Full text of Economic Quarterly (Federal Reserve Bank of Richmond) : Spring 1999, Vol. 85, No. 2

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

The Fed’s Entry into Check
Clearing Reconsidered
Jeffrey M. Lacker, Jeffrey D. Walker, John A. Weinberg

T

he Federal Reserve’s check clearing business has been a significant part
of its operations since its founding and has set the precedent for other
payment services offered by the Federal Reserve (Fed) to depository
institutions. While there is considerable debate about the proper role for the
Fed in the modern payment system, there seems to be much less disagreement
concerning the Fed’s entry into check collection.1 Many scholars believe that
when the Fed took on the check payment function during the first decade of the
institution’s existence, its entry served to enhance the efficiency of the check
payment system. Indeed, Fed documents on its role in the payment system
speak of the “breakdown of the check collection system” around the turn of
the century.2 According to the conventional view, check collection prior to the
founding of the Fed was decentralized and defective in a number of ways. By
centralizing the system, the Fed was able to eliminate many of the defects.
Our purpose in this article is to reexamine the facts concerning the Fed’s
entry into check clearing and to evaluate the conventional view in light of those
facts. We find that the evidence of inefficiency in the pre-Fed check collection
system is inconclusive. Further, inefficiency would imply that there was some
form of market failure, yet most discussions of check clearing in the early part
of this century are vague or silent on possible sources of market failure. Absent
a clearly articulated explanation of why participants in the check collection
system failed to achieve efficient results, we find the conventional view to be
unconvincing.

The authors wish to thank Ned Prescott, John Walter, Alex Wolman, and Tom Humphrey for
helpful comments. The views expressed do not necessarily reflect those of the Federal Reserve
Bank of Richmond or the Federal Reserve System. The authors remain solely responsible for
the contents of this article.
1 See,

for example, Benston and Humphrey (1997).
of Governors of the Federal Reserve System (1990).

2 Board

Federal Reserve Bank of Richmond Economic Quarterly Volume 85/2 Spring 1999

1

2

Federal Reserve Bank of Richmond Economic Quarterly

We propose a different interpretation of the Fed’s entry, one based on the
network characteristics of check collection. Under this alternative view, preFed check collection arrangements were relatively efficient, and the complaints
many observers voiced about the excessive costs of the pre-Fed system should
be understood as complaints about the distribution of the system’s costs rather
than about its aggregate costs. Moreover, this interpretation explains why the
founders felt compelled to give the Reserve Banks check clearing powers, given
the reserve requirements in the Federal Reserve Act. New light is also shed on
the par collection controversy, and the tortuous process, spanning several years,
by which the Reserve Banks established their check collection service. Hence,
the economics of network organization gives a coherent account of the facts
concerning check collection prior to the founding of the Fed and the process
by which the Fed entered the check clearing business.
Before presenting our view of the Fed’s entry into check clearing, we
present some of the key facts and review the conventional view. The relevant
facts concern the system before the Fed and the means by which the Fed became
a significant provider of check clearing services. Section 1 discusses nonpar
remittance and the importance of correspondent relationships for clearing outof-town checks in the pre-Fed system. Nonpar remittance occurs when a bank
on which a check is drawn pays a collecting bank less than the par value of
the check. Correspondents are banks, usually larger city banks, that perform a
variety of services, including check collection, for other banks.
The Fed’s ability to successfully penetrate the check clearing market was
dependent on Congress giving it the proper authority. While the Federal Reserve
Act authorized the Reserve Banks to clear checks, the Fed’s initial attempts at
inducing fully voluntary participation by member banks were unsuccessful, as
we discuss in Section 2. It was not until Congress granted the Reserve Banks a
competitive advantage—the sole right to present by mail at par—that the Fed
was able to become a significant participant in the market.
Sections 3 and 4 deal with the conventional view, according to which many
of the features of the correspondent banking system represent inefficiencies
that existed because of nonpar payment. Chief among these features was the
observation that occasionally a check would pass through the hands of many
widely dispersed intermediaries on its way to the paying bank. Such “circuitous
routing” is often cited as unambiguous evidence of inefficiency. However, circuitous routing is quite consistent with our alternative view of the pre-Fed
system as efficient, as we discuss in Section 5. In Section 6 we reconsider the
Fed’s entry into check clearing in light of our alternative view. The Fed was
able to gain market share because it enjoyed a legal privilege in presentment
that was unavailable to private collecting banks. Exercising that privilege had
the effect of shifting the allocation of the common costs of check clearing away
from collecting banks and toward small country banks and taxpayers.

Lacker, Walker, Weinberg: Check Clearing Reconsidered

1.

3

CHECK CLEARING BEFORE THE
FOUNDING OF THE FED

By the mid-nineteenth century, the use of checks had become a prominent
means of payment in American banking and commerce. As early as 1855,
the value of checkable deposits exceeded the value of bank notes in circulation (Spahr 1926, p. 84). In this earlier period, however, there were distinct
geographic differences in payment practices. Checks were used primarily for
payments within cities, and notes were used predominantly in the countryside.3
Payments between the country and the city and across geographic regions were
made using bank drafts. A bank draft is like a check, except it is drawn on
an account held by one bank with another. Hence, a Midwesterner wishing
to make a purchase from an East Coast city would go to his local bank and
purchase a draft drawn on that bank’s balances held with a bank in an eastern
city.
Toward the end of the nineteenth century, checks began to replace drafts
as means of payment in interregional transactions, a change that was nearly
complete by the turn of the century (Preston 1920, p. 566). During this same
period, the check also replaced the bank note as a means of payment among
people in the countryside. By 1900, the value of demand deposits was more
than quadruple the value of currency in circulation (Friedman and Schwartz
1963, p. 705). In the period just prior to the founding of the Fed, the check
had become a dominant payment instrument for making both long distance and
local payments.
Check clearing involves the delivery of items to the banks on which they
are drawn. Many observers have pointed out that, in the United States prior to
the existence of the Fed, clearing was affected by the different legal treatments
accorded to different forms of delivery.4 While a paying bank was obligated to
make payment (remit) at par for checks presented in person (over the counter),
there was no such obligation for checks presented through the mail.5 Banks
were free to extract a presentment fee (exchange charge) from their payments
on such indirect presentments. This practice of nonpar banking is the focus
of many discussions of the Fed’s entry into the check collection business. The
prospects of receiving less than par for a check gives a collecting bank an
incentive to find a way of getting the check to the bank on which it is drawn
without mailing it directly. Alternative means of transport and presentment will
be used, presumably, if the total cost does not exceed the presentment fee.
3 Spahr

(1926, p. 60); Federal Reserve Bank of Richmond (1922, p. 1).
(1926, pp. 103–05); Baxter (1983, p. 559); Duprey and Nelson (1986, p. 20); Summers and Gilbert (1996, p. 4); Weinberg (1997, p. 38); Gilbert (1998, pp. 123, 129); James (1998,
p. 143).
5 See the discussion in Spahr (1926, pp. 103–04). The requirement that checks presented
over the counter be paid at par had its origins in English common law.
4 Spahr

4

Federal Reserve Bank of Richmond Economic Quarterly

For a check drawn on a nearby bank, in-person presentment was relatively cheap. Hence the clearing and settlement of local checks presented few
challenges for the banking system of the United States.6 In the larger cities
a number of banks typically would have frequent business with one another,
making it worthwhile for them to form cooperative clearing organizations such
as clearinghouses.7 In such an arrangement, the banks’ representatives would
meet daily at a designated location to exchange items drawn on each other,
avoiding the duplicative cost of bilateral contacts. By mutual agreement among
participants, presentment at the clearinghouse was taken to be equivalent to
presentment in person at the paying bank’s premises.8
In less densely populated areas, a typical bank had a relatively small number of banks nearby from which it regularly received checks. Maintaining a
clearinghouse arrangement among the smaller number of banks did not tend to
be economical. Instead, rural banks usually made direct exchanges with other
banks in the same general area (Spahr 1926, p. 98). Such direct presentations
were made once or twice a week, or daily, depending on the distance between
the banks and on the volume of checks flowing between them. Settlement of
local checks, either in the city clearinghouses or among banks in rural communities, could be made through the exchange of currency or by debiting interbank
balances (Cannon 1900, pp. 36– 46).
The clearing of out-of-town, or interregional, checks was accomplished
via a network of bilateral agreements on clearing terms that generally took
the form of correspondent banking relationships.9 This relationship involved a
bank in a larger city serving as a correspondent bank for a bank in a smaller
city or town. The latter bank, the respondent, would hold balances with its
correspondent. When the respondent received a check drawn on a bank in the
city or area where the correspondent conducted business, the respondent would
send the check to the correspondent, who would, in turn, present the check
directly to the paying bank. The correspondent would receive payment from
the paying bank and credit the amount to the respondent’s account. Often, the
correspondent would credit the respondent for the par value of the check even
if the paying bank did not remit at par (Spahr 1926, pp. 101, 111). Sometimes
the respondent agreed, in return, to remit at par on checks sent to it by its
correspondent. The correspondent’s main form of compensation was typically
the interest margin it could earn on the funds held as balances by the respondent
bank (Spahr 1926, pp. 101, 111–12). It was not uncommon for a correspondent

