Monetary Histor

Monetary History

Indrajit Mallick

Centre for Studies in Social Sciences, Calcutta

Money has always played an important role in our lives. Sometimes it has been necessary to win wars (see Dickson (1967), Ferguson (1998) and Ferguson (2001)), at other times it has been the key factor in bringing back order and peace (Bosher (1970) and Mcdonald (2003)). Eitherway, money and power have travelled together and have played the most crucial role in financial innovations (see Allen and Gale (1994)) and international lending and borrowing (see Ashton (1960), Outhwaite (1966), Kindleberger (1993), Neal (1990) and Ferguson (2008)).

Davies (2002) and Chown (1994) trace the path travelled by money in different time periods in different geographical areas. Among primitive non-metallic money there were barley, rice, salt, cattle and cowry shells. There were also whale teeth, yap stones and wampum. With mining and discoveries, precious metals came up to take the place of money side by side with the non-metallic media of exchange. All these kinds of primitive money required storage, patronage and trust in the socio-economic setups where they were used. Minting of coins took for the first time in the western world in Lydia around 650-600 BC. This led to the introduction of Greek silver coins and subsequently, in the Roman Empire, gold and silver coins (see Goldsmith (1987)). In China and India bronze coins came up during the early phase of classical antiquity, and gold and silver coins were first exported by Rome to India during the Maurya period. Gold bars were introduced in Egypt while silver bars were introduced as money in Mesopotamia. Some metallic bars served as money during ancient times in Latin America and some mineral rich islands and continents. In Europe, prior to the 17th Century, most money was commodity money, typically gold or silver. However, promises to pay were widely circulated and accepted as value atleast five hundred years earlier both in Europe and Asia. Bank notes evolved in China from promissory notes during the Song dynasty in the 7th century (bank notes began to circulate in Europe heavily in the 14th century), negotiable bills of exchange were first discovered in China in the 8th century and then used by Arab merchants during the 10th-13th century, by Italian merchants in 12th-16th century and gradually spread in the rest of Europe during the period, while paper money of the Yuan dynasty came to be known through the writings of Marco Polo in the 13th century. The first (short lived) attempt to introduce paper money through a central bank took place in 1661 in Sweden. However, permanent banknote issue was successful in 1694 by the Bank of England. In the next 250 years, different bank notes issued by central banks of different countries moved towards becoming the legal tender for each of these countries.

Money can be classified in three ways: commodity money, representative money and fiat money. These monies in turn generate a number of negotiable instruments like promissory notes, bank notes, bills of exchange and checks. With commodity money, there was always a natural incentive for debasement by the governments and clippings by the public both of which brought about distortions like inflation, hoardings, shortages etc. Further, commodity money was in high usage and fell in popularity with the rise of issuing authority as it happened in the case of gold bezant of the Byzantine empire (high value and usage in high middle ages to decline in popularity and a switch to silver by Europe in later times). In the middle ages, as in the ancient times, money supply was determined by coinage in circulation. Typically there has been more than one kind one of money in any country during any given period. Gold coins and silver coins coexisting had produced bimetallism which was an unstable system despite the different advantages of different types of money (gold for large payments, silver for small payments, copper serving in between and bills of exchange and notes) used in ports for international and domestic trade). The instability of bimetallism arose due to the following reason: Individuals would bring precious metals to the mint and they would be coined according to the mint price ratio. If the mint price of silver in terms of gold exceeded (fell short of) the market price of silver in terms of gold, then individuals would take silver (gold) to the mint to be coined and hoard and export gold (silver). Sargent and Velde (2002) have investigated the paradox of shortage of silver coins of small denominations and the depreciation in their values in Europe during the medieval ages. Their explanation is in terms of the inability of the price level to move to either increase the value of the coins or to increase the incentive for minting them. There is another explanation. During the middle ages, silver was the currency and it was short in supply in Western Europe due to chronic adverse balance of trade with the far east, India, China and the Baltic (Kindleberger (1993)). So the public had a general incentive to hoard silver and silver value was generally kept artificially low by speculators. With the commercial revolution and the crusades bringing in negotiability of international bills of exchange, the effective money supply increased in Europe significantly and brought about the growth of trade and incomes between 11th and 16th century AD (see Lopez. (1971)). However, the chronic shortage of silver due to balance of trade deficits, the philosophy of mercantilism and the quest for power using modern navigating technologies resulted in new hopes in European states of creating a balanced monetary system based on species as well as negotiable instruments. In the early modern period (between the 15th and 18th centuries), merchant capitalism and mercantilism were established in theory and practice on the basis of expanding international trade with backing by the state, subsidies and monopolies to promote the accumulation of precious metals like gold and silver at home. In the 16th-18th century, silver from Latin America and gold from Africa flooded Europe (particularly Spain and Portugal respectively) and started an upward spiral in prices (and profits in commerce and industry) known as the price revolution (see Hamilton (1928) and Braudel and Spooner (1967)). In 1717 Newton as the master of the mint, put England on a defacto gold standard (The gold standard was a monetary system with the unit of account based on a fixed quantity of gold. During gold standard, money supply has been stable for the countries adopting it) by driving silver out of circulation. In 1821 England formally adopted the gold standard and other countries followed eventually at the end of the century, leaving bimetallism.

