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19 9 8 A N N U A L R E P O R T
Federal Reserve Bank of Richmond
MERCANTILISTS
and CLASSICALS:
Insights From
Doctrinal History
A Message from the President
and First Vice President
We are pleased to present the Bank’s Annual Report for 1998. The Federal Reserve System faced
important challenges in 1998, including considerable turbulence in domestic and international financial markets in the second half of the year, continued rapid consolidation in the banking industry, and
strong demand from depository institutions for efficient and innovative financial services. Ensuring
that data processing and communications systems make a smooth transition to the next century and
that the general public is provided with clear and useful information about System activities and
accomplishments were also priorities throughout the year.
We believe this Bank made important contributions to the System’s efforts to meet these challenges, as highlighted in the “Year in Review” section of this Report. The Bank opened a new supervision and regulation office in Charlotte to enhance supervisory oversight; some of the largest banking organizations – the result of the latest wave of bank mergers – are based in North Carolina. Our
financial services activities fully met their cost recovery and quality objectives for priced services in
1998, and several Bank staff members played leadership roles in Systemwide efforts to improve payments and other services to depository institutions and the U.S. Treasury. In an effort to increase
our communication and interaction with new constituencies, our Community Affairs Office formed
a new Community Development Advisory Council comprised of community group leaders from
across the District. Also, a member of our Public Affairs staff was instrumental in establishing a new
national center for economic education for the hearing impaired at Gallaudet University. Finally, in
1998, the Bank achieved all of its benchmark objectives with respect to its preparation for the century date change.
The approach to the new millennium provides a particularly appropriate occasion to review, in
broad perspective, the long discussion over what monetary policy can and cannot accomplish. During
the past three centuries, a succession of events, episodes, and policy controversies reveal that certain
classical theories of monetary policy have stood the test of time far better than other theories
whose superficial, albeit fallacious, logic makes them perennially popular with the general public. It is
important to distinguish the robust from the fallacious theories and to lock the former into place
so that past policy errors will not be repeated. We are pleased to have Tom Humphrey, arguably the
world’s leading historian of the quantity theory of money, review the debates between mercantilist
and classical theories of monetary policy in the feature article.
J. Alfred Broaddus, Jr.
Walter A. Varvel
PRESIDENT
FIRST VICE PRESIDENT
1
MERCANTILISTS
and CLASSICALS:
Insights From Doctrinal History
Thomas M. Humphrey
Thomas M. Humphrey is a vice
president and economist in the
Research Department. He has
2
served as long-time editor of the
Bank’s Economic Quarterly.
The views expressed do not
necessarily reflect those of the
Federal Reserve System.
1
Introduction
Economists typically view their discipline as a
progressive science in which superior new ideas
relentlessly supplant inferior old ones in a Darwinian struggle toward the truth. Thus it came
as something of a shock when Milton Friedman
challenged this belief in the May 1975 issue of
the American Economic Review. In response to
the question “What have we learned in the past
25 years?”, Friedman argued that what monetary economists have learned since 1950 are
hardly new ideas but rather a rediscovery of old
ideas inherited from David Hume and his contemporaries more than 200 years ago.
Three years later, the British economist
Ivor F. Pearce shocked his readers even more.
He denied that the Keynesian Revolution had
contributed a single new or useful idea to monetary economics. Instead, he (1978, p. 93) insisted that “human history is guided not by new
ideas, for there are none,” but rather by “some
ephemeral sub-group of... old ideas.” Such old
ideas, “often believed to be new,” are “seized
upon as the . . . solution to whatever difficulties
immediate experience has made to seem
important, and congealed into a crust of dogma
by endless repetition and obeisance.”
. . . much of the history
of monetary theory
reduces to a struggle
between opposing
mercantilist and
classical camps.
The above sentiments express what every
doctrinal historian knows, namely that much of
what passes for novelty and originality in monetary theory and policy is really ancient teaching dressed up in modern guises. To be sure, the
increasing application of mathematical modeling
has given these concepts greater rigor and precision. Likewise, better data and more powerful
empirical techniques have improved our statistical estimates of the relevant quantitative magnitudes. Still, the basic ideas themselves often
remain much the same. Thus instead of a steady
progression of new paradigms, one sees repeated cycles of existing ones whose periodic rise
and fall perpetually casts them in and out of
fashion.
By itself, this recycling of established ideas
need be no cause for alarm.Theories may survive
because experience indicates that they possess
a high degree of validity and because no better
theories have been found. The trouble is, however, that sound theories are not the only ones
to survive. Unsound theories may coexist with
the sound ones.
Unfortunately, policymakers and the general public are in no position to realize as much.
Preoccupied by the pressing problems of the
day, they have neither the time, inclination, or
training, nor indeed the duty to trace the history of the ideas they employ or endorse. They
have no reason to be aware of earlier policy
debates in which sound theories were distinguished from fallacious ones. The result is
twofold. Policymakers may subscribe to old
theories under the mistaken impression that
those theories are new. Worse, they may unwittingly deploy policies whose underlying theory
has been challenged and found wanting in earlier policy debates.
Here is where the doctrinal historian can
help. His comparative advantage lies in identifying the origin and tracing the evolution of rival
monetary doctrines across a succession of writers, events, episodes, and policy controversies.
3
4
Each such incident constitutes a test, or observation, of the relative strengths and weaknesses
of the competing doctrines. While no single test
can yield conclusive results, many such tests
may do so. Taken together, they reveal which
doctrine has emerged from past experience as
the more robust analytically. By demonstrating
as much, the historian specifies those ideas that
seem to offer the most effective basis for public policy. Of course, there is no assurance that
the policymaker will heed the doctrinal historian and employ the best ideas. On the contrary,
he may reject them or temporarily accept and
subsequently abandon them. Here again the historian has something to say. His study of the
forces influencing the receptivity and implementation of ideas permits him to predict a
doctrine’s prospective success or failure. In this
manner, the unique perspectives of doctrinal
history may prove their worth.
This article puts those perspectives to
work. It shows that from a broad standpoint,
much of the history of monetary theory
reduces to a struggle between opposing mercantilist and classical camps. Mercantilists, with
their fears of hoarding and scarcity of money
together with their prescription of cheap (low
interest rate) and plentiful cash as a stimulus to
real activity, tend to gain the upper hand when
unemployment is the dominant problem. Classicals, chanting their mantra that inflation is
always and everywhere a monetary phenomenon, tend to prevail when price stability is the
chief policy concern.
Currently, the classical view is in the driver’s seat. By all rights it should remain there
since it long ago exposed the mercantilist view
as fundamentally flawed. It is by no means certain, however, that the classical view’s reign is
secure. For history reveals that, whenever one
view holds center stage, the other, fallacious or
not, is waiting in the wings to take over when
the time is ripe. In this manner, the mercantilism
of John Law and Sir James Steuart gave way to
the classicism of David Hume and David Ricardo,
the Currency School’s classicism bowed to John
Maynard Keynes’s mercantilism, the mercantilist
doctrines of Keynes’s disciples yielded to Milton
Friedman’s classical monetarism, and so forth.
Even today, with central bankers in several
nations expressing commitment to the classical
goal of price stability and monetarists advocating systematic, zero-inflation rules for monetary
policy, mercantilist undercurrents still run
strong. Supply-siders who argue that monetary
policy must be accommodative to allow tax cuts
to work their magic echo mercantilist opinion.
So too do those who contend that, with global
competition and rapid technological progress
holding inflation in check, monetary policy is
free to pursue nonprice objectives such as
boosting growth and achieving full employment.
Finally, observers who believe that monetary
policy is powerless to stimulate the currently
depressed Japanese economy harbor mercantilist fears of unspent hoards of idle cash.
The following paragraphs attempt to spell
out the core propositions of the original mercantilist and classical views and to establish the
centrality of those propositions in the famous
Currency School-Banking School and Keynesianmonetarist controversies – the two leading
monetary policy debates of the nineteenth and
twentieth centuries.1 From this doctrinal historical exercise, three themes emerge. First, with
some exceptions, classicals tend to be quantity
theorists; mercantilists, anti-quantity theorists.
Second, classicals prefer rules; mercantilists, discretion. Third, for all their cogency, classicals
may be doomed to face a perpetual mercantilist
challenge. As long as some observers continue
to believe, rightly or wrongly, that inflation and
deflation are nonmonetary, or real, phenomena
and that unemployment is a monetary one
capable of correction by the central bank, the
debate will be unending.
2
Mercantilist and Classical Monetary Doctrines
The roots of the debate trace back to the original mercantilist writers of the preclassical era
1550-1770. Those writers argued that a nation’s
stock of precious metals constituted the source
of its plenty (wealth), power, prestige, and prosperity. For countries possessing no gold mines,
augmentation of those conditions required the
accumulation of specie through foreign trade.
Accordingly, mercantilists advocated protectionist policies in the form of export promotion
and import restriction schemes to obtain a permanent trade balance surplus matched by corresponding persistent inflows of specie from
abroad.
This policy prescription was of course the
mercantilists’ main claim to fame. But the hallmark that secures them a permanent niche in
the history of monetary doctrines was their
contra- or anti-quantity theory of money. 2 They
used that theory to deny that money determines
prices and to tout the employment benefits of
money-stock expansion fueled either by specie
inflows or by paper money creation should
those inflows languish. Consisting of at least
seven propositions, the mercantilists’ contraquantity theory held that (1) money stimulates
trade, (2) real cost-push forces determine the
price level and the inflation rate, (3) the interest
rate is a purely monetary variable whose level,
high or low, is proof of the scarcity or abundance of money, (4) idle hoards absorb any cash
not employed in driving trade, (5) causality runs
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.
from prices and real activity to money such that
the money stock passively adapts to the needs
of trade, (6) overissue is impossible when the
money stock is backed by the nominal value of
real property, and (7) discretion outperforms
rules in the conduct of monetary policy.
John Law (1671-1729)
The clearest and most emphatic statements of
the foregoing propositions came from John Law
and Sir James Steuart, two economists writing
near the close of the mercantilist era.3 Of the
two, Law’s name is synonymous with the moneystimulates-trade doctrine that forms the central
core and theme of his 1705 Money and Trade
Considered; with a Proposal for Supplying the
Nation with Money. Writing against the backdrop
of a chronically depressed and underemployed
Scottish economy (his home country), he argued
that a shortage of metallic money was to blame,
that a bank-issued paper currency must replace
the deficient metallic one, and that the resulting
expansion of the stock of paper notes would
permanently increase the level of output and
employment without increasing prices.4 His
argument stemmed from his assumptions of
(1) the availability of idle resources at unchanged
prices and (2) constant returns to scale in production. Given these conditions, it followed that
the economy’s long-run aggregate supply curve
was perfectly horizontal up to the point of full
5
employment. It likewise followed that moneyinduced increases in aggregate commodity
demand would, via rightward shifts along the
supply curve, generate matching increases in
equilibrium real output without raising prices.
Indeed, Law suggested that the price level might
even fall if scale economies in production rendered the aggregate supply curve negatively
sloped.5 In no case, however, would expansion
of the stock of paper money raise prices.
Having argued that causation runs from
money to output, Law perceived that it could be
made to run in the opposite direction too. With
appropriate financial linkages put in place,output
could induce the very monetary means of its
own expansion. Indeed, Law thought this outcome was assured provided that banks issued
money on productive loans secured by claims
to future product or its equivalent. Coaxed
forth by real output in this fashion, the paper
money stock would grow in step with the real
demand for it such that its purchasing power
would be preserved unchanged. To ensure that
the nominal money stock automatically expanded equally with the real demand for it, he advocated that paper notes be backed dollar-fordollar with the nominal value of land. Collateralized by land, money would, he thought, enjoy
stability of value. When economic development
or cyclical recovery brought more land into cultivation, the money stock, secured by the extra
land, could expand to meet the growing needs
of trade at unchanged prices. Here was the prototype of the real bills doctrine later attacked
6
1705
1700
Agricultural Revolution begins in Great
Britain. Farmworker productivity, scarcely
higher in 1700 than 20 centuries earlier,
doubles in the next 100 years.
Mercantilists
150
Law
U.K. PRICE LEVEL
Source: Deane and Cole, British Economic
Growth 1688-1959, Appendix.
Sir James Steuart (1721-1780)
To Law’s doctrines, Steuart in his 1767 An
Enquiry into the Principles of Political Oeconomy
added four more. First was his explicit rejection
of a monetary for a real cost-push theory of
inflation. Tracing a causal chain from the degree
of competition in labor markets to wage rates
to unit labor cost to product prices, he concluded that cost and competition determine the
prices of all goods and thus the price level as a
whole. Likewise, he held that the monopoly
power of producers determines their profit
margins as embodied in the profit mark-up
component of individual and aggregate prices. In
other words, he alleged that the same real
forces – market power and cost – that govern
1709
Abraham
Darby invents coke
smelting of
iron ore.
1710
1712
In England, Thomas
Newcomen invents a
workable steam pump
for use in mines.
Mercantilist views are prevalent
Classicals
Unavailability of an inflation rate series for
1700-1880 necessitated use of a price-level
series instead (see left scale). After 1880,
an inflation rate series was used.
so vigorously by classical writers.
As for the doctrine that low interest rates
spell monetary ease and high rates monetary
tightness, Law accepted it without reservation.
Anticipating Keynes’s liquidity preference theory of interest, Law saw interest rates as the price
of money’s use, a price that varied inversely
with the quantity available to use. Being purely
monetary phenomena, low rates unambiguously
signified an abundance of money and high rates
a scarcity of it. Law, an ardent advocate of low
rates, argued that they reduced the businessman’s cost of capital and so spurred investment
and real activity. For him, money exerted its
stimulus through indirect interest rate channels
as well as through direct expenditure ones.
100
90
80
John Law’s Money and Trade Considered
declares that money stimulates economic
activity.
“Domestic trade depends on the
Law introduces the prototype of the real
bills doctrine when advocating that
paper notes be backed dollar-for-dollar
with the nominal value of land.
A limited sum can only set a
money. A greater quantity employs
more people than a lesser quantity.
number of people to work proportion’d to it, and ’tis with little
success laws are made for employing the poor or idle in countries
where money is scarce.”
John Law in Money and
Trade Considered
relative prices account for absolute prices as
well. He advanced a relative price theory of the
absolute price level.6
Steuart’s second contribution was his doctrine of the hoards which he used to bolster his
denial that money determines prices. He argued
that idle hoards of specie absorb excess cash
from circulation just as they release into circulation additional coin to correct a monetary
shortage. Consequently, there can be no monetary excess or deficiency to spill over into the
commodity market to affect prices. The hoarding-dishoarding mechanism ensures as much.7
For those occasional increases in the money
stock that do manage to elude the hoarding
mechanism and spill over into the commodity
market, he argued, like Law, that they produce
matching shifts in commodity demand along a
horizontal supply schedule such that quantities
of output alter at unchanged prices.
Third was his reverse causation doctrine
according to which causality runs from prices to
money and its circulation velocity rather than
vice-versa as in the quantity theory. Positing a
two-step process, he said that cost and competition first determine prices. Then, with prices
settled, the circulation velocity of coin adjusts
to render the existing stock sufficient to accommodate the prevailing level of real activity at the
given prices.8 If the money stock is excessive,
wealth-holders remove the excess from circulation, melt it down, and hold it in the form of
ornaments and bullion such that velocity falls.
Conversely, if coin is deficient, the resulting
1717
1719
recourse to paper substitutes and other expedients allows transactors to economize on coin
whose velocity therefore rises. Via such devices,
velocity adjusts to ensure that the stock of coin
is just enough to purchase all the goods offered
for sale at the predetermined level of prices. In
this way, causation runs from prices to money
and velocity. Here is the origin of the notion
that changes in the stock of circulating media
(coin and its paper substitutes) merely validate
price changes that have already occurred and
do nothing to produce such changes.
Finally, there was Steuart’s uncompromising
stance on the perennial issue of rules versus discretion in the conduct of policy. Like all mercantilists, Steuart sided with discretion. Monetary
rules, whether of fixed or feedback variety, met
with his skepticism as did all self-correcting
adjustment mechanisms, natural or designed. To
him, nothing but discretionary fine-tuning would
do.9 Such enlightened intervention was the hallmark of his omnipotent, ever-active, benevolent
statesman whose job was to manipulate the
volume of real activity in the national interest.10
Steuart’s statesman alone possessed the detailed
knowledge necessary to conduct what today is
known as a successful cheap-money, full-employment policy.The gap between actual and potential
output, the monetary injection required to close
the gap, and the interest rate necessary to draw
the required metal from idle hoards: all revealed
themselves to the statesman’s astute and vigilant scrutiny. So too did the ever-changing circumstances to which he tailored his actions.