6 Spahr

(1926, p. 98); Duprey and Nelson (1986, p. 19).
(1900, pp. 148–54); Spahr (1926, pp. 79–82).
8 Hallock (1903, p. 59); Spahr (1926, pp. 104–05).
9 For descriptions of correspondent banking at the Fed’s founding, see Watkins (1929,
Ch. 6), Spahr (1926, pp. 99–101).
7 Cannon

Lacker, Walker, Weinberg: Check Clearing Reconsidered

5

to pay presentment fees to its respondents while paying them par for all the
checks it collected for them.
Often a bank would act as correspondent for banks outside the region,
offering to collect checks drawn on any bank in the neighboring territory, with
the proceeds credited to the account of the distant bank. There appears to have
been active competition for collection business between correspondent banks,
as evidenced by the many advertisements in bank directories from the late
nineteenth century.10
The importance of correspondent relationships is reflected in the magnitude
of interbank balances. In the years preceding the Fed’s founding, the amount
of deposits at national banks that were held for other banks was roughly 40
percent as large as national bank deposits held for individuals (Watkins 1929,
pp. 10–18). These interbank balances were held predominantly at banks in the
larger cities and especially in the major financial centers.
Correspondent banks, then, were linked together into a network of banks
through which checks were collected. When a bank received a check drawn
on an out-of-town correspondent bank—what might be termed a regular interregional check—it would be presented through the established clearing arrangement.11 When a bank received a check drawn on a distant bank with which it
did not have an established relationship—what might be termed an irregular
interregional check—the check would most likely be sent on to a correspondent.
If a correspondent received from a respondent a check drawn on a paying bank
with which the correspondent did not have a relationship, then the correspondent would typically send the check to one of its correspondent banks located
near the paying bank.12 In fact, to aid routing, bank directories listed each
bank’s correspondents; the bank holding the check could look for correspondents it shared with the paying bank.13 The next bank receiving the check might
present it directly to the paying bank. Such indirect routing had two advantages
for the correspondent. First, it avoided having to pay a presentment fee to a
paying bank from which it received no compensating benefit. Second, it saved
the cost of sending a single item to the paying bank instead of bundling the
item with others being sent on a normal shipment (Cannon 1900, p. 76).
10 Williams (1901). Typical notices: “Prompt and careful attention given to collections
throughout Mississippi and Alabama” (First National Bank of Meridian, Mississippi); “Unsurpassed facilities for handling collections, especially Oklahoma and Kansas” (Kansas National
Bank, Wichita, Kansas); “Send us your Southwest Collections” (Home Savings Bank & Trust
Co., Phoenix, Arizona).
11 The term “correspondent” is sometimes used narrowly to refer to a small number of distant
banks that a bank formally designates to receive items drawn on it. A bank typically had no more
than two or three correspondents in this sense, and they were listed in banking directories. The
term is often used more broadly, however, to refer to any bank with which a bank regularly
exchanges items by mail. We will use the term “correspondent” in this broader sense.
12 Cannon (1900, p. 76); Spahr (1926, pp. 111–12).
13 Williams (1901).

6

Federal Reserve Bank of Richmond Economic Quarterly

Irregular interregional items, then, were often handled by sending them to
banks with whom the correspondent conducted regular interregional business.
Concerns about the operation of the check clearing system prior to the founding
of the Fed focused largely on these irregular interregional checks. In such a
system, there were inevitably cases in which the next bank to receive a check
was not a correspondent of the paying bank. Hence, the process of sending the
check to a correspondent might be repeated more than once. Furthermore, some
mistakes in judgment and in handling of items were inevitable. Accordingly,
there are documented examples of checks traveling circuitous routes, through
the hands of many banks, in making their way from the bank of first deposit
to the paying bank.14
Settlement of an irregular interregional check began when the paying bank
remitted to the bank that finally presented the check. If the presenting bank
was a correspondent for the paying bank, then settlement could be made by
debiting the paying bank’s account balances. If there was no account relationship between the paying and presenting banks, then payment would typically
be made in the form of a draft on the paying bank’s account with one of its
correspondents, often a New York bank (most banks maintained a relationship
with at least one New York bank).15 The presenting bank could send the draft
to its New York correspondent who would credit the amount to the presenting
bank’s account. The presenting bank’s New York correspondent would, in turn,
present the draft to the paying bank’s correspondent through the New York
clearinghouse. In this way, New York reserve balances served increasingly as
a universal settlement medium. This use of bank drafts in settlement stands in
contrast to the greater use of specie earlier in the nineteenth century.16
Collecting and paying banks incurred a variety of expenses in the process
of clearing and settling interregional checks. The resource costs incurred by
collecting banks, including the costs of recordkeeping and postage, were estimated to have amounted on average to about 3/4 of 1 percent to 1 percent of the
value of collected items (Spahr 1926, p. 113). Other costs borne by collecting
banks resulted from the negotiated arrangements for clearing and collection.
For instance, many collecting banks gave credit to their account holders at the
time of an item’s deposit. By doing so, the collecting bank would incur the
float costs that accrued until settlement was received from the paying bank.
In addition, national banks faced a tax of 1/2 of 1 percent on deposits. These
costs, together with the presentment fee charged by some paying banks (1/8
of 1 percent on average), added roughly another 3/4 of 1 percent to the costs
incurred by collecting banks (Spahr 1926, p. 114). On the other side of the
14 We

discuss the examples of circuitous routing below.
(1900, p. 46); Spahr (1926, p. 100); Watkins (1929, p. 104); Williams (1901,
passim). Alternatively, payment could be made in specie or banknotes.
16 Preston (1920, p. 565); Spahr (1926, pp. 45–51).
15 Cannon

Lacker, Walker, Weinberg: Check Clearing Reconsidered

7

transaction, paying banks incurred clerical costs in receiving and remitting for
checks presented on them (Langston 1921, pp. 13–39).
It seems apparent that a substantial share of the cost of clearing interregional checks was borne by collecting banks (Spahr 1926, p. 113). Customers
of collecting banks typically received the full par value for their deposits of
out-of-town checks. Even if the collecting bank passed along some charge to
the depositor of the check, there appears to be little evidence of systematic price
discrimination by businesses between customers paying for goods and services
with out-of-town checks and those paying by other means. Most observers
conclude that competition for both local deposits and correspondent business
drove city banks to absorb much of the cost of collecting country checks.17

2.

