------ EH.NET BOOK REVIEW ------
Title: Monetary Theory and Policy from Hume and Smith to Wicksell: Money,
Credit, and the Economy

Published by EH.NET (October 2011)

Arie Arnon, /Monetary Theory and Policy from Hume and Smith to Wicksell:
Money, Credit, and the Economy/. New York: Cambridge University Press,
2010.  xxii + 424 pp. $99 (hardcover), ISBN: 978-0-521-19113-5.

Reviewed for EH.Net by Thomas M. Humphrey, Federal Reserve Bank of Richmond
(retired).

The history of monetary theory from David Hume (1752) to Knut Wicksell (1898)
is a history of the dawning realization that money cannot be left to itself,
but must be managed to avert financial panics, crises, inflation, deflation,
and depression. At the beginning of the era, economists saw monetary
management as requiring nothing more than (1) a metallic monetary standard,
(2) free convertibility of paper money into bullion, and (3) competitive
banking. Both Hume -- with his quantity theoretic price-specie-flow mechanism
-- and Adam Smith -- with his real bills doctrine depicting competitive
bankers lending against the security of commercial paper representing real
goods in the process of production, together with his rudimentary monetary
approach to the balance of payments -- contended that as long as paper notes
were freely convertible into gold bullion at a fixed price upon demand, the
money stock, commodity prices, balance of payments, real output, and
employment would take care of themselves and tend toward their natural
equilibrium levels.

This conclusion was challenged by the suspension of the gold convertibility
of the British pound during the Napoleonic Wars. Lacking a convertibility
constraint to limit the banknote issue, the British money stock, general
prices, price of bullion, and exchange rate (paper pound price of a unit of
foreign currency) were free to rise and did so, thus provoking the question
of whether an inconvertible currency could be governed to forestall these
phenomena.

The Antibullionist defenders of the Bank of England’s willingness to
tolerate expansions of the stock of paper money contended that the question
was otiose because even an inconvertible currency required no regulation when
issued against the security of real commercial paper representing real
output, and anyway Britain’s inflated prices and depreciated exchange rate
stemmed from real cost push shocks to the balance of payments rather than
from monetary overissue. But David Ricardo, John Wheatley, Walter Boyd and
other strict Bullionists excoriated this reasoning and maintained that an
inconvertible currency, while theoretically capable of effective management
by reference to, and targeting of, such indicators as the price of bullion,
exchange rate, and gold flows through the balance of payments, could never in
practice be trusted to the discretion of Bank officials whose profit
incentives were aligned with overissue. For that reason, Bullionists
advocated resumption of gold convertibility as soon as possible.  Only Henry
Thornton and Thomas Attwood, both of whom feared the crises, panics, and
depressions of real output and employment that gold drains and their
attendant deflationary monetary contractions might bring under
convertibility, saw the potential advantages of an inconvertible currency.

In any case, the 1821 restoration of gold convertibility was followed by a
succession of crises and recessions suggesting that convertibility per se was
an inadequate safeguard to over- and underissue and needed supplementation
with additional measures. The Currency School prescribed these measures in
the form of Bank of England monopolization of and mandatory 100 percent gold
reserve backing for the banknote issue.

The rival Banking School strenuously objected to these provisions even as
they were being enacted into Peel’s Bank Act of 1844. The Banking School
denied the necessity for statutory control of convertible notes on the
grounds that the needs of trade and the law of reflux (according to which
borrowers would return excess notes to the banks to pay off costly loans)
automatically limited the note issue to the public’s demand for it, such
that no excess could spill over into the commodity markets to cause
inflation. The School also pointed to the impossibility of controlling the
total circulation by means of mandatory gold cover of its note issue
component alone since the public could readily resort to money substitutes --
checking deposits and bills of exchange (both exempt from gold reserve
requirements under Peel’s Act) -- instead.  Most of all, the Banking
School noted that the limitation imposed by rigid gold reserve requirements
could hamper the Bank’s efforts to stem liquidity crises and bank runs
through emergency expansions of paper money.

This recognition set the stage for Walter Bagehot’s classic 1873
description of central bank lender-of-last-resort policy: Satiate
panic-induced demands for money by credibly committing to lend Bank of
England notes without stint at a high interest rate to illiquid but solvent
borrowers even if such temporary emergency lending means violating required
gold reserve ratios.