1720
1730
South Sea Bubble
Law organizes his colonial trading enterprise,
the Mississippi Company, and merges it two
years later with the
Banque Royale in France.
Law flees France in
disgrace and spends
his remaining days
at the gambling tables
of Venice.
Law’s Mississippi Scheme
sees excessive paper
money expansion culminate
in an inflationary boom
and collapse in France.
7
South Sea Bubble, the
English equivalent of Law’s
speculation craze, bursts.
These propositions formed the core of mercantilist monetary theory which Law and
Steuart deployed to analyze the underemployed
economies of their time. Of the two writers,
only Law, the paper money mercantilist, was
able to translate his theory into action. His
famous Mississippi scheme, which merged
France’s national bank of issue with a trading
and land development firm (the Mississippi
Company) while simultaneously promising to
reduce the French public debt, involved paper
money expansion on a mammoth scale.11
The resulting spectacular inflationary boom
and collapse of Law’s system had three consequences.12 It revealed that the initial output
stimulus of a monetary expansion eventually
vanishes leaving only inflation in its wake. It
served to discredit paper money and financial
innovation schemes for many years to come. It,
together with the similar debacle of the assignats,
a nominally land-backed paper currency issued
by the French revolutionary government to
inflationary excess in the years 1794 to 1796,
provoked classicals to reject mercantilist trade
and monetary theory root and branch.
8
Classical Counterpropositions
Denouncing the mercantilist identification of
wealth with precious metals, Adam Smith
observed that national wealth consists not of
specie or bullion but rather of stocks of productive resources – land, labor, and capital – and
the efficiency with which they are used. With
1730
respect to the mercantilist prescription of protectionism as the path to opulence, both Smith
and David Ricardo noted that wealth-enhancing,
efficient resource allocation requires not protectionism but rather free trade in order to exploit
comparative advantages stemming from specialization 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 to
demonstrate the impossibility of the mercantilist goal of a permanently favorable trade balance and corresponding persistent specie
inflow. Hume (pp. 62-3) noted that the additional specie, by raising domestic prices relative
to foreign ones and so discouraging exports
and spurring imports, would render the trade
balance unfavorable and reverse the specie
flow.14 The resulting drain of monetary metal
would continue until domestic prices fell to the
level consistent with trade balance equilibrium.
Similarly, Hume (pp. 33, 37, 48) showed that the
mercantilist fear of scarcity of money was
unwarranted since any quantity of money, via a
proportionate adjustment in the price level,
could drive the trade of a nation. To prove as
much, Hume (pp. 62-3) advanced a rigid version
of the quantity theory according to which an
exogenously given one-time reduction in the
stock of money has no lasting effect on real
activity but leads ultimately to a proportionate
change in the money price of goods.
1733
1740
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 spinning
jenny and the power loom, lead to the mechanization
of industry and the development of textile mills in England.
Mercantilist views are prevalent
150
Richard Cantillon writes Essai
sur la Nature du Commerce en
Général (published in 1755) partly
as a critique of Law’s system.
U.K. PRICE LEVEL
Hume
100
90
80
Distinction between
Absolute and Relative Prices
Hume’s classical followers immediately seized
upon his quantity theory and deployed it against
the mercantilists. David Ricardo applied it to
refute cost-push theories of the price level.15
Accusing cost-pushers of confounding relative
prices (market exchange ratios) with the absolute,nominal,or general level of prices,Ricardo
flatly denied that a rise in costs – wage costs in
particular – could raise general prices without
an accompanying expansion of the money stock.
True, he did acknowledge that a wage hike
might raise the prices of labor-intensive goods
and so require consumers to spend more on
those goods. But he also insisted that without
accommodating increases in the money stock
to foster spending, consumers would have less
to spend on capital-intensive goods whose prices
would therefore fall. The upshot was clear. Any
wage-induced rise in some relative prices would
be offset by compensating falls in others leaving
the general average of all prices unchanged.
Short-Run Nonneutrality and
Long-Run Neutrality Propositions
Classicals reserved their severest criticism for
John Law’s money-stimulates-trade doctrine.
Hume insisted that the doctrine holds in the
short run but not the long.16 At first, moneystock changes indeed affect output and employment. Eventually, however, the output stimulus
vanishes and only higher prices remain. Law’s
doctrine holds in the short run because prices
are temporarily sticky, or inflexible, in response
to money stock changes. Such stickiness Hume
attributed to the imperfect information pricesetters possess on money-stock changes and
their resulting failure to perceive and act upon
the changes. Distribution effects constituted for
him another source of temporary nonneutrality, or transitory influence on real activity, inasmuch as new money is initially concentrated in
few hands and only gradually becomes dispersed
throughout the economy.17
With prices sticky and money’s circulation
velocity given, it follows that changes in the
money stock are absorbed by output which
accordingly deviates temporarily from its natural equilibrium level. Prices only begin to adjust
when price-setters discover that their inventories of goods and labor are abnormally high or
low. Eventually, monetary and price-perception
errors are corrected as are initial distribution
effects. At that point, the price level fully adjusts
to the new money stock and output returns to
its natural equilibrium level. Here is the source
of the classical doctrine of the short-run nonneutrality and long-run neutrality of money.18
9
Classical Case For Rules
Four remaining mercantilist arguments clamored for demolition. Classicals were glad to
oblige. First was the mercantilist claim that discretion was superior to rules. Classicals countered with the opposite claim that rules
replaced destabilizing activist intervention with
smoothly operating, or stabilizing, automatic
1750
1760
Seven Years War (1756-1763)
Industrial Revolution in Great Britain (1750-1850)
David Hume, in his essays
“Of Money,” “Of Interest,”
no other effect, if fixed, than to
and “Of the Balance of Trade,”
raise the price of labour... and ...
advances the classical ideas
commodities .... In the progress
of the price-specie-flow mechtoward these changes, the augmen- anism, the quantity theory,
and the long-run neutrality
tation may have some influence,
and short-run nonneutrality
by exciting industry; but after the of money.
Swedish Bullionist Controversy (1755-1765)*
“Money, however plentiful, has
prices are settled, suitably to the
new abundance of gold and silver,
it has no manner of influence.”
David Hume in “Of Interest”
*After Sweden switched from a metallic to an inconvertible
paper currency in 1745, the resulting price inflation and
exchange rate depreciation provoked a policy debate
over the cause of these phenomena. Mercantilists traced
the cause to external real shocks to the balance of payments and prescribed export promotion and import restriction schemes as remedies. Others, notably P. N. Christiernin,
found the cause in the Riksbank’s overissue of notes. He
urged halting the excess issue but refrained from prescribing a roll-back of prices to their pre-inflation level fearing
such deflation would bring an intolerable transitory loss
of output and employment.
adjustment mechanisms. Unlike Steuart, classicals held a low opinion of the knowledge, capabilities, and motivation of the policy authorities.
In particular, classicals, especially Ricardo, John
Wheatley, and other Bullionist critics of the Bank
of England, feared that central bankers operating
under the kind of floating exchange rate, inconvertible paper regime prevailing in England during the Napoleonic Wars, would, if left to their
own discretion, pursue inflationary policies.
Since classicals regarded stability of the value
of money as the overriding policy objective,
they advocated rules obligating policymakers to
achieve that goal. One such rule was the gold
standard. By requiring the maintenance of a fixed
currency price of gold, this rule, provided that
the gold price of goods also remained fairly
steady, was tantamount to stabilizing the money
price of goods. And with the price level stable,
money could function reliably as a unit of account
and medium of exchange. In so doing, it could
make its maximum contribution to the efficient
operation of the real economy and cease to be
a source of financial crises and panics.
10
Say’s Law of Markets
Next in line for rejection was the mercantilist
claim that deficient aggregate demand condemns cash-poor economies to perpetual
unemployment. Not so, wrote the classicist
Jean Baptiste Say in his 1803 Traité d’économie
politique. The value of goods produced equals
the cost of the inputs absorbed in their fabrication. It follows that the very act of production
creates, in the form of factor payments, incomes
sufficient to buy the goods off the market. And
those incomes indeed will be spent. The insatiability of wants together with the unlikelihood
that rational people would hoard their savings
indefinitely in the form of sterile money ensures
as much.
Far from going unspent, saving automatically
translates itself into investment. People deposit
their savings with banks to earn interest. Those
intermediaries,upon lending the saving to capitalist entrepreneurs to finance investment projects,
guarantee that it enters the spending stream just
as surely as if it were consumption spending.The
upshot is that full-capacity supply creates its own
demand such that mercantilist fears of general
gluts and permanent stagnation are unfounded.
Say’s Law of Markets identifies the natural level
of real activity with full employment.19
Real Interest Rate
As for the mercantilist argument that the interest rate is purely a monetary phenomenon,
Hume, Ricardo, and Henry Thornton all repudiated it.20 They contended (1) that the natural
equilibrium rate of interest is a real magnitude
determined by productivity and thrift, and
(2) that money, being neither of those variables,
cannot affect the natural rate whose level is
therefore resistant to monetary control. True,
they conceded that a one-time monetary injection could temporarily depress the loan rate of
interest below its equilibrium level. But they
stressed the transience of this effect. They
1769
1760
1770
James Watt’s steam engine adds a condenser to Newcomen’s atmospheric engine,
boosting its efficiency by a factor of four.
Seven Years War (1756-1763)
Industrial Revolution in Great Britain (1750-1850)
Mercantilist views are prevalent
Swedish Bullionist Controversy (1755-1765)
“It is the business of a statesman ...
to ... guard against ... stagnation ....
U.K. PRICE LEVEL
150
100
90
80
Sir James Steuart’s An Enquiry into
the Principles of Political Oeconomy
enunciates four main doctrines of
mercantilism: real forces determine
the price level, hoarding prevents
money from affecting prices, the
monetary circulation determines the
level of real activity, and discretion
outperforms rules in the conduct
of monetary policy.
He must facilitate circulation
by drawing into the hands of the
public ... coin ... locked up [in idle
hoards]; and he must supply the
Steuart
actual deficiency of the metals, by
[issuing] paper credit.”
Sir James Steuart in An Enquiry
into the Principles of Political
Oeconomy, Vol. II
pointed out that the monetary injection puts
upward pressure on prices. And since with higher prices more loans are needed to finance a
given real quantity of investment projects, it follows that loan demands increase.The rise in loan
demands reverses the initial fall in the loan rate
and restores it to its natural level thereby frustrating attempts to keep it low. Supplementing
the price-induced rise in loan demand is a fall in
loan supply. For as prices rise, people need more
cash to mediate hand-to-hand transactions. The
resulting conversion of notes and deposits into
coin precipitates a cash drain from banks that
diminishes bank reserves. To protect their
reserves from depletion, banks raise their loan
rates. Or what is the same thing, they contract
their loan supply. The contraction of loan supply
combines with the rise in loan demand to
restore the interest rate to its natural equilibrium level determined by productivity and thrift.
Criticism of Backing Theories of Money
Last but not least was Law’s idea of a landcollateralized paper money stock. Henry Thornton was merciless in his criticism. He excoriated
the plan on the grounds that it would fail to
limit the money supply and in so failing would
render the price level indeterminate.21 The plan’s
flaw, wrote Thornton, is that it ties money to
the nominal or dollar value, rather than to the
fixed physical acreage, of land. By anchoring
each dollar to another dollar, it sets up a dynamically unstable price-money-price feedback loop
rendering prices indeterminate. The result is
1776
that any random shock which raises land’s price
would, by raising land’s value, increase money’s
backing and so justify an expansion of its supply.
The consequent expansion would further bid
up land’s price thereby justifying still further
increases in the money stock which would raise
prices again and so on ad infinitum. In short,
backing money with the nominal value of land –
or, for that matter, with commercial paper representing the nominal value of goods in the
process of production and distribution – would
destabilize prices rather than stabilize them.
Price stability required another principle of
monetary limitation.
Thornton’s refutation of the nominal backing
idea completed the list of the original classical
rebuttals of mercantilist monetary doctrine.
Having contested this doctrine once, however,
classicals and their descendants were called
upon to counter it repeatedly throughout the
nineteenth and twentieth centuries. Mercantilist views, despite their devastating initial
rejection, reemerged to form the Banking
School position in the famous Currency SchoolBanking School controversy that took place in
England in the mid-1800s. Most of the usual
suspects – cost-push, hoarding, reverse causality, discretion, nominal backing – appeared in the
Banking School’s roundup. In opposing them,
classicals, in their Currency School guise, found
occasion to deploy the same quantity theoretic,
price-specie-flow concepts they had earlier
deployed against Law and Steuart.
1788
1780
Henry Court invents the puddling process leading to
larger-scale iron furnaces and a 30-fold expansion in
the output of iron between 1760 and 1899.
Signing of the Declaration of Independence
American Revolution (1775-1783)
11
1790
French Revolution (1789-1799)
Classical views are prevalent
Adam Smith publishes
Wealth of Nations, refuting
mercantilist protectionist
doctrines with classical free
trade principles. He also
refutes the mercantilist claim
that money (gold) constitutes
national wealth.
Assignat Experiment in France (1789-1795)*
“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.”
Smith
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 revolutionary
government, the assignat experiment
reprises Law’s land-backed paper money
scheme. The resulting inflation provokes
a classical, or anti-mercantilist, backlash
in monetary thought.
3
Currency School-Banking School Debate (1830-1850)
Ending a 24-year experiment with inconvertible
paper, Britain had restored the gold convertibility of her currency in 1821. The ensuing
Currency-Banking debate focused on whether
the note component of such a convertible, goldstandard currency required regulation to prevent overissue.22 The Currency School’s classical
predecessors, notably David Ricardo, Henry
Thornton, and others, had assumed that a convertible currency needed no such protection. If
the currency were convertible, they reasoned,
any excess note issue which raised British prices
relative to foreign prices would be converted
into gold to make cheaper purchases abroad.23
The resulting loss of specie reserves would
immediately force banks to contract their note
issue thus quickly arresting the drain and
restoring the money stock and prices to their
pre-existing equilibrium level. Given smooth
and rapid adjustment (monetary self-correction), convertibility alone was its own safeguard.
A series of monetary crises in the 1820s and
1830s, however, convinced the Currency School
that adjustment was far from smooth and that
convertibility per se was by no means a guaranteed safeguard to overissue. It was an inadequate
safeguard because it allowed banks, commercial
and central, too much discretion in the management of their note issue. Banks, facing no mini-
12
1790
1792
Opening of the New
York Stock Exchange
mum required reserve ratio and willing to sacrifice safety for profit, could and did continue to
issue notes even as gold was flowing out, delaying contraction until the last possible moment,
and then contracting with a violence that sent
shock waves throughout the economy.
Currency School’s Monetary Rule
What was needed, the Currency School
thought, was a rule removing the note issue
from the discretion of bankers and placing it
under strict regulation. To be effective, this rule
should require the banking system to contract
its note issue one-for-one with losses of gold
reserves so as to put a gradual and early stop to
specie drains. Such a rule would embody the
Currency School’s principle of metallic fluctuation
according to which a mixed currency of paper
and coin should be made to behave exactly as if
it were wholly metallic, automatically expanding
and contracting to match inflows and outflows
of gold.24
Departure from this rule, the Currency
School argued, would permit persistent overissue of paper. Such overissue, by forcing a protracted efflux of specie through the balance of
payments, would in turn endanger the gold
reserve, threaten gold convertibility, compel the
need for sharp contraction, and thereby precip-
1793
1800
1802
1803
Louisiana
Purchase
Eli Whitney invents
the cotton gin.
French Revolution (1789-1799)
Industrial Revolution in Great Britain (1750-1850)
Classical views are prevalent
Assignat Experiment in France (1789-1795)
U.K. PRICE LEVEL
150
100
90
80
Bullionist-Antibullionist Debate (1797-1821)*
Henry Thornton in
his Paper Credit of
Great Britain refutes
Law’s idea of backing money with the
nominal value of
land saying it would
render the price
level indeterminate.
*After England suspends gold payments and goes on an inconvertible paper standard
in 1797, the resulting inflation provokes perhaps the most famous monetary
controversy of all time. Led by David Ricardo, the bullionists blame the Bank of
England for creating inflation through excessive issues of paper notes. Antibullionists
attribute 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 specific
commodities and posit the real bills doctrine to argue that money, advanced on
loan to finance sound business projects, cannot affect prices.
Thornton
Jean Baptiste Say
enunciates his Law
of Markets (1803).
itate financial panics. Such panics would be
exacerbated if internal gold drains coincided
with external ones as domestic money holders,
alarmed by the possibility of immanent suspension of cash payments, sought to convert paper
currency into gold. No such consequences
would ensue, the School felt, if the currency
conformed to the metallic principle. Forced to
behave like gold (regarded by the School as the
stablest of monetary standards), the currency
would be spared those sharp procyclical fluctuations in quantity that amplified disturbances
arising from real shocks.
