------------ EH.NET BOOK REVIEW --------------
Published by EH.NET (February 2005)
Marc Flandreau and Frederic Zumer, _The Making of Global Finance,
1880-1913_. Paris: OECD, 2004. 144 pp. $30 (paperback), ISBN:
92-64-01534-5.
Reviewed for EH.NET by Hugh Rockoff, Department of Economics, Rutgers
University.
The authors of this careful and vigorously argued monograph enter the
debate over the role of the gold standard in the international
economic system at the end of the nineteenth century. One issue is
whether or not a country's adherence to the gold standard mattered to
international financial markets. One school of thought holds that it
mattered a great deal, that financial markets approved of countries
that joined the gold standard. The literature that supports this view
includes Michael Bordo and Hugh Rockoff (1996), Nathan Sussman and
Yishay Yafeh (2000), and Maurice Obtsfeld and Alan M. Taylor (2003).
Flandreau and Zumer, however, are firmly on the other side. As far as
they can see, international capital markets were supremely
indifferent to whether or not a country adhered to gold.
(There is, I have to confess, a certain satisfaction in knowing that
I have at least helped stirred things up. A famous economic historian
once told me, however, that it wasn't enough to have papers and books
attacking you -- you hadn't really arrived in economic history until
an entire conference was held to refute your ideas!)
The methodology that Flandreau and Zumer use is straightforward and
in some ways is simply a further development of what has gone before.
They run a regression in which the dependent variable is the
difference between the yield for a particular country's bond and the
yield on U.K. bonds. The independent variables include a dummy
variable for adherence to the gold standard and other variables that
they classify as structural variables, reputational variables, and
political variables. The structural variables include debt burden
(defined as government interest payments relative to government
revenues), exports relative to population, bank reserves relative to
banknotes, exports relative to population, government deficits
relative to government revenue, and exchange rate volatility. The
reputational variables include whether or not a country has defaulted
on its bonds and a memory variable to allow for the slow recovery of
its reputation. The political variables include the enfranchised
share of the population and political crises.
The great strength of the monograph is the care that Flandreau and
Zumer have put into measuring their variables and running alternative
specifications of the regression to test the robustness of their
results. The sample consists of annual data for seventeen countries
from 1880 to 1913. The countries were chosen mainly, it seems,
because Flandreau and Zumer found data for them in the archives of
the Credit Lyonnais that they could use to double check their
variables and to be sure that they were looking at things in the way
that a major participant in the market looked at things. For this
reason some countries that you might want to include, such as the
United States, Canada, and Australia, are omitted. Nevertheless,
there is something to be said for having authors work with data they
are sure about. Their data is reported in appendices, and available
at http://www.eh.net/databases/finance/.
The main finding is that the coefficient on the gold standard dummy
turns out to be small and insignificant in most of the regressions
and the coefficient on the debt burden variable turns out to be large
and significant. Flandreau and Zumer conclude that adherence to the
gold standard did not matter, but that the debt burden did. The
dragon has been slayed. One can't help but be impressed with the
effort and care that has gone into the monograph. Still, I have some
reservations about the test that I have grouped under five headings.
Some of these reservations might be regarded more as ideas for future
research than as direct criticisms of what Flandreau and Zumer have
done.
1. Left-hand and right-hand variables
The variable that Flandreau and Zumer tout as the scourge of the gold
standard dummy is the debt burden: interest payments divided by
revenue. This is the real determinant of interest rates, they claim,
because this is what the Credit Lyonnais looked at, and because it
just makes sense as an indicator of the likelihood of bankruptcy.
Just as a bank lending to a homebuyer would want to know the debt
burden of the potential buyer relative to his or her ability to pay,
bankers at the turn of the century wanted to look at the debt burden
of the governments to which they lent relative to the ability of the
governments to pay. One problem with using this variable in a linear
regression, however, is that the variable on the left hand side, the
yield for a particular country less the U.K. yield, is closely
related by construction to the variable on the right hand side,
interest payments divided by revenues. Consider the following
example. You have two countries identical in every way except A
borrows at a high rate of interest and B at a low rate of interest.
If they both borrow the same amount, interest payments will be higher
for A than for B -- interest rate and debt burden will be positively
correlated. Or consider what happens if the rate on a government's
bond falls, and the government refinances some of its debt at the
lower rate. Again, the dependent variable and independent variable
move together by construction.
2. Upstream and downstream variables
A second, perhaps more important, problem is that the regression
strategy combines what I like to call upstream and downstream
variables. An extreme example will make the distinction I have in
mind clearer. Suppose someone claims that prohibiting construction
near a lake increases the amount of fish caught in a lake. A
regression of fish caught per acre of water on a dummy variable for
whether or not construction was permitted near a lake might show that
prohibiting construction increases the catch. Add the stock of fish
per acre in each lake to the regression and the significance of the
prohibition of construction might disappear. The number of fish in
the lake determines how many will be caught. One could then jump to
the conclusion that prohibiting construction near lakes has no
effect. Presumably, with enough data one could tease out the effects
of limiting construction and other variables that might affect the
amount of fish in the lake. In practice, however, this might be
difficult if there are a small number of lakes in the sample.
