Robert Hetzel, a distinguished historian of monetary theory and of monetary institutions, deployed his expertise in both fields in his recent The Federal Reserve: A New History. Hetzel’s theoretical point departure is that the creation of the Federal Reserve System in 1913 effectively replaced the pre-World War I gold standard, in which the value of the dollar was determined by the value of gold into which a dollar was convertible at a fixed rate, with a fiat-money system. The replacement did not happen immediately upon creation of the Fed; it took place during World War I as the international gold standard collapsed with all belligerent countries suspending the convertibility of their currencies into gold, to allow the mobilization of gold to finance imports of food and war materials. As a result, huge amounts of gold flowed into the US, where of much of those imports originated, and continued after the war when much of the imports required for European reconstruction also originated there, with the US freely supplying dollars in exchange for gold at the fixed price at which the dollar was convertible into gold, causing continued postwar inflation beyond the wartime inflation.
Holding more than half the world’s total stock of monetary gold reserves by 1920, the US could determine the value of gold at any point (within a wide range) of its own choosing. The value of the dollar was therefore no longer constrained by the value of gold, as it had been under the prewar gold standard, because the value of gold was now controlled by the Federal Reserve. That fundamental change was widely acknowledged at the time by economists like Keynes, Fisher, Robertson, Mises, and Hawtrey. But the Fed had little understanding of how to exercise that power. Hetzel explains the mechanisms whereby the power could be exercised, and the large gaps and errors in the Fed’s grasp of how to deploy the mechanisms. The mechanisms were a) setting an interest rate at which to lend reserves (by rediscounting commercial bank assets offered as collateral) to the banking system, and b) buying or selling government securities and other instruments like commercial paper (open-market operations) whereby reserves could be injected into, or withdrawn from, the banking system.
In discussing how the Fed could control the price level after World War I, Hetzel emphasizes the confusion sewed by the real-bills doctrine which provided the conceptual framework for the architects of the Federal Reserve and many of its early officials. Hetzel is not the first to identify the real-bills doctrine as a key conceptual error that contributed to the abysmal policy mistakes of the Federal Reserve before and during the Great Depression. The real-bills doctrine has long been a bete noire of Chicago School economists, (see for example the recent book by Thomas Humphrey and Richard Timberlake, Gold, the Real Bills Doctrine and the Fed), but Chicago School economists since Milton Friedman’s teacher Lloyd Mints have misunderstood both the doctrine (though not in the same way as those they criticize) because they adopt a naive view of the quantity theory the prevents them from understanding how the gold standard actually worked.
Long and widely misunderstood, the real-bills doctrine was first articulated by Adam Smith. But, as I showed in a 1992 paper (reprinted as Chapter 4 of my recent Studies in the History of Monetary Theory), Smith conceived the doctrine as a rule of thumb to be followed by individual banks to ensure that they had sufficient liquidity to meet demands for redemption of their liabilities (banknotes and deposits) should the demand for those liabilities decline. Because individual banks have no responsibility, beyond the obligation to keep their redemption commitments, for maintaining the value of their liabilities, Smith’s version of the real-bills doctrine was orthogonal to the policy question of how a central bank should discharge a mandate to keep the general price level reasonably stable.
Not until two decades after publication of Smith’s great work, during the Napoleonic Wars that confusion arose about what the real-bills doctrine actually means. After convertibility of the British pound into gold was suspended in 1797 owing to fear of a possible French invasion, the pound fell to a discount against gold, causing a general increase in British prices. The persistent discount of the pound against gold was widely blamed on an overissue of banknotes by the Bank of England (whose notes had been made legal tender to discharge debts after their convertibility into gold had been suspended. The Bank Directors responded to charges of overissue by asserting that they had strictly followed Smith’s maxim of lending only on the security of real bills of short duration. Their defense was a misunderstanding of Smith’s doctrine, which concerned the conduct of a bank obligated to redeem its liabilities in terms of an asset (presumably gold or silver) whose supply it could not control, whereas the Bank of England was then under no legal obligation to redeem its banknotes in terms of any outside asset.
Although their response misrepresented Smith’s doctrine, that misrepresentation soon became deeply imbedded in the literature on money and banking. Few commentators grasped the distinction between the doctrine applied to individual banks and the doctrine applied to the system as a whole or to a central bank issuing a currency whose value it can control.
The Bank Directors argued that because they scrupulously followed the real-bills doctrine, an overissue of banknotes was not possible. The discount against gold must therefore have been occasioned by some exogenous cause beyond the Bank’s control. This claim could have been true only in part. Even if the Bank did not issue more banknotes than it would have had convertibility not been suspended, so that the discount of the pound against gold was not necessarily the result of any action committed by the Bank, that does not mean that the Bank could not have prevented or reversed the discount by taking remedial or countervailing measures.
The discount against gold might, for example, have occurred, even with no change in the lending practices of the Bank, simply because public confidence in the pound declined after the suspension of convertibility, causing the demand for gold bullion to increase, raising the price of gold in terms of pounds. The Bank could have countered such a self-fulfilling expectation of pound depreciation by raising its lending rate or otherwise restricting credit thereby withdrawing pounds from circulation, preventing or reversing the discount. Because it did not take such countermeasures the Bank did indeed bear some responsibility for the discount against gold.
Although it is not obvious that the Bank ought to have responded in that way to prevent or reverse the discount, the claim of the Bank Directors that, by following the real-bills doctrine, they had done all that they could have done to avoid the rise in prices was both disingenuous and inaccurate. The Bank faced a policy question: whether to tolerate a rise in prices or prevent or reverse it by restricting credit, perhaps causing a downturn in economic activity and increased unemployment. Unwilling either to accept responsibility for their decision or to defend it, the Bank Directors invoked the real-bills doctrine as a pretext to deny responsibility for the discount. An alternative interpretation would be that the Bank Directors’ misunderstanding of the situation they faced was so comprehensive that they were oblivious to the implications of the policy choices that an understanding of the situation would have forced upon them.
The broader lesson of the misguided attempt by the Bank Directors to defend their conduct during the Napoleonic Wars is that the duty of a central bank cannot be merely to maintain its own liquidity; its duty must also encompass the liquidity and stability of the entire system. The liquidity and stability of the entire system depends chiefly on the stability of the general price level. Under a metallic (silver or gold) standard, central banks had very limited ability to control the price level, which was determined primarily in international markets for gold and silver. Thus, the duty of a central bank under a metallic standard could extend no further than to provide liquidity to the banking system during the recurring periods of stress or even crisis that characterized nineteenth-century banking systems.
Only after World War I did it become clear, at least to some economists, that the Federal Reserve had to take responsibility for stabilizing the general price level (not only for itself but for all countries on the restored gold standard), there being no greater threat to the liquidity—indeed, the solvency—of the system than a monetarily induced deflation in which bank assets depreciate faster than liabilities. Unless a central bank control the price level it could not discharge its responsibility to provide liquidity to the banking system. However, the misunderstanding of the real-bills doctrine led to the grave error that, by observing the real-bills doctrine, a central bank was doing all that was necessary and all that was possible to ensure the stability of the price level. However, the Federal Reserve, beguiled by its misunderstanding of the real-bills doctrine and its categorical misapplication to central banking, therefore failed abjectly to discharge its responsibility to control the price level. And the Depression came.
Uneasy Money 