The Currency School scored a triumph
when its monetary rule was enacted into law.
The Bank Charter Act of 1844 embodied its
prescription that, except for a small fixed
amount of notes issued against government
securities, bank notes were to be backed by an
identical value of gold. In modern terminology,
the Act established a marginal gold reserve
requirement of 100 percent behind note issues.
With notes rigidly tied to gold in this fashion,
their volume would start to shrink as soon as
specie drains signaled the earliest appearance of
overissue. Monetary overexpansion would be
corrected automatically, swiftly, and gently
before it could do much damage. Here was a
practical policy application of Hume’s quantity
theoretic, specie flow doctrines. Here was the
notion of a channel of influence running from
note overissue to rising prices to trade deficits
to gold drains to corrective reductions in the
1810
note issue, reductions that restore general
prices to their target equilibrium level. Here
too was the classical preference for rules – in
this case a 100 percent gold reserve requirement rule – rather than discretion in the conduct of banking policy.
Banking School
The rival Banking School flatly rejected the
Currency School’s prescription of mandatory
100 percent gold cover for notes. Indeed, the
Banking School denied the need for statutory
note control of any kind. Instead, the School
argued that a convertible note issue was automatically regulated by the needs of trade and
required no further limitation. This conclusion
stemmed directly from the real bills doctrine and
the law of reflux which together posited guaranteed safeguards to overissue obviating the need
for monetary control.
The School’s real bills doctrine stated that
the money stock could never be inflationary or
deflationary if issued by way of collateralized
loans advanced to finance transactions in the
nominal volume of real goods and services.
Similarly, the law of reflux asserted that overissue was impossible because any excess notes
would be returned instantaneously to the banks
for conversion into coin or for repayment of
loans. Both doctrines embodied the notions of
a passive, demand-determined money supply
and of reverse causality running from prices and
1812
1817
13
1820
War of 1812
Britain invades U.S.
Napoleonic Wars (1800-1815)
Birmingham School (1817-1821)**
“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] commodities; 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)
David Ricardo’s The High Price
of Bullion blames inflation on
the Bank of England.
**Led by Thomas Attwood, the Birmingham
School opposes restoration of gold convertibility of the British pound at the pre-war
parity. They fear the resulting deflation will
Ricardo writes Princicause unemployment. They advocate continuples of Political Economy
ation of the wartime regime of floatingand Taxation. He denies
exchange-rate inconvertible paper currency
that a rise in wage
that brings high and rising prices. In short,
rates could raise prices
the inflationist, full-employment-at-any-cost
without an accompanywriters of the Birmingham School oppose
ing expansion of the
a return to the gold standard.
money stock.
Thornton (1802) and Ricardo
(1817) write that the equilibrium
interest rate, being determined by
productivity and thrift, is resistant
to monetary control. Classicals
reject Law’s money-stimulatestrade doctrine saying that the
neutrality-of-money proposition
renders it invalid in the long run.
Ricardo
economic activity to money rather than vice
versa as in the Currency School’s view.25
According to the reverse causality hypothesis,
changes in the level of prices and production
induce corresponding shifts in the demand for
bank loans which banks accommodate via variations in their note issue. In this way, prices help
determine the note component of the money
stock, the expansion of which is the result, not
the cause, of price inflation. As for the price
level itself, the Banking School attributed its
determination to factor incomes or costs
(wages, interest, rents, etc.), thus positing a costpush theory of price movements. The importance of cost-push theorizing to the Banking
School cannot be overestimated. It even led
Thomas Tooke, the School’s leader, to argue
that high-interest-rate tight-money policies
were inflationary since they raised the interest
component of business costs.26
Mercantilist Ideas
The concepts of cost inflation, reverse causality,
and passive money are the hallmarks of an
extreme anti-quantity theory of money to
which the Banking School adhered. Additional
mercantilist hallmarks included the School’s
propositions (1) that international gold movements are absorbed by idle hoards of excess
specie reserves without affecting the volume of
money in active circulation, (2) that gold drains
stem from real shocks to the balance of payments rather than from domestic price infla-
14
tion, (3) that changes in the stock of money are
offset by compensating changes in the stock of
money substitutes leaving the total circulation
unchanged, and (4) that discretion is superior to
rules in the conduct of monetary policy.
The Banking School put these propositions
to work in its critique of the classical monetary
doctrines of the Currency School. Those doctrines, of course, contended that note overissue
is the root cause of domestic inflation and
specie drains. In opposing them, the Banking
School argued as follows: Overissue is impossible since the stock of notes is determined by
the needs of trade and cannot exceed demand.
Therefore, no excess supply of money exists to
spill over into the goods market to bid up prices.
In any case, causality runs from prices to money
rather than vice versa. Finally, specie drains stem
from real rather than monetary shocks to the
balance of payments and are totally independent of domestic price-level movements.
These arguments severed all but one of the
links in the Currency School’s monetary transmission mechanism running from money to
prices to the trade balance, thence to specie
flows and their impact on the monetary base,
and finally back again to the money stock. The
final link was broken when the Banking School
asserted that gold flows come from idle hoards
– buffer stocks of excess specie reserves – and
not from the volume of money in circulation.
Falling solely on the hoards, gold drains would
find their monetary effects neutralized (steril-
1829
1820
G. Stephenson’s
steam locomotive,
Rocket, wins contest.
U.K. overtakes the
Netherlands in manhour productivity.
1830
Stephenson’s engines pull
the first fully scheduled trains.
Railroad age begins.
Industrial Revolution in Great Britain (1750-1850)
Classical views are prevalent
“Restore the depreciated
“Mr. Attwood opines, that the multiplication of the circulat-
state of the currency and
ing medium, and the consequent diminution of its value ...
you restore the reward of
give employment to labour... to an indefinite extent ....
150
Mr. Attwood’s error is that of supposing that a depreciation
production, ... consumption,
of the currency really increases the demand for all articles,
[and] everything that
and consequently their production, because, under some
constitutes the commercial
circumstances, it may create a false opinion of an increase
prosperity of the nation.”
Thomas Attwood in
The Remedy: or, Thoughts
on the Present Distresses
U.K. PRICE LEVEL
industry, ... confidence, ...
100
of demand; which false opinion leads, as the reality would
Mill
do, to an increase of production, followed, however, by a
90
fatal revulsion as soon as the delusion ceases.”
80
John Stuart Mill in “The Currency Juggle”
Thomas Tooke, leader of the Banking
School and author of the six-volume
History of Prices (1837-1857), stresses the real bills doctrine, the notion
of reverse causality, and the costpush theory of price movements.
Lord Overstone (Samuel Jones Loyd),
leader of the Currency School, uses
the quantity theory to argue that
mandatory 100 percent gold cover
for bank notes is needed to prevent
overissue.
Classicals see the economy
as inherently self-regulating.
Mercantilists see it as requiring
government intervention
and discretionary fine-tuning.
ized) by the implied fall in excess reserves. To
ensure that these hoards would always be sufficient to accommodate gold drains, the Banking
School recommended that the Bank of England
hold larger metallic reserves.
With regard to the Currency School’s prescription that discretionary policy be replaced
by a fixed rule, the Banking School rejected it
on the grounds that rigid rules would prevent
the banking system from responding to the
needs of trade and would hamper the central
bank’s power to deal with financial crises.
Finally, the Banking School asserted the
impossibility of controlling the monetary circu-
1840
lation via control of the gold and bank note
component alone since limitation of that component would simply induce the public to
resort to money substitutes (deposits and bills
of exchange) instead. In other words, the circulation is like a balloon; when squeezed at one
end, it expands at the other. More generally, the
Banking School questioned the efficacy of base
control in a financial system that could generate
an endless supply of money substitutes.
The Currency School, however, rejected this
criticism on the grounds that the volume of
deposits and bills was rigidly constrained by the
volume of gold and notes and therefore could
1844
1846
1848
Potato crop failure in Gold is discovered
Ireland spurs waves of in California.
emigration to America.
Currency School-Banking School Debate (1830-1850)
“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 consequence of prices.”
Tooke
Thomas Tooke in An Inquiry
into the Currency Principle
The 1844 Bank Charter Act embodies the Currency
School prescription that, except for a small fixed
fiduciary issue, bank notes must be backed poundfor-pound by gold, thus establishing a marginal
gold reserve requirement of 100 percent.
Tooke’s An Inquiry into the Currency Principle
uses cost-push theorizing to claim that interest
rate hikes and reductions, by raising and lowering business costs, cause corresponding rises
and falls in the price level.
15
1850
be controlled through the latter alone. In short,
the total circulation was like an inverted pyramid resting on a gold and bank note base, with
variations in the base inducing equiproportional variations in the superstructure of money
substitutes. In counting deposits as part of the
superstructure, the Currency School excluded
them from its concept of money. It did so on
the grounds that deposits, unlike notes and
coin, were not generally acceptable in final payments during financial crises.
Evaluation
In retrospect, the Currency School erred in failing to define deposits as money to be regulated
like notes. This failure enabled the Bank of England to exercise discretionary control over a
large and growing part of the circulating medium, contrary to the School’s intentions. The
School also erred in failing to recognize the
need for a lender of last resort to avert liquidity panics and domestic cash drains. By the end
of the nineteenth century it was widely recognized that the surest way to arrest an internal
drain was through a policy of liberal lending.
Such drains were caused by panic-induced
demands for high-powered money (gold coin
and Bank of England notes) and could be terminated by the Bank’s announced readiness to
satiate those demands. The Currency School
nevertheless remained opposed to such a policy,
fearing it would place too much discretionary
16
1855
1850
First iron Cunard
steamer crosses
the Atlantic in nine
and a half days.
power in the hands of the central bank. These
shortcomings in no way invalidated the School’s
monetary theory of inflation which was superior to any explanations its critics had to offer.
As for the Banking School, it rightly stressed
the importance of checking deposits in the payments mechanism. But it was wrong in insisting
that the real bills doctrine,which tied note issues
to loans made for productive purposes, would
prevent inflationary money growth. Like Henry
Thornton, the Currency School triumphantly
exposed this flaw by pointing out that rising
prices would generate a growing demand for –
and nominal collateral backing of – loans to
finance the same level of real transactions.These
collateralized loan demands, when accommodated in the form of deposit and note creation,
would enlarge the money stock. In this way
inflation would justify the monetary expansion
necessary to sustain it and the real bills criterion
would fail to limit the quantity of money in existence. Also, by 1900 Knut Wicksell and Irving
Fisher had rigorously demonstrated the same
point made by Thornton in 1802, namely that an
insatiable demand for loans and a corresponding
inexhaustible supply of eligible bills results when
the loan rate of interest is below the expected
rate of profit on capital. In such cases, the real
bills criterion provides no bar to overissue.
1856
1859
Henry Bessemer
Darwin writes
revolutionizes the On the Origin
steel industry
of the Species.
with his new converter process.
1860
1862
U.S. issues its first
legal-tender fiat currency, the greenbacks.
U.S. Civil War (1861-1865)
Classical views are prevalent
150
U.K. PRICE LEVEL
Jevons
100
90
80
William Stanley Jevons, in his A Serious
Fall in the Value of Gold Ascertained and
its Social Effects Set Forth, calculates the
geometric mean of the prices of 39 major
and 79 minor commodities to establish that
the general price level had risen and the
value of gold had fallen in the order of
9 to 15 percent since 1845-1850. Written
15 years after the California and Australian
gold discoveries, Jevons’s pathbreaking
work on index number construction and
application lends strong statistical support
to the quantity theory approach to pricelevel determination.
4
The Keynesian Revolution and
Monetarist Counter-Revolution (1936-1985)
Classicals won the Currency-Banking dispute.
Their victory lasted until ex-classical John Maynard Keynes, having defected to the opposite
side, routed them in 1936.27 But they regained
their crown when monetarists (with help from
the new classical school) dislodged Keynesian
macroeconomics in the 1970s and 1980s.
Keynes launched his attack in the midst of
the Great Depression when the stark conditions
of stagnation, poverty, and mass unemployment
mocked the classical notion of a self-equilibrating, fully employed economy. Clearly the time
was ripe for a mercantilist revival. That revival
took the form of the Keynesian Revolution with
the leader’s General Theory as its bible. In that
book, Keynes replaced the full capacity, quantity
theoretic doctrines of the classicals with at
least four propositions inherited from Law and
Steuart.
Keynes’s Mercantilist Propositions
First, like Law, he argued that in times of mass
unemployment the primary stimulative effects
of expansionary monetary policy fall on real
output and employment rather than on prices.
That is, they do so unless negated by liquidity
traps and interest-insensitive investment demand schedules, both of which cause velocity
1870
1871
reductions to absorb the impact of monetary
expansion. Absent such phenomena, however,
Keynes’s model implied that monetary stimuli
affect real activity rather than prices. Like Law,
he stressed that the stimulus works through an
interest rate channel. More money means lower
interest rates, a cheapened cost of capital, and
thus a rise in investment spending.The increased
investment induces additional rounds of consumption spending causing aggregate demand
to rise by a multiple of the new investment
spending. With idle resources available to draw
upon,production expands to meet the increased
aggregate demand. In expounding his interest
rate transmission mechanism, Keynes praised
his mercantilist forebears for anticipating it.
Indeed, the “Notes on Mercantilism” section of
his General Theory argues that the notion of a
linkage running from money to interest rates to
investment to output constituted the rationale
for the mercantilists’ advocacy of export surpluses financed by specie inflows.
Second, like Steuart, Keynes held that product prices are determined by unit labor cost
plus a markup to cover profits and nonlabor
costs. Here is the mercantilist notion of the
price level as a nonmonetary phenomenon.28
True, Keynes admitted that monetary expansion
through its stimulus to employment might,
1873
1876
17
1880
Alexander Graham Bell invents the telephone.
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.
Walter Bagehot’s Lombard Street spells
out the classic lender-of-last-resort prescription for quelling liquidity panics
and averting bank runs. The central
bank must announce its readiness to
satiate all panic-induced demands for
cash – to “lend freely at a high rate.”
Marshall
Alfred Marshall in an unpublished manuscript originates the
Cambridge cash balance approach to the value of money.
20
15
Bagehot
10
U.K. UNEMPLOYMENT (%)
Series begins at 1851. Reliable estimates
for earlier periods unavailable.
5
0
Sources: (1851-1855) Mitchell, Abstracts
of British Historical Statistics, p. 64.
(1856-1879) Layard, Nickell, and Jackman,
Unemployment: Macroeconomic Performance
and the Labour Market, p. 3.
because of diminishing returns to labor, raise
unit labor costs and so prices. But he tended to
minimize or disregard money’s price-raising
effects. Instead, he treated the price level as an
institutional datum governed by nominal wage
rates which autonomous forces – union wagesetting policy, worker money illusion, and the
like – render downwardly inflexible at low levels
of employment. By expressing prices in terms of
exogenously given factor costs, he pointed the
way to a cost-push theory of the price level. His
immediate followers, Joan Robinson, Nicholas
Kaldor, and Richard Kahn, certainly interpreted
him this way and accordingly denied money a
role in price determination.29
Third, Keynes restated Steuart’s doctrine of
hoarding in the form of his concept of the liquidity trap. The trap, he wrote, might come into
operation in deep depressions when the interest rate falls to a level so low that everybody
unanimously believes it cannot stay there but
must return to its conventional normal height.
At the floor rate, all are indifferent between
holding cash or earning assets whose prices,
which vary inversely with the interest rate, are
expected to fall. Indeed, asset prices are expected to fall by an amount such that the resulting
anticipated capital loss just equals the interest
return on the assets. As there is no advantage
to holding such assets instead of zero-yield
cash, the latter becomes a perfect substitute for
the former in individuals’ portfolios. At this
point, the demand for money becomes insatiable
and infinitely sensitive to the slightest change in
18
1880
interest rates. Keynes called this pathological
condition absolute liquidity preference.
When this condition rules, no increase in the
money stock, no matter how large, can reduce
the interest rate. Suppose the central bank
expands the money stock by purchasing bonds
on the open market. Such bidding puts incipient
upward pressure on bond prices. But the slightest rise of the latter induces bondholders to sell
to the central bank and then to hoard the cash
proceeds. Since at the floor rate of interest the
demand for money is insatiable and the willingness to sell bonds absolute, no amount of open
market operations can overcome absolute liquidity preference and reduce interest rates.
And with rates at their irreducible minimum,
they cannot fall to stimulate real activity. Here is
Keynes’s expression of the mercantilist fear that
monetary expansion cannot be counted upon
to stimulate spending because the new money
may disappear into idle hoards.
