and

Insights From Doctrinal History

MERCANTILISTSCLASSICALS:

Thomas M. Humphrey

Thomas M. Humphrey is a vice

president and economist in the

Research Department. He has

served as long-time editor of the

Bank’s Economic Quarterly.

The views expressed do not

necessarily reflect those of the

Federal Reserve System.

2

The above sentiments express what everydoctrinal historian knows, namely that much ofwhat passes for novelty and originality in mon-etary theory and policy is really ancient teach-ing dressed up in modern guises.To be sure, theincreasing application of mathematical modelinghas given these concepts greater rigor and pre-cision. Likewise, better data and more powerfulempirical techniques have improved our statis-tical estimates of the relevant quantitative mag-nitudes. Still, the basic ideas themselves oftenremain much the same.Thus instead of a steadyprogression of new paradigms, one sees repeat-ed cycles of existing ones whose periodic riseand fall perpetually casts them in and out offashion.

By itself, this recycling of established ideasneed be no cause for alarm.Theories may survivebecause experience indicates that they possessa high degree of validity and because no bettertheories have been found. The trouble is, how-ever, that sound theories are not the only onesto survive. Unsound theories may coexist withthe sound ones.

Unfortunately, policymakers and the gener-al public are in no position to realize as much.Preoccupied by the pressing problems of theday, they have neither the time, inclination, ortraining, nor indeed the duty to trace the histo-ry of the ideas they employ or endorse. Theyhave no reason to be aware of earlier policydebates in which sound theories were distin-guished from fallacious ones. The result istwofold. Policymakers may subscribe to oldtheories under the mistaken impression thatthose theories are new.Worse, they may unwit-tingly deploy policies whose underlying theoryhas been challenged and found wanting in earli-er policy debates.

Here is where the doctrinal historian canhelp. His comparative advantage lies in identify-ing the origin and tracing the evolution of rivalmonetary doctrines across a succession of writ-ers, events, episodes, and policy controversies.

Economists typically view their discipline as aprogressive science in which superior new ideasrelentlessly supplant inferior old ones in a Dar-winian struggle toward the truth. Thus it cameas something of a shock when Milton Friedmanchallenged this belief in the May 1975 issue ofthe American Economic Review. In response tothe question “What have we learned in the past25 years?”, Friedman argued that what mon-etary economists have learned since 1950 arehardly new ideas but rather a rediscovery of oldideas inherited from David Hume and his con-temporaries more than 200 years ago.

Three years later, the British economistIvor F. Pearce shocked his readers even more.He denied that the Keynesian Revolution hadcontributed a single new or useful idea to mon-etary economics. Instead, he (1978, p. 93) insist-ed that “human history is guided not by newideas, for there are none,” but rather by “someephemeral sub-group of . . .old ideas.” Such oldideas, “often believed to be new,” are “seizedupon as the . . . solution to whatever difficultiesimmediate experience has made to seemimportant, and congealed into a crust of dogmaby endless repetition and obeisance.”

. . . much of the history

of monetary theory

reduces to a struggle

between opposing

mercantilist and

classical camps.

1

Introduction

3

Each such incident constitutes a test, or obser-vation, of the relative strengths and weaknessesof the competing doctrines.While no single testcan yield conclusive results, many such testsmay do so. Taken together, they reveal whichdoctrine has emerged from past experience asthe more robust analytically. By demonstratingas much, the historian specifies those ideas thatseem to offer the most effective basis for pub-lic policy. Of course, there is no assurance thatthe policymaker will heed the doctrinal histori-an and employ the best ideas. On the contrary,he may reject them or temporarily accept andsubsequently abandon them. Here again the his-torian has something to say. His study of theforces influencing the receptivity and imple-mentation of ideas permits him to predict adoctrine’s prospective success or failure. In thismanner, the unique perspectives of doctrinalhistory may prove their worth.

This article puts those perspectives towork. It shows that from a broad standpoint,much of the history of monetary theoryreduces to a struggle between opposing mer-cantilist and classical camps. Mercantilists, withtheir fears of hoarding and scarcity of moneytogether with their prescription of cheap (lowinterest rate) and plentiful cash as a stimulus toreal activity, tend to gain the upper hand whenunemployment is the dominant problem. Classi-cals, chanting their mantra that inflation isalways and everywhere a monetary phenome-non, tend to prevail when price stability is thechief policy concern.

Currently, the classical view is in the dri-ver’s seat. By all rights it should remain theresince it long ago exposed the mercantilist viewas fundamentally flawed. It is by no means cer-tain, however, that the classical view’s reign issecure. For history reveals that, whenever oneview holds center stage, the other, fallacious ornot, is waiting in the wings to take over whenthe time is ripe. In this manner, the mercantilismof John Law and Sir James Steuart gave way tothe classicism of David Hume and David Ricardo,the Currency School’s classicism bowed to John

4

Maynard Keynes’s mercantilism, the mercantilistdoctrines of Keynes’s disciples yielded to MiltonFriedman’s classical monetarism, and so forth.Even today, with central bankers in severalnations expressing commitment to the classicalgoal of price stability and monetarists advocat-ing systematic, zero-inflation rules for monetarypolicy, mercantilist undercurrents still runstrong. Supply-siders who argue that monetarypolicy must be accommodative to allow tax cutsto work their magic echo mercantilist opinion.So too do those who contend that, with globalcompetition and rapid technological progressholding inflation in check, monetary policy isfree to pursue nonprice objectives such asboosting growth and achieving full employment.Finally, observers who believe that monetarypolicy is powerless to stimulate the currentlydepressed Japanese economy harbor mercan-tilist fears of unspent hoards of idle cash.

The following paragraphs attempt to spellout the core propositions of the original mer-cantilist and classical views and to establish thecentrality of those propositions in the famousCurrency School-Banking School and Keynesian-monetarist controversies – the two leadingmonetary policy debates of the nineteenth andtwentieth centuries.1 From this doctrinal histor-ical exercise, three themes emerge. First, withsome exceptions, classicals tend to be quantitytheorists; mercantilists, anti-quantity theorists.Second, classicals prefer rules; mercantilists, dis-cretion. Third, for all their cogency, classicalsmay be doomed to face a perpetual mercantilistchallenge. As long as some observers continueto believe, rightly or wrongly, that inflation anddeflation are nonmonetary, or real, phenomenaand that unemployment is a monetary onecapable of correction by the central bank, thedebate will be unending.

The roots of the debate trace back to the orig-inal mercantilist writers of the preclassical era1550-1770. Those writers argued that a nation’sstock of precious metals constituted the sourceof its plenty (wealth), power, prestige, and pros-perity. For countries possessing no gold mines,augmentation of those conditions required theaccumulation of specie through foreign trade.Accordingly, mercantilists advocated protec-tionist policies in the form of export promotionand import restriction schemes to obtain a per-manent trade balance surplus matched by cor-responding persistent inflows of specie fromabroad.

This policy prescription was of course themercantilists’ main claim to fame. But the hall-mark that secures them a permanent niche inthe history of monetary doctrines was theircontra- or anti-quantity theory of money. 2 Theyused that theory to deny that money determinesprices and to tout the employment benefits ofmoney-stock expansion fueled either by specieinflows or by paper money creation shouldthose inflows languish. Consisting of at leastseven propositions, the mercantilists’ contra-quantity theory held that (1) money stimulatestrade, (2) real cost-push forces determine theprice level and the inflation rate, (3) the interestrate is a purely monetary variable whose level,high or low, is proof of the scarcity or abun-dance of money, (4) idle hoards absorb any cashnot employed in driving trade, (5) causality runs

5

from prices and real activity to money such thatthe money stock passively adapts to the needsof trade, (6) overissue is impossible when themoney stock is backed by the nominal value ofreal property, and (7) discretion outperformsrules in the conduct of monetary policy.

John Law (1671-1729)

The clearest and most emphatic statements ofthe foregoing propositions came from John Lawand Sir James Steuart, two economists writingnear the close of the mercantilist era.3 Of thetwo, Law’s name is synonymous with the money-stimulates-trade doctrine that forms the centralcore and theme of his 1705 Money and TradeConsidered; with a Proposal for Supplying theNation with Money. Writing against the backdropof a chronically depressed and underemployedScottish economy (his home country),he arguedthat a shortage of metallic money was to blame,that a bank-issued paper currency must replacethe deficient metallic one, and that the resultingexpansion of the stock of paper notes wouldpermanently increase the level of output andemployment without increasing prices.4 Hisargument stemmed from his assumptions of(1) the availability of idle resources at unchangedprices and (2) constant returns to scale in pro-duction. Given these conditions, it followed thatthe economy’s long-run aggregate supply curvewas perfectly horizontal up to the point of full

Classicals sought to anchor money

with a fixed physical quantity

– mercantilists with the nominal

dollar value – of some real object.

The mercantilist plan leaves

money anchorless. Essentially,

it anchors each dollar with another

dollar – no anchor at all.

2

Mercantilist and Classical Monetary Doctrines

employment. It likewise followed that money-induced increases in aggregate commoditydemand would, via rightward shifts along thesupply curve, generate matching increases inequilibrium real output without raising prices.Indeed, Law suggested that the price level mighteven fall if scale economies in production ren-dered the aggregate supply curve negativelysloped.5 In no case, however, would expansionof the stock of paper money raise prices.

Having argued that causation runs frommoney to output, Law perceived that it could bemade to run in the opposite direction too.Withappropriate financial linkages put in place,outputcould induce the very monetary means of itsown expansion. Indeed, Law thought this out-come was assured provided that banks issuedmoney on productive loans secured by claimsto future product or its equivalent. Coaxedforth by real output in this fashion, the papermoney stock would grow in step with the realdemand for it such that its purchasing powerwould be preserved unchanged. To ensure thatthe nominal money stock automatically expand-ed equally with the real demand for it, he advo-cated that paper notes be backed dollar-for-dollar with the nominal value of land. Collater-alized by land, money would, he thought, enjoystability of value. When economic developmentor cyclical recovery brought more land into cul-tivation, the money stock, secured by the extraland, could expand to meet the growing needsof trade at unchanged prices. Here was the pro-totype of the real bills doctrine later attacked

6

so vigorously by classical writers.As for the doctrine that low interest rates

spell monetary ease and high rates monetarytightness, Law accepted it without reservation.Anticipating Keynes’s liquidity preference theo-ry of interest, Law saw interest rates as the priceof money’s use, a price that varied inverselywith the quantity available to use. Being purelymonetary phenomena, low rates unambiguouslysignified an abundance of money and high ratesa scarcity of it. Law, an ardent advocate of lowrates, argued that they reduced the business-man’s cost of capital and so spurred investmentand real activity. For him, money exerted itsstimulus through indirect interest rate channelsas well as through direct expenditure ones.