The same problem, arises, I believe, in the current context. One
example is the inclusion of both exchange rate volatility and the
gold standard dummy in the same equation. Exchange rate stability
(which turns out to have a large and significant coefficient in many
of the regressions) is downstream from the gold standard. We might
substitute it for the gold standard dummy, but to include both
exchange rate volatility and the gold standard dummy obscures the
effect of the choice of exchange rate regime.
The debt burden variable is also, to some extent, a downstream
variable. The point of attaching one's currency to gold was not to
fool investors, while going about one's old spendthrift ways. The
point was to achieve long-run discipline. A country could not run
continual deficits and inflate them away and remain permanently on
the gold standard. Defending the currency was the principle that
allowed central banks and governments to follow more conservative
policies than they otherwise would. Ultimately, of course, the goal
was to have modest deficits and a debt well within the capacity of
the country to service. Putting all of these variables into the right
hand side of the regression tends to obscure the effect of adhering
to gold on the achievement of these long-term goals.
3. The gold standard dummies
While the authors have put a great deal of energy into perfecting the
other variables in the equation, they have put no energy into
improving the gold standard variables. Indeed, it seems at points as
if they can hardly be bothered to look at such nonsense. It is clear
to me, however, that the current gold-standard variables are rather
primitive because they fail to reflect the credibility of the
commitment to the gold standard. True, credibility is not easily
measured, but it is none-the-less crucial. The United States is a
good example. Flandreau and Zumer, as I noted, exclude the United
States. But it is the case I know best, and it makes the point. The
dollar was convertible into gold, except during financial crises,
from the time that convertibility was established after the Civil War
until the Great Depression. One could represent this by simply
assigning a dummy variable of one (on the gold standard) in every
year in the period that Flandreau and Zumer examine. Yet the
credibility of the U.S. commitment to the gold standard varied. When
the Free Silver movement was at its height in the 1890s the fear that
the United States would leave the gold standard was real. Milton
Friedman and Anna Schwartz, looking at short-term interest rates,
conclude that the resolution of the fear that the United States would
leave gold explains a sharp drop in the level of the short-term
U.S.-U.K. differential between 1874 and 1896. According to Friedman
and Schwartz (1982, 515) peaks in the differential in 1893 and 1896
are consistent with this interpretation.
"The peak in 1893 is connected to the banking panic in that year. The
initial banking difficulties reinforced fears, endemic before 1896
because of silver politics, that the United States would go off gold
and the dollar would depreciate. ... The peak in 1896 is connected
with the capital flight of that year accelerated by Bryan's
nomination, which greatly strengthened fears that the United States
would leave gold. In both cases, fear of devaluation meant that
owners of United Kingdom capital were reluctant to participate in the
United States short-term market except at a substantial premium. The
election of McKinley changed the situation drastically. It made
United States' retention of the gold standard secure for the time
being, and the subsequent flood of gold from South Africa, Alaska,
and Colorado removed all doubts."
Charles Calomiris (1992), similarly, thought that the threat of free
silver affected the capital market, although he argued that the
markets simply feared a temporary suspension of convertibility and
post-suspension devaluation, rather than a permanent abandonment of
gold. The point, however, is that even in the case of the United
States which in the end remained solidly committed to gold,
credibility varied, and that a dummy variable that simply looks at
whether convertibility was maintained during a particular year is
insufficient to capture the credibility of the commitment.
4. The changing credibility of the gold standard The credibility of
the gold standard itself changed over the period 1880 to 1913. The
correlation between the gold standard dummies and the defaults shows
why. In 1880, the first year in the sample, 10 of the 17 countries in
the sample were adhering to the gold standard. Up to 1913 only one,
Portugal, would default. One country, Spain, was off gold and in
default in 1880. The remaining six countries in the sample were off
gold in 1880, but paying their debts. Three of the six would later
default. Being on or off gold in 1880, in other words, turned out to
be a good predictor of which countries would pay their debts. I
suppose that participants in international financial markets might
have ignored this information on the grounds that it was irrelevant.
The ratio of interest payments to government revenues was equally
good as a predictor of default. Nevertheless, adhering to gold was a
device for achieving long-term stability. Perhaps recognition of the
connection between being off gold and defaulting is why countries
made an effort to stay on or get on gold. Of the 10 countries on the
gold standard in 1880 only one was off in 1913. Of the seven
countries off the gold standard in 1880, six were on by 1913
including all those that defaulted. In short, of the 17 countries in
the sample, 15 had made the decision by 1913 to adhere to the gold
standard. Given this scenario, it is possible that the credibility of
the gold standard itself, as a means of achieving and as a symbol of
financial rectitude was increasing over the period 1880 to 1913. The
regression strategy as far as I can see simply assumes that being on
gold in 1880 meant the same thing to participants as being on gold in
1913.
