized interest rates, credit ceilings, and capital controls to affect either the quantity or the allocation of credit. This approach was claimed by its advocates in the IMF and elsewhere to stabilize the economy, and provide a framework for robust and sustainable economic growth, and moreover, to be the ‘best practice’ and even ‘optimal approach’ to central bank policy. But rather than being a historically dominant and optimal approach to central bank policy, this recipe – no support for government expenditure, reluctance to manage exchange rates, opposition to the use of capital controls, and a refusal to engage in credit allocation policies to support economic sectors – is in fact a highly idiosyncratic one. As a package, it is dramatically different from the historically dominant theory and practice of central banking, not only in the developing world, but, notably, in the now developed countries themselves. Throughout the early and recent history of central banking in the US, UK, Europe, and elsewhere, financing governments, managing exchange rates, and supporting economic sectors by using ‘direct methods’ of intervention have been among the most important tasks of central banking and, indeed, in many cases, were among the reasons for central banks’ existence. The neoliberal policy package that dominated on the eve of the Global Crisis, then, is drastically out of step with the history and dominant practice of central banking throughout most of its history (Epstein 2007a). 1. This section draws liberally on some of my earlier work, including Epstein (2007a; 2007b; 2008).

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CENTRAL BANKS AS AGENTS OF DEVELOPMENT: DEVELOPING COUNTRIES

The Great Depression and World War II were major watersheds in the historical evolution of central banking. This included the developing as well as in the developed world. In developing countries, central banks were emphatically agents of economic development and to a greater extent than witnessed in the developed countries during the same period. As described by renowned monetary historian of the New York Federal Reserve, Arthur I. Bloomfield, in 1957: During the past decade there has been a marked proliferation and development of central banking facilities in the underdeveloped countries of the world, along with an increasing resort to the use of monetary policy as an instrument of economic control. Since 1945, central banks have been newly established and pre-existing ones thoroughly reorganized, in no less than some twentyfive underdeveloped countries. In other cases the powers of pre-existing central banks have been broadened, in large part the recent growth of central banking in the economically backward areas has also reflected a desire on the part of the governments concerned to be able to pursue a monetary policy designed to promote more rapid economic development and to mitigate undue swings in national money incomes. (Bloomfield 1957, p. 190)

Bloomfield goes on to describe the functions, powers, and goals of these central banks: Many of the central banks … are characterized by unusually wide and flexible powers. A large number of instruments of general and selective credit control, some of a novel character, are provided for. Powers are given to the central bank to engage in a wide range of credit operations with commercial banks and in some cases with other financial institutions … These and other powers were specifically provided in the hope of enabling the central banks … to pursue a more purposive and effective monetary policy than had been possible for most … that had been set up … during the twenties and thirties … [that] for the most part [had] been equipped with exceeding orthodox statutes and limited powers which permitted little scope for a monetary policy designed to promote economic development and internal stability … (Ibid., p. 191, emphases added)

Of course, the Federal Reserve continued to be concerned about the importance of stabilization, controlling excessive credit creation and maintaining moderate inflation. But [the central bank’s] efforts need not, and in fact should not, stop here. The majority of central banks in underdeveloped countries have in actual practice adopted a variety of measures designed more effectively to promote the over-all development of their economies. Some of these measures are admittedly outside the traditional scope of central banking, but central banking in these countries should not necessarily be evaluated in terms of the standards and criteria applied in the more developed ones … the central bank can seek to influence the flow of bank credit and indeed of savings in directions more in keeping with development ends. (Ibid., p. 197)

Bloomfield describes tools of credit manipulation that, as we will see, were also used by developed countries’ central banks following World War II, and that have now been revived by some central banks in the aftermath of the Great Financial Crisis: ‘… selective credit controls applied to the banking system, through help in establishing and supporting special credit institutions catering to specialized credit needs, and through influence over the lending policies of such institutions, [the central bank]

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can help to some degree to re-channel real resources in desired directions, both between the public and private sector and within the private sector itself’ (ibid., p. 198).2 In a later article, Federal Reserve Governor Andrew Brimmer and his associates describe a variety of techniques that central banks pursued in the 1960s. These included: providing capital to development institutions, such as industrial and agricultural development banks; extending credit to development banks and purchasing their securities; buying a small part of the equity of development banks; establishing a ‘securities regulation fund’ to create a market for the securities of various development finance institutions, by using the profits from the ordinary operations of the central bank (Brimmer 1971, p. 785); using differential discount rates to allocate credit to capital development projects;3 the establishment of portfolio ceilings on activities having a low priority; various types of reserve requirements, including differential reserve requirements to influence the allocation of credit;4 using import deposit requirements, (primarily intended to deal with balance of payments difficulties) to also influence the allocation of bank credit5 (ibid.). Brimmer on the whole is somewhat negative about the effectiveness of many of these techniques, with the evidence from Brimmer’s study providing mixed results about the effectiveness of these policies. The possible trade-off between the developmental central bank and the maintenance of financial and macroeconomic stability is also a continuing concern of Brimmer’s. Other research paints a much more positive view of the impact of these and related policy approaches on development in the 1950s, 1960s, and 1970s. Among the most significant is the evidence from Alice Amsden’s seminal book The Rise of ‘the Rest’. Amsden reports that the role of medium and long-term financing, often supported by central banking mechanisms as just described, were key to the ‘Rise of “the Rest”,’ the newly industrializing developing countries that gained so significantly in the latter part of the twentieth century6 (Amsden 2001). The countries of ‘the rest,’ according to Amsden, acquired a manufacturing base in the years prior to World War II and then, after the war, industrialized rapidly, moving eventually into mid-level and even high-technology production (ibid., pp. 1–2). Among many other factors, Amsden stresses the important role of finance in the success of these countries, and especially the

2. Of course, Bloomfield cautions that: ‘Such measures would for the most part be justified, however, only to the extent that they do not conflict with the overriding requirement of financial stability or involve the central bank in details of a sort that might distract its attention and energies from the effective implementation of a policy aimed at stability’ (ibid. p. 197). 3. These were used in many countries: Argentina, Bolivia, Brazil, Colombia, Costa Rica, the Dominican Republic, Ecuador, Peru and Venezuela, Israel, India, Indonesia, Korea, Pakistan, the Philippines, Republic of China, and Thailand. The central bank charges a preferential rate on discounts or advances against favored types of paper to induce commercial banks to increase their lending (Brimmer 1971, p. 786). 4. These were used in: Argentina, Brazil, Chile, Columbia, the Dominican Republic, Israel, Mexico, and Peru among other countries (Brimmer 1971, p. 788). 5. Imports of developmentally important goods are subject to lower deposit requirements and hence are favored. This has been used in Argentina, Brazil, Chile, Colombia, Ecuador, Indonesia, Israel, Pakistan, Paraguay, the Philippines, Uruguay and Vietnam (Brimmer 1971, p. 789). 6. Amsden’s ‘rest’ consist of China, India, Indonesia, Malaysia, South Korea, Taiwan, and Thailand in Asia; Argentina, Brazil, Chile and Mexico in Latin America; and Turkey in the Middle East (Amsden 2000, p. 1). © 2013 The Author

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mobilization and allocation of medium-term and long-term finance for industrialization that was supported by a key set of public financial tools. The state’s main agent for financing investment was the development bank. Sometimes, the whole banking sector in these countries was mobilized to direct long-term credit to targeted industries, thereby ‘acting as a surrogate development bank’ (ibid., p. 129). Lending terms of development banks were almost always concessionary (ibid., p. 132). The public finance behind the rest’s development banking was often ‘off-budget’ and related to non-tax revenues. Many central banks played a key role here as well. More specifically, central banks played an important role in accommodating the development-oriented policies of these governments. Most kept effective real interest rates low, even negative. They also used capital controls to insulate domestic markets from hot money flows that could lead to over-valued exchange rates and crises. Furthermore, central banks also played an important role in the ‘off-budget’ financing of a number of these countries using the techniques described by Bloomfield and Brimmer. These experiences were not all unqualified successes, of course. Still, in many cases, as part of an overall, coherent government policy, they often helped underwrite significant economic development. As an important historical note that has great relevance for the current conjuncture following the Great Financial Crisis, it is not well understood that in playing these developmental roles, the central banks of developing countries were following strong precedents set by central banks in many developed economies, especially after World War II (Epstein 2007a).

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4.1

MODERN DEVELOPMENTAL CENTRAL BANKING: CASE STUDIES OF DEVELOPMENTAL CENTRAL BANKING IN ARGENTINA AND BANGLADESH Case study one: the Central Bank of Argentina’s new mandate

Prevailing ideology has held that the only legitimate task for central banks is to control inflation, which often comes at the expense of broader goals such as employment creation, financial stability or economic growth. Now, in a bold and important move, the government of Argentina has fought against this neoliberal ‘conventional wisdom’ and broadened the mandate of the Argentine Central Bank to include economic growth and financial stability, and empowered it to use more tools to support credit allocation to promote productive investment and job creation. In March of 2012, the Argentinian Parliament approved a new charter for the Central Bank of Argentina, a charter that embodies some key goals of developmental central banking. Article 3 of the new Charter states that ‘the purpose of the Central Bank is to promote monetary stability, financial stability, employment and economic development with social equity, within the scope of its powers and under the framework of the policies determined by the national government’ (Banco Central De La Republica Argentina, July, 2012). As the premier issue of the Central Bank’s Macroeconomic and Monetary Policy Report states, ‘The Reform of the Central Bank of Argentina Charter has brought about a historical change in the institutional structure of our country’s economic policy. From a Central Bank conceived as an institution with a minor role, minimum instruments and an inadequate coordination with the remaining economic policies, we have now a Central Bank with more comprehensive objectives, a wider set of instruments and a performance coordinated with the remaining areas of the economic policy’ (ibid., preface). © 2013 The Author

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The reform also creates new instruments of monetary and credit policy: it allows the Central Bank to lend directly to the government up to 12 percent of the monetary base and advance funds that correspond to no more than 10 percent of the government revenue in the previous 12 months. It also allows for the use of international reserves for the payment of the foreign debt obligations of the national government, eliminating some restrictions that were in place over the use of international reserves. Perhaps most importantly, the reform allows the bank to provide funds for domestic banks and other financial institutions involved in the financing of long-term productive investment. These new mandates and tools, which came into force in April, 2012, embody a dramatic transformation from the neoliberal straitjacket that confined the Argentinian Central Bank and monetary policy just a little more than a decade before following the disastrous Convertibility Plan that tied the Argentine currency to the US dollar in 1991. This led to economic collapse in 2002 with a debt default and severe economic crisis. The Convertibility Law required that the Central Bank maintain the fixed value of the peso relative to the dollar, and, as such, was an extreme version of the neoliberal monetary policy focused on fighting inflation to the exclusion, and therefore at the expense of, economic growth, job creation and economic development. In fact, this charter reform allowed the Central Bank to recover the powers it had exercised from 1935 to 1992 when the charter was amended (BCRA Second Half 2012). The new law is already attracting criticism from orthodox critics. The Economist, for example, proclaimed that the Argentine Central Bank had become the ‘piggy bank’ of the Argentine government, ‘losing the last shred of its legal independence’ (March 3, 2012, www.economist.com/node/21551507). This, they claimed, would lead to massive inflation and runaway budget deficits. But, as I have argued above, the new Argentine mandate is quite in line with historical practices of central banks. The Central Bank of Argentina has begun implementing these new mandates. According to official central bank reports, steps taken by the Bank along these lines include the following: 1. Medium and Long-Term Lending for Productive Investment. The Central Bank has initiated the ‘Bicentenary Productive Financing Program,’ with the aim of increasing productive investment. To do this, the Central Bank gives a line of credit to banks to enable them to make longer-term loans (a minimum of 2½ years) to finance longer-term productive investment. This program was initiated in 2010 but has now been expanded with the passage of the new Central Bank Charter. The Central Bank instructs banks to set up a credit line for the financing of investment projects. The loans are to be for a term of 24 months or more (with an effective maturity of at least 36 months), with a fixed interest rate of no more than 15 percent p.a. By the end of 2012, each financial institution with at least 1 percent of the country’s deposits, or which act as government agents, should have granted an amount equivalent to 5 percent of its deposits. Half of this was to be granted to micro, small and medium-sized companies. In August, 2012, the program was extended for certain real estate investment projects (BCRA Second Half 2012, p. 8). 2. Extend Banking’s Geographical Coverage. A new system for licensing branches was implemented to encourage the extension of banking facilities to underserved areas. This should reduce financial exclusion and provide the basis for more credit provision later. The Charter change is recent and so it remains to be seen how it will be implemented. But the charter change helps to set an important precedent for other central banks in © 2013 The Author

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Latin America and elsewhere to recover the important roles that central banks can play as agents of development. 4.2

Case study two: Bangladesh Central Bank as an agent of economic development7

According to the Bangladesh Bank’s document, ‘Developmental Central Banking In Bangladesh; Recent Reforms and Achievements’ (2009–2012), the Bangladesh Bank (BB) is mandated by its charter to promote and maintain a high level of output, employment, and real income, fostering growth and development of the country’s productive resources along with preserving monetary and financial stability (Bank of Bangladesh 2012, foreword, p. 1). The BB adopts a two-pronged approach to promoting Economic Development and Economic Stability. First, its financial inclusion and developmental finance campaign tries to engage the private financial sector to help reach underserved households and businesses with both banking services and credit to help generate employment, investment and growth. Second, it tries to promote financial stability by helping to channel credit away from destabilizing activities and toward productive investments. Thus the BB has charted a course of engaging the private financial sector in pursuit of a norm of ‘social responsibility’ in which developmental central banking and policies to further ‘financial inclusion’ also promote financial and economic stability. In pursuing this agenda, the BB has set up modest refinance lines and interest subsidies from the government budget to promote lending to smallholder and tenant farmers and small and medium-sized enterprises (SMEs). The central bank has also encouraged private banks to provide access to banking facilities through mobile/ smart phones and through active Micro Finance Institutions (MFIs). The Central Bank has also engaged state-owned banks to open bank accounts for small and rural customers, and it has opened as many as 10 million new accounts in recent years. The BB has also initiated a Green Banking program to promote projects that improve environmental outcomes. In pursuing these multiple objectives, the BB has utilized multiple tools, including the standard monetary tools such as manipulating short-term interest rates, as well as other tools including moral suasion, direct rules and regulations and subsidies for desired activities. The specific types of developmental banking activities that have been pursued by the BB include: 1. Financial Inclusion Campaign has attempted to engage private financial institutions in providing banking services to a wider range of households and individuals, especially in rural areas, including through mobile banking. 2. Support and promotion of agricultural lending. While state-owned banks continue to provide credit to the agricultural sector, the BB has encouraged private financial institutions to also deliver agricultural services and credits. These private banks extend credit either directly to agricultural borrowers, or indirectly through micro-credit institutions or through other institutions in the agricultural ‘value-chain.’ This is achieved through moral suasion and occasional subsidies and is monitored by a dedicated office at the central bank. Under one set of programs, agricultural credit is extended at a concessional 4 percent per year interest 7. The main source for this discussion is the BB: ‘Developmental Central Banking in Bangladesh; Recent Reforms and Achievements (2009–12),’ Bangladesh Bank, Dakha. © 2013 The Author

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rate; the banks get a 6 percent interest subsidy that is paid by the government budget and administered by the Central Bank. Among these projects is a joint project with private banks in which the banks finance a technology to help farmers turn cow manure into cooking gas. The BB offers a line of credit so that banks are incentivized to finance the purchase of cows and the equipment to make this possible. This program was designed jointly by the BB and the private banks with the help of local farmers and farming organizations. Credit program for share croppers. Sharecropper farmers are typically excluded from credit and other banking services, largely because they typically lack collateral. To overcome this problem, the BB launched a refinance scheme for landless sharecroppers in Bangladesh. They partnered with BRAC, one of the largest and best known non-governmental development organizations in the world. The scheme uses ‘social collateral,’ that is, peer pressure among groups of sharecroppers to sustain repayment. This is the first ever credit program for sharecroppers in Bangladesh, and undoubtedly a rarity (if not a unique program) worldwide. Under this scheme, BRAC has provided loans to almost 481 000 sharecroppers as of September, 2012. In support of this program, the BB has provided BRAC with a refinance facility. Green credit support. The BB has introduced a refinance line for banks against their loans to environmentally beneficial projects at a concessional 5 percent interest rate. These projects include effluent treatment plants and new energy efficient technologies. Small and medium-sized enterprise (SME) credit programs. SME development has been a central developmental goal for the BB. An indicative yearly target of disbursing SME credit by banks and financial institutions has been fixed for every year since 2010. The SME activities of all banks and financial institutions are subject to strict monitoring by the BB. In addition to indicative targets, the BB, with the help of the government and various development agencies, is implementing five refinance schemes in the form of revolving funds for SMEs. Women’s entrepreneurship development. The BB has taken several initiatives to improve women’s access to financial facilities and credit. It has stipulated that at least 15 percent of the total BB refinance fund for the SME sector must be allocated to female entrepreneurs at a reduced interest rate of 10 percent. Banks and financial institutions may offer loans up to a certain level to female entrepreneurs without collateral, as long as they provide a personal guarantee in order to use the BB refinance facility. The share of women entrepreneurs in total SME loan disbursements has been increasing successively. The BB and industrial policy. The BB has also given guidelines and helped to play a facilitating role in several industrial policy schemes. These include a strategy to develop industrial clusters around particular manufacturing products, especially with a goal of promoting small and medium-sized enterprises. The BB encourages banks and financial institutions to provide credit in support of the development of such clusters. The BB and green development. The bank issued policy guidelines for Green Banking in February, 2011. The guidelines stipulate that all banks need to undertake and report on green banking activities. The BB has also launched a revolving finance scheme for solar energy, bio-gas and effluent treatment facilities at a subsidized rate. The BB report indicates that they take into account the management capacity of banks in this area so as not to over-burden them with reporting and implementation demands. At the same time, the BB does keep track of these

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activities and takes them into account when making decisions with respect to approving new branching requests and similar changes for individual banks.

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CENTRAL BANKS’ ROLE AS AGENTS OF DEVELOPMENT: LESSONS FROM THE CASE STUDIES

A number of key lessons emerge from the case studies of developmental central banking in Argentina and Bangladesh that can be extended and generalized with respect to developmental central banking elsewhere. Several other key points can be added: 1. One Size does not Fit All: goals and tools can be tailored to fit specific national and conjunctural needs. Unlike with inflation targeting, which establishes a low inflation rate as the central bank’s single goal and a short-term interest rate as the central bank’s single instrument, the targets and instruments associated with developmental central banking can be diverse and specific. Goals include the development of small and medium-sized enterprise, the development of green energy or conservation, employment generation, and financial inclusion; tools include moral suasion, subsidized credit, regulatory leverage over private financial institutions, and coordination roles and market makers, to name just a few. And the central bank must pay attention to targets and instruments. As Tinbergen argued in his classic piece on policymaking (Tinbergen 1952), one needs at least as many independent instruments as targets to reach one’s objectives. 2. Specific groups and areas can be targeted. In the case of the Bangladesh Bank, group targeting included specific programs designed for women, other programs designed for sharecroppers, and others for small business entrepreneurs, among others. In both Argentina and Bangladesh, under-served regions were targeted allowing the central bank to have finely honed tools to develop specific regions. 3. Central banks become focused on more than inflation. In both cases, the central bank leadership and staff must focus on issues beyond simply controlling inflation. It helps to change the culture of the central bank from a culture of being isolated from broader economic concerns and from the broader government, to a culture of being connected to broader economic concerns and cooperating with others in the government and broader economy, such as NGOs, private financial institutions and others, to achieve broader goals. 4. Central banks develop broader expertise and search for new tools. Central banks are required to develop broader expertise beyond an understanding of inflation to one of understanding employment issues, distributional issues, green technology, and a concern with poverty and development. As these cases show, they also develop new tools to achieve these goals. 5. Developmental targeting. Central banks can develop explicit developmental goals, make them public and then report on their degree of success in achieving these goals. Like with inflation targeting, this approach can increase the accountability and transparency of developmental central banking. 6. Developmental central banking can enhance coordination with broader governmental macroeconomic and developmental policy. Developmental central banking works best when the central bank coordinates with the broader government to achieve developmental goals. The central bank can and should still retain some autonomy, especially with respect to broader stabilization issues, but it is best if the Central Bank engages with the government in discussion about © 2013 The Author

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trade-offs, modalities and coordination of all policies, including stabilization policies. 7. Trade-off between stability and development? There need not be a trade-off between developmental central banking and financial and economic stability. Indeed, the approach of the Bangladesh Bank is to help direct credit to productive investment, rather than to speculative uses. In this sense, developmental central banking can promote financial and economic stability. 8. Developmental goals must be consistent with capacity. Both the Bank of Bangladesh and the Bank of Argentina have adopted goals that are consistent with the banks’ capacity to implement and monitor the programs, and also are sensitive to the capacities and goals of the private sector firms and NGOs they interact with. It is important not to over-reach beyond the institutional and economic capacity to successfully implement these policies.

6

OTHER CONSIDERATIONS: CAPITAL MANAGEMENT TECHNIQUES AND OTHER GOALS OF DEVELOPMENTAL POLICY8

It is also important to step back from specific case studies and consider some key macroeconomic enabling institutions that may be required to implement developmental central banking. Most importantly, governments may need policy space from the vagaries of international capital markets to preserve autonomous monetary and other policies along the lines discussed here. In particular, to achieve this policy space they may need capital controls, exchange controls or, more generally, capital management techniques. The IMF has come to refer to these as capital flow management techniques, but I will call them Capital Management Techniques (CMTs). As Grabel (2013) shows, even the IMF has now changed its tune somewhat, and in some publications has accepted the view that CMTs can be helpful to macroeconomic management under some conditions. These can help stabilize the economy, and can also support credit allocation policies for developmental ends. CMTs can enhance policy autonomy in a number of ways: they can reduce the severity of currency risk, and can thereby allow authorities to protect a currency peg; they can create space for the government and/or the central bank to pursue growth-promoting and/or reflationary macroeconomic policies by neutralizing the threat of capital flight; by reducing the risk of financial crisis in the first place, CMTs can reduce the likelihood that governments may be compelled to use contractionary macroeconomic, microeconomic and social policy to attract foreign investment back to the country or as a precondition for IMF assistance; finally, CMTs can reduce inappropriate foreign control or ownership of domestic resources. It follows from the above that capital management can enhance democracy by reducing the potential for speculators and external actors to exercise undue influence over domestic decisionmaking directly or indirectly (via the threat of capital flight). CMTs can reduce the veto power of the financial community and the IMF, and create space for the interests of other groups (such as advocates for the poor) to play a role in the design of policy. They can thus be said to enhance democracy because they create the opportunity for pluralism in policy design (Epstein et al. 2003). 8. This section draws heavily on joint work with Ilene Grabel and K.S. Jomo. See Epstein et al. 2003. © 2013 The Author

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Other possible real targets for monetary policy

Employment targeting The central bank can identify a number of quite specific developmental goals depending on the specific needs of the economy. These can include, for example, targeting employment generation, which is a good in and of itself, and is also a key component of poverty reduction. Real GDP growth (economic growth) Economic growth is a natural alternative target for central banks, since it is generally considered a broad measure of economic performance and is widely thought to be influenced, at least in the short to medium term, by macroeconomic policy, including monetary policy. Moreover, many other important variables, such as employment and investment, are broadly affected by the rate of economic growth. Its breadth and generality might also make it less amenable to monetary and credit policy than narrower measures such as employment and investment. As a broad measure, it might also be less directly linked to specific outcomes with high social priority, such as poverty reduction and employment. Investment For some countries, employment generation is not the most immediate macroeconomic problem. Rather, productivity growth is a more important concern. In this case, investment, rather than employment, might be a more appropriate target. If the central bank were to adopt an investment target subject to an inflation constraint, it could do so in a targeting framework. In this case, the central bank would adopt target ranges for investment and would estimate the relationship between central bank policy and investment. It would also estimate the relationship between policy, investment and inflation and other important variables, such as exchange rate instability. It would choose a target range for inflation and assess whether the investment goal and the inflation goal are consistent. Just as in the inflation targeting framework, decisions would have to be made as to the proper index of investment to use. Based on the estimate of the relationship between the central banks’ policy instrument, the central bank would try to achieve its target. Here, too, the problems that arise will be similar to those that arise in the inflation targeting approach. What is the best instrument to use? Most central banks use short-term interest rates as their policy tool. But other variables are likely to be more directly related to investment, including long-term interest rates and credit availability. Therefore, central banks may find that other instruments, such as open market operations directed at long-term debt securities, directed lending, or incentives such as asset-based reserve requirements to induce banks to lend longer term, are more effective. A stable and competitive real exchange rate (SCRER) A number of central banks and governments in Asia and Latin America, including China, Singapore, Brazil, and Argentina, have adopted a stable and competitive real exchange rate (SCRER) as an important monetary and exchange rate target (Epstein and Yeldan 2009). This target highlights the importance of the traded goods sector © 2013 The Author

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for employment, productivity growth, and development. Capital management techniques and foreign exchange reserve accumulation and intervention are key complementary tools to achieve this target.

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CONCLUSION

The current day orthodoxy of central banking – namely, that the top priority goal for central banks is to keep inflation in the low single digits – is, in general, neither optimal nor desirable. This orthodoxy is based on several false premises: first, that moderate rates of inflation have high costs; second, that in this low-inflation environment, economies will naturally perform best, and in particular, will generate high levels of economic growth and employment; and third, that there are no viable alternatives to this ‘inflation-focused’ monetary policy. In fact, moderate rates of inflation have very low or no costs; countries where central banks have adopted formal or informal inflation targeting have not performed better in terms of economic growth or employment generation, and even the impacts of these regimes on inflation itself is a matter of dispute. And there are viable alternatives to inflation targeting, historically, presently, and looking forward. Historically, countries both in the currently developed and developing worlds had central banks with multiple goals and tools, and pursued broad developmental as well as stabilization goals. Currently, very successful economies such as Argentina, Bangladesh, China and India have central banks that are using a broad array of tools to manage their economies for developmental purposes. Inflation-focused monetary policy has an insidious impact on central banks and, indeed, on the whole macroeconomic policy apparatus. It creates in central banks a culture of single-minded inflation focus, or even inflation obsession. Hundreds of thousands and even millions of dollars are spent on studying every aspect of inflation and few aspects of unemployment; thousands of hours of the time of highly scarce, skilled economists are spent poring over complex models designed to show how to get inflation down from 8 percent to 4 percent, but not how to create a single high-paying job; and if other government officials or those in civil society ask the central bank to do something about employment creation, the central banks can respond, ‘that’s not our job.’ In short, more than anything else, the cost of inflation-focused monetary regimes is to divert the attention of some of the most highly trained and skilled economists and policymakers in developing countries away from the tasks that previous generations of central bankers took for granted as being their main job: to help their countries develop, to create jobs, and to foster socially productive economic growth. It is time to return to an earlier generation of central banking where central banks were seen as agents of economic development, including being agents of employment creation. Central banks and economists in many parts of the world have discovered that the recently dominant neoliberal approaches to central banking were not adequate for either preventing the great financial crisis or for promoting recovery. Experiments in central banking are taking place in many countries, including those ostensibly most dedicated to the old orthodoxy – the European Central Bank, the Bank of England, and (the less orthodox) Federal Reserve. Developing countries’ central banks should no longer take their leads from what the advanced countries’ central banks and the IMF say, but rather look at what they do and go beyond them in their own, careful experimentation. As they do so, like the Bank of Argentina and the Bangladesh Bank, they will create a revived tradition of developmental central banking that, like some of the earlier practices, can help promote inclusive and sustainable development along with economic and financial stability. © 2013 The Author

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REFERENCES Amsden, Alice H. 2001. The Rise of ‘The Rest’; Challenges to the West from Late-Industrializing Economies. Oxford: Oxford University Press. Bank of Bangladesh. 2012. ‘Developmental Central Banking in Bangladesh, Recent Reforms and Achievements (2009–2012).’ Available at: www.bangladesh-bank.org/pub/special/dcbbd.pdf. BCRA (Banco Central De La Republica Argentina). Second half 2012. Financial Stability Report. Buenos Aires, Argentina. Bernanke, B.S., Laubach, Th., Posen, A.S., and Mishkin, F.S. 1999. Inflation Targeting: Lessons from the International Experience. Princeton, NJ: Princeton University Press. Blanchard, Olivier. 2011. ‘Monetary Policy in the Wake of the Crisis,’ IMF, Macro Conference. Available at: http://www.imf.org/external/np/seminars/eng/2011/res/pdf/ob2presentation.pdf. Bloomfield, Arthur I. 1957. ‘Some Problems of Central Banking in Underdeveloped Countries,’ The Journal of Finance, 12 (2), 190–204. Brimmer, Andrew F. 1971. ‘Central Banking and Economic Development: The Record of Innovation,’ Journal of Money, Credit and Banking, 3 (4), 780–792. Cynamon, Barry Z., Fazzari, Steven M., and Setterfield, Mark. 2013. After the Great Recession; The Struggle for Economic Recovery and Growth. New York: Cambridge University Press. Epstein, Gerald. 2007a. ‘Central Banks as Agents of Economic Development,’ in Ha-Joon Chang, ed., Institutional Change and Economic Development. New York: United Nations University and Anthem Press, pp. 95–113. Epstein, Gerald. 2007b. Central Banks, Inflation Targeting and Employment Creation, Economic and Labor Market Papers, International Labor Office, 2007/2 Employment Analysis and Research Unit, Economic and Labor Market Analysis Department, February. Geneva: ILO. Epstein, Gerald. 2008. ‘Central Banks as Agents of Employment Creation,’ in José Antonio Ocampo and Jomo K.S., eds, Towards Full and Decent Employment. London: Zed Books and New York: United Nations, pp. 92–122. Epstein, Gerald, Grabel, Ilene, and K.S., Jomo. 2003. ‘Capital Management Techniques in Developing Countries,’ in Ariel Buira, ed., Challenges to the World Bank and IMF; Developing Country Perspectives. London: Anthem Press, pp. 141–174. Epstein, Gerald and Yeldan, Erinc, eds. 2009. Beyond Inflation Targeting: Monetary Policy For Employment Generation and Poverty Reduction. Northampton, MA: Edward Elgar. Gallagher, Kevin and Ocampo, José Antonio. 2013. ‘The IMF’s New View of Capital Controls,’ Economic and Political Weekly, March 12. Grabel, Ilene. 2013. ‘Productive Incoherence in a Time of Aperture: The IMF and the Resurrection of Capital Controls,’ in Martin H. Wolfson and Gerald Epstein, eds, The Handbook of the Political Economy of Financial Crises. Oxford: Oxford University Press, pp. 563–577. Kindleberger, Charles. 1986. The World in Depression. Berkley: University of California Press. Palley, Thomas. 2013. ‘Monetary Policy and Central Banking After the Crisis: The Implications of Rethinking Macroeconomic Theory,’ in Martin H. Wolfson and Gerald Epstein, eds, The Handbook of the Political Economy of Financial Crises. Oxford: Oxford University Press, pp. 624–643. Pérez Caldentey, Esteban, and Matías Vernengo. 2013. ‘Heterodox Central Bankers: Eccles, Prebisch and Financial Reform in 1930s,’ in Gerald Epstein, Tom Schlesinger and Matias Vernengo, eds, Financial Institutions, Global Markets, and Financial Crisis: Essays in Honor of Jane Webb D’Arista. Northampton, MA: Edward Elgar (forthcoming). Tinbergen, J. 1952. On the Theory of Economic Policy. Amsterdam: North-Holland.

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Review of Keynesian Economics, Vol. 1 No. 3, Autumn 2013, pp. 288–299

The nation-building purposes of early US central banks Jane Knodell Professor of Economics, University of Vermont, USA

The First and Second Banks of the US (1791–1811 and 1816–1836 respectively) provide historical examples of quasi central banking institutions that fulfilled purposes beyond and other than monetary stabilization. Both Banks were chartered and organized for the purpose of addressing postwar public finance problems facing a young national government seeking to establish its independence from external powers and its internal integrity as a national entity. Both Banks performed monetary stabilization services as well, as a by-product of their public finance and nation-building roles. Keywords: central banking, early US history, public finance JEL codes: N22, E58, E42

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INTRODUCTION

The United States had two ‘central banks’ prior to the Federal Reserve: the First Bank of the US (1791–1811) and the Second Bank of the US (1816–1836). In the academic literature on these banks, much of the debate has to do with whether these banks were ‘central banks’ in the modern sense of conducting counter-cyclical monetary policy and providing lender-of-last-resort services to private commercial banks. With some notable exceptions, the nation-building purposes of these institutions receives relatively little attention, a lacuna I seek to address in this paper. Quasi-public monetary institutions like these were designed for purposes that went considerably beyond monetary stabilization, and they demonstrate the potential flexibility of such organizations for achieving desired social and economic ends. In the 1790s, nation building meant the establishment of the US as a separate national unit outside of the English imperial system. From a monetary and financial point of view, the project was to create and sustain a separate national monetary unit, and to establish the US government as a fiscal entity capable of keeping its promises to pay with its creditors, many of which were in London, Amsterdam, and Paris. By 1816, the territory under the control of the US had expanded significantly on its western frontier after the Louisiana Purchase of 1803 and the transfer of land from Indian to US sovereignty before and during the War of 1812. With the military and financial strength of the US vis-à-vis external powers established, the nation building project turned inward, to the integration of a geographically large and dispersed space into a national unit. The First and Second Banks provided a wide range of monetary and fiscal functions for the national government. The nature of these functions was determined by the postwar public finance and currency problems that the banks were designed, and chartered, to implement. In Sections 2 and 3, I describe these problems and their public finance © 2013 The Author

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solutions, with a focus on their monetary implications. In Section 4, I show how the Banks’ roles as fiscal agent for the federal government tended to draw them into central banking activities. My claim is that monetary stabilization was a by-product of the Banks’ fundamental purpose of providing fiscal support for the governmental entity that chartered them. This is in contrast to the Federal Reserve, which I discuss briefly in a final and concluding section. The founding of the Federal Reserve was triggered by a severe financial panic, not by postwar disarray in the public finances, as with the First and Second Banks. The Federal Reserve came to play an important role in the financing of World War I and World War II, but these functions were clearly added on to its core function of providing liquidity to commercial banks. 2

PUBLIC FINANCE AFTER THE REVOLUTIONARY WAR AND THE FIRST BANK OF THE US

The public credit of the United States deteriorated during the time that the states were loosely organized as a national unit under the Confederation (1783–1789), when Congress requisitioned the states for taxes to meet the expenses of federal administration and debt service. Congress failed to meet interest payments due on some of its debt held abroad after 1785, and on principal payments after 1787. Domestically, the price of US debt sold at prices between 10 and 40 cents on the dollar, depending on the form of the debt and the credibility of state support for debt repayment.1 Over that decade, the responsibility for servicing the Revolutionary War debt progressively devolved to the states. By the end of the Confederacy, the states were handling all of the debt service on the war debt, and three states, New York, Pennsylvania, and Maryland, had converted $9m of domestically held public debt, out of a total of $42m, from federal to state securities.2 At the same time, the states found that their existing revenue sources (largely nontax sources such as interest on investments, interest earned by land banks, and revenue from sales of public lands) were insufficient to meet their newly assumed debt obligations. As a result, there was a large increase in the tax burden over a short period of time, largely in the form of direct taxes such as poll taxes, property taxes, and taxes on slaves, which led to various forms of tax resistance and growing tax arrears.3 The US Constitution, adopted and ratified between 1787 and 1789, established the basis for improving the credibility of the federal government as an international and domestic borrower. Perhaps most importantly, it gave the federal government exclusive rights to levy import and export taxes, which had formerly been levied by the states. Imports and exports would be taxed at the same rate in all ports, eliminating competition across states for tax base, which would tend to drive down rates of taxation. Income from customs duties increased significantly in the 1790s due to growth in trade, increases in customs rates, and increased efficiency in collections, allowing the onerous direct taxes, which had been levied by the states, to fall.4 With exclusive access to the customs secured for the federal government, the Revolutionary War debt was restructured and consolidated at the federal level. Under the plan designed by Alexander Hamilton and adopted by Congress in 1790, the federal 1. 2. 3. 4.