Sir James Steuart (1721-1780)

To Law’s doctrines, Steuart in his 1767 AnEnquiry into the Principles of Political Oeconomyadded four more. First was his explicit rejectionof a monetary for a real cost-push theory ofinflation. Tracing a causal chain from the degreeof competition in labor markets to wage ratesto unit labor cost to product prices, he con-cluded that cost and competition determine theprices of all goods and thus the price level as awhole. Likewise, he held that the monopolypower of producers determines their profitmargins as embodied in the profit mark-upcomponent of individual and aggregate prices. Inother words, he alleged that the same realforces – market power and cost – that govern

1700 1710 1712

In England, ThomasNewcomen invents aworkable steam pumpfor use in mines.

Agricultural Revolution begins in GreatBritain. Farmworker productivity, scarcelyhigher in 1700 than 20 centuries earlier,doubles in the next 100 years.

1705

Mercantilist views are prevalent

Mercantilists

Classicals

150

100

90

80

John Law’s Money and Trade Considereddeclares that money stimulates economicactivity.

Law introduces the prototype of the realbills doctrine when advocating thatpaper notes be backed dollar-for-dollarwith the nominal value of land.

U . K . P R I C E L E V E L

Unavailability of an inflation rate series for1700-1880 necessitated use of a price-levelseries instead (see left scale). After 1880,

an inflation rate series was used.

Source: Deane and Cole, British Economic Growth 1688-1959, Appendix.

“Domestic trade depends on the

money. A greater quantity employs

more people than a lesser quantity.

A limited sum can only set a

number of people to work propor-

tion’d to it, and ’tis with little

success laws are made for employ-

ing the poor or idle in countries

where money is scarce.”

John Law in Money and Trade Considered

Law

1709

AbrahamDarby in-vents cokesmelting ofiron ore.

relative prices account for absolute prices aswell. He advanced a relative price theory of theabsolute price level.6

Steuart’s second contribution was his doc-trine of the hoards which he used to bolster hisdenial that money determines prices. He arguedthat idle hoards of specie absorb excess cashfrom circulation just as they release into circu-lation additional coin to correct a monetaryshortage. Consequently, there can be no mon-etary excess or deficiency to spill over into thecommodity market to affect prices. The hoard-ing-dishoarding mechanism ensures as much.7

For those occasional increases in the moneystock that do manage to elude the hoardingmechanism and spill over into the commoditymarket, he argued, like Law, that they producematching shifts in commodity demand along ahorizontal supply schedule such that quantitiesof output alter at unchanged prices.

Third was his reverse causation doctrineaccording to which causality runs from prices tomoney and its circulation velocity rather thanvice-versa as in the quantity theory. Positing atwo-step process, he said that cost and compe-tition first determine prices. Then, with pricessettled, the circulation velocity of coin adjuststo render the existing stock sufficient to accom-modate the prevailing level of real activity at thegiven prices.8 If the money stock is excessive,wealth-holders remove the excess from circula-tion, melt it down, and hold it in the form ofornaments and bullion such that velocity falls.Conversely, if coin is deficient, the resulting

7

recourse to paper substitutes and other expe-dients allows transactors to economize on coinwhose velocity therefore rises.Via such devices,velocity adjusts to ensure that the stock of coinis just enough to purchase all the goods offeredfor sale at the predetermined level of prices. Inthis way, causation runs from prices to moneyand velocity. Here is the origin of the notionthat changes in the stock of circulating media(coin and its paper substitutes) merely validateprice changes that have already occurred anddo nothing to produce such changes.

Finally, there was Steuart’s uncompromisingstance on the perennial issue of rules versus dis-cretion in the conduct of policy. Like all mercan-tilists, Steuart sided with discretion. Monetaryrules, whether of fixed or feedback variety, metwith his skepticism as did all self-correctingadjustment mechanisms, natural or designed. Tohim, nothing but discretionary fine-tuning woulddo.9 Such enlightened intervention was the hall-mark of his omnipotent, ever-active, benevolentstatesman whose job was to manipulate thevolume of real activity in the national interest.10

Steuart’s statesman alone possessed the detailedknowledge necessary to conduct what today isknown as a successful cheap-money, full-employ-ment policy.The gap between actual and potentialoutput, the monetary injection required to closethe gap, and the interest rate necessary to drawthe required metal from idle hoards: all revealedthemselves to the statesman’s astute and vigi-lant scrutiny. So too did the ever-changing cir-cumstances to which he tailored his actions.

1720 17301717 1719

Law’s Mississippi Schemesees excessive papermoney expansion culminatein an inflationary boomand collapse in France.

South Sea Bubble, the English equivalent of Law’sspeculation craze, bursts.

Law flees France indisgrace and spendshis remaining days at the gambling tablesof Venice.

Law organizes his colo-nial trading enterprise,the Mississippi Compa-ny, and merges it twoyears later with theBanque Royale in France.

South Sea Bubble

These propositions formed the core of mer-cantilist monetary theory which Law andSteuart deployed to analyze the underemployedeconomies of their time. Of the two writers,only Law, the paper money mercantilist, wasable to translate his theory into action. Hisfamous Mississippi scheme, which mergedFrance’s national bank of issue with a tradingand land development firm (the MississippiCompany) while simultaneously promising toreduce the French public debt, involved papermoney expansion on a mammoth scale.11

The resulting spectacular inflationary boomand collapse of Law’s system had three conse-quences.12 It revealed that the initial outputstimulus of a monetary expansion eventuallyvanishes leaving only inflation in its wake. Itserved to discredit paper money and financialinnovation schemes for many years to come. It,together with the similar debacle of the assignats,a nominally land-backed paper currency issuedby the French revolutionary government toinflationary excess in the years 1794 to 1796,provoked classicals to reject mercantilist tradeand monetary theory root and branch.

Classical Counterpropositions

Denouncing the mercantilist identification ofwealth with precious metals, Adam Smithobserved that national wealth consists not ofspecie or bullion but rather of stocks of pro-ductive resources – land, labor, and capital – andthe efficiency with which they are used. With

8

respect to the mercantilist prescription of pro-tectionism as the path to opulence, both Smithand David Ricardo noted that wealth-enhancing,efficient resource allocation requires not protec-tionism but rather free trade in order to exploitcomparative advantages stemming from special-ization and division of labor.13

Price-Specie-Flow and Quantity Theory Propositions Other classicals joined the attack. David Hume(1752) used his price-specie-flow mechanism todemonstrate the impossibility of the mercan-tilist goal of a permanently favorable trade bal-ance and corresponding persistent specieinflow. Hume (pp. 62-3) noted that the addi-tional specie, by raising domestic prices relativeto foreign ones and so discouraging exportsand spurring imports, would render the tradebalance unfavorable and reverse the specieflow.14 The resulting drain of monetary metalwould continue until domestic prices fell to thelevel consistent with trade balance equilibrium.Similarly, Hume (pp. 33, 37, 48) showed that themercantilist fear of scarcity of money wasunwarranted since any quantity of money, via aproportionate adjustment in the price level,could drive the trade of a nation. To prove asmuch, Hume (pp. 62-3) advanced a rigid versionof the quantity theory according to which anexogenously given one-time reduction in thestock of money has no lasting effect on realactivity but leads ultimately to a proportionatechange in the money price of goods.

1730 17401733

John Kay invents the flying shuttle, a device for throwing a weaving shuttle faster than could be done manually. It, together with other inventions including the spinningjenny and the power loom, lead to the mechanization of industry and the development of textile mills in England.

Mercantilist views are prevalent

Richard Cantillon writes Essai sur la Nature du Commerce enGénéral (published in 1755) partlyas a critique of Law’s system.150

100

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Hume

Distinction between Absolute and Relative PricesHume’s classical followers immediately seizedupon his quantity theory and deployed it againstthe mercantilists. David Ricardo applied it torefute cost-push theories of the price level.15

Accusing cost-pushers of confounding relativeprices (market exchange ratios) with the ab-solute,nominal,or general level of prices,Ricardoflatly denied that a rise in costs – wage costs inparticular – could raise general prices withoutan accompanying expansion of the money stock.True, he did acknowledge that a wage hikemight raise the prices of labor-intensive goodsand so require consumers to spend more onthose goods. But he also insisted that withoutaccommodating increases in the money stockto foster spending, consumers would have lessto spend on capital-intensive goods whose priceswould therefore fall. The upshot was clear. Anywage-induced rise in some relative prices wouldbe offset by compensating falls in others leavingthe general average of all prices unchanged.

Short-Run Nonneutrality and Long-Run Neutrality PropositionsClassicals reserved their severest criticism forJohn Law’s money-stimulates-trade doctrine.Hume insisted that the doctrine holds in theshort run but not the long.16 At first, money-stock changes indeed affect output and employ-ment. Eventually, however, the output stimulusvanishes and only higher prices remain. Law’sdoctrine holds in the short run because prices

9

are temporarily sticky, or inflexible, in responseto money stock changes. Such stickiness Humeattributed to the imperfect information price-setters possess on money-stock changes andtheir resulting failure to perceive and act uponthe changes. Distribution effects constituted forhim another source of temporary nonneutrali-ty, or transitory influence on real activity, inas-much as new money is initially concentrated infew hands and only gradually becomes dispersedthroughout the economy.17

With prices sticky and money’s circulationvelocity given, it follows that changes in themoney stock are absorbed by output whichaccordingly deviates temporarily from its natu-ral equilibrium level. Prices only begin to adjustwhen price-setters discover that their invento-ries of goods and labor are abnormally high orlow. Eventually, monetary and price-perceptionerrors are corrected as are initial distributioneffects. At that point, the price level fully adjuststo the new money stock and output returns toits natural equilibrium level. Here is the sourceof the classical doctrine of the short-run non-neutrality and long-run neutrality of money.18

Classical Case For RulesFour remaining mercantilist arguments clam-ored for demolition. Classicals were glad tooblige. First was the mercantilist claim that dis-cretion was superior to rules. Classicals coun-tered with the opposite claim that rulesreplaced destabilizing activist intervention withsmoothly operating, or stabilizing, automatic

1750 1760

“Money, however plentiful, has

no other effect, if fixed, than to

raise the price of labour...and...

commodities .... In the progress

toward these changes, the augmen-

tation may have some influence,

by exciting industry; but after the

prices are settled, suitably to the

new abundance of gold and silver,

it has no manner of influence.”