Fourth, Keynes found still another obstruction to block the interest rate channel. Even if
monetary injections were successful in lowering
interest rates, those injections still might fail to
stimulate real activity if investment spending
were unresponsive to the lower rates. If so, then
two obstacles – an interest-insensitive investment schedule as well as a liquidity trap – could
render monetary policy ineffective in a depression. In both cases, a rise in the money stock
would be offset by a fall in velocity leaving total
spending unchanged. With variable velocity
absorbing the impact of money stock changes,
1883
1890
1893
Thomas Alva Edison invents
the electric light bulb.
U.S. overtakes U.K.
in man-hour productivity.
Bank panic
and gold
runs sap
U.S. gold
reserve.
Classical views are prevalent
Bimetallism Debate (1880-1896)*
20
10
0
U.S. INFLATION RATE (%)
-10
Fisher
Inflation rate measured as the annual
rate of change of the GDP deflator.
Source: Barro, Macroeconomics, 5th ed., p. 8.
*This controversy concerning the cause of the post-1879 secular price deflation 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 and
communication, and increased competition. By contrast, bimetallists attribute deflation to the failure of the gold-backed money supply to grow as
fast as real output and the demand for real cash balances. Monometallists
thus stress the mercantilist, or cost-push, view of price-level determination
while bimetallists stress the classical, or quantity theory, view.
-20
none would be transmitted to nominal income.
The rigid links connecting money to nominal
income and prices as postulated by the classics
would 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 inflationary
post-World War II period added others. Some
interpreted inflation as a cost-push phenomenon emanating from union bargaining strength,
business monopoly power, oligopoly administered prices, commodity shortages, supply
shocks, and other real and institutional forces
putting upward pressure on factor costs and
profit mark-ups. Then too, “cheap money” advocates held that expansionary monetary policy
could be used to peg interest rates at low levels so as to minimize the interest burden of the
public debt while simultaneously stimulating
real activity. An alternative version of the same
argument, associated with the Phillips curve
trade-off approach to policy questions, held that
monetary policy could peg the unemployment
rate at permanently low levels at the cost of a
stable (nonaccelerating) rate of inflation.
Underlying all these arguments were the
presuppositions (1) that full employment is the
dominant policy concern, (2) that the employment benefits of monetary stimuli exceed their
inflationary costs, and (3) that disinflationary
monetary policy, because entrenched inflation is
1896
1898
1900
Blaming the gold standard for deflation and
its evils, W.J. Bryan delivers his Cross-of-Gold
speech as new gold fields and the invention
of the cyanide process are producing inflationary floods of monetary gold.
Knut Wicksell, in his Interest and
Prices, explains how spreads between
natural (equilibrium) and market loan
rates of interest produce cumulative
changes in the general price level.
so resistant to it, would produce intolerably
large and protracted reductions in output and
employment. John Law of course held similar
presuppositions, as did other mercantilists.30
There remained the mercantilist ideas of
reverse causation, passive money, and futility of
base control of money and of inflation. Nicholas
Kaldor supplied these ideas in his 1982 The
Scourge of Monetarism. Representing the peak of
post-Keynesian skepticism of the relevance of
the quantity theory, Kaldor’s Scourge denied the
possibility of base control given the central
bank’s duty to guarantee bank liquidity and the
financial sector’s ability to engineer changes in
the turnover velocity of money via the manufacture of money substitutes. Kaldor’s transmission
mechanism runs from trade unions to wages to
prices to money and thence to bank reserves.
Unions determine wages, wages determine
prices, prices influence loan demands, and loan
demands, via their accommodation in the form
of bank-created checking deposits, determine
the money stock, with central banks permissively supplying the necessary reserves. Far from
exerting an activating influence, money appears
at the end of the causal chain.
19
Monetarists’ Response to
Keynes and the Keynesians:
the Classical Comeback
Even as Keynesianism was riding high, critics
were sniping at it from the sidelines. Eventually
these criticisms would culminate in a monetarist
1903
1908
Wright Brothers
take first flight.
Henry Ford introduces
his Model T.
1910
“There is a certain level of the ... rate of interest ...
such that the general level of prices has no tendency
20
to move either upwards or downwards. This we
call ... the natural capital rate .... If ... the ... [loan] rate
15
of interest is set and maintained below this normal
Wicksell
level ... prices will rise and will go on rising ....
If ... the rate ... is maintained ... above ... the natural
Irving Fisher in his Appreciation and Interest
distinguishes between nominal and real interest
rates, with the expected rate of price change
constituting the difference between the two.
10
rate, prices will fall continuously and without limit.”
Knut Wicksell in Interest and Prices
5
0
U.S. UNEMPLOYMENT (%)
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.
counterrevolution that would dethrone mercantilist doctrines and restore classical ones. At
least eight mileposts mark the route of the classical comeback.
First came the theory of the real balance
effect. Enunciated by Gottfried Haberler, A. C.
Pigou, and Don Patinkin, it denied that Keynesian
liquidity traps and interest-insensitive investment
schedules could bar full employment.31 That is,
it denied they could do so provided (1) wealth
in the form of real money balances influences
consumers’ spending decisions, and (2) prices
possess some downward flexibility. The latter
condition should hold in a slump since a depressed economy implies an excess supply of
goods exerting downward pressure on prices.
Lower prices in turn raise the real value, or purchasing power, of cash balances in consumers’
wealth portfolios. The rise in real cash balances
stimulates consumption spending until full
employment is reached. Indeed, it is unnecessary to wait for falling prices to activate the real
balance effect. The central bank can achieve the
same result directly by increasing the money
supply. In principle, then, Say’s Law holds and
money is hardly powerless to affect aggregate
demand even under extreme Keynesian conditions. Keynes might have realized as much had
he incorporated real balances into his consumption function.
Second came the empirical work of Clark
Warburton, Milton Friedman, and Anna
Schwartz confirming money’s power to affect
spending. Contrary to Keynes’s claim that idle
20
1910
1912
hoards and offsetting velocity movements might
negate money’s impact on nominal expenditure,
Warburton established that (1) an erratic
money stock through its impact on spending
had been the chief factor causing most U.S.recessions, (2) money’s initial impact was on output,
and (3) with a lag, prices eventually adjusted to
fully absorb the money stock change. 32 Friedman
and Schwartz (1963) then corroborated Warburton by showing that a one-third contraction
of the money stock was the cause of the Great
Depression of the 1930s. These studies, together with Friedman’s findings that persistent inflation is largely or solely the result of excessive
monetary growth, effectively reestablished the
classical doctrine of the short-run nonneutrality and long-run neutrality of money. They also
showed that classical doctrine could account
for the Great Depression.
Third came Karl Brunner’s and Allan Meltzer’s 1967 critique of the Law-Keynes theory of
interest rates as a policy guide. That theory
claimed that the interest rate, a purely monetary variable, accurately measured the degree of
monetary ease or tightness. Brunner and
Meltzer disagreed. The rate, they said, is an
unreliable indicator of monetary ease or tightness. It is unreliable because it registers the
impact of nonmonetary determinants – notably
business loan demands – as well as monetary
ones. The rate might be low or high not
because money was easy or tight but rather
because loan demand was weak or strong.
Neglect of this important consideration could
1913
1920
U.S. Congress creates
the Federal Reserve
System.
World War I (1914-1918)
Classical views are prevalent
20
U.S. INFLATION RATE (%)
10
0
-10
-20
Irving Fisher publishes his classic
The Purchasing Power of Money, the
best and most complete exposition
of the quantity theory of money
in the entire economic literature.
German hyperinflation
(1922-1923)*
*Reichsbank officials deploy mercantilist arguments to deny that
overissue of deutsche marks
caused the hyperinflation. Critics
use classical quantity theory
reasoning supplemented with
rational expectations arguments
to put the blame squarely on the
Reichsbank. The critics were right.
The hyperinflation was a monetary, rather than a nonmonetary,
phenomenon.
lead to perverse, destabilizing policy. For example, in times of depression, when slack business
loan demands rendered the rate low, the
authorities, misinterpreting the low rate as signifying easy money, might contract the money
stock and thereby intensify the depression.
Contrariwise, in times of inflation when
booming credit demands rendered the interest
rate high, the authorities, misinterpreting the
high rate as signaling tight money, might expand
the money supply and so escalate the inflation.
By confounding the effects of loan demands
with those of monetary ease or tightness, the
central bank would engineer a perverse, procyclical monetary policy. This critique did much
to discredit the Law-Keynes theory of the interest rate.
Milton Friedman’s case for monetary rules
constituted the fourth monetarist milestone.
Friedman (1960) argued that long and variable
time lags render discretionary countercyclical
monetary policy destabilizing. Because such lags
make forecast errors inevitable, the central
bank cannot predict the short-run impact of its
moves. The result is that expansionary actions
aimed at fighting recessions may take effect at
precisely the wrong time when the economy is
booming just as contractionary anti-inflation
actions may hit the economy when it is already
mired in a slump. Friedman’s solution was to
recommend a rigid rule fixing the money stock’s
growth rate equal to the trend growth rate of
output. Such a rule would operate as an automatic stabilizer working to restore aggregate
1927
1929
Charles Lindbergh
makes first transatlantic flight.
U.S. stock
market
crashes.
spending to its long-run non-inflationary, fullemployment path. Inflationary spending that
outruns the rule-determined money stock
could not be sustained and must slacken. Conversely, spending that falls short of money stock
growth, as in recessions, would eventually quicken under the impact of the monetary stimulus.
In this way, such rule-induced corrections
would ensure that money acts countercyclically
and that long-run aggregate demand grows at
the same trend rate as real output such that
prices remain stable.
The fifth milestone, and the one that more
than any other turned the tide in favor of the
classicals, was the stagflation experience of the
1970s. That episode saw the simultaneous
appearance of rapid monetary growth, rising
unemployment, and accelerating inflation – an
impossible combination according to the predictions of John Law and the Keynesian school.This
experience did much to discredit mercantilist
beliefs that money stimulates trade and that the
price level is independent of the money supply.
Natural Rate Hypothesis
The sixth milestone was the monetarists’ natural rate hypothesis according to which unemployment returns to its natural, equilibrium level
regardless of the inflation rate. Milton Friedman
(1968) and Edmund Phelps (1967) established
this conclusion with the aid of an expectationsaugmented Phillips curve. They showed that
when inflationary expectations are incorporated into the Phillips curve, no permanent
1936
1930
21
1940
World War II (1939-1945)
The Great Depression (1929-1933)
Mercantilist views are prevalent
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.”
Keynes
John Maynard Keynes in a letter
to R.F. Harrod (August 27, 1935)
John Maynard Keynes
publishes The General
Theory of Employment,
Interest, and Money.
His assault on classical
economics starts the
Keynesian Revolution
and ushers in a
mercantilist revival.
20
15
10
5
0
U.S. UNEMPLOYMENT (%)
“I want to do justice to schools of thought
inflation-unemployment trade-offs remain to be
exploited. True, like David Hume, they acknowledged that short-run trade-offs might still exist.
Unanticipated rises in inflation, by lowering real
wages, could stimulate employment and output
temporarily. But once the increased inflation
was fully perceived, anticipated, and therefore
incorporated into nominal wage rates, the
resulting rise in real wages would restore
unemployment to its natural equilibrium level.
In this way, the adjustment of expected to actual inflation transforms downward-sloping
Phillips curves into a vertical line at the natural
rate of unemployment. The classicals were
right. Inflationary stimuli are temporary, never
permanent. One cannot use a higher stable rate
of inflation to peg the unemployment rate at
arbitrarily low levels since there are no permanent employment gains to be had at any steady
rate of inflation. Such gains can be had, if indeed
they are available at all, only at the cost of everaccelerating inflation.
Many Keynesians eventually came to accept
the natural rate hypothesis. Even so, they still
contended that disinflation was too costly to
pursue. Their fear stemmed from early versions
of the expectations-augmented Phillips curve.33
Those versions embodied the assumption that
agents revise their inflationary anticipations
downward in mechanical, or adaptive, errorlearning fashion only when actual, reported
inflation turns out to be lower than expected.
Accordingly, if the authorities sought to eradicate inflationary expectations – an absolute
22
1940
1944
1945
Sir Winston Churchill becomes
prime minister of Great Britain.
D-Day
Invention of the
first atomic bomb
requirement of any successful disinflationary
policy – they would have to force actual inflation below expected inflation thereby inducing
the latter to adjust toward the former as it converged on the desired target rate. This
sequence required the central bank to employ
contractionary monetary policy to raise unemployment above its natural level. The resulting
excess unemployment would put downward
pressure on the actual rate of inflation to which
the expected rate would adjust with a lag.
Through this long and painful error-learning
adjustment process, both actual and anticipated
inflation eventually would be squeezed out of
the economy, albeit at the cost of much lost
output and employment.
Rational Expectations Lower
the Cost of Disinflation
The seventh monetarist/new classical milestone
disposed of this Keynesian concern. Pairing John
Muth’s (1961) seminal work on rational expectations with Friedman’s natural rate hypothesis,
Robert Lucas (1972) and Thomas Sargent and
Neil Wallace (1975) showed that if expectations
are formed rationally rather than mechanically
then disinflation need not be a painful drawnout process. On the contrary, the unemployment cost of disinflation might be far less than
Keynesians feared. For if people formed their
anticipations rationally, they would take into
account all systematic, and therefore predictable, future disinflationary policy actions and
embody them in their price forecasts. Provided
1950
1953
James Watson
and Francis Crick
propose a double
helical structure
for DNA.
World War II (1939-1945)
Mercantilist views are prevalent
20
U.S. INFLATION RATE (%)
10
0
-10
-20
Bretton Woods plan
for post-war monetary
order calls for the
establishment of the
International Monetary
Fund and World Bank.
Clark Warburton’s empirical
work provides evidence,
contrary to Keynes’s liquidity
trap and interest-unresponsive
investment schedule models,
of money’s power to influence
Gottfried Haberler (1941), spending.
A.C. Pigou (1943, 1947),
and Don Patinkin (1948)
explain how a real cash
balance effect works to
stimulate consumption
spending and to restore
full employment following a depression.
Criticism of the Keynesian model emerges
to set the stage for the
monetarist counterrevolution.
realize that once their new price predictions
are formulated and acted upon, the bank will be
tempted to renege on its promise and create a
surprise inflation in order to boost output and
employment. Such knowledge induces the
rational public to discount the announcement
and to maintain inflationary expectations at levels high enough to remove the bank’s temptation to cheat. The result is that equilibrium
unemployment is no lower than it otherwise
would be, and yet equilibrium inflation is too
high. What prevents inflation from immediately
dropping to zero at the natural rate of unemployment is the central bank’s inability to promise credibly not to create surprise inflation.
Needed is something to convince the public that
the central bank will not succumb to the temptation to inflate. That something is a monetary
rule replacing the bank’s discretionary power
with a precommitment binding it irrevocably to
price stability.34 In demonstrating as much, the
time inconsistency argument reinforced the
classical case for rules.35
The cumulative effect of the foregoing developments was to shift mainstream monetary
opinion away from the extremes of Keynesian
mercantilism toward classical monetarism. Not
all Keynesian doctrines were abandoned, of
course. Nor were all monetarist ones embraced.
On the contrary, mainstream opinion assimilated an eclectic amalgam of competing views. But
a new consensus definitely had emerged. After
four or five decades of mercantilist dominance,
the classical view was at the wheel once again.
Time Inconsistency Case For Rules
The last milestone was the time inconsistency
argument which strengthened the classical case
for rules by showing how they reinforce policy
credibility. Enunciated by Finn Kydland and
Edward Prescott (1977) and by Robert Barro
and David Gordon (1983a,b), the argument is
simplicity itself. Suppose a discretionary, finetuning central bank wants to eradicate inflationary expectations so it can have a favorable
temporary inflation-unemployment trade-off to
exploit.The bank announces its intention to pursue a policy of price stability. It assumes people
will believe the announcement and revise their
inflation predictions accordingly. The announcement, however, lacks credibility. Private agents
1958
1960
1961
1962
1963
1967
Berlin Wall is erected. President John F. Kennedy
is assassinated.
Cuban Missile Crisis
Martin Luther King, Jr.,
is assassinated.
Phillips
A.W. Phillips
presents his
empirical Phillips
curve relating
the rate of wage
and price inflation to the unemployment rate.
In the tradition of
Henry Simons’s 1936
case for rules over
discretion, Milton
Friedman enunciates
his famous k-percent
money growth
rate rule.
Keynesians interpret the Phillips curve
as a stable trade-off relationship permitting the policymakers to achieve permanently lower unemployment rates at the
cost of higher stable rates of inflation.
Friedman
Schwartz
Friedman and Anna Schwartz corroborate Warburton by showing, in their
monumental A Monetary History of the
United States: 1870-1960, that a severe
monetary contraction caused or intensified the Great Depression.
1968
1969
23
1970
First
astronaut
walks on
the moon.