5. Policy variables and non-policy variables One reason why (some)
economists and economic historians focus on adherence to the gold
standard is because this was a policy variable, a choice actually
being made by many countries at the turn of the century. Again, this
was clearly true in the United States. Free silver (bimetallism at a
ratio of 16 units of silver to one of gold) was a genuine alternative
to the gold standard. It was promoted by one of the two major
political parties, and might have been adopted by the United States.
Fiscal policies, perhaps to a lesser degree, fall in the same
category. It is important to see what might have been driving these
debates, and what effects the choices made had on the U.S. economy.
There are other potential fundamentals that might have been more
important than adherence to the gold standard in shaping the flow of
capital, but were not policy variables. It may have been extremely
important to British lenders that the population of a country be
predominantly white, Anglo-Saxon, and Protestant. Being a colony of
Britain may have been important as well. And having a high level of
education may have impressed potential investors. Of course, if these
factors were important they must be given their due in order to see
what impact policy choices actually had. But the focus on policy
variables, even when their potential contribution is marginal, is
important if history is to provide lessons for today.
To be sure, what is or is not a policy variable is to some extent a
matter of costs and benefits. Educational levels, colonial status,
even religion can be, and in some cases have been deliberately
changed. And it is always possible to look at a more fundamental
analysis in which what look to be policy choices are really
predetermined outcomes. There are variables, in other words, that
explain why a country "chose" to adhere or not adhere to gold. When
the election of 1896 began it seemed as if Bryan might win, and so
Americans debated his policies at length. It seems as if Americans
could make a choice. Yet it may also be true that there exists some
model of the political process that takes into account various
political fundamentals (the ethnic mix of the population, the rate of
growth of the economy, and so on) that would show us why Bryan was
destined to lose. Hillel is right: "all is foreseen, and freewill is
given."
The lack of clear distinctions between policy and non-policy
variables affects the usefulness of the concluding section of the
book. Flandreau and Zumer feel that the choice of exchange rate
regime didn't matter. This is useful advice -- don't waste your time
worrying about gold or bimetallism. Perhaps today the advice would be
don't worry about fixed or flexible exchange rates. The debate over
free silver in the United States and many other countries was,
evidently, a lot of sound and fury signifying nothing. But what
should people have worried about? Here Flandreau and Zumer make a
number of assertions, but few of them qualify as practical advice.
They note that "The adoption of 'good' [their quotation marks]
domestic policies expedited the globalization of capital much more
decisively than did the removal of legal barriers to financial
exchange." They also note that "debt burden was the one key factor
that determined market access." And they note that "Political crises
such as wars or domestic unrest were detrimental to a country's
credit." And that "=8Athe reduction of public debts was achieved not
through fiscal balance but _via_ [their emphasis] economic growth,"
which leads them to conclude that this "shows the importance of
development policies in fostering international financial integration
..." But what are we to make of all this? Surely every politician and
government official knew that debt burdens and political crises were
bad and that economic growth was good. The question was not where
they wanted to go, but what policies would help them get there.
If I were starting to work on the "Good Housekeeping" paper again I
would certainly write it differently. I would certainly want to take
into account the important work by Flandreau and Zumer based on the
archives of the Credit Lyonnais to better describe the channels
through which adherence to gold mattered. But I am not persuaded that
the gold standard was a matter of no concern, and that all of the
debate over it at the end of the nineteenth century was a waste of
time. I am persuaded, however, that Flandreau and Zumer are fine
scholars, and have written an important book that future research in
this area will need to take into account.
References:
Michael Bordo and Hugh Rockoff, "The Gold Standard as a Good
Housekeeping Seal of Approval." _Journal of Economic History_ 56
(June 1996): 389-428.
Charles Calomiris, "Greenback Resumption and Silver Risk: The
Economics and Politics of Monetary Regime Change in the United
States, 1862-1900." NBER Working Paper, w4166, September 1992.
Milton Friedman and Anna J. Schwartz, _Monetary Trends in the United
States and the United Kingdom: Their Relation to Income, Prices, and
Interest Rates, 1867-1975_. Chicago: University of Chicago Press,
1982.
Maurice Obstfeld and Alan M. Taylor, "Sovereign Risk, Credibility and
the Gold Standard: 1870-1913 versus 1925-31." _Economic Journal_
(April 2003): 241-75.
Nathan Sussman and Yishay Yafeh. "Institutions, Reforms, and Country
Risk: Lessons from Japanese Government Debt in the Meiji Era."
_Journal of Economic History_ 60 (June 2000): 442-67.
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