Finally, the era’s high water mark of money management plans came with Knut
Wicksell’s natural rate-market rate proposal for adjusting the rate of
interest on loans of inconvertible, central-bank-controlled,
purely-checking-deposit money in response to deviations of actual from target
level of prices in order to stabilize that target index of general prices.

Arie Arnon, an associate professor of economics at Israel’s Ben-Gurion
University, traces the foregoing history in his splendidly written book,
which, as one of the more complete and systematic accounts of the development
of classical and early neoclassical monetary thought, seems destined to take
its place alongside such classics as Jacob Viner’s /Studies in the Theory
of International Trade/, F. W. Fetter’s /Development of British Monetary
Orthodoxy, 1797-1875/, David Laidler’s /The Golden Age of the Quantity
Theory/, and D.P. O’Brien’s recent /The Development of Monetary
Economics/. True, Arnon covers much the same ground as those authors. But his
net value added consists of the reams of fresh detail he brings. Showing that
there is nothing new under the sun, Arnon demonstrates that the same issues
that divided twentieth century monetarists and non-monetarists as well as
current macroeconomists -- namely issues such as rules v. discretion,
inflation as a monetary v. real cost push phenomenon , direct v. inverse
money-to-price causality, central bank-determined v. market demand-determined
money stocks, exogenous v. endogenous money, backing v. supply-and-demand
theories of money’s value -- were absolutely central to the nineteenth
century Bullionist-Antibullionist and Currency School-Banking School
controversies.

Unlike Viner, Laidler, and O’Brien, however, Arnon favors non-quantity
theoretic over quantity theoretic approaches to the analysis of monetary
policy. He also holds that the credit, or asset side of bank balance sheets,
is more fundamental than the money, or liability side. Quoting J. R.
Hicks’s assertion that historically and analytically money emerged from and
is based on credit rather than vice versa, Arnon, citing Joseph
Schumpeter’s famous distinction, prefers, he says, “credit theories of
money to monetary theories of credit.”

Fortunately, Arnon’s perspective doesn’t affect the story he tells -- he
gives ample, impartial, and balanced recognition to the quantity theory. But
it does influence his choice of economists to highlight. For example, he
devotes an entire chapter to Karl Marx, whose anti-quantity theoretic,
credit-oriented approach to monetary theory and policy is, to this reviewer
at least, entirely unoriginal, unhelpful, and derivative of Banking School
ideas. Better to devote the chapter to unjustly overlooked and neglected
early quantity theorists such as Pehr Nicklas Cristiernin, John Wheatley, and
William Blake, all of whom, unlike Marx, contributed original and innovative
ideas to the classical theory of monetary policy.

The chapter on Marx notwithstanding, Arnon is at his best when discussing the
ideas of individual economists. In this connection, he lavishes careful and
detailed attention not only to luminaries Hume, Smith, Ricardo, Marshall, and
Bagehot, but also to key second-tier figures including Walter Boyd, Sir
Francis Baring, Charles Bousanquet, Thomas Joplin, John Fullarton, and Henry
Parnell, all typically glossed over in most histories.  Especially arresting
is his treatment of Thomas Tooke and Robert Torrens, both of whom underwent
180 degree reversals in their policy positions during their careers, Tooke
transmuting from quantity theoretical Bullionist to anti-quantity theoretical
leader of the Banking School, Torrens from Antibullionist to quantity
theoretical member of the Currency School.

But Arnon’s real superstars are Henry Thornton and Knut Wicksell, He exalts
them because they and they alone recognized the central bank’s
responsibility to function not merely as a lender of last resort that
forestalls liquidity crises and protects the payments mechanism (as Walter
Bagehot had stressed), but also as stabilizer of the macroeconomic aggregates
of money, prices, output, and employment. Arnon also pays tribute to
Thornton’s definitive critique of the real bills doctrine and to his
seminal analysis of the regional balance of payments mechanism that keeps
local non-London banknote issues rigidly in line with the Bank of England’s
issues. Surprisingly, however, he misses the opportunity to note Thornton’s
other prescient innovations to monetary theory. The distinctions between real
v. nominal interest rates, natural v. nominal rates, internal v. external
gold drains; the application of the concept of comparative cost advantage to
explain external drains; the notions of lags in the effect of monetary
change, and of agents’ confusion of relative v. absolute price changes; the
comprehensive recognition of all the forces (real, monetary, and purchasing
power parity) determining exchange rates; the distinction between temporary
and permanent shocks; the essentials of liquidity preference theory; the
notion of forced saving: Thornton enunciated them all.