Incorporating inflation
expectations into the
Phillips curve, Friedman
and Edmund Phelps
posit the natural rate
hypothesis. This concept
says that, when expected inflation adjusts to
actual inflation, real
activity returns to its
natural equilibrium level
such that no permanent
inflation-unemployment
trade-offs remain to
be exploited.
20
15
10
5
0
U.S. UNEMPLOYMENT (%)
policymakers behaved in a non-haphazard, credible fashion, actual and expected rates of inflation and disinflation would coincide such that
no gap would develop between them. With no
gap, there would be no need for excess unemployment to generate it. Consequently, inflation,
actual and expected, would be brought to its
zero target level with no cost in terms of
excess unemployment. In actuality, of course,
this conclusion proved to be a bit too facile and
sanguine. In a world in which wages and prices
are to some degree sticky or inflexible such
that markets fail to clear instantaneously, even
rationally expected disinflation would incur
some unemployment cost. Nevertheless, the
analysis showed that these costs could be much
lower than Keynesians feared.
5
Conclusion
Three centuries of monetary controversy and
experience have established certain hard-won
classical truths. Inflation and deflation are monetary rather than cost-push phenomena. There
are no long-run inflation-output trade-offs to
exploit; central banks cannot permanently peg
real variables at disequilibrium levels. Attempts
to do so produce explosive, ever-worsening
inflation or deflation. Money-stock changes at
best 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 prerequisite
of an efficiently functioning real economy. All
non-negligible inflation rates violate this prerequisite and are therefore harmful. Monetary rules
contribute to such stability.
Presently these truths are in the driver’s seat.
The proof is that many central bankers now view
their primary mission as providing a stable pricelevel environment within which businesspeople
can receive accurate market signals and allocate
resources efficiently. Still the classical wisdom,
though ruling, is hardly secure. For mercantilist
views continue to abound. Even today, some
economists still insist that it is better to live
with inherited inflation than to fight it because
disinflation is too costly to pursue. Others echo
Steuart’s cost-push theory, attributing the disinflation of the 1990s to such nonmonetary forces
as increased global competition, rapid techno-
24
1972
1970
1973
Following the Israeli-Arab War,
oil-producing countries quadruple oil
prices leading to an energy crisis
and queues at the gas pumps.
1974
logical progress, falling computer and healthcare costs, weakened power of labor unions, and
the like. Still others evoke the Steuart-Keynes
image of liquidity traps in holding that monetary
policy is powerless to stimulate the currently
depressed Japanese economy. Commentators
even parrot Law’s monetary theory of interest
when they cite Japan’s low interest rates as proof
that the country is awash with money when the
opposite is true. And always there are those
who argue that, with prices determined by real
considerations, monetary policy should be free
to pursue nonprice objectives such as achieving
full employment and maximizing real growth.
The challenge then is to ensure that the classical truths will not be forgotten. But that is a
tall order given that memories fade, that central
bank leadership changes, that the current generation of economists familiar with the Keynesianmonetarist controversy is passing from the
scene, that revisionist scholars can be counted
upon to reinterpret the record radically, and
that future generations may well be as reluctant
as the present one to study the lessons of the
past. The task of countering these influences
and preserving the classical wisdom falls to the
doctrinal historian. As curator of the stock of
eclipsed and unfashionable ideas, he has his
work cut out for him.
An even more important challenge is to
embed, or lock, the classical truths into endur-
1975
1980
1982
The personal computer is born with
Ed Roberts’s invention
of the MITS Altair.
Classical views are prevalent
The Great Inflation (1968-1984)
Bretton Woods fixed-exchange-rate system
abandoned: world leaves the gold standard.
10
U.S. INFLATION RATE (%)
Responding to the natural
rate hypothesis, Keynesians argue that when
agents form their inflation
expectations adaptively
in mechanical errorlearning fashion, real
activity returns very slowly to its natural level.
If so, then disinflation is
too costly to pursue and
society must learn to live
with inherited inflation.
The Volcker disinflation (1978-1984)
20
0
-10
-20
Lucas
Robert Lucas scrutinizes Keynesian fears of
costly disinflation. Using John Muth’s concept
of rational expectations, he shows that all
Phillips curve trade-offs, temporary and permanent, vanish provided (1) agents form their
inflation expectations rationally rather than
adaptively, (2) price flexibility prevails so that
markets clear, and (3) the authorities conduct
policy in systematic, credible fashion. These
conditions render disinflation costless.
Finn Kydland and Edward C.
Prescott state the time inconsistency case for replacing policymaker discretion with a precommitment binding the authorities irrevocably to the objective
of achieving price stability.
Nicholas Kaldor’s
The Scourge of
Monetarism represents the peak of
post-Keynesian
skepticism of the
quantity theory
of money.
The Fed worked hard
to build credibility
as an inflation-fighter
and desires to maintain
that credibility;
policy rules help.
ing institutional arrangements that allow no
room for mercantilist policy alternatives. To this
end, proponents of the classical view propose a
variety of possible arrangements. These include
(1) congressional mandates for price stability,
(2) formal contracts between elected governments and central banks fixing quantitative targets for price-level behavior, (3) guaranteed
independence for central bankers to insulate
them from the political pressure to inflate, and
(4) the appointment of conservative, inflationaverse central bankers committed to the goal of
price stability. The trouble is, however, that none
of these proposed arrangements can assure
that classical policies will reign supreme for all
time. Mandates can be changed, contracts terminated, guarantees revoked, and appointments
altered. The upshot is that it is too early to
1987
1989
Crash of the
U.S. Stock Market
Fall of the
Persian Gulf War
Berlin Wall Hubble Space Telescope
put in orbit.
1990
declare a permanent victory for the classical
view. Indeed, there may always be a market for
the opposing view that central banks need not
and must not be bound to the goal of price stability. For better or worse, that view will challenge the classical view whenever the public
perceives unemployment or sluggish real
growth rather than inflation to be the dominant
economic problem.
Still, the inherent cyclicality of ideas suggests
an inevitable classical response to that challenge. Classicism, in short, will return to prominence to be confronted anew. For history
shows it to be nothing if not resilient. Over long
spans of time, it has proved resistant to the
kinds of economic shocks that occasionally propel mercantilists to prominence. That is one of
the chief insights of doctrinal history.
1991
25
2000
Human Genome Project aimed
at mapping and sequencing all
human DNA nears completion.
Popularity of the Internet
Central bankers worldwide give precedence to the goal of price stability.
The European
Monetary Union
and the European
Central Bank
are launched.
20
15
10
Kaldor
5
0
U.S. UNEMPLOYMENT (%)
The U.S. enjoys its
longest peacetime expansion while disinflation
brings the price level
close to absolute stability.
E N D N OT E S
1. Additional famous policy debates pitting
mercantilists and classicals include (1) the
Swedish 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 elements
also characterize the fixed-exchange-rate,
small-open-economy case of the monetary
approach to the balance of payments, some
observers may be tempted to equate mercantilism with that approach. In fact, however, the two theories differ markedly. First,
the monetary approach applies the quantity
theory, rather than its opposite, to closedeconomy and inconvertible-paper, floatingexchange-rate regimes. By contrast, mercantilists, with few exceptions, tended to apply
the anti-quantity theory indiscriminately to
all regimes. Second, the monetary approach
rejects the mercantilist money-stimulatestrade 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).
26
4. Law’s fear of monetary shortage under
a metallic standard is incompatible with
the monetary approach to the balance of
payments. The latter sees a small open
economy, like Scotland, taking its price level
as given from the closed world economy
with money then flowing in through the
balance of payments to support that price
level such that no monetary shortage
occurs. 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, see
Screpanti and Zamagni (1993, p. 53).
7. Not all mercantilists were as sanguine
as Steuart on hoards. Indeed they were
somewhat ambivalent on the subject.
Hoards to them could be either desirable
or undesirable. On the one hand, hoards,
by draining excess cash from circulation,
would tailor the remaining stock precisely
to the needs of trade. On the other hand,
if output and so the needs of trade were
expandable under the impact of a monetary
stimulus, such hoards, by removing the
source of that stimulus, could unduly constrain real activity. Even so, such hoards
would see to it that no monetary excess
ever developed to spill over into the commodity market to bid up prices.
8. See Screpanti and Zamagni (1993, p. 53).
9. Steuart of course never resorted to
such modern terminology. Nevertheless,
the concepts were his.
10. On Steuart’s statesman, see Eltis (1986)
and Skinner (1981).
11. Law denied that the monetary expansion was excessive on the grounds that
much of it went to redeem outstanding
government bonds and equity claims to his
trading firm. Since to him bonds and stocks
shared money’s characteristic as a transactions medium, he saw them as exerting
the same influence on spending. In his view,
money swapped for bonds and equities
leaves the total supply of financial purchasing power – money, bonds, and stocks –
unchanged. Such monetary issue therefore
is noninflationary. He erred. Not being
transactions media, bonds and stocks are
far from perfect substitutes for money in
spending. Monetizing them can be inflationary. See Niehans (1990, p. 51).
12. See Murphy (1997) for an exhaustive
account of the rise and fall of Law’s system.
13. Thus a follower of Smith might attribute Scotland’s penury not to monetary deficiency and the absence of banks, but rather
to lack of specialization and division of
labor resulting from a small population.
14. Cesarano (1998) argues that Hume
actually rejected the price-specie-flow
mechanism and its attendant relative price
effects for the monetary approach to the
balance of payments. By contrast, the standard view emphasized here holds that
neither Hume nor his classical followers
subscribed 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 sources
of short-run nonneutrality including sticky
nominal interest rates, fixed nominal
charges such as rents and taxes, fixed nominal incomes of wage earners and rentiers,
confusion of relative- for absolute price
changes, market size encouragement to
specialization and division of labor, and
deliberate efforts on the part of organized
groups to maintain real incomes. See
Humphrey (1993, pp. 251-63).
18. Hume ([1752] 1955, pp. 39-40) admitted that money might exhibit long-run
super-nonneutrality. Being unanticipated
(perhaps because agents formulate their
expectations in a backward-looking way),
a steady succession of money stock changes
might perpetually frustrate the attempt
of prices to catch up and therefore permanently affect the level of real output.
19. Perhaps too cavalierly, classicals dismissed or minimized the problem of unemployment. To them joblessness, while it
certainly occurred from time to time, was
necessarily short-lived and self-correcting
through automatic wage, price, and interestrate reductions. Only their inflationist,
full-employment-at-any-cost counterparts
of the Birmingham School, especially the
Attwood 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 the
same criticism to the real bills doctrine
which ties the issue of bank money (notes
and checking deposits) to the nominal volume of commercial paper that borrowers
offer as collateral for bank loans.
22. For classic accounts of the Currency
School-Banking School debate, see Viner
(1937, Ch. 5), Fetter (1965, Ch. 6), Robbins
(1958, Ch. 5), and Mints (1945, Ch. 6). For
recent interpretations, see O’Brien (1975,
pp. 153-59) and Schwartz (1987).
23. With the exception of John Wheatley,
classicals held that national price levels could
deviate temporarily from their purchasing
power parity, or long-run equilibrium, levels.
24. O’Brien (1975, p. 153) credits Joplin,
Drummond, Page, Pennington, and McCulloch with the simultaneous enunciation
of the metallic principle.
25. Because these doctrines are consistent
with those of the monetary approach to
the balance of payments, Skaggs (1999)
interprets the Banking School as early anticipators of that approach. Even so, the
School hardly derived its conclusions from
the logic of the monetary approach. The
conclusions may have been the same, but
they were reached by a different route.
26. On Tooke’s interest cost-push theory
and Knut Wicksell’s definitive critique of it,
see Humphrey (1998, pp. 60-64).
27. Before he abandoned classicism, Keynes
was one of its luminaries. Both his 1923
A Tract on Monetary Reform and his 1930
A Treatise on Money are squarely in the classical tradition. He returned to the classical
fold shortly before his death in 1946.
28. Keynes applied this notion to a closed
economy. He was not referring to the
case where, with foreign prices given and
the exchange rate fixed, the real terms
of trade drives the price level in a small
open 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 collection
of his relevant papers, many published
between 1944 and 1953.
33. See Taylor (1997, pp. 278-9).
34. Alternatively, an established reputation
as a zealous inflation fighter would do.
35. The time consistency case for rules
differs a bit from Friedman’s argument. He
sees rules as overcoming the central bank’s
inability to predict the short-run impact
of its actions. By contrast, the time inconsistency argument is that rules are good for
commitment reasons even though central
bankers have full knowledge of the impact
of their moves.
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a Natural Rate Model,” Journal of Political
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Barro, Robert, and David B. Gordon.
“Rules, Discretion, and Reputation in a Model
of Monetary Policy,” Journal of Monetary
Economics, vol. 12 (June 1983), pp. 101-22.
Blaug, Mark. Economic Theory in Retrospect,
5th ed. Cambridge: Cambridge University
Press, 1996.
Brunner, Karl, and Allan H. Meltzer.
“The Meaning of Monetary Indicators,”
in G. Horwich, ed., Monetary Process and
Policy: A Symposium. Homewood, Ill.:
R. D. Irwin, 1967.
Cesarano, Filippo. “Hume’s Specie-Flow
Mechanism and Classical Monetary Theory:
An Alternative Interpretation,” Journal of
International Economics, vol. 45 (June 1998),
pp. 173-86.
Eltis, Walter. “Sir James Steuart’s Corporate
State,” in R. D. Collison Black, ed., Ideas in
Economics. London: Macmillan, 1986.
Fetter, Frank W. Development of British
Monetary Orthodoxy, 1797-1875. Cambridge,
Mass.: Harvard University Press, 1965.
Friedman, Milton, and Anna J. Schwartz.
A Monetary History of the United States,
1867-1960. Princeton, N. J.: Princeton
University Press for the National Bureau
of Economic Research, 1963.
Friedman, Milton. “25 Years after the Rediscovery of Money: What Have We Learned?”
Discussion, American Economic Review, vol. 65
(May 1975), pp. 176-79.
Friedman, Milton. “The Role of Monetary
Policy.” American Economic Review, vol. 58
(March 1968), pp. 1-17.
Friedman, Milton. A Program for Monetary
Stability. New York: Fordham University
Press, 1960.
Grampp, William D. “The Liberal Elements
in English Mercantilism,” Quarterly Journal
of Economics, vol. 66 (November 1952),
pp. 465-501.
Haberler, Gottfried. Prosperity and Depression: A Theoretical Analysis of Cyclical Movements. Geneva: League of Nations, 1941.
Hume, David. “Of Money,” “Of the Balance
of Trade,” and “Of Interest,” (1752), in
Hume’s Writings on Economics, E. Rotwein,
ed. Madison, Wis.: University of Wisconsin
Press, 1955.
Humphrey, Thomas M. “Historical Origins
of the Cost-Push Fallacy,” Federal Reserve
Bank of Richmond Economic Quarterly,
vol. 84 (Summer 1998), pp. 53-74.
Humphrey, Thomas M. Money, Banking and
Inflation: Essays in the History of Monetary
Thought. Aldershot, England: Edward Elgar
Publishing Ltd., 1993.
Hutchison, Terence W. Before Adam Smith:
The Emergence of Political Economy, 16621776. Oxford: Basil Blackwell, 1988.
Kaldor, Nicholas. The Scourge of Monetarism.
Oxford: Oxford University Press, 1982.
Keynes, John Maynard. The General Theory
of Employment, Interest and Money. London:
Macmillan, 1936.
Kydland, Finn, and Edward Prescott. “Rules
Rather Than Discretion: The Inconsistency
of Optimal Plans,” Journal of Political Economy,
vol. 85 (June 1977), pp. 473-91.
Law, John. Money and Trade Considered, with
a Proposal for Supplying the Nation with Money.
Edinburgh, 1705.
Lucas, Robert E., Jr. “Expectations and the
Neutrality of Money,” Journal of Economic
Theory, vol. 4 (April 1972), pp. 103-24.
Meek, R. L. “Rehabilitation of Sir James
Steuart,” in his Economics and Ideology and
Other Essays. London: Chapman and Hall,
1967.
Mints, Lloyd W. A History of Banking Theory.
Chicago: University of Chicago Press, 1945.
Murphy, Antoin E. John Law: Economic Theorist and Policy-Maker. Oxford: Clarendon
Press, 1997.
Muth, John F. “Rational Expectations and the
Theory of Price Movements,” Econometrica,
vol. 29 (July 1961), pp. 315-35.
Niehans, Jurg. A History of Economic Theory:
Classic Contributions, 1720-1980. Baltimore:
Johns Hopkins University Press, 1990.
O’Brien, Denis P. The Classical Economists.
New York: Oxford University Press, 1975.
Patinkin, Don. “Price Flexibility and Full
Employment,” American Economic Review,
vol. 38 (September 1948), pp. 543-64.