Ferguson (1961, pp. 251–253). Ferguson (1961, pp. 242–253); Dewey (1903). Edling and Kaplanoff (2004, pp. 729–730). Edling and Kaplanoff (2004, p. 740).

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government assumed responsibility for the Revolutionary War debt issued by the states and the federal debts which had been assumed by the state governments. At the same time, the securities were converted into British-style consuls with indefinite terms to maturity, on terms that ensured that they would be fully and easily transferable, thus allowing owners to liquidate through sale rather than through retirement. These and other measures brought public debt service in line with the nation’s current income levels. By 1800, US debt was selling above par in US financial markets.5 Refunding of the debt also served the purpose of alleviating monetary stringency. In his First Report on the Public Credit, Hamilton drew a connection between the condition of the public debt and monetary conditions: ‘… one serious inconvenience of an unfunded debt is, that it contributes to the scarcity of money … It is a well-known fact, that, in countries in which the national debt is properly funded, and an object of established confidence, it answers most of the purposes of money. Transfers of stock or public debt are their equivalent to payments in specie; or, in other words, stock, in the principal transactions of business, passes current as specie.’6 The use of public securities in large domestic transactions freed up specie for bank reserves and those international payments for which only specie or its equivalent (balances with English and European merchant bankers) would serve. To implement the financial plan, the Federal government needed a stable monetary form in which to collect custom duties and service the national debt. The Coinage Act of 1792 defined the US dollar as the unit of account and pegged its value to that of the Spanish milled dollar.7 This high quality coin, produced in Mexican and other South American mints, enjoyed a wide international circulation. This law also provided for US coins to be produced at the US Mint, but it would be 60 years before the Mint provided enough domestic coins to meet domestic demand. In terms of paper currency, the national Continental Currency, issued to finance the Revolutionary War in the form of promises to pay the bearer Spanish milled dollars, had depreciated to the point that by 1781 it took $167.50 of Continental Currency to purchase one Spanish milled dollar.8 At the time Hamilton’s plan was adopted, there were three types of monetary instruments available for the collection and disbursement of federal receipts: fiat currency issued by seven of the 13 existing state governments in local pound units (Pennsylvania pounds, New York pounds, etc.), whose continued issuance had been prohibited by the Constitution; silver and gold coins, all minted abroad and denominated in foreign monetary units; and ‘specie dollars’ issued by three statechartered commercial banks in Philadelphia, New York, and Boston, chartered between 1782 and 1784.9 State fiat currency and silver and gold coin (specie) had significant limitations from a federal revenue collection point of view. The state fiat currency was denominated in a different unit (local pounds) than that of the national debt (US dollars), and its quantity would fall over time as existing issues were retired through state tax collection and 5. Martin (1969, p. 9). 6. McKee (1957, pp. 7–8). In the 1780s, US debt had also circulated as money ‘in the sale of land or commodities and in discharge of debts,’ but at depreciated prices, not ‘current as specie’; Ferguson (1961, p. 251). 7. This peso coin was called a ‘dollar’ in the American colonies, the anglicized expression for the German ‘thaler’ coin that circulated in England and was physically similar to the peso. 8. Ferguson (1961, p. 32). 9. The American colonies had been forbidden to mint coin or charter banks. © 2013 The Author

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no new issues were emitted.10 Specie was very expensive to use in interregional and international payments, was issued in non-US monetary units, and its quantity was not under the control of the government or the banks, but depended on changes in the international balance of payments and differences in the value of silver and gold coins in the US and abroad. The banknotes and deposits issued by state-chartered banks could have served the fiscal needs of the federal government. By 1792, there were state banks in all of the cities with significant port operations and customs collections. Prior to 1791, the state banks issued monetary liabilities in the form of ‘specie dollars,’ which referred to Mexican dollars, not US dollars, tied in value to both specie and to local pound units. For example, the Bank of Massachusetts, chartered in 1784, kept its books ‘on the basis of Mexican dollars and seventy-seconds thereof. Each of these Mexican dollars was regarded as equal to six shillings of Massachusetts currency … the explanation of the division of the dollar into seventy-seconds is that the corresponding 7 shillings contained 72 pence.’11 The fact that state banknotes and deposits were denominated in ‘Mexican dollars’ was not a big problem because, as noted above, the US dollar had been set equal to the peso, making it easy to convert between the two units of account. Further, after the refunding of the debt, the state-chartered banks and state governments did switch to using the US dollar as their unit of account, which was important in creating a single price for specie and eliminating competitive specie appreciations/local pound devaluations at the state level. The degree to which the three banks accepted each other’s notes and deposits is not clear, but it is likely that the state banks would have established correspondent relationships with each other to handle intercity federal payments, had they been selected as federal depositories. For the federal government, there were still two problems associated with using existing state banks as depositories and fiscal agents. First, it needed some control over the scarce stock of specie, as specie represented the ultimate means of international payment. In his Report on a National Bank to Congress, Alexander Hamilton, the first US Treasury Secretary, described the precious metals as ‘… the commodity taken in lieu of every other, … as the money of the world, it is of great concern to the state, that it possess a sufficiency of it to face any demands which the protection of its external interest may create.’12 The US Treasury needed to know that, as a last resort, it could obtain specie to ship to London, Paris, or Amsterdam to keep current on its debt service on the $12m of federal debt held abroad after the refunding of the debt, almost one-fifth of the total US government debt of $63m.13 Private holders of silver and gold (merchants and banks) did not have the national objective of retaining specie in mind, but would take advantage of international arbitrage opportunities as they arose, creating the possibility for domestic stocks of specie to fall below payment requirements. The designation of the First Bank of the US as the fiscal agent of the US government, chartered by Congress in 1791, concentrated the specie holdings of the young nation in the 10. As Hamilton observed, ‘Previously to the Revolution, circulation was in a great measure carried on by paper emitted by the several local governments. … This auxiliary may be said to be now at an end.’ McKee (1957, p. 70). 11. Gras (1937, pp. 40 and 233). A copy of the Bank of Massachusetts’s journal book shows accounts kept in ‘dollars and parts of dollars,’ not ‘dollars and cents.’ The US dollar was divided into 100 cents. 12. McKee (1957, p. 66). 13. Dewey (1903, pp. 92–96). © 2013 The Author

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First Bank of the US, giving the federal government access to the nation’s specie stock. This, I argue, was a more significant monetary role for the First Bank than the issuance of a uniform currency with which to collect revenues and make payments, which the state-chartered banks would have been likely to have been able to provide. As the federal government’s fiscal agent, the Bank was the place where federal receipts were deposited, where federal payment warrants were executed, and where intercity transfers for the federal government were made. The US Treasury accepted three kinds of money in tax payments: domestic specie (of which there was little), foreign specie that was granted legal tender status by the US government, and First Bank notes and deposits. The notes and deposits of state-chartered banks were not accepted, requiring individuals and businesses with tax obligations to the US Treasury to keep accounts at the Bank.14 As specie was paid into the US government, it created a credit to the US government’s deposit account with the First Bank, and the specie accumulated in the Bank’s specie reserves. As First Bank notes and deposits were paid into the US Treasury, their ownership was redistributed from private to public holders, and specie was retained within the Bank. If there had been multiple depositories, or if state bank notes had been accepted in payments to the federal government, the specie that accumulated, or was retained, within the banking system would have been distributed across multiple banks, and managed from an individual-bank perspective. Instead, ‘… the specie in the vaults of the bank, … was considered … as an aggregate fund in which the Government and the bank were jointly interested.’15 The second problem with using state-chartered banks, from the US Treasury’s point of view, was that they were oriented toward their state governments and local economies. The federal government needed a bank it could call its own, a bank that would place a higher priority on supporting the debt of the federal government and ensuring the timely collection of federal revenues and payment of federal obligations than on serving the interests of state government and local capital. The very capitalization of the Bank supported the federal government’s credit. The equity capital of the Bank was set at $10m, one-fifth of which was to be held by the US government and four-fifths by private owners.16 Private buyers could pay for up to 75 percent of their shares with new Treasury debt issued in the refunding program. The ability to buy Bank stock with government debt increased the demand for the debt, providing an immediate support to its price after the refunding program was implemented. The demand for First Bank stock was bolstered by the strong earnings record of the three existing state-chartered banks.17 The importance of having a bank of one’s own became immediately apparent. The federal government, newly organized under the Constitution, experienced annual deficits in 3 of its first 5 years, due to the combination of higher military spending and 14. In principle, the state banks could have provided their customers with First Bank notes and deposits, but in practice, their balances with the Bank were small in relation to customs receipts and deposits held by individuals. Wettereau (1985, Consolidated Balance Sheets 1792–1800, pp. 229–284). 15. Holdsworth (1910, p. 53). 16. The ownership structure of the First and Second Banks distinguished them from modern central banks, which are public institutions in non-competitive relationships with privately owned commercial banks. Bank management had to balance the objectives of profit and duty, and its profit motive complicated its relationships with the state-chartered banks. 17. The Bank of North America’s dividend return ranged between 6 percent and 14.5 percent between 1782 and 1792; Lewis (1882, appendix 8). First Bank paid dividends averaged 8.5 percent, over 1791–1811; Holdsworth 1910, p. 122). © 2013 The Author

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slow revenue growth, gaps that were filled through borrowing from the First Bank. Federal government debt to the Bank reached $6m by 1795, which represented 60 percent of the Bank’s capital, causing the Bank’s Directors to become concerned about tying up so much of the Bank’s capital in loans to a single borrower, even if that borrower was the US government. The government responded by selling its own holdings of First Bank stock (much of it to international bankers in London and Amsterdam), and using the proceeds to retire its debt to the Bank.18 The First Bank’s role in strengthening the credit-worthiness of the federal government evolved from direct lending to the government to direct lending to those who were responsible for the bulk of the government’s revenues. During its first 10 years, the First Bank was not a central part of the Treasury’s machinery for the collection of customs revenue. Instead, customs revenues were kept in the hands of the collectors, who issued bonds to the government against future duties. After 1800, the Bank was inserted into the heart of the customs collection process. In the largest ports, revenue bonds were issued by the merchants themselves, then deposited in the Bank of the US and its branches, which collected the proceeds when due on behalf of the Treasury. This resulted in ‘greater punctuality and economy’ in the collection of customs revenue.19 Merchants who defaulted on their revenue bonds were denied further accommodation. However, there was a carrot as well as a stick: merchants who deposited their bonds at the Bank had access to discounting facilities at the Bank if they secured an indorser, which helped the merchants avoid default and helped the government collect revenue in a timely way, as the loan proceeds were immediately credited to the Government’s account.20 The underlying fiscal reorganization must get most of the credit for the vast improvement in the US government’s standing as a borrower, internationally and domestically, between 1791 and 1811, but the supporting role of the First Bank of the US as the government’s fiscal agent also deserves recognition. Despite the fact that the Bank performed up to expectations, it did not survive the political battle of its rechartering and closed in 1811. 3

PUBLIC FINANCE AFTER THE WAR OF 1812 AND THE SECOND BANK OF THE US

The War of 1812 demonstrated the problem with not having a national bank, and with having a public finance system reliant on custom duties as a revenue source: war disrupts trade, which causes customs duties to fall, especially when war is being waged with one’s largest trading partner. Going into the war, customs duties made up over 90 percent of federal revenues. Under the Jefferson administration (1801–1809), the collection of excise and direct taxes was suspended on the grounds that these taxes were burdensome and that their reduction would prevent the development of an oversized central state.21 As a result, when customs duties fell off by 50 percent, or $6m, at 18. Holdsworth (1910, pp. 42–49). 19. Holdsworth (1910, p. 65). According to Holdsworth, the collectors had acted as lenders themselves, securing interest income for themselves, but delaying payment to the Treasury. 20. Holdsworth (1910, pp. 65–66). 21. The Federalists in Congress had argued that it was ‘inexpedient to destroy the administrative machinery organized for the collection of (internal) taxes, which had been brought into good working order through ten years of experience’; Dewey (1903, p. 120). © 2013 The Author

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the same time that military spending increased by $8m, the government was unprepared to collect other kinds of taxes in the near term to pay for the war, and had no source of ready bridge funding. Over 1812–1815, the government spent roughly $120m, collected $50m in receipts, and financed the gap with a combination of long-term securities, bank loans, and Treasury notes.22 By the end of the war, the government increasingly relied on Treasury notes, a form of currency finance, as debt issues were only partially subscribed and sold at deeper and deeper discounts. Treasury notes provided a uniform currency for revenue collection, replacing some of the state bank notes as a circulating medium. The government had suffered losses from having accepted state banknotes at face value for taxes and duties even after they depreciated in value when banks outside of New England suspended specie payments. The real (specie) cost of debt payments to New Englanders rose, as the Treasury had to buy New England banknotes with depreciated notes from other states to pay interest and principal. The larger, interest-bearing Treasury notes were attractive to the banks as reserves, while the smaller notes enjoyed a strong demand since they were legal tender in payments to the Treasury, had convenient denominations for the new excise taxes, and the total quantity issued was small in relation to tax obligations.23 At the end of the War, public credit was in a weakened state: debt had grown from $56m to $127m, and the government had resorted to issuing its own small notes to finance itself and to secure a uniform currency. Although the Treasury notes had been well received by banks and the public at large, Congress and the administration were anxious to withdraw them since most national leaders thought that their issuance was implicitly prohibited by the Constitution.24 The virtues of a national bank were now apparent to national leaders who had waged war without one, and a bill to charter the Second Bank of the US was adopted and signed into law in 1816. The Second Bank was capitalized at $35m, 20 percent of which was to be held by the US government. Of the $28m balance to be subscribed by private individuals or businesses, $7m was to be paid in ‘gold or silver coin of the US, or in gold coin of Spain, or the dominions of Spain … or in other foreign gold or silver coin … and $21m … in like gold or silver coin, or in the funded debt of the United States contracted at the time of the subscriptions respectively.’ The charter also specified the prices at which different US debt issues would be accepted in payment for Second Bank stock; in all cases, these prices yielded a premium of 18–25 percent over their market prices.25 As in the case of the First Bank, the capitalization of the Second Bank retired a significant portion of the government debt and supported the price of the outstanding debt. And, as with the First Bank, the first order of business was to extend a loan to the federal government to cover ‘urgent liabilities,’ and to discount notes of merchants with customs duties to pay.26 The fiscal and monetary purposes of the Second Bank were very similar to those of the First Bank, after which it was modeled. The Bank was a vehicle for collecting 22. Dewey (1903, pp. 131–142). 23. Kagin (1943). 24. That is, that the explicit prohibition of state government issuance of ‘bills of credit’ extended by implication to the federal government as well. 25. Dewey (1910, pp. 268–269). In Boston, the 6 percent coupon bonds were accepted at par, or $100 for every $100 of face value, and had a market price of 80; the 3 percent coupon bonds, at $65 and had a market price of $50–$55; and the 7 percent bonds, at $106.51 when their market price was $90. Martin (1969, p. 14). 26. Catterall (1902, pp. 453–454). © 2013 The Author

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federal revenue, for supporting the public debt, and for concentrating the nation’s specie stock in a place accessible to the central government. Fulfilling these tasks was more challenging for the Second Bank than for the First Bank in two regards. The first challenge facing the Second Bank lay in differentiating between strong and weak state-chartered banks. The state-chartered banking system had grown significantly after the demise of the First Bank; in 1820, Second Bank notes and deposits were only 13 percent of all notes and deposits, compared with the First Bank’s 24 percent share in 1810, and in many places there were no Second Bank branches, so it would be difficult to avoid the use of state banknotes in federal tax payments altogether.27 It took a few years for the Second Bank and the Treasury to come to agreement on the treatment of state banknotes in payments to the Treasury. Initially, the federal government received payment for taxes and land sales in any and all state banknotes, which were deposited with Second Bank branches to the credit of the Treasurer at full par value. Not all state banks were able to clear these debts to the Second Bank, resulting in losses to the Bank. After that, the Second Bank accepted only the notes of certain specified state banks identified by the Treasury in payments to, and at the risk of, the Treasury. By 1826, almost all federal revenues were received as Second Bank notes and deposits, and federal spending was carried out with warrants drawn on Treasury deposits at the Bank. As with the First Bank, the Second Bank’s role as the federal government’s fiscal agent tended to concentrate specie holdings with the Bank. Between 1820 and 1834 (when the Jackson administration started moving Treasury deposits out of the Bank), the Bank held 34 percent of all specie in the banking system but issued only 22 percent of all notes and deposits held by the Treasury and the nonbank public. The second challenge rose out of the growth in the geographic scope of the national government and the national economy in the 1810s. With the western expansion of territory and population, federal receipts and expenditures were more spatially dispersed than they had been in the First Bank period, when the majority of the federal government’s receipts and outlays were located in the major port cities. In 1791–1811, customs revenues averaged 91 percent of total receipts and were collected in the major port cities of the eastern seaboard; interest averaged 40 percent of total outlays, and was payable primarily in the major port cities, home to the majority of domestic owners of US debt.28 Although customs duties still comprised the lion’s share of all revenues in 1816, there were over 9000 points throughout the nation where revenue was collected, including land offices, post offices, receivers of internal revenue, federal marshals, and clerks and courts. Expenditures were less concentrated in debt service as the federal government progressively retired its debt in the 1820s, and were consequently more dispersed spatially.29 Given the high transportation costs prior to the development of canals and railroads, transferring federal revenues between cities was a potentially costly proposition for the Bank, particularly when it came to the transmission of small amounts over long distances. The Bank made collections and payments for the federal government using its branch network, which, with branches and agencies in both the major eastern seaboard cities and in interior cities, matched the geographic scope of the national government. The branch 27. Historical Statistics of the U.S., Table Cj7-21, p. 248. 28. Author’s calculations from annual federal budget data in Dewey (1903). Ferguson (1961) shows that ownership of the public debt had concentrated in the commercial centers over the course of the 1780s. 29. Interest made up 28 percent of federal outlays in 1820, and 12.5 percent in 1830. © 2013 The Author

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network was an effective infrastructure for managing payments and receipts between the federal government and the private sector and for transferring funds within the federal government, but it represented a large fixed cost for the Second Bank. During the Bank presidency of Nicholas Biddle (1823–1836), the Bank dealt with this problem by identifying ways to generate revenue from the ‘domestic exchanges,’ the contemporary term for the instruments, markets, and institutions that merchants used to move funds over long distances in an era when the notes and deposits of state-chartered banks did not circulate outside of their immediate market area. The Bank’s exchange business included the purchase of bills of exchange at discounts from face value and the sale of drafts on Second Bank branches at premia over face value within its own branch network; the collection of bills that were payable at banks outside of its branch network for a fee; and the sale of drafts, at a premium, drawn on banks outside of its branch network. In this way, the expenses associated with the transfer of governmental funds were covered by revenues associated with services of value to merchant groups operating across state lines, and that entailed the same collection-and-remittance functions required for Treasury transfers. After the crisis of 1825–1826, the Bank moved aggressively into the foreign exchange business as well, which provided another revenue source to cover the Bank’s significant investment in overhead.30 During the battle for rechartering at the end of his term as President, Biddle told Congress that ‘no facilities of traveling and transportation can so completely abridge the wide spaces which separate the parts of this extensive country, as the removal of those great barriers which the want of easy commercial exchanges interpose to their prosperity.’31 Moving funds was most expensive when it had to be done with specie. In the early 1820s, the cost of shipping specie from Cincinnati, Ohio (where receipts from western land offices were collected) to New York was 4 percent of the dollar value shipped.32 The average cost of shipping gold between New York and London in 1821–1830 was 1.5 percent for exports from New York, and 2.2 percent for imports into New York.33 In its exchange operations, the Bank had a strong motivation to supply paper exchange, and to keep its cost inside the ‘specie points,’ so as to avoid the expense of shipping specie on government account either between cities within the US, or between the US and its foreign creditors in England and Europe. The Bank succeeded in keeping the price of paper exchange, domestic and international, well within specie points between 1823 and 1834, when the Bank began to wind down. While Biddle may have gone too far in his claim that the Bank’s management of long-distance payments did more to reduce barriers to trade than transportation improvements such as steamboats, canals, and the packet lines along the Atlantic coast, the Bank did promote monetary integration and internal market formation, providing the basis for sustained growth in per capita income in the nineteenth century US. This is a prime example of the broader social purposes which quasi-public monetary institutions can serve. The federal government chartered the Bank so that it would assist its own fiscal operations and provide a uniform currency; in doing so, the Bank went well beyond this purpose to become a powerful instrument for national economic integration.

30. 31. 32. 33.

Knodell (2003). Govan (1959, p. 86). Knodell (1998, appendix). Officer (1996, p. 129).

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4

HOW THE FIRST AND SECOND BANKS’ FISCAL FUNCTIONS DREW THEM INTO MONETARY STABILIZATION

As shown above, the designation of the First and Second Banks as the government’s fiscal agent, and of their notes and deposits as legal tender in payments to the federal government, drew specie to these Banks. These Banks were the largest, and tended to be the most liquid, banks in the system. Once the specie was in their vaults, these institutions took actions to preserve their own holdings, to prevent drains out of the banking system or the national economy, and to provide liquidity assistance to individual banks, sometimes in coordination with the US Treasury or, in the case of the First Bank, at the direction of the US Treasury. The First and Second Banks both maintained reserve ratios that were higher than those of the state-chartered banking system, on average, lowering the average rate of credit expansion. Reliance on customs duties for federal revenues, combined with use of the Banks as fiscal agents of the federal government, created an automatic monetary stabilizer. During cyclical expansions, imports tended to rise, causing import duties to rise and bank deposits to shift from the state banks to the First or Second Bank, and the overall reserve ratio to rise. Conversely, the overall reserve ratio would fall during contractions in imports and income. By having higher reserve ratios, the Banks tended to stay in a net creditor position vis-à-vis the state banks, which protected them from having to pay out specie to the state banks to clear interbank debt. In his work on the First Bank of the US, David Cowen argued that, in 1791–1811, the US Treasury was actually the central banker, and that the Bank implemented the Treasury’s policy.34 Cowen bases his conclusion on the fact that the Treasury supervised all banks and interacted with all banks, while First Bank branches interacted only with state banks in their local markets. He also provides a number of examples of the Treasury directing the Bank to exercise forebearance with specific state banks in interbank clearing, and of the Treasury, not the Bank, making direct extensions of credit to individual state banks in distress.35 In comparison, the Second Bank of the US was more independent of the Treasury. Under the direction of the head office of the Bank, the branches established regular interbank settlement in cities where they were located, and accepted only the notes of ‘specie-paying banks,’ as designated by the Treasury, in payments to the Treasury. When these notes were deposited, they were promptly returned to the local issuing bank for clearing into specie or its equivalent (the Bank’s own notes or Treasury notes, if available). In the 1820s, the Bank refrained from taking arbitrage profits on its gold holdings, in contrast to the behavior of private agents. Throughout the 1820s, the US was nominally on a bimetallic standard (convertibility of the US dollar into both gold and silver), but effectively on a silver standard.36 The international price of gold rose above the domestic price (set in 1792 and not adjusted until 1834) by enough to cover the cost of shipping gold, and then some, creating the incentive for domestic merchants to make foreign payments in gold or for domestic foreign exchange dealers to earn 34. Cowen (2000). Cowen’s view is that the Treasury and the Bank worked ‘together in a principal/agent relationship with the Treasury in the lead as the central banker and the BUS as the central bank, with both parties aware of the ramifications of their actions’ (p. 160). 35. Cowen (2000, pp. 153 and 157). The Treasury extended credit by depositing checks drawn on its account with the First Bank at the banks with liquidity stresses, on the understanding that the Treasury would not draw on these accounts until the banks were able to cover them. 36. Martin (1968). © 2013 The Author

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arbitrage profits through a combined transaction in foreign exchange and gold. By the end of the 1820s, all of the remaining stock of gold was held by the Second Bank of the US. Further, the Bank restricted credit to exchange dealers and sold government debt to prevent the export of specie by dealers.37 This behavior reveals the Bank’s priority on preventing specie exports whenever possible. In terms of national economic stabilization, the Second Bank took its cue from the sterling exchange market to indicate when a change in the pace of credit creation was called for. When sterling exchange started rising above the specie export point, the Bank sold sterling bills of exchange, which financed the external deficit in the first instance and moved the Bank into a larger net creditor position vis-à-vis the state banks in the second instance, compelling them to reduce their own lending. Sales of foreign exchange exerted a contractionary effect on money and credit, much the same as open market sales of government securities by the Federal Reserve.38 Given the high import content of bank credit-financed spending, reduced bank lending reduced private domestic demand for sterling exchange. The ultimate purpose of these operations was to protect the national stock of specie, which served the fiscal goal of ensuring timely payment in specie on government obligations held abroad, and, as a by-product, exerted a stabilizing effect on the expansion of money and credit as well. 5

THE CONTRAST WITH THE FEDERAL RESERVE, AND A CONCLUSION

In contrast with the First and Second Banks of the US, the US Federal Reserve System (1913–present) was created after a sequence of bank panics in 1873–1907 coalesced public opinion around the need for an institution that would lend to banks during periods of monetary stringency, providing an ‘elastic currency’ for the national economy. Unlike the charters of the early US ‘central’ banks, which directed them to serve as fiscal agent for the central government, the Federal Reserve Act said that the US Treasurer ‘may’ deposit money in the general fund of the Treasury in the Federal Reserve banks, which banks, ‘when required,’ shall act as fiscal agents of the United States.39 Two years after adoption of the Federal Reserve Act, the Treasury Secretary did designate the Federal Reserve Banks as fiscal agent of the US government. After entry into World War I, the Reserve Banks quickly became deeply involved in the financing of the World War I effort. This was the first war mobilization in the US in which the federal government had a central bank to assist with financing the war. The Reserve Banks played a leadership role in the Liberty Bond marketing campaign, and created a discounting facility under which member banks could borrow to finance customers’ purchases of Liberty Bonds.40 The early US central banks were created to fix public finance problems, not banking instability problems. Their functions as fiscal agents for the US government were front and center in their charters, which were silent as to these banks’ monetary stabilization purposes. However, as shown here, the public finance and fiscal functions of the First and Second Banks inevitably positioned these institutions to play a regulatory role vis-à-vis the state-chartered banks, their competitors, and to take actions to protect 37. 38. 39. 40. war

Govan (1959, pp. 96–98). Parsons (1977, ch. 5). Chapman (1923, p. 44). See Garbade (2012, ch. 6), on the role of the Federal Reserve Banks in the marketing of bonds.

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and preserve the nation’s stock of specie, which represented both outside money for the domestic banking system and the means for maintaining the US government’s credibility as an international borrower.

REFERENCES Carter, Susan B., Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead, Richard Sutch, and Gavin Wright, eds. 2006. Historical Statistics of the United States (Millennial Edition On Line, Cambridge University Press). Catterall, Ralph C.H. 1902. The Second Bank of the United States (Chicago: The University of Chicago Press). Chapman, John M. 1923. Fiscal Functions of the Federal Reserve Banks (New York: The Ronald Press). Cowen, David. 2000. The Origins and Economic Impact of the First Bank of the U.S., 1791–1797 (New York: Garland Publishing). Dewey, Davis Rich. 1903. Financial History of the United States (New York: Longmans, Green). Dewey, Davis R., for the National Monetary Commission. 1910. The Second United States Bank (Washington: Government Printing Office), 61st Congress, 2nd Session, Sen. Doc. No. 571. Edling, Max M. and Mark D. Kaplanoff. 2004. ‘Alexander Hamilton’s Fiscal Reform: Transforming the Structure of Taxation in the Early Republic.’ The William and Mary Quarterly, 61 (4), 713–744. Ferguson, E. James. 1961. The Power of the Purse (Chapel Hill: The University of North Carolina Press). Garbade, Kenneth D. 2012. Birth of a Market: The U.S. Treasury Securities Market from the Great War to the Great Depression (Cambridge, MA: MIT Press). Govan, Thomas Payne. 1959. Nicholas Biddle; Nationalist and Public Banker, 1786–1844 (Chicago: The University of Chicago Press). Gras, N.S.B. 1937. The Massachusetts First National Bank of Boston, 1784–1934 (Cambridge, MA: Harvard University Press). Holdsworth, John Thom. 1910. The First Bank of the United States. Published as Senate Doc. No. 571, 61st Cong., 2nd Sess. Kagin, Donald H. 1943. ‘Monetary Aspects of the Treasury Notes of the War of 1812.’ The Journal of Economic History, 44 (1), 69–88. Knodell, Jane. 1998. ‘The Demise of Central Banking and the Domestic Exchanges: Evidence from Antebellum Ohio.’ The Journal of Economic History, 58 (3), 714–730. Knodell, Jane. 2003. ‘Profit and Duty in the Second Bank of the United States’ Exchange Operations.’ Financial History Review, 10 (1), 5–30. Lewis, Laurence. 1882. A History of the Bank of North America (New York: J.B. Lippincott). Martin, David A. 1968. ‘Bimetallism in the United States before 1850.’ The Journal of Political Economy, 76 (3), 428–442. Martin, Joseph G. 1969. Martin’s History of the Boston Stock and Money Markets (New York: Greenwood Press). McKee, Samuel. 1957. Alexander Hamilton’s Papers on Public Credit, Commerce and Finance (New York: The Liberal Arts Press). Officer, Lawrence H. 1996. Between the Dollar–Sterling Gold Points (Cambridge, UK: Cambridge University Press). Parsons, Burke Adrian. 1977. British Trade Cycles and American Bank Credit (New York: Arno Press). Wettereau, James O. 1937. ‘New Light on the First Bank of the United States.’ The Pennsylvania Magazine of History and Biography, 6 (3), 263–285. Wettereau, James O. 1985. Statistical Records of the First Bank of the United States (New York: Garland Publishing). © 2013 The Author

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Review of Keynesian Economics, Vol. 1 No. 3, Autumn 2013, pp. 300–313

A shackled revolution? The Bubble Act and financial regulation in eighteenth-century England William E. McColloch Lewis and Clark College, Portland, Oregon, USA

Revisionist estimates of growth rates during the British industrial revolution, though largely successful in presenting a more modest picture of Britain’s ‘take-off’ prior to the 1830s, have also posed fresh analytical difficulties for champions of the new economic history. If eighteenth-century Britain was witness to a diffuse explosion of ‘useful knowledge,’ why did aggregate growth rates or industrial output growth rates not more closely shadow the pace of technological change? In an effort to explain this paradox, Peter Temin and Hans-Joachim Voth have claimed that a few key institutional restrictions on financial markets – namely the Bubble Act, and the tightening of usury laws in 1714 – served to amplify the crowding-out impact of government borrowing. Against this vision, the present paper contends that the adverse impact of financial regulation and state borrowing in eighteenth-century Britain has been greatly overstated. To this end, the paper first briefly outlines the historical context in which the Bubble Act emerged, before turning to survey the existing diversity of perspectives on the Act’s lasting impact. It is then argued that there is little evidence to support the view that the Bubble Act significantly restricted firms’ access to capital. Following this, it is suggested that the ‘crowding-out’ model, theoretical shortcomings aside, is largely inapplicable to eighteenth-century Britain. The savingsconstrained vision of British capital markets significantly downplays the extent to which the Bank of England, though founded as an institution to manage the public debt, provided the entire financial system with liquidity in the eighteenth century. Keywords: Bubble Act, Bank of England, financial regulation, industrialization JEL codes: N13, N23, O43, E44

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INTRODUCTION

Within the heterodox literature there is no shortage of lamentations that the experience of the ‘Great Financial Crisis’ failed to prompt a sober reassessment of neoliberal policy prescriptions. That a restructuring of mainstream economic theory did not materialize is undoubtedly disappointing, but something less than unexpected, mainstream economic theory having long since shown itself to be impervious to many of the features of reality. It would appear that the crisis has, however, lent renewed vigor to certain, otherwise arcane, research agendas in economic history. The hope, it seems, is that if the experience of the past 3 decades offers limited testimony to the virtues of deregulation, more distant history might speak in its stead. Here, as ever, Britain’s experience of © 2013 The Author

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industrialization is made to serve as the first proving ground for competing models of long-run growth. Revisionist estimates of growth rates during the British industrial revolution, though largely successful in presenting a more modest picture of Britain’s ‘take-off’ prior to the 1830s (Crafts and Harley 1992), have also posed fresh analytical difficulties for champions of the new economic history. If eighteenth-century Britain was witness to a diffuse explosion of ‘useful knowledge’ (Mokyr 2002), why did aggregate growth rates or industrial output growth rates not more closely shadow the pace of technological change? While languid aggregate growth rates over the period are often explained as the consequence of a dual economy in which the relatively stagnant agricultural sector remained dominant, the pace of manufacturing growth remains somewhat of a puzzle. In an effort to resolve this puzzle, a host of authors (Williamson 1984; Black and Gilmore 1990; Temin and Voth 2005) have suggested that British government borrowing crowded out private investment, and stifled what otherwise would have been a more robust industrial revolution prior to 1830. More recently, Peter Temin and Hans-Joachim Voth (2013) have offered a somewhat refined version of this argument. Specifically, they have claimed that a few key institutional restrictions on financial markets – namely the Bubble Act,1 and the tightening of usury laws in 17142 – served to amplify the impact of government borrowing, and ‘ensured that Britain experienced a revolution in public borrowing that harmed private finance more than it helped’ (ibid. 2013, p. 158). In this view, the rapacious demands of wartime borrowing fell upon a financial sector whose lending was already limited in scope, given its inability to exact risk premiums in the face of a statutory maximum interest rate. Further, the contention is that the Bubble Act, from its introduction in 1720 to its repeal in 1825, greatly limited the expansion of the joint-stock corporate form by forcing prospective limited liability corporate bodies to obtain a charter from Parliament, and thus denied many nascent firms access to a broad share market in which their stock would be freely transferable. The financial revolution of the eighteenth century, far from constructing some of the necessary conditions for the industrial revolution, is reduced to a case study of the consequences of over-zealous financial regulation. Against this vision, the present paper contends that the adverse impact of financial regulation and state borrowing in eighteenth century Britain has been greatly overstated. To this end, the paper first briefly outlines the historical context in which the Bubble Act emerged, before turning to survey the existing diversity of perspectives on the Act’s lasting impact. It is then argued that there is little evidence to support the view that the Bubble Act significantly restricted firms’ access to capital. Following this, it is suggested that the ‘crowding-out’ model, theoretical shortcomings aside, is largely inapplicable to eighteenth century Britain. The savings-constrained vision of British capital markets significantly downplays the extent to which the Bank of England, though founded as an institution to manage the public debt, provided the entire financial system with liquidity in the eighteenth century.

