Central Bank History (3/5) 1914-1980

This series of posts is based on a single lecture (Lecture 13 of Advanced Macro II) exploring the evolving functions of Central Banks through time. It goes through a vast amount of material in a very short time, and hence is a very sketchy treatment. This is the 3rd post,  which deals with the period from WW! to the 1980s. The 15m segment of Lecture 13 dealing with this time period is linked below. The writeup below is a somewhat edited and abbreviated version of: Monetary Policy from 1914 to 1980s

Background: Central Banks were created to provide funding for wars, and were extremely successful at this function. When wealth is measured in gold, then Mercantilism is the natural economic theory – we use trade to get gold from foreigners. If this fails, wars can be used to acquire the gold by force. European history is marked by nearly constant warfare, even after the end of religious wars (Peace of Westphalia 1648). The Gold Standard is inherently a zero-sum, adversarial system of trade.  Polanyi (The Great Transformation) writes that “The nineteenth century produced a phenomenon unheard of in the annals of Western civilization, namely, a hundred years’ peace—1815-1914”.  The main explanation for this is the transnational character of the Central Banks. The 19th Century was devoted to the colonization of the globe by Europe. In this effort, the Lords of Finance found transnational cooperation useful, and wars inconvenient. Polanyi describes the “sudden change” when patriotism went from being a great virtue to a barbaric relic of the past – this change in public sentiment was created by the interest in maintaining peace in Europe by haute finance. Wars among the European powers did not make sense when financial and material power could be used to capture the resources of the entire planet. By the early 20th Century, about 85% of the globe had fallen under the influence of European powers. The internal dynamics of capitalism seek continuous expansion, and exhaustion of global frontiers led naturally to World War 1 in 1914. What is worth noting is that it was high finance that created the wars of the 18th Century, and the same force which produced the peace of the 19th.

The Interregnum: 1914 to 1944 (between WW1 and WW2): The heavy expenses of war incurred by all European powers led to the abandonment of the gold. Post-WW1 there was a massive effort made to restore the gold standard. This is because nearly everyone incorrectly attributed prewar European prosperity to international trade made possible by the gold standard. In fact, prosperity had been due to the vast inflow of resources from colonization, accompanied by trade. Despite massive efforts, the gold standard could not be restored because it was inherently flawed as a basis for global trade. Use of the gold standard creates a strong conflict between the needs of the domestic economy and the stability of exchange rates required for international trade. In the pre-war era, Central Banks had ignored the needs of the domestic economy, and set stability of exchange rates as their goal. In the inter-war era, with European economies lying in ruins, this was no longer possible. An expansionary monetary policy was required to rebuild economies, but this was not compatible with the stringency required for restoring the gold standard. Eichengreen provides a detailed analysis on how Central Bank policies, and their effects, underwent a radical change in the inter-war period, because of the necessity of emphasizing the domestic economy. For a detailed discussion, see “International Financial Architecture: Part II”.

The Great Depression of 1929

The destruction of the European economies, and the isolation of the USA, led to the emergence of USA as the financial center of the world in the post-war era. The creation of the Federal Reserve Bank in 1914 substantially strengthened the ability of banking sector of the USA to create credit. See “Completing the Circle: GD ’29 to GFC ‘07” for a brief discussion of how this led to a spree of credit creation which financed the roaring 20’s in the USA. The speculative boom led to a spectacular crash famous as the Great Depression of 1929. It was widely realized that this was due to irresponsible behavior by banks, and massive regulations on banking were enacted. As a result of heavy regulations, there were no systemic banking crises for about fifty years, and hence also, no efforts by Central Banks to control crises. During this period, experience led to clearer understanding of the Role of Central Bank Versus Treasury. Central Banks were assigned the responsibilities of managing the foreign exchange rate, and reserves. They were given the job of implementing banking regulations. In addition, Central Banks were in charge of debt management, liquidity management, and management of the financial markets.

Creation of Keynesian Economics

Apart from regulation of the financial industry, another major revolution caused by the Great Depression was the inventions of Keynesian Economics. Whereas classical economics held that money was neutral, Keynes argued that expansionary monetary and fiscal policy was required to lift economies out of recession. This created another set of tasks for the Central Bank – maintenance of full employment, in addition to guarding against inflation. In some countries, this task was given to The Treasury, to handle Monetary Policy as well as Budget & Fiscal Policy.

From the earliest times, Central Banks have been closely connected with financing for wars. The next major development occurred when the Bretton-Woods Conference was held in June 1944, a little before the end of World War II. It was clear that the efforts to restore the Gold Standard had failed in the inter-war period, and the second World War had put the gold standard permanently out of reach. There was a need to design a new system for international trade, which would not be based on gold. Although Keynes came to the conference prepared with a sensible, well-designed, symmetric system, this was shunted aside in favor of a system based on the dollar, backed by gold. This was called a gold-exchange standard, in the sense that at the core was a currency which could be exchanged for gold, since US had gold reserves which had not been affected much by World War II. This use of dollar created an asymmetric system with huge benefits for the center currency and huge disadvantages for all others; see “A Lopsided System”.

The Nixon Shock & Floating Exchange Rates

The next development in evolution of money was caused by the Vietnam War. Financing the war required printing dollars in quantities which made it impossible to back them with gold at the announced rate. The 1971 announcement that dollars would no longer be backed by gold has been termed the “Nixon Shock”.  Just as fixed exchange rates are natural in a gold-standard world, floating exchange rates are natural for a world of fiat currencies without any backing. However, this was a new experience for the world. There was substantial apprehension that wild gyrations of exchange rates would be a huge barrier to international trade and hence global prosperity. This has been called the “Fear of Floating”. One illustration of this fear was the attempt by the Hunt Brothers to acquire a monopoly on silver, under the belief that floating exchange rates were bound to fail, causing a return to gold and silver. Despite these fears, the world learned to live with floating exchange rates, and these are in fact an essential feature of Modern Monetary Theory as the right way to manage international trade.