David Hume in “Of Interest”

Industrial Revolution in Great Britain (1750-1850)

Swedish Bullionist Controversy (1755-1765)*

*After Sweden switched from a metallic to an inconvertiblepaper currency in 1745, the resulting price inflation andexchange rate depreciation provoked a policy debate over the cause of these phenomena. Mercantilists tracedthe cause to external real shocks to the balance of pay-ments and prescribed export promotion and import restric-tion schemes as remedies. Others, notably P. N. Christiernin,found the cause in the Riksbank’s overissue of notes. Heurged halting the excess issue but refrained from prescrib-ing a roll-back of prices to their pre-inflation level fearingsuch deflation would bring an intolerable transitory loss of output and employment.

David Hume, in his essays “Of Money,” “Of Interest,” and “Of the Balance of Trade,”advances the classical ideas of the price-specie-flow mech-anism, the quantity theory,and the long-run neutralityand short-run nonneutrality of money.

Seven Years War (1756-1763)

adjustment mechanisms. Unlike Steuart, classi-cals held a low opinion of the knowledge, capa-bilities, and motivation of the policy authorities.In particular, classicals, especially Ricardo, JohnWheatley,and other Bullionist critics of the Bankof England, feared that central bankers operatingunder the kind of floating exchange rate, incon-vertible paper regime prevailing in England dur-ing the Napoleonic Wars, would, if left to theirown discretion, pursue inflationary policies.

Since classicals regarded stability of the valueof money as the overriding policy objective,they advocated rules obligating policymakers toachieve that goal. One such rule was the goldstandard.By requiring the maintenance of a fixedcurrency price of gold, this rule, provided thatthe gold price of goods also remained fairlysteady, was tantamount to stabilizing the moneyprice of goods. And with the price level stable,money could function reliably as a unit of accountand medium of exchange. In so doing, it couldmake its maximum contribution to the efficientoperation of the real economy and cease to bea source of financial crises and panics.

Say’s Law of MarketsNext in line for rejection was the mercantilistclaim that deficient aggregate demand con-demns cash-poor economies to perpetualunemployment. Not so, wrote the classicist Jean Baptiste Say in his 1803 Traité d’économiepolitique. The value of goods produced equalsthe cost of the inputs absorbed in their fabrica-tion. It follows that the very act of production

10

creates, in the form of factor payments, incomessufficient to buy the goods off the market. Andthose incomes indeed will be spent.The insatia-bility of wants together with the unlikelihoodthat rational people would hoard their savingsindefinitely in the form of sterile money ensuresas much.

Far from going unspent, saving automaticallytranslates itself into investment. People deposittheir savings with banks to earn interest. Thoseintermediaries,upon lending the saving to capital-ist entrepreneurs to finance investment projects,guarantee that it enters the spending stream justas surely as if it were consumption spending.Theupshot is that full-capacity supply creates its owndemand such that mercantilist fears of generalgluts and permanent stagnation are unfounded.Say’s Law of Markets identifies the natural levelof real activity with full employment.19

Real Interest RateAs for the mercantilist argument that the inter-est rate is purely a monetary phenomenon,Hume, Ricardo, and Henry Thornton all repudi-ated it.20 They contended (1) that the naturalequilibrium rate of interest is a real magnitudedetermined by productivity and thrift, and(2) that money, being neither of those variables,cannot affect the natural rate whose level istherefore resistant to monetary control. True,they conceded that a one-time monetary injec-tion could temporarily depress the loan rate ofinterest below its equilibrium level. But theystressed the transience of this effect. They

1760 1770

Sir James Steuart’s An Enquiry intothe Principles of Political Oeconomyenunciates four main doctrines ofmercantilism: real forces determinethe price level, hoarding preventsmoney from affecting prices, themonetary circulation determines thelevel of real activity, and discretionoutperforms rules in the conduct of monetary policy.

“It is the business of a statesman...

to ...guard against ... stagnation....

He must facilitate circulation

by drawing into the hands of the

public ... coin... locked up [in idle

hoards]; and he must supply the

actual deficiency of the metals, by

[issuing] paper credit.”

Sir James Steuart in An Enquiryinto the Principles of Political Oeconomy, Vol. II

150

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Swedish Bullionist Controversy (1755-1765)

Mercantilist views are prevalent

Steuart

Industrial Revolution in Great Britain (1750-1850)

Seven Years War (1756-1763)

1769

James Watt’s steam engine adds a con-denser to Newcomen’s atmospheric engine,

boosting its efficiency by a factor of four.

pointed out that the monetary injection putsupward pressure on prices. And since with high-er prices more loans are needed to finance agiven real quantity of investment projects, it fol-lows that loan demands increase.The rise in loandemands reverses the initial fall in the loan rateand restores it to its natural level thereby frus-trating attempts to keep it low. Supplementingthe price-induced rise in loan demand is a fall inloan supply. For as prices rise, people need morecash to mediate hand-to-hand transactions. Theresulting conversion of notes and deposits intocoin precipitates a cash drain from banks thatdiminishes bank reserves. To protect theirreserves from depletion, banks raise their loanrates. Or what is the same thing, they contracttheir loan supply.The contraction of loan supplycombines with the rise in loan demand torestore the interest rate to its natural equilibri-um level determined by productivity and thrift.

Criticism of Backing Theories of MoneyLast but not least was Law’s idea of a land-collateralized paper money stock.Henry Thorn-ton was merciless in his criticism. He excoriatedthe plan on the grounds that it would fail tolimit the money supply and in so failing wouldrender the price level indeterminate.21 The plan’sflaw, wrote Thornton, is that it ties money tothe nominal or dollar value, rather than to thefixed physical acreage, of land. By anchoringeach dollar to another dollar, it sets up a dynam-ically unstable price-money-price feedback looprendering prices indeterminate. The result is

11

that any random shock which raises land’s pricewould, by raising land’s value, increase money’sbacking and so justify an expansion of its supply.The consequent expansion would further bidup land’s price thereby justifying still furtherincreases in the money stock which would raiseprices again and so on ad infinitum. In short,backing money with the nominal value of land –or, for that matter, with commercial paper rep-resenting the nominal value of goods in theprocess of production and distribution – woulddestabilize prices rather than stabilize them.Price stability required another principle ofmonetary limitation.

Thornton’s refutation of the nominal backingidea completed the list of the original classicalrebuttals of mercantilist monetary doctrine.Having contested this doctrine once, however,classicals and their descendants were calledupon to counter it repeatedly throughout thenineteenth and twentieth centuries. Mercan-tilist views, despite their devastating initialrejection, reemerged to form the BankingSchool position in the famous Currency School-Banking School controversy that took place inEngland in the mid-1800s. Most of the usualsuspects – cost-push, hoarding, reverse causali-ty, discretion, nominal backing – appeared in theBanking School’s roundup. In opposing them,classicals, in their Currency School guise, foundoccasion to deploy the same quantity theoretic,price-specie-flow concepts they had earlierdeployed against Law and Steuart.

1780 17901776

Signing of the Declaration of Independence

American Revolution (1775-1783) French Revolution (1789-1799)

Assignat Experiment in France (1789-1795)*Adam Smith publishesWealth of Nations, refutingmercantilist protectionistdoctrines with classical freetrade principles. He alsorefutes the mercantilist claimthat money (gold) constitutesnational wealth.

“Some of the best English writers ... set out with observing,

that the wealth of a country consists, not in its gold and

silver only, but in its lands, houses, and consumable goods ... ,

however, the lands, houses, and consumable goods ... slip out

of their memory, and... their argument frequently supposes

that all wealth consists in gold and silver.”

Adam Smith in Wealth of Nations

“Without once mentioning it [Sir James Steuart’s book], I flatter myself that every

false principle in it will meet with a clear and distinct confutation in mine.”

Smith in a letter to William Pulteney (1772)

*Instituted by the French revolutionarygovernment, the assignat experimentreprises Law’s land-backed paper moneyscheme. The resulting inflation provokesa classical, or anti-mercantilist, backlashin monetary thought.

Smith

Classical views are prevalent

1788

Henry Court invents the puddling process leading tolarger-scale iron furnaces and a 30-fold expansion in

the output of iron between 1760 and 1899.

Ending a 24-year experiment with inconvertiblepaper, Britain had restored the gold convert-ibility of her currency in 1821. The ensuing Currency-Banking debate focused on whetherthe note component of such a convertible, gold-standard currency required regulation to pre-vent overissue.22 The Currency School’s classicalpredecessors, notably David Ricardo, HenryThornton, and others, had assumed that a con-vertible currency needed no such protection. Ifthe currency were convertible, they reasoned,any excess note issue which raised British pricesrelative to foreign prices would be convertedinto gold to make cheaper purchases abroad.23

The resulting loss of specie reserves wouldimmediately force banks to contract their noteissue thus quickly arresting the drain andrestoring the money stock and prices to theirpre-existing equilibrium level. Given smoothand rapid adjustment (monetary self-correc-tion), convertibility alone was its own safeguard.

A series of monetary crises in the 1820s and1830s, however, convinced the Currency Schoolthat adjustment was far from smooth and thatconvertibility per se was by no means a guaran-teed safeguard to overissue. It was an inadequatesafeguard because it allowed banks, commercialand central, too much discretion in the manage-ment of their note issue. Banks, facing no mini-

12

1790 18001792

Classical views are prevalent

1802 1803

Louisiana Purchase

*After England suspends gold payments and goes on an inconvertible paper standardin 1797, the resulting inflation provokes perhaps the most famous monetary controversy of all time. Led by David Ricardo, the bullionists blame the Bank ofEngland for creating inflation through excessive issues of paper notes. Antibullionistsattribute the price rises to such real shocks as domestic crop failures, overseas military expenditures, and the wartime disruption of foreign trade. They stress cost-push influences exerting upward pressure on the individual prices of specificcommodities and posit the real bills doctrine to argue that money, advanced on loan to finance sound business projects, cannot affect prices.