1. 6 Geo I, c.18, passed by Parliament on June 9 of 1720. 2. The statute, formally titled ‘An Act to reduce the Rate of Interest, without any Prejudice to Parliamentary Securities,’ which lowered the maximum rate of interest that could be charged on a loan, was passed by Parliament in 1713 (13 Anne, c.15), but took effect on September 29 of 1714. © 2013 The Author

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THE ORIGIN OF THE BUBBLE ACT

The cursory outlines of the South Sea Bubble have become an increasingly familiar story in the wake of the crisis of 2008, and a brief outline of the Bubble’s origins may suffice. The budget of the English state had expanded markedly in the latter half of the seventeenth century, from £2.3 million in 1668 to £5.6 million in 1692, of which nearly a fifth was borrowed (Carswell 1960, p. 22). In light of the limited success of the tontine lotteries and financial ‘innovations’ in raising funds, alternative proposals for the Crown’s finances found a ready audience. Viewed at the time as a temporary institution born out of short-term need, the Bank of England had been granted a Royal charter as a joint-stock company in 1694 on the basis of its assumption of £1.2 million of the Crown’s debt. The Bank and its subscribers were to receive interest of 8 percent in perpetuity, with the Bank being forbidden to make additional loans to the Crown without Parliamentary consent (Clapham 1944 [1966], p. 18). Though Parliament was not initially confident that the Bank would find subscribers for its shares, the initial offering was filled with ‘contemptuous ease’ in the span of 10 days (Dickson 1967, p. 55). The Bank’s directors, like those of the established East India Company, were predominantly Whigs. Anxious to replicate the success of the Bank, Tory-supported schemes to manage the public debt quickly proliferated. The Bank had to contend in its first years of existence with a variety of aspirant rivals, from displaced goldsmith banks to Barbon’s land bank. Though these challengers regularly lobbied Parliament for incorporation offering the state more generous terms, they typically succeeded only in forcing the Bank to match their terms. Wary of its potential competitors, the Bank eventually gained a more secure footing with the so-called Ingraftment Act of 1697. As a consequence of the Act, the Bank agreed to take on a unlimited number of new subscribers, and to accept from them as payment government tallies at par value. The Bank was then to receive 8 percent interest on these ‘ingrafted’ tallies. Crucially, the Act also granted the Bank a temporary monopoly, as it prohibited the chartering of any additional banks until August of 1710 (Clapham 1966, pp. 48–50). The security yielded to the Bank by the Ingraftment Act was, however, to be fleeting. Among the rival start-ups that continued to emerge, the Sword Blade Company (SBC) was perhaps the most prominent. While the SBC had begun its history as a manufacturer of hollow sword blades, it had long since outgrown its name and formal charter. By the turn of the century the original charter of the SBC had been sold, and the Company was ‘restructured’ as a financial institution. As a result of the Glorious Revolution, landowners that had remained loyal to James II were expropriated by William of Orange, with the new King choosing to bequeath these estates to his personal favorites. After some political uproar, initiated in part by principal shareholders of the SBC, the King was forced to cancel these land grants and to resell the estates at auction in 1702, where the SBC was a significant buyer. We should note that the payment received by the Crown in this ‘auction’ was that the SBC funded some £200 000 in back pay due to the Army, by exchanging the Crown’s debentures for Sword Blade stock. On the basis of these newly acquired assets, the SBC emerged as a land bank, discounting notes, as well as issuing short-term mortgages, along with banknotes, much to the displeasure of the Bank of England (Sperling 1960). The true encroachment of the Sword Blade Company in the Bank of England’s territory did not finally occur until the second decade of the eighteenth century. In 1710, England marked its eighth year of engagement in the War of Spanish Succession, the debts from which Marlborough largely financed through rising direct taxation, much © 2013 The Author

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of which was borne by the predominantly Tory landowning classes. As Tory criticism of Marlborough’s management of the War rose, many of the State’s previously reliable sources of credit began to dry up. Moreover, a particularly severe winter and harvest failure in 1709 led to a Continent-wide downturn, and a more general scarcity of credit. The ascension of Robert Harley to the position of Lord Treasurer, and the election of a new Tory Parliament that viewed with reproach the significant debts the previous Parliament had incurred through the Bank of England, initiated the transformation of the SBC into the State’s primary financier. Harley, in particular, brought the level of the State’s debt to Parliament’s attention through the accounting inquiries he undertook shortly after acquiring his new position.3 From this point on, the SBC took a leading role in the organization and management of the State’s lotteries, which garnered renewed interest through the payment of higher and higher effective rates of interest. In a broader sense, the transition in 1710 between Whig and Tory Parliaments can be seen as a contest between rival financial interests, with Whig interests lying in the Bank of England and Tory interests with the SBC. Some tangible evidence of Parliament’s shifting financial allegiances is offered by David Stasavage (2003, pp. 83–84) who argues that the Tory electoral victory caused a nearly immediate and dramatic fall in the Bank of England’s share prices prior to any of the proposals for the South Sea Company. Moreover, the Bank’s share price remained depressed for nearly 4 years, not returning to its pre-Tory heights until 1714. Still, the funds raised through lotteries reflected only a small fraction of the debt the Crown continued to incur, and a longer-term solution to secure the sustainability of the public debt was sought. Mirroring the basic model upon which the Bank of England was founded, a new joint-stock company – the South Sea Company (SSC) – was chartered to essentially refinance the Crown’s existing floating debt. Championed by Harley, and other Tory MPs, the proposed company was met with ridicule and violence from Whig opposition, though the Tory majority ensured that the charter was never truly in doubt.4 Parliament eventually carried the proposal in late May of 1711. In total, the SSC assumed ₤9 million of the State’s floating and unsecured debt, which was traded on par with shares in the newly created company. In exchange, the company was to receive interest payments of 6 percent from the Exchequer; a rate well below what had been paid on recent lotteries (Carswell 1960, p. 45). Further, the fact that this massive issue of public debt was, for nearly a decade, successful magnifies the historical significance of the SSC from our vantage. Despite this bitter opposition, the Tory majority in Parliament eventually carried the proposal in late May of 1711. The chartered joint-stock company, though it was also granted a monopoly over the British slave trade with the Spanish colonies of the Americas, showed relatively little interest in developing the trade.5 Aping the Bank’s proven and lucrative model of state finance was always the SSC’s true ambition. Plainly, not one member of the SSC’s board of directors had any experience in the slave trade. Trade in the SSC’s shares throughout its early years clearly testifies to public skepticism with regard to the profitability of the slave trade. For over 5 years from the first issue of the company’s stock its value lingered well below the par value of the State debt assumed by the company, 3. Harley’s survey placed the total level of the State’s floating debt, extending back to the reign of William of Orange, at some ₤9.5 million (Sperling 1960, p. 3). 4. Harley was, in fact, stabbed while making his proposal to Commons. It was only during his recovery that the plans for the creation of the SSC were finalized. 5. It should be noted that the company did eventually manage the transportation of slaves to the Americas in significant numbers, even in the wake of the Bubble’s collapse (Paul 2004). © 2013 The Author

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and there was little expectation that the company could hope for anything more than the 6 percent paid by the Exchequer.6 Though there is no reason to believe that Harley or the other architects of the SSC foresaw the financial ruin that the scheme was to bring, from the beginning there was little expectation that the SSC would be anything other than a shell-company for the State’s debt. The final expansion of SSC involvement in state finance seems clearly to have drawn from the exploits of John Law and his management of the French State’s finances. As one English observer of Law’s ‘financial innovations’ noted, ‘[b]y the success of Mr. Law’s projects the public debt is paid off at a single stroke and the French King remains master of an immense revenue and credit without bounds’ (Carswell 1960, p. 95).7 In 1719, the SSC proposed to Parliament the conversion of the entirety of the state’s outstanding annuities into SSC stock. Though the Bank of England was also permitted to bid on the conversion, and was successful in thwarting the SSC’s attempt to convert the debt the Bank had already assumed, the SSC was eventually granted the right to convert more than £30 million worth of debt, both redeemable and irredeemable (Paul 2010, p. 45). The final proposal was approved in February of 1720, and the SSC agreed to pay up to £7.5 million for the privilege, depending on the quantity of annuities successfully converted. It was only once it had seemingly emerged as the state’s preeminent financier that the speculative mania came in 1720 to surround the SSC, and the British market for joint-stock shares generally. Importantly for the SSC, the profitability of the venture depended on its share price. The higher the SSC’s market valuation, the fewer would be the shares necessary to exchange with the government’s annuitants. Further, a rising market in SSC shares made it easier for the company to attract holders of irredeemable state debt, and carried the clear promise of higher returns to the Company’s share issues to the open market (Dickson 1967, pp. 100–101). 3

MOTIVATION FOR THE BUBBLE ACT

While a substantial literature surrounds the origins and history of the South Sea Bubble, it is difficult to point to a consensus regarding the intent and effects of the Bubble Act of 1720. A survey of the existing literature reveals at least three distinct interpretations of the Act. The surprisingly durable but least substantiated of these interpretations holds that the Bubble Act reflected a hasty response by Parliament to the rising tide of speculative activity, or ‘stock-jobbing.’8 Though this reading has sometimes mistakenly 6. Here it is worth noting that the administrative task of converting the State’s floating debt into SSC stock was an involved administrative task that took nearly 2 years (Dale 2004, pp. 46–47). 7. Indeed, the South Sea Company and Law’s experimentation in state finance mutually conditioned each other throughout their respective histories. Law initially patterned his Mississippi Company after the SSC, though his company did earnestly pursue its commercial ambitions to a greater extent (Dale 2004, pp. 65–71). Proceeding from the other direction, John Law’s ambitious scheme seemed to prove that the expansion of public debt should no longer be treated as a grave development, but rather that such debt could even serve as the basis for new and highly profitable commercial ventures. While Law certainly enjoyed a degree of centralized power over the State incomparable with that wielded by the SSC, the basic point to be made is that the historical coincidence of the two schemes was far more than that (Garber 1990). 8. Niall Ferguson is perhaps the most prominent adherent to this view, claiming in a 2009 New York Times op-ed that the Bubble Act is the ‘classic example’ of the ‘usual response to introduce a raft of new laws and regulations designed to prevent the crisis from repeating itself.’ © 2013 The Author

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gained traction, the historical reality is that the Bubble Act was passed on June 9 of 1720, well before the Bubble’s peak in August of that year. Beyond this basic problem of dating, the Bubble Act has been interpreted by some authors as a reflection of public distrust in the principle of limited liability. Even some frequent critics of orthodox understandings of the State’s role in development, such as Ha-Joon Chang, uncritically accept this point.9 Such a reading is little more than a refashioning of the largely discredited view that the Bubble Act was meant to curb speculation in general. Certainly there were members of Parliament that appreciated some of the dangers of the speculative mania they were witnessing, though this was undoubtedly a minority. Among these opponents of speculation, Archibald Hutcheson was arguably the most prominent. Hutcheson was evidently quite active as a pamphleteer, writing primarily on economic matters, and warned of the growing burden of the national debt. Generally, he advocated for extinguishing the national debt as quickly as possible by means of sinking funds. To this end, earlier in his Parliamentary career he promoted a plan to pay off the debt on the basis of a broadly applied flat 10 percent tax on property (Paul 2012). Favoring his own approach, Hutcheson was a critic of the South Sea Company from the first. As the bubble surrounding the SSC inflated over the course of the Spring and Summer of 1720, Hutcheson had warned of impending collapse, writing that ‘[t]he Managers of the South Sea Scheme appear to me to have copied exactly after the French Mississippi in all the steps which have been hitherto taken … Is there not, therefore, reason to fear, that the parallel will happen throughout?’ (Hutcheson 1721, p. 65). Hutcheson later served as a member of the committee in the House of Commons that drafted the text of the Bubble Act, and if his approach had prevailed, a stronger regulatory structure could likely have taken shape. He argued that there was already ample legislation governing incorporation, and that what was truly necessary was a new regulatory body that would have controlled ‘stock-jobbing’ and reined in the excesses of the SSC and others (Dale 2004, p. 135). Though such regulation may well have been warranted, Hutcheson lacked the influence to carry his proposals, and his voice cannot be said to have contributed substantially to the clauses of the Bubble Act. Other authors, seeking to frame the Bubble Act within public choice theory, argue that the Act reflected the opportunism of Parliament. Margaret Patterson and David Reifen (1990) claim that the Act was meant to increase Parliamentary revenues as more companies would be forced to seek Parliamentary approval for their charters, and perhaps offer concessions to the fiscal demands of the State. They suggest that the primary means available to Parliament in claiming a share of corporate profits was through the chartering fees it charged. As many joint-stock companies in the early eighteenth century obtained their charters secondhand from failed joint-stock companies, this source of revenue was increasingly circumvented. Thus, ‘Parliament had not anticipated a used-charter market, it had not extracted a payment for the “salvage value” of a charter when the charter was originally granted’ (ibid, p. 168). Moreover, as a greater number of firms entered the market, opportunities for profit were eroded, and the share of profits Parliament could lay claim to was diminished. The principal difficulty with this interpretation is the near absence of prosecutions under the Bubble Act. Had Parliament’s basic motive in passing the Act been to raise its own revenues, one would expect the record of prosecutions under the Act 9. Chang notes that ‘[limited liability] was also believed, with some justification, to be an important cause of financial speculation. Britain banned the formation of new limited liability companies on these grounds with the Bubble Act in 1720’ (Chang 2003, p. 85). © 2013 The Author

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to be far more voluminous than it, in fact, is. Beyond this, Patterson and Reifen display either naïveté or wilful ignorance with regard to the history of the South Sea Company. As we have argued, Parliament had found the Bank of England and the SSC to be ready instruments for the assumption of any debt they could accrue. The basic advantage of these mechanisms was that they offered far lower debt-servicing burdens for Parliament. Thus, the notion that Parliament faced a budgetary crisis, and saw a revival of legal chartering as a means to solve it, appears to stretch credibility. The most accurate reading of the Bubble Act is that it was passed at the behest of the SSC’s board of directors in order to draw investment away from the SSC’s competitors and maintain the momentum of SSC shares. This position was clearly articulated by John Sperling who found that ‘[t]here is good reason to believe that the Act resulted from the lobbying of the South Sea directors who wished to cut off speculation in these companies because it drew money out of the market in South Sea stock’ (1960, pp. 31–32). Support for this position is also found in Carswell (1960), and more recently and stridently by Ron Harris (1994). The interpretive difficulty lies in the fact that the Bubble Act did herald the collapse of the South Sea Bubble, despite having been passed with the opposite intent. The speculative frenzy was not limited to SSC shares alone, as several hundred newly-formed joint-stock firms, only some of which had legitimate commercial aims, emerged in the first 6 months of 1720. Harris (2000, p. 62) estimates that at the bubble’s peak a nominal capital of £224 million had been invested. By the early summer of 1720, SSC shares had nearly peaked, but there was little to suggest that any collapse in share price was imminent. In fact, many investors were eagerly awaiting the payment of substantial dividends, having been assured by the Company that its finances were unassailable. Well before any prosecutions of the SSC’s competitors were initiated, the passage of the Act seems to have given rise to anxiety among the Company’s investors. Even before the Act had formally passed, SSC shares began to slip. Prices were, however, quickly revived by the announcement of a new subscription that required only 10 percent down on the share price, with a second 10 percent payment not due for another 6 months. Investors could thus bank on an increase in SSC shares to make their future payments, and given this incentive SSC shares rose to their ultimate peak between late June and early August of 1720. In the first weeks of August, SSC stock began to drift downwards once again, but without any precipitous drop. However, on August 18, following continued pressure from the SSC directors, writs of scire facias where brought against several of the SSC’s smaller competitors for violating clauses of the Bubble Act (Sperling 1960, p. 32). These companies were targeted at the insistence of the SSC’s directors, and were perceived to have been diverting investment away from the SSC itself. The initiation of these legal proceedings brought a rapid fall in the share prices of these companies and set in motion a process of de-leveraging. As the general bubble in London markets had been driven by highly leveraged buying and a steady inflow of foreign capital, the collapse of share prices in even a small portion of the market had contagion effects and spurred rapid capital flight. SSC share prices soon began their irreversible downward slide, and by September the Company’s liabilities exceeded its assets by some £3 million. As the turbulent year closed, SSC stock had returned roughly to par with the original State debt the Company had assumed, and various proposals for the punishment of the SSC directors, and remuneration of the Company’s ruined shareholders, were being floated. An attentive reading of the historical record draws one, unavoidably, to the conclusion that the Bubble Act was never meant to curb joint-stock speculation in general. Instead, the Act is best seen as a last-ditch effort on the part of the SSC’s directors © 2013 The Author

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to perpetuate their scheme with the aid of their long-standing alliance with Tory elements of Parliament. In the preceding discussion we have argued that by the closing decade of the seventeenth century there was a newfound willingness on the part of the English Crown and Parliament to explore new means of state finance. The creation of the Bank of England represented the first successful venture to spread large portions of the Crown’s debt to the public. Put another way, state debt truly became public debt for the first time as debt instruments were both sold to the general public, and guaranteed not by the King but by Parliament and its tax revenues. As factions of Parliament came to a greater apprehension of the potential profits of joint-stock companies founded on public debt, and military debts continued to mount, competitors to the Bank of England’s monopoly arose. The Bank of England owed its privileged position, fundamentally, to Whig support. Consequently, the shift in Parliamentary power to the Tories in 1710 saw the rise of the Sword Blade Bank as the state’s new financier. The SSC, having been incorporated by the principal investors of the Sword Blade Bank, was very much Parliament’s creation as well. Thus, the Bubble Act was a futile attempt by Parliament to preserve its own interests. There was, no doubt, significant public outcry against the pernicious effects of speculation following the collapse of the South Sea Bubble. Understandably then, the casual student of the Bubble Act might be persuaded that it represented an earnest attempt at financial regulation. A more careful study leaves no room for this interpretation. 4

THE IMPACT OF THE BUBBLE ACT

That the Bubble Act was passed at the behest of the SSC does not, of course, automatically imply that it had no lasting effects on the process of industrialization. Though unchartered corporate partnerships developed throughout the 100-odd year period that the Act remained law, partners in these companies did not enjoy limited liability, possibly limiting the number of investors that could be attracted to industrial ventures. Indeed, Temin and Voth (2013) are not alone in elements of this supposition, despite being more forceful in their conclusions. Alfred Marshall10 (1919) and Armand DuBois (1938) long ago suggested that the more widespread adoption of the jointstock form was markedly constrained by the Act. Dubois was, however, careful to note that whatever Parliament’s initial hesitancy to grant charters in the aftermath of the Bubble, ‘at the middle of the century there was a perceptible increase in Parliamentary acts of incorporation’ which became ‘even more pronounced’ in the closing 2 decades of the eighteenth century (1938, p. 36). Neither is it clear that the Bubble Act was the decisive piece of legislation that led to a limited number of formal incorporations after 1720. In a thorough study of English governing corporate bodies, Ron Harris (2000, p. 79) contends the decision limit incorporation and to prosecute firms for abuses of their charters was ‘a matter of public policy rather than new law or interpretation of the law.’11 10. For Marshall, the consequence of the Bubble Act was that ‘associations abounded that were called “companies,” but had no legal status as such. As each member of such a company was liable for all its debts, a prudent and responsible man was unwilling to take a share in it, even though it afforded reasonable prospects of high gains’ (1919, p. 312). 11. Harris also notes that the regulation of Exchange Alley was extended, outlawing trading in certain types of options and futures, in 1734 following another market collapse (Harris 2000, p. 225). © 2013 The Author

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Assessing the impact of the Bubble Act invariably involves a significant degree of counter-factual speculation, as we have little way of knowing how many prospective firms might have availed themselves of the joint-stock form in the absence of regulation. It is true that manufacturing firms were rarely granted incorporation in the eighteenth century, while charters for the construction of canals, turnpikes, and shipping infrastructure appear to have been obtained with relative ease (Harris 2000, p. 194).12 It is not, however, clear that the joint-stock form would have been preferred by early manufacturers had it been easier to obtain. As emphasized by Pressnell (1956, p. 256), there was not a rush on the part of manufacturers to obtain charters following the Bubble Act’s repeal in 1825. Of equal importance, unchartered joint-stock companies, which were rarely prosecuted in the 50 years prior to the Act’s repeal, were not regularly found in the manufacturing sector. One may just as easily speculate that the more measured spread of chartered joint-stock companies after the Bubble restrained any number of poorly managed or sham firms, and served to restore public confidence in the joint-stock form as a legitimate and stable means of finance. That active and liquid joint-stock share markets persisted in their smooth operation following the Bubble is itself rather remarkable. As Ann Carlos and Larry Neal (2006) have argued in a survey of the Bank of England’s stockholders between 1720 and 1725, owners of the Bank’s stock post-Bubble remained a diverse body with respect to social class, occupation, and nationality. Moreover, the Bank was successful in attracting new investors in the years immediately following the Bubble, ensuring the survival of a liquid market for public debt. Beyond the survival of the Bank, the absence of joint-stock companies in manufacturing should not lead one to the conclusion that they played no role in industrialization. Rather, it is telling that legally chartered joint-stock companies were the predominant financiers in the wave of canal construction that swept England and Wales between 1755 and 1815. In practice, of the 50 canal projects undertaken during the period, only one – the Duke of Bridgewater’s canal – was not undertaken by a joint-stock company (Ward 1974, p. 18). Though varying in size and complexity, the average canal project raised a subscribed capital of £340 000, and found subscribers in a broad cross-section of social classes. Moreover, both the primary and secondary markets for canal stock seem to have been predominantly local, with modest turnover rates.13 The simple conclusion that suggests itself is that joint-stock incorporation was preferred by firms investing in transportation infrastructure with significant capital needs, and that such charters were regularly granted. For manufacturers with more modest, short-term borrowing needs, endogenous modes of finance emerged; forms that were crucially aided by the Bank of England in its emergent role as a central bank.

12. Adam Smith, though critical of course of the monopoly rights granted to the great jointstock trading companies, argued that the joint-stock form was uniquely suited to the needs of canal and aqueduct construction, along with banking and insurance. Outside of these domains, Smith noted that capital needs were not ‘requisite for rendering reasonable the establishment of a joint-stock company’ (Smith 1776 [1994], p. 818). 13. Data on canal stock turnover in secondary markets is, unsurprisingly, quite fragmentary. Nevertheless, of the three projects surveyed by Ward, none averaged an annual turnover rate of greater than 10 percent. © 2013 The Author

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0.12

0.1

0.08

0.06

0.04

0.02 1692

1704

1716

1728

1740 1752 Year

1764

1776

1788

1800

Source: Mitchell (1988, pp. 578–580 and 600–602) and author’s calculations.

Figure 1

5

Effective interest paid on outstanding public debt

THE BANK’S ROLE POST-BUBBLE

It seems clear that the experiments in public finance of the early eighteenth century, abortive though some may have been, were fundamentally transformative. Despite the collapse of the Bubble, the SSC had succeeded in converting much of the state’s irredeemable debt into stock, and thus served to radically reduce the public debtservicing burden (Brewer 1988, pp. 125–126).14 The dramatic magnitude of this transformation is worth emphasizing. Taking annual debt-service expenditures as a percentage of total debt outstanding gives a rough index of the effective rate of interest paid on the aggregate sum of debt. In 1718, this figure stands at slightly more than 7 percent, whereas by 1726 it had fallen to little more than 5 percent, and approached 4 percent by 1730. A broader picture of the state’s interest burden in the eighteenth century is given in Figure 1. With the problem of the irredeemable debt effectively solved, the Bank of England, devoid after the Bubble of any serious competitors, was free to expand its role as public financier. Parliament and the Crown were likewise enabled to expand public debt as necessary to finance military expenditures, with the government sector remaining a consistent source of domestic demand at an average of 12 percent of GDP between 1721 and 1799. What is at issue for a portion of the literature is the impact that the Bank of England came to have on the process of industrialization in the latter half of the century. 14. While recognizing the importance of the Bank in remaking public finance, Brewer forcefully argued that the development of an efficient bureaucracy for the assessment and collection of taxes in England was of equal significance. Our argument is not intended to contravene this thesis, but rather sketches something of the Bank’s role in the industrial revolution outside of public finance. © 2013 The Author

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Temin and Voth’s (2013) position regarding the adverse impact of government borrowing in the eighteenth century can be sketched simply. Periods of heightened borrowing flooded capital markets with higher-yielding assets, thereby inducing depositors of the goldsmith banks to withdraw their funds. In the face of the 5 percent upper bounds on interest rates enforced by the usury laws, the contraction of deposits forced the goldsmith banks to more carefully ration credit. In this story, bankers may also have found the near risk-free returns on government securities to be more attractive assets in which to place their capital, and thus preferred them to their interest-rateconstrained private loans. Stated somewhat more broadly, this thesis has a long, if somewhat discontinuous, lineage. Ashton (1955), while noting England was generally ‘blessed with cheap money’ in the eighteenth century, contended that the usury laws ‘at times’ diverted resources away from the private sector, and directly led to great volatility in the level of activity. The ‘crowding-out’ argument has also been presented in this context by Jeffery Williamson (1984) and Robert Barro (1987). What is conspicuously missing from this general discussion is any serious attention to the positive role that may have been played by the Bank of England, both in the financing of industrial development, and in enhancing the stability of the nascent financial system generally. As John Clapham (1944 [1966], p. 172) rightly noted in his comments about the Bank’s position at the close of the eighteenth century, ‘[i]t is not to be supposed that the Bank, though most emphatically central, had acquired or been given all the functions associated today with that adjective.’ While there can be little doubt that the Bank of England served primarily in the eighteenth century as an institution to finance the needs of the state, the Bank’s role in financing the private sector has been too often neglected. It is clear that in addition to its business with Parliament, the Bank discounted bills of exchange for a number of the larger merchants of London, and not simply for East India and South Sea companies (Mathias 1983, p. 149). In sketching this feature of the Bank’s activity, two points merit initial emphasis. First, as has long been apparent from Clapham’s data, the Bank did not maintain anything approaching a fixed ratio between its bullion reserves and note issue. Particularly in the latter half of the eighteenth century, the Bank appears to have significantly expanded its discounting activities during periods of crisis, acting, in the view of some scholarship, as a lender of last resort (Lovell 1957). Second, while the private banks of London were formally prohibited from discounting directly with the Bank, a number of partners of some of the major London houses maintained drawing accounts with the Bank which likely came with informal access to the Bank’s discount facilities upon occasion (Clapham 1941, p. 83). Further, Clapham (1944 [1966], p. 129) records that while the volume of discounts remains relatively stable between 1720 and 1750, there was, by the early 1760s, a ‘gigantic increase’ in volume. This increase plainly coincides will the rise of the country banks, and the emerging process of industrialization generally. The significance of these points to our argument cannot be overemphasized. The case for crowding-out rests upon the premise that the Bank had little inaction with the private banking sector, beyond supplying it with an increasingly widely accepted unit of account. Absent this assumption, a very different picture of the British financial system emerges. Namely if, as seems evident, the Bank expanded and contracted the credit it afforded according to the needs of trade, rather than in response to variations in its bullion reserves, the British financial system as a whole cannot have been deposit-constrained. Though adopting a different theoretical perspective from that advanced in this paper, Patrick O’Brien (2011) has also emphasized that the Bank’s directors in the eighteenth century never articulated a singular © 2013 The Author

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principle by which their note issues where regulated. While O’Brien contends that the state of confidence of the Bank’s directors and their resultant note issue governed the size of the money supply, and imperfectly regulated the credit extended by London and country banks, his emphasis on the interconnectedness of the rising financial system is nevertheless compatible with a demand-led model of credit creation. Apart from the question of whether the private banks were forced to ration credit during periods of heightened government borrowing, the uses to which private loans were put is also at issue. Focusing primarily on two of the more significant West End banks, Hoare’s and Child’s, Temin and Voth (2013) observe and document a marked ‘gentrification’ of goldsmith bankers’ dominant clientele following the tightening of usury laws in 1714.15 From this trend, they admittedly speculate that the borrowers who came to be excluded were ‘gentlemen and successful members of the growing middle class, successful merchants and manufacturers, which … suggests that Hoare’s did not only offer consumption loans’ (Temin and Voth 2013, p. 79). That both Hoare’s and Child’s came to be the favored banks of the landed aristocracy, receiving rents of their estates and managing investments on their behalf, is not under dispute (Joslin 1954, p. 176). The operative question is whether the gentrification of the West End banks’ customers can be purely ascribed to the usury laws. In Mathias’s (1983, p. 150) opinion, the West End banks ‘rather looked down on soiling their hands with commerce: close association with it might have prejudiced their custom with their main clients – the aristocracy, gentry and wealthy gentlemen.’ Following the specialization of the West End banks, the finance of industry and trade was left to the banks of the City and, more importantly, to the ‘country’ banks that emerged in the industrial cities of the North in the latter half of the eighteenth century. The country banks were not typically the outgrowths of local goldsmiths, and seem often to have been the partially self-serving creation of local industrialists (Pressnell 1956, p. 13). As a general pattern, it appears that country banks in predominantly agricultural counties found depositors in excess of potential borrowers, and invested much of their surplus capital in the London money markets. Conversely, banks within the rising industrial districts drew upon London to satisfy local demands for credit (Kindleberger 1984, pp. 80–81). Prior to the nineteenth century, most of these industrial banks can be traced to owners of textile firms or foundries. Bearing this in mind, the expansion of local credit facilities in the industrial towns should be seen as an endogenous response to the needs of industry, rather than as an outgrowth of the London money market. Once established, the country banks forged relationships with the City banks by means of regular agents who handled their business in London. As the literature has regularly emphasized, the fixed capital required for many of the early innovations of the industrial revolution was relatively meagre (Deane 1965, p. 178). Of greater importance was access to short-term finance for the payment of wages and the purchase of raw materials, and it was in such provision that the country banks regularly specialized. As Pressnell (1956, p. 76) has emphasized with respect to country banks located in industrial areas, ‘[w]hen money was scarce country banks in general turned to London, much as London firms turned to the Bank of England, as the lender of last resort.’ Thus the Bank of England, though clearly established and expanded as an 15. The text of the act makes explicit its intent to promote the ‘advancement of trade,’ and to relieve the landowning classes. In regard to the latter we are told that ‘the heavy burden of the late long and expensive war hath been chiefly born by the owners of the land of this kingdom by reason whereof they have been necessitated to contract large debts, and thereby, and by abatement of the value of their lands, are become greatly impoverished’ (Raithby 1811, p. 488). © 2013 The Author

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agent to manage the public debt, seems to have played at least an indirect role in the finance of industrialization. In sum, then, the contention that financial regulation and mounting public borrowing constrained industrialization seems to rely on an overly atomistic vision of the financial sector in eighteenth century England. The Bubble Act, though originally intended to support speculation in the South Sea Company, did not seriously constrain firms’ access to credit in the latter half of the eighteenth century. Importantly, the chartered joint-stock form was heavily utilized in the central infrastructural investments of the eighteenth century wherein the need for capital was much larger. The manufacturing sector, with its more modest and short-term credit needs, was well supplied by the emerging country banks. Moreover, these country banks did not simply harness local pools of savings, but instead regularly drew upon London to meet the local demand for credit. Finally, the existence of the Bank of England, in addition to creating a secure and liquid market for public debt, supplied credit directly and indirectly to the English banking system through its discounting operations. Private lending was consequently not savings-constrained, and depended rather on the demand for loans and on the number of credit-worthy borrowers. The English state was both beneficial to, and inseparable from, the process of industrialization in the eighteenth century.

REFERENCES Ashton, T.S. (1955). An Economic History of England: The 18th Century. London: Methuen. Barro, Robert J. (1987). ‘Government Spending, Interest Rates, Prices, and Budget Deficits in the United Kingdom, 1701–1918.’ Journal of Monetary Economics, 20 (2), 221–247. Black, Robert A. and Claire G. Gilmore (1990). ‘Crowding Out During Britain’s Industrial Revolution.’ The Journal of Economic History, 50 (1), 109–131. Brewer, John (1988). The Sinews of Power: War, Money and the English State 1688–1783. Cambridge, MA: Harvard University Press. Carlos, Ann M. and Larry Neal (2006). ‘The Micro-foundations of the Early London Capital Market: Bank of England Shareholders During and After the South Sea Bubble, 1720–25.’ Economic History Review, 59 (3), 498–528. Carswell, John (1960). The South Sea Bubble. London: Cresset Press. Chang, Ha-Joon (2003). Kicking Away the Ladder: Development Strategy in Historical Perspective. New York: Anthem Press. Clapham, John (1941). ‘The Private Business of the Bank of England, 1744–1800.’ The Economic History Review, 11 (1), 77–89. Clapham, John (1944 [1966]). The Bank of England, vol. I. Cambridge: Cambridge University Press. Crafts, N.F.R. and C.K. Harley (1992). ‘Output Growth and the British Industrial Revolution: A Restatement of the Crafts–Harley View.’ The Economic History Review, 45 (4), 703–730. Dale, Richard (2004). The First Crash: Lessons from the South Sea Bubble. New York: Princeton University Press. Deane, Phyllis (1965). The First Industrial Revolution. Cambridge: Cambridge University Press. Dickson, P.G.M. (1967). The Financial Revolution in England. London: Macmillan. DuBois, Armand B. (1938). The English Business Company After the Bubble Act: 1720–1800. New York: The Commonwealth Fund. Ferguson, Niall (2009). ‘Diminished Returns.’ The New York Times, May 15: MM19. Print. Garber, Peter M. (1990). ‘Famous First Bubbles.’ The Journal of Economic Perspectives, 4 (2), 35–54. Harris, Ron (1994). ‘The Bubble Act: Its Passage and its Effects on Business Organization.’ The Journal of Economic History, 54 (3), 610–627. © 2013 The Author

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Harris, Ron (2000). Industrializing English Law. Cambridge: Cambridge University Press. Hutcheson, Archibald (1721). A Collection of Treatises Relating to the National Debts and Funds. London: self-published. Joslin, D.M. (1954). ‘London Private Bankers, 1720–1785.’ The Economic History Review, 7 (2), 167–186. Kindleberger, Charles P. (1984). A Financial History of Western Europe. New York: Routledge. Lovell, Michael C. (1957). ‘The Role of the Bank of England as Lender of Last Resort in the Crises of the 18th Century.’ Explorations in Entrepreneurial History, 10, 8–21. Marshall, Alfred (1919). Industry and Trade. London: Macmillan. Mathias, Peter (1983). The First Industrial Nation: An Economic History of Britain 1700–1914. London: Methuen. Mitchell, Brian R. (1988). British Historical Statistics. New York: Cambridge University Press. Mokyr, Joel (2002). The Gifts of Athena: Historical Origins of the Knowledge Economy. Princeton: Princeton University Press. O’Brien, Patrick (2011). ‘Mercantilist Institutions for a First but Precocious Industrial Revolution.’ London School of Economics Working Paper, No. 156. Patterson, Margaret and David Reifen (1990). ‘The Effect of the Bubble Act on the Market for Joint Stock Shares.’ The Journal of Economic History, 50 (1), 163–171. Paul, Helen Julia (2004). ‘The South Sea Company’s Slaving Activities.’ Proceedings of the Economic History Society Annual Conference. Paul, Helen Julia (2010). The South Sea Bubble. New York: Routledge. Paul, Helen Julia (2012). ‘Archibald Hutcheson’s Reputation as an Economic Thinker: Pamphlets, the National Debt and the South Sea Bubble.’ Essays in Economic and Business History, 30, 93–104. Pressnell, L.S. (1956). Country Banking in the Industrial Revolution. Oxford: Clarendon. Raithby, John, ed. (1811). The Statutes at Large of England and of Great Britain, vol 7. London: Eyre and Strahan. Smith, Adam (1776 [1994]). An Inquiry into the Nature and Causes of the Wealth of Nations. New York: Modern Library. Sperling, John G. (1960). The South Sea Company: An Historical Essay and Bibliographical Finding List. Boston: Harvard Graduate School of Business Administration. Stasavage, David (2003). Public Debt and the Birth of the Democratic State. New York: Cambridge University Press. Temin, Peter and Hans-Joachim Voth (2005). ‘Credit Rationing and Crowding Out during the Industrial Revolution: Evidence from Hoare’s Bank, 1702–1862.’ Explorations in Economic History, 42 (3), 325–348. Temin, Peter and Hans-Joachim Voth (2013). Prometheus Shackled: Goldsmith Banks and England’s Financial Revolution After 1700. Oxford: Oxford University Press. Ward, J.R. (1974). The Finance of Canal Building in Eighteenth-Century England. Oxford: Oxford University Press. Williamson, J.G (1984). ‘Why was British Growth so Slow during the Industrial Revolution?’ Journal of Economic History, 44 (3), 687–712.

