Monetary Economics in the 1990s

In recent years there has been a lot of discussion about US budget deficits. Many economists and other observers have viewed these deficits as harmful to the US and world economies. The supposed harmful effects, predicted by theories of the life-cycle type, include high real interest rates, low saving, low rates of economic growth, large current-account deficits in the United States and other countries with large budget deficits, and either a high or low dollar (depending apparently on the time period). On the other hand, this crisis scenario has been hard to maintain along with the robust performance of the US economy since late 1982. This performance features high average growth rates of real GNP, declining unemployment, much lower inflation than before, a sharp decrease in nominal interest rates and some decline in expected real interest rates, high values of real investment expenditures, and a dramatic boom in the stock market.

Political economy tries to explain the conduct of economic policy. There are two approaches. One is to assume that economic policy makers want to maximize a — somehow defined — welfare function of their people. This is the public interest view of government. It treats nations as the basic decision units. The other approach is the public choice perspective. It assumes that economic policy makers can, and often do, act against the public interest. It tries to explain economic policy by their personal preferences and restrictions. Since policy makers always claim to be guided by the public interest, the public choice approach is inherently critical and distrustful. Since policy makers try to justify their actions with normative economic theories, the public choice theorist faces a double task: he must show that these normative arguments are false or inapplicable, and he must present his own alternative explanation.

Speculative booms and crashes have been observed throughout history. In the first century Pliny reported a boom in land prices in the vicinity of Rome, a ‘sudden advance’ in prices which he said was ‘much discussed’ at the time.¹ There was a boom in the prices in, of all things, tulip bulbs in Holland in 1637, where prices rapidly ascended until one record-setting bulb sold for 5500 guilders or about £25 000 at today’s price of gold. This bizarre boom was followed the same year by a dramatic collapse, after which bulbs could not be sold at 10 per cent of their peak price. Then there was the Florida land price boom of the mid-1920s, when people seemed suddenly to conclude that available land in this vacation spot and mecca for retirees was suddenly running out; prices soared. They soon found out that land was not so scarce after all: prices dropped precipitously in 1926. Then of course there was the stock market boom of the 1920s, with prices rising almost five-fold between Summer 1921 and Fall 1929. Following this there was a crash: between 3 September 1929 and 8 July 1932 the Dow Jones Industrial Average lost 84.4 per cent of its real (inflation-corrected) value, and lost 12.8 per cent of its value in one day, 28 October 1929.

There is more to the history of macroeconomics than a series of bilateral conflicts between competing schools of thought, but such debates have been a significant part of the story. Most recently the competing schools have worn the labels ‘New-classical’ and ‘New-Keynesian’, and the major issue between them has been the role of money wage- and price-stickiness in generating those more or less regular fluctuations in economic activity which we refer to as ‘the business cycle’. For New-classicals, output and employment fluctuations are either responses to shocks to tastes and technology, or to unanticipated shifts in aggregate demand, typically stemming from money supply changes. In either cases though, prices give signals to which quantities respond, and variations in real magnitudes take place precisely because prices change. New-Keynesians emphasise demand-side shocks but, in their view, quantities vary, not because prices vary, but because they do not.

I perhaps owe my readers an apology for referring once again to the doctrine of lender of last resort. The late Fred Hirsch brought the subject to the forefront of discussion with a brilliant paper half a generation ago (Hirsch, 1977). Hugh Rockoff discussed it earlier in this series honouring Henry Thornton (1986). Governor Carlo Ciampi of the Bank of Italy lectured on the subject in his own country in February of this year (Ciampi, 1992). The issue has been pursued in at least two of my books (1986, Chs. ix, x; 1993, passim, but especially pp. 277–83 of the 1984 edition). On this occasion, however, my purpose is not to defend the doctrine in the face of monetarists who believe that the money supply should be fixed, or grow at a fixed rate, rather than be allowed to expand in periods of widespread illiquidity and distress. That issue, to my mind, has been settled in favour of a lender of last resort in financial crisis. Rather, I suggest that the world may have pushed the doctrine too far with deposit insurance for commercial banks and thrifts, the rescue from bankruptcy of such bodies as New York City, some corporations such as Penn Central, Lockheed and Chrysler Corporation, banks ‘too big to fail’ even though their deposits exceed insured limits by wide margins, brokerage houses that loaned to such a commodity speculator as Bunker Hunt, who tried to corner the world silver market in the early 1980s. Even now in Japan, government money is called upon to make whole an institution owned by a rich bank, the troubles of which were caused by fraud rather than mistakes (The Economist, 1992, p. 105). Many high-minded principles suffer from entropy or decay over time, and the lender of last resort may be one of them.

A lecture on the ‘Conduct of Monetary Policy in an Open Economy’ is easily linked to the ideas of Henry Thornton who contributed significantly to the theory of money of his time, even though the underlying conditions have changed at the end of the twentieth century.

It is always a pleasure to return to London, where I spent fifteen happy months associated with the International Monetary Research Programme in 1975–6. Those were eventful days in Britain’s postwar economic history — in a manner that is relevant to the subject of this lecture. In 1975, the inflation rate in the United Kingdom hit an historic peak of 25 per cent.

Money and interest rates have always been discussed in an ethical and moral context. For a long time charging interest was considered disreputable, and at times liable to hard secular and ecclesiastical punishment. The second Lateran Council, for example, decided in 1139:

Furthermore, we condemn that practice accounted despicable and blameworthy by divine and human laws, denounced by Scripture in the Old and New Testaments, namely, the ferocious greed of usurers; and we sever them from every comfort of the church, forbidding any archbishop or bishop, or an abbot of any order whatever or anyone in clerical orders, to dare to receive usurers, unless they do so with extreme caution; but let them be held infamous throughout their whole lives and, unless they repent, be deprived of a Christian burial.¹