Assignat Experiment in France (1789-1795)

Jean Baptiste Sayenunciates his Lawof Markets (1803).

Henry Thornton inhis Paper Credit ofGreat Britain refutesLaw’s idea of back-ing money with thenominal value ofland saying it wouldrender the pricelevel indeterminate.

Opening of the NewYork Stock Exchange

1793

Eli Whitney invents the cotton gin.

French Revolution (1789-1799)

3

Currency School-Banking School Debate (1830-1850)

mum required reserve ratio and willing to sac-rifice safety for profit, could and did continue toissue notes even as gold was flowing out, delay-ing contraction until the last possible moment,and then contracting with a violence that sentshock waves throughout the economy.

Currency School’s Monetary Rule

What was needed, the Currency Schoolthought, was a rule removing the note issuefrom the discretion of bankers and placing itunder strict regulation. To be effective, this ruleshould require the banking system to contractits note issue one-for-one with losses of goldreserves so as to put a gradual and early stop tospecie drains. Such a rule would embody theCurrency School’s principle of metallic fluctuationaccording to which a mixed currency of paperand coin should be made to behave exactly as ifit were wholly metallic, automatically expandingand contracting to match inflows and outflowsof gold.24

Departure from this rule, the CurrencySchool argued, would permit persistent overis-sue of paper. Such overissue, by forcing a pro-tracted efflux of specie through the balance ofpayments, would in turn endanger the goldreserve, threaten gold convertibility, compel theneed for sharp contraction, and thereby precip-

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Thornton

Bullionist-Antibullionist Debate (1797-1821)*

13

note issue, reductions that restore generalprices to their target equilibrium level. Heretoo was the classical preference for rules – inthis case a 100 percent gold reserve require-ment rule – rather than discretion in the con-duct of banking policy.

Banking School

The rival Banking School flatly rejected theCurrency School’s prescription of mandatory100 percent gold cover for notes. Indeed, theBanking School denied the need for statutorynote control of any kind. Instead, the Schoolargued that a convertible note issue was auto-matically regulated by the needs of trade andrequired no further limitation. This conclusionstemmed directly from the real bills doctrine andthe law of reflux which together posited guaran-teed safeguards to overissue obviating the needfor monetary control.

The School’s real bills doctrine stated thatthe money stock could never be inflationary ordeflationary if issued by way of collateralizedloans advanced to finance transactions in thenominal volume of real goods and services.Similarly, the law of reflux asserted that overis-sue was impossible because any excess noteswould be returned instantaneously to the banksfor conversion into coin or for repayment ofloans. Both doctrines embodied the notions ofa passive, demand-determined money supplyand of reverse causality running from prices and

1810 18201812

War of 1812Britain invades U.S.

1817

Napoleonic Wars (1800-1815)

Birmingham School (1817-1821)**

Thornton (1802) and Ricardo(1817) write that the equilibriuminterest rate, being determined byproductivity and thrift, is resistantto monetary control. Classicalsreject Law’s money-stimulates-trade doctrine saying that theneutrality-of-money propositionrenders it invalid in the long run.

“Mr. Law considered security as every

thing, and quantity as nothing. He

forgot that there might be no bounds

to the demand for paper; that the

increasing quantity would contribute

to the rise of [the price of] commodi-

ties; and [that] the rise ... require, and

seem to justify, a still further increase.”

Henry Thornton in a speech on the Bullion Report (May 11, 1811)

Ricardo writes Princi-ples of Political Economyand Taxation. He deniesthat a rise in wagerates could raise priceswithout an accompany-ing expansion of themoney stock.

David Ricardo’s The High Priceof Bullion blames inflation onthe Bank of England.

itate financial panics. Such panics would beexacerbated if internal gold drains coincidedwith external ones as domestic money holders,alarmed by the possibility of immanent suspen-sion of cash payments, sought to convert papercurrency into gold. No such consequenceswould ensue, the School felt, if the currencyconformed to the metallic principle. Forced tobehave like gold (regarded by the School as thestablest of monetary standards), the currencywould be spared those sharp procyclical fluctu-ations in quantity that amplified disturbancesarising from real shocks.

The Currency School scored a triumphwhen its monetary rule was enacted into law.The Bank Charter Act of 1844 embodied itsprescription that, except for a small fixedamount of notes issued against governmentsecurities, bank notes were to be backed by anidentical value of gold. In modern terminology,the Act established a marginal gold reserverequirement of 100 percent behind note issues.With notes rigidly tied to gold in this fashion,their volume would start to shrink as soon asspecie drains signaled the earliest appearance ofoverissue. Monetary overexpansion would becorrected automatically, swiftly, and gentlybefore it could do much damage. Here was apractical policy application of Hume’s quantitytheoretic, specie flow doctrines. Here was thenotion of a channel of influence running fromnote overissue to rising prices to trade deficitsto gold drains to corrective reductions in the

Ricardo

**Led by Thomas Attwood, the BirminghamSchool opposes restoration of gold convert-ibility of the British pound at the pre-warparity. They fear the resulting deflation willcause unemployment. They advocate continu-ation of the wartime regime of floating-exchange-rate inconvertible paper currencythat brings high and rising prices. In short,the inflationist, full-employment-at-any-costwriters of the Birmingham School oppose a return to the gold standard.

Stephenson’s engines pull the first fully scheduled trains.Railroad age begins.

U.K. overtakes theNetherlands in man-hour productivity.

economic activity to money rather than viceversa as in the Currency School’s view.25

According to the reverse causality hypothesis,changes in the level of prices and productioninduce corresponding shifts in the demand forbank loans which banks accommodate via vari-ations in their note issue. In this way, prices helpdetermine the note component of the moneystock, the expansion of which is the result, notthe cause, of price inflation. As for the pricelevel itself, the Banking School attributed itsdetermination to factor incomes or costs(wages, interest, rents, etc.), thus positing a cost-push theory of price movements. The impor-tance of cost-push theorizing to the BankingSchool cannot be overestimated. It even ledThomas Tooke, the School’s leader, to arguethat high-interest-rate tight-money policieswere inflationary since they raised the interestcomponent of business costs.26

Mercantilist IdeasThe concepts of cost inflation, reverse causality,and passive money are the hallmarks of anextreme anti-quantity theory of money towhich the Banking School adhered. Additionalmercantilist hallmarks included the School’spropositions (1) that international gold move-ments are absorbed by idle hoards of excessspecie reserves without affecting the volume ofmoney in active circulation, (2) that gold drainsstem from real shocks to the balance of pay-ments rather than from domestic price infla-

14

tion, (3) that changes in the stock of money areoffset by compensating changes in the stock ofmoney substitutes leaving the total circulationunchanged, and (4) that discretion is superior torules in the conduct of monetary policy.

The Banking School put these propositionsto work in its critique of the classical monetarydoctrines of the Currency School. Those doc-trines, of course, contended that note overissueis the root cause of domestic inflation andspecie drains. In opposing them, the BankingSchool argued as follows: Overissue is impossi-ble since the stock of notes is determined bythe needs of trade and cannot exceed demand.Therefore, no excess supply of money exists tospill over into the goods market to bid up prices.In any case, causality runs from prices to moneyrather than vice versa. Finally, specie drains stemfrom real rather than monetary shocks to thebalance of payments and are totally independ-ent of domestic price-level movements.

These arguments severed all but one of thelinks in the Currency School’s monetary trans-mission mechanism running from money toprices to the trade balance, thence to specieflows and their impact on the monetary base,and finally back again to the money stock. Thefinal link was broken when the Banking Schoolasserted that gold flows come from idle hoards– buffer stocks of excess specie reserves – andnot from the volume of money in circulation.Falling solely on the hoards, gold drains wouldfind their monetary effects neutralized (steril-

1820 1830

Classical views are prevalent

Thomas Tooke, leader of the BankingSchool and author of the six-volumeHistory of Prices (1837-1857), stress-es the real bills doctrine, the notionof reverse causality, and the cost-push theory of price movements.Lord Overstone (Samuel Jones Loyd),leader of the Currency School, usesthe quantity theory to argue thatmandatory 100 percent gold coverfor bank notes is needed to preventoverissue.

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“Restore the depreciated

state of the currency and

you restore the reward of

industry, ... confidence, ...

production, ... consumption,

[and] everything that

constitutes the commercial

prosperity of the nation.”

Thomas Attwood in The Remedy: or, Thoughts on the Present Distresses

“Mr. Attwood opines, that the multiplication of the circulat-

ing medium, and the consequent diminution of its value ...

give employment to labour... to an indefinite extent ....

Mr. Attwood’s error is that of supposing that a depreciation

of the currency really increases the demand for all articles,

and consequently their production, because, under some

circumstances, it may create a false opinion of an increase

of demand; which false opinion leads, as the reality would

do, to an increase of production, followed, however, by a

fatal revulsion as soon as the delusion ceases.”

John Stuart Mill in “The Currency Juggle”

Mill

1829

G. Stephenson’s steam locomotive,

Rocket, wins contest.

ized) by the implied fall in excess reserves. Toensure that these hoards would always be suffi-cient to accommodate gold drains, the BankingSchool recommended that the Bank of Englandhold larger metallic reserves.

With regard to the Currency School’s pre-scription that discretionary policy be replacedby a fixed rule, the Banking School rejected iton the grounds that rigid rules would preventthe banking system from responding to theneeds of trade and would hamper the centralbank’s power to deal with financial crises.

Finally, the Banking School asserted theimpossibility of controlling the monetary circu-

15

lation via control of the gold and bank notecomponent alone since limitation of that com-ponent would simply induce the public toresort to money substitutes (deposits and billsof exchange) instead. In other words, the circu-lation is like a balloon; when squeezed at oneend, it expands at the other. More generally, theBanking School questioned the efficacy of basecontrol in a financial system that could generatean endless supply of money substitutes.

The Currency School, however, rejected thiscriticism on the grounds that the volume ofdeposits and bills was rigidly constrained by thevolume of gold and notes and therefore could

1840 18501844 1846

Potato crop failure inIreland spurs waves ofemigration to America.

1848

Gold is discoveredin California.