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Review of Keynesian Economics, Vol. 1 No. 3, Autumn 2013, pp. 314–321

Economic crises and the development of the industrial state: the industrial intervention of the Bank of Italy and the Bank of England, 1918–1939 Valerio Cerretano Lecturer in Management, Adam Smith Business School, University of Glasgow, UK

Although it is little known at least among economists, central banks in industrial countries became involved with industry in the past and particularly after the First World War. This was at least the case in Italy and Britain where central banks provided long-term finance to ailing firms and banks, becoming important industrial players in their countries. This article explores this episode in a comparative setting, and concludes that intervention did not stem from a grand design of policy or from anti-market ideologies. It was, rather, piecemeal and a consequence of financial austerity. It is also argued here that intervention was the outcome of the over-expansion of the heavy industries more than the consequence of the weakness of one particular financial system. Moreover, this history also seems to indicate that the direct management of ailing firms and banks proved less expensive for central banks than the continuous provision of funds to concerns whose managers were alien – and therefore unaccountable – to the central banks’ bureaucracy. Keywords: central banks, industrial policy, public intervention in industry JEL codes: N1, N2, L5, O25

1

INTRODUCTION

When first presenting my research about the involvement of central banks with industry, someone in the audience objected that there probably was something wrong with the title of my presentation. Central banks cannot take those or similar responsibilities, remarked he, their duty being rather the regulation of the money supply and the surveillance of the banking system. So long as we refer to textbook theory, he was correct. Not so, however, when considering historical reality. We should avoid sweeping generalisation at this stage of research. Yet it is safe to conclude that in the past – especially during the inter-war era – central banks in Europe and in the industrial world held a role in industry and in industrial finance. They came to own industrial assets and entire industrial concerns; they provided long-term finance to industrial firms, promoting the reconstruction of entire industrial sectors. This was the case in particular for the Bank of England and for the Bank of Italy, the industrial involvement of which has been well documented. Less known and yet seemingly important was the involvement of the Bank of France,

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the Bank of Japan and the German Reichsbank in what we may broadly name industrial intervention. To be sure, the acquisition of these functions was concomitant with the increasing loss of central banks’ autonomy from national governments. With regard to this point, it may be useful to recall here that, until the late 1920s, not all industrial countries had a central bank and that in some there were a number of issuing banks. Most of these, moreover, were private, profit-making joint-stock banks which enjoyed a special relationship with their respective governments to which they provided financial support. The functions and mission of central banks became more clearly defined only by the latter half of the 1930s. The Bank of Italy and the Bank of France came under closer government control only in the years 1936–1937, whereas the Bank of England experienced nationalisation (that is, the transfer of the Bank’s capital stock, now publicly owned, to the Treasury) under the Labour government as late as 1946. Here, I shall compare the Bank of Italy and the Bank of England’s industrial intervention in an attempt to draw some general points feeding into the broader discussion about central banks and economic development. There is an extensive literature on the topic at hand (Bamberg 1988; Bowden and Collins 1992; Burk 1982; Cairncross 1995; Caracciolo 1992; Cerretano 2008 and 2009; Clay 1957; Garside and Greaves 1996 and 1997; Greaves 2002 and 2005; Heim 1984; Howson 1974; Kynaston 1995; Lazonick 1981; Peden 1993 and 2000; Romeo 1991, pp. 132–134; Ross 1996; Sayers 1976; Toniolo and Guarino 1993). This literature has however examined the theme from a rigidly national or insular perspective. British and Italian historians have considered this topic in the belief that their respective countries were the only ones to have experienced an increasing involvement of central banks with industry. Although we still know comparatively little about it, it is however safe to maintain – as the French and German cases also seem to testify – that the involvement of central banks with industry was an international phenomenon. Why did central banks and in particular the Bank of England and the Bank of Italy become involved with industrial matters? More particularly, why did they become enmeshed with the direct management of industrial concerns? And why did they become a government’s instrument for industrial intervention? What follows will attempt to answer those questions. Specifically, Section 2 will consider the weight of deflation and austerity in spurring intervention, emphasising the experimental nature of the latter. Section 3 will examine how the Italian and British central banks began intervention by rescuing armament firms, arguing that intervention stemmed from the war and postwar over-extension of the heavy and traditional industries more than from the alleged inner weaknesses of one particular national – that is, the German and continental or the alternative British – model of industrial finance. Section 4 will pass on to consider the legacy and size of intervention, suggesting that in Britain it was much smaller and yet significant in relation to the evolution of some industries in particular. The article will conclude with some generalisations about the role of central banks in industrial development. 2

TEMPORARY OR PERMANENT INVOLVEMENT?

From the outset, we should emphasise that intervention in both Italy and Britain was not prompted by any particular anti-market ideology or grand design of policy (Cerretano 2008 and 2009). As will be seen here, the intervention of the Bank of Italy and the Bank of England was influenced not so much by ideological © 2013 The Author

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considerations as by some specific industrial and economic problems. While considered exceptional and above all temporary, intervention in both countries proved moreover piecemeal. The central banks became involved with industry, first, by providing liquidity to ailing banks and to ailing firms which had come to be owned by the government or which had developed a special relationship with the latter after 1914; and, second, by guaranteeing, under the indication of the government, the bond issues of a number of industrial concerns which found themselves in financial need after 1929. In all cases, both central banks obtained industrial assets as collateral, thus becoming industrial owners. In both countries, moreover, central banks sought to sell those assets at a premium, a task that took quite some time under the difficult circumstances of the inter-war period. Before shedding them, however, both banks administered industrial interests via holding companies (see Table 1). As mentioned earlier, both central banks were originally asked by their respective governments to take up industrial interests. Intervention was thought to offer temporary relief to banks and firms experiencing serious difficulties soon after the war and once again after 1929. Central banks would provide liquidity, put the firms and industrial interests on a sound footing again and finally sell them on the market. But as the depression and as deflation worsened, it became increasingly difficult to perform that task. It may be inferred that the extent to which both central banks became involved with industry was a (positive) function of the severity of the depression and credit scarcity (Cerretano 2009). This point is borne out in particular by the Italian experience, where original solutions of public ownership were undertaken in the aftermath of the 1931 financial turmoil and where the newly-established state-owned agency, the Istituto per la Ricostruzione Industriale (hereafter the I.R.I.), became a permanent

Table 1 Bank of Italy and Bank of England: industrial interests and holding companies Bank of Italy Assets from

Bank of England

Holding companies/state agencies

Assets from

Holding companies/state agencies

1921–23 Banco di Roma Sezione Autonoma 1921–23 Lancashire banks Securities Trust Armstrong Banca Italiana CSVI* Ministry of di Sconto Istituto di Munitions and (Ansaldo) Liquidazione* other ministries (1926) 1925 Armstrong 1931–33 Comit Istituto Mobiliare 1930–31 Beardmore Securities Credito Italiano (I.M.I.) Kylsant Group Management Banca Agricola Istituto per la (shipping) Trust Italiana Ricostruzione Bankers Industriale (I.R.I.) Development Co. Sectors: armaments, electricity generation, Sectors: armaments, cotton spinning, automobiles, shipbuilding, shipping, rayon, shipbuilding, shipping, rayon, iron and steel, iron and steel, chemicals coal, aluminium Note: *Part of I.R.I. by 1933. Source: Cerretano 2008, p. 91 (table 4) and 2009, pp. 87–92.

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body only in 1937, after it had become clear that, given the prevailing financial and economic context, it was near to impossible to liquidate the industrial stakes now under public ownership within a reasonable time. On this point, we can note a divergent evolution between Italy and Britain after 1931 (Cerretano 2008, pp. 87–92). With Britain experiencing a mild depression and after 1931 a quick recovery as well as a reviving financial market – which was, it should be stressed, much larger than the Italian capital market – and then rearmament (this latter made assets in the heavy industries once more profitable), the Bank of England succeeded in selling most of its industrial interests which were, as we shall see later, mostly in the heavy and traditional industries (see Table 1). Not so in Italy, where credit scarcity and deflation continued unabated after 1931 and where the liquidation of industrial assets now under public control proved much more problematic. While unwanted and unplanned, intervention followed to some extent from very orthodox policy measures of financial austerity which were implemented in Britain and in Italy respectively after 1921 and after 1926 (Ferri and Garofalo 1994). While urging the sale of industrial stakes that governments and central banks had directly and indirectly acquired during and soon after the war, deflation retarded the liquidation of those assets – who could after all buy these mostly unprofitable industrial interests in a context of deflation and credit scarcity? – encouraging their transfer under the control of the central bank and the state. 3

THE ROOT CAUSES OF INTERVENTION: INADEQUATE FINANCIAL SYSTEMS OR OVER-EXPANSION OF INDUSTRY?

The issue of the central banks’ intervention in industry feeds, unsurprisingly, into the broader issue of industrial finance, which has received considerable scholarly attention (for a discussion of the theme, see Ross 1996). Commentators in both Britain and Italy have considered the industrial involvement of central banks as stemming from the fundamental flaws of their national financial systems, unable to provide sufficient long-term finance to industry. A discussion about an alleged lack of industrial finance began to take shape in both countries, and particularly in Britain, soon after the First World War. To a growing number of British observers – testimony is the well-known Macmillan Report of the summer of 1931 – the financial system centred on the City of London had failed domestic industry, while the German model of mixed banking represented the best viable alternative to support long-term industrial development. As for Italy, by contrast, policymakers and bankers were well aware of the pro-cyclical character and inherent weaknesses of mixed banking; they considered a British-like separation between industry and banking as a sine qua non to avoid future collapses and to ensure economic survival. The fact that the continental system collapsed in 1931 was all the more ironic, and showed how inconclusive postwar debate on industrial finance had been. That collapse – and the inherent fragility of the continental banking model, as well as the underperformance of British industry in the 1920s – indeed raises the question as to whether (and if so, to what extent) intervention really stemmed from the inherent fragility of those alternative models of industrial finance (that is, the British one and the continental one). Evidence seems to indicate that, beyond the specific weaknesses of one or other financial system, what occasioned the intervention of central banks was rather the over-expansion of manufacturing sectors, mostly the armament and heavy industries (Edgerton 2006; Falco 2005). These – from coal, to iron and steel, to shipbuilding, to engineering and armament-making – had experienced astounding growth © 2013 The Author

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during the war, remaining over-expanded until the latter half of the 1930s. Although unprofitable, these sectors continued to be of paramount importance in military and economic terms until the outbreak of the Second World War, inasmuch as they produced arms and battleships, employed a large number of people, and secured large invisible earnings – hence, massive state support (Edgerton 2006; Falco 2005). This point becomes more concrete when considering the fact that both central banks began their massive intervention in industry when rescuing the national champions of the armament industry, respectively the British Armstrong (the largest European armament-maker) and the Genova-based giant group Ansaldo. Armament-makers were conglomerates of large, vertically integrated, multidivisional firms producing a vast array of items, from guns to aeroplanes to battleships – the latter absorbing about two-thirds of the output of iron and steel in Britain in the mid-1920s – but also coal, iron and steel, and other special alloys, accounting for a good deal of the domestic production of these articles (Cerretano 2009). Unsurprisingly, these firms, as mentioned earlier, had also become particularly sizeable in relation to the whole domestic economy during the conflict. Ansaldo, for example, was by far the largest Italian firm by capital in 1921. The Bank of England was a traditional banker of the Armstrong group. After 1915, the Bank accumulated large blocks of Armstrong’s securities as collateral for loans which the armament firm was unable to repay after the end of the conflict. By 1925, the Bank of England became the largest shareholder of the Armstrong group (Sayers 1976, vol. I). Likewise, the Bank of Italy acquired Ansaldo from the Banca Italiana di Sconto which collapsed in 1921. Britain and Italy’s central banks spent much energy after 1921 in reorganising and selling the firms of Armstrong and Ansaldo’s groups. The Bank of England and the Bank of Italy set up holding companies controlling and managing those participations: the Sezione Autonoma del CSVI, the Istituto di Liquidazione and then the I.R.I. in Italy; and the Securities Trust and the Securities Management Trust in Britain (see Table 1). 4

THE SIZE AND LEGACY OF INTERVENTION

One reason why central banks became involved with industry must very likely be found in the fact that they could provide much-needed financial resources in a context of credit scarcity and financial austerity (Cerretano 2009). Evidence suggests that both the Bank of Italy and the Bank of England had made huge profits by placing public debt, which had grown exponentially after 1914, on the capital market. In addition to that, moreover, they could provide ailing firms and banks with valuable personnel and managers. Of additional interest is the fact that in both Italy and Britain the removal of previous management and the direct administration of firms on the part of central banks became standard practice. Central banks did not entrust their resources to people alien to their bureaucracy, one major fear being that a lack of supervision could result in additional and prolonged financial commitment. The direct management and supervision of interests proved less expensive than the straightforward and unconditional provision of loans at least in the medium term. When considering the size of intervention, we may on the other hand safely conclude that it was much larger in Italy than in Britain in relation to money circulation. Small as it was, however, in Britain intervention proved crucial in relation to the size and development of certain firms and industrial sectors – not only the traditional ones, © 2013 The Author

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such as cotton, shipping, shipbuilding and the armament industry in general, but also innovative industries, such as man-made fibres (acetate rayon) and aluminium (Cerretano 2009). The Bank of England was instrumental in the reorganisation of the armament industry, spearheading the amalgamation between Armstrong and Vickers in 1927–1928, while supporting the reconstruction of Beardmore, a Scottish armament and shipbuilding firm. In addition to this, it promoted in 1928 the Lancashire Cotton Corporation which became the country’s largest cotton firm after acquiring a number of small cotton spinners in the early 1930s (Bamberg 1988). The Bank of England finally played a role in the postwar reconstruction of British Celanese, a producer of acetate rayon, and in the launch of the North British Aluminium Co., a major Scottish aluminium-maker. The weight of these firms in the development of what proved some of the most rapidly growing British and European high-tech industries of the interwar era (that is, aluminium and man-made fibres) can hardly be exaggerated. The Bank of England managed to get rid of most of its interests in iron and steel firms during the course of the 1930s. The reasons for this success, as I have mentioned earlier, must be found, among other things, in rearmament which made those firms profitable once more; and, second, in the fact that Britain experienced far less of a credit crunch than Italy and other industrial countries in the 1930s. In Italy, by contrast, Bank and state’s intervention took quite a different turn. The parlous state of Credit and Comit – the largest Italian mixed banks, controlling a large portion of national industry – prompted intervention once again at the end of 1930. The Bank of Italy was instrumental in setting up, along with the government, first the Istituto Mobiliare Italiano (I.M.I.) and then the I.R.I. This agency took the industrial assets under the control of those banks and other agencies (that is, the Istituto di Liquidazioni) in exchange for fresh liquidity which was raised through bond issues, and was finally entrusted with the financing, management, reorganisation and eventual sale of these assets (Ferri and Garofalo 1994). This proved a Herculean task as the I.R.I. came to control more than 40 per cent of Italian public companies and about 90 per cent of Italian steel and iron as well as shipbuilding industries in a context of depressed market conditions (Romeo 1991). Launched in 1933 to provide temporary relief to ailing industrial firms, the I.R.I. became a permanent body in 1937 as part of Italy’s broad financial reform by which the Bank of Italy was put under closer government scrutiny and mixed banking was abolished, on the assumption that the state – through the I.R.I. and through the launch of bond issues guaranteed by the government – would become the main provider of industrial, long-term finance. With hindsight, intervention proved probably most impressive and innovative in Italy when considering postwar Italian industrial development, in which the I.R.I. held a central role. Less impressive in relation to Britain’s national economy, the intervention of the Bank of England in the inter-war era proved nevertheless crucial to the development of new, capital-intensive and high-tech industrial sectors, such as manmade fibres and the aluminium industries, but also to the reconstruction of more traditional sectors, namely the armament and cotton industries. It also provided a template for postwar nationalisation of the heavy industries and postwar plans for the so-called depressed areas (Bowden and Collins 1992; Heim 1984). 5

CONCLUSION

Although the picture of the industrial involvement of central banks is far from being firm or complete, we may safely conclude that intervention in industry and the © 2013 The Author

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provision of industrial finance became important duties of central banks after the First World War, especially in Italy and in Britain. Likewise, evidence (taken with a pinch of salt) seems to point to the broader conclusion that the Bank of Italy and the Bank of England – as with the central banks of other industrial economies – held a varying and yet important role in industrial development in the inter-war era, a period of economic turmoil which saw the progressive loss of central banks’ independence from national governments. If there is any lesson to be learned from this story, it is of some importance for current developments to stress that, first, this involvement did not stem from anti-market ideologies, and that, second, the direct involvement in the management of ailing banks and firms was seen in both Italy and Britain as less expensive than the continuous provision of finance to firms whose managers were not held accountable to the central bank and treasuries’ bureaucracy.

REFERENCES Bamberg, James (1988). The rationalisation of the British cotton industry in the inter-war period. Textile History, 19 (1), 83–102. Bowden, Susan and Michael Collins (1992). The Bank, industrial regeneration and hire purchase between the wars. Economic History Review, 45 (1), 120–136. Burk, Kathleen (1982). The Treasury: from impotence to power. In K. Burk (ed.), War and the State: The Transformation of British Government, 1914–1919. London: Allen and Unwin, pp. 84–107. Cairncross, Alec (1995). The Bank and the British economy. In Kathleen Burk and Donald Kynaston (eds), The Bank: Money, Power and Influence, 1694–1994. Oxford: Oxford University Press, pp. 56–82. Caracciolo, Alberto (ed.) (1992). La Banca d’Italia tra l’Autarchia e la Guerra, 1936–1945. Rome-Bari: Editori Laterza. Cerretano, Valerio (2008). Deflazione e intervento pubblico nel periodo tra le due guerre mondiali: Gran Bretagna e Italia a confronto. Rivista di Storia Economica, 24 (1), 59–101. Cerretano, V. (2009). The Treasury, Britain’s postwar reconstruction and the industrial intervention of the Bank of England, 1921–9. Economic History Review, 62 (S1), 80–100. Clay, Henry (1957). Lord Norman. London: Macmillan. Edgerton, David (2006). Warfare State: Britain, 1920–1970. Cambridge: Cambridge University Press. Falco, Gian Carlo (2005). Spese militari, congiunture economiche e consolidamento dell’industria in Italia, 1919–1934. In P. Del Negro, N. Labanca, A. Staderini (eds), Militarizzazione e Nazionalizzazione Nella Storia d’Italia. Milan: Unicopli, pp. 207–249. Ferri, Giovanni and Paolo Garofalo (1994). Collana storica della Banca d’Italia. La crisi finanziaria nella Grande Depressione in Italia. In Ricerche per la Storia della Banca d’Italia, Vol V: Il Mercato del Credito e la Borsa; i Sistemi di Compensazione; Statistiche Storiche: Salari Industriali e Occupazione. Rome-Bari: Editori Laterza, pp. 97–151. Garside, William R. and Julian I. Greaves (1996). The Bank and industrial intervention in interwar Britain. Financial History Review, 3 (1), 69–86. Garside, William R. and Julian I. Greaves (1997). Rationalisation and Britain’s industrial malaise: the inter-war years revisited. Journal of European Economic History, 26, 37–68. Greaves, Julian I. (2002). Competition, collusion and confusion: the state and the reorganisation of the British cotton industry, 1931–1939. Enterprise and Society, 3 (1), 48–79. Greaves, J.I. (2005). Industrial Reorganisation and Government Policy in Interwar Britain. Aldershot–Burlington: Ashgate Publishing. Heim, Carol E. (1984). Limits to intervention: the Bank and industrial diversification in the depressed areas. Economic History Review, 37 (4), 533–550. © 2013 The Author

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Economic crises and the development of the industrial state, 1918–1939 321 Howson, Susan (1974). The origins of dear money. Economic History Review, 27 (1), 88–107. Kynaston, Donald (1995). The Bank and the government. In Kathleen Burk and Donald Kynaston (eds), The Bank: Money, Power and Influence, 1694–1994. Oxford: Oxford University Press, pp. 19–55. Lazonick, William (1981). Competition, specialisation and industrial decline. Journal of Economic History, 41 (1), 31–38. Peden, George C. (1993). The road to and from Gairloch: Lloyd George, unemployment, inflation and the ‘Treasury view’ in 1921. Twentieth Century British History, 4 (2), 224–249. Peden, G.C. (2000). The Treasury and British Public Policy, 1906–1959. Oxford: Oxford University Press. Romeo, Rosario (1991). Breve Storia della Grande Industria in Italia. Milan: Il Saggiatore. Ross, Duncan (1996). Commercial banking in a market-oriented financial system: Britain between the wars. Economic History Review, 49 (2), 314–335. Sayers, Richard S. (1976). The Bank of England, 1891–1944 (3 Vols); Vol I. Cambridge: Cambridge University Press. Toniolo, Giovanni and Giuseppe Guarino (eds) (1993). La Banca d’Italia e il Sistema Bancario. Rome-Bari: Editori Laterza.

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Review of Keynesian Economics, Vol. 1 No. 3, Autumn 2013, pp. 322–346

Endogenous money and public foreign debt during the Argentinean Convertibility Juan Matías De Lucchi Master in Economics (IE-UFRJ), CEFID-AR researcher, Argentina

This paper tries to demonstrate that the endogeneity of money in the Argentinean currency board, known as Convertibility, was compatible with the heterodox endogenous money approach. The Argentinean Convertibility was interpreted by the conventional view as a pure case of the Mundell–Fleming model with fixed exchange rate (MFFER). This approach points out that domestic money became ‘endogenous’ because the central bank loses the ability to determine the monetary policy. However, this last endogenity process has nothing to do with the heterodox endogenous money approach. While the MFFER endogeneity is ‘supply-led’ (balance of payment effect), the heterodox approach is ‘demand-led’ (bank credit effect). So, given the structural external constraint (not only due to the historical Argentinean balance of payments constraint, but also increased by the need for backing the monetary base with foreign reserves) the Central Bank of Argentina operated as a lender of last resort to an unsustainable expansion of public foreign indebtedness. The dollar credit rationing to the government was the limit to the central bank’s accommodation policy. Keywords: convertibility, endogenous money, public foreign indebtedness, Argentina JEL codes: E12, E50, F32, F34, F41, H63

1

INTRODUCTION

The Argentine currency board, known as Convertibility, was implemented on April 1, 1991 and worked officially until January 6, 2002 when it collapsed with dramatic social consequences. We may say ‘officially’ because Convertibility ended really on December 3, 2001 when the government restricted deposit withdrawals by decree. In the economic history of Argentina, a currency board experience was not new. These reforms had a historical precedent in the period running from 1899 to 1930 (Pérez Caldentey and Vernengo 2007). However, the respective institutional contexts in which these currency boards were implemented were very different. When the old currency board was implemented, the Argentinean economy did not yet have a national monetary authority acting as a lender of last resort. But when the Convertibility was implemented in 1991, the Central Bank of Argentina (BCRA, in the Spanish acronym) already had 56 years of experience. This point is not trivial. Convertibility marked a huge institutional setback that would restrict the essence of any central bank – that is, to be an unlimited lender of last resort in domestic currency. However, as we will see, the BCRA did not abandon monetary policy interventions, but it was constrained and could only act as a limited lender of last resort with respect to the domestic currency. © 2013 The Author

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According to Ponsot (2003, p. 84), the Convertibility presented a different motivation in comparison to the old currency board: In contrast to past practices, the principal aim is to ‘import’ monetary stability in order to boost credibility, without serious considerations of the degree of integration with the issuer of the key currency.

The main objectives to the Convertibility Plan were to stop the instability of the rate of exchange and the chronic high inflation. Convertibility did ‘succeed’ in stabilizing prices, because the exchange rate appreciated; and the high unemployment derived from the deregulation, liberalization, and privatization policies was able to ‘discipline’ wage claims (the inflation rate between 1996 and 1998 was positive, but under two digits, and between 1999 and 2001 it was negative). However, in a monetary economy of production, the absence of a free central bank had catastrophic consequences. According to the conventional view, the Argentinean Convertibility regime worked according to the Mundell–Fleming Model with a fixed exchange rate (MFFER), where the stock of money is endogenous and determined by the balance of payments, or, in other words, monetary base creation (destruction) is determined by inflows (outflows) of foreign reserves because the central bank is committed to a fixed exchange rate. Also, in this model, the sterilization process or compensation mechanism does not occur; it also assumes a stable money multiplier. However, Convertibility did not work in this way. According to Lavoie (2006), even under a currency board regime, money is endogenous but not for the ‘supplyled’ reasons advocated by the MFFER model, an apt description to refer to the monetary effect of the balance of payments when no compensations mechanism operates. Under Convertibility, endogenous money is still ‘demand-led,’ consistent with the post-Keynesian endogenous money literature.1 Here, we mean money is exogenous or endogenous relative to the ability of the central bank to control the quantity of money. So, money is exogenous (endogenous) if the central bank controls (does not control) the quantity of money. In the traditional and conventional (neoclassical) view, within a closed economy, it is standard to claim that money is exogenous because of the direct creation of the monetary base by central bank operations and the indirect creation of credit through the stable monetary multiplier. But in an open economy, to say that money is endogenous and supply-led would imply the direct creation of a monetary base by foreign reserve variations and the indirect creation of credit through of the stable money multiplier. In a heterodox approach, however, money is endogenous and demand-led because of the direct creation of credit by commercial banks to accommodate the credit-worthy demand, and the indirect creation of bank reserves (and monetary base) as a residual of the banking system. So, as the commercial banks accommodate credit-worthy demand and the central bank accommodates the demand for bank reserves, the ‘financial Say’s Law’ does not operate (Serrano 2002) but something like a ‘financial’ effective demand principle does. So, the term ‘money’ will be used to express the current means of payment, such as currency or demand deposits, regardless of the approach adopted.

1. There are many descriptions of this approach, going back at least to Nicholas Kaldor and Basil Moore. See, for example, Lavoie (1992) and Rochon (1999). © 2013 The Author

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Hence, it is important here to understand the deep differences between a ‘supplyled’ endogeneity of money and one that is demand-led. As pointed out by Lavoie (2001): In the neoclassical instance of the endogenous money supply, the endogeneity process is supply-led, whereas in the post-Keynesian approach, the money supply is endogenous because it is demand-led. (Lavoie 2001, p. 218)

It is very important to note that, in our analysis of the Convertibility Plan, both the exchange rate and the interest rate are given. On the exchange rate there is not much to say: the Convertibility Law ‘was’ a fixed exchange regime with a particular nominal parity of 1 peso equal to 1 dollar. But on the interest rate, this assumption does not mean that a dynamic analysis of the rate of interest on the public foreign debt is not important. Precisely, the interest rate may become ‘endogenous’ when the economy has an unsustainable foreign debt, but this is not a problem that is dealt with in this work, because this paper only tries to explain the money creation in ‘normal’ times. Hence, as this paper focuses on ‘quantities’ (currency, bank reserves, deposits, credit and foreign reserves) and not on ‘prices’ (interest rate and exchange rate), we will omit the post-Keynesian discussion between ‘horizontalists’ and ‘structuralists’ (De Lucchi, 2012). Thus, this separation of prices and quantities, even in the financial sphere, is consistent with a non-marginalist approach. According to Rochon (1999, p. 11): It appears to me that the use of supply and demand analysis with respect to money gives rise to more inconveniences than advantages. If we assume that the supply of money is endogenous, and determined by demand, the notion of a supply itself loses all its significance. The only quantity of money foreseeable, possible and normal, would be the ‘desired’ quantity, i.e. that arising from the internal economic needs of the system. A money supply function is unthinkable because apart from the precise intersection with the demand function, all other points on the supply curve represent something which is not money. … Hence there is no such thing as a money market where a supply and demand for money interact.

The rest of this paper is divided into the following five sections. Section 2 analyses briefly the orthodox endogenous money approach derived from the MFFER model. Section 3 analyses briefly the heterodox endogenous money approach, while Section 4 analyses the conventional interpretation of the Convertibility Law based on the orthodox approach. Finally, Section 5 analyses our alternative interpretations of Convertibility based on the heterodox approach. Section 6 provides a few conclusions.

2

ENDOGENOUS SUPPLY-LED MONEY APPROACH

Prior to the emergence of the ‘New Consensus,’ the mainstream macroeconomic approach to the open economy was summarized in the Mundell–Fleming Model that assumes exogenous money. However, under this old neoclassical model, if central banks set the exchange rate, then money turns out to be an endogenous variable. Fortunately, following the Wicksellian tradition, the New Consensus abandoned the assumptions of exogenous money and incorporated endogenous money ‘non supplyled’ in neoclassical models – that is, eliminating the LM curve (Romer 2000). But unfortunately, given its neoclassical consistency, the New Consensus reinforces the © 2013 The Author

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neutrality of money in the long run and the existence of a ‘natural’ rate of interest. As Smithin points out: The difference in Wicksellian-type theory is the presumed coexistence of two different concepts of the rate of interest at the same time. It is an uneasy, and arguably ultimately untenable, hybrid of the classical theory and the horizontalist theory. (Smithin 2005, p. 25)

There are several logical and empirical problems with the notion of a natural rate of interest (and the concomitant natural rate of unemployment developed by Milton Friedman).2 According to Smithin (2005, pp. 15–16): The natural rate is the rate consistent both with equilibrium in the capital market and with full employment. By necessity, in this theory it has to be left extremely vague as to what real investment and real saving actually consist of. In the national income accounts these are simply sums of money deflated by a price index, but in theoretical principle the terms supposedly refer to ‘real resources’ in some sense.

Hence, the endogenous money approach in a heterodox framework should also be supported by the non-neutrality of money approach. In a consistent non-neoclassical approach, both the quantity of money and the output should be endogenous and demand-led. To summarize the MFFER model, we can say that it assumes an auto-regulating general equilibrium adjustment among the goods and services market (IS curve), the money market (LM curve), and the FX market (BP curve). However, the model assumes the possibility of transitory short-run disturbances with rigid wages and prices; so, economic policy could restore the general equilibrium. The Mundell–Fleming model assumes exogenous money supply and a theoretically necessary stable money multiplier due to the fact that any modern monetary economy has a banking system with a greater or lesser degree of development. In this sense, the central bank controls bank reserves directly and all means of payments indirectly (such as demand deposits). To illustrate the MFFER’s reasoning we will suppose that the economy is in a general equilibrium position, but that some ‘populist’ central banker wants to reduce the unemployment below its ‘natural’ rate through an expansionary monetary policy. As such, the central bank expands the monetary base (bank reserves) through open market operations. Due to this policy, commercial banks increase loans to the private sector in order to reduce the bank’s surplus reserves. Then, given the money demand, the increase in money supply generates a decrease in the rate of interest to the ‘international’ rate, plus a ‘risk country premium’ and the expectation of exchange rate devaluation.3 This implies that exchange markets are now in disequilibrium, but with a higher level of income. On the one hand, given the export and import coefficient, a higher level of income increases the imports and generates a current account deficit. But on the other hand, the negative interest rate gap induces capital outflows generating a capital account deficit. In other words, this balance of payments deficit forces the central bank to lose foreign reserves until the general equilibrium is restored automatically.

2. For a discussion on the limitations of the neoclassical approach and the natural rate notion, see Galbraith (1997). 3. The euphemism ‘international’ rate corresponds to the rate of interest on the ‘hegemonic’ country debt. The hegemonic country disposes enough power (ultimately, military) to impose its own unit of account in the international trade, something like an international central bank. © 2013 The Author

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Given the fixed exchange rate, foreign reserve losses generate the reverse economic process. The contraction of the monetary base (and demand deposits) raises the rate of interest and restores the money market equilibrium at the ‘natural’ rate of unemployment. Simultaneously, the interest rate gap starts to be positive and the foreign exchange market restores the equilibrium. Consequently, the central bank stops losing foreign reserves, and the stock of money, income, and employment return to the initial general equilibrium position. Now, we will suppose that the central banker is a conservative ‘market-friendly’ one that wants to raise the interest rate to benefit rentiers in an extraordinary manner. The contractionary monetary policy generates the reverse process mentioned above until the general equilibrium automatically reasserts itself. This policy reduces income and net imports (current account surplus) and the positive interest rate gap induces capital inflows (capital account surplus). So, the balance of payments surplus (foreign exchange reserves accumulation) increases the stock of money and the economy returns to the initial general equilibrium position. The MFFER model concludes that, in any non-hegemonic economy with capital mobility (perfect or imperfect), monetary policy is ineffective. Also, sterilization mechanisms do not occur even in the short run and a stable money multiplier operates. Thus, the means of payment are fully determined by foreign reserves variations. The political lesson to be learned, in the conventional view, is that a ‘moderate’ central bank is the best alternative – that is, a passive and neutral policy in the long run. In this sense, the orthodox MFFER concludes that money is endogenous and supplyled. In other words, the economic policy’s trilemma determines that in an economy with capital mobility, central banks may fix the foreign exchange rate or control the quantity of money (the rate of interest in a New Consensus model), but never control both variables simultaneously.4 3

ENDOGENOUS DEMAND-LED MONEY APPROACH

The main point of the heterodox endogenous money approach is that money or the means of payment are credit-driven and demand-determined (Moore 1988). Moreover, banks are not required to accommodate all credit demand. Banks only lend to those banks considered ‘credit-worthy’ (Wolfson 1996). This means that banks are not merely passive financial entities. Banks have the power to ration (or rather constrain) credit, although they have no reason to ration credit-worthy demand in normal times. However, in periods of macroeconomic instability there may be no guarantee that certain firms and households that are solvent will not suffer credit rationing by the existence of ‘asymmetric expectations’ between the creditor (banks) and the potential debtor. The heterodox approach rejects the ‘financial Say’s Law’ assumed by the exogenous money approach – like in the more traditional Monetarist approach – and by the fully endogenous money supply-led approach (MFFER). Banks do not need prior reserves to make loans, because they are creators of money ex nihilo. First, banks lend to credit-worthy borrowers (banks create demand deposits); and then they look for (demand) bank reserves in the interbank market. As a result, given the institutionallydetermined, target overnight rate of interest, the central bank creates (sterilizes) bank reserves when the interbank market has a deficit (surplus). 4.

For a conventional and recent discussion of the trilemma, see Obstfeld et al. (2010).