From 1870 to 1914 there was a period of Gold Standard which integrated the world economy to a considerable extent. Every country accepted the gold as the international currency and and pegged their exchange rates to gold with gold as a basis for international reserves. The countries in Monetary Unions also accepted the gold standard. This period saw high growth rates and low levels of economic and financial instability under the imperial and financial cum industrial rule of Great Britain and the coming of power to USA through innovations in transport, communication and management systems. Capital exports from Britain was very high during recessions thus stabilizing the global economic system and the expanding American economy received a major share of capital exports from Britain and other major European powers. Central banks in major European countries ensured stability in exchange rates and international trade due to the stable capital allocation patterns in the global financial system. Major financial centres came up which were to be sources for portfolio diversification, financial innovations and credit. The monetary and banking systems in Europe benefited from the innovations and financial stability while the USA had periodic banking and financial market crisis due to the absence of a central bank which only came in 1913.

The most influential and durable account of how the gold standard system worked is due to the price-specie flow model of (see Hume (1752)). He constructed a theory of automatic balancing of a country’s trade account. This is a classical quantity theory model in which employment and output is at the full employment level, velocity is determined by institutional factors and price level varies one to one with a change in the money stock. In his model, a country having a trade deficit to start with would see an outflow of gold (of paper currency in a model with banks) and as a result spending on domestic goods would come down which could cause price deflation (the opposite of course, would happen in the country starting with trade surplus). As a result of the deflation, the international competitiveness of the country would increase and net exports rise to a point so that trade account would become balanced. The primary weakness of this theory was to account for limited international flows of gold as observed in data (between traders in a model without banks and between central bankers in a model with banks and paper currency). An improved explanation was in terms of a theoretical framework which allowed the central bank to possess instruments of intervention like the discount rate and open market operations. Thus, a central bank, anticipating gold outflows, could raise the discount rate or sell bonds and thus contract the money supply (see Eichengreen (1996) and Neal (2000)). This could lead to a reduction in the price level, improve export competitiveness and obviate gold outflows and keep the trade account in balance. This was known as “playing by the rules”. There is another view of how the gold standard worked without necessitating to much gold flows across international borders. This is a revisionist view with Keynesian flavour where spending determines the equilibrium outcome with price level not having not so much effect. Consider the flotation of a large new issue of American railway bonds in the 19th century London capital market. Under the classical adjustment mechanism, this transfer would be treated as an exogenous force inducing gold to flow into the United States, causing inflation, and out of Great Britain, causing deflation. However, the revisionist theory would argue that income and the propensity to spend on imports there-from, would determine trade surplus or deficit, and not prices (in other words, the income effect would dominate the price effect). From the revisionist perspective of the integrated capital and goods markets, however, the capital transfer would cause an up upward propensity to spend on goods and services in USA and the opposite in Great Britain (causing net exports to fall in the former and net exports to rise to rise in the latter country). To the extent that the British trade surplus fell short of the capital outflow due to the bond issue, an offsetting inflow of short term capital to London would be the residual balancing item. Apart from these reasons, the modern gold standard did not require too much gold flows between countries because of a well functioning international clearing and settlements system taken care of by a few advanced western countries. Since the early modern periods, colonial finance practiced by the imperial powers had been engineering outflows of gold from Latin America, India, Australia and Africa (see Bagchi (1982)). As a consequence, these economies could not adjust well to the gold standard.