From World War II until the 1970’s was a golden era for Western economies. It seemed that Keynesian economics had delivered the magic formula, and Central Banks were able to maintain full employment and price stability. However, this period of prosperity led to a rise in the wealth share of the laborers, and a corresponding decline in the wealth share of the top 1%; see The Power of Economic Theory: Graphically Illustrated. As Karl Marx noted, capitalism works by the willing consent of the laborers to their own exploitation. This consent is created by misleading and deceptive theories (see ET1%: Economic Theory of the top 1%) which promote policies which appear to be beneficial for all, but in fact strongly favor the rich and powerful. One of these theories is “Monetarism”.

The Monetarist Counter-Revolution

The first shot in the battle of the rich against the poor was fired when Milton Friedman wrote “A Re-statement of the Quantity Theory of Money” in 1956. This laid the theoretical foundations for the “Monetarist Counter-Revolution” against the Keynes. Keynesian theory gave great importance to the role of money – too little would lead to unemployment while too much would cause inflation. This meant that the Central Bank had to accurately target the money stock to be at just the right level. Friedman restored the pre-Keynesian view that money does not matter in the real economy. There are two fundamental misconceptions about money which are embodied in the quantity theory advocated by Friedman. The first is the idea that money is “exogenous” – that is, the government creates the stock of High-Powered Money, and the total amount of money in the economy is just a fixed multiple of this amount. This means that the government can control the amount of money in the economy. The second misconception is that money is neutral – that is, the money only effects prices, and has no other real effects on the economy. There is a massive amount of empirical and theoretical evidence against both of these myths. The Bank of England paper on “Money Creation in the Modern Economy”. Private banks create money when they give loans, so that money is not exogenous – demands of borrowers lead to creation of money. Similarly, extensive evidence on the wide-ranging effects of money throughout the economy (as opposed to neutrality) is available from “Market Power and Monetary Policy” as well as “The Trouble with Macro”.

Friedman’s re-instatement of the Quantity Theory of Money was based on a popular misinterpretation of Keynes which provided the basis for the neoclassical synthesis. According to this idea, money is neutral in the long run. Short run Keynesian effects arise because prices are fixed in the short run. Thus, when money supply increases, the real wage decreases, but laborers suffer from money illusion, and do not notice this, because the nominal wage is fixed. Thus, they become more willing to work, and the firms hire more labor, temporarily increasing employment. However, as prices rise, and everyone notices this, unemployment goes back to its “natural rate”. The lesson is that while expansionary monetary policy can have short run beneficial effects, in the long run it can only cause harm to the real economy by building in inflationary expectations. Also, monetary policy works by creating a “money illusion” because workers fail to distinguish between nominal wages and real wages, in the short run.

Paul Volcker and the Failure of the Friedman Rule

Based on this analysis (which is completely erroneous), Friedman came to the conclusion that monetary authorities should create and announce a target for monetary growth and stick to this target as the optimal form of monetary policy. This is the Friedman rule for monetary policy: Keep reserves growing at 6%. This will create a fixed and known rate for inflation, eliminating “money illusion”, and eliminating the harmful effects of unpredictable shifts in money supply. Since the real economy works best on its own without interference from government, the Friedman rule will lead to optimal economic results, creating Price Stability, Financial Stability and Growth.

US intervention in favor of Israel in the Yom Kipur War led to the oil embargo, and dramatically increased prices for oil in the USA. Cost-push inflation reached 9% in the late 1970’s when Paul Volcker was made the head of the Federal Reserve. Volcker announced that he follow the Friedman Rule, in order to bring down the inflation. Contrary to general expectations, he achieved this goal, bringing down inflation remarkably. However, huge real costs were inflicted upon the economy. The contractionary monetary policy followed by Volcker created the deepest recession seen since GD ’29. There is considerable controversy about Volcker. Friends praise him for controlling inflation, while enemies blame him for causing the recession. For example, see Goodfriend and King “The Incredible Volcker Disinflation” who argue that real costs of recession were low, and benefits of disinflation were high. Another article in praise of Volcker is about Volcker’s Rules.  A more global perspective on huge costs of the Volcker Recession of the early 1980s is provided in the Wikipedia article on the topic: the Early 1980s Recession.

Regardless of how one normatively evaluates this Volcker episode as good or bad, it had an extremely important influence on shaping Central Bank policy. Despite efforts by the Central Bank, it proved impossible to keep the money supply on target growth rates. This is because endogenous credit creation by private banks is not under central bank control. Thus, the Friedman rule is impossible to implement, simply because money supply is not exogenous. Since then, the instrument used for monetary policy has been the interest rate. In particular, the overnight discount rate offered by the Central Bank governs short term interest rates throughout the financial markets. Also, buy buying and selling short term bonds as required, the Central Bank can ensure that the policy determined interest rate prevails on the market. However, controlling interest rates means losing control of the money supply – sales and purchase of bonds will create or destroy money to ensure a match between demand and supply of credit at the policy rate. These are some of the key insights of Modern Monetary Theory, which is very different from conventional monetary and macro theory taught in standard textbooks

POSTSCRIPT: See Monetary Policy from 1914 to 1980s for a brief description and list of the previous posts in this sequence on Central Bank History.

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