An ancient debate among economists is whether the monetary authority should be subject to and constrained by an explicit operating rule or should be allowed discretion to act as it sees fit. The debate goes back to the Bullion Debates in Britain after the British government, in the early stages of the Napoleonic Wars, suspended the obligation of the Bank of England to convert their banknotes into gold at the legally prescribed value of the pound. One side in the debate, the Bullionists, argued that the Bank of England, enjoying special legal privileges that made it the center of the British monetary system, should be bound by a fixed rule, the absolute duty to convert Bank of England notes, on demand, into a fixed quantity of gold. The other side, the Anti-Bullionists, maintained that there was no need for the Bank of England to be bound by the obligation to convert.
Over 20 years of intermittent exchanges between opponents and supporters of the suspension, producing some of the most important contributions to monetary thought of the nineteenth century, the Bullion Debates led to a general (though not unanimous) acceptance of the need for convertibility into gold as a stabilizing anchor for a money and banking system in which private banks produce a large share of all the money in circulation. Despite the resumption of convertibility in 1821, Great Britain experienced damaging financial disturbances in 1825 and 1836, leading to the passage of Bank Charter Act in 1844, imposing a fixed limit on the total amount of banknotes issued by the Bank of England and by other private banks, requiring 100% gold cover for any banknotes issued beyond that fixed limit.
Hopes that, by mimicking the fluctuation of a purely gold currency in response to gold inflows and outflows, the reformed monetary system would avoid future crises were soon disappointed, Britain suffering financial crises in 1847, 1857, and 1866. Each time the government was forced to grant immunity to the directors of the Bank of England for violating the Bank Charter Act and issuing banknotes in excess of the legal maximum in order to calm commercial panics triggered by fears that the Bank of England would be prevented by the Bank Charter Act from satisfying the demand for credit. Once temporary suspension of the Act was announced, the panic subsided, the knowledge that credit could be obtained if needed sufficing to moderate the precautionary demand for credit.
By the last two decades of the nineteenth century, the Bank of England, the key institution managing what had become an international gold standard, seemed to have figured out how to do its job reasonably well, and the period of 1880 to 1913 is still looked upon as a golden age of economic stability, growth and prosperity. But the gold standard couldn’t withstand the pressures of World War I, effectively being suspended in substance in almost all countries. The attempt to recreate the gold standard in the 1920s led to the Great Depression, because the way the gold standard worked before World War I was not well enough understood for the system to be recreated, more or less from scratch, under the new postwar conditions. Attempting to follow a misguided conception of how a gold standard ought to work, countries, especially France, redesigned their monetary institutions in ways that inordinately increased the total world demand for gold, producing a world-wide deflation that began in the summer of 1929.
The two economists who really understood the nature of the pathology overtaking the international economy in 1929 were Ralph Hawtrey and Gustav Cassel, having warned of just the potential for a deflationary increase in the demand for gold as a consequence of a simultaneous restoration of the gold standard by many countries, but their warnings went largely unheeded. Instead, the focus of most economists, central bankers, governments, and practitioners of la haute finance, was to preserve the gold standard at all costs, because to tamper with the gold standard was to allow the unbridled exercise of discretion, to make monetary policy unpredictable, to sanction runaway inflation and monetary anarchy. But runaway inflation was not the danger — in Hawtrey’s immortal analogy to warn of inflation was like crying “fire, fire” in Noah’s flood – it was runaway deflation. But rules are rules, and one must always follow the rules. That the rules had been broken, or at least suspended, in the nineteenth century didn’t seem to matter, because as the old maxim teaches, we must do what is right though the world should perish.
The Great Depression came to an end mainly because the rules were not only broken, they were tossed out the window. The gold standard was junked. First, Britain gave up in September 1931, and a recovery started within a few months. The US held out till March 1933, but when Franklin Roosevelt became President, understanding that prices had to rise before a recovery could start, he suspended the gold standard, devalued the dollar, thereby igniting the fastest expansion of industrial output in any 4-month period (57%) in American history while the Dow Jones average nearly doubled.
In our own Little Depression, we have become attached – I would say dysfunctionally attached – to an inflation target of 2% or less. The inflation target is to the Little Depression what the gold standard was to the Great Depression. The consequences this time are less horrific than they were last time, but they are plenty bad. And the justification is equally spurious. I would not go so far as to say that rules are made to be broken. Some rules should not be broken under almost any circumstances, and almost any rule may have to be broken under some very extreme circumstances. But not every rule — certainly not a rule that says that inflation may never exceed 2% — is entitled to such deference.
The European union and the common European currency are now on the verge of disaster because the European Central Bank, dominated by a German aversion to inflation, refused to provide enough monetary expansion to allow the weaker members of the Eurozone to generate enough nominal income to service the interest obligations on their debt. In the Great Depression, it was Germany that was overindebted and unable to service its obligations. Attempting to play under the dysfunctional rules of the gold standard, Germany imposed draconian austerity measures in the form of tax increases and public expenditure reductions and wage cuts. But all such measures were doomed from the start. All that was accomplished was to pave Hitler’s path to power. And now, in a historic role reversal, it is Germany that is paving the way for consequences which we may not yet even be able to imagine. But evidently as long as the European Central Bank can achieve its inflation target, it will be worth it, because, as the old maxim teaches, one must do what is right even if the world should perish.