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The endogenous money approach incorporates the principle of effective demand with the financial sphere of analysis. The existence of an ex ante stable money multiplier makes no sense under these circumstances. In any case, the money multiplier is not stable and it is ultimately an ex post relation.5 For this reason, a ‘credit divisor’ – that is, the inverse of the money multiplier (1/r) – and an ex ante relation cannot be stable either. As it turns out, it is the credit-worthy demand for credit (C) that determines the bank reserves through of the credit divisor:   1 ΔBR ¼ rΔC ¼ ΔC: 1=r Note that, in a closed economy when credit is growing, the central bank will directly accommodate demand for reserves to avoid large changes in the overnight interest rate or a liquidity crisis. It is not reasonable to assume that the velocity of money can increase systematically. But in an open economy context the central bank’s accommodation may become considerably more complex. For example, it is absolutely true that sterilization and compensation mechanisms occur in the real world, but it is also true that there are no reasons to assume that foreign exchange reserve inflows are always fully sterilized. So, the imperfect or partial sterilization processes provide liquidity to the interbank market. This means that the central bank does not always need to directly create all needed bank reserves at the given interest rate when credit is growing. In this case, the central bank has already partially created these bank reserves in the foreign exchange market. As another example, when the central bank prints money to finance government spending, this ex ante exogenous money creation indirectly provides liquidity to the interbank market. However, as in the previous example, the ex post monetary base is a residual (endogenous) variable regardless of the mechanisms used by the central bank to provide liquidity – that is, directly (through the open market or discount window’s operations) or indirectly (imperfect sterilizations or printing money). Table 1 (overleaf) illustrates the two approaches discussed here, where BP is the balance of payment, R are the foreign reserves, H is the monetary base and C is the credit. The arrows show the direction of the causality and ðΔH − ΔDÞ expresses the sterilization process. Note that in an open economy the variation in reserves might always have an impact on money supply (H), but whereas in the conventional view credit is fully determined by the external accounts, in the heterodox approach it is still the demand for credit (C) that determines the means of payment. 5. Suppose that, in a certain economy, all the means of payment are expressed only in bank money to simplifying the reasoning. That is, firms and households do not use currency to pay or to retain. In this case, variations of the means of payment (demand deposit, DD) are determined by variations of the bank reserves BR and the money multiplier 1/r – that is, the inverse of the reserve requirements ratio: 1 ΔDD ¼ ΔBR r So, the ‘financial Say’s Law’ operates because the supply of bank reserves determines its own demand deposits (credit) through the money multiplier. However, note that it is not necessary to assume the existence of reserve requirements for the operation of the financial Say’s Law. Only assuming certain desired bank reserve ratios is enough to conclude in this conventional way where supply determines demand. © 2013 The Author

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Table 1 Endogenous money approaches Endogenous money supply-led

BP ! ΔR ! ΔH ! ΔC Endogenous money demand-led

BP ! ΔR ! ðΔH − ΔDÞ

4

ΔC

CONVERTIBILITY ACCORDING THE MFFER MODEL

As in the conventional view, the money creation process during the Convertibility was as in a pure MFFER model, where the automatic adjustment process from the foreign reserves to monetary base operates fully. The causality would be from the balance of payments to the printing of currency. A typical conventional view suggests that: Thus, the central bank gives up monetary policy, as money supply becomes entirely endogenous. Hume’s endogenous adjustment mechanism is under full operation … Since March 1991, changes in the monetary base were primarily determined by changes in international reserves … (Kiguel 1999, p. 10)

However, the robustness of the Convertibility would not be created just by the causality from reserves variations to money (condition assumed for any open economy), but mainly by the compulsory convertibility ratio equal to 1 dollar per peso that would provide additional systemic stability. According to the authors who were behind the Convertibility Law: In a fixed-rate regime the amount of foreign currency reserves at the central bank indicates the potential sustainability of the plan. The smaller the amount, the more difficult it becomes for the central bank to sustain a fixed parity. But this is not true of the convertibility program. Because for every peso that circulates there must be a dollar waiting at the central bank, the foreign currencies at the central bank are not ‘reserves’ in that they cannot be freely used by the bank. For instance, they cannot be used to cancel foreign debt. The truth is that the reserves are the property of the peso holders. (Cavallo and Mondino 1996, p. 9)

Also, demand deposits would be indirectly endogenous and supply-led, in this view, due to the existence of a stable money multiplier. Thus, at the beginning of the Convertibility: … capital inflows increased both credit supply and aggregate demand … (Rodriguez 1995, p. 44)

This is the case, in the conventional view, because: … money multipliers and credit operate fully, resulting in a pro-cyclical response of the economy … (Damill 1999, p. 16)

Finally, the BCRA would lose the ability to set the monetary policy and the ability to act as a lender of last resort. In their words: In order to print pesos, the central bank must buy an equal amount of dollars. It is impossible to debase the currency. If the domestic financial market required more liquidity, it would © 2013 The Author

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have to provide the central bank with dollars. The only scope left for a marginally independent monetary policy is to conduct open market operations in dollar-denominated securities. Even these are restricted by law to no more than 20 percent of the base; in fact, they represent a smaller proportion of the base. Monetary policy is, then, for any meaningful economic time span, completely subordinated to U.S. monetary policy. (Cavallo and Mondino 1996, p. 8)

However, some orthodox economists suggested that the BCRA was not very different than a regular central bank, and argued that: Argentina’s currency board-like system differs from an orthodox currency board in several ways, as do the currency board-like systems of Estonia (established in 1992), Lithuania (1994), Bulgaria (1997), and Bosnia (1998) (Hanke 1997). An orthodox currency board system has no central bank and no room for discretionary monetary policy. (Hanke and Schuler 1999, p. 5) An orthodox currency board does not hold significant domestic assets; does not engage in sterilized intervention (buying or selling domestic assets to offset the effects on the money supply of gaining or losing foreign reserves); does not lend to the government; and does not act as a lender of last resort to banks … (Schuler 2005, p. 243)

In a way, this ability to still have some functions of a regular central bank were seen as a potential failure by some orthodox authors. 5

AN ALTERNATIVE INTERPRETATION OF CONVERTIBILITY

Certainly, the BCRA was not a ‘pure’ currency board, if by pure one means an absolutely passive institution that does not set the interest rate and does not operate with treasury bills and bonds in the secondary markets. As pointed out by Lavoie (2006): ‘Pure’ currency boards hold a single type of asset – foreign reserves, gold or foreign currencies such as the American dollar or the euro. They provide no domestic credit. Currency boards, in contrast to central banks, make no advances to the domestic private sector nor do they hold domestic government assets. Any increase in the stock of high-powered money must be accompanied by an influx of foreign reserves, i.e., a favorable balance of payments. (Lavoie 2006, p. 4)

However: The currency board may also function along the lines of a stable endogenous-money economy, as described by post-Keynesian economists (Kaldor 1982; Moore 1988), but it may do so within a much narrower zone. (Lavoie 2006, p. 5) The currency board behaves no differently than a central bank under a regime of fixed exchange rates. In both cases, it is possible for the monetary authorities to set interest rates at the level of their choice. In both cases, the money supply is endogenous and demand-led. Surpluses in the balance of payments do not create any excess money supply or excess liquidity in the monetary system. The compensation thesis, which is an outgrowth of the Banking School reflux principle, rules both with the currency board and with the central bank. (Lavoie 2006, p. 20)

Just to give some examples of the special features of the Argentinean currency board, the BCRA could compute as ‘foreign reserves’ a limited quantity of national bonds only denominated in foreign currency (dollars) at market prices. It allowed © 2013 The Author

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that the ‘backing’ of the monetary base was more flexible during negative shocks associated with a shortage of foreign reserves. With these attributes, the BCRA had the somewhat limited ability to print money without a corresponding influx of dollars. Figure 1 shows the percentage of national public bonds in foreign currency (computed as foreign reserves) of the total foreign reserves held by the central bank. Note that the limit established by law was 20 percent of the total reserves computed and 33 percent for a short period. Also, the BCRA implemented an unusual ‘liquidity policy,’ called Contingent Repo Facility. Under this program, the BCRA had the option to sell national bonds for dollars to groups of international banks subject to a repurchase clause in the case of a banking crisis. Finally, the BCRA also participated in sterilization operations and in the interbank market to set the base interest rate – that is, a typical policy of a central bank, but not of a currency board. According to Vernengo and Bradbury (2011): The central bank could act in limited fashion as a lender of last resort providing credit to the banking system, but only on a short term basis. The central bank could provide credit to the government in a limited fashion and only indirectly through the purchase of government securities. The central bank retained the power to regulate required bank reserves. Later, in response to the pressures brought about by the Mexican devaluation and Tequila crisis of 1995 more latitude was given to the central bank to act as a lender of last resort. This latitude was provided when the central bank was allowed to incur foreign indebtedness and conduct repo agreements with large international banks in order to provide short-term loans to the domestic financial system (Prospectus 2004). (Vernengo and Bradbury 2011, p. 453)

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99

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18.9%

4.8%

5.0%

5.8%

7.4%

8.3%

13.7%

10.5%

11.1%

11.7%

20 18 16 14 12 10 8 6 4 2 0

12.1%

Percent

Certainly, this degree of flexibility around the currency board’s architecture provided the BCRA with a narrow margin to accommodate the endogenous liquidity demand. But from a more general point of view this narrow zone depends on the degree of free foreign reserves and the absence of dollars credit rationing. While the BCRA had enough surplus of dollars, it could accommodate unconditionally the demand for reserves without any liquidity problems in the system.

20

01

Source: National Institute of Statistics and Censuses.

Figure 1 National public bonds in foreign currency as a percentage of the total foreign reserves computed © 2013 The Author

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110 000 100 000

Millions pesos/dollars

90 000 80 000

Debt securities in foreign currency (residents)

70 000

Debt securities in foreign currency (non-residents)

60 000 50 000

National currency debt securities (residents)

40 000

National currency debt securities (non-residents)

30 000 20 000 10 000 0 1994

1995

1996

1997

1998

1999

2000

2001

Source: National Institute of Statistics and Censuses.

Figure 2 holders

Stock of national public bonds by kind of currency and residence of the

But without free foreign reserves the accommodation of the BCRA depended on the ability of the Argentinean State to obtain funding in foreign currency. In this case, the government could sell public debt denominated in dollars, to foreign and/or domestic residents, to accumulate the foreign reserves necessary to back the monetary base flow derived from the internal endogenous credit creation and the withdrawal of deposits by households or firms. A few comments on public debt are necessary before we proceed to discuss the limits of the strategy adopted by the Argentinean government. First, the government does not need to issue debt denominated in dollars to obtain dollars in the primary market. If a non-resident agent buys a bond denominated in domestic currency, the central bank accumulates foreign reserves too. But this ‘privilege’ (typical of countries with ‘sovereign money’) is not possible in economies with chronic current account deficits.6 The reason is simple: the creditors want to cover fully for the devaluation risk. In these cases, as per Argentina in the 1990s, the financial markets do not validate contracts in domestic currency whatever the level of rate of the domestic interest,7 as we see in Figure 2. Second, the conventional accountability of the balance of payments (BIS, Eurostat, IMF, OECD, Paris Club, UNCTAD, and World Bank) defines the public debt as ‘foreign’ (‘domestic’) if the creditor is non-resident (resident). Hence, this classification ignores the monetary denomination of the debt. For our analytical purposes this classification is incorrect, since the important point is to emphasize the kind of currency in which contracts were signed regardless of the residence of the creditor. The sustainability of the public debt is a monetary phenomenon, not real one. Behind 6. This is what Eichengreen and Hausmann (1999) refer to as the ‘original sin.’ 7. During the last decade, the external conditions (commodities prices and high international liquidity) improved substantially in the majority of the Latin American economies. This is the reason why some Latin American countries can issue debt denominated in domestic currency, like Brazil which decreased the stock of public debt denominated in dollars even with a current account deficit since 2007. © 2013 The Author

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the conventional accounting is the neoclassical Loanable Funds Theory. The aim of this Wicksellian approach would be to compute the international flows of (real) savings between the domestic economy and the rest of the world. But the capital and financial account of the balance of payment does not compute the net inflows of ‘foreign saving,’ but the net inflows of financial assets.8 Hence, the national public indebtedness did not result from insufficient savings or as the consequence of a supply constraint, but was caused by a shortage of foreign exchange reserves or a balance of payment constraint aggravated by a quasi dollarization regime. Thus, the residence of the bond holders in dollars is irrelevant when the government should fulfilling its commitments in dollars. In fact, the Argentinean bond holders in dollars were an important component of the public indebtedness, especially at the end of the Convertibility experiment.9 Thus, regardless of the residence of the creditor, if the public debt is denominated in domestic currency we should call it ‘domestic debt’ and analyse it in terms of the functional finance approach, in which default is by definition impossible.10 But if debt is denominated in foreign currency we should be call it ‘foreign debt’ and analyse it in terms of the Structuralist (or post-Keynesian) approach to the balance of payments constraints (for example, McCombie and Thirlwall 1994), where default is possible or even likely under certain circumstances. Once the distinction between domestic and foreign debt is clarified, it is easy to understand why Convertibility collapsed. The BCRA did not have enough free foreign 8. Under the effective demand principle this conventional accounting does not make sense. ‘Saving’ is a macroeconomic residual irrelevant to the determination of the output. According to Possas (1999): ‘What is called usually as “saving”, as we have seen, is absolutely not saving in the technical sense: it is a financial investment of a stock of wealth; that is, a decision of portfolio composition of the assets of agents, and thus related to their stock of wealth, and not to an eventual savings flow – by definition previous and economically extinct – that he has made’ (Possas 1999, p. 6, author’s translation). Thus, the theoretical inconsistency implicit in the concept of ‘foreign saving’ is related to the impossibility of determining it ex ante, since it is an ex post residual. Further, as noted by Serrano (2000), the concept of foreign savings also has problems related to the ex post accounting identity between savings and investment. For him: ‘This is not really representing the rest of the world sector’s saving but its surplus (that is, it is not income less consumption, but income less expenditures), because among the expenditures by non-residents it does not discriminate between how much was in consumer goods and capital goods. Apparently, the justification for it seems to be this: a capital good exported may not increase domestic production capacity, and the definition of the sum of the “savings” [public, private, and external] should be made in order to match it with the total domestic investment’ (Serrano 2000, author’s translation). 9. As we see in Figure 2, in the period 2000–2001 the credit rationing by non-residents was compensated with informal ‘agreement’ between the government and the banks. The government pressured banks to buy public debt with the pension funds administrated by the banks soon after retirement system privatization. 10. However, it is true that there could be links between public domestic debt and the balance of payments. For example, as we saw above, under certain circumstances the central bank could accumulate foreign reserves through public indebtedness with contracts in domestic currency and under national law. In contrast, in a ‘flight-to-quality’ situation the holders of public domestic bonds could switch to foreign assets, reducing the stock of foreign reserves. But whatever the case, this public domestic debt in national currency could never go unpaid because the State prints the currency in which these contracts are denominated. Of course, this does not mean that a country could not have problems of the balance of payments induced by the domestic debt market. This is the difference between a fiscal crisis and an external crisis. © 2013 The Author

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reserves. Simultaneously, the government was suffering foreign credit rationing because the degree of its external financial fragility had reached high levels. The liberalization process with a boom in imports and no significant increase in exports was behind the dollar shortage, which was reduced for a while with IMF loans. The accommodation of the central bank could also occur even in the absence of foreign reserves, because of the issue of public foreign debt compensating the shortage of dollars on the asset side of the central bank balance sheet. However, at this stage we cannot say that the accommodation of the central bank was unconditional because it depended on the decisions of the foreign creditors. If the government is suffering credit rationing, the central bank loses the ability to act as a lender of last resort. In this sense, under a currency board regime, the monetary authorities are a limited lender of last resort, and that was certainly the case with the BCRA. In order to understand the collapse of the Convertibility system we will develop a simple model assuming that we are starting with a convertibility ratio equal to 1 – that is, when the monetary base is equal to the ‘formal’ foreign reserves computed, which include bonds in dollars on the asset side of the central bank’s balance sheet. Of course, this means that the effective foreign reserves – dollar and gold stocks – are lower than the monetary base but within the institutional limits. The Convertibility condition is that the monetary base variation must be equal to or less than the effective foreign reserves and bonds in dollar variations. In other words: ΔH ≤ ΔR ΔH ≤ ðΔR þ ΔBÞ where the bonds computed as foreign reserves B are a flexible fraction b of the formal foreign reserves stock computed R. Remember that the permanent limit was 20 percent of the total foreign reserves computed. This gives us: R ¼ R þ B B ¼ Rb R ¼ Rð1 − bÞ 0 < b < 0; 2: Further, to analyse this stability condition, we need to point out the determinants of the monetary base and of foreign reserves. On the one hand, the monetary base is endogenous and determined by the credit creation process, as discussed above (also see Moore 1988; Rochon 1999). To simplify, we will assume that the currency held by households and firms is a fixed coefficient α, and greater than unity. Changes in the monetary base are determined in the following way: ΔH ¼ αΔBR ¼ αrΔC: On the other hand, changes in foreign reserves or in the balance of payments are determined by the difference between the capital and financial account (F) and the current account deficit (CAD). To put it formally: ΔR ¼ F − CAD ΔRð1 − bÞ ¼ F − CAD: © 2013 The Author

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Thus, rewriting the sustainability condition, we have that: ðαrΔCÞ ≤ ðF − CADÞ: Now, assuming that the convertibility ratio is equal to 1 at t = 0, we will see that the government may issue foreign debt in order to adjust the foreign reserves to the endogenous increase of the monetary base. Under this convertibility ratio and with a chronic current account deficit (or an insufficient surplus), the government may get the monetary base back raising its foreign liabilities. Hence the institutional limit in the BCRA balance sheet is resolved by increasing the financial fragility of the government’s balance sheet. In formal terms: ΔDt ¼ ΔHt−1 − ΔRt−1 ΔDt ¼ ΔHt−1 − ΔRð1 − bÞt−1 : And with some rewriting: ΔDt ¼ ðαrΔCÞt−1 − Ft−1 − CADt−1 : Note that, in our model, the flexibilities in the accounting of reserves allow for the system to avoid permanent violations of the Convertibility law when the economy and credit are growing. As the increase in the monetary base precedes the indebtedness process and the foreign reserve adjustments, the compulsory convertibility ratio equal to 1 could not be validated. However, the central bank always kept an operational buffer stock based on national bonds computed as foreign reserves. Hence, our Convertibility model may work without failures in spite of our extreme assumptions (for example, there are no ex ante free foreign reserves). The main point here is that, if the monetary base is greater than the effective foreign reserves, the State should cover this discrepancy with foreign debt, in order to avoid a devaluation of the exchange rate. According to Serrano and Summa (2011): Thus capital inflows alone do not directly generate credit booms even under a currency board regime where monetary issue must have rigid backing in foreign currency. What happens, in fact, in countries adopting this system is that domestic banks lend the amount they want in local currency to borrowers considered creditworthy, given the basic interest rate and the bank spread. In this case, an increase in bank lending in the country tends to create the usual need to increase bank reserves, a need that is supplied to the system as a whole, whether through increased loans from the central bank to the private banking sector, whether by sale of government bonds from banks to the central bank. In both cases the monetary base expands endogenously pulled by the endogenous expansion of credit and money supply. Naturally this increased base decreases the degree of coverage of foreign exchange ballast system. This forces the government of the country trying to attract more foreign funds to enlarge the foreign reserves and restore the backed currency system. The end result known is a strong increase in external public debt (foreign currency) with the international private sector (and/or with the government of the metropolis in the case of colonies that have used this scheme) which becomes necessary if the domestic banking system is to pay for activities that use very little foreign exchange. (Serrano and Summa, 2011, p. 12, author’s translation)

Under this simplified model, when the government is not suffering foreign credit rationing, we can say that foreign public indebtedness is largely endogenous. But in a more realistic model, the level of the foreign public debt is also determined by © 2013 The Author

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110 000 100 000 Millions pesos (dollars)

90 000 80 000

Term deposits (dollar)

70 000

Term deposits (peso)

60 000

Demand deposits (dollar)

50 000

Demand deposits (peso)

40 000

Currency

30 000

Foreign reserves

20 000

Monetary base

10 000 I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV I II IIIIV

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: Central Bank of Argentina.

Figure 3

Stock of money and foreign reserves

autonomous decisions of the government. Thus, we may consider as endogenous the public indebtedness that backs the monetary base, since it is a necessary condition for the normal operations of Convertibility. We can write: ΔDt ¼ ΔHt−1 − ΔRt−1 : However, we may consider as exogenous or autonomous the public indebtedness necessary to provide a foreign reserve surplus, free foreign reserves or buffer stock of dollars, depending on what one wants to call it: ΔDt > ΔHt−1 − ΔRt−1 : During the Convertibility, the BCRA had full coverage of foreign reserves for the monetary base, but not for all demand and time deposits. As Figure 3 shows, foreign reserves never backed the money supply in a broad sense. The BCRA never held the dollars to back the currency plus the demand deposits – that is, the current means of payment of the economy.11 And, if we incorporate the time deposits, the situation was even worse in terms of systemic fragility. It is true that the monetary base seems to be fully covered during the Convertibility period. However, in 1995, the BCRA used the ‘creative’ foreign reserve accounting mentioned above as a way to avoid a violation of the Convertibility Law. From the beginning of the Convertibility, the Argentinean government and its ideological supporters – several economists, politicians, journalists, bankers, the IMF, etc. – propagated the idea that the system was absolutely safe, and this was quite effective in swaying public opinion. The reasoning was simple: ‘How could the Convertibility have insolvency risk if the BCRA has enough dollars to back money?’ ‘How could there be devaluation risk if the Argentinean Congress approved a Convertibility Law to prevent any discretionary change in the exchange rate policy?’ 11. Note that from 1995 the currency and the monetary base were equal. This is because the BCRA allowed banks to deposit all their bank reserves in the current account of the Deutsche Bank in New York. Hence the BCRA allowed that even that fraction of deposits in pesos could be transformed into foreign bank reserves. © 2013 The Author

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Less than 4 years later (1991–1994), however, the evidence with respect to the structural fragility of the system was becoming quite evident. During this period, Convertibility worked and maintained price stability, but at the cost of assuming increasing systemic risk. In the first quarter of 1995, the ‘flight to quality’ derived from the ‘Tequila crisis’ was an unstoppable earthquake. As we saw, the BCRA did not have the backing for broad money, the Tequila effect caused a withdrawal of 18 percent of deposits in the banking system, and the BCRA lost 33 percent of its foreign reserves (or approximately $6 billion).12 After this financial crisis, the policymakers tried to reinforce the Convertibility by accumulating foreign reserves in ‘excess’ – that is, above the monetary base. Hence, the only way to create this buffer stock of dollars or free foreign reserves was accelerating public foreign indebtedness. Thus, maintaining our assumption of a convertibility ratio equal to 1, we may incorporate an exogenous or autonomous component of the public indebtedness in our formalization: ΔDt ¼ ΔHt−1 − ΔRð1 − bÞt−1 þ ΔFRd t where ΔFRd ¼ Rd − H e : Rewriting: e ΔDt ¼ ðαrΔCÞt−1 − Ft−1 − CADt−1 þ ΔRd t − ΔHt

where FR are the desired free foreign reserves, Rd are the desired foreign reserves and H e is the expected monetary base by the policymakers. The desired free foreign reserves (ex ante by definition) may only be a ‘desire’ because the government does not control the balance of payments, or variations in the ex ante foreign reserves, and the endogenous money creation. Hence, the free foreign reserves are an ex post variable that may be more or less than the desired foreign reserves. As we can see, really this was an artificial buffer stock because the accumulation of foreign reserves in the BCRA balance sheet generated an increase of the foreign liabilities in the government balance sheet and an increase of the public debt services in an explosive trend. Table 2 illustrates in stylized presentation this accommodation by the process of increasing foreign indebtedness. This is seen using the balance sheets of commercial banks, the central bank and the government. In step 1, commercial banks accommodate the credit-worthy demand by 100 monetary units denominated in pesos. As the bank creates money ex nihilo, it lends to households or firms, and accounts for it in its balance sheet as a new asset (loan) and a new liability (deposit). In step 2, as we are assuming that neither the bank nor the banking system has excess reserves, the central bank lends (prints) 20 pesos to the bank to meet the compulsory requirements (assuming that it is 20 percent of deposits). Thus, this reserve expansion decreases the convertibility 12. Given the vulnerability of the Convertibility some orthodox economists, such as the deputy managing director of the IMF, Stanley Fisher, pointed out: ‘The Convertibility could work much more easily if all banks were foreign, supervised by the monetary authorities of other countries and with access to their respective lenders of last resort’ (Beker and Escudé 2007, p. 14, author’s translation). This thesis was absolutely refuted during the period before the collapse of the Convertibility because foreign banks, that had increased their market share in the Convertibility years, were the main contributors to the undercapitalization of the banking system. Instead of requesting liquidity to their headquarters, they moved their funds abroad. © 2013 The Author

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Table 2 Description of cash flows (government deposits at the central bank) Step

1 2

3a

Commercial bank Assets

Liabilities

Loan +100 Loan +100

Deposit +100 Deposit +100

Central bank Assets

Liabilities

Government Assets

Liabilities

Advance to Bank reserves bank +20 +20

Compulsory Advance from CB +20 deposit at CB +20 Bond Loan +100 Deposit +100 Advance to Bank reserves Government deposit at CB (dollar) bank +20 +20 (dollar) +20 +20 Foreign Government Compulsory Advance from reserves deposit CB +20 deposit at +20 (dollar) +20 CB +20

ratio – that is, the relation of foreign reserves to the monetary base. But as shown in step 3a, to hold the previous convertibility ratio constant the government issues foreign debt (bonds) in the primary market to receive 20 dollars, which it then deposits in its account at the central bank. Thus, government deposits are counted as foreign reserves, thereby re-establishing the convertibility ratio at the level of step 1. Note that we can see in these government deposits a kind of ‘sterilization’ process because this accumulation of foreign reserves does not have an expansionary monetary effect. But the integration mechanism of the dollars received by the government to fund the foreign reserves stock could change without any general implications. In Table 3, step 3b, the government deposits the dollars received in a commercial bank and not in the central bank. The process is now a little more complicated. Assuming that the compulsory requirement is also 20 percent for dollar deposits, the government makes a deposit for 20 dollars in a commercial bank. Due to the fact that the ex ante money multiplier does not exist, the bank does not lend to households or firms and only makes a compulsory deposit for 4 dollars and a voluntary deposit for 16 dollars at the central bank. But as we see in step 4b, automatically the bank sterilizes the voluntary deposits because it prefers to invest in a security, like a bond, to earn a yield. The bank buys from the central bank 16 dollars in bonds in the secondary market (sterilization). In our simplification, the central bank sets the interest rate by selling bonds in the secondary market when the demand for them increases, to avoid an increase in the prices of bonds. Thus, the central bank accumulates 20 dollars (in foreign reserves) without expansionary monetary effect, as a result of the process of sterilization. Another point that must be understood, and that complicates the picture somewhat, is that during the Convertibility period loans were not only made in pesos, but also in dollars. Yet this particularity does not change our story. If the bank loan is in pesos, the BCRA needs the dollars to back the printing of banknotes necessary to accommodate the demand for reserves. If the bank loan is in dollars, the BCRA needs the same dollars to accommodate the demand for reserves in dollars. No doubt, while the process of bank loans in pesos has only potential institutional constraints (Convertibility), the process of bank loans in dollars has potential external constraints. But under the currency board, both kinds of loans appear to have the same constraints. For this reason, during the Convertibility period, the credit creation process was endogenous regardless of the monetary denomination of the bank loans. © 2013 The Author

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Table 3 Description of cash flows (government deposits at a commercial bank) Step

Commercial bank Assets

Liabilities

3b

Loan +100

Deposit +100

4b

Compulsory deposit at CB +20 Compulsory deposit at CB (dollar) +4 Voluntary deposits at CB (dollar) +16 Loan +100 Deposit +100

Central bank Assets

Liabilities

Government Assets

Liabilities

Bond Advance to Bank reserves Government bank +20 +20 deposit at (dollar) bank (dollars) +20 +20 Bank reserves Advance from Foreign CB +20 reserves (dollar) +20 +20 Government deposit (dollar) +20

Compulsory Advance deposit at from CB +20 CB +20 Compulsory Government deposit at deposit CB (dollar) (dollar) +20 +4 Bond (dollar) +16

Advance to Bank reserves Government Bond bank +20 +20 deposit at (dollar) bank (dollars) +20 +20 Foreign Bank reserves reserves (dollar) +4 +20 Bond (dollar) −16

Figure 4 shows the strong increase of the ratio between the bank loans stock denominated in dollars (to the private sector) and the GDP in current prices compared with the same ratio with loans in pesos. The Figure shows a low degree of bank loans in terms of the GDP, but also shows a rapid process of dollarization of the loans of the banking system. Given the demand by creditworthy borrowers, the acceleration of bank loans in dollars could also be explained as an attempt by the private banks to avoid a ‘debt deflation’ process associated with an eventual devaluation of the exchange rate. As banks had an important influx of time deposits in dollars, they could stabilize their portfolios dollarizing their assets, especially the foreign banks that remitted their profits to their headquarters. However, this bank balance sheet dollarization did not eliminate the default risk on these loans, because an eventual devaluation also increased the firms and households’ debt service requirements measured in pesos. Hence, this stabilization based on the credit dollarization was generating its own structural instability through a potential debt deflation on the debtor’s balance sheet side due to expected devaluation (Minsky 1986 [2008b]). After all, the devaluation risk had never been eliminated in spite of a Convertibility Law voted by the national parliament. In this © 2013 The Author

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18 16

Percent

14 Loans in dollars to private sector/GDP current prices Loans in pesos to private sector/GDP current prices

12 10 8 6 I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV

1993 1994 1995 1996 1997 1998 1999 2000 2001 Source: Central Bank of Argentina and National Institute of Statistics and Censuses.

Figure 4

Loans to private sector by kind of currency (and 4 period moving averages)

sense, it is reasonable to assume that credit rationing in pesos existed due to the expectations of devaluation (Wolfson 1996). It is not surprising that devaluation expectations never disappeared because in economies with no hegemonic currency, balance of payments constraints cannot be eliminated merely by fiat, with a parliamentary act. According to Serrano (2003): The madness of dollarization is that it tends to be adopted by countries suffering from chronic shortage of foreign exchange caused by structural deficiencies of competitiveness. But all dollarization does is to dramatically increase the domestic demand for dollars (since the dollars are being used for a number of purposes, beyond the traditional payment of imports), while it does nothing to increase its supply. (Serrano 2003, p. 3, author’s translation)

Of course, a full dollarization system does not have the flexibility of the Argentinean Convertibility. But in spite of these institutional ‘advantages’ (especially in the short term), under full dollarization the level of the demand for dollars would be equal to that under a Convertibility regime. Under a full dollarized regime or a full currency board non-dollarized system, the economy needs the same amount of dollars to circulate as currency or to back the domestic currency, and to integrate the bank reserves or to back the bank reserves in pesos. One way to see the Convertibility’s external implications is observing the balance of payments and the capital and financial account by macroeconomic sectors. Figure 5 (overleaf) shows the current account, the capital and financial account by sectors, and the foreign reserves variations. The nonfinancial public sector and the central bank were crucial for the support of the Convertibility experiment with respect to the behavior of the nonfinancial private sector and the banking sector.13 This means that the State was the main agent responsible to 13. The statistics obtained for this work do not distinguish between public and private banks in the banking sector. It would be more interesting to add the public banks into a consolidated public sector (nonfinancial public sector, central bank, and public banks), but we believe that, in spite of this, the additional information would not change the general conclusions. © 2013 The Author

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15 000

CFA: central bank 10 000 Millions dollars

CFA: banking sector 5 000 CFA: nonfinancial private sector

0

Net errors and omissions −5 000 Current account

−−10 000 International reserves variation −−15 000 Capital and financial account −−20 000 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: National Institute of Statistics and Censuses.

Figure 5

Balance of payments and capital and financial account by sectors

provide the dollars demanded by the current account deficit and the domestic monetary regime. Figure 6 shows the capital and financial account composition of the consolidated public sector (nonfinancial public sector and central bank) to illustrate the main instruments used to obtain dollars in the financial markets. The issue of bonds in foreign currency by the government was the main instrument for funding, followed by international organisms loans. Note that the central bank contribution was only moderately important in 1995 and strong, but insufficient to avoid the collapse in 2001, even though the assistance from the International Monetary Fund increased.14 Finally, the role of privatization was also significant. But in contrast to the official promises, privatizations had a poor net effect in terms of dollar contributions, except in 1999 when the government privatized the Argentinean oil company (Yacimientos Petrolíferos Fiscales, YPF).15 The strategy based on selling public real assets indiscriminately to support the current account deficit was ineffective in the short run and catastrophic for economic development in the long run. Figure 7 shows with more clarity the consolidated public sector behavior in the balance of payments. We compare the sectoral performances using a ratio between the sectoral capital and financial account balance to the overall current account deficit. We see that, when capital inflows to the nonfinancial private and banking sector 14. The central bank sector only became really relevant in 2001 when the Treasury was suffering dollar credit rationing. Curiously, the ‘financial markets’ could distinguish between the government and the central bank as if the two institutions were not part of the same State. This curious fact appears again in 2002 when, after the collapse, the Argentinean government decided that the central bank should issue its own bills to operate in the interbank market to avoid credibility problems associated with the fact that the government was technically in default and the central bank was not. 15. YPF is the largest company in Argentina to this day. After the systematic disinvestment by Repsol – the Spanish company that had bought YPF – recently, in May 2012, YPF was renationalized by a Parliament act to restore the national energy self-sufficiency. © 2013 The Author

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20 000

Millions dollars

15 000

CFA: nonfinancial public sector: bonds CFA: nonfinancial public sector: international organisms CFA: central bank: international monetary fund CFA: nonfinancial public sector: privatizations CFA: consolidated public sector (1992−1993) CFA: consolidated public sector: other

10 000 5 000 0 −5 000

−10 000

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Source: National Institute of Statistics and Censuses.

Figure 6

Capital and financial account: consolidated public sector16

250 200 150

Percent

100 50

CFA (consolidated public sector) / CAD

0 −50

CFA (nonfinancial private and banking sectors) / CAD

−100 −150 −200 −250 −300 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: National Institute of Statistics and Censuses.

Figure 7

Capital and financial account by sectors to current account deficit ratio

decreased, the consolidated public sector compensated it by accelerating its foreign indebtedness in order to maintain the same level of foreign exchange reserves. It is possible therefore to distinguish two periods within Convertibility, as shown in Figure 8 (overleaf). The first was between the beginning of Convertibility up to the Tequila crisis in 1995. This was the Convertibility ‘golden age,’ since the nonfinancial private sector was determinant in the net capital inflows. The second period goes from the Tequila crisis to the final collapse in 2001. In this last period, the consolidated 16. The data for 1992 and 1993 was not available. © 2013 The Author

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9000 8000 7000 6000

Consolidated public sector

5000

Nonfinancial public sector

4000

Central bank Nonfinancial private sector

3000

Banking sector

2000

International reserves variation 1000 0 −1000 Average 1992−1994

Average 1995−2001

Average 1992−2001

Source: National Institute of Statistics and Censuses.