Currency School-Banking School Debate (1830-1850)

The 1844 Bank Charter Act embodies the CurrencySchool prescription that, except for a small fixedfiduciary issue, bank notes must be backed pound-for-pound by gold, thus establishing a marginalgold reserve requirement of 100 percent.

Tooke’s An Inquiry into the Currency Principleuses cost-push theorizing to claim that interestrate hikes and reductions, by raising and low-ering business costs, cause corresponding risesand falls in the price level.

Classicals see the economy

as inherently self-regulating.

Mercantilists see it as requiring

government intervention

and discretionary fine-tuning.

“The prices of commodities do not

depend on the ...amount of the whole

of the circulating medium: but ...

on the contrary, the amount of the

circulating medium is the conse-

quence of prices.”

Thomas Tooke in An Inquiry into the Currency PrincipleTooke

U.S. Civil War (1861-1865)

be controlled through the latter alone. In short,the total circulation was like an inverted pyra-mid resting on a gold and bank note base, withvariations in the base inducing equiproportion-al variations in the superstructure of moneysubstitutes. In counting deposits as part of thesuperstructure, the Currency School excludedthem from its concept of money. It did so onthe grounds that deposits, unlike notes andcoin, were not generally acceptable in final pay-ments during financial crises.

EvaluationIn retrospect, the Currency School erred in fail-ing to define deposits as money to be regulatedlike notes. This failure enabled the Bank of Eng-land to exercise discretionary control over alarge and growing part of the circulating medi-um, contrary to the School’s intentions. TheSchool also erred in failing to recognize theneed for a lender of last resort to avert liquidi-ty panics and domestic cash drains. By the endof the nineteenth century it was widely recog-nized that the surest way to arrest an internaldrain was through a policy of liberal lending.Such drains were caused by panic-induceddemands for high-powered money (gold coinand Bank of England notes) and could be termi-nated by the Bank’s announced readiness tosatiate those demands. The Currency Schoolnevertheless remained opposed to such a policy,fearing it would place too much discretionary

16

1850 186018591856

Henry Bessemerrevolutionizes thesteel industrywith his new con-verter process.

1855

First iron Cunardsteamer crosses

the Atlantic in nineand a half days.

Classical views are prevalent

power in the hands of the central bank. Theseshortcomings in no way invalidated the School’smonetary theory of inflation which was superi-or to any explanations its critics had to offer.

As for the Banking School, it rightly stressedthe importance of checking deposits in the pay-ments mechanism. But it was wrong in insistingthat the real bills doctrine,which tied note issuesto loans made for productive purposes, wouldprevent inflationary money growth. Like HenryThornton, the Currency School triumphantlyexposed this flaw by pointing out that risingprices would generate a growing demand for –and nominal collateral backing of – loans tofinance the same level of real transactions.Thesecollateralized loan demands, when accommo-dated in the form of deposit and note creation,would enlarge the money stock. In this wayinflation would justify the monetary expansionnecessary to sustain it and the real bills criterionwould fail to limit the quantity of money in exis-tence. Also, by 1900 Knut Wicksell and IrvingFisher had rigorously demonstrated the samepoint made by Thornton in 1802, namely that aninsatiable demand for loans and a correspondinginexhaustible supply of eligible bills results whenthe loan rate of interest is below the expectedrate of profit on capital. In such cases, the realbills criterion provides no bar to overissue.

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of the Species.

1862

U.S. issues its firstlegal-tender fiat cur-rency, the greenbacks.

Jevons

William Stanley Jevons, in his A SeriousFall in the Value of Gold Ascertained andits Social Effects Set Forth, calculates thegeometric mean of the prices of 39 majorand 79 minor commodities to establish thatthe general price level had risen and thevalue of gold had fallen in the order of 9 to 15 percent since 1845-1850. Written 15 years after the California and Australiangold discoveries, Jevons’s pathbreakingwork on index number construction andapplication lends strong statistical supportto the quantity theory approach to price-level determination.

Classicals won the Currency-Banking dispute.Their victory lasted until ex-classical John May-nard Keynes, having defected to the oppositeside, routed them in 1936.27 But they regainedtheir crown when monetarists (with help fromthe new classical school) dislodged Keynesianmacroeconomics in the 1970s and 1980s.

Keynes launched his attack in the midst ofthe Great Depression when the stark conditionsof stagnation, poverty, and mass unemploymentmocked the classical notion of a self-equilibrat-ing, fully employed economy. Clearly the timewas ripe for a mercantilist revival. That revivaltook the form of the Keynesian Revolution withthe leader’s General Theory as its bible. In thatbook, Keynes replaced the full capacity, quantitytheoretic doctrines of the classicals with atleast four propositions inherited from Law andSteuart.

Keynes’s Mercantilist Propositions

First, like Law, he argued that in times of massunemployment the primary stimulative effectsof expansionary monetary policy fall on realoutput and employment rather than on prices.That is, they do so unless negated by liquiditytraps and interest-insensitive investment de-mand schedules, both of which cause velocity

17

reductions to absorb the impact of monetaryexpansion. Absent such phenomena, however,Keynes’s model implied that monetary stimuliaffect real activity rather than prices. Like Law,he stressed that the stimulus works through aninterest rate channel. More money means lowerinterest rates, a cheapened cost of capital, andthus a rise in investment spending.The increasedinvestment induces additional rounds of con-sumption spending causing aggregate demandto rise by a multiple of the new investmentspending. With idle resources available to drawupon,production expands to meet the increasedaggregate demand. In expounding his interestrate transmission mechanism, Keynes praisedhis mercantilist forebears for anticipating it.Indeed, the “Notes on Mercantilism” section ofhis General Theory argues that the notion of alinkage running from money to interest rates toinvestment to output constituted the rationalefor the mercantilists’ advocacy of export sur-pluses financed by specie inflows.

Second, like Steuart, Keynes held that prod-uct prices are determined by unit labor costplus a markup to cover profits and nonlaborcosts. Here is the mercantilist notion of theprice level as a nonmonetary phenomenon.28

True,Keynes admitted that monetary expansionthrough its stimulus to employment might,

1870 18801876

Alexander Graham Bell invents the telephone.

U . K . U N E M P L O Y M E N T ( % )

Series begins at 1851. Reliable estimates for earlier periods unavailable.

Sources: (1851-1855) Mitchell, Abstracts of British Historical Statistics, p. 64.

(1856-1879) Layard, Nickell, and Jackman, Unemployment: Macroeconomic Performanceand the Labour Market, p. 3.

1871 1873

Called by pro-silver forces the “Crime of 1873,” the Coinage Act of that year omits the silver dollar from the list of coins to be minted,thus ending the legal status of bimetallism in the U.S.

4

The Keynesian Revolution and Monetarist Counter-Revolution (1936-1985)

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Marshall BagehotAlfred Marshall in an unpub-lished manuscript originates theCambridge cash balance ap-proach to the value of money.

Walter Bagehot’s Lombard Street spellsout the classic lender-of-last-resort pre-scription for quelling liquidity panicsand averting bank runs. The centralbank must announce its readiness tosatiate all panic-induced demands forcash – to “lend freely at a high rate.”

because of diminishing returns to labor, raiseunit labor costs and so prices. But he tended tominimize or disregard money’s price-raisingeffects. Instead, he treated the price level as aninstitutional datum governed by nominal wagerates which autonomous forces – union wage-setting policy, worker money illusion, and thelike – render downwardly inflexible at low levelsof employment. By expressing prices in terms ofexogenously given factor costs, he pointed theway to a cost-push theory of the price level. Hisimmediate followers, Joan Robinson, NicholasKaldor, and Richard Kahn, certainly interpretedhim this way and accordingly denied money arole in price determination.29

Third,Keynes restated Steuart’s doctrine ofhoarding in the form of his concept of the liq-uidity trap. The trap, he wrote, might come intooperation in deep depressions when the inter-est rate falls to a level so low that everybodyunanimously believes it cannot stay there butmust return to its conventional normal height.At the floor rate, all are indifferent betweenholding cash or earning assets whose prices,which vary inversely with the interest rate, areexpected to fall. Indeed, asset prices are expect-ed to fall by an amount such that the resultinganticipated capital loss just equals the interestreturn on the assets. As there is no advantageto holding such assets instead of zero-yieldcash, the latter becomes a perfect substitute forthe former in individuals’ portfolios. At thispoint, the demand for money becomes insatiableand infinitely sensitive to the slightest change in

18

1880 18901883

Thomas Alva Edison inventsthe electric light bulb.

Classical views are prevalent

*This controversy concerning the cause of the post-1879 secular price defla-tion pits gold standard advocates against proponents of a bimetallic currency.The former group attributes price deflation to real cost-reducing forces such as rapid technological progress, improvements in transportation andcommunication, and increased competition. By contrast, bimetallists attrib-ute deflation to the failure of the gold-backed money supply to grow as fast as real output and the demand for real cash balances. Monometalliststhus stress the mercantilist, or cost-push, view of price-level determinationwhile bimetallists stress the classical, or quantity theory, view.

Bimetallism Debate (1880-1896)*

interest rates. Keynes called this pathologicalcondition absolute liquidity preference.

When this condition rules, no increase in themoney stock, no matter how large, can reducethe interest rate. Suppose the central bankexpands the money stock by purchasing bondson the open market. Such bidding puts incipientupward pressure on bond prices. But the slight-est rise of the latter induces bondholders to sellto the central bank and then to hoard the cashproceeds. Since at the floor rate of interest thedemand for money is insatiable and the willing-ness to sell bonds absolute, no amount of openmarket operations can overcome absolute liq-uidity preference and reduce interest rates.And with rates at their irreducible minimum,they cannot fall to stimulate real activity. Here isKeynes’s expression of the mercantilist fear thatmonetary expansion cannot be counted uponto stimulate spending because the new moneymay disappear into idle hoards.

Fourth, Keynes found still another obstruc-tion to block the interest rate channel. Even ifmonetary injections were successful in loweringinterest rates, those injections still might fail tostimulate real activity if investment spendingwere unresponsive to the lower rates. If so, thentwo obstacles – an interest-insensitive invest-ment schedule as well as a liquidity trap – couldrender monetary policy ineffective in a depres-sion. In both cases, a rise in the money stockwould be offset by a fall in velocity leaving totalspending unchanged. With variable velocityabsorbing the impact of money stock changes,

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U.S. overtakes U.K. in man-hour productivity.