The World Wars and the great depression changed the scenario by bringing in exchange control, diversion of capital from many developing countries and destroying the Gold Standard. A new international monetary system through the Bretton Woods Agreement in 1944 was created. After the demise of gold standard, a fixed exchange rate regime was created with exchange rates of each member countries being pegged to the dollar (but with dollars convertible into gold) and with the International Monetary Fund being created to help member countries to tide over temporary balance of payments problems. Thus though the money supply became more flexible, the reliance on gold retained the stability it needed.

In 1972, America moved away from the rule of dollar being convertible to gold due to a large balance of payments crisis. This led to the complete abandonment of fixed exchange rates by 1976 and ushered in a system of “managed float” or flexible exchange rates managed by respective central banks. With managed float, money supply of a country depends on the net foreign assets and currencies held by the central bank which in turn depends both on policies and interest rates in asset markets (see Michie (2006) and Neal (2000). In recent times, with managed float in currency markets and fiat money the dominant mode of unit of account, medium of exchange and store of value, money supply can be increased by liquidity injections through central bank open market operations, reducing the reserve-deposit ratio and reducing the interest rate on discount window lending to commercial banks. According to monetarists, money demand is a stable function of the rate of interest while Keynesians explain much of aggregate fluctuations through the instability of the money demand mechanism.

Let me briefly make some observations on the negotiable instruments created by money and trade (see also Neal (1990)). Bank notes were circulating from the 17h century (first issued in 1661 by the Bank of Sweden) and became popular among the larger banks as a profitable means of expanding commerce in a given geographical area. They were either convertible into gold or non-convertible. There was always the danger of over issue of notes creating temporary booms which would end in non-repayment by banks issuing the notes and causing a financial crisis. Thus there were various restrictions placed by governments on note issuing banks. There were restrictions on which type of banks could issue notes and in which areas. Bank notes were payable in demand and were convertible into commodity money like gold most of the times. When not convertible, there could be excessive issue of notes leading to artificial and unsustainable booms and inflationary episodes. As a result, in UK, the Bank Charter Act of 1844 was passed which ensured that bank note issue was restricted to the Bank of England only and with full convertibility (into gold or silver of equal value). In other countries, there were similar acts promulgated at different points of time (but with the same underlying concern about excessive issue of bank notes) which led to central banking with exclusive issue of notes or paper money. This meant that private bank note issues were gradually replaced by bills of exchange and then checkable deposits. A bill of exchange involved four parties at the least. The importing merchant drew a bill on her banker and gave it to the exporting merchant who deposited the bill in his bank. The exporting bank could send it to the other bank and make a claim for immediate payment. It could also pass the bill to any other merchant who would accept it and had a liquid cash to offer in exchange for it. The second route created negotiability of the bill and created liquidity in the market. Of course, the buyer of the bill would not make the payment equal to the par value but show his time preference by asking for a lower price. This was known as discounting the bill. Endorsement by previous possessors of bills and assignment of financial responsibilities on them on the event of default created trust and liquidity. As the final date of extinction of the bill approached the discount would gradually fall unless there arose of a possibility of illiquidity or bankruptcy of the importer’s bank. The sequence of transactions would end with the extinguishing of the bill by the bank of the importing trader by claiming the value of imports from the importer. With the 1844 Bank Charter Act, a scarcity of funds developed in many regions and countries which led to further innovations like cheques written on deposits being made legal tender, the money supply thus became more flexible in response to the demands of commerce and industry in modern times. The modern day debit card used in ATM machines has reduced the need for cheques and bank drafts and has increased the liquidity of money. It must be noted that fiat money or negotiable instruments without private bank note issue can only expand according to the demands of commerce and industry and thus accommodate growth without the dangers of inflation. This is a significant improvement over the money supply driven inflation during some periods of commodity money and fixed exchange rate currency and unlimited private bank note issue. However, the volatile asset market has created new problems in the international monetary order.