THE FED’S ENTRY INTO CHECK CLEARING

A flurry of banking and monetary reform proposals around the turn of the
century ultimately led to the passage of the Federal Reserve Act on December
23, 1913. The central motive of the Act, and many other reform proposals
as well, was to prevent recurrent financial panics of the kind typical of the
late-nineteenth and early-twentieth centuries in the United States. The Federal
Reserve System was designed to prevent such panics by providing “an elastic
currency” that allowed a relatively rapid expansion of the supply of notes when
needed.18
Nationwide Federal Reserve check clearing was not envisioned in the earliest versions of the Act introduced in Congress.19 The bill introduced by Senator
Carter Glass in February 1913, for example, required Reserve Banks to accept
from their members at par any checks drawn on any other member’s deposit
at a Reserve Bank. This would have allowed member banks to settle obligations to other member banks with checks drawn on their own Reserve Bank
deposits, much the way interbank obligations were settled using drafts drawn
on bank deposits at New York banks. Ultimately, however, the final version of
the Federal Reserve Act allowed Reserve Bank check clearing. Each Reserve
Bank was required to accept checks written by depositors at member banks,
and was permitted, though not required, to accept checks written by depositors
at member banks of other Reserve Banks.20
17 Watkins (1929, p. 106); Fellows (1940, p. 18); Miller (1949, p. 11); Duprey and Nelson
(1986, p. 20); Summers and Gilbert (1996, p. 4).
18 See Willis (1923) or Timberlake (1978), for example.
19 See Stevens (1996) for an account of the legislative history of the check clearing provisions
of the Federal Reserve Act.
20 Board of Governors (1915, pp. 23– 44). Section 16 of the Federal Reserve Act as finally
passed on December 23, 1913, stated, in part, “Every Federal reserve bank shall receive on
deposit at par from member banks or from Federal reserve banks checks and drafts drawn upon
any of its depositors, and when remitted by a Federal reserve bank, checks and drafts drawn by

8

Federal Reserve Bank of Richmond Economic Quarterly

It was a number of years before the Reserve Banks successfully penetrated
the check collection business. On March 4, 1915, the Federal Reserve Board
announced that it had directed the Reserve Banks to establish a “voluntary
reciprocal plan” for intradistrict check clearing.21 Member banks would be
able to collect at par from all other member banks in their district that joined
the plan. A member bank joining the plan had to agree to accept their own
checks at par. Details of the scheme were left up to the individual Reserve
Banks. The hope was that many member banks would join, making the plan
attractive to those that at first held out. The voluntary reciprocal plan proved
disappointing, however. By late July the Reserve Banks were reporting that
most banks said they would not join unless the plan were made mandatory.
Reported participation in the plan peaked in October 1915 at only 2,456 banks,
out of about 7,600 member banks, and withdrawals exceeded additions every
month thereafter.22
A new plan was introduced early the next year. On May 1, 1916, the
Federal Reserve Board released a circular to member banks—Circular No. 1,
Series of 1916—detailing a “compulsory plan” to be put into effect in June
(later postponed to July 15).23 Member banks would now be required to pay
at par on checks presented to them by their Reserve Bank. Presentation by
a Reserve Bank through the mail would be construed as presentation at their
counters. The Reserve Bank would defray the paying bank’s cost of sending
payment, either in notes or acceptable checks on other banks, if the bank’s reserve balance was insufficient. Each Reserve Bank would accept checks from

any depositor in any other Federal reserve bank or member bank upon funds to the credit of
said depositor in said reserve bank or member bank. Thus each Reserve Bank was required to
accept on deposit at par from member banks or other Reserve Banks checks and drafts drawn
upon any of its depositors. Section 16 went on to state, “The Federal Reserve Board . . . may at
its discretion exercise the functions of a clearing house for such Federal reserve banks, or may
designate a Federal reserve bank to exercise such functions, and may also require each bank to
exercise the functions of a clearing house for its member banks.” Section 13 adds that “Any
Federal Reserve Bank may receive from any of its member banks . . . checks and drafts upon
solvent member banks, payable upon presentation; or solely for exchange purposes, may receive
from other Federal reserve banks . . . checks and drafts upon solvent member or Federal reserve
banks, payable upon presentation.” Thus each Reserve Bank was permitted to accept from its
member banks checks or drafts drawn upon solvent member banks, or, “solely for exchange
purposes,” checks or drafts from other Federal Reserve Banks drawn upon solvent member banks
or other Federal Reserve Banks.
21 Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (1915, pp.
6–9) [hereafter “Federal Reserve Bulletin”].
22 Federal Reserve Bulletin (1915, pp. 192–95); Spahr (1926, pp. 174).
23 Federal Reserve Bulletin (1916, pp. 259–60, 262–64). Each Reserve Bank issued its own
circular detailing the operation of the plan in its district; Chicago’s is reprinted in the Federal
Reserve Bulletin (1916, pp. 312–14). Regulation J was released later in 1916, incorporating the
September 7, 1916, amendment (see below) and superceding Circular No. 1. To this day Regulation J codifies the Board’s requirement that member banks accept checks at par (see Board of
Governors [1998], 12 CFR 210.9).

Lacker, Walker, Weinberg: Check Clearing Reconsidered

9

its member banks at par if they were drawn on other member banks or on
nonmember banks that paid at par, although a small per-item service charge
was allowed.24 The plan was nationwide in scope; each Reserve Bank would
accept at par checks drawn on banks in other districts if they were Federal
Reserve members or they agreed to pay at par. Member banks were still free to
collect checks outside of the Federal Reserve System as they saw fit, and they
were free to carry balances with other banks for purposes of clearing. They
were still free to charge presentment fees as well, but the Board’s Circular
prevented them from charging presentment fees to the Reserve Banks.
The original Federal Reserve Act did not permit the Reserve Banks to accept checks drawn upon nonmembers. Early in 1916 the Board recommended
to Congress various changes in the Act, including alteration of Section 13 of
the Act to allow Reserve Banks to accept “checks and drafts payable upon
presentation within its district.”25 The amendment passed without change on
September 7, 1916. The amendment also removed the qualification that Reserve
Banks could only accept checks drawn on “solvent” banks, further expanding
the field of acceptable checks. The Fed’s strategy was to make the service as
attractive as possible by increasing the number of banks on which they could
collect.26
Although nonmember banks still could not deposit checks directly with the
Reserve Banks, they were entitled to send checks to the Fed through their correspondents that were member banks, and many apparently did (Spahr 1926, p.
197). The Board viewed the inability to accept checks directly from nonmember
banks as an impediment to the success of the compulsory plan: “Any clearing
and collection plan to be effective must be so comprehensive as to include
all checks.”27 The Reserve Bank check collection service was at first intended
as a benefit of membership, but the Board decided that it would be better to
offer clearing services to nonmembers to entice them to remit at par on checks
sent to them by the Reserve Banks through the mail. As part of a package
of suggested amendments sent to the Congress in December 1916, the Board
included an amendment to Section 16 that would permit nonmember banks to
use the Fed’s clearing service, provided they agreed to pay their own checks at
par and kept a “compensating balance” with the Reserve Bank. The amount of
the compensating balance was to be determined by the Federal Reserve Board.
24 The Board’s circular stipulated that Reserve Banks keep an accurate account of the cost
of the clearing service and that the Board would fix the charge by rule. Charges ranged from 0.9
cents to 2.0 cents per item. Charges were ultimately lowered and then abolished on July 1, 1918
(Spahr 1926, pp. 192–93, 211).
25 Federal Reserve Bulletin (1916, pp. 323–24).
26 In discussing the compulsory plan in June 1916, the Board said “it is thought that in the
near future checks upon practically all banks throughout the United States can be handled at par
by Federal Reserve Banks” (Federal Reserve Bulletin 1916, p. 263).
27 Federal Reserve Bulletin (1917, p. 100).

10

Federal Reserve Bank of Richmond Economic Quarterly

Congress ultimately enacted the suggested check clearing provisions, but
not without a fight that revealed the depth of opposition to the Fed’s check collection plans.28 After being called back into session in April, Congress again
took up the Board’s suggested amendments. Representatives of the American
Bankers Association took the opportunity to lobby for a bank’s right to charge
presentment fees, even against the Reserve Banks. As a result, Senator Hardwick of Georgia introduced an amendment that would have added to Section
16 the proviso that nothing in the Act shall be construed as prohibiting a
member or nonmember bank from “making reasonable charges, but in no case
to exceed 10 cents per $100 . . . for collection or payment of checks and
drafts. . . .”29 As drafted, the Hardwick Amendment would have effectively
negated the provision of Circular No. 1 requiring banks participating in the
compulsory plan to pay at par on checks sent by the Reserve Banks through
the mail.
The Hardwick Amendment was ruled out of order in the House, where
the Board’s suggested amendments were passed on May 5. The Senate then
approved the bill but included the Hardwick Amendment, despite the opposition
of the Federal Reserve Board. In conference, Glass prevailed upon the conferees
to modify the Amendment in two ways. The Federal Reserve Board was given
the authority to determine and regulate the charges, and a clause was added
stating that “no such charges shall be made against the Federal reserve banks.”
The House passed the resulting bill, as did the Senate, after the reading of a
letter from President Wilson that described the original Hardwick Amendment
“as most unfortunate and as almost destructive of the function of the Federal
reserve banks as a clearing house for member banks.”30 The Board’s ban on
charging presentment fees against Reserve Banks was now law.31
As part of the compulsory plan, the Board directed Reserve Banks to maintain so-called “par lists” consisting of the nonmember banks in their districts
that accepted checks at par. The par list and the Fed’s campaign for universal
par presentment became the center of the celebrated “par collection controversy” (see Spahr [1926], Ch. 7). At first, only banks that explicitly agreed
to remit at par were added to the System’s list, but in early 1919 a concerted
effort was begun to expand the list. Reserve Banks took aggressive measures to