There are at least five potentially controversial issues in Arnon’s book.
Most contentious perhaps is his carefully considered rejection of the notion
that a bona fide, fully developed Free Banking School existed in England to
rival the Currency and Banking Schools. Second is his contention that Henry
Thornton was an Antibullionist, contrary to the judgment of a majority of
monetary historians who classify him as a moderate Bullionist. Third,
contradicting J. R. Hicks’ opinion that there were two Thorntons, namely
the 1798 anti-deflation, pro-inconvertibility dove, and the 1810
anti-inflation, pro-convertibility hawk, Arnon holds that there was but one
Thornton who adhered to a single consistent theory throughout.

Here Arnon is absolutely correct. Unfortunately, however, he gives no
explanation for his verdict although one is readily available. Thornton’s
consistent view stems from his distinction between real v. monetary shocks to
the balance of payments.  These shocks produce current account deficits
financed by gold exports accompanied by money-stock contraction as specie
exporters cash in banknotes to obtain gold from their banks. To Thornton,
however, real shocks of the kind that provoked the 1797 restriction of cash
payments should require no such deflationary contraction. They were
short-lived and self-correcting. There was no need to put the economy through
the wringer of output-and-employment-destroying deflationary monetary
contraction to correct something that would correct itself. Better to
maintain the stock of money in the face of these temporary gold outflows
either through compensatory expansion of the Banknote issue under
convertibility or by suspending convertibility and moving onto an
inconvertible paper regime. By contrast, monetary shocks of the kind
occurring later in the Napoleonic wars invariably took the form of
inflationary expansion of the inconvertible banknote issue. As these shocks,
unlike real ones, were not temporary and self-reversing, they required
correction through contractionary policy and restoration of convertibility.
In short, Thornton’s successive dove-to-hawk policy stances were part and
parcel of his real v. monetary shock distinction.

Fourth, Arnon alleges that Thornton adhered to credit theories of money
rather than vice versa, implying that he (Thornton) put bank credit (loans
and discounts) above the stock of bank money (notes and deposits) as the
crucial aggregate influencing economic activity. But this implication is
contradicted by Thornton’s own statement that in periods of sharp and
sudden credit and monetary contraction, it is not the credit crunches but
rather the money stock collapses that produce declines in real activity. To
Thornton, money dominates credit as a source of economic disturbance.

Fifth, Arnon argues that the quantity theory ceases to hold in Wicksell’s
hypothetical pure credit economy where no reserve requirements exist to limit
credit creation and so preserve nominal determinacy. But once one realizes
that the “credit” to which Wicksell refers consists of checking deposit
money directly controllable by the central bank -- the only bank and indeed
the entire banking system in Wicksell’s pure credit model -- without the
need for reserve requirements, it becomes evident that the quantity theory
link between money and prices holds. Indeed, it is through changes in the
stock of deposit money that Wicksell’s central bank brings the market rate
of interest into equality with the natural rate to achieve price level
stability.

These issues hardly mar an exceptional and accessible book. This reviewer
recommends it for historians of economic thought who tend to overlook the
monetary side of their discipline, for current macro and monetary economists
often unaware of the eighteenth and nineteenth century origins of the ideas
they employ, for commercial bankers desiring to know more about the evolution
of their profession, and for central bankers seeking historical perspective
to enlighten their task of fighting crises, panics, recessions, and
inflations.

Thomas M. Humphrey is a retired senior economist and research advisor at the
Federal Reserve Bank of Richmond. He is the author of /Essays on Inflation/
(fifth edition 1986, Federal Reserve Bank of Richmond), /Money, Banking and
Inflation: Essays in the History of Monetary Thought/ (1993, Elgar), /Money,
Exchange and Production: Further Essays in the History of Economic Thought/
(1998, Elgar), and co-author (with Robert E. Keleher) of /The Monetary
Approach to the Balance of Payments, Exchange Rates, and World Inflation/
(1982, Praeger).

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Geographic Location: Europe
Subject: Financial Markets, Financial Institutions, and Monetary History,
History of Economic Thought; Methodology
Time: 18th Century, 19th Century