The tendency of the government to keep the monetary power centralized has been often witnessed in history. The concept of central banking is a feature of modern history but had antecedents in the nexus between merchants and early governments (see Goldsmith (1987)). The medieval European Knights Templar ran probably the best well known early prototype of a central banking system, as their promises to pay were widely regarded, and many regard their activities as having led the basis for the modern banking system. As the first public bank to offer accounts not directly convertible to coins, the Bank of Amsterdam established in 1609 is considered to be a precursor to a Central Bank. In 1668, the Central Bank of Sweden or the “Riksbanken” was established in Stockholm and is the oldest Central Bank still operating today. In 1689 England entered the Nine Years War with France which led to a big crisis in government finance. It was thought that government needed to borrow an enormous amount of money by borrowing indirectly from the public and a powerful financial intermediary was needed. In 1693 the idea of a Bank of England received support among businessmen and financiers. In 1694 the Bank was borne through an act of parliament with Royal Assent. This is what can be called the birth of the modern financial system in England. Although Central Banks today are associated with fiat money, the 19th and early 20th century Central Banks in most of Europe and Japan developed under the International Gold Standard, elsewhere free banking or currency boards were most usual. Problems with collapses of banks during economic downturns was leading to support for establishing Central banks in countries which did not have them, most notably Australia and to some extent USA. Initially, the idea of a powerful monetary institution that could control the lives of the majority of the population created a hostile attitude among the public in USA and licences of two powerful banks had to be recovered. The US Federal Reserve was created by the US Congress by passing the Glass-Owen Bill, signed by the President Woodrow Wilson on December 23rd 1913. With the collapse of the Gold Standard after World War I, central banks became much more widespread. Australia established its first central bank in 1920, Colombia in 1923, Mexico and Chile in 1925, Canada and New Zealand in the aftermath of the Great Depression in 1934 and India in 1935 some years prior to independence. By 1935, the only significant independent nation which did not possess a central bank was Brazil, which developed a precursor thereto in 1945 and created its present central bank twenty years later. When African and Asian countries gained independence, all of them rapidly formed central banks or monetary unions. The People’s Bank of China evolved its role as a central bank starting in about 1979 with the introduction of market reforms in that country, and this accelerated in 1989 when the country took a generally capitalist approach to developing atleast its export economy. Thus People’s Bank of China has become in all senses a modern central bank has emerged partly as a response to the European Central Bank. This is the most modern bank model and was introduced with the Euro to coordinate with the European central banks which continue to manage their respective economies other than currency exchange and base interest rates. The art of central banking has evolved over time by playing both political and economic role but it is debatable whether the evolution has been on an optimal path (see Goodhart (1988), Bagchi (1997) and Mallick (2014)).

I conclude this section with a brief survey of empirical research on modern money.