28 See

Spahr (1926, p. 200) and Wyatt (1944).
contemporary account of the legislative action appears in “The Hardwick Amendment”
(1917, pp. 40 – 41).
30 Miller (1949, p. 20); Congressional Record (1917, p. 3761).
31 At the request of the Federal Reserve Board, the Attorney General issued an opinion on
the scope of the new language in Section 13. He said that the Federal Reserve had no power to
regulate the exchange charges of nonmember banks who were not depositors under the clearing
system, and if nonmembers insisted on making charges, the Reserve Banks could not handle
checks drawn on them, since Section 13 now prohibited such charges (Federal Reserve Bulletin
1918, pp. 367–70).
29 A

Lacker, Walker, Weinberg: Check Clearing Reconsidered

11

attempt to collect at par on all banks in their districts.32 Some Reserve Banks
put recalcitrant banks on the par list without their explicit permission; they
accumulated their checks and had them presented directly over the counter,
where banks were generally required to pay par.33 The nonmember par list
grew from about 10,000 in December 1918 to over 19,000 at the high-water
mark in November 1920, leaving only about 1,700 nonpar banks.34
The opposition to the Federal Reserve’s methods was fierce in some quarters, however. Some banks refused to cooperate, and the resulting litigation—
including cases that reached the Supreme Court—established limits on the
measures the Reserve Banks could employ to obtain par remittance.35 Checks
could no longer be accumulated for presentation at the counter to “coerce”
banks into paying par. Banks could pay checks at their counter by draft rather
than lawful money. Moreover, the Supreme Court ruled that the Federal Reserve
was under no congressional mandate to bring about universal par clearance. In
response, the Board ordered the Reserve Banks to cease using agents other
than banks in making collections and to stop accepting checks drawn on nonpar banks.36 Banks withdrew from the par list until nonpar banks numbered
nearly 4,000.37 Nonpar banking persisted thereafter, chiefly in small one-bank
towns or in small towns with only nonpar banks.38 The number of nonpar banks
declined sharply in the early 1970s and finally sank to zero in 1980.39

3.

THE CONVENTIONAL VIEW

Many payments system researchers have described the pre-Federal Reserve
check collection system as inefficient in the sense that real resource costs were
higher than they would have been under a centrally run system. Likewise, it
is conventionally argued that the Fed-imposed clearing arrangements resulted
in lower real resource costs than private arrangements. Walter Spahr (1926)
32 See Harding (1921); Tippetts (1924, pp. 635–36); Tippetts (1929, pp. 277–80); Preston
(1920, pp. 571–78).
33 Under some state laws, however, the bank was not required to pay in legal tender but
could pay instead with a draft. See Spahr (1926, pp. 284–86).
34 Spahr (1926, p. 248) displays data compiled from various issues of the Federal Reserve
Bulletin.
35 The major cases are described in Spahr (1926, pp. 249–82, 284–86) and Tippetts (1924,
1929). The key decision came in the “Richmond case,” Farmers and Merchants National Bank of
Monroe, North Carolina, et al. v. Federal Reserve Bank of Richmond, Virginia, in which the U.S.
Supreme Court upheld the constitutionality of a North Carolina law that authorized state banks
to charge a presentment fee of no more than 1/8 of 1 percent and specifically allowed payment
by draft for checks presented over the counter by a Federal Reserve Bank, post office, or express
company.
36 Federal Reserve Bulletin (1923, pp. 903–04, 1194).
37 Federal Reserve Bulletin (1928, p. 535).
38 Stevens (1998, p. 19); Jessup (1967, p. 26).
39 The reasons for the decline of nonpar banking have not, to our knowledge, been studied.

12

Federal Reserve Bank of Richmond Economic Quarterly

compiled the most comprehensive and widely cited statement of this view 12
years after the founding of the Federal Reserve. Most recent proponents of the
conventional view echo Spahr.
Spahr claimed that one of the most serious problems with the pre-Fed
system was the excessive cost of collecting country checks and that nonpar
checking was to blame. The practice of nonpar checking had its origins in
earlier times when banks incurred significant shipping costs in remitting specie
to distant banks for settlement. The amount of the charges had been steadily declining during the 50 years immediately prior to the Fed as transportation costs
fell; nevertheless, nonpar remittance practices remained a significant source of
revenue to some country banks and a significant source of irritation to some
city banks in 1914. The most widespread criticism of exchange charges was
that technological advances had removed most of the country banks’ settlement
costs, eliminating the once-valid justification for the fees. Spahr describes the
fees as “excessive” and out of proportion to the costs incurred by the levying
banks (Spahr 1926, p. 241).
Besides imposing excessive costs, presentment fees were said to cause
costly and inefficient collection practices. Chief among these was circuitous
routing: some checks were sent to banks in roundabout ways through a number
of different banks in order to avoid presentment fees, resulting in excessive
postage and clerical costs and extended check float. Although there are no data
on the extent of circuitous routing to avoid exchange charges, the literature contains a number of examples. Cannon (1900) describes an example of a check
drawn on The Peconic Bank of Sag Harbor, Long Island, and deposited in a
bank in Hoboken, New Jersey. The now-famous check traveled from the Hoboken bank to a New York City bank, and then to banks in Boston, Tonawanda,
Albany, Port Jefferson, Far Rockaway, New York City (again, but a different
bank), Riverhead, and Brooklyn, before finally arriving at the Sag Harbor bank.
James Hallock (1903) cites the Sag Harbor check and three others as well. Spahr
(1926) cites the Sag Harbor check, Hallock’s Stonington, Connecticut, check,
plus two additional examples. Other writers typically cite Cannon’s Sag Harbor
check.40
Most of the pre-Fed writers on check clearing were city bankers; there
is almost no early academic literature on the subject. Nonetheless, virtually
all authors around that time supported the thrust of Spahr’s argument. In his
1890 annual report, the Comptroller of the Currency conveys an early official
opinion on exchange charges by saying a conservative estimate of their total
amount “would constitute a heavy burden upon the commercial interests of
the country.” Hallock (1903, p. 17) asserts that the “avoidance of collection

40 See,

for example, Conway and Patterson (1914, p. 324), Miller (1949, p. 10), or Baxter
(1983, p. 560).

Lacker, Walker, Weinberg: Check Clearing Reconsidered

13

charges is the motive for shunting a check up and down the country” and
that “the practice is not unusual.” Oliver Sprague (1910, p. 42) observes that
“collections and payments are subject to delay and involve heavy expense.”
Similarly, turn-of-the-century Banker’s Magazine and A.B.A. Journal articles,
some of which Spahr references in his book, confirm the common perception
that bankers saw a need for reform. An array of historical descriptions of the
U.S. payments system written since 1914 have either referenced or endorsed
Spahr’s evaluation of the pre-Fed clearing system.41
Many of the founders of the Federal Reserve System shared Spahr’s assessment. In a debate prior to the Federal Reserve Act, Carter Glass revealed
that he thought centralized clearing by the government would reallocate costs
in a welfare-improving way:
Precisely how much difficulty and cost will be incurred by the Federal Reserve Banks in carrying out the provisions of this section cannot be precisely
calculated. It can, however, be positively stated that such expenditures will be
very much less than those incurred by banks at the present day in carrying
through their exchanges. The proposed provision will eliminate the numerous
and well-founded complaints of unjust charges for exchange; and, while it
will prevent certain banks from profiting as they do by exchange transactions
it will correspondingly benefit the community.42