Patinkin, Don. Money, Interest, and Prices,
2nd ed. New York: Harper and Row, 1965.
Pearce, Ivor F. “Confrontation with Keynes,”
in The Coming Confrontation: Will the Open
Society Survive to 1989? London: The Institute of Economic Affairs, 1978.
Phelps, Edmund S. “Phillips Curves, Expectation of Inflation and Optimal Unemployment Over Time,” Economica, vol. 34
(August 1967), pp. 254-81.
Pigou, Arthur C. “Economic Progress in
a Stable Environment,” Economica, vol. 14
(August 1947), pp.180-90.
Pigou, Arthur C. “The Classical Stationary
State,” Economic Journal, vol. 53 (December
1943), pp. 343-51.
Ricardo, David. The Works and Correspondence of David Ricardo, Vols. I and II, edited
by P. Sraffa with M. H. Dobb. Cambridge:
Cambridge University Press, 1951-1973.
Robbins, Lionel. Robert Torrens and the
Evolution of Classical Economics. London:
Macmillan, 1958.
Sargent, Thomas J., and Neil Wallace. “Rational Expectations, the Optimal Monetary
Instrument, and the Optimal Money Supply
Rule,” Journal of Political Economy, vol. 83
(April 1975), pp. 241-54.
Say, Jean-Baptiste. Traité d’économie politique:
Ou, simple exposition de la manière dont se
forment, se distribuent, et se consomment les
richesses, Vol. 1. Paris: Deterville, 1803. Translated under the title ATreatise on Political Economy, 4th ed. Philadelphia: G. R. Elliot, 1834.
Schwartz, Anna J. “Banking School, Currency
School, Free Banking School,” in J. Eatwell,
M. Milgate, and P. Newman, eds., The New
Palgrave – A Dictionary of Economics, Vol. 1.
London: Macmillan, 1987.
Screpanti, Ernesto, and Stefano Zamagni.
An Outline of the History of Economic Thought,
translated by David Field. New York:
Oxford University Press, 1993.
Skaggs, Neil. “Changing Views: TwentiethCentury Opinion on the Banking SchoolCurrency School Controversy,” forthcoming
in History of Political Economy, vol. 31
(Summer 1999), pp. 361-91.
Skinner, Andrew S. “Sir James Steuart:
Author of a System,” Scottish Journal of
Political Economy, vol. 28 (February 1981),
pp. 20-42.
Tavlas, George S. “Keynesian and Monetarist
Theories of the Monetary Transmission
Process: Doctrinal Aspects.” Journal of Monetary Economics, vol. 7 (May 1981), pp. 317-37.
Taylor, John B. “Comment,” in Christina and
David H. Romer, eds., Reducing Inflation:
Motivation and Strategy. Chicago: University
of Chicago Press, 1997, pp. 276-80.
Thornton, Henry. An Enquiry into the Nature
and Effects of the Paper Credit of Great Britain
(1802).Together with His Speeches on the
Bullion Report, May 1811. F. A. von Hayek,
ed. London: G. Allen & Unwin, 1939.
Viner, Jacob. Studies in the Theory of InternationalTrade. New York: Harper Brothers, 1937.
Warburton, Clark. Depression, Inflation and
Monetary Policy, Selected Papers 1945-1953.
Baltimore: Johns Hopkins University Press,
1966.
27
Year in Review
28
Despite considerable domestic and international financial turbulence in the latter part of
the year, the U. S. economy continued its robust
growth in 1998. Unemployment fell to its
lowest level since the early 1970s, real wages
rose more rapidly than at any time since that
period, and inflation remained low. The Fifth
District’s economy shared in the national prosperity, particularly in the areas of employment
growth and construction activity – residential
and commercial. Accompanying the region’s
strong economic conditions was substantial
bank merger activity, including the creation of
two of the nation’s largest banking companies
headquartered in the District. The Federal
Reserve System’s monetary policy strategy
aimed at price-level stability helped set the
stage and establish the financial framework for
the national and Fifth District growth. Through
its research and communication efforts, the
Federal Reserve Bank of Richmond contributed
to the support of this strategy as well as to
banking and payments system policymaking.
The Bank worked to achieve these and other
System objectives not only through research
and communications, but also its activities
in public and community affairs, banking supervision, and financial services.
Economic Research and Public Outreach
The Bank continued to produce economic
research relevant to Federal Reserve monetary
and banking policy, the Fifth District economy,
and the payments mechanism. Research staff
analyzed current policy issues and advised
Mr. Broaddus in preparation for Federal Open
Market Committee meetings and presented
monetary policy research in both Federal
Reserve and academic forums. The Research
Department also provided Mr. Broaddus and
Mr. Varvel strong analytical support in meeting
their banking and payment system responsibilities. In addition, the Bank provided valuable
input to Systemwide understanding of the
reserve accounting, Federal Reserve credit
extension, data reporting, banking supervision,
and payment policy needs of interstate banking
organizations.
Public outreach efforts bolstered current
initiatives and introduced new products and public programs. Mr. Broaddus continued to meet
with business and community leaders around
the District and maintained an active public
speaking schedule. Direct contact with District
businesses increased in 1998 to meet growing
public demand for timely and comprehensive
information about the region’s economy.
The Bank used its publications and web
site to communicate information about the
Fifth District, the national economy, and Federal
Reserve monetary policy. The Bank’s business
magazine, Region Focus, received several awards
and increased its circulation. Articles from the
Economic Quarterly earned media recognition and
international acknowledgment. With new sections on economic education, financial services,
and century date change preparations, the Bank’s
web site became a popular source of information. State Economic Profiles were reformatted
on the web site to better meet user needs for
information on state economic activity.
Continuing to build on established partnerships with economic education organizations
around the District, the Bank helped establish
a new national center for Economic Education
at Gallaudet University in Washington, D.C.,
a four-year liberal arts college serving the deaf
and hearing impaired. In addition, the District
held three “Fed Challenge” competitions for high
school students and one for college students.
The Bank also formed a new Community
Development Advisory Council to increase
communication between the Bank and consumer, community, and labor groups across
the District. In other communication efforts,
the Community Affairs Office sponsored more
than 20 public seminars and distributed over
25,000 copies of its publications.
Banking Supervision
The financial condition of banking organizations
in the Fifth District remained strong, and banking industry consolidation continued at a rapid
pace. At year-end 1998, 220 Fifth District bank
holding companies controlled total assets of
$1.1 trillion, an increase of $420 billion from
the previous year. This increase resulted from
several large bank acquisitions, most notably
NationsBank Corporation’s acquisition of
Barnett Banks, Inc., and subsequent merger with
BankAmerica Corporation; and First Union
Corporation’s purchase of CoreStates Financial Corp. Consolidation activity also spurred
the opening of several de novo banks in the
District. Seven new banks opened as state
member banks during 1998, while four existing
banks converted to state member status.
In response to increased supervisory
responsibilities for three large interstate
banking organizations headquartered in North
Carolina, the Bank opened a new banking
supervision and regulation office in Charlotte.
Banking Supervision strengthened its new
approach to conducting examinations that
focuses on each institution’s management
and control of business risks. This risk-based
supervisory approach and joint efforts with
the Office of the Comptroller of the Currency
and state banking authorities reduced the
supervisory burden imposed on bank holding
companies and state member banks.
Financial Services and Other Operations
The financial services areas continued to offer
quality services to meet the needs of depository institutions and the U.S. Treasury. The
Bank realized 105.8 percent cost recovery in
1998, exceeding its financial targets for priced
services. Also, the financial services functions
improved their unit cost and productivity
measures and met their key quality targets.
Surveys of the accounting, automated clearinghouse (ACH), check, customer support, funds
transfer, and securities transfer areas indicated
that customers were well satisfied with the
Bank’s services.
The Bank continued to pursue payment
system efficiencies through the expansion of
ACH, electronic check presentment and imagebased services. Partnering with the District’s
three ACH associations, the ACH function
conducted successful educational and promotional campaigns for direct deposit and direct
bill payment programs. ACH also introduced
new software to support financial electronic
data interchange. Operating efficiencies permitted the Federal Reserve to further reduce
the price of ACH services during the year and
to effect substantial reductions in funds transfer fees. In addition, government check processing operations were converted to a highspeed image capture platform in August 1998.
Commercial electronic check presentment and
truncation volume as a percentage of numbers
of items processed grew from 8.7 percent at
year-end 1997 to 13.6 percent at year-end 1998,
resulting in the second highest check truncation volume in the System.
The Bank also provided extensive support
to the U.S. Treasury in 1998. A senior Bank
officer continued to serve as the System’s
Treasury Liaison; he coordinated 20 joint Treasury and Federal Reserve initiatives and provided consultative support. The Currency
Technology Office supported the Treasury in
introducing new currency and in counterfeit
sampling, and assisted the Bureau of Engraving
and Printing with the design of the new $20
note. Finally, the Bank provided full support for
the U.S. Treasury’s Automated Standard Application for Payments and the Department of
Agriculture’s Account Management Agent
applications, and served as one of five regional
processing sites for savings bonds.
The Reserve Accounting and Loans
areas played a major role in supporting the
numerous account changes associated with
bank mergers and in encouraging depository
institutions to make preparations to borrow
from the Fed’s discount window should the
need arise. Accounting and Control implemented a COSO-based framework for
evaluating the adequacy of internal controls
associated with the Bank’s financial reporting.
PricewaterhouseCoopers LLP reviewed and
attested to the internal control evaluation
performed by Bank management in 1998.
Preparations for the century date change
(CDC) were intense. The Bank met end-ofyear targets and milestones for its critical
hardware and software systems. It also provided
extensive automated systems test support for
depository institutions and supervisory oversight for CDC preparations at bank holding
companies and state member banks. During
1999, CDC preparations will include follow-up
supervisory examinations, continued test support for institutions, and refinement of the Bank’s
contingency and event management plans.
29
FEDERAL RESERVE BANK OF RICHMOND
December 31, 1998
To the Board of Directors:
The management of the Federal Reserve Bank of Richmond (“FRB Richmond”)
is responsible for the preparation and fair presentation of the Statement
of Financial Condition, Statement of Income, and Statement of Changes in
Capital as of December 31, 1998 (the “Financial Statements”). The Financial
Statements have been prepared in conformity with the accounting principles,
policies, and practices established by the Board of Governors of the Federal
Reserve System and as set forth in the Financial Accounting Manual for
the Federal Reserve Banks, and as such, include amounts, some of which
are based on judgments and estimates of management.
The management of the FRB Richmond is responsible for maintaining an
effective process of internal controls over financial reporting including the
safeguarding of assets as they relate to the Financial Statements. Such internal controls are designed to provide reasonable assurance to management
and to the Board of Directors regarding the preparation of reliable Financial Statements. This process of internal controls contains self-monitoring
mechanisms, including, but not limited to, divisions of responsibility and a
code of conduct. Once identified, any material deficiencies in the process of
internal controls are reported to management, and appropriate corrective
measures are implemented.
Even an effective process of internal controls, no matter how well designed,
has inherent limitations, including the possibility of human error, and therefore can provide only reasonable assurance with respect to the preparation
of reliable financial statements.
The management of the FRB Richmond assessed its process of internal
controls over financial reporting including the safeguarding of assets
reflected in the Financial Statements, based upon the criteria established in
the “Internal Control – Integrated Framework” issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO). Based
on this assessment, the management of the FRB Richmond believes that
the FRB Richmond maintained an effective process of internal controls
over financial reporting including the safeguarding of assets as they relate
to the Financial Statements.
Federal Reserve Bank of Richmond
J. Alfred Broaddus, Jr.
Walter A. Varvel
PRESIDENT
FIRST VICE PRESIDENT
30
FEDERAL RESERVE BANK OF RICHMOND
Report of Independent Accountants
To the Board of Directors of the Federal Reserve Bank of Richmond:
We have examined management’s assertion that the Federal Reserve Bank
of Richmond (“FRB Richmond”) maintained effective internal control over
financial reporting and the safeguarding of assets as they relate to the
Financial Statements as of December 31, 1998, included in the accompanying Management’s Assertion.
Our examination was made in accordance with standards established by
the American Institute of Certified Public Accountants, and accordingly,
included obtaining an understanding of the internal control over financial
reporting, testing, and evaluating the design and operating effectiveness
of the internal control, and such other procedures as we considered necessary in the circumstances. We believe that our examination provides a
reasonable basis for our opinion.
31
Because of inherent limitations in any internal control, misstatements due
to error or fraud may occur and not be detected. Also, projections
of any evaluation of the internal control over financial reporting to future
periods are subject to the risk that the internal control may become
inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assertion that the FRB Richmond
maintained effective internal control over financial reporting and over
the safeguarding of assets as they relate to the Financial Statements as of
December 31, 1998, is fairly stated, in all material respects, based upon
criteria described in “Internal Control – Integrated Framework” issued by
the Committee of Sponsoring Organizations of the Treadway Commission.
Richmond, Virginia
March 5, 1999
FEDERAL RESERVE BANK OF RICHMOND
Report of Independent Accountants
To the Board of Governors of The Federal Reserve System
and the Board of Directors of The Federal Reserve Bank of Richmond:
We have audited the accompanying statements of condition of The Federal
Reserve Bank of Richmond (the “Bank”) as of December 31, 1998 and
1997, and the related statements of income and changes in capital for the
years then ended. These financial statements are the responsibility of the
Bank’s management. Our responsibility is to express an opinion on the
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 3, the financial statements were prepared in conformity with the accounting principles, policies, and practices established by
the Board of Governors of The Federal Reserve System. These principles,
policies, and practices, which were designed to meet the specialized
accounting and reporting needs of The Federal Reserve System, are set
forth in the “Financial Accounting Manual for Federal Reserve Banks” and
constitute a comprehensive basis of accounting other than generally
accepted accounting principles.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of the Bank as of
December 31, 1998 and 1997, and results of its operations for the years
then ended, on the basis of accounting described in Note 3.
Richmond, Virginia
March 5, 1999
32
FEDERAL RESERVE BANK OF RICHMOND
Statements of Condition
(IN MILLIONS)
AS OF
AS OF
DECEMBER 31, 1998
DECEMBER 31, 1997
Assets
Gold certificates
Special drawing rights certificates
Coin
Items in process of collection
U.S. government and federal agency securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Interdistrict settlement account
Bank premises and equipment, net
Other assets
Total assets
$
807
$
965
792
53
792
63
624
35,974
474
41,294
3,066
340
4,985
1,177
391
—
201
85
217
86
$46,927
$45,459
$41,577
$32,459
1,898
54
676
157
2,062
40
650
47
—
64
25
8,468
59
23
44,451
43,808
1,238
1,238
833
818
2,476
1,651
$46,927
$45,459
Liabilities and Capital
33
Liabilities:
Federal Reserve notes outstanding, net
Deposits:
Depository institutions
Other deposits
Deferred credit items
Surplus transfer due U.S. Treasury
Interdistrict settlement account
Accrued benefit cost
Other liabilities
Total liabilities
Capital:
Capital paid-in
Surplus
Total capital
Total liabilities and capital
The accompanying notes are an integral part of these financial statements.
FEDERAL RESERVE BANK OF RICHMOND
Statements of Income
(IN MILLIONS)
FOR THE YEAR ENDED
FOR THE YEAR ENDED
DECEMBER 31, 1998
DECEMBER 31, 1997
$2,212
$2,309
65
26
2,277
2,335
Interest Income:
Interest on U.S. government securities
Interest on foreign currencies
Total interest income
Other Operating Income (Loss):
Income from services
Reimbursable services to government agencies
Foreign currency gains (losses), net
65
31
290
Government securities gains, net
Other income
62
26
(179)
3
4
Total other operating income (loss)
1
2
393
(88)
157
141
Operating Expenses:
Salaries and other benefits
34
Occupancy expense
24
24
Equipment expense
Cost of unreimbursed Treasury services
84
—
104
Assessments by Board of Governors
57
48
(60)
(57)
262
266
$2,408
$1,981
$
$
Other expenses (credits)
Total operating expenses
Net income prior to distribution
6
Distribution of Net Income:
Dividends paid to member banks
Transferred to surplus
Payments to U.S. Treasury as interest on
Federal Reserve notes
Payments to U.S. Treasury as required by statute
Total distribution
The accompanying notes are an integral part of these financial statements.
61
420
34
515
733
1,194
1,432
$2,408
$1,981
—
FEDERAL RESERVE BANK OF RICHMOND
Statements of Changes in Capital
FOR THE YEARS ENDED DECEMBER 31, 1998
AND DECEMBER 31, 1997
(IN MILLIONS)
Balance at January 1, 1997
(6.4 million shares)
Surplus
Total Capital
$ 318
$ 310
$ 628
Net income transferred to surplus
—
515
515
Statutory surplus transfer to the U.S. Treasury
Net change in capital stock issued
—
(7)
515
—
515
$ 833
$ 818
$1,651
—
420
420
405
—
405
$1,238
$1,238
$2,476
(10.3 million shares)
Balance at December 31, 1997
(16.7 million shares)
Net income transferred to surplus
Net change in capital stock issued
(8.0 million shares)
Balance at December 31, 1998
(24.7 million shares)
35
Capital Paid-in
The accompanying notes are an integral part of these financial statements.