Figure 8

Capital and financial account by sectors

public sector was the main contributor of dollars through an unsustainable foreign indebtedness process. The averages of the respective capital and financial account results for the 1992–1994 and 1995–2001 periods provide strong evidence for the switch between private and public sector as the main sources of dollars to back Convertibility. While the consolidated public sector inflows increased by 174 percent, the rest of the capital and financial account decreased by 98 percent for the average of the 1992–2001 period. However, when we look at the balance of payment by sectors (Figure 9), it is clear that the consolidated public sector ‘funded’ the nonfinancial private sector and the Convertibility regime.17 The nonfinancial private sector balance is negative for the average 1992–2001 period and worse for the 1995–2001 phase. Only if we analyse the average 1992–1994 period does this sector register a positive balance. Looking at the balance of payment by sectors confirms the two periods described above: the shorter ‘golden age’ period, when Convertibility was supported by both the nonfinancial private and the public sector, and the longer ‘in between crisis’ when the Convertibility was only supported by the public sector increasing its indebtedness. However, when we observe the current account deficit in Figure 10, the nonfinancial public sector interest payments were an important component that shows the perverse effects of the mechanism of increasing foreign indebtedness. The public foreign debt, issued to fund the current account deficit, increased even more than the current

17. Due to the lack of data on the net export by sectors, we assume, as in Basualdo (2010), that all imports and exports corresponded to the nonfinancial private sector. Of course, it is an arbitrary but fairly reasonable assumption. It is arbitrary because the other sectors never appear in formal terms as importers (exporters), but it does not mean that they are not responsible for some imports, and much less likely of exports. However, the assumption is reasonable because net imports are not relevant in the banking sector and the State net imports cannot be relevant in a capitalistic economy going through an aggressive privatization process. © 2013 The Author

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5000

4000

3000

2000 Millions dollars

Consolidated public sector Nonfinancial public sector

1000

Central bank Nonfinancial private sector

0

Banking sector International reserves variation

−1000 −2000 −3000 −4000 Average 1992–1994

Average 1995–2001

Average 1992–2001

Source: National Institute of Statistics and Censuses.

Figure 9

Balance of payments by sectors

8 000

Nonfinancial public sector interests Central bank interests

6 000 4 000 Millions dollars

2 000

Other income

0 −2 000 −4 000

Services

−6 000

Goods

−8 000 −10 000

Current account

−12 000

International reserves variation

−14 000 −16 000

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: National Institute of Statistics and Censuses.

Figure 10

Current account

account deficit, via interest on debt in a cumulative process that led to increasing financial fragility. Hence, Figure 11 (overleaf) shows the strong increase of the national government foreign debt services to export ratio and also the amount of the debt service (interests © 2013 The Author

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40 000 Debt service

800

35 000

Debt service/exports

700

30 000

600 Percent

25 000 500 20 000 400 15 000

300 200

10 000

100

5 000

0

Millions dollars

344

0 1993

1994

1995

1996

1997

1998

1999

2000

2001

Source: National Institute of Statistics and Censuses and Ministry of Economics.

Figure 11 National public foreign debt services to exports ratio (left) and the amount of national public foreign debt services (right) plus amortization). Note that this data is not only showing the increase of the debt services proportionally to the increasing of its foreign liabilities, but also the increase of its financial costs by the rise in the ‘country risk.’ In 2001, the combination of an inconclusive IMF bailout program with a very significant loss of foreign reserves was insufficient to stop the inevitable.18 For this reason, the Argentine currency board was unsustainable not only in banking terms by the dollarization of deposits, but above all in terms of the balance of payments. The collapse in 2001 was a banking crisis and a public foreign debt default.19 6

CONCLUSION

This paper tried to demonstrate that, even under a currency board, the money creation (pesos and dollars) process is endogenous and demand-led. In the Argentinean case, 18. The political conditions of the IMF based on an aggressive contractive fiscal policy generated an improvement in net exports: the recession reduced imports but to a level insufficient to resolve the current account deficit and the balance of payments constraints. However, as tax revenues are endogenous to the level of economic activity, recession aggravated the fiscal deficit. Then, the government issued bonds in dollars (the only types of bonds validated by the market) to cover public spending. Summarizing, contractive fiscal policy increased net export indirectly to mitigate the current account deficit, but at the same time incorporated an additional source of public indebtedness in dollars. 19. Note that if, during the Convertibility, the economy had not been dollarized the banking system would not have suffered important problems in legal terms in the face of a devaluation. The banking contracts did not ensure a future exchange rate. So, devaluation redistributed income to the banks to the detriment of the depositors but did not violate any contract. But, of course, all problems associated with the balance of payments constraint would remain and the Convertibility would disappear too. © 2013 The Author

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the short-term sustainability of Convertibility with endogenous and demand-driven money creation could only be maintained by a process of increased and unsustainable public foreign indebtedness. This was the result of the economy’s chronic current account deficit (or insufficient surplus) to provide for dollars. The currency board scheme cannot be sustained in the long run because the credit in dollars is not unlimited for countries with chronic current account problems. Credit rationing in dollars is a precautionary response to the debtor’s financial fragility. Hence, under a chronic current account deficit, currency boards only worsen the balance of payments constraints. Convertibility never could be stable because the convertibility ratio is endogenous and it cannot be administrated with foreign debt in the long run: foreign reserves are determined by the balance of payments and the monetary base is driven by domestic credit demand. To control the convertibility ratio, public indebtedness deepened the chronic current account deficit via greater interests and worsened the public sector’s financial fragility. In contrast to other recent experiences of dollarization, such as the Ecuadorian case, the Argentinean Convertibility did not have the ‘advantage’ of an Anthropo-Export Model to mitigate the balance of payment constraint (Vernengo and Bradbury 2011). The remittances and the ability to ‘export people’ never were a viable social alternative. The main lesson of the Convertibility collapse is that money is an essential part of State sovereignty – that is, the ability to make monetary and fiscal policy without external institutional constraints. Hence, the existence of a monetary authority with the ability to provide domestic currency without limits – that is, a central bank – is an indispensable institutional device for any economic development strategy. Monetary integration, as Convertibility can be described since it’s a quasi-dollarization case, does not occur as the result of the spontaneous decisions of private agents to minimize transactions costs, as the Metalist theory points out. Convertibility demonstrated that a monetary regime and money are always a ‘creature of the State’ (Lerner 1947) even when the political purpose is to turn the State into a creature of financial interests (Smithin 2000).

REFERENCES Basualdo, E. (2010), Estudios de la Historia Económica Argentina, Buenos Aires: Siglo Veintiuno. Beker, V.A. and Escudé, G.J. (2007), ‘Vida, pasión y muerte de la Convertibilidad en Argentina,’ Estudios Económicos, 25 (50), 1–36. Cavallo, D.F. and Mondino, G. (1996), ‘Argentina’s Miracle: From Hyperinflation to Sustained Growth,’ in Bruno, M. and Pleskovic, B. (eds), Annual World Bank Conference on Development Economics, Washington, DC: The World Bank. Damill, M. (1999), ‘Convertibilidad, capitales volátiles y estabilización. El papel de las finanzas del gobierno,’ Revista de Economía Política, 19 (1), 73. De Lucchi, J.M. (2012), ‘El enfoque de dinero endógeno y tasa de interés exógena. Reflexiones sobre la Convertibilidad y la Pos-Convertibilidad argentina,’ DT No 44, CEFID-AR. Eichengreen, B. and R. Hausmann (1999), ‘Exchange rates and financial fragility,’ in New Challenges for Monetary Policy, Kansas City, MO: Federal Reserve Bank of Kansas City, pp. 329–368. Galbraith, J.K. (1997), ‘Time to ditch the NAIRU,’ Journal of Economic Perspectives, 11 (1), 93–108. Hanke, S.H. (1997), ‘A field report from Sarajevo and Pale,’ Central Banking, 3 (3), 36–40. © 2013 The Author

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Hanke, S.H. and Schuler, K. (1999), ‘A dollarization blueprint for Argentina,’ Friedberg’s Commodity and Currency Comments Experts’ Report (1 February). Toronto: Friedberg Commodity Management. Kaldor, N. (1982), The Scourge of Monetarism, Oxford: Oxford University Press. Kiguel, M.A. (1999), ‘The Argentine Currency Board,’ Working Paper, Universidad del CEMA, Buenos Aires. Lavoie, M. (1992), Foundations of Post-Keynesian Economic Analysis, Aldershot, UK: Edward Elgar. Lavoie, M. (2001), ‘The reflux mechanism and the open economy,’ in Rochon, L.-P. and Vernengo, M. (eds), Credit, Interest Rates and the Open Economy: Essays on Horizontalism, Cheltenham, UK: Edward Elgar, pp. 215–242. Lavoie, M. (2006), ‘A fully coherent post-Keynesian model of currency boards,’ in Gnos, C. and Rochon, L.-P. (eds), Post-Keynesian Principles of Economic Policy, Cheltenham, UK: Edward Elgar, pp. 185–207. Lerner, A. (1947), ‘Money as a creature of the state,’ The American Economic Review, 37 (2), 312–317, Papers and Proceedings of the Fifty-ninth Annual Meeting of the American Economic Association, May. McCombie J. and Thirlwall, A. (1994), Economic Growth and the Balance of Payments Constraint, Basingstoke: Macmillan. Minsky, H.P. (1986 [2008b]), Stabilizing an Unstable Economy, New Haven, CT and London, UK: Yale University Press. Moore, B. (1988), Horizontalists and Verticalists: The Macroeconomics of Credit Money, Cambridge, UK: Cambridge University Press. Obstfeld, M., Shambaugh, J., and Taylor, A. (2010), ‘Financial stability, the trilemma, and international reserves,’ American Economic Journal: Macroeconomics, 2 (2), 57–94. Pérez Caldentey, E. and Vernengo, M. (2007), A Tale of Two Monetary Reforms: Argentinean Convertibility in Historical Perspective, Utah: University of Utah. Ponsot, J.F. (2003), ‘The obsession of credibility: a historical perspective on full dollarization and currency boards,’ Journal of Political Economy, 33 (1), 83–99. Possas, M. (1999), ‘Demanda efetiva, investimento e dinâmica: a atualidade de Kalecki para a teoria macroeconômica,’ Revista de Economia Contemporânea, 3 (2), 17–46. Prospectus (2004), ‘The Republic of Argentina: debt securities, warrants, units,’ Amendment no. 3 to the registration statement under schedule b of the Securities Act of 1933, Securities and Exchange Commission, Registration no. 333-117111. Rochon, L.-P. (1999), ‘The creation and circulation of endogenous money: a circuit dynamique approach,’ Journal of Economic Issues, 33 (1), 1–21. Rodríguez, C.A. (1995), ‘Ensayo sobre el Plan de Convertibilidad,’ CEMA, Working Papers: Serie Documentos de Trabajo, no 105. Romer, D. (2000), ‘Keynesian Macroeconomics without the LM Curve,’ Journal of Economic Perspectives, 14 (2), 149–169. Schuler, K. (2005), ‘Ignorance and influence: U.S. economists on Argentina’s depression of 1998–2002,’ Econ Journal Watch, 2 (2), 234–278. Serrano, F. (2000), ‘A soma das Poupanças determina o investimento?’ Archetypon, 8 (3). Serrano, F. (2002), A Política Monetária e a Abordagem da Taxa de Juros Exógena, Rio de Janeiro: IE-UFRJ. Serrano, F. (2003), ‘Dolarização na America Latina,’ Mimeo, IE-UFRJ, Rio de Janeiro. Serrano, F. and Summa, R. (2011), Mundell–Fleming Sem a Curva LM: A Taxa de Juros Exógena na Economia Aberta, Rio de Janeiro: IE-UFRJ. Smithin, J. (2000), What is Money? London: Routledge. Smithin, J. (2005), The Theory of Interest Rate, Toronto: York University. Vernengo, M. and Bradbury, M. (2011), ‘The limits to dollarization in Ecuador: lessons from Argentina,’ Journal of the Political Economy of the World-Systems Section of the American Sociological Association, XVII (2), 447–462. Wolfson, M. (1996), ‘A post-Keynesian theory of credit rationing,’ Journal of Post Keynesian Economics, 18 (3), 443–470. © 2013 The Author

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Review of Keynesian Economics, Vol. 1 No. 3, Autumn 2013, pp. 347–369

Is inflation targeting operative in an open economy setting? Esteban Pérez Caldentey* Economic Commission for Latin America and the Caribbean (ECLAC) and the United Nations

Matías Vernengo* Central Bank of Argentina and University of Utah, USA

The justification for inflation targeting rests on three core propositions. The first is called ‘lean against the wind,’ which refers to fact that the monetary authority contracts (expands) aggregate demand below capacity when the actual rate of inflation is above (below) target. The second is ‘the divine coincidence,’ which means that stabilizing the rate of inflation around its target is tantamount to stabilizing output around its full employment level. The third proposition is that of stability. This means that the inflation target is part of an equilibrium configuration which generates convergence following any small disturbance to its initial conditions. These propositions are derived from a closed economy setting which is not representative of the countries that have actually adopted inflation targeting frameworks. Currently there are 27 countries, 9 of which are classified as industrialized and 18 as developing countries that have explicitly implemented a fully fledged inflation targeting regime (FFIT). These countries are open economies and are concerned by the evolution of the external sector and the exchange rate as proven by their interventions in the foreign exchange markets. We show that these three core propositions and the practice of inflation targeting are inoperative in an open economy context. Keywords: inflation targeting, open economies, exchange rate JEL codes: E42, E58, F41

1

INTRODUCTION

A fully fledged inflation targeting regime (FFIT) is generally defined as a framework consisting in the public announcement of numerical targets for the inflation rate with the explicit acknowledgement that a low and stable rate of inflation is the main objective of monetary policy. The framework also requires a commitment to transparency and accountability in the monetary policy decisionmaking process and in its results. Inflation targeting has gained prominence as a monetary strategy since the late 1990s (see Roger 2009). Currently 27 countries, 9 of which are classified as industrialized and 18 as developing countries have explicitly implemented a fully fledged inflation targeting regime (FFIT). Inflation targeting is presented by its proponents as a * The opinions here expressed are those of the authors and may not coincide with those of the institutions with whom they are affiliated. The authors wish to thank Cecilia Vera for useful comments on an earlier version of this paper. © 2013 The Author

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coherent and flexible approach to monetary policy differing from the more rigid ones based on monetary rules or fixed exchange rates and proving to be a better and more successful alternative in the control of inflation. In this paper we argue that the raison d’être and, ultimately, the validity of a fully fledged inflation targeting regime is founded on three core propositions. The first states that the central bank follows a ‘lean against the wind’ strategy in the implementation of monetary policy. This refers to the fact that, provided the output gap is the policy variables, the monetary authority contracts aggregate demand below capacity when the actual rate of inflation is above target.1 The second one is an equivalency proposition termed ‘the Divine Coincidence.’2 This means that stabilizing the rate of inflation around its target is tantamount to stabilizing output around its full employment level. The main implication is that the monetary authorities should worry about inflation. The third proposition which follows from the previous two is that of stability. The inflation target is part of an equilibrium configuration of an economy derived from a Taylor rule, a New Keynesian Phillips curve and a standard aggregate demand function. Moreover, the economy will converge towards its equilibrium position following any small disturbance to its initial conditions.3 We also show that these three core propositions follow from a closed economy model that is hardly representative of the countries that have adopted inflation targeting and which are, by most criteria, open economies. Their concern for external conditions is illustrated by their active intervention in the foreign exchange markets. In line with the evidence presented, once the inflation targeting framework is modified to include the open economy dimension in a meaningful sense, we show that these three core propositions are inoperative theoretically and empirically and that the practice of inflation targeting leads to fundamental policy dilemmas. This presumes the utilization of the conventional model, often referred to as the New Consensus, which has several significant flaws (see, for example, Arestis and Sawyer 2008; Arestis 2009). The paper is divided into six further sections. Section 2 sketches the basics of inflation targeting with a focus on fully fledged inflation targeting (FFIT). Section 3 derives formally the core propositions of inflation targeting using a quadratic loss function subject to the structure of the economy encapsulated in a New Keynesian Phillips curve and an IS function. Section 4 underscores the importance of the external sector for the economies that have adopted FFIT and shows empirically that these countries actively intervene in the foreign exchange market. Section 5 introduces the external sector in the inflation targeting framework and shows the inoperative character of the core propositions. Section 6 illustrates this point empirically for all 27 economies in the sample. Section 7 concludes. 2

A BASIC SKETCH OF INFLATION TARGETING

Inflation targeting is traditionally defined as a monetary policy strategy framework consisting in the public announcement of numerical targets for the inflation rate, acknowledging that price stability is the fundamental goal of monetary policy and 1. See Clarida et al. (1999). 2. See Blanchard and Gali (2005). 3. See Setterfield (2006); Rochon and Setterfield (2007). Note that if the notion of a natural rate, which has significant logical problems and not much evidence to favor it, is abandoned, then the main conclusions about leaning against the wind and the divine coincidence do not hold. © 2013 The Author

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a firm commitment to transparency and accountability.4 Within the context of this definition, numerical targets can refer to a point inflation rate, a range or a point with a tolerance range. The inflation rate can refer to the headline consumer price index (CPI), as is the standard case for most developing economies, or to the core CPI.5 Transparency means that the monetary authorities must communicate their targets, forecasts of inflation, decisions on monetary policy, and the motivation for their decisions. Finally, accountability here means that the monetary authorities are responsible for attaining the announced objectives and subject to ‘public scrutiny for changes in their policy or deviations from their targets.’6 The above definition typifies the components of a fully fledged inflation targeting regime (FFIT). There are currently 27 countries that have announced that they are operating on an FFIT. Among these, 18 (or 67 percent of the total) are developing and 9 (or 33 percent of the total) are developed countries. The greater majority of developed countries adopted inflation targeting in the 1990s. For their part, developing countries implemented inflation targeting regimes mainly in the past decade (see Table 1, overleaf). In practice, FFITs do not, as a rule, follow ‘a firm commitment to transparency and accountability.’ The evidence indicates that a small majority (66.7 percent of total FFITs) abide by the transparency criterion in so far as the respective central banks publish the minutes of the monetary authorities. Still, this means that 33.3 percent do not. In terms of accountability, only in 25.9 percent of the country cases do the central banks provide an open letter explaining their policy outcomes. However, the great 4. Bernanke et al. (1999, p. 4) define inflation targeting as a: ‘framework for monetary policy characterized by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by the explicit acknowledgement that low, stable inflation is monetary policy’s primary goal.’ According to Mishkin (2004), inflation targeting comprises five distinct but interrelated aspects: ‘(i) the public announcement of medium-term numerical targets for inflation; (ii) an institutional commitment to price stability as the primary goal of monetary policy; (iii) an information inclusive strategy in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments; (iv) increased transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives, and decisions of the monetary policy authorities; and (v) increased accountability of the central bank for attaining its inflation objectives.’ Svensson (2007) provides a similar definition. 5. Note that price stability is not an easy concept to define. It is defined generally in terms of the demand for money – that is, a situation where agents do not change their demand for money in response to price changes. Angeriz and Arestis (2007) quote Greenspan (1988) on price stability: ‘a situation in which households and businesses in making their savings and investment decisions can safely ignore the possibility of sustained generalized price increases or price decreases.’ Clarida et al. (1999, p. 1669) refer to price stability as the inflation rate at which inflation is no longer a public concern. According to these authors, an inflation rate between 1 and 3 percent meets this definition and is perhaps the explanation for the 3 percent mean inflation target in the case of Chile. 6. Svensson (2007, pp. 2–3) states: ‘In several countries inflation-targeting central banks are subject to more explicit accountability. In New Zealand, the Governor of the Reserve Bank of New Zealand is subject to a Policy Target Agreement, an explicit agreement between the Governor and the government on the Governor’s Responsibilities. In the UK, the Chancellor of the Exchequer’s remit to the Bank of England instructs the Bank to write a public letter explaining any deviation from the target larger than one percentage point and what actions the Bank is taking in response to the deviation. In several countries, central-bank officials are subject to public hearings . . . and in several countries monetary policy is . . . subject to extensive reviews by independent experts.’ © 2013 The Author

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Table 1 FFIT countries, industrialized/developing, date of IT adoption, inflation target in 2012 and target horizon Country

Industrialized/ developing

Adoption of inflation targeting

Target measure

Target 2012

Target horizon

Armenia Australia Brazil Canada

D I D I

2006 1993 1999 1989

HCPI HCPI HCPI HCPI

4%+/−1.5pp 2%–3% 4.5%+/−2pp 2%

Chile Colombia Czech Republic Ghana Guatemala Hungary Iceland Indonesia Israel Mexico New Zealand Norway Peru Philippines Poland Romania Serbia South Africa Korea, Rep. Sweden Thailand Turkey United Kingdom

D D D

1999 1999 1997

HCPI HCPI HCPI

3%+/−1pp 2%–4% 2%+/−1pp

D D D I D I D I I D D D D D D I I D D I

(2002) 2007 2005 2001 2001 2005 (1992) 1997 2001 1989 2001 2002 2002 1998 2005 (2006) 2009 2000 1998 1995 2000 2006 1992

HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI HCPI

8.7%+/−2pp 4.5%+/−1pp 3% 2.50% 4.5%+/−1pp 1%−3% 3%+/−1% 1%–3% 2.50% 2%+/−1pp 4.0%+/−1pp 2.5%+/−1pp 3%+/−1pp 4.0%+/−1.5pp 3%–6% 3%+/−1pp 2% 3.0%+/−1.5pp 5.0%+/−2pp 2%

Medium term Medium term Yearly target 6–8 quarters; current target extends to December 2016 2 years Medium term Medium term, 12–18 months 18–24 months End of year Medium term On average Medium term Within 2 years Medium term Medium term Medium term Continually Medium term Medium term Medium term Medium term Continually 3 years 2 years 8 quarters 3 years Continually

Note: Dates in parentheses in column 3 indicate the year in which FFIT was adopted informally in the respective countries. Years without parentheses refer to the year in which FFIT was adopted formally. We use the latter as the reference point for our analysis and empirical results. Source: Hammond (2012).

majority (70.4 percent of the total) have parliamentary hearings on monetary policy (see Table 2). All countries, with no exceptions, have a time horizon to achieve their target inflation, illustrating the fact that they all practice ‘flexible inflation targeting’ as opposed to ‘strict inflation targeting.’ Flexible inflation targeting implies that the monetary authorities or the central bank do not have only a monetary objective (stabilizing inflation) but also have a real objective (stabilizing real output). As put by Svensson (2007, p. 1): ‘In practice inflation targeting is never “strict” inflation targeting but always © 2013 The Author

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Table 2 Percent of total FFIT countries, developed and industrialized, that comply with different aspects of inflation targeting institutionality Percentage Percentage of of total developed countries

Percentage of Percentage of developing LA countries countries

Setting of the inflation target Government Central bank Both

11.1 33.3 55.6

22.2 11.1 66.7

5.6 44.4 50.0

0.0 83.3 16.7

Decision making process Consensus Governor Majority vote

29.6 3.7 66.7

44.4 11.1 44.4

22.2 0.0 77.8

0.0 0.0 100.0

Acountability Open letter (afirmative) Open letter (negative)

25.9 74.1

22.2 77.8

27.8 72.2

16.7 83.3

Parliamentary hearing (afirmative) Parliamentary hearing (negative)

70.4 29.6

100.0 0.0

55.6 44.4

100.0 0.0

Transparency CB minutes published (afirmative) CB minutes published (negative)

66.7 33.3

66.7 33.3

66.7 33.3

83.3 16.7

Source: Based on Hammond (2012).

“flexible” inflation targeting, in the sense that all inflation-targeting central banks . . . not only aim at stabilizing inflation around the inflation target but also put some weight on stabilizing the real economy . . . implicitly or explicitly stabilizing a measure of resource utilization such as the output gap between actual output and “potential output”.’ The literature also refers to ‘flexible’ inflation targeting as pursuing stability of interest rates or of the variation of the exchange rate in an open economy.7 The adoption of ‘flexible’ inflation targeting entails pursuing a ‘gradualist’ approach to the achievement of monetary policy objectives. ‘Flexible’ inflation targeting and hence a gradualist approach to monetary policy is conceptually justified mainly on the grounds of uncertainty regarding: (1) the workings and current state of the economy; (2) the transmission mechanisms and policy parameters; and (3) the nature of external shocks as well. A gradualist policy can also contribute to buffer the effects on real variables caused by external shocks.

3

INFLATION TARGETING AND ITS CORE PROPOSITIONS

At a conceptual level, the inflation targeting framework is generally presented and analysed for a closed economy setting. More importantly, this closed economy context allows the derivation of the core propositions on which inflation targeting rests, 7.

See Svensson (1997; 1999; 2007) and Jonas and Mishkin (2005).

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including the ‘lean against the wind’ feature, the occurrence of the ‘divine coincidence’ (that is, that ‘stabilizing inflation is equivalent to stabilizing output around its natural level’ (Blanchard 2006, p. 413)) and the stability properties, that make it such a desirable monetary policy from the point of view of the mainstream. These three fundamental properties can be derived from ‘first principles,’ by assuming that inflation targeting is an optimal targeting rule derived from an explicit objective function. More precisely, central banks solve a ‘standard optimal control problem, choosing the path of the price level that minimizes a quadratic loss function subject to the constraints imposed by the linear structure of the economy’ (Cecchetti and Kim 2006, p. 176). Formally the loss function is specified as: L ¼ ðya − yn Þ2 þ βðπt − πT Þ2 þ γðit − it−1 Þ2

(3.1)

Where ya , yp = actual and potential output; πt , πT = actual and target inflation rates, and it is the short-term nominal interest rate (that is, the monetary policy rate).8 According to the logic imbedded in Equation (3.1), a deviation of the rate inflation from its target or of output from its natural level produces a loss of utility for the central bank. The parameter β and its particular value characterizes the degree to which a central bank is inflation-averse. If β = 1, (>1) the central bank places the same (greater) weight on output fluctuations as on the deviation of inflation from its target. The greater is the parameter β, the greater is the aversion towards inflation. To the extent to which the control of inflation (which in this case means the reduction of the variance of the actual rate of inflation relative to its target point or range) is the hierarchical objective of the central bank (Svensson 2004), β is >1 by definition. The loss function (Equation (3.1)) is minimized subject to the ‘structure of the economy,’ captured by a New Keynesian Phillips curve (πt = Etπt+1 + α(ya − yn)) and a standard aggregate demand curve (ygt ¼ −φ ðit − Eπtþ1 Þ þ Eygtþ1 ), where ygt is the output gap. This is stated formally as follows: 2 2 t T 2 Min E o ∑∞ t¼0 β ððya − yn Þ þ βðπt − π Þ − γðit − it−1 Þ Þ; where β ∈ ð1; 0Þ

(3.2)

is the discount factor, subject to πt ¼ E t πtþ1 þ αðya − yn Þ

ðPhillips CurveÞ

ygt ¼ −φðit − Eπtþ1 Þ þ Eygtþ1

ðIS CurveÞ

(3.3) (3.4)

8. The loss function includes an interest rate smoothing term γðit − it−1 Þ2 that captures the empirical fact that central banks adjust interest rates according to a smooth path capturing the fact that the policy rate moves in sequences of small steps, and that interest rate reversals are ‘infrequent.’ See Sack and Wieland (1999) and Amato and Laubach (2003). The quadratic nature of the loss function implies a symmetry in the weight placed on the deviations above and below targets for both inflation and output. As a result, the specification of the loss function suggests that since the central bank is concerned to the same extent by inflation and deflation, its reaction to both situations is also symmetric. © 2013 The Author

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The first order conditions from the single period minimization of the objective function subject to both constraints are: δL ¼ βπgt − λ1 ¼ 0 δπt δL ¼ ygt þ αλ1 − λ2 ¼ 0 δygt δL ¼ γðit − it−1 Þ − λ2 θ ¼ 0 δit

(3.5)

Where λ1, λ2 are the Langrangean multipliers and πgt is the inflation gap.9 Using the first order condition and replacing it in the second order conditions and setting the second Lagrangean multiplier λ2 = 0 yields the first important attribute of inflation targeting regimes, namely the ‘lean against the wind’ or countercyclical feature: ygt ¼ −αβπgt

ðLean against the windÞ

(3.6)

Equation (3.6) states that the minimization of the loss function and the optimal derivation of y for each value of the inflation rate is, in fact, equivalent to a negative relation between the output and the inflation gap (ygt ; πgt respectively) given by −αβ. This implies that when the actual rate of inflation is above its target (πt > πT ), the monetary authorities will lower actual output below its natural level (ya < yn). In other words, within the inflation targeting logic, a rate of inflation above its target implies that the monetary authorities must contract aggregate demand by raising interest rates. The Central Bank will then focus on the trade-offs between the output and inflation. In a similar manner, a rate of inflation below its target implies that the monetary authorities must expand aggregate demand by decreasing interest rates. Monetary policy is by design counter-cyclical (Clarida et al. 1999). The extent to which monetary policy is counter-cyclical depends on the parameters α and β. A second important result derived from the above analysis is the absence of a tradeoff between the output and inflation gap, the so-called ‘divine coincidence’ (Blanchard and Gali 2005). More precisely, the specification of the loss function implies that both the stabilization of inflation and output are desirable goals and that there is no conflict between them. As inflation approaches its target, output approaches its natural level as well. In line with Equation (3.6), we imply that for any given values of α and β the smaller is the inflation gap, the smaller will be the output gap. ðya − yn Þ ¼ −αβðπt − πT Þ and πt ! πT ) ya ! yn ðDivine coincidenceÞ10

(3.7)

9. In the derivation of the first order conditions we do not address the issue of commitment/ discretion which has been of recent relevance to the inflation-targeting literature. When the monetary authorities do not have a commitment regarding the future path of inflation they practice discretion, and the above optimization problem is reduced to a period-by-period optimization. Within the logic of inflation targeting, when the central bank makes promises about future inflation (and thus acts under commitment), this has a positive effect on current inflation, since according to the literature – and also Equation (3.3) above – current inflation depends in part on future inflation. See Lam (2010). 10. At first sight, the ‘lean against the wind’ and ‘divine coincidence’ appear contradictory. According to the former, there is a trade-off between stabilizing output and inflation. The latter denies the existence of a trade-off. A way to make both views compatible is to argue that the © 2013 The Author

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The obvious implication is that since inflation stabilization is the hierarchical and main objective of monetary policy, it is equivalent to stabilizing output. As put by Blanchard (2006, p. 3): Stabilizing inflation also stabilizes the distance of output from first best – the welfare-relevant output gap. This is really an important result. It implies that central banks should indeed focus just on inflation, and we can sleep well at night. If they succeed in stabilizing inflation, they will automatically generate the optimal level of activity. Put another way, even if you do not care about inflation, but only about activity, you would still want the central bank to focus on inflation. Inflation targeting is an output-friendly rule.11

Finally, the third important attribute of inflation targeting is the property of stability, or more precisely that the inflation target is ‘part of an aggregate equilibrium configuration toward which the economy will return following any disturbance’ (Setterfield 2006, p. 657). In order to derive the stability attribute, the equation describing the reaction function of the central bank is required. The reaction function can be obtained by manipulating the three first-order conditions from the central bank optimization problem. That is, from the first and third first-order conditions we obtain: δL ¼ βπgt − λ1 ¼ 0 , λ1 ¼ βπgt δπt δL γðit − it−1 Þ ¼ γðit − it−1 Þ − λ2 θ ¼ 0 , λ2 ¼ δit θ

(3.8)

Then, substituting the value of both λ1 and λ2 into the second first-order condition, we get an equation for the rate of interest: δL γðit − it−1 Þ ¼0 ¼ ygt þ αλ1 − λ2 ¼ 0 , ygt þ αβπgt − θ δygt θαβ g θ g π þ y , it ¼ it−1 þ γ t γ t

(3.9)

‘lean against the wind’ applies to the short run while the ‘divine coincidence’ is applicable to the long run. This view finds its justification in Blanchard and Gali (2005), who argue that the divine coincidence applies in the absence of ‘trivial rigidities.’ This line of thinking implies that a positive inflation gap will result in actions tending to decrease the output below trend but that eventually output will converge towards its potential level. This is consistent with the stability proposition. Our empirical results on both properties apply to both long and short periods of time. Some countries have had FFIT in operation for roughly 2 decades, while for others its application has not surpassed a period of 10 years. In any case, according to our interpretation, the divine coincidence is a proposition that can be understood and tested in terms of variances: the smaller is the variance of the inflation gap, the smaller is the variance of the output gap. 11. Woodford and Giannoni (2003, p.3) also state: ‘The present theory implies not only that price stability should matter in addition to stability of the output gap, but also that, at least under certain circumstances, inflation stabilization eliminates any need for further concern with the level of real activity . . . the time varying efficient level of output is the same as the level of output that eliminates any incentive for firms on average to either raise or lower prices.’ © 2013 The Author

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Equation (3.9) is a particular expression of a more general optimal interest rate rule commonly known as a Taylor rule equation. It states that the difference between the actual real rate of interest from its natural level (r i − r n or r gt ) is proportional to the output gap, or the nominal interest gap is proportional to the inflation and output gaps (πgt and ygt respectively).12 This idea is easily incorporated into our model by incorporating both the inflation rate and the natural rate of interest as variables in Equation (3.9). Accordingly, when the actual rate of inflation is equal to its target (π↓i = π↑T), and given the ‘divine coincidence’, the level of output is equal to its natural level (yi = yn); then the actual rate of interest is also at its equilibrium or natural level (ri = rn). This is exactly the sort of result that Knut Wicksell had suggested long ago. The interest rate equation, together with the Phillips curve and the aggregate demand (IS) function, completes the system required to prove the stability property. This can be seen by rewriting the corresponding system composed of Equations (3.3, 3.4, and 3.9) as a system of differential equations: y˙ g ¼ − φ˙r π˙ ¼ αyg θαβ g θ g π þ y r˙ ¼ γ γ

(3.10)

Substitution of the interest equation (˙r ) into the output gap equation (˙y " g) reduces the system to two differential equations which can be expressed in matrix form as: 2 3 2 3 θ θαβ " g # φθαβπT  g y −φ −φ y˙ 6 7 6 γ γ 7 γ (3.11) ¼4 þ4 5 5 π˙ π α 0 0 The stability of the system is provided by matrix. Since the determi the 2Jacobian  φθα β nant of the Jacobian matrix is positive > 0 and the trace is negative γ (−φ θγ < 0), the 2 × 2 system is stable. 4

THE FFITs AS OPEN ECONOMIES

The economies that have formally adopted FFIT regimes are different in terms of size and development, productive structure, and export base. Nonetheless, they share one common feature. They have become increasingly open over time, since before the adoption of FFIT regimes. Figure 1 shows, for FFIT developed and developing economies, the composition of trade in GDP, weighted tariff rates, the participation of private financial flows in GDP and the degree of financial openness measured by the Chinn–Ito index, 10 and 5 years before and 5 and 10 years after the adoption of inflation targeting. On average, 10 years prior to the adoption of a FFIT regime, the participation of trade (exports plus imports) in GDP for all economies included in our sample reached 56 percent. Ten years following the adoption of inflation targeting, it increased to 12. Here we assume that monetary policy responds to the current inflation and output gaps. In some specifications, monetary policy responds in the first instance only to the inflation gap, and only in a second stage does it respond to the output gap. © 2013 The Author

Journal compilation © 2013 Edward Elgar Publishing Ltd

© 2013 The Author 5 years after

10 years after

(c)

Private capital flows (I)

5 years before

5 years before

(b)

(d)

5 years after

10 years after

10 years after

Financial openness (I)

5 years after

Weighted tariff (I)

Adoption of IT

Adoption of IT

Financial openness (D)

Financial openness

10 years before

Weighted tariff (D)

Weighted tariff

10 years before

Figure 1 Real and financial indicators of the degree of openness of the FFIT economies (10 and 5 years before the adoption of inflation targeting and 5 and 10 years after) (exports and imports (X+M) as % of GDP, weighted tariffs rates, private capital flows as % of GDP and the Chinn–Ito index of financial openness)

Note: The Chinn–Ito is an index of openness in capital account transactions. The higher the value of the index, the greater the degree of openness of an economy to cross-border capital transactions. Source: Authors’ own computations on the basis of World Bank (2013); Chinn–Ito (2013).