Glass expresses the idea here that although exchange-charging country banks
will be made worse off, a Federal Reserve clearing system will make others
better off by lowering their clearing costs. He appears to have in mind the
proposition that aggregate costs will be lower overall, and thus the community will benefit. H. Parker Willis, Glass’s advisor and the first Secretary to
the Federal Reserve Board, made similar criticisms of the old system in his
post-1914 works. For example, Willis wrote the lead article in the March 1914
American Economic Review on the new Federal Reserve legislation and referred
to exchange charges as “extortion.”43
41 For

example, Conway and Patterson (1914) explain the “disadvantages” of the old methods, highlighting circuitous routing, excessive exchange charges, and unnecessary check float.
Gidney (1916, p. 607) states, “Important economies are expected to be effected in the total cost
of check collection, through having checks reach the paying bank by a reasonably direct route and
after having passed through relatively few banks. . . .” Kemmerer (1928) describes a “defective
exchange and transfer system,” adding “large shipments of currency” as another inefficiency.
Tippetts (1929) gives a similar account, calling the system “the source of a number of evils.”
Watkins (1929) emphasizes that exchange charges “operated under the old system to lessen its
efficiency” and goes on to argue that such charges caused unduly large bankers’ balances. See
also Miller (1949), Jessup (1967), Duprey and Nelson (1986), and Moore (1990).
42 U.S. Congress, House (1913) pp. 55–56.
43 For Willis’s opinion on Spahr (1926) and Cannon (1900), see Willis, et al. (1933), p. 238.
W. P. G. Harding, then Governor of the Federal Reserve Board, stated that “the establishment of a
universal country wide par-collection system” would result in the “elimination of the burdensome
delays and expenses incident to the old indirect routing system” (Harding 1921, p. 338).

14

Federal Reserve Bank of Richmond Economic Quarterly

In the conventional view, the Fed’s entry was a struggle by the progressive
forces of banking reform against the vested interests of nonpar bankers. Duprey
and Nelson (1986, p. 18) write:
At the turn of the century . . . the private banking sector was widely acknowledged to have produced an inefficient and counterproductive arrangement for
collecting checks beyond the local level. The invisible hand wasn’t working.
This failure to produce an adequate solution for collecting out-of-town checks
efficiently was one reason that the Congress, as part of its banking reform
measures developed between 1908 and 1913, gave the Federal Reserve System
both a regulatory role and an operating role in check clearing and collection.

They go on to argue that the Fed’s quest for a universal par clearance system
was frustrated by “stiff opposition and competition” from the correspondent
banking system.44 Nonetheless, the Fed did enjoy “some success in improving
the efficiency of intercommunity check collection”—the Fed reduced the number of nonpar banks “and probably helped limit abuses” in their practices.
Summers and Gilbert (1996), drawing on Spahr, note “widespread dissatisfaction” with the settlement of interregional transactions pre-Fed and cite
enhancing payment system efficiency as an important purpose for creating the
Federal Reserve. In a similar vein, Gilbert (1998) concludes that, based on the
fall in reserve holdings at banks joining the system, “evidence from the period
when the Fed was founded suggests that the Fed’s services improved payments
system efficiency.”45

4.

A PROBLEM WITH THE CONVENTIONAL VIEW

One reason to question the conventional view is that (with only a few exceptions) most writers do not explain why the participants in the check collection
system were unable to implement efficiency improvements, if they were available. In other words, it is not clear why there would be a market failure in check
44 Duprey

and Nelson (1986, p. 19).
(1998, p. 137). One view which we do not discuss at length here is that Congress
wanted the Fed to collect checks in order to prevent disruptions in check collection that accompanied financial panics, like the one in 1907 that occasioned widespread suspension of cash
payments at banks (Corrigan 1983, pp. 345–48). While preventing financial panics was clearly
the central motive behind the provisions moving reserve accounts over to the Reserve Banks, we
know of no evidence that any of the founders perceived the functioning of the check collection
system during panics, per se, as a motive for granting check clearing powers to the Reserve
Banks. Moreover, it is hard to see why the rediscounting and open market powers of the Reserve
Banks should not be sufficient to prevent financial disruption. Walter (1988, p. 57) reports that in
congressional debate on the Federal Reserve Act there is no mention of the Fed providing check
collection services to produce a safer payment system. “Senator Bristow and O. M. W. Sprague
agreed, in an exchange during Senate hearings, that the problems with inter-city check collection
during panics were caused by a lack of a lender of last resort” (U.S. Congress, Senate, Senate
Committee on Banking and Currency 1913, pp. 512–13), cited in Walter (1988).
45 Gilbert

Lacker, Walker, Weinberg: Check Clearing Reconsidered

15

collection. One might argue that it was beyond the capability of participants
to create the Federal Reserve’s clearing system, since the Fed is a collective
nonprofit institution.46 And yet the Reserve Bank’s check collection activities
employed precisely the same technology and organizational techniques employed by the private sector. The Reserve Banks were essentially correspondent
banks for the members of their clearing system, and their relationship with their
respondents was organized in essentially the same way as private correspondent
relationships. The Reserve Banks did set up a wire transfer system for moving
funds rapidly between Reserve Banks, but private banks had been moving funds
via wire transfer prior to the founding of the Fed (Langston 1921, pp. 168–72).
Private clearinghouses were collective nonprofit institutions set up by
banks, often endowed with quasi-regulatory power over their members.47 In
fact, in the decades prior to the founding of the Fed, clearinghouses were
making moves to expand their clearing activities to encompass checks drawn
on country banks.48 The Boston clearinghouse had been clearing New England
country checks for years.49 In short, banks could have set up the equivalent of
the Federal Reserve Bank clearing system on their own. Presumably they would
have done so if it would have made some participants better off without making
others worse off—for example, if it would have appreciably lowered the costs
of collecting checks. The fact that they did not do so seems to suggest that it
would not have lowered costs. If the Reserve Bank clearing system lowered
check clearing costs, why couldn’t the private sector do the same?
Some believe one possible answer is that nonpar country banks enjoyed
monopoly power. Presentment fees were set inefficiently high in order to extract rents from collecting banks. Such fees, it is said, “can lead to costly
and complicated countermeasures” to avoid nonpar transactions.50 This view
envisions a bank facing a choice between mailing directly to a nonpar bank
with which it does not have a correspondent relationship and sending the check
on to a correspondent who can present it at par. But it is not clear that this
was always the case. In fact, presentment fees were often paid to nonpar banks
by their correspondents. These collecting banks appeared to pay fees willingly in exchange for the respondent banks’ reserve balances (Spahr 1926, p.
111). Hence, presentment fees were often voluntarily agreed to as a component of a broader correspondent-respondent relationship. It is not clear how to
46 Duprey and Nelson (1986) seem to advocate this position when they argue that “wellestablished rivalries” between city and country banks somehow prevented banks from voluntarily
agreeing to a mutually beneficial national clearing system.
47 Gorton (1985); Gorton and Mullineaux (1987).
48 Cannon (1900); Hallock (1903); Spahr (1926, pp. 119–30); Duprey and Nelson (1986, pp.
22–23).
49 Federal Reserve Bulletin (1916, p. 317). The Federal Reserve Bank of Boston took over
the operations of the Boston clearinghouse by unanimous consent in 1916.
50 McAndrews (1995, p. 56). See also Gilbert (1998).

16

Federal Reserve Bank of Richmond Economic Quarterly

reconcile this market power view with the documented features of correspondent relationships.
Check collection routes were determined by the pattern of correspondent
relationships. Thus, it is the market for correspondent relationships—as opposed
to the market for the clearance of a particular check—that is relevant to the
question of market power. What a country bank had to offer as a respondent—
reserve balances—was available from other country banks as well. It appears
unlikely that small country banks exercised any monopoly power in the market
for correspondent relationships.

5.