(7)
FEDERAL RESERVE BANK OF RICHMOND
Notes to Financial Statements
1. Organization
The Federal Reserve Bank of Richmond (“Bank”) is part of the Federal Reserve System (“System”) created by
Congress under the Federal Reserve Act of 1913 (“Federal Reserve Act”) which established the central bank
of the United States. The System consists of the Board of Governors of the Federal Reserve System (“Board
of Governors”) and twelve Federal Reserve Banks (“Reserve Banks”). The Reserve Banks are chartered by the
federal government and possess a unique set of governmental, corporate, and central bank characteristics.
Other major elements of the System are the Federal Open Market Committee (“FOMC”), and the Federal
Advisory Council. The FOMC is composed of members of the Board of Governors, the president of the Federal Reserve Bank of New York (“FRBNY”) and, on a rotating basis, four other Reserve Bank presidents.
Structure
The Bank and its branches in Baltimore, Maryland, Charlotte, North Carolina, Columbia, South Carolina, and
Charleston, West Virginia serve the Fifth Federal Reserve District, which includes Maryland, North Carolina,
South Carolina, Virginia, District of Columbia, and a portion of West Virginia. In accordance with the Federal
Reserve Act, supervision and control of the Bank is exercised by a Board of Directors. Banks that are members of the System include all national banks and any state chartered bank that applies and is approved for membership in the System.
Board of Directors
The Federal Reserve Act specifies the composition of the board of directors for each of the Reserve Banks.
Each board is composed of nine members serving three-year terms: three directors, including those designated
as Chairman and Deputy Chairman, are appointed by the Board of Governors, and six directors are elected by
member banks. Of the six elected by member banks, three represent the public and three represent member
banks. Member banks are divided into three classes according to size. Member banks in each class elect one
director representing member banks and one representing the public. In any election of directors, each member bank receives one vote, regardless of the number of shares of Reserve Bank stock it holds.
2. Operations and Services
The System performs a variety of services and operations. Functions include: formulating and conducting monetary policy; participating actively in the payments mechanism, including large-dollar transfers of funds, automated
clearinghouse operations and check processing; distribution of coin and currency; fiscal agency functions for the
U.S. Treasury and certain federal agencies; serving as the federal government’s bank; providing short-term loans
to depository institutions; serving the consumer and the community by providing educational materials and
information regarding consumer laws; supervising bank holding companies, and state member banks; and administering other regulations of the Board of Governors. The Board of Governors’ operating costs are funded
through assessments on the Reserve Banks.
The FOMC establishes policy regarding open market operations, oversees these operations, and issues
authorizations and directives to the FRBNY for its execution of transactions. Authorized transaction types
include direct purchase and sale of securities, matched sale-purchase transactions, the purchase of securities
under agreements to resell, and the lending of U.S. government securities. Additionally, the FRBNY is authorized by the FOMC to hold balances of and to execute spot and forward foreign exchange and securities contracts in fourteen foreign currencies, maintain reciprocal currency arrangements (“F/X swaps”) with various
central banks, and “warehouse” foreign currencies for the U.S. Treasury and Exchange Stabilization Fund (“ESF”)
through the Reserve Banks.
3. Significant Accounting Policies
Accounting principles for entities with the unique powers and responsibilities of the nation’s central bank have
not been formulated by the Financial Accounting Standards Board. The Board of Governors has developed specialized accounting principles and practices that it believes are appropriate for the significantly different nature
and function of a central bank as compared to the private sector. These accounting principles and practices are
documented in the “Financial Accounting Manual for Federal Reserve Banks” (“Financial Accounting Manual”),
36
which is issued by the Board of Governors. All Reserve Banks are required to adopt and apply accounting policies and practices that are consistent with the Financial Accounting Manual.
The financial statements have been prepared in accordance with the Financial Accounting Manual. Differences exist between the accounting principles and practices of the System and generally accepted accounting
principles (“GAAP”). The primary differences are the presentation of all security holdings at amortized cost,
rather than at the fair value presentation requirements of GAAP, and the accounting for matched sale-purchase
transactions as separate sales and purchases, rather than secured borrowings with pledged collateral, as is
required by GAAP. In addition, the Bank has elected not to present a Statement of Cash Flows or a Statement
of Comprehensive Income. The Statement of Cash Flows has not been included as the liquidity and cash position of the Bank are not of primary concern to the users of these financial statements. The Statement of Comprehensive Income, which comprises net income plus or minus certain adjustments, such as the fair value
adjustment for securities, has not been included because as stated above the securities are recorded at amortized cost and there are no other adjustments in the determination of Comprehensive Income applicable to
the Bank. Other information regarding the Bank’s activities is provided in, or may be derived from, the Statements of Condition, Income, and Changes in Capital. Therefore, a Statement of Cash Flows or a Statement of
Comprehensive Income would not provide any additional useful information. There are no other significant differences between the policies outlined in the Financial Accounting Manual and GAAP.
The preparation of the financial statements in conformity with the Financial Accounting Manual requires
management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported
amounts of income and expenses during the reporting period. Actual results could differ from those estimates.
Unique accounts and significant accounting policies are explained below.
a. Gold Certificates
37
The Secretary of the Treasury is authorized to issue gold certificates to the Reserve Banks to monetize gold
held by the U.S. Treasury. Payment for the gold certificates by the Reserve Banks is made by crediting equivalent amounts in dollars into the account established for the U.S. Treasury. These gold certificates held by the
Reserve Banks are required to be backed by the gold of the U.S. Treasury. The U.S. Treasury may reacquire the
gold certificates at any time and the Reserve Banks must deliver them to the U.S. Treasury. At such time, the
U.S. Treasury’s account is charged and the Reserve Banks’ gold certificate accounts are lowered. The value of
gold for purposes of backing the gold certificates is set by law at $42 2/9 a fine troy ounce. The Board of Governors allocates the gold certificates among Reserve Banks once a year based upon Federal Reserve notes outstanding in each District at the end of the preceding year.
b. Special Drawing Rights Certificates
Special drawing rights (“SDRs”) are issued by the International Monetary Fund (“Fund”) to its members in proportion to each member’s quota in the Fund at the time of issuance. SDRs serve as a supplement to international monetary reserves and may be transferred from one national monetary authority to another. Under the
law providing for United States participation in the SDR system, the Secretary of the U.S. Treasury is authorized to issue SDR certificates, somewhat like gold certificates, to the Reserve Banks. At such time, equivalent
amounts in dollars are credited to the account established for the U.S. Treasury, and the Reserve Banks’ SDR
certificate accounts are increased. The Reserve Banks are required to purchase SDRs, at the direction of the
U.S. Treasury, for the purpose of financing SDR certificate acquisitions or for financing exchange stabilization
operations. The Board of Governors allocates each SDR transaction among Reserve Banks based upon Federal
Reserve notes outstanding in each District at the end of the preceding year.
c. Loans to Depository Institutions
The Depository Institutions Deregulation and Monetary Control Act of 1980 provides that all depository institutions that maintain reservable transaction accounts or nonpersonal time deposits, as defined in Regulation D
issued by the Board of Governors, have borrowing privileges at the discretion of the Reserve Banks. Borrowers
execute certain lending agreements and deposit sufficient collateral before credit is extended. Loans are evaluated for collectibility, and currently all are considered collectible and fully collateralized. If any loans were
deemed to be uncollectible, an appropriate reserve would be established. Interest is recorded on the accrual
basis and is charged at the applicable discount rate established at least every fourteen days by the Board of
Directors of the Reserve Banks, subject to review by the Board of Governors. However, Reserve Banks retain
the option to impose a surcharge above the basic rate in certain circumstances. There were no outstanding
loans to depository institutions at December 31, 1998 and 1997 respectively.
d. U.S. Government and Federal Agency Securities
and Investments Denominated in Foreign Currencies
The FOMC has designated the FRBNY to execute open market transactions on its behalf and to hold the resulting securities in the portfolio known as the System Open Market Account (“SOMA”). In addition to authorizing
and directing operations in the domestic securities market, the FOMC authorizes and directs the FRBNY to execute operations in foreign markets for major currencies in order to counter disorderly conditions in exchange
markets or other needs specified by the FOMC in carrying out the System’s central bank responsibilities.
Purchases of securities under agreements to resell and matched sale-purchase transactions are accounted for as separate sale and purchase transactions. Purchases under agreements to resell are transactions in
which the FRBNY purchases a security and sells it back at the rate specified at the commencement of the transaction. Matched sale-purchase transactions are transactions in which the FRBNY sells a security and buys it
back at the rate specified at the commencement of the transaction.
Reserve Banks are authorized by the FOMC to lend U.S. government securities held in the SOMA to U.S.
government securities dealers and to banks participating in U.S. government securities clearing arrangements, in
order to facilitate the effective functioning of the domestic securities market. These securities-lending transactions are fully collateralized by other U.S. government securities. FOMC policy requires the lending Reserve Bank
to take possession of collateral in amounts in excess of the market values of the securities loaned. The market
values of the collateral and the securities loaned are monitored by the lending Reserve Bank on a daily basis, with
additional collateral obtained as necessary. The securities loaned continue to be accounted for in the SOMA.
Foreign exchange contracts are contractual agreements between two parties to exchange specified currencies, at a specified price, on a specified date. Spot foreign contracts normally settle two days after the trade
date, whereas the settlement date on forward contracts is negotiated between the contracting parties, but will
extend beyond two days from the trade date. The FRBNY generally enters into spot contracts, with any forward contracts generally limited to the second leg of a swap/warehousing transaction.
The FRBNY, on behalf of the Reserve Banks, maintains renewable, short-term F/X swap arrangements with
authorized foreign central banks. The parties agree to exchange their currencies up to a pre-arranged maximum amount and for an agreed upon period of time (up to twelve months), at an agreed upon interest rate.
These arrangements give the FOMC temporary access to foreign currencies that it may need for intervention
operations to support the dollar and give the partner foreign central bank temporary access to dollars it may
need to support its own currency. Drawings under the F/X swap arrangements can be initiated by either the
FRBNY or the partner foreign central bank, and must be agreed to by the drawee. The F/X swaps are structured so that the party initiating the transaction (the drawer) bears the exchange rate risk upon maturity. The
FRBNY will generally invest the foreign currency received under an F/X swap in interest-bearing instruments.
Warehousing is an arrangement under which the FOMC agrees to exchange, at the request of the Treasury, U.S. dollars for foreign currencies held by the Treasury or ESF over a limited period of time. The purpose
of the warehousing facility is to supplement the U.S. dollar resources of the Treasury and ESF for financing purchases of foreign currencies and related international operations.
In connection with its foreign currency activities, the FRBNY, on behalf of the Reserve Banks, may enter
into contracts which contain varying degrees of off-balance sheet market risk, because they represent contractual commitments involving future settlement, and counter-party credit risk. The FRBNY controls credit
risk by obtaining credit approvals, establishing transaction limits, and performing daily monitoring procedures.
While the application of current market prices to the securities currently held in the SOMA portfolio and
investments denominated in foreign currencies may result in values substantially above or below their carrying
values, these unrealized changes in value would have no direct effect on the quantity of reserves available to
the banking system or on the prospects for future Reserve Bank earnings or capital. Both the domestic and
foreign components of the SOMA portfolio from time to time involve transactions that can result in gains or
losses when holdings are sold prior to maturity. However, decisions regarding the securities and foreign currencies transactions, including their purchase and sale, are motivated by monetary policy objectives rather than
profit. Accordingly, earnings and any gains or losses resulting from the sale of such currencies and securities are
incidental to the open market operations and do not motivate its activities or policy decisions.
U.S. government and federal agency securities and investments denominated in foreign currencies comprising the SOMA are recorded at cost, on a settlement-date basis, and adjusted for amortization of premiums or
accretion of discounts on a straight-line basis. Interest income is accrued on a straight-line basis and is reported
as “Interest on U.S. government securities” or “Interest on foreign currencies,” as appropriate. Income earned on
securities lending transactions is reported as a component of “Other income.” Gains and losses resulting from
sales of securities are determined by specific issues based on average cost. Gains and losses on the sales of U.S.
government and federal agency securities are reported as “Government securities gains, net.” Foreign currency
denominated assets are revalued monthly at current market exchange rates in order to report these assets in
U.S. dollars. Realized and unrealized gains and losses on investments denominated in foreign currencies are
38
reported as “Foreign currency gains (losses), net.” Foreign currencies held through F/X swaps, when initiated
by the counter party, and warehousing arrangements are revalued monthly, with the unrealized gain or loss
reported by the FRBNY as a component of “Other assets” or “Other liabilities,” as appropriate.
Balances of U.S. government and federal agencies securities bought outright, investments denominated in
foreign currency, interest income, amortization of premiums and discounts on securities bought outright, gains
and losses on sales of securities, and realized and unrealized gains and losses on investments denominated in foreign currencies, excluding those held under an F/X swap arrangement, are allocated to each Reserve Bank. Securities purchased under agreements to resell and the related premiums,discounts and income,and unrealized gains
and losses on the revaluation of foreign currency holdings under F/X swaps and warehousing arrangements are
allocated to the FRBNY and not to other Reserve Banks. Income from securities lending transactions is recognized only by the lending Reserve Bank.
e. Bank Premises and Equipment
Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated on
a straight-line basis over estimated useful lives of assets ranging from 2 to 50 years. New assets, major alterations, renovations and improvements are capitalized at cost as additions to the asset accounts. Maintenance,
repairs and minor replacements are charged to operations in the year incurred.
f. Interdistrict Settlement Account
At the close of business each day, all Reserve Banks and branches assemble the payments due to or from other
Reserve Banks and branches as a result of transactions involving accounts residing in other Districts that
occurred during the day’s operations. Such transactions may include funds settlement, check clearing and automated clearinghouse (“ACH”) operations, and allocations of shared expenses. The cumulative net amount due
to or from other Reserve Banks is reported as the “Interdistrict settlement account.”
g. Federal Reserve Notes
39
Federal Reserve notes are the circulating currency of the United States. These notes are issued through the
various Federal Reserve agents to the Reserve Banks upon deposit with such Agents of certain classes of collateral security, typically U.S. government securities. These notes are identified as issued to a specific Reserve
Bank. The Federal Reserve Act provides that the collateral security tendered by the Reserve Bank to the Federal Reserve Agent must be equal to the sum of the notes applied for by such Reserve Bank. In accordance
with the Federal Reserve Act, gold certificates, special drawing rights certificates, U.S. government and agency
securities, loans allowed under Section 13, and investments denominated in foreign currencies are pledged as
collateral for net Federal Reserve notes outstanding. The collateral value is equal to the book value of the collateral tendered, with the exception of securities, whose collateral value is equal to the par value of the securities tendered. The Board of Governors may, at any time, call upon a Reserve Bank for additional security to
adequately collateralize the Federal Reserve notes. To satisfy its obligation to provide sufficient collateral for its
outstanding Federal Reserve notes, the Reserve Banks have entered into an agreement that provides that certain assets of the Reserve Banks are jointly pledged as collateral for the Federal Reserve notes of all Reserve
Banks. In the event that this collateral is insufficient, the Federal Reserve Act provides that Federal Reserve
notes become a first and paramount lien on all the assets of the Reserve Banks. Finally, as obligations of the
United States, Federal Reserve notes are backed by the full faith and credit of the United States government.
The “Federal Reserve notes outstanding, net” account represents Federal Reserve notes reduced by cash
held in the vaults of the Bank of $9,343 million, and $6,713 million at December 31, 1998 and 1997, respectively.
h. Capital Paid-in
The Federal Reserve Act requires that each member bank subscribe to the capital stock of the Reserve Bank
in an amount equal to 6% of the capital and surplus of the member bank. As a member bank’s capital and surplus
changes, its holdings of the Reserve Bank’s stock must be adjusted. Member banks are those state-chartered
banks that apply and are approved for membership in the System and all national banks. Currently, only onehalf of the subscription is paid-in and the remainder is subject to call. These shares are nonvoting with a par
value of $100. They may not be transferred or hypothecated. By law, each member bank is entitled to receive
an annual dividend of 6% on the paid-in capital stock. This cumulative dividend is paid semiannually. A member
bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it.
i. Surplus
The Board of Governors requires Reserve Banks to maintain a surplus equal to the amount of capital paid-in as
of December 31. This amount is intended to provide additional capital and reduce the possibility that the Reserve
Banks would be required to call on member banks for additional capital. Reserve Banks are required by the
Board of Governors to transfer to the U.S. Treasury excess earnings, after providing for the costs of operations, payment of dividends, and reservation of an amount necessary to equate surplus with capital paid-in. Payments made after September 30, 1998 represent payment of interest on Federal Reserve notes outstanding.