Private capital flows (D)

Private capital flows

0 Adoption of IT

−1 5 years before

20

40

0

60

1

10 years before

10 years after

X + M (D)

5 years after

2

(a)

X + M (I)

Adoption of IT

80

X+M

5 years before

3

10 years before

10 8 6 4 2 0

100

50

55

60

65

70

75

Percentages

4

Percentage of total

Percentage of GDP

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67 percent. For the same period, the weighted tariff rate declined from 8.2 percent to 5.6 percent. Similarly private financial flows which stood at 2.5 percent of GDP 10 years prior to the adoption of inflation targeting expanded to attain 3 percent of GDP 5 years after. Finally, the degree of financial openness (Chinn–Ito index) rose for all economies in the sample after the instauration of FFIT regimes. In the case of developed countries, the standardized index measured on a scale from 1 to 100 took values of 53 and 83, 5 and 10 years prior to the adoption of the FFIT, attaining a maximum of 100 thereafter. For developing countries, the Chinn–Ito index had an average value of 3, at the time of the adoption of the FFIT, and 56 a decade after. The fact that the FFIT economies are open economies in terms of trade and finance, and the broad majority of these are developing economies, underscores the importance of the exchange as a transmission mechanism of monetary policy and also of external shocks (Svensson 2000). In a closed economy, the decisions of economic policy are transmitted through aggregate demand and the associated expectations channels. Changes in the rate of interest or even monetary aggregates directly impact on aggregate demand via changes in consumption, investment and imports.13 In turn, variations in aggregate demand impinge directly on the rate of inflation if the economy is at full employment, which is what the conventional model presumes with the notion of the ‘divine coincidence,’ or indirectly by altering the bargaining position of workers. In addition, changes in expectations can also have an effect on inflation ‘via wage and price setting behavior’ (ibid., p. 3). In an open economy, the monetary policy transmission mechanism is more complex. Changes in the nominal exchange rate affect the rate of inflation directly through their effect on the price in domestic currency of imported final goods. At the same time, the rate of exchange has an influence on the cost of goods produced locally through changes in the domestic price of imported inputs. Changes in the nominal exchange rate also operate indirectly on the rate of inflation. To the extent that a nominal exchange rate variation affects the real exchange rate, it alters the relative price of traded-to-non-traded goods, reinforcing the aggregate demand channel. An increase in the relative price of traded-to-non-traded goods (a devaluation in real terms), will make locally produced goods more competitive and will thus increase the incentives to shift resources towards the production of domestic goods. As a result, domestic absorption (internal demand) will increase, putting pressure on prices if the economy is close to full employment. An additional transmission channel for the exchange rate is the balance sheet channel. Changes in the exchange rate affect the position in assets and liabilities of firms, households, and also of the government. The balance sheet channel can offset partly or completely the expansionary effects of a depreciation, depending on the importance of assets in foreign currency held by a different sector of the economy. A depreciation of the currency increases the stock of external debt as well as interest service and thus exerts a negative effect on aggregate demand. In other words, changes in the exchange rate may have a significant impact on income distribution and may turn out to be contractionary. Moreover, the exchange rate also operates as a transmission vehicle for foreign disturbances and external demand shocks. This channel is relevant because of the high degree of international integration among economies, and the strong economic 13. Evidence suggests that interest rates affect housing investment, but do not have a major impact on private investment, which tends to respond to quantities rather than cost of capita measures. See, for example, Fazzari (1993). © 2013 The Author

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dependence of developing economies on external markets and developed country resources. This transmission mechanism is even more significant depending on the extent to which the exchange rate behaves like an asset price (that is, ‘when it responds to potential capital gains or losses in forward markets’ (Eatwell and Taylor 2000, p. 63)). According to the logic of inflation targeting, the level or value of the exchange rate should not be, in principle, a main concern for monetary policy. In fact, inflation targeting proponents argue that a flexible exchange rate regime is a ‘requirement for a well functioning inflation targeting regime.’ This view responds to the fact that in a world of full capital mobility, the monetary authorities cannot maintain an independent monetary policy and a stable exchange rate at the same time, the so-called Impossible Trinity or Trilemma.14 More importantly, since the main policy instrument, the rate of interest affects both the inflation rate and the exchange rate, worrying about the exchange rate would imply that the authorities are trying to manage two targets with one instrument. Yet, in practice, due to the institutional openness of the economies that have adopted FFIT regimes, the importance of the exchange rate as a transmission mechanism and as a determinant of the level and composition of output, the value of the exchange rate matters. The central banks of FFITs are not indifferent to exchange rate movements and indeed intervene in foreign exchange markets. This is illustrated in Table 3. It shows, on a country-by-country basis, before and after inflation targeting the reaction of foreign exchange reserves to changes in the real exchange rate (RER). This is captured by regressing the change in international reserves on the deviation of the real exchange rate from its trend. It also shows, for the same periods and countries, the degree of foreign exchange market intervention. This is measured by the statistic (FEIS = foreign exchange intervention statistic): FEIS ¼

σΔForexReserves ; where σ ¼ standard deviation and Δ ¼ xt − xt−4 σΔForexReserves þ σExchangeRate

The FEIS ranges between 0, which reflects a pure float, to 1, which reveals that monetary authorities intervene to smooth out variations in the exchange rate. The FEIS was computed using both the real and the nominal exchange rate. As a benchmark value for the computations using the real exchange rate we use the value provided in Ostry et al. (2012), 0.73, which reflects the degree of intervention for emerging market economies that do not pursue an inflation targeting strategy and thus do not adhere in principle to a floating exchange rate regime. The results show that all foreign exchange intervention statistics (FEIS) are positive and with a few exceptions significantly different from the 0.73 benchmark. All countries, whether developing or developed, intervene in the foreign exchange markets. On average, the exchange intervention statistic (using the real exchange rate) is 0.65 for the whole sample, 0.68 for developed countries, and 0.62 for developing economies. While, for the most part, the FEIS is lower in the period following the adoption of inflation, the differences between the FEIS before and after inflation targeting are 14. Note that the Trilemma does not apply to the Hegemonic country that holds the global reserve currency. Also, under certain circumstances, when the balance of payments constraint is not binding, developing countries are relatively free of the constraints imposed by the Trilemma. © 2013 The Author

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Table 3 Foreign exchange intervention index and regression analyses between the change in international reserves (ΔRESt) and the real exchange rate gap ((RER) ↓t↑g) for FFIT economies Regression analysis ΔRESt (dependent variable)

FEISa

RERgt Before After Before FFIT FFIT FFIT Australia Brazil Canada Chile Colombia Czech Republic Ghana Hungary Iceland Israel Mexico New Zealand Norway Philippines Poland South Africa Sweden United Kingdom

0.79 0.03 0.72 0.29 0.88 0.88 0.70 0.54 0.73 0.72 ... 0.52 0.51 0.87 0.85 0.81 0.61 0.81 0.31 0.75 0.70 0.81 0.95 0.84 0.83 0.82 0.80 0.34 0.37 0.85 0.84 0.72 0.73 0.54 0.81

0.73 0.02 0.61 0.59 0.67 0.69 0.64 0.52 0.47 0.46 0.66 0.52 0.83 0.78 0.71 0.70 0.70 0.65 0.73 0.69 0.53 0.55 0.73 0.92 0.71 0.71 0.72 0.72 0.60 0.59 0.56 0.55 0.76 0.76 0.52 0.89

1.78 (2.01) 1.05 (9.55) −1.72 (−0.46) 0.65 (1.66) 0.1 (0.26) ... 0.02 (0.13) −1.29 (−1.10) 1.25 (1.41) −0.81 (−1.10) 0.26 (0.34) −2.95 (−2.46) −0.19 (−0.22) 0.52 (0.51) 0.03 (13.3) 0.74 (0.02) 1.03 (2.51) 0.98 (1.89)

After FFIT −0.14 (−0.25) 1.22 (7.70**) 0.06 (0.13) −0.08 (−0.24) 0.36 (1.97**) 1.39 (2.81**) −0.42 (−0.59) −0.10 (−0.18) 0.61 (1.02) −0.05 (−0.15) 0.39 (1.68**) 1.82 (3.81**) 0.25 (0.37) 1.27 (2.73**) 1.38 (3.44**) 0.28 (1.43*) 0.71 (1.79**) 0.99 (2.91**)

AR(1)

No. obs.

R2

Before FFIT/ Before FFIT/ Before FFIT/ after FFIT after FFIT after FFIT 0.75(7.13)/ 0.66(7.5**) 0.89(15.05)/ 0.66(6.90**) 0.67(5.53**)/ 0.58(6.56**) 0.82 (12.3**)/ 0.72(7.28**) 0.84(8.9**)/ 0.67(6.9**) 0.67(6.45**)

47/78

0.54/0.42

73/53

0.83/0.77

40/87

0.36/0.32

74/52

0.69/0.52

39/52

0.66/0.59

0.70(8.8**)/ 0.79(7.63**) 0.82(10.7**)/ 0.63(4.88**) 0.61(6.76**)/ 0.56(4.3**) 0.77(8.46**)/ 0.83(17.3**) 0.74 (6.19**)/ 0.72(6.83**) 0.44/(2.82**)/ 0.72(10.1**) 9.22(0.73)/ 0.64(5.38**) 0.60(6.56**)/ 0.85(10.16**) 0,84(13.3**)/ 0.67(4.84**) 0,51(4.9**)/ 0.88(13.1**) 0.40(3.14**)/ 0.79(10.6**) 0.90(13.8**)/ 0.78(2.91**)

83/43

0.48/0.59

54/41

0.65/0.36

80/44

0.41/0.37

66/61

0.53/83

44/47

0.53/57

35/91

0.34/0.61

80/47

0.52/0.39

83/43

0.35/0.79

72/35

0.71/0.63

75/51

0.26/0.81

55/71

0.34/0.63

47/80

0.79/0.57

55

0.59

Notes: The FEIS columns include the computation of the statistics with the real and nominal exchange rate respectively. ** and * denote significance at the 95% and 90% level of confidence. An increase (decrease) in the real and nominal exchange rate refers to an appreciation (depreciation) of the national currency. All regression analyses included the standard diagnostics which are not presented for want of space. All regressions were checked for basic goodness of fit indicators. All computations were performed using quarterly data. Bold font in column 5 highlights the coefficients that are significant at the 95% level after the adoption of the FFIT. a FEIS = foreign exchange intervention statistic. Source: Authors’ own computations on the basis of IMF (2013). © 2013 The Author

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also not significant. Finally, the evidence also underscores the fact that FFITs regimes take into account not only the real exchange rate but also the nominal exchange rate. The fact that FFIT countries intervene in the foreign exchange rate markets and thus that none follows a float is compounded by the regression analyses. In more than half of the cases considered, the deviation of the real exchange rate from its trend is statistically significant in explaining the change in the stock of foreign reserves. 5

INTRODUCING THE OPEN ECONOMY DIMENSION IN AN INFLATION TARGETING FRAMEWORK

The empirical evidence presented above is an indication that not only does the exchange rate matter, but that, in fact, in terms of the conventional model presented before, it forms part of the loss function of FFIT central banks. Yet, as will be shown below, the introduction of the exchange rate in the central banks’ loss functions creates important complications for the management of monetary policy within an inflation targeting framework. In fact it can be shown that, with a modified loss function, the core propositions of inflation targeting are inoperative and that the practice of this monetary policy strategy leads to important policy dilemmas, even if one accepts the conventional model.15 Assume that the central bank minimizes a loss function that includes, in addition to the output and inflation gaps and interest rate smoothing, the nominal exchange rate gap. Equation (3.1) is thus modified to yield: L ¼ ðya − yn Þ2 þ βðπt − πT Þ2 þ γðit − it − 1 Þ2 þ ψðet − eT Þ2

(5.1)

where et ; eTt refer to the actual and target nominal exchange rate. In addition, modify the respective constraints so as to include the nominal exchange rate in the Phillips curve and the real exchange rate in the aggregate demand (IS) equation: πt ¼ E t πtþ1 þ αðya − yn Þ þ ωEt Δet

(5.2)

ygt ¼ − φðit − Eπtþ1 Þ þ Eygtþ1 þ θrer t

(5.3)

The first order conditions become respectively: δL ¼ βπgt − λ1 ¼ 0 δπt δL ¼ ygt þ αλ1 − λ2 ¼ 0 δygt δL ¼ γðit − it − 1 Þ − λ2 θ ¼ 0 δit δL ¼ ψegt − λ1 ω ¼ 0 δet

(5.4)

15. See Granville and Mallick (2008) and Ncube and Ndou (2011) for attempts to include the exchange rate in an inflation targeting framework for developing economies. © 2013 The Author

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Set the second Lagrangean multiplier (λ↓2) to 0, and through successive substitution the value of the first Lagrangean multiplier (λ↓1) is seen to be equal to the output, inflation, and exchange rate gaps. The inflation gap ðβπgt Þ is not only equal to the opposite sign of the output gap but also to that of the exchange rate. Formally: yg λ1 ¼ βπgt πgt ¼ − t βα ψegt λ1 ¼ − ) (5.5) ω yg ψeg πgt ¼ − t λ1 ¼ − t α ωβ This implies that a ‘lean against the wind’ policy is necessarily mediated, in an open economy, by movements in the exchange rate. As such, when the rate of inflation is above target, the central bank must implement a contraction in aggregate demand, so that the output gap is negative. It must also ensure simultaneously that the exchange rate moves in the right direction – that is, that it appreciates to permit the reduction of inflation (inflation enters as an argument in the Phillips curve besides appearing in the loss function). Thus the logic of the model implies that the exchange rate (in this particular case the appreciation of the exchange rate) is an instrument alongside aggregate demand to maintain the rate of inflation in line with its enunciated target. By construction of the model, a ‘lean against the wind’ monetary policy also implies an appreciation of the real exchange rate (rert). Thus ultimately the attempt of the monetary authorities to reduce inflation impacts negatively on output through the decline in aggregate demand and via the appreciation of the exchange rate (nominal and real) (the external sector). In this sense, the monetary authorities face the dilemma of reducing inflation at the cost of a decline in competitiveness. This presumes that an appreciation does have a significant impact on competitiveness and does lead to an increase in imports (and probably to some decrease in exports) sufficient to constrain growth. The contractionary impact on output can only be compensated by expansionary fiscal policy if there is no external constraint. Note, however, that in the conventional model presented here this is not possible since the economy would be at potential output when inflation is at the target and the rate of interest is at the natural level. Hence the role of fiscal policy, which was ignored in the closed version of the conventional model, must become relevant in the open economy case. Further, once the exchange rate is introduced in the model, achieving the ‘divine coincidence’ is not a straightforward matter and can become a source of controversy. From Equation (5.2) above it is clear that, if πt = Etπt+1, the level of output would not be equal to its natural level, that is, ygt ¼ 0. Indeed, even if the monetary authorities reached their inflation target, the output gap would still differ from zero. It would be equal to ω(EtΔet). A reduction in the variance of output and inflation is always a possibility if πt → πT and Δet → 0. The ‘divine coincidence,’ in the open economy conventional model, thus requires two conditions: πt → πT and et → eT. This may turn out to be contradictory to the extent that the nominal exchange rate moves in the same direction as the real exchange, as seems to be the case in an open economy FFIT framework. Once again, as with the ‘lean against the wind’ proposition, achieving the ‘divine coincidence’ can require an appreciation of the real exchange rate and thus a worsening of the competitiveness which undermines the very achievement of the Divine Coincidence. In this sense, in an open economy, the Divine Coincidence appears to be an impossibility.

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Once the exchange rate is introduced in the loss functions and in the Phillips and aggregate demand curves, it also appears in the interest rate rule of the central bank. Indeed, manipulation of the first order conditions provides two interest rate rules. The first is the same one as that for a closed economy in which the rate of interest is a function of its past value, the output and inflation gaps. According to the second rule, the interest rate is a function of its past value, the inflation and exchange rate gaps. Formally: θαβ g θ g π þ y γ t γ t θαψ g θ g e þ y it ¼ it − 1 þ γω t γ t

it ¼ it − 1 þ

(5.6)

Both rules coincide only if the output gap maintains a given relation with the exchange rate gap (that is, if θψ/γω e↓t↑g = β/θ π↓t↑g). In reality, there is no mechanism to ensure this equality, and the most reasonable interpretation is that the central bank has two interest rate rules. More importantly, since the ‘divine coincidence’ does not apply once the exchange rate is introduced into the loss function, the inflation targeting framework implies necessarily that the central bank has one instrument to achieve three goals: low and stable inflation, full employment output, and exchange rate stability and competitiveness. Regarding stability, since there are two interest rate rules there are also two possible solutions for stability. The first one, using the interest rate rule without the exchange rate (Equation (5.6)), corresponds to that found for a closed economy. This is explained by the fact that the configuration of the Jacobian determinant is the same. A second possible solution consists of using the interest rule equation with the exchange rate (Equation (5.6)). In this case, the Phillips curve, the aggregate demand curve and the interest rule equation (Equations (5.2), (5.3) and (5.5)) would be insufficient to assess the stability of the system. In fact it can be shown that the Jacobian determinant is equal to 0 and thus that the inflation and output gap equations are linearly dependent.

6

A STYLIZED REPRESENTATION OF THE PRACTICE OF INFLATION TARGETING IN OPEN ECONOMIES

The inoperative nature of the three core propositions of inflation targeting in an open economy materializes in the way in which countries practice inflation targeting ‘de facto.’ To illustrate this point, we analyse to what extent these three propositions (lean against the wind, the divine coincidence, and stability) characterize FFIT countries’ implementation of inflation targeting. In order to assess whether FFIT countries do or do not lean against the wind, we calculated the correlation coefficient over time between the inflation and the output gap as postulated by Equations (3.6) and (5.5) above.16 A negative and statistically significant coefficient provides an indication that countries practice monetary policy 16. Note that the output gap is computed as an average of the actual output method, following conventional approaches of measuring it, and assumes that it is determined by supply side forces as in the conventional model. The results are even more blurred if potential output hysteresis is present, and it is affected by demand management policies. © 2013 The Author

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counter-cyclically.17 For analytical purposes we also provide the correlation coefficients between the inflation and the nominal exchange rate gaps and that between the output and nominal exchange rate gaps. The second proposition, the divine coincidence, is tested empirically by the correlation in the variances of the output and inflation gaps. A positive and statistically significant correlation between both variances suggests that the divine coincidence hypothesis cannot be refuted. As the actual rate of inflation narrows its deviation with respect to the inflation gap, the actual level of output tends towards its trend level. As with the case of the ‘lean against the wind,’ we also included the exchange rate in our computations. Finally, we tried to test for stability of the inflation targeting model consisting of Equations (5.2), (5.3) and (5.6) (the interest rate rule without the exchange rate), by solving it as a system and seeing whether the estimate parameters comply with the stability conditions of a positive Jacobian determinant and a negative trace. The results show that more than half of the correlation coefficients between the inflation and the output gap, for the countries for which there is available data, are positive and significant (Column (1) in Table 4). In other words, keeping in mind that the policy instrument is the output gap, FFIT countries in their vast majority do not seem to follow the ‘lean against the wind’ optimal monetary strategy consisting of contracting demand below capacity whenever inflation is above its targeted value, and vice versa when inflation is below its target. A second and interesting piece of evidence is that the relationship between the output gap and the exchange rate is positive (Column (2) in Table 4, overleaf). That is, a negative deviation of the exchange rate from its trend value (appreciation) is accompanied by a decline of output below capacity. And a positive deviation of the exchange rate from its trend value (depreciation) is accompanied by a rise of output above capacity. This result may reflect the fact that developing countries facing an external constraint, aggravated by competitiveness problems associated with an appreciated exchange rate, are forced to slow down their economies.18 A third piece of evidence relevant to characterizing the practice of inflation targeting is that the majority of countries (59 percent of the total) pass the ‘divine coincidence’ test as shown by the positive and significant correlation between the variance of the output and inflation gaps. This is consistent with the evidence presented in favor of inflation targeting regimes, namely that the inflation rate and its variability is lower in the majority of the cases in the post-FFIT relative to the pre-FFIT period. An analysis of the evolution of inflation for all FFTI economies shows that this is indeed the case. The median pre- and post-FFIT rate of inflation reached 10 percent and 4 percent for all 27 countries, 4 percent and 2 percent for the developed group, 17. The statistical significance of the correlation coefficient was determined on the basis of the pffiffiffiffiffiffiffiffi ffi

rð n − 2Þ formula: ρ ¼ pffiffiffiffiffiffiffiffi2 where r is the simple correlation coefficient and n the number of observ1−r ations. ρ follows a student-t distribution. 18. Note that there is a vast literature on the positive effects of devaluation on economic growth (for example Rodrik 2008). We do not necessarily suggest that our results corroborate that proposition. Note that the vast majority of studies that find a positive relation between real depreciation and economic growth are very sensitive to both the sample of countries, which may imply sample selection bias, and the measure of devaluation, which is often taken from deviations from Purchasing Power Parity. Our only suggestion is that the exchange rate is connected more to real phenomena associated ultimately with the management of the balance of payments than with anti-inflationary policies.

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Table 4 The core propositions of inflation targeting in practice for FFIT economies Country

Lean against the wind πgt ; ygt (1)

Armenia Australia Brazil Canada Chile Colombia Czech Republic Ghana Guatemala Hungary Iceland Indonesia Israel Mexico New Zealand Norway Peru Philippines Poland Romania Serbia South Africa Korea, Rep. Sweden Thailand Turkey United Kingdom

πgt ; egt (2)

ygt ; egt (3)

Divine coincidence

Stability

ðVarðπÞgt ; ygt Þ ðVarðπÞgt ; egt Þ ðVarðyÞgt ; egt Þ Trace J DET J (7) (8) (4) (5) (6)

... 0.03 ... −0.20* −0.30** 0.33** −0.13 −0.45** 0.32** 0.10 0.28** 0.17 0.31** 0.02 0.32** 0.48** 0.07 0.38** 0.02 0.18 0.29**

... 0.40** −0.90** 0.44** 0.90** 0.59** 0.16

0.04 −0.35** 0.72** 0.18 −0.18 0.08 −0.64**

... 0.24** −0.77** 0.72** −0.15 0.15 0.30**

... 0 0 >0 0 0 >0 0 ... 0

0.88** 0.80** 0.96** 0.26**

0.77** ... ... 0.23*

0 >0 >0

... ... 0.24 0.42** ... 0.27** 0.52** 0.61**

−0.20 0.07 0.11 0.23* ... ... 0.08 −0.06 0.17 0.43** −0.01 0.15 ... . . .. 0.52 0.41** . . . ... 0.51** −0.68** −0.19 0.45**

...

0.41** 0.06 0.47** . . . 0.50 ... 0.02 −0.11

... 0.51** ... ... 0.63**

0.71** ... ... 0.04

Notes: ** and * denote significant at the 95% and 90% level of confidence. An increase (decrease) in the real and nominal exchange rate refers to an appreciation (depreciation) of the national currency. The inflation gap was computed as the difference between actual and target inflation (we used two inflation gaps in the case of target inflation tolerance bands). Target inflation was obtained on the basis of Hammond (2012) and on the basis of information provided by the respective central banks of the different countries. All regression analyses included the standard diagnostics which are not presented for want of space. All regression in the systems used to calculate the determinant and trace of the Jacobian matrix were checked for basic goodness of fit indicators. The cases that comply with the stability conditions positive Jacobian determinant and negative trace are highlighted in bold (columns 7 and 8). All computations were performed using quarterly data. Source: Authors’ own computations on the basis of IMF (2013).

and 8 percent and 5 percent for the developing economies. This result is generally presented as evidence of the success of FFIT regimes. Furthermore, a test of differences in variance for the inflation rate for each of the 27 countries shows that 81 percent

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All FFIT countries

Inflation

RER

Developing FFITs

Developing FFITs

Nominal Erate

(a)

Industrialized FFITs (c)

GDP growth

All FFIT countries

Post-FFIT

GDP growth

Pre-FFIT

Industrialized FFITs

Post-FFIT

Inflation rate

Pre-FFIT

0

1

2

3

4

5

6

7

8

15

65

70

75

80

85

90

20

(b)

75

Figure 2 Selected indicators on FFIT performance and the inflation rate and variability for the world. (a) Inflation rate and GDP growth in the pre-FFIT and post-FFIT (averages for all 27 FFITs). (b) Percentage of world countries that experienced lower inflation rate and inflation variability in the period 1996–2012 relative to 1980–1995. (c) Percentage of FFIT countries that have reduced the variability in inflation, GDP growth, nominal and real exchange rates in the post-FFIT relative to the pre-FFIT period. (d) Histogram showing the percentage of time that FFIT countries stay ‘within and on target’

(d)

70

Inflation variability

25 30 35 40 45 50 55 60 65 Percentage of the time that FFITs stay on target

Inflation rate

Sample of 160 countries worldwide

s2 Note: The F test was computed as F = 12 with H0 s21 ¼ s22 vs. H1 s21 > s22 at a 95% confidence level. s2 Source: Authors’ own computation on the basis of IMF financial statistics data.

0

20

40

60

80

100

0

2

4

6

8

10

Percentage of total No countries

12

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experienced lower inflation variability in the post-FFIT relative to the pre-FFIT period (see Figures 2b and 2c). However, it is difficult to attribute this to the implementation of inflation targeting since the empirical evidence shows that the majority of the time most FFIT economies do not stay within the announced inflation target range (or near the announced point target for those economies that do not have an explicitly announced inflation range). On average, FFIT countries stay on target 40 percent of the time. Also, several countries that did not adopt an FFIT also had a reduction in inflation levels which may be attributed to other causes beyond central bank policies, like subdued wage resistance and increasing external competition. A more detailed analysis is provided in Figure 2d, which shows a histogram with the abscissa representing the percentage of the time FFIT countries stay within the announced inflation target and the ordinates representing the number of countries. According to Figure 2, only 6 out of the 27 FFIT countries (22 percent) have managed to stay within the target range for more than 50 percent of the time, and only one has complied with the target more than 70 percent of the time. Rather than responding to inflation targeting practices, the occurrence of divine coincidence is due to two unrelated phenomena. On the one hand, countries across the world witnessed a reduction in the inflation levels and their variability, with independence of their monetary policy regimes, from the middle of the 1990s onwards – which happens to coincide with the adoption of inflation targeting in all 27 countries of the sample. An analysis of inflation behavior for a sample of 160 counties worldwide, using quarterly data from 1980 to 2012, shows that 75 percent of the countries had a lower rate of inflation in the period 1996–2012 relative to 1980–1995. Similarly more than 80 percent of the countries in the sample show lower inflation variability in the latter period relative to the former period. On the other hand, FFIT countries managed in the majority of cases to narrow the variance of the output and exchange rate gap jointly (Columns (4) and (6) in Table 4). In light of the evidence presented in an earlier section, this perhaps indicates that countries narrowed the output gap through foreign exchange interventions. Jointly with the fact that the relation between the inflation and exchange rate gap is mostly insignificant, these findings (Column (3) in Table 4) provide an indication that the tendency of all the FFIT economies to intervene in the foreign exchange markets discussed above, rather than being driven by price considerations, responds to real factors (the deviation of output from its trend level).19 More precisely, we could even argue that the evidence presented indicates that the interventions in the foreign exchange market appear to be independent of the course and evolution of inflation, but not of the evolution of output. Further, it seems reasonable to assume that output considerations are in many cases related to balance of payments conditions. In other words, when faced with an external constraint, central banks may be forced to allow the currency to depreciate and end up missing the inflation target. This de facto dichotomy between inflation and the exchange rate can create important policy dilemmas for the monetary authorities in a context of a simultaneous increase in inflation and appreciation of the currency. The rise in inflation requires 19. Arguably, the lack of correlation between the exchange rate and inflation gaps may reflect the fact that pass-through effects are generally lower in the world, and hence the effects of exchange rate variability on domestic prices has been attenuated (Frankel et al. 2012). This may reflect lower wage resistance from workers in the context of globalization. That is, depreciation does not lead to wage increases and higher inflation as it did in the 1970s. © 2013 The Author

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an increase in the monetary policy rate, if indeed inflation is caused by excessive demand (as is presumed in the conventional model); but the appreciation of the currency (which is accompanied by a level of output below capacity – that is, excess capacity) demands the opposite policy action, namely a decline in the rate of interest. This type of policy dilemma explains the reason why, when both events (inflation and appreciation) occur, central banks tend to miss their inflation target: they cannot at the same time increase and decrease the rate of interest. This type of dilemma can perhaps also be part of the explanation about the mixed evidence for FFIT countries in terms of growth performance. On a country-by-country basis, 15 countries of the entire sample (55 percent of the total) achieved a higher growth rate in the post-FFIT period. For the sub-sample set of developing and developed countries, 3 and 10 economies (or 33 percent and 53 percent of each) experienced higher rates of growth in the post-FFIT period. Similar results are obtained for GDP variability using a difference in variance test on a country-by-country basis (see Figure 2, parts a and c). Note, however, that the rates of growth have accelerated in many countries for reasons that are orthogonal to the monetary regime. For example, there is strong evidence supporting the notion that in Latin America the easing of the external constraint associated with positive terms of trade shock since 2003 is correlated with the growth performance. Equally, many countries have been affected by the Global Crisis that started in 2008, irrespective of their monetary regimes. Finally, regarding the third core property of stability, the evidence shows that more than half of the countries (54 percent) fail to corroborate it. In other words, the target rate of inflation does not appear to be part of a stable equilibrium configuration (see Table 4, p. 364).20 As a general remark, it is worth noticing that if one abandons the conventional model assumptions regarding the existence of a supply-constrained potential output, with the concomitant notion of a natural rate of unemployment for which there is little evidence,21 and the notion that inflation is essentially demand-driven, then the very idea of the three core properties of inflation targeting collapse, even in the case of a closed economy, for there would be no such thing as an output gap. Moreover, in an open economy, without a natural rate of unemployment or a potential level of output, the reasons to expect that a central bank could achieve several targets – full employment, price stability, and external competitiveness – with only one instrument, the rate of interest, are even less plausible. This indicates that central banks with broader policy goals must coordinate with domestic fiscal authorities the management of domestic demand, and that other instruments must complement monetary and fiscal policy in order to achieve all the goals. Industrial policies, import and price management, as well as other income policies which used to be part of the box of tools of developmental governments should not be excluded, a priori, on the basis of a theoretical model that presents, even if one accepts its limited logic, inherent contradictions and significant policy problems.

20. These results represent only a first approximation at the stability issue under inflation targeting. 21. For the discussion of the irrelevance of the natural rate hypothesis, see Galbraith (1997). For the empirical failure of the natural rate hypothesis in the American economy, see Fair (2000). © 2013 The Author

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CONCLUDING REMARKS

As we saw, the justification for inflation targeting rests on the closed economy model propositions that central banks lean against the wind, the belief in the divine coincidence suggesting that if the rate of inflation is around its target then output will be at the full employment level, and that following any disturbance to its initial conditions the system has a tendency to move towards its equilibrium. All these propositions are highly questionable from a theoretical point of view for an open economy, and are not clearly supported by the evidence. The strategy adopted in this paper was to analyse whether those three propositions could be sustained in the actual countries that implement a fully fledged inflation targeting regime (FFIT). It is noted that even within the mainstream model, once open economy considerations are introduced, the main propositions (lean against the wind, divine coincidence, and stability), based on the evidence of the 27 countries that have explicitly implemented a FFIT regime, do not hold in the real world. Moreover, these countries are open economies and are fundamentally concerned by the evolution of the external sector and the exchange rate, as proven by their interventions in the foreign exchange markets, and external sector considerations can have hierarchical priority over other policy goals. The trade-offs faced by central banks in open economies are significantly more complex than those suggested by the New Consensus model, and reliance on the FFIT regime should be taken with extreme caution, given the unreliability of its empirical results. REFERENCES Amato, J.D and Laubach, Th. (2003). The Value of Interest Rate Smoothing: How the Private Sector Helps the Federal Reserve. Economic Review, Federal Reserve Bank of Kansas City, issue Q III, 47–64. Angeriz, A. and Arestis, Ph. (2007). Assessing the Performance of ‘Inflation Targeting Lite’ Countries, World Economy, 30 (11), 1621–1645. Arestis, P. (2009). New Consensus Macroeconomics: A Critical Appraisal. Levy Economics Institute, Working Paper No 564. Arestis, Ph. and Sawyer, M. (2008). A Critical Reconsideration of the Foundations of Monetary Policy in the New Consensus Macroeconomics Framework. Cambridge Journal of Economics, 32 (5), 761–779. Bernanke, B.S., Laubach, Th., Mishkin, F.S., and Posen, A.S. (1999). Inflation Targeting. Lessons from the International Experience. Princeton: Princeton University Press. Blanchard, O. (2006). Monetary Policy; Science or Art? Panel discussion, presented at Monetary Policy: A Journey from Theory to Practice. An ECB colloquium held in honor of Otmar Issing, March. Blanchard, O. and Gali, J. (2005). Real Wage Rigidities and the New Keynesian Model. NBER WP 11806, November. Chinn, M. and Ito, H. (2013). The Chinn–Ito Index: A De Jure Measure of Financial Openness. http://web.pdx.edu/~ito/Chinn-Ito_website.htm. Clarida, R., Galí, J., and Gertler, M. (1999). The Science of Monetary Policy: A New Keynesian Perspective. Journal of Economic Literature, XXXVII (December), 1661–1707. Eatwell, J. and Taylor, L. (2000). Global Finance at Risk: The Case for International Regulation. New York: Policy Press. Fair, R. (2000). Testing the NAIRU Model for the United States. Review of Economics and Statistics, 82 (1), 64–71.