AN ALTERNATIVE VIEW

The conventional view sees the pre-Fed check collection system as inefficient
and disjointed, with much of the inefficiency being driven by the practice
of nonpar remittance. An alternative interpretation is possible if we view the
check collection system as a whole and focus on its network characteristics.51
While such terms as “network effect” or “network externality” are used widely
by economists in reference to a variety of market settings, a check collection
system (or any other payment clearing system) literally is a communication network. Two key characteristics are central to understanding the organization and
performance of network communications industries: joint benefits and common
costs.
For most goods, a unit of consumption provides benefits to a single user.
Some other goods or services provide simultaneous benefits to many people.
For most such goods, a musical performance for example, one person’s utility
does not depend on whether anyone else is partaking. One unit of a communication service, however, necessarily involves two “consumers”: a sender and a
receiver. Neither party derives a benefit from communication unless the other
one does. Similarly, the clearing of a check provides benefits jointly to both the
payor and the payee. Note that the presence of joint benefits affects the criterion
for judging whether provision of a unit of a good is economically efficient. For
an ordinary good, we would say that a unit’s provision is efficient if the buyer’s
willingness-to-pay exceeds the incremental resource costs of the good. For a
network communication service, we would say that the provision of a unit of
service is efficient if the sum of the willingness-to-pay of the sender and the
receiver (or payor and payee in the case of a payment instrument) exceeds the
incremental cost.52
51 For a discussion of the characteristics of network services as applied to payment systems,
see Weinberg (1997) and Lacker and Weinberg (1998). James McAndrews (1995) first suggested
that check collection at the founding of the Fed should be viewed as a network communications
industry, analogous to credit card and ATM clearing networks. See also Summers and Gilbert
(1996, pp. 6–7).
52 This distinction is emphasized by Baxter (1983).

Lacker, Walker, Weinberg: Check Clearing Reconsidered

17

The fact that check clearing services provide joint benefits to pairs of users
implies that there are common costs even at the level of the individual unit
of service. Common costs are costs that cannot be uniquely attributed to the
provision of service to particular users or groups of users. The incremental
cost of a unit of a payment clearing service is common to the payor and
payee in that it cannot be uniquely attributed to either. In network services
markets, common costs tend to exist at a variety of levels. The technology for
such services often includes substantial fixed infrastructure costs. The physical
transport of items such as checks involves common costs since the cost of a
trip cannot be attributed to particular items or particular pairs of senders and
receivers. Many common costs in such markets are fixed relative to the quantity
of a service provided. For example, the cost of a transportation node facility,
such as a terminal, or (in the case of checks) a bank branch, often cannot be
uniquely attributed to any particular item passing through it.
The presence of substantial common costs implies that it is impossible to
specify precisely an individual user’s share of total costs. Consequently, there
is some ambiguity in determining the “right” price for a particular user to face.
Efficiency requires that no individual or group pay less than its incremental
cost, defined as the cost of extending service to the group in question given the
level of services provided to all other users. Otherwise they might inefficiently
overuse the service.53 If all users pay incremental cost, however, the service
will not recover all of the costs that are common across groups of users. In
order to cover common costs, the service must charge some users more than
their incremental cost. There are often many ways to allocate common costs,
all of which are consistent with efficient provision of the service.54
The presence of joint benefits and common costs gives rise to what are
often called “network effects.” One person’s participation in a network brings
benefits to that person as well as to all others who wish to communicate with
him. It is important to note, however, that while these benefits may be external to the individual’s action, they are internal to the network in which he
participates. A network’s participants, as a group, may have an incentive to
shift common costs away from some individual participants: those who place

53 This principle must be modified in the presence of joint benefits: see discussion on the
next page.
54 We use the term “efficient” in the sense of Pareto efficiency. An allocation is Pareto efficient if no party can be made better off without making some other party worse off. Some readers
may be familiar with the Ramsey cost allocation principle, which states that each price charged
by a multi-product provider should be set at a markup over costs that is inversely proportional
to demand elasticity. This would appear to prescribe a uniquely efficient allocation of common
costs. The Ramsey allocation is optimal, however, only under a particular assumption about the
way in which social benefits are calculated, specifically, by adding up the utilities of individual
agents. The Pareto criterion is less restrictive, and there will tend to be multiple Pareto efficient
allocations.

18

Federal Reserve Bank of Richmond Economic Quarterly

a relatively low private value on participation but who bring large external
benefits to other participants. Efficient participation may even require that an
individual pay less than their incremental cost.
To be more precise, consider an existing network whose incremental cost
of adding a particular new member is cn , while the mutual benefit to existing
members of adding this new member is vn . For the potential new member, the
corresponding incremental costs and benefits are ci and vi . It is efficient to add
this member if vn + vi > cn + ci . Suppose that the network charges the new
member the price p. The new member is willing to participate if vi > ci + p.
The network is willing to add the new member if vn + p > cn . Thus, any price
satisfying vi − ci > p > cn − vn induces efficient participation. Note that if
vi − ci < cn , then the network must charge less than the network’s incremental
cost of adding the new member, because the new member’s private net benefit
from joining is low. Participation is efficient nonetheless because of the value,
vn , the member brings to the network. Since the new member’s participation
in the network brings joint benefits to all network participants, both cn and ci
are common costs. The price determines who bears the common costs.

6.

PRE-FED CHECK CLEARING

When seen in terms of the allocation of the common costs of a network service,
a very different view of the pre-Fed check collection system emerges. The centerpiece of the conventional view is the practice of nonpar collection and the
resulting circuitous routing of checks. The level of presentment fees, however,
helps determine the allocation of the common costs of check collection. Moreover, circuitous routing is not obviously wasteful, given the common costs of
shipping check bundles. And complaints about excessive costs appear to be
motivated by dissatisfaction with the allocation of costs among participants
rather than the overall level of aggregate costs.
Correspondent banking relationships were central to the clearing of checks
before the founding of the Fed and can be understood quite clearly in terms
of common costs. The correspondent relationship bundled together a number
of distinct functions: the respondent used the correspondent to clear checks
drawn on banks in the vicinity of or that had relationships with the correspondent; the correspondent presented checks drawn on the respondent; and the
respondent held balances with the correspondent, which were used to settle
clearings in either direction (Spahr 1926, p. 111). Settlement via interbank balances has clear advantages over settlement by remittance of specie or exchange
draft, since the common cost of correspondent balances serves both investment
and settlement functions (Watkins 1929, pp. 3–5). Holding balances with a
bank in a financial center, where they could earn interest, was preferable to
holding sterile reserves in the vault. Combining several items into a single

Lacker, Walker, Weinberg: Check Clearing Reconsidered

19

shipment saved shipping costs. Selecting a limited number of correspondents
was advantageous because it economized on the fixed costs associated with
any given relationship; bilateral clearing and settlement arrangements with the
universe of depository institutions would obviously be far too costly. The overall advantage of a correspondent relationship is that certain common costs are
spread among a number of distinct payment services rather than duplicated
across multiple service providers.
Presentment fees can be easily understood as a means of allocating common costs. The presentment fee was the price paid to the paying bank for
accepting presentment by mail rather than over the counter, where the paying
bank was obligated to pay at par. Presentments, whether over the counter or
by mail, were generally paid by debits to correspondent balances or by drafts.
Mailing drafts to presenting banks involved postage costs, and so for some
checks there was a positive incremental cost to the paying bank of accepting
mail presentment. Otherwise the paying bank was largely indifferent about
the means by which checks arrived for payment (Spahr 1926, pp. 99–101).
In terms of our earlier notation, interpreted here as the incremental benefits
and costs of accepting presentment by mail rather than over the counter, vi was
approximately zero and ci was slightly positive. A collecting bank, on the other
hand, was likely to place considerable value on having a means to avoid the real
resource costs of making over-the-counter presentments at long distances. Thus
we would expect a large value for −cn , the positive cost savings associated
with mail presentment to country banks. Apart from costs, the collecting bank
should be relatively indifferent about means of presentment, so vn should be
approximately zero as well.
If q is the presentment fee, then using our earlier notation, q = −p.
With this change of variables, the condition for efficient participation is now
ci − vi < q < vn − cn . The presentment fee must exceed the paying banks’ cost
of participating, net of benefits, ci − vi > 0. Similarly, the presentment fee must
not exceed vn −cn ≈ −cn > 0, the net incremental benefit to the collecting bank
of adding the paying bank to the mail presentment network. The net benefit of
switching to mail presentment is vn + vi − cn − ci ≈ −cn − ci , which is positive
when the cost savings to the presenting bank, −cn , exceeds the incremental
cost to the paying bank, ci . It seems likely that for many country checks, direct
presentment was more costly than postage for remittance, and therefore mail
presentment was economically efficient.
Under the property rights inherent in the pre-Fed check clearing, the paying
bank was free to choose the presentment fee q. In this setting one would predict
that paying banks would set q as high as possible. We therefore should have observed q = −cn , presentment fees equal to the collecting bank’s net willingness

