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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