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Fazzari, Steven M. (1993). The Investment–Finance Link. Public Policy Brief No. 9, The Jerome Levy Economics Institute. Frankel, J., Parsley, D., and Wei, S.-J. (2012). Slow Pass-through Around the World: A New Import for Developing Countries? Open Economies Review, 23 (2), 213–251. Galbraith, J.K. (1997). Time to Ditch the NAIRU. Journal of Economic Perspectives, 11 (1), 93–108. Granville, B. and Mallick, S. (2010). Monetary Policy in Russia: Identifying Exchange Rate Shocks. Economic Modelling, 27 (1), 432–444. Greenspan, A. (1988). Statement before the Subcommittee on Domestic Monetary Policy. Committee on Banking, Finance and Urban Affairs, US House of Representatives, Washington, DC, 28 July. Hammond, G. (2012). State of the Art of Inflation Targeting – 2012. Handbook No 29. Centre for Central Banking Studies, Bank of England. IMF (2013). International Financial Statistics. Available at: http://elibrary-data.imf.org/. Jonas, J. and Mishkin, F.S. (2005). Inflation Targeting in Transition Economies: Experience and Prospects. In Bernanke, B.S. and Woodford, M. (Eds), The Inflation Targeting Debate. Chicago: University of Chicago Press, pp. 353–413. Kamil, H. (2008). Is Central Bank Intervention Effective Under Inflation Targeting Regimes? The Case of Colombia. IMF Working Paper WP/08/88. Lam, J.P. (2010). The Importance of Commitment in the New Keynesian Model. Mimeo. Mishkin, F.S. (2004). Can Inflation Targeting Work in Emerging Market Countries? NBER Working Papers 10646, National Bureau of Economic Research. Ncube, M. and Ndou, E. (2011). Inflation Targeting, Exchange Rate Shocks and Output: Evidence from South Africa. African Development Group. Working paper Series. WP No. 134. Ostry, J.O., Ghosh, A.R., and Chamon, M. (2012). Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies. IMF Staff Discussion Note. February 29. Rochon, L.-P. and Setterfield, M. (2007). Post Keynesian Interest Rate Rules and Macroeconomic Performance: A Comparative Evaluation. Available at: http://www.univ-paris13.fr/cepn/IMG/ pdf/Texte_Rochon_100409.pdf. Rodrik, D. (2008). The Real Exchange Rate and Economic Growth. Brookings Papers on Economic Activity, 2 (Fall), 365–412. Roger, S. (2009). Inflation Targeting at 20: Achievements and Challenges. IMF Working Paper WP/09/236. Sack, B. and Wieland, W. (1999). Interest Rate Smoothing and Optimal Monetary Policy: A Review of Recent Empirical Evidence. Mimeo. Setterfield, M. (2006). Is Inflation Targeting Compatible with Post Keynesian Economics? Journal of Post Keynesian Economics, 28 (4), 653–671. Svensson, L.L. (1997). Inflation Targeting in an Open Economy: Strict or Flexible Inflation Targeting. Mimeo. Svensson, L. (1999). Inflation Targeting as a Monetary Policy Rule. Journal of Monetary Economics, 43 (3), 607–654. Svensson, L. (2000). Open-Economy Inflation Targeting. Journal of International Economics, 50 (1), 155–183. Svensson, L. (2004). Commentary. Inflation Targeting: Prospects and Problems, Federal Reserve Bank of St. Louis, 86 (4), 161–164. Svensson, L. (2007). Inflation Targeting. Mimeo for The New Palgrave Dictionary of Economics, 2nd edn, edited by Larry Blum and Durlauf Steven. Woodford, M. and Giannoni, M.P. (2003). Optimal Inflation Targeting Rules. NBER Working Paper Series, WP 9939, August. World Bank (2013). World Development Indicators. Available at: http://databank.worldbank. org/ddp/home.do.

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Review of Keynesian Economics, Vol. 1 No. 3, Autumn 2013, pp. 370–373

Book review John King, The Microfoundations Delusion: Metaphor and Dogma in the History of Macroeconomics (Edward Elgar, Cheltenham, UK and Northampton, MA, USA 2012) 304 pp. Philip Pilkington Masters Candidate, Kingston University, UK

King has entitled his book The Microfoundations Delusion and indeed the shadow of Richard Dawkins and his supposed mechanistic overthrow of all things holy and aggregated lurks in the depths of King’s narrative. Because, when we boil it down, King’s book is really an exercise in charting the trajectories of two different types of rationalist thought that grew out of the Enlightenment. One, rigid and mechanistic, claims to spurn aggregation in favour of a simple causal explanation of the world modelled on a clock or a billiard table. The other, nuanced and holistic, tries to capture a complex world in which actions have reactions and aggregates are not simply the sum of their parts. Macroeconomics, need it be said, falls into the former group, while microeconomics aspires to falling into the latter and, as King surmises, the Lucas critique is essentially based on a championing of the mechanistic viewpoint to the point of it becoming a methodological imperative. ‘Your aggregates are without foundations,’ says Lucas (in paraphrase). ‘And we must construct theories which start with the atoms and only later form into the molecules.’ The problem, as King shows in his book, is that this is all based on bad metaphors and a poor understanding of what it means to talk about the individual and the whole. Post-Lucasian macroeconomics, if we may coin a contentious term, criticises macroeconomics for dealing with abstract aggregates but then falls back on aggregates of its own. Sure, the post-Lucasian can posit an abstraction called a ‘representative agent’, but we can always break this down further and further. After all, isn’t this agent but another aggregate in the sense that it is a sort of mean or average of all the individuals supposed to exist in the economy at any given time? Further still, what on earth justifies us in talking about these ‘individuals’ at all? Philosophers have long known that what we colloquially call ‘the individual’ is actually open to as much division as we care to engage in. Is ‘the individual’ not just a basket of fleeting emotions? Does ‘the individual’ really have any constancy in the scientific sense of the term? The post-Lucasians naively assume that they do; but in doing so they simply sneak in another aggregation through the back door in the form of the Representative Agent with Rational Expectations (RARE). King quotes the econometrician-turnedmethodologist Kevin Hoover in this regard: No one has proposed an analysis of macroeconomic aggregates that truly begins with the individual. Who would know how? Is this because the problem is just too difficult? Or is it because it cannot be done on principle? The advocate of the representative agent model implicitly believes the former … The irony of microfoundations is that … it embraces the representative © 2013 The Author

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agent, which is as close to an untethered Hegelian World (or Macroeconomic) Spirit as one might fear in the microfoundationalist’s worst nightmare. (King 2012, pp. 223–224)

What we end up with, instead of an economics based on the individual, is one based on a RARE agent conceived of as a sort of Hegelian Spirit that drives history through the a priori principles of rationality (or Reason?). There is nothing ‘micro’ about this manoeuvre at all, and after reading through the detailed methodological and historical survey in King’s book one is left wondering how anyone ever conceived that there was. King begins his book by taking the reader on a whirlwind tour through literary criticism, the philosophy of science, biology (where Dawkins’ shadow briefly appears), sociology and the social sciences. He shows us that, across the sciences, aggregation and abstraction are always taking place at a variety of different levels. The choice of what level of abstraction we engage in is dictated by the requirements of our task. The car mechanic need only know the car at a fairly aggregated level to work on it; while the metallurgist will be interested in the same car at a wholly different level of aggregation. Where one sees carburettors and spark plugs, the other sees alloys and molecules. And it is likewise across the fields that King surveys. Upon emergence from this tour, and now equipped with a firm grounding in the issues at hand, the reader can then explore with King the issues of micro-reduction as it has arisen in the economics literature since 1936. King runs from Keynes’s General Theory through those writing in what might broadly be termed the ‘Keynesian era’. Here we see some rather surprising figures, such as those with backgrounds in the Arrow–Debreu Walrasian school, defending macroeconomics as a separate discipline; while more Keynesian-orientated authors such as James Tobin and Sidney Weintraub emerge as somewhat surprising advocates of microfoundations. King then leads us through the period 1975–2012 and shows quite clearly that, while the issue of microfoundations became a key feature of most mainstream economics discussions, it was nevertheless never studied at a methodological level and indeed was justified only through allusion and metaphor. It was in this era that the phenomenon of the Rational Agent with Rational Expectations (RARE) – a phenomenon which, as we have seen above, is merely a new type of aggregation – came to dominate economic thought. It is in these two chapters that the reader gets a strong impression that the question of microfoundations, so disparate and so badly conceived, is probably more a fad or fashion than it is a serious research program. In surveying the dissenters of microfoundations King finds that those who fall into the neoclassical and Institutionalist camps were rather disorganised with regard to the macrofoundations controversy, with many big names swaying this way and that on the issue. The post-Keynesians – more surprisingly – also prove somewhat incoherent with many big names championing microfoundations at least in the early days of the debate.1 The Austrians come across as even more muddled than the other schools with some members explicitly rejecting aggregative principles while continuing to use them in their economic analyses. This appears mostly due to the fact that many of them eschew macroeconomics as a general principle yet at the same time allow obviously macroeconomic terms to slip into their economic discourse.2

1. The notably consistent exceptions to this being Jan Kregel and Sheila Dow who both insisted that it is microeconomics that needs macrofoundations and not vice versa. 2. Perhaps, in a somewhat ironic way, buttressing the very ‘macro’ claim made by some philosophers that language is a collective phenomenon from which the individual cannot escape and is, to a large degree, shaped by – even though they may not be consciously aware of this. © 2013 The Author

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In contrast to the economists, many of the methodologists surveyed in the book seem quite sceptical of the notion of microfoundations, perhaps because they are better placed to understand the implications of the doctrine. As noted above, Kevin Hoover comes out with some particularly poignant criticisms which were largely accepted in the journals he published in – before they sank into the swamp of intellectual forgetting. On one point King is somewhat inconsistent however. In the early parts of the book he suggests, seemingly in contrast to what the rest of his narrative appears to entail, that we should place macroeconomics and microeconomics on an equal footing. Thus, for King, while they are both important and interdependent fields of study, there is no hierarchy between them. He says this in response to those, like Negishi and Colander,3 who claim that microeconomics should be subordinate to macroeconomics. We can illustrate why this is incorrect by using a simple but powerful analogy that King himself introduces in the book; namely, that of a football stadium in which every individual alone can stand up to get a better view, but if all of them stand up none do. If we think about this in detail it will soon become clear that while the effects of the actions of the group can constrain the action of the individual, the reverse is simply not the case. If one individual stands up to get a better view of the action going on below, this does not change the view that every other individual in the group can potentially get by each of them standing up, except the view of the individual standing immediately behind the now standing individual. However, if the entire group stands up the actions of each individual are constrained in that they cannot undertake any action to get a better view. We can make this even more realistic by adding a simple behavioural assumption. Let us assume that the group is one hundred people sitting in ten rows of ten people. Let us further assume that if a single individual stands up to get a better view, the person behind them who has their view obscured will counteract this by standing up. Clearly even if the individuals with the most potential influence on the group – that is, the individuals in the front row – stand up, their actions will only have an effect on nine individuals. By standing up, this front-row individual ‘constrains’ nine individuals, in that they will no longer have the option of standing up to get a better view. The individuals with the least influence – namely, those in the back row – have absolutely no potential constraining effects on the rest of the group. Clearly, then, there is a difference between aggregate behaviour and its constraining effects on each individual and the individual’s ability to constrain the group. Put another way: the group has more power over the individual than the individual has over the group. To give another rather more informal example, consider that an individual may find it remarkably difficult to incite a large group to charge together as in a riot or a military incursion, while if a single individual finds himself in the middle of such a charge he will be crushed if he does not partake. These analogies can be extended to all the familiar so-called macro–micro ‘paradoxes’. In the ‘paradox’ of thrift, for example, the aggregate savings desires constrain the individual’s ability to save while the individual’s savings desires have only a minimal effect on the aggregate group (through a slightly diminished multiplier). It is, in fact, all a simple numbers game and this highlights clearly why microeconomics needs to be, by construction, subordinate to macroeconomics. 3. We should also note a highly original essay published by James Galbraith in Prospect in 1993 in which Galbraith lays out the parallels between the hierarchy of macro and micro phenomena in both economics after Keynes’s General Theory and in physics after Einstein’s theory of relativity. (See Galbraith 1993). © 2013 The Author

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All this should not be seen as a fundamental criticism of King’s book which, apart from its rather contentious conclusion that there is no inherent hierarchy between micro and macro, covers every issue relevant to the debate majestically and in great detail. It is this reviewer’s sense that, should the profession choose to engage with this book in a substantial and sustained way, these methodological questions which have lurked underneath the surface of economic discourse since at least Keynes’s time can finally and once and for all be resolved. REFERENCES Galbraith, James. 1993. ‘Keynes, Einstein, and Scientific Revolution’. The American Prospect, 5 (16). Available at: http://prospect.org/article/keynes-einstein-and-scientific-revolution. King, John. 2012. The Microfoundations Delusion: Metaphor and Dogma in the History of Macroeconomics. Cheltenham, UK and Northampton, MA: Edward Elgar.

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Book review Robert Skidelsky, Keynes: The Return of the Master (Public Affairs, New York, USA 2009, reprinted in 2010) 228 pp. Slim Thabet Department of Economics and Management, University of Picardie Jules Verne, France

The financial and banking crisis, which started in spring 2007, had a rather unexpected outcome: it generated a new passion for the work of John Maynard Keynes. Indeed, it resulted in a number of publications from both ends of the ideological spectrum, among which Skidelsky’s Keynes: The Return of the Master is definitely one of the best. Skidelsky, along with Donald Moggridge (1992) and the late Gilles Dostaler (2007), is certainly one of the great authorities on Keynes, having previously written a three-volume biography on the British economist, totalling some 1700 pages. The Return of the Master is a fascinating short book, which Skidelsky wrote to entertain the thought of ‘how the genius [Keynes] would have analyzed the ongoing crisis’.1 The book answers that question perfectly well. Despite the fact that it took just 5 months to write, it is a very well written and argued book, and a pleasure to read. Skidelsky emphasizes how he had wished to write a book dealing with history rather than economics, thereby allowing it to be read by a public with no prior knowledge of economics. Right from the beginning, Skidelsky highlights the modernity and relevance of Keynes’s thought for analysing the crisis, for two reasons. The first reason deals with the expansionist policies implemented since the start of the crisis. In this respect, Skidelsky quite adamantly emphasizes that Keynes’s thought cannot be confused with a ‘tool box’ to be opened only in a time of crisis and closed when the storm is over. Second, Skidelsky argues that some of Keynes’s other ideas, often ignored, force us to reconsider our priorities and our choices, and to renew our faith in a global vision of the future of mankind and the means to achieve it. The first part of the book is a critical analysis of the crisis which, according to Skidelsky in chapter I, is entirely rooted in mainstream economic theory, and its policies. The author carefully analyses the sequence of events that contributed to the crisis, starting with the subprime market fiasco, which was amplified by a string of financial innovations. He then focuses on the banking system and the panic that struck at the heart of the financial market, and ends with a discussion of the Great Recession of the productive economy. The amazing bail-out of the banking system, in addition to the fiscal stimulus adopted by various governments, helped to mitigate the initial impact of the financial earthquake. However, the stimulus was short-lived, and in order to avoid repeating the mistakes of the past, Keynes was quickly denounced, and austerity policies were adopted by the same governments who, a year earlier, were advocating stimulus. But Keynes denounced these austerity policies in the aftermath of the 1929 crash, and would have certainly denounced them today, claiming they would only fuel of fire of depression. 1.

‘Les histoires de l’Oncle Keynes’, lemonde.fr, September 23, 2009.

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Such an interpretation is perhaps not highly original, but it allows Skidelsky to spell out an alternative explanation of the crisis. For him, what explains the magnitude of the crisis is not the Fed’s wrong monetary policy, but rather the collapse of the real estate market and mainly the drop in (global) aggregate demand. Skidelsky then moves on to denounce bankers, rating agencies, pension funds, central bankers, regulators and the governments themselves, who do not share the responsibility on the same scale of the economic and financial collapse (‘blame games’, p. 22). But here is one of Skidelsky’s strongest arguments: the root of evil lies ultimately in the restored free-market ideology Keynes never stopped criticizing, which was restored following a neoliberal counter-revolution, particularly in the academic milieu, through the New Classical and New Keynesian Economics. Skidelsky’s most devastating critique is targeted at the first because of its core dogma: the theory of efficient markets, rational expectations and real business cycles. Moreover, because of their reliance on asymmetric information, New Keynesians cannot escape this criticism. The fatal mistake of those two schools is to have rejected radical uncertainty and its implications. For Skidelsky, uncertainty in its radical sense has nothing in common with the alluring concept of ‘Black swans’ developed by Taleb (2007). Thereby, the author agrees with the critiques spelled out by some post-Keynesians like Terzi (2010) and Davidson (2010). The second part of the book starts with a short but fascinating chapter dealing with an unknown aspect of Keynes’s life: his activity as a speculator, which must have deeply influenced both his economic thinking and his economic policy recommendations. It is not entirely a new view since Bateman (1996) and Skidelsky himself (1992) already mentioned this in previous writings. Chapter IV is a wonderful summary of the controversy between the (Neo)classicals and Keynes, over uncertainty, institutions and conventions. They show how Keynes’s thoughts are still relevant for the ongoing debates over institutions. One could even say that they anticipate recent ‘discoveries’ of experimental economics. Chapter V delves into the explanation of the failure of ‘the Keynesian Revolution’. Neither Samuelson’s ‘Neoclassical Synthesis’ nor the interventionism of the so-called ‘Glorious thirties’ have anything in common with Keynes’s true thinking. Skidelsky recalls nonetheless that the interventionist policies between 1951 and 1973 were much more efficient than the neoliberal policies of the ‘Washington consensus’ (1981–2009). A collective action both at the national and international level is thereby perfectly justified as long as we go back to Keynes’s fundamental lessons, which are addressed in the third and last part of the book. Skidelsky is correct in recalling that Keynes, before becoming the well-known bright economist, was deeply interested in philosophy, aesthetics, morals, epistemology and history. All through his life, he never forgot his ‘early beliefs’ as to what is Beauty and Right, the meaning of life (individually and in society) or the significance of historical events. Herein lies the true sense of his harsh critique of unfettered capitalism. He dreamed of a world free from scarcity and economic rationing as well as largely free from the yoke of greed. Keynes dreamed of an Ideal City in which citizens would devote their time to the Art of life, meditation and the deepening of social links. But he was under no illusions: major reforms are required to attain this ‘utopia’. Skidelsky argues correctly that Keynes’s dream and ultimate project rests on two pillars: economic policies, the less dangerous pillar for the Establishment, and the much more radical pillar of Institutional reforms. Keynes shares this belief in the priority of Institutional reforms leading to the ‘Middle way’ (pp. 135 and 163–166) with John Rogers Commons. The author emphasizes (p. 164), as he did previously (see 1992, p. 229; 2003, p. 368), the © 2013 The Author

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crucial influence of Commons on Keynes. The American economist is indeed the major theoretician of collective action and the architect of institutional reforms in Wisconsin, which paved the way for the New Deal of Franklin D. Roosevelt. The last chapter of this fascinating book is the most challenging. It gives complete sense to the title of the book and, further, it spells out many recommendations that are inspired by what ‘the Master’ would have proposed. For Skidelsky, one must first oblige finance and banks to play their normal role: the ‘true’ reason is to replace the false reason of pure financial logic. Prudential rules are not enough: since banks ignore borders, only a multilateral action is able to break up the rule of finance. There is more: in the context of very advanced globalization and the rising role of emerging countries, one must put at the front of the stage Keynes’s vision in Bretton Woods where he defended an astute system of regulation of international disequilibrium. He failed, but his spirit is to be discovered again. Skidelsky adds that any policy of reinforcing aggregate demand can be successful if it is implemented simultaneously at the nation state level and at the level of regional homogenous areas. Finally, Skidelsky offers his opinion on what should be the fundamental priority of teaching economics. If it cannot be denied that economics has failed, it must be rebuilt on a pluralist foundation. Economics’ curriculum must reduce the burden of formalization and give way to the history of economic thought and economic facts. Skidelsky puts forward an ambitious reform of postgraduate curricula in economics: microeconomics should be taught in business schools while macroeconomics should be associated with other social sciences, and even taught in the same departments as those sciences. Even though this stimulating book was published in late 2009, it is still perfectly relevant considering the ongoing recession, especially as it is developing in Europe. Indeed, 4 years after the gigantic collapse of Lehman Brothers, the ‘Keynes Moment’ is over and austerity policies are again ubiquitous. Getting rid of austerity is not an easy mission; even Keynes was aware of this obstacle. Indeed, here lies my sole criticism of Skidelsky: he gives too much emphasis to the role of ideas, which lead him to forget the role of social forces/political machinations that could prevent the ideas of ‘the Master’ coming into practice. What is ultimately the core message of the book is that, despite the fact that so many times Keynes has been decreed buried forever, his project remains sensible and alive. The time has not come for this message to be forgotten. REFERENCES Bateman, B. (1996), Keynes’s Uncertain Revolution, Ann Arbor: Michigan University Press. Davidson, P. (2010), ‘Black swans and Knight’s epistemological uncertainty: are these concepts also underlying behavioral and post-Walrasian theory?’, Journal of Post Keynesian Economics, 32 (4), 567–570. Dostaler, G. (2007), Keynes and his Battles, Cheltenham, UK: Edward Elgar. Moggridge, D. (1992), Maynard Keynes: An Economist’s Biography, Routledge: London. Skidelsky, R. (1992), John Maynard Keynes, Volume 2: The Economist as Saviour: 1920–1937, London: Macmillan. Skidelsky, R. (2003), Keynes: Economist, Philosopher, Statesman, London: Macmillan. Taleb, N. (2007), The Black Swan: The Impact of the Highly Improbable, New York: Random House. Terzi, A. (2010), ‘Keynes’s uncertainty is not about white or black swans’, Journal of Post Keynesian Economics, 32 (4), 559–566. © 2013 The Author

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Review of Keynesian Economics, Vol. 1 No. 3, Autumn 2013, pp. 377–379

Book review Claudio Sardoni, Unemployment, Recession and Effective Demand: The Contributions of Marx, Keynes and Kalecki (Edward Elgar, Cheltenham, UK and Northampton, MA, USA 2011) 192 pp. James Andrew Felkerson Graduate Student, College of Arts and Sciences, University of Missouri–Kansas City, USA

The concept of effective demand is central to any truly ‘post’-Keynesian economics. But the notion of effective demand can rightly be said to have been anticipated by Marx, in a certain manner of speaking, and is held to have been discovered independently of and prior to Keynes’s exposition by Kalecki. Given this connection, inquiry into the theoretical affinities between Marx, Keynes, and Kalecki is warranted and often productive. This is a line of inquiry to which Professor Sardoni has devoted considerable effort over the years. In the 25 years since his treatment of the topic in Marx and Keynes on Economic Recession (1987), some of the more contemplative orthodox theorists have been compelled to revisit the question of the determination of output and employment as a whole as a result of the inability of mainstream theory to provide suitable answers to the causes of economic fluctuations of increasing frequency and severity. In light of the recent Global Financial Crisis and subsequent tenuous recovery, this book – which is largely a revised and updated version of Marx and Keynes on Economic Recession – is timely to say the least. Sardoni begins with the acute observation that the Marxian and post-Keynesian traditions have never greatly concerned themselves with developing a rigorous and mutual understanding of the potential analytical similarities they share. Both, however, share strong ties with Kalecki, whose works sit astride the traditions, and to whom Sardoni gives pride of place as a bridge between the schools of thought. Furthermore, Sardoni posits that Kalecki’s economics can be thought of as an improvement over the theories advanced by Marx and Keynes, in that he was able to provide important theoretical answers to questions which they were not. However, we are quickly warned, for obvious reasons I suppose, that we will not be investigating the possibility of any ideological or political resemblance nor developing an intricate comparison between the theoretical systems; that is, we are taking up, except in cases necessitating further clarification, the question of unemployment and effective demand. Say’s Law has long served as a bulwark against challenges to the legitimacy of conventional economic theory. However, as Sardoni notes, Marx and Keynes approached the upending of Say’s Law from different angles. Marx’s concern was to show that insufficient levels of effective demand could result in crises characterized by the temporary underemployment of labor and capital, while Keynes concerned himself with the theoretical possibility that no impetus exists to move the economy towards the full employment of labor and capital from less than full employment, regardless of how it found itself in the underemployment situation. To provide an account of Marx and Keynes’s challenge to Say’s Law, Sardoni presents both authors’ rejection © 2013 The Author

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of the assumption that a capitalist economy functions not unlike one organized under the auspices of barter. For the orthodoxy in the time of both Keynes and Marx, money was theoretically viewed solely as a device for enabling transactions in real things. The classical/neoclassical account is that money is a ‘veil’ behind which the production process is carried out in order to directly or indirectly satisfy wants. Now the point of production may very well ultimately be consumption, but this rendering of the production process fails to take account of the fact that production in a capitalist economy in undertaken unambiguously for the purpose of winning profits. Sardoni illustrates how this is captured in Marx’s famous ‘M–C–M’ schemes which were also adopted by Keynes in early drafts of The General Theory. If capitalists are uncertain about the possibility of adequate return on their outlays they may choose to hold purchasing power in the form of money hoards. The possibility that money is hoarded and not spent, abstracting from the existence or influence of a banking system, is enough to show that national income many indeed depart from national expenditure. By attributing to money more than the function of a medium of exchange, Marx and Keynes were able to disabuse the notion that Say’s Law imbues the operation of a capitalist economy with coherence. In both cases the admission of money as a critical variable in economic analysis leads to the conclusion that there should be no reason for the system to behave in the manner predicted by classical or neoclassical theory. Starting from a shared emphasis on money’s role in the determination of effective demand and employment, Sardoni shows how Marx and Keynes diverge on the operation of a capitalist economy. Marx gives us the economics of crisis. A story is told how, as the result of contradictions internal to the very structure of the capitalist mode of production, generalized overproduction crises emerge as capitalists find themselves unable to realize in full the value of abstract labor embodied in produced commodities. For Marx, the capitalist is impelled to produce and invest in such a way as to obtain the highest possible rate of profit on capital advanced. Should the capitalist believe that profits are not forthcoming, the accumulation process seizes up as capitalists choose to hoard money instead of throwing it back into circulation. Crisis then ensues, but, interestingly enough, once the critical event has passed, the same forces which begat the crisis propel the economy back to full employment in a fairly timely fashion. Keynes, on the other hand, gives us the possibility of prolonged periods of underutilization of productive capacity and labor. Money is again central to this analytical conclusion, in that hoarded money can leave the rate of interest at too high a level to encourage investment and therefore employment. Should the rate of interest on liquid money remain above the rate of return on illiquid investment, investment will not be forthcoming and the economy will display no tendency toward full employment, either in the near or long term. We are stuck, if you will, with equilibrium below full employment. As Sardoni capably points out, Keynes’s account of things need not be accompanied by crisis and Marx’s cannot be achieved independent of a crisis. So we have here two irrefutable, or perhaps more accurately the defining, characteristics of capitalism. Unfortunately, Sardoni argues, neither narrative is capable of providing a satisfactory general description of a process that gives rise to both. Only through significant, and unacceptable, modification are we able to generate both crisis and malaise in either theoretical system. The inability of Marx or Keynes to provide a convincing explanation is largely the consequence of the microfoundations underlying their models. Thus, the book in large part consists of developing these underlying microfoundations and then putting forward a critique. Albeit for different reasons, both Marx and Keynes adopted the assumption of some form of freely competitive market structures. Marx’s assumption © 2013 The Author

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of freely competitive market structures leads him to accept that a return to full employment is logical in the aftermath of a crisis. This eventuality is at odds with the common observation that economies frequently remain at less than full employment for extended periods of time. Keynes’s interpretation of free competition does yield sustained underemployment of labor and capital, but crucially depends upon unrealistic assumptions regarding the shape of short-run cost curves. Furthermore, Sardoni argues that Keynes’s marginal efficiency of capital schedule is untenable for the usual reasons for which it is objected to. It is argued that both upward-sloping short period supply curves and downward-sloping investment demand curves are necessary for Keynes to produce persistent underemployment equilibrium. Indeed, once we correct the flaws in Keynes’s microeconomic theory, we are left with fundamentally the same outcome as Marx; that is, ultimately there are no prevalent forces to prevent the economy from achieving full employment. Kalecki’s emancipation from the theoretical results obtained by Marx and Keynes derives from his rejection of any form of freely competitive market structures. This analytical result is achieved by showing that, regardless of downward-sloping demand curves and in the absence of any barriers to a level of aggregate demand consistent with full employment, imperfectly competitive firms do confront a limit to their rate of growth and can tend toward underemployment equilibrium positions. By hypothesizing that the firm faces a financial constraint limiting the amount of finance that can be raised in capital markets, Kalecki can argue that the level of investment falls short of the level necessary to achieve full employment as both industrialists and financiers encounter ‘increasing risk’ in the financing of investment. Furthermore, if the primacy of the capitalist class is viewed as threatened, there exist significant ‘non-economic’ factors which prevent the system from realizing and maintaining full employment. For Sardoni, Kalecki’s attempt to more closely approximate the real world in his analysis enables him to present an internally consistent model capable of generating both crisis and less than full employment positions of rest. There is a great deal to commend in this book. The structure of the argument is concise and easy to follow. Sardoni leads the reader logically from one point to the next in such a way that there is little doubt where we have been, where we are going, or why. The line between ‘principles of’ and ‘recent controversies in’ can be exceedingly fine when treating complex theoretical issues in brief, but it is a line that Sardoni walks with aplomb. This approach makes the book perfectly accessible to all readers with advanced economic training; in fact, there is much to be gained even by specialists in the field from Sardoni’s argument. Given the structure of the book, it is ideally suited for young researchers of the graduate or post-graduate level, and even for neoclassical economists shaken by the most recent failure of mainstream models. It appears that this notion is in the back of Sardoni’s mind when he composed chapter 8, which culminates in an appeal to greater plurality in economics. It may be, though, that this optimism is misplaced. Casual inspection of the recent literature published in ‘reputable’ journals unfortunately shows mainstream economists to be doing exactly what Sardoni advises them against through the ‘uncritical reproduction of essentially the same model, enriched by some minor variations’ (p. 137). REFERENCE Sardoni, C. (1987), Marx and Keynes on Economic Recession, Brighton, Sussex: Wheatsheaf Books. © 2013 The Author

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Review of Keynesian Economics, Vol. 1 No. 3, Autumn 2013, pp. 380–382

Book review Robert M. Solow and Jean-Philippe Touffut (eds), What’s Right with Macroeconomics? (Edward Elgar, Cheltenham, UK and Northampton, MA, USA 2012) 240 pp. John King Professor of Economics, School of Economics, La Trobe University, Melbourne, Australia

This is a strange title for a most unusual book, which presents the proceedings of a conference with the same title that was held at the Cournot Centre in Paris in December 2010. The great majority of the contributors are European: French (Jean-Bernard Chatelain, Xavier Ragot, Xavier Timbeau, Jean-Philippe Touffut), Italian (Giancarlo Corsetti, Giovanni Dosi, Giorgio Fagiolo, Mauro Napoletano, Andrea Roventini), Belgian (Paul De Grauwe) or German (Volker Wieland). One is Australian (Wendy Carlin) and two are veteran Americans (Robert Solow, born 1924, and Robert J. Gordon, born 1940). This strong European focus gives the book a very special flavour. A brief introduction by the editors is followed by seven papers and an extended round table discussion that includes major presentations by Carlin and Gordon, with comments by Solow and (from the floor) several other conference participants, all of them European. Regrettably, the editors do not provide a concluding chapter. Each of the seven papers is critical, to a greater or lesser degree, of what several of the contributors refer to as ‘modern macroeconomics’ (otherwise known as the new neoclassical synthesis). Most of the authors would agree with Timbeau (pp. 10–11), who endorses George Akerlof’s critique of the ‘five neutralities’ that are assumed to hold in the new neoclassical synthesis (independence of current income and current consumption; irrelevance of debt; Ricardian equivalence; a supply-determined ‘natural rate’ of unemployment; efficient financial markets). Dosi, Fagiolo, Napoletano and Roventini criticise ‘the theoretical vacuum present nowadays in macroeconomics’ (p. 110); De Grauwe is highly critical of ‘standard economics’, as reflected in DSGE models (pp. 187–188); Ragot concludes that a ‘new research programme, or even a new paradigm is needed’ (p. 192); Carlin insists that income distribution and ‘the debt cycle’ need to be grafted on to ‘Taylor Rule macro’ (p. 205); and Gordon criticises DSGE models for ignoring investment and for making assumptions that are ‘patently false’ (p. 217), not least with respect to ‘Euler-equation consumers’, so that ‘modern macro has too much micro and too little macro’ (p. 218). Not much is ‘right with macroeconomics’, or so it seems. However, several of the contributors also pull their punches, to a greater or lesser degree. ‘It would be presumptuous to call for a paradigm shift’, according to Timbeau (p. 29). Wieland concurs, arguing that ‘there is no reason for forecasting professionals using time series methods or traditional Keynesian-style models to dismiss modern DSGE models’ (p. 60). Even Solow maintains that we ‘should not start from the opposition of good and bad models. Even the simplest fundamentalist dynamic stochastic

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general equilibrium (DSGE) models contain a certain amount of ordinary common-sense economics that no-one would be against in principle’ (p. 195). Some contributions from the floor at the end of the round table discussion were much more critical of DSGE models than this (pp. 219–225), and several of the authors, though not all of them, would agree with Chatelain: ‘For now, we do not know to what extent the forthcoming macroeconomic theory will take into account a weakly regulated financial sector and the rejection of the efficient capital market hypothesis. I am disturbed by the presentiment that we are on the eve of failing once again, and that key assumptions in the current way of doing mainstream macroeconomics may not be changed for a long time’ (p. 107). What, then, do they have to offer by way of alternatives? Uniquely, Wieland calls for pluralism in modelling and in theory construction, though this seems to extend only to ‘Old Keynesian’ and ‘New-Keynesian DSGE models’ (p. 61). There is some evidence among other contributors of nostalgia for ‘traditional macro’ of the Old Keynesian variety, but there are also two less reactionary proposals. De Grauwe’s paper is in effect a summary of his book on behavioural macroeconomics (De Grauwe 2012), which I have reviewed elsewhere (King 2013). And Dosi, Fagioli, Napoletano and Roventini argue strongly for agent-based modelling that ‘bridges Schumpeterian theories of technology-driven economic growth with Keynesian theories of demand generation’ (p. 140). In its current state, behavioural macroeconomics has serious problems, not the least of them being, as De Grauwe admits, the absence of financial markets and of a banking sector (p. 177). There are additional problems with agent-based modelling, not least the ontological and epistemological issues that are raised by simulation experiments and their connection (if any) to capitalist reality. One alternative is almost entirely absent from this book. There are three rather slight references to Hyman Minsky, but no other post-Keynesian author receives a mention in the index to this book, and there seem to be no citations of papers from the Journal of Post Keynesian Economics or, for that matter, any other heterodox journal. As already mentioned, the editors do not provide a concluding chapter that might have commented on these questions and responded to Chatelain’s ‘presentiment’. I would have liked more in particular from Robert Solow, who does not confront the serious theoretical challenge that is implicit in three of Carlin’s diagrams, in which ‘neoclassical growth theory’ is accurately presented as the parent of ‘real business cycle theory’ and therefore as the grandparent of the ‘New Keynesian DSGE model’, both of which she correctly criticises (Figures 8.1, 8.3, 8.9, pp. 196, 198, 205). Solow would presumably claim that his model applies only to the long run and has been inappropriately extended to the short run by real business cycle theorists, but this gives rise to a host of methodological problems (see Sanfilippo 2011). As Dosi and his co-authors ask, why should ‘Keynesian theories of demand generation’ be excluded from long-run modelling (p. 141)? On the evidence of this volume, then, dissident mainstream macroeconomics is alive and well in Europe, if not (perhaps) in the United States. It needs to broaden its outlook and extend its sources, not least to the post-Keynesian literature. For their part, post-Keynesians need to discover ways of making contact with these dissidents and to pay serious critical attention to the theoretical and methodological issues raised by agent-based modelling and behavioural macroeconomics.

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REFERENCES De Grauwe, P. 2012. Lectures on Behavioral Macroeconomics, Princeton, NJ: Princeton University Press. King, J.E. 2013. ‘Review of De Grauwe (2012)’, European Journal of Economics and Economic Policy, 10 (1), 122–123. Sanfilippo, E. 2011. ‘The short period and the long period in macroeconomics: an awkward distinction’, Review of Political Economy, 23 (3), 371–388.

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