20

Federal Reserve Bank of Richmond Economic Quarterly

to pay to avoid over-the-counter presentment.55 For checks drawn on country
banks the cost savings associated with mail presentment were substantial, and
thus −cn was large. When the paying bank was nearby, the resource cost
of over-the-counter presentment was likely to be quite low, and the collecting
bank’s willingness to pay for mail presentment would be correspondingly small.
This is consistent with country bank presentment fees that are close to the cost
to collecting banks of making a direct presentment through an agent or an
express company, and the general absence of presentment fees in the city. The
presentment fee effectively passes the collecting bank’s cost savings on to the
country paying bank as an inducement to participate via mail presentment. All
of the joint benefits of mail presentment, −cn −ci = q−ci , accrue to the paying
bank.
Although some banks complained that presentment fees exceeded the direct
outlays of the paying bank for remittance (postage, the cost of exchange, and so
on),56 there is no economic efficiency reason why they should not. It is clearly
possible for the presentment fee to exceed ci , the paying bank’s direct outlays
for remittance, without violating the condition for efficient participation. Thus
presentment fees that are “excessive” in this sense are not necessarily evidence
of monopoly power as some have claimed.57
Did the system in fact economize on the costs of moving checks? Much
of the commentary on this topic has argued the contrary, based on welldocumented instances of circuitous routing. But it is not at all obvious that the
examples of circuitous routing constitute strong evidence of excessive costs.
Cannon (1900, p. 76), commenting on the famous Sag Harbor check, writes
that
The reason why banks forward checks in this apparently unreasonable way,
often getting the items far out of their regular course, is easy to explain. It
sometimes appears cheaper to the one who has the check in hand to enclose it
with other items to some regular correspondent, who, assumedly, is nearer the
bank on which the check is drawn, than to hunt up a special correspondent
for it alone.

This reasoning suggests that the cost comparison implicit in the conventional
interpretation of the circuitous routing examples is not the relevant one. The
appropriate comparison for the bank holding the check is between the cost of
sending the item directly to the paying bank (or a “special correspondent” for
this check alone) and the cost of including the item with a batch of checks
being sent to an established correspondent in the hope that the correspondent
55 An

alternative property rights regime in which collecting banks were entitled to mail presentment at par would result in q = ci − vi . In this case the cost savings from mail presentment
would accrue to the collecting banks rather than to the paying banks.
56 Spahr (1926, p. 240–43).
57 Stevens (1998), for example.

Lacker, Walker, Weinberg: Check Clearing Reconsidered

21

would be better able to get the check to its ultimate destination. For an irregular
check—one drawn on a bank with whom one does not have a correspondent
relationship—the incremental cost of sending the check directly to the paying
bank would include the postage on the letter, along with the cost of preparing a
separate shipment. The incremental cost of adding a check to a regular shipment
to a nearby correspondent was probably negligible. Note also that settlement
was probably less costly through established correspondent relations. Consequently, the latter was almost certainly less costly than direct presentment for
a bank holding a check drawn on a country bank. Critics of pre-Fed check
clearing implicitly attribute to the wayward check all of the common cost of
the shipment to the correspondent.58
The bank deciding where to send an item would not consider the costs
incurred by the next bank to hold the check. The next bank could send it on to
another correspondent, which could send it on again to one of its correspondents, and so on. Could this lead to excessively costly check routes? From a
social point of view, the correct cost comparison is between the expected cost
of sending the check along to the next correspondent bank (including the cost
of sending it to subsequent correspondents) and the cost of a more direct route.
Again, there is no reason to believe that the expected cost of indirect routing
was not almost always less than that of direct routing of irregular interregional
checks. The fact that some items ended up following routes that look excessively costly ex post does not mean that routing choices were inefficient ex
ante.
Some mistaken routing choices were inevitable in a decentralized system
with thousands of banks. The average costs of such mistakes constitute a valid
part of the social cost of the pre-Fed system. The mere existence of such costs,
however, does not imply inefficiency for the system as a whole. Only if the costs
of the decentralized system exceeded the costs of creating a centralized system
would inefficiency be implied. None of the critiques of the pre-Fed system has
presented evidence on this dimension.59 Evidence that it is possible to reduce
some collection costs is not, by itself, conclusive evidence that an alternative
arrangement would be superior. Yet as implied in the comments by Carter
58 A possibility we do not pursue here is that the cost of postage does not represent the
social cost of mailing checks. Since postage rates, then as now, are uniform across destinations, it
is quite likely that postage on the irregular country checks in question was lower than incremental
social cost, in the sense that the total postal revenue on shipments to the country bank’s location
failed to cover the incremental cost of service to that location. This would provide yet another
reason to question the cost comparison implicit in the circuitous routing evidence. It would also
cast doubt on the social value of the movement to shift to direct mail presentment as opposed to
direct presentment by an agent such as an express company.
59 There appear to be no available estimates of the frequency of such circuitous routing.
Cannon (1900), Hallock (1903), and Spahr (1926) cite only eight examples between them. Referring to the Sag Harbor check, James (1998, p. 144) notes that “Given the paucity of other
examples, one might be suspicious of this example’s general applicability.”

22

Federal Reserve Bank of Richmond Economic Quarterly

Glass above, to build an alternative system that reduces the costs associated
with collecting certain checks would itself be costly. Similarly, some pre-Fed
writers, such as Cannon (1900) and Hallock (1903), used evidence on the costs
of collecting country checks to argue for the value of creating and operating
a country clearinghouse. As noted above, the frustratingly slow pace of such
efforts suggests that the costs of creating a country clearinghouse exceeded the
available cost savings.
If the status quo was efficient, why was there so much dissatisfaction with
it? Here, it is important to note that complaints about the system are almost
entirely voiced from the point of view of city banks. It was argued that the cost
of collecting country checks was too high, and it was widely acknowledged
that a par collection system would reduce the earnings of the nonpar country
banks.60 In other words, par collection would reduce net costs for city banks
and raise net costs for nonpar country banks. The complaints of the city banks
seem to have been driven by dissatisfaction with the allocation of costs implied
by the status quo arrangements, rather than by dissatisfaction with aggregate
cost.61
What city banks wanted was for presentment through the mail to have
parity with direct presentment, in which case the paying bank would be obligated to pay at par, without deducting a presentment fee. Such a regime
would have inevitably shifted costs toward country banks and away from city
banks. Although city banks were generally unable to obtain par presentment
legislation, the Federal Reserve Board ultimately granted that right to Reserve
Banks by regulatory fiat.

7.

THE FED’S ENTRY INTO CHECK CLEARING
RECONSIDERED

According to the conventional view, self-evident inefficiencies motivated and
rationalized the Fed’s entry into the check collection industry. The process involved a struggle between a progressive reform effort and the vested interests
of nonpar banks. Our alternative view suggests a very different interpretation
60 Most of Spahr’s (1926, pp. 240–43) “arguments for par collection” amount to claims that
costs borne by collecting city banks could and should be reduced. For example, he argues that
par collection under the Federal Reserve would “relieve trade . . . of the burden” of clearing costs
because “the costs would fall to the Federal Reserve Banks and reduce to that extent the earnings
that go to the government” (Spahr 1926, p. 240). That is, the government should defray collecting
bank costs.
61 City banks’ complaints about the costs of collecting country checks should also be viewed
in the context of secular trends in the structure of the banking industry. The total number of banks
in the country grew from 12,424 in 1902 to 26,765 in 1914, and many of these new banks were
small country banks (U.S. Treasury, Office of the Comptroller of the Currency 1903, 1915). Thus
there were a growing number of country banks to contend with.