1893

Bank panicand goldruns sap U.S. goldreserve.

U . S . I N F L A T I O N R A T E ( % )

Inflation rate measured as the annual rate of change of the GDP deflator.

Source: Barro, Macroeconomics, 5th ed., p. 8.

U . S . U N E M P L O Y M E N T ( % )

Sources: (1880-1889) Combines estimated decade average rate and estimated peak year rate (1885).Lebergott, Manpower in Economic Growth, pp. 179-180, 189.

(1890-present) Barro, Macroeconomics, 5th ed., p. 6.0

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1900 191018981896

Blaming the gold standard for deflation andits evils, W.J. Bryan delivers his Cross-of-Goldspeech as new gold fields and the invention of the cyanide process are producing inflation-ary floods of monetary gold.

1903 1908

Wright Brotherstake first flight.

Henry Ford introduceshis Model T.

Knut Wicksell, in his Interest andPrices, explains how spreads betweennatural (equilibrium) and market loanrates of interest produce cumulativechanges in the general price level.

none would be transmitted to nominal income.The rigid links connecting money to nominalincome and prices as postulated by the classicswould be severed or severely weakened.Steuart had said exactly the same thing in 1767.

Post-Keynesian Extensions

To Keynes’s own mercantilist doctrines,Keynes’s followers writing in the inflationarypost-World War II period added others. Someinterpreted inflation as a cost-push phenome-non emanating from union bargaining strength,business monopoly power, oligopoly adminis-tered prices, commodity shortages, supplyshocks, and other real and institutional forcesputting upward pressure on factor costs andprofit mark-ups.Then too, “cheap money” advo-cates held that expansionary monetary policycould be used to peg interest rates at low lev-els so as to minimize the interest burden of thepublic debt while simultaneously stimulatingreal activity. An alternative version of the sameargument, associated with the Phillips curvetrade-off approach to policy questions, held thatmonetary policy could peg the unemploymentrate at permanently low levels at the cost of astable (nonaccelerating) rate of inflation.

Underlying all these arguments were thepresuppositions (1) that full employment is thedominant policy concern, (2) that the employ-ment benefits of monetary stimuli exceed theirinflationary costs, and (3) that disinflationarymonetary policy, because entrenched inflation is

so resistant to it, would produce intolerablylarge and protracted reductions in output andemployment. John Law of course held similarpresuppositions, as did other mercantilists.30

There remained the mercantilist ideas ofreverse causation, passive money, and futility ofbase control of money and of inflation. NicholasKaldor supplied these ideas in his 1982 TheScourge of Monetarism. Representing the peak ofpost-Keynesian skepticism of the relevance ofthe quantity theory, Kaldor’s Scourge denied thepossibility of base control given the centralbank’s duty to guarantee bank liquidity and thefinancial sector’s ability to engineer changes inthe turnover velocity of money via the manufac-ture of money substitutes.Kaldor’s transmissionmechanism runs from trade unions to wages toprices to money and thence to bank reserves.Unions determine wages, wages determineprices, prices influence loan demands, and loandemands, via their accommodation in the formof bank-created checking deposits, determinethe money stock, with central banks permis-sively supplying the necessary reserves. Far fromexerting an activating influence, money appearsat the end of the causal chain.

Monetarists’ Response to Keynes and the Keynesians: the Classical Comeback

Even as Keynesianism was riding high, criticswere sniping at it from the sidelines. Eventuallythese criticisms would culminate in a monetarist

Irving Fisher in his Appreciation and Interestdistinguishes between nominal and real interestrates, with the expected rate of price changeconstituting the difference between the two.

Wicksell

“There is a certain level of the ...rate of interest ...

such that the general level of prices has no tendency

to move either upwards or downwards. This we

call ... the natural capital rate .... If ... the ... [loan] rate

of interest is set and maintained below this normal

level ...prices will rise and will go on rising....

If ... the rate ... is maintained...above ... the natural

rate, prices will fall continuously and without limit.”

Knut Wicksell in Interest and Prices

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counterrevolution that would dethrone mer-cantilist doctrines and restore classical ones. Atleast eight mileposts mark the route of the clas-sical comeback.

First came the theory of the real balanceeffect. Enunciated by Gottfried Haberler, A. C.Pigou,and Don Patinkin, it denied that Keynesianliquidity traps and interest-insensitive investmentschedules could bar full employment.31 That is,it denied they could do so provided (1) wealthin the form of real money balances influencesconsumers’ spending decisions, and (2) pricespossess some downward flexibility. The lattercondition should hold in a slump since a de-pressed economy implies an excess supply ofgoods exerting downward pressure on prices.Lower prices in turn raise the real value, or pur-chasing power, of cash balances in consumers’wealth portfolios. The rise in real cash balancesstimulates consumption spending until fullemployment is reached. Indeed, it is unneces-sary to wait for falling prices to activate the realbalance effect. The central bank can achieve thesame result directly by increasing the moneysupply. In principle, then, Say’s Law holds andmoney is hardly powerless to affect aggregatedemand even under extreme Keynesian condi-tions. Keynes might have realized as much hadhe incorporated real balances into his consump-tion function.

Second came the empirical work of ClarkWarburton, Milton Friedman, and AnnaSchwartz confirming money’s power to affectspending. Contrary to Keynes’s claim that idle

20

hoards and offsetting velocity movements mightnegate money’s impact on nominal expenditure,Warburton established that (1) an erraticmoney stock through its impact on spendinghad been the chief factor causing most U.S.reces-sions, (2) money’s initial impact was on output,and (3) with a lag, prices eventually adjusted tofully absorb the money stock change. 32 Friedmanand Schwartz (1963) then corroborated War-burton by showing that a one-third contractionof the money stock was the cause of the GreatDepression of the 1930s. These studies, togeth-er with Friedman’s findings that persistent infla-tion is largely or solely the result of excessivemonetary growth, effectively reestablished theclassical doctrine of the short-run nonneutrali-ty and long-run neutrality of money. They alsoshowed that classical doctrine could accountfor the Great Depression.

Third came Karl Brunner’s and Allan Melt-zer’s 1967 critique of the Law-Keynes theory ofinterest rates as a policy guide. That theoryclaimed that the interest rate, a purely mone-tary variable, accurately measured the degree ofmonetary ease or tightness. Brunner andMeltzer disagreed. The rate, they said, is anunreliable indicator of monetary ease or tight-ness. It is unreliable because it registers theimpact of nonmonetary determinants – notablybusiness loan demands – as well as monetaryones. The rate might be low or high notbecause money was easy or tight but ratherbecause loan demand was weak or strong.Neglect of this important consideration could

1910 19201912 1913

U.S. Congress creates the Federal Reserve System.

Classical views are prevalent

Irving Fisher publishes his classic The Purchasing Power of Money, thebest and most complete expositionof the quantity theory of money in the entire economic literature.

World War I (1914-1918)

*Reichsbank officials deploy mer-cantilist arguments to deny thatoverissue of deutsche markscaused the hyperinflation. Criticsuse classical quantity theory reasoning supplemented withrational expectations argumentsto put the blame squarely on theReichsbank. The critics were right.The hyperinflation was a mon-etary, rather than a nonmonetary,phenomenon.

German hyperinflation(1922-1923)*

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lead to perverse, destabilizing policy. For exam-ple, in times of depression, when slack businessloan demands rendered the rate low, theauthorities, misinterpreting the low rate as sig-nifying easy money, might contract the moneystock and thereby intensify the depression.

Contrariwise, in times of inflation whenbooming credit demands rendered the interestrate high, the authorities, misinterpreting thehigh rate as signaling tight money, might expandthe money supply and so escalate the inflation.By confounding the effects of loan demandswith those of monetary ease or tightness, thecentral bank would engineer a perverse, pro-cyclical monetary policy. This critique did muchto discredit the Law-Keynes theory of the inter-est rate.

Milton Friedman’s case for monetary rulesconstituted the fourth monetarist milestone.Friedman (1960) argued that long and variabletime lags render discretionary countercyclicalmonetary policy destabilizing. Because such lagsmake forecast errors inevitable, the centralbank cannot predict the short-run impact of itsmoves. The result is that expansionary actionsaimed at fighting recessions may take effect atprecisely the wrong time when the economy isbooming just as contractionary anti-inflationactions may hit the economy when it is alreadymired in a slump. Friedman’s solution was torecommend a rigid rule fixing the money stock’sgrowth rate equal to the trend growth rate ofoutput. Such a rule would operate as an auto-matic stabilizer working to restore aggregate

21

spending to its long-run non-inflationary, full-employment path. Inflationary spending thatoutruns the rule-determined money stockcould not be sustained and must slacken. Con-versely, spending that falls short of money stockgrowth, as in recessions,would eventually quick-en under the impact of the monetary stimulus.In this way, such rule-induced correctionswould ensure that money acts countercyclicallyand that long-run aggregate demand grows atthe same trend rate as real output such thatprices remain stable.

The fifth milestone, and the one that morethan any other turned the tide in favor of theclassicals, was the stagflation experience of the1970s. That episode saw the simultaneousappearance of rapid monetary growth, risingunemployment, and accelerating inflation – animpossible combination according to the predic-tions of John Law and the Keynesian school.Thisexperience did much to discredit mercantilistbeliefs that money stimulates trade and that theprice level is independent of the money supply.

Natural Rate HypothesisThe sixth milestone was the monetarists’ natu-ral rate hypothesis according to which unem-ployment returns to its natural, equilibrium levelregardless of the inflation rate. Milton Friedman(1968) and Edmund Phelps (1967) establishedthis conclusion with the aid of an expectations-augmented Phillips curve. They showed thatwhen inflationary expectations are incorpo-rated into the Phillips curve, no permanent

1930 19401927 1929

Charles Lindberghmakes first trans-atlantic flight.

U.S. stockmarketcrashes.

1936

World War II (1939-1945)

John Maynard Keynespublishes The GeneralTheory of Employment,Interest, and Money.His assault on classicaleconomics starts theKeynesian Revolutionand ushers in a mercantilist revival.

“I want to do justice to schools of thought

which the classicals have treated as

imbecile for the last hundred years

and... to show that I ...have important

predecessors and am returning to an

age-long tradition of common sense.”