I first discuss the empirical evidence on properties of money demand and supply functions and on velocity. Historians like Kindleberger (1993) and theorists like Keynes (1936) have argued that money supply accommodates the demand for money to a large extent and determines the rate of interest where money demand is generated by the needs of commerce and industry. Keynes (1913) demonstrated how money matters by analyzing the change in Indian currency from the silver standard to a gold standard. Bronfenbrenner and Mayer (1960) and Meltzer (1963) found that a (post-Keynesian) Tobin (1958) type demand for money equation with interest rate and non-human wealth as exogenous variables seems to fit the data well, while Laidler (1977) found that money demand as a function of permanent income (as suggested by Friedman (1959)) fits the data significantly better. Teigen (1974) finds evidence supporting Keynesian views on interest elasticity of money demand and money supply functions in the American economy. Goldfeld (1973) found that the money demand function for the American economy was of a Keynesian type with negative response to interest rates and positive response to real income and the short-run responsiveness of money demand to changes in interest rates and income is considerably less than the long-run responses. However, the Goldfeld estimated money demand equation does not fit the data well in the 1970s and 1980s and though money demand is seen to respond negatively to interest rates and positively to real income, it is found to be unstable. Since then, many studies have been conducted but have not altered the contention that the money demand function is unstable and significantly unpredictable (see Mallick (2014)). It should be also mentioned that with changes in acceptability of different monetary theories and with the political and economic demands of time, the money supply function also becomes unstable. Friedman and Meiselman (1963) report a secular downward trend of estimated velocity in USA between 1870 and 1954 which fits well the actual velocity and during this period. They find that velocity significantly decreases with changes in permanent income (proxied by average of (discounted) historical and present income data (where the data are trend data)). Later studies of quantity theory find that velocity has been rising over time, is a function of interest rates and is unstable and unpredictable and playing a big role in recent financial crises (see Mallick (2014)) and major inflationary episodes of the past (see Cagan (1956), Sargent (1982) and Fry (1988)). However some economists claim that velocity (adjusted for financial innovations and interest rate fluctuations) has been constant in US.

Next I discuss the relationship between money growth and changes in (nominal) income. In USA the growth of the money stock and the growth of nominal income has had a stable relationship and money stock has had a good predictive power for income (see Friedman and Schwartz (1963) but see also Sims (1996) who agrees that though money has a good predictive power, it is only “causally prior” and most of the effect on income comes from interest rates and that the money supply is endogenous in the sense that it reacts to feedbacks from interest rate changes and inflation. This leaves open the possibility that the time series could be demand driven). Friedman and Schwartz (1963) found that the changes in real income or output is independent of the money stock. Recent studies by Post-Keynesians find evidence that positive money growth increases growth rate of money income upto fairly high inflation rates as long as the resulting inflation does not increase inflation uncertainty. On the other hand, Barro (1995) finds that money growth has a low but a negative effect on per capita growth rate in the short run and money growth induced inflation has a significantly large negative effect on per capita income in the long run.

Phillips (1958) found an inverse relation between wage inflation and unemployment in the UK economy over the period 1861-1957 and also noted a pattern of very fast wage inflation tendencies during low unemployment. Subsequent research have confirmed the basic findings of Phillips for short run relationship between wage inflation and unemployment, but have found the long run Phillips curve to be vertical at the (controversial) natural rate of unemployment. Lucas (1973) explained (by using an empirical counterpart of the famous rational expectations hypothesis) that the Phillips curve relation was generated by inability of agents to distinguish between (permanent money shocks) general shocks and (temporary real) relative shocks which led agents to increase activity whenever the price level rises. Barro (1978) focuses on unanticipated money shocks which, according to his empirical analysis creates responses from employment and output and on prices with a distributed lag. Barro finds that 5 years after the unanticipated money shock, output and employment comes back to their previous values (so that the ultimate result of the unanticipated shock is such that only the price level is affected) so that the long run is quite short due to rational inference of agents. As far as recent data is concerned, Mishkin (2007) finds that (i) inflation persistence has declined (ii) the (short run) Phillips curve has flattened and (iii) inflation has become less responsive to other shocks.

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 A Reconsideration of the Twentieth Century Author(s): R. A. Mundell Source: The American Economic Review, Vol. 90, No. 3 (Jun., 2000), pp. 327-340 Published by: American Economic Association Stable