The Omnibus Budget Reconciliation Act of 1993 (Public Law 103-66, Section 3002) codified the existing
Board surplus policies as statutory surplus transfers, rather than as payments of interest on Federal Reserve
notes, for federal government fiscal years 1998 and 1997 (which began on October 1, 1997 and 1996, respectively). In addition, the legislation directed the Reserve Banks to transfer to the U.S. Treasury additional surplus
funds of $107 million and $106 million during fiscal years 1998 and 1997, respectively. Reserve Banks were not
permitted to replenish surplus for these amounts during this time. The Reserve Banks made these transfers on
October 1, 1997 and October 1, 1996, respectively. The Bank’s share of the 1997 transfer is reported as “Statutory surplus transfer to the U.S. Treasury.”
In the event of losses, payments to the U.S. Treasury are suspended until such losses are recovered through
subsequent earnings. Weekly payments to the U.S. Treasury vary significantly.
j. Cost of Unreimbursed Treasury Services
The Bank is required by the Federal Reserve Act to serve as fiscal agent and depository of the United States.
By statute, the Department of the Treasury is permitted, but not required, to pay for these services. The costs
of providing fiscal agency and depository services to the Treasury Department that have been billed but will
not be paid are reported as the “Cost of unreimbursed Treasury services.”
k.Taxes
The Reserve Banks are exempt from federal, state, and local taxes, except for taxes on real property, which are
reported as a component of “Occupancy expense.”
4. U.S. Government and Federal Agency Securities
Securities bought outright and held under agreements to resell are held in the SOMA at the FRBNY. An undivided interest in SOMA activity, with the exception of securities held under agreements to resell and the
related premiums, discounts and income, is allocated to each Reserve Bank on a percentage basis derived from
an annual settlement of interdistrict clearings. The settlement, performed in April of each year, equalizes
Reserve Bank gold certificate holdings to Federal Reserve notes outstanding. The Bank’s allocated share of
SOMA balances was approximately 7.877% and 9.515% at December 31, 1998 and 1997, respectively.
The Bank’s allocated share of securities held in the SOMA at December 31, that were bought outright,
were as follows (in millions):
1998
Par value:
Federal agency
U.S. government:
Bills
Notes
Bonds
Total par value
Unamortized premiums
Unaccreted discounts
Total allocated to Bank
$
27
15,343
14,801
5,473
35,644
582
(252)
$35,974
1997
$
65
18,756
16,575
5,652
41,048
590
(344)
$41,294
Total SOMA securities bought outright were $456,667 million and $434,001 million at December 31, 1998 and
1997, respectively.
The maturities of U.S. government and federal agency securities bought outright, which were allocated to
the Bank at December 31, 1998, were as follows (in millions):
Par value
Maturities of Securities Held
Within 15 days
16 days to 90 days
91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
Total
U.S. Government
Securities
$
91
7,809
11,315
8,486
3,531
4,385
$35,617
Federal Agency
Obligations
$—
2
6
5
14
—
$27
Total
$
91
7,811
11,321
8,491
3,545
4,385
$35,644
40
At December 31, 1998, and 1997, matched sale-purchase transactions involving U.S. government securities
with par values of $20,927 million and $17,027 million, respectively, were outstanding, of which $1,648 million
and $1,620 million were allocated to the Bank. Matched sale-purchase transactions are generally overnight
arrangements.
5. Investments Denominated in Foreign Currencies
The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign central banks and the
Bank for International Settlements and invests in foreign government debt instruments. Foreign government
debt instruments held include both securities bought outright and securities held under agreements to resell.
These investments are guaranteed as to principal and interest by the foreign governments.
Each Reserve Bank is allocated a share of foreign-currency-denominated assets, the related interest income,
and realized and unrealized foreign currency gains and losses, with the exception of unrealized gains and losses
on F/X swaps and warehousing transactions. This allocation is based on the ratio of each Reserve Bank’s capital
and surplus to aggregate capital and surplus at the preceding December 31. The Bank’s allocated share of investments denominated in foreign currencies was approximately 15.499% and 6.906% at December 31, 1998 and
1997, respectively.
The Bank’s allocated share of investments denominated in foreign currencies, valued at current exchange
rates at December 31, were as follows (in millions):
41
German Marks:
Foreign currency deposits
Government debt instruments including
agreements to resell
Japanese Yen:
Foreign currency deposits
Government debt instruments including
agreements to resell
Accrued interest
Total
1998
1997
$1,620
368
$ 571
222
103
960
40
338
15
$3,066
6
$1,177
Total investments denominated in foreign currencies were $19,769 million and $17,046 million at December
31, 1998 and 1997, respectively, which include $15 million and $3 million in unearned interest for 1998 and
1997 respectively, collected on certain foreign currency holdings that is allocated solely to the FRBNY.
The maturities of investments denominated in foreign currencies which were allocated to the Bank at
December 31, 1998, were as follows (in millions):
Maturities of Investments Denominated in Foreign Currencies
Within 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Total
$2,917
77
72
$3,066
At December 31, 1998 and 1997, there were no open foreign exchange contracts or outstanding F/X swaps.
At December 31, 1998, the warehousing facility was $5,000 million, with nothing outstanding.
6. Bank Premises and Equipment
A summary of bank premises and equipment at December 31 is as follows (in millions):
Bank premises and equipment:
Land
Buildings
Building machinery and equipment
Construction in progress
Furniture and equipment
Accumulated depreciation
Bank premises and equipment, net
1998
1997
$ 16
115
32
3
288
454
(253)
$201
$ 16
115
31
1
310
473
(256)
$217
Depreciation expense was $44 million and $61 million for the years ended December 31, 1998 and 1997,
respectively.
Bank premises and equipment at December 31 include the following amounts for leases that have been
capitalized (in millions):
1998
Bank premises and equipment
Accumulated depreciation
Capitalized leases, net
$86
(77)
$ 9
1997
$77
(66)
$11
The Bank leases unused space to outside tenants. Those leases have terms ranging from 1 to 3 years.Rental income
from such leases was $1.4 million and $1.3 million for the years ended December 31, 1998 and 1997, respectively. Future minimum lease payments under agreements in existence at December 31, 1998, were (in millions):
1999
2000
2001
42
$1.2
1.0
0.9
$3.1
7. Commitments and Contingencies
At December 31, 1998, the Bank was obligated under noncancelable leases for premises and equipment with
terms ranging from 1 to approximately 6 years. These leases provide for increased rentals based upon increases in real estate taxes, operating costs or selected price indices.
Rental expense under operating leases for certain operating facilities, warehouses, and data processing and
office equipment (including taxes, insurance and maintenance when included in rent), net of sublease rentals,
was $37 million and $38 million for the years ended December 31, 1998 and 1997, respectively. Certain of the
Bank’s leases have options to renew.
Future minimum rental payments under noncancelable operating leases and capital leases, net of sublease
rentals, with terms of one year or more, at December 31, 1998, were (in millions):
1999
2000
2001
2002
2003
Thereafter
Less: Amount representing interest
Present value of net minimum lease payment
Operating
Capital
$1.3
0.9
0.6
0.3
0.2
0.1
$3.4
$0.7
0.5
0.4
—
—
—
1.6
(0.1)
$1.5
At December 31, 1998, there were no other commitments and long-term obligations in excess of one year.
Under the Insurance Agreement of the Federal Reserve Banks dated as of June 7, 1994, each of the
Reserve Banks has agreed to bear, on a per incident basis, a pro rata share of losses in excess of 1% of the capital of the claiming Reserve Bank, up to 50% of the total capital and surplus of all Reserve Banks. Losses are
borne in the ratio that a Reserve Bank’s capital bears to the total capital of all Reserve Banks at the beginning
of the calendar year in which the loss is shared. No claims were outstanding under such agreement at December 31, 1998 or 1997.
The Bank is involved in certain legal actions and claims arising in the ordinary course of business. Although
it is difficult to predict the ultimate outcome of these actions, in management’s opinion, based on discussions
with counsel, the aforementioned litigation and claims will be resolved without material adverse effect on the
financial position or results of operations of the Bank.
8. Retirement and Thrift Plans
Retirement Plans
The Bank currently offers two defined benefit retirement plans to its employees, based on length of service and
level of compensation. Substantially all of the Bank’s employees participate in the Retirement Plan for Employees of the Federal Reserve System (“System Plan”) and the Benefit Equalization Retirement Plan (“BEP”). The
System Plan is a multi-employer plan with contributions fully funded by participating employers. No separate
accounting is maintained of assets contributed by the participating employers. The Bank’s projected benefit
obligation and net pension costs for the BEP at December 31, 1998 and 1997, and for the years then ended,
are not material.
Thrift plan
Employees of the Bank may also participate in the defined contribution Thrift Plan for Employees of the Federal Reserve System (“Thrift Plan”). The Bank’s Thrift Plan contributions totaled $3 million and $4 million for
the years ended December 31, 1998 and 1997, respectively, and are reported as a component of “Salaries and
other benefits.”
9. Postretirement Benefits Other Than Pensions and Postemployment Benefits
43
Postretirement benefits other than pensions:
In addition to the Bank’s retirement plans, employees who have met certain age and length of service requirements are eligible for both medical benefits and life insurance coverage during retirement.
The Bank funds benefits payable under the medical and life insurance plans as due and, accordingly, has no
plan assets. Net postretirement benefit cost is actuarially determined using a January 1 measurement date.
Following is a reconciliation of beginning and ending balances of the benefit obligation (in millions):
Accumulated postretirement benefit obligation at January 1
Service cost-benefits earned during the period
Interest cost of accumulated benefit obligation
Actuarial loss (gain)
Contributions by plan participants
Benefits paid
Plan amendments, acquisitions, foreign currency exchange
rate changes, business combinations, divestitures,
curtailments, settlements, special termination benefits
Accumulated postretirement benefit obligation at December 31
1998
1997
$54.1
1.8
3.9
9.3
0.3
(2.2)
$54.9
1.6
3.7
(4.4)
0.3
(2.0)
—
$67.2
—
$54.1
Following is a reconciliation of the beginning and ending balance of the plan assets, the unfunded postretirement benefit obligation, and the accrued postretirement benefit cost (in millions):
1998
1997
Fair value of plan assets at January 1
Actual return on plan assets
Contributions by the employer
Contributions by plan participants
Benefits paid
Fair value of plan assets at December 31
$ —
—
1.9
0.3
(2.2)
$ —
$ —
—
1.7
0.3
(2.0)
$ —
Unfunded postretirement benefit obligation
Unrecognized initial net transition asset (obligation)
Unrecognized prior service cost
Unrecognized net actuarial gain (loss)
Accrued postretirement benefit cost
$67.2
—
0.7
(12.7)
$55.2
$54.1
(1.4)
0.6
(1.8)
$51.5
Accrued postretirement benefit cost is reported as a component of “Accrued benefit cost.”
The weighted-average assumption used in developing the postretirement benefit obligation as of December 31 is as follows:
Discount rate
1998
1997
6.25%
7.00%
For measurement purposes, an 8.5% annual rate of increase in the cost of covered health care benefits was
assumed for 1999. Ultimately, the health care cost trend rate is expected to decrease gradually to 4.75% by
2006, and remain at that level thereafter.
Assumed health care cost trend rates have a significant effect on the amounts reported for health care
plans. A one percentage point change in assumed health care cost trend rates would have the following effects
for the year ended December 31, 1998 (in millions):
1 Percentage
Point Increase
Effect on aggregate of service and interest cost components
of net periodic postretirement benefit cost
Effect on accumulated postretirement benefit obligation
$ 1.2
13.0
1 Percentage
Point Decrease
$ (1.1)
(12.2)
The following is a summary of the components of net periodic postretirement benefit cost for the years ended
December 31 (in millions):
Service cost-benefits earned during the period
Interest cost of accumulated benefit obligation
Amortization of prior service cost
Recognized net actuarial loss
Net periodic postretirement benefit cost
1998
1997
$1.8
3.9
—
—
$5.7
$1.6
3.7
—
—
$5.3
Net periodic postretirement benefit cost is reported as a component of “Salaries and other benefits.”
Postemployment benefits:
The Bank offers benefits to former or inactive employees. Postemployment benefit costs are actuarially determined and include the cost of medical and dental insurance, survivor income, and disability benefits. Costs were
projected using the same discount rate and health care trend rates as were used for projecting postretirement
costs. The accrued postemployment benefit costs recognized by the Banks at December 31, 1998 and 1997,
were $8.8 million and $7.6 million, respectively. This cost is included as a component of “Accrued benefit cost.”
Net periodic postemployment benefit costs included in 1998 and 1997 operating expenses were $1.9 million
and $1.8 million, respectively.
44
FEDERAL RESERVE BANK OF RICHMOND
Summary of Operations
(UNAUDITED)
DOLLAR AMOUNT
1998
1997
VO L U M E
1998
1997
Cash
Currency received and counted
30.9 Billion
35.8 Billion
Currency destroyed
Coin bags received and counted
7.0 Billion
71.5 Million
8.2 Billion
106.7 Million
1.2 Trillion
1.0 Trillion
2.5 Billion
2.5 Billion
609.5 Million
711.9 Million
124.5 Thousand 184.4 Thousand
Noncash Payments
Commercial checks processed
Commercial checks, packaged
items handled
45
494.2 Billion
U.S. government checks processed
62.2 Billion
Automated Clearing House transactions:
Commercial
650.5 Billion
Government
347.3 Billion
Fedwire funds transfers
18.7 Trillion
1.6 Billion
1.5 Billion
274.3 Billion
783.2 Million
578.1 Million
76.3 Billion
35.7 Million
43.6 Million
586.2 Billion
382.1 Billion
18.5 Trillion
178.0 Million
17.8 Million
9.9 Million
150.8 Million
17.6 Million
7.8 Million
Loans to Depository Institutions
Discount window loans made
2.0 Billion
3.5 Billion
39
33
Securities Services
Safekeeping balance of book-entry
securities as of December 31
Fedwire securities transfers
278.0 Billion
10.1 Trillion
180.1 Billion
5.2 Trillion
N/A
N/A
674.9 Thousand 489.5 Thousand
Services to U.S. Treasury and Government Agencies
Issues, redemptions and exchanges
of U.S. savings bonds
Federal tax deposits processed
Food stamps redeemed
N/A = not applicable
760.2 Million
239.8 Million
902.7 Million
935.0 Million
263.5 Million
1.1 Billion
8.8 Million
8.6 Million
10.9 Thousand 12.4 Thousand
176.1 Million
211.2 Million
Editor: Elaine M. Mandaleris
Managing Editor: Alice Felmlee
Design Firm: Communication Design, Inc.
Design – Bil Cullen
Illustration – Robert J. Meganck
Photographer: Mark Mitchell
Printer: Cadmus Graphic Solutions
Feature Article
For valuable comments the author is indebted to his Richmond Fed colleagues
Alice Felmlee, Marvin Goodfriend, Bob Hetzel, Elaine Mandaleris, and Ned Prescott.
Feature Article Timeline
Research: Alice Felmlee and Thomas M. Humphrey
Text: Thomas M. Humphrey
Chart Research: Jeff Walker. We would also like to thank Mark Thomas and
Richard Vedder for their helpful input.
We especially thank Faye Ball for valuable research and production assistance,
and Anne Hallerman and Rowena Johnson for research assistance.
Artwork: Mark Blaug deserves special thanks for allowing us to use photos
of economists from his books Great Economists before and since Keynes.
1800 Woodcuts by Thomas Bewick and his School, Dover Publications –
Trading scene (p. 7)
Corbis Images – Yarn-spinning plant (pp. 9, 14)
The Edison and Ford Winter Estates – The Edison Effect (p. 18)
Federal Reserve Bank of Minneapolis – Anna Schwartz photo (p. 23)
Handbook of Early Advertising Art, Dover Publications – Civil War (p. 16)
The Library of Congress – Signing of the Declaration of Independence (p. 11),
Prospector photo (p. 15), First Flight (p. 19), WWI poster (p. 20)
The Library of Virginia – The Liberty of the Subject (p. 12), WWII photo (p. 22)
National Archives and Records Administration – Great Depression photo (p. 21)
PhotoDisc, Inc. – Personal computer photo (p. 24)
The Thomas Jefferson Memorial Foundation, Inc. – Spinning jenny (p. 8)
University of Rochester, History Department – Steam pump (p. 6)
The Woodrow Wilson National Fellowship Foundation – DNA (p. 22)
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