John Maynard Keynes in a letter to R.F. Harrod (August 27, 1935)

Keynes

The Great Depression (1929-1933)

Mercantilist views are prevalent

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inflation-unemployment trade-offs remain to beexploited. True, like David Hume, they acknowl-edged that short-run trade-offs might still exist.Unanticipated rises in inflation, by lowering realwages, could stimulate employment and outputtemporarily. But once the increased inflationwas fully perceived, anticipated, and thereforeincorporated into nominal wage rates, theresulting rise in real wages would restoreunemployment to its natural equilibrium level.In this way, the adjustment of expected to actu-al inflation transforms downward-slopingPhillips curves into a vertical line at the naturalrate of unemployment. The classicals wereright. Inflationary stimuli are temporary, neverpermanent. One cannot use a higher stable rateof inflation to peg the unemployment rate atarbitrarily low levels since there are no perma-nent employment gains to be had at any steadyrate of inflation. Such gains can be had, if indeedthey are available at all, only at the cost of ever-accelerating inflation.

Many Keynesians eventually came to acceptthe natural rate hypothesis. Even so, they stillcontended that disinflation was too costly topursue. Their fear stemmed from early versionsof the expectations-augmented Phillips curve.33

Those versions embodied the assumption thatagents revise their inflationary anticipationsdownward in mechanical, or adaptive, error-learning fashion only when actual, reportedinflation turns out to be lower than expected.Accordingly, if the authorities sought to eradi-cate inflationary expectations – an absolute

22

requirement of any successful disinflationarypolicy – they would have to force actual infla-tion below expected inflation thereby inducingthe latter to adjust toward the former as it con-verged on the desired target rate. Thissequence required the central bank to employcontractionary monetary policy to raise unem-ployment above its natural level. The resultingexcess unemployment would put downwardpressure on the actual rate of inflation to whichthe expected rate would adjust with a lag.Through this long and painful error-learningadjustment process, both actual and anticipatedinflation eventually would be squeezed out ofthe economy, albeit at the cost of much lostoutput and employment.

Rational Expectations Lower the Cost of DisinflationThe seventh monetarist/new classical milestonedisposed of this Keynesian concern. Pairing JohnMuth’s (1961) seminal work on rational expec-tations with Friedman’s natural rate hypothesis,Robert Lucas (1972) and Thomas Sargent andNeil Wallace (1975) showed that if expectationsare formed rationally rather than mechanicallythen disinflation need not be a painful drawn-out process. On the contrary, the unemploy-ment cost of disinflation might be far less thanKeynesians feared. For if people formed theiranticipations rationally, they would take intoaccount all systematic, and therefore pre-dictable, future disinflationary policy actions andembody them in their price forecasts. Provided

1940 19501944 1945

D-Day

Bretton Woods planfor post-war monetaryorder calls for theestablishment of theInternational MonetaryFund and World Bank.

Criticism of the Keynes-ian model emerges to set the stage for themonetarist counter-revolution.

Gottfried Haberler (1941),A.C. Pigou (1943, 1947),and Don Patinkin (1948)explain how a real cashbalance effect works tostimulate consumptionspending and to restorefull employment follow-ing a depression.

Sir Winston Churchill becomesprime minister of Great Britain.

Invention of thefirst atomic bomb

1953

James Watsonand Francis Crickpropose a doublehelical structurefor DNA.

Mercantilist views are prevalent

Clark Warburton’s empiricalwork provides evidence, contrary to Keynes’s liquiditytrap and interest-unresponsiveinvestment schedule models,of money’s power to influencespending.

World War II (1939-1945)

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policymakers behaved in a non-haphazard, cred-ible fashion, actual and expected rates of infla-tion and disinflation would coincide such thatno gap would develop between them. With nogap, there would be no need for excess unem-ployment to generate it. Consequently, inflation,actual and expected, would be brought to itszero target level with no cost in terms ofexcess unemployment. In actuality, of course,this conclusion proved to be a bit too facile andsanguine. In a world in which wages and pricesare to some degree sticky or inflexible suchthat markets fail to clear instantaneously, evenrationally expected disinflation would incursome unemployment cost. Nevertheless, theanalysis showed that these costs could be muchlower than Keynesians feared.

Time Inconsistency Case For RulesThe last milestone was the time inconsistencyargument which strengthened the classical casefor rules by showing how they reinforce policycredibility. Enunciated by Finn Kydland andEdward Prescott (1977) and by Robert Barroand David Gordon (1983a,b), the argument issimplicity itself. Suppose a discretionary, fine-tuning central bank wants to eradicate infla-tionary expectations so it can have a favorabletemporary inflation-unemployment trade-off toexploit.The bank announces its intention to pur-sue a policy of price stability. It assumes peoplewill believe the announcement and revise theirinflation predictions accordingly. The announce-ment, however, lacks credibility. Private agents

23

realize that once their new price predictionsare formulated and acted upon, the bank will betempted to renege on its promise and create asurprise inflation in order to boost output andemployment. Such knowledge induces therational public to discount the announcementand to maintain inflationary expectations at lev-els high enough to remove the bank’s tempta-tion to cheat. The result is that equilibriumunemployment is no lower than it otherwisewould be, and yet equilibrium inflation is toohigh. What prevents inflation from immediatelydropping to zero at the natural rate of unem-ployment is the central bank’s inability to prom-ise credibly not to create surprise inflation.Needed is something to convince the public thatthe central bank will not succumb to the temp-tation to inflate. That something is a monetaryrule replacing the bank’s discretionary powerwith a precommitment binding it irrevocably toprice stability.34 In demonstrating as much, thetime inconsistency argument reinforced theclassical case for rules.35

The cumulative effect of the foregoing devel-opments was to shift mainstream monetaryopinion away from the extremes of Keynesianmercantilism toward classical monetarism. Notall Keynesian doctrines were abandoned, ofcourse.Nor were all monetarist ones embraced.On the contrary, mainstream opinion assimilat-ed an eclectic amalgam of competing views. Buta new consensus definitely had emerged. Afterfour or five decades of mercantilist dominance,the classical view was at the wheel once again.

1960 19701961 1962 1963

Berlin Wall is erected.

Cuban Missile Crisis

President John F. Kennedyis assassinated.

1967 1968 1969

Martin Luther King, Jr.,is assassinated.

1958

In the tradition ofHenry Simons’s 1936case for rules overdiscretion, MiltonFriedman enunciateshis famous k-percentmoney growth rate rule.

Friedman and Anna Schwartz corrobo-rate Warburton by showing, in theirmonumental A Monetary History of theUnited States: 1870-1960, that a severemonetary contraction caused or intensi-fied the Great Depression.

Incorporating inflationexpectations into thePhillips curve, Friedmanand Edmund Phelpsposit the natural ratehypothesis. This conceptsays that, when expect-ed inflation adjusts toactual inflation, realactivity returns to itsnatural equilibrium levelsuch that no permanentinflation-unemploymenttrade-offs remain to be exploited.

First astronautwalks onthe moon.

A.W. Phillipspresents hisempirical Phillipscurve relatingthe rate of wageand price infla-tion to the unem-ployment rate.

Keynesians interpret the Phillips curveas a stable trade-off relationship permit-ting the policymakers to achieve perma-nently lower unemployment rates at thecost of higher stable rates of inflation.

Phillips Friedman Schwartz

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Three centuries of monetary controversy andexperience have established certain hard-wonclassical truths. Inflation and deflation are mon-etary rather than cost-push phenomena. Thereare no long-run inflation-output trade-offs toexploit; central banks cannot permanently pegreal variables at disequilibrium levels. Attemptsto do so produce explosive, ever-worseninginflation or deflation. Money-stock changes atbest affect output and employment temporarily.The output effect vanishes when prices adjust;all that remains is a changed rate of inflation.Stability of the value of money is a prerequisiteof an efficiently functioning real economy. Allnon-negligible inflation rates violate this prereq-uisite and are therefore harmful. Monetary rulescontribute to such stability.

Presently these truths are in the driver’s seat.The proof is that many central bankers now viewtheir primary mission as providing a stable price-level environment within which businesspeoplecan receive accurate market signals and allocateresources efficiently. Still the classical wisdom,though ruling, is hardly secure. For mercantilistviews continue to abound. Even today, someeconomists still insist that it is better to livewith inherited inflation than to fight it becausedisinflation is too costly to pursue. Others echoSteuart’s cost-push theory, attributing the disin-flation of the 1990s to such nonmonetary forcesas increased global competition, rapid techno-

24

1970 19801972 19741973 1975

The personal com-puter is born with Ed Roberts’s inventionof the MITS Altair.

Nicholas Kaldor’sThe Scourge ofMonetarism repre-sents the peak ofpost-Keynesianskepticism of thequantity theory of money.

Robert Lucas scrutinizes Keynesian fears ofcostly disinflation. Using John Muth’s conceptof rational expectations, he shows that allPhillips curve trade-offs, temporary and per-manent, vanish provided (1) agents form theirinflation expectations rationally rather thanadaptively, (2) price flexibility prevails so thatmarkets clear, and (3) the authorities conductpolicy in systematic, credible fashion. Theseconditions render disinflation costless.

1982

5

Conclusion

logical progress, falling computer and health-care costs,weakened power of labor unions, andthe like. Still others evoke the Steuart-Keynesimage of liquidity traps in holding that monetarypolicy is powerless to stimulate the currentlydepressed Japanese economy. Commentatorseven parrot Law’s monetary theory of interestwhen they cite Japan’s low interest rates as proofthat the country is awash with money when theopposite is true. And always there are thosewho argue that, with prices determined by realconsiderations, monetary policy should be freeto pursue nonprice objectives such as achievingfull employment and maximizing real growth.

The challenge then is to ensure that the clas-sical truths will not be forgotten. But that is atall order given that memories fade, that centralbank leadership changes, that the current gener-ation of economists familiar with the Keynesian-monetarist controversy is passing from thescene, that revisionist scholars can be countedupon to reinterpret the record radically, andthat future generations may well be as reluctantas the present one to study the lessons of thepast. The task of countering these influencesand preserving the classical wisdom falls to thedoctrinal historian. As curator of the stock ofeclipsed and unfashionable ideas, he has hiswork cut out for him.