Lacker, Walker, Weinberg: Check Clearing Reconsidered

23

of the process by which the Fed entered the check collection industry. In our
view, the motive was to attract membership, and the process involved a struggle
over the allocation of the common costs of check collection.
All national banks were required to join the Federal Reserve System, but for
state-chartered banks, membership was optional. From the beginning, attracting
members, and their reserve balances, was viewed as critical to the success of
the institution (White 1983, p. 130). A key perceived defect of the previous
system was the “pyramiding” of reserves in financial centers, which left the
latter vulnerable to sudden widespread withdrawals. Through rediscounting the
Reserve Banks would provide an elastic supply of balances in response to rapid
demand shifts, preventing financial panics (White 1983, pp. 63–125).
In this context, the Reserve Bank check clearing service authorized by the
Act could help attract members, as the early leaders of the Federal Reserve
clearly understood. A mid-1915 report to the Reserve Bank Organizing Committee spelled out the link between Reserve Bank check clearing services and
the membership question:
It must be borne in mind that the banking power of the United States will divide more sharply than it has ever done before into two groups—members and
non-members. It is the intent of the Act itself to bring non-members into the
system. But so long as there is any considerable body of non-member banks,
the two groups will of necessity be in competition with one another, producing
two parallel clearing systems. . . . (T)he domestic exchange business of the
Federal reserve system must be so arranged as to offer constant inducements
to non-members to enter the system. At the same time, members must find it
more profitable to use the Federal reserve system than to make collections as
at present. The situation is more complex when it is taken into consideration
that member banks are in a position to deal on favorable terms either with the
Federal reserve banks and their members or with non-members.62

The Fed’s check clearing service should aim to reduce costs to members and
attract nonmembers to join the system. To do so, they would need to attract
the check clearing business of their members, who were under no obligation
to clear through the Fed.
The reserve requirements in the Federal Reserve Act, while essential to the
monetary goals of the Act, made it more difficult to attract members. Prior to
the founding of the Fed, banks kept reserves with correspondents in addition to
specie and notes in their vaults. Correspondent balances could be used to satisfy
legal reserve requirements, up to a limit, under state laws and the National Bank
Act (Watkins 1929, pp. 67, 96). Moreover, correspondents would often grant
62 Preliminary

Committee on Organization (1914, pp. 58–59). The organizing committee
consisted of the Comptroller of the Currency and the Secretaries of the Treasury and Agriculture.
The Preliminary Committee on Organization reported to them and was chaired by H. Parker
Willis.

24

Federal Reserve Bank of Richmond Economic Quarterly

immediate credit for deposited checks, and these counted toward the respondent’s required reserves. Under the Federal Reserve Act, reserve requirements
had to be met with balances held at the Reserve Banks; correspondent balances
would no longer count. If the Reserve Banks did not offer check clearing
services, member banks would have to hold separate correspondent balances
in order to clear checks, and these balances would have a higher opportunity
cost, since they would no longer do double duty. Willis (1923, p. vi) described
the implications in dramatic terms:
It was recognized that, without these powers, [referring to Reserve Bank check
clearing authority] the reserve banks would become merely the holders of dead
balances carried for the member banks without any service to them; and, since
the business public abhors an idle or unnecessary institution, just as nature is
traditionally said to abhor a vacuum, it would not submit long to the needless
burden created by such emergency institutions designed to put out financial
fire.

Failure to offer attractive check clearing services to justify member bank reserve
balances would threaten support for the System.63
The reserve requirement provisions of the Federal Reserve Act were to
be phased in over three years, so the System had time to develop a strategy.
According to the original Act, member bank required reserves would be transferred over from correspondents in annual steps from November 16, 1914, to
November 16, 1917.64 These provisions were revised by the amendments of
June 21, 1917, in connection with measures to aid financing of the government’s
war effort, lowering the requirements but making them effective immediately.65
The Fed’s struggle to establish its check clearing service is readily understandable from our alternative perspective. The first national check clearing
venture, the “voluntary reciprocal plan” initiated by the Board in March 1915,
was unsuccessful, never attracting more than a third of the member banks. In
exchange for agreeing to accept mail presentment at par, member banks were
able to clear at par on members that joined. This was essentially a voluntary
clearinghouse, modeled after the city clearinghouses. That it failed should be
no surprise, given the terms that were offered. Reciprocal par presentment
allocates common costs according to each bank’s outlays. This allocation successfully attracts members where the cost of over-the-counter presentment is
low, as among city banks. In this case, a bank joining the scheme gives up little
in presentment fee income. But where over-the-counter presentment costs are
63 Stevens

(1998) also discusses the role of reserve requirements in the evolution of the
Fed’s check clearing activities.
64 Starting on November 16, 1914, correspondent balances could count towards a maximum
of 6/15 of required reserves in the first year, 5/15 the second year, 4/15 the third year, 3/15 the
third year, and not at all after November 16, 1918.
65 The Board gave banks until July 15, 1917, to comply (Federal Reserve Bulletin 1917, pp.
508–09).

Lacker, Walker, Weinberg: Check Clearing Reconsidered

25

high and banks have the right to charge for remittance outside the scheme, this
allocation of common costs may fail to induce participation; some prospective
members would have no incentive to join, even if their participation would be
worthwhile. Two-thirds of member banks apparently did not want to join under
the reciprocal par presentment cost allocation. Some might have brought large
benefits to the other participants in the scheme by lowering presentment costs,
even though they themselves placed a relatively low value on participation. As
we noted above, these are just the types of banks that charge presentment fees.
The Fed needed to find a way to induce their participation.
With its second venture, the “compulsory” plan, the Fed found a solution
to the problem: under Circular No. 1 (May 1, 1916), members were required
to accept mail presentment at par. Having failed to induce more than a third
of their members to voluntarily give up charging presentment fees against the
Reserve Banks, the Fed prohibited such fees outright. The compulsory plan was
more attractive to members than the voluntary-reciprocal plan on two counts.
First, the Reserve Banks were offering to clear checks on any member bank,
regardless of how many member banks joined the scheme. The Reserve Banks
immediately had over 7,000 par endpoints. Second, the cost of joining the
second plan was much lower for many banks. Under the previous plan they
would have had to give up presentment fees. Under the new plan, the Board had
already taken away their right to charge presentment fees against the Reserve
Banks. Joining was less of a sacrifice now.
Success was not yet assured. In about a year, reserves would be transferred
over from correspondents to the Reserve Banks under the new reserve requirements. As we noted above, correspondent balances were a key component of
the bundle of mutual clearing services that made up the typical correspondent
banking relationship. Settling cleared checks by crediting or debiting correspondent balances was less costly than remitting specie or exchange drafts. Members
would need to retain some correspondent balances to clear checks on nonmembers, and such balances would no longer do double duty as required reserves.
The new reserve requirements would break apart some of the shared common
costs built into pre-Fed correspondent banking arrangements, raising member
bank costs.66 The Fed’s strategy now was to rebuild that cost sharing around
member bank balances at Reserve Banks. The objective was to offer to collect
at par checks drawn on every bank in the country.67 In theory, member banks
would no longer need external correspondent balances, the Reserve Banks having taken over all the essential clearing functions connected with them.
To this end, the Board sought the amendments passed on September 7,
1916, allowing Reserve Banks to clear checks drawn on nonmembers. But the
66 Martin,

et al. (1915, pp. 369–70).
clearing and collection plan to be effective must be so comprehensive as to include
all checks” (Federal Reserve Bulletin 1917, p. 100).
67 “Any

26

Federal Reserve Bank of Richmond Economic Quarterly

Reserve Banks had trouble getting nonmember banks to accept presentment at
par, as one would expect; the Reserve Banks had nothing of value to offer in
exchange. This led the Board in early 1917 to seek amendments allowing the
Reserve Banks to accept checks deposited by nonmembers. Perhaps reciprocal
check clearing privileges would entice nonmembers to give up their presentment fee income. By early 1917, however, the Board’s ban on presentment
fees against the Reserve Banks made clear that check collection costs would
be reallocated as a by-product of the Fed’s strategy to eliminate presentment
fees. Bankers who would be disadvantaged by such a reallocation mobilized
to push the Hardwick Amendment. The resulting legislative battle exposed the
divergent interests in the allocation of check collection costs. The Hardwick
Amendment was effectively defeated following a “nationwide campaign . . . by
the Credit Men’s Association, the mail-order houses, manufacturers, jobbers,
wholesalers and merchants in the large centers.”68 Payees, in other words,
lobbied in favor of shifting costs towards payor banks.69
An ensuing opinion by the Attorney General spelled out the new distribution of property rights.70 Reserve Banks could not pay presentment fees.
Nonmember banks could decide for themselves whether to charge fees, but
assessing fees against a Reserve Bank for mail presentment was the equivalent
of not accepting mail presentment from them. In this environment, the Reserve
Banks attempted to exercise as much leverage