An even more important challenge is toembed, or lock, the classical truths into endur-

The Volcker disinflation (1978-1984)

The Great Inflation (1968-1984)

Responding to the naturalrate hypothesis, Keynes-ians argue that whenagents form their inflationexpectations adaptivelyin mechanical error-learning fashion, realactivity returns very slow-ly to its natural level. If so, then disinflation istoo costly to pursue andsociety must learn to livewith inherited inflation.

Bretton Woods fixed-exchange-rate systemabandoned: world leaves the gold standard.

Lucas

Classical views are prevalent

Finn Kydland and Edward C.Prescott state the time inconsis-tency case for replacing policy-maker discretion with a pre-commitment binding the author-ities irrevocably to the objectiveof achieving price stability.

Following the Israeli-Arab War, oil-producing countries quadruple oil

prices leading to an energy crisisand queues at the gas pumps.

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1990 20001989 1991

Persian Gulf War

Hubble Space Telescopeput in orbit.

Human Genome Project aimedat mapping and sequencing allhuman DNA nears completion.

Fall of theBerlin Wall

1987

Crash of the U.S. Stock Market

Popularity of the Internet

Central bankers worldwide give precedence to the goal of price stability.

ing institutional arrangements that allow noroom for mercantilist policy alternatives.To thisend, proponents of the classical view propose avariety of possible arrangements. These include(1) congressional mandates for price stability,(2) formal contracts between elected govern-ments and central banks fixing quantitative tar-gets for price-level behavior, (3) guaranteedindependence for central bankers to insulatethem from the political pressure to inflate, and(4) the appointment of conservative, inflation-averse central bankers committed to the goal ofprice stability.The trouble is, however, that noneof these proposed arrangements can assurethat classical policies will reign supreme for alltime. Mandates can be changed, contracts ter-minated, guarantees revoked, and appointmentsaltered. The upshot is that it is too early to

The Fed worked hard

to build credibility

as an inflation-fighter

and desires to maintain

that credibility;

policy rules help.

declare a permanent victory for the classicalview. Indeed, there may always be a market forthe opposing view that central banks need notand must not be bound to the goal of price sta-bility. For better or worse, that view will chal-lenge the classical view whenever the publicperceives unemployment or sluggish realgrowth rather than inflation to be the dominanteconomic problem.

Still, the inherent cyclicality of ideas suggestsan inevitable classical response to that chal-lenge. Classicism, in short, will return to promi-nence to be confronted anew. For historyshows it to be nothing if not resilient. Over longspans of time, it has proved resistant to thekinds of economic shocks that occasionally pro-pel mercantilists to prominence. That is one ofthe chief insights of doctrinal history.

Kaldor

The EuropeanMonetary Unionand the EuropeanCentral Bank are launched.

The U.S. enjoys itslongest peacetime expan-sion while disinflationbrings the price levelclose to absolute stability.

full-employment-at-any-cost counterparts of the Birmingham School, especially theAttwood brothers, Thomas and Matthias,were gravely concerned with it.

20. See Hume (1752, pp. 47-59); Ricardo(1951-73, I, pp. 363-4; III, pp. 88-89, 91,92;IV, p. 233; V, p. 445); Thornton ([1802] 1939,pp. 253-56).

21. Thornton ([1811] 1939, p. 342). He([1802] 1939, pp. 244, 253-6) applies thesame criticism to the real bills doctrinewhich ties the issue of bank money (notesand checking deposits) to the nominal vol-ume of commercial paper that borrowersoffer as collateral for bank loans.

22. For classic accounts of the CurrencySchool-Banking School debate, see Viner(1937, Ch. 5), Fetter (1965, Ch. 6), Robbins(1958, Ch. 5), and Mints (1945, Ch. 6). Forrecent interpretations, see O’Brien (1975,pp. 153-59) and Schwartz (1987).

23. With the exception of John Wheatley,classicals held that national price levels coulddeviate temporarily from their purchasingpower parity, or long-run equilibrium, levels.

24. O’Brien (1975, p. 153) credits Joplin,Drummond, Page, Pennington, and McCul-loch with the simultaneous enunciation of the metallic principle.

25. Because these doctrines are consistentwith those of the monetary approach tothe balance of payments, Skaggs (1999)interprets the Banking School as early antic-ipators of that approach. Even so, theSchool hardly derived its conclusions fromthe logic of the monetary approach. Theconclusions may have been the same, butthey were reached by a different route.

26. On Tooke’s interest cost-push theoryand Knut Wicksell’s definitive critique of it,see Humphrey (1998, pp. 60-64).

27. Before he abandoned classicism, Keyneswas one of its luminaries. Both his 1923 A Tract on Monetary Reform and his 1930 A Treatise on Money are squarely in the clas-sical tradition. He returned to the classicalfold shortly before his death in 1946.

28. Keynes applied this notion to a closedeconomy. He was not referring to the case where, with foreign prices given andthe exchange rate fixed, the real terms of trade drives the price level in a smallopen economy.

29. On the cost-push pricing theories of Keynes and his followers, see Tavlas(1981, pp. 324-330).

30. On the mercantilists’ policy goal of full employment, see Grampp (1952).

31. See Haberler (1941, pp. 242, 389, 403),Pigou (1943, 1947), and Patinkin (1948, 1965).

32. See Warburton (1966) for a collectionof his relevant papers, many publishedbetween 1944 and 1953.

ENDNOTES

1. Additional famous policy debates pittingmercantilists and classicals include (1) theSwedish Bullionist controversy (1755-1765),(2) the English Bullionist-Antibullionist,or Bank Restriction, dispute (1797-1821),(3) the Bimetallism debate (1880-1896),and (4) the German hyperinflation debate(1922-1923).

2. Because anti-quantity theory elementsalso characterize the fixed-exchange-rate,small-open-economy case of the monetaryapproach to the balance of payments, someobservers may be tempted to equate mer-cantilism with that approach. In fact, howev-er, the two theories differ markedly. First,the monetary approach applies the quantitytheory, rather than its opposite, to closed-economy and inconvertible-paper, floating-exchange-rate regimes. By contrast, mercan-tilists, with few exceptions, tended to applythe anti-quantity theory indiscriminately toall regimes. Second, the monetary approachrejects the mercantilist money-stimulates-trade doctrine.

3. On Law’s monetary theory, see Murphy(1997, Chs. 6 and 8) and Hutchison (1988,pp. 134-40). On Steuart’s theory, see Eltis(1986), Hutchison (1988, pp. 341-51), Meek(1967), and Skinner (1981).

4. Law’s fear of monetary shortage undera metallic standard is incompatible with the monetary approach to the balance ofpayments. The latter sees a small openeconomy, like Scotland, taking its price levelas given from the closed world economywith money then flowing in through thebalance of payments to support that pricelevel such that no monetary shortageoccurs. Of these two propositions, Law recognized the first but denied the second.See Murphy (1997, Ch. 8).

5. See Blaug (1996, p. 16).

6. On Steuart’s cost-push theory, seeScrepanti and Zamagni (1993, p. 53).

7. Not all mercantilists were as sanguineas Steuart on hoards. Indeed they weresomewhat ambivalent on the subject.Hoards to them could be either desirableor undesirable. On the one hand, hoards,by draining excess cash from circulation,would tailor the remaining stock preciselyto the needs of trade. On the other hand,if output and so the needs of trade wereexpandable under the impact of a monetarystimulus, such hoards, by removing thesource of that stimulus, could unduly con-strain real activity. Even so, such hoardswould see to it that no monetary excessever developed to spill over into the com-modity market to bid up prices.

8. See Screpanti and Zamagni (1993, p. 53).

9. Steuart of course never resorted tosuch modern terminology. Nevertheless,the concepts were his.

26

10. On Steuart’s statesman, see Eltis (1986)and Skinner (1981).

11. Law denied that the monetary expan-sion was excessive on the grounds thatmuch of it went to redeem outstandinggovernment bonds and equity claims to histrading firm. Since to him bonds and stocksshared money’s characteristic as a transac-tions medium, he saw them as exerting the same influence on spending. In his view,money swapped for bonds and equitiesleaves the total supply of financial purchas-ing power – money, bonds, and stocks –unchanged. Such monetary issue thereforeis noninflationary. He erred. Not beingtransactions media, bonds and stocks arefar from perfect substitutes for money inspending. Monetizing them can be inflation-ary. See Niehans (1990, p. 51).

12. See Murphy (1997) for an exhaustiveaccount of the rise and fall of Law’s system.

13. Thus a follower of Smith might attrib-ute Scotland’s penury not to monetary defi-ciency and the absence of banks, but ratherto lack of specialization and division oflabor resulting from a small population.

14. Cesarano (1998) argues that Humeactually rejected the price-specie-flowmechanism and its attendant relative priceeffects for the monetary approach to thebalance of payments. By contrast, the stan-dard view emphasized here holds that neither Hume nor his classical followerssubscribed to the approach’s proposition of instantaneous purchasing power parity,or law of one price.

15. See Ricardo (1951-73, I, pp. 46, 61-3,104-5, 126, 302-3, 307-8, 315).

16. See Hume ([1752] 1955, pp. 37-8, 47-8).

17. Classicals recognized still other sourcesof short-run nonneutrality including stickynominal interest rates, fixed nominalcharges such as rents and taxes, fixed nomi-nal incomes of wage earners and rentiers,confusion of relative- for absolute pricechanges, market size encouragement tospecialization and division of labor, anddeliberate efforts on the part of organizedgroups to maintain real incomes. SeeHumphrey (1993, pp. 251-63).

18. Hume ([1752] 1955, pp. 39-40) admit-ted that money might exhibit long-runsuper-nonneutrality. Being unanticipated(perhaps because agents formulate theirexpectations in a backward-looking way),a steady succession of money stock changesmight perpetually frustrate the attempt of prices to catch up and therefore perma-nently affect the level of real output.

19. Perhaps too cavalierly, classicals dis-missed or minimized the problem of unem-ployment. To them joblessness, while it certainly occurred from time to time, wasnecessarily short-lived and self-correctingthrough automatic wage, price, and interest-rate reductions. Only their inflationist,

27

33. See Taylor (1997, pp. 278-9).

34. Alternatively, an established reputationas a zealous inflation fighter would do.

35. The time consistency case for rules differs a bit from Friedman’s argument. Hesees rules as overcoming the central bank’sinability to predict the short-run impact of its actions. By contrast, the time inconsis-tency argument is that rules are good forcommitment reasons even though centralbankers have full knowledge of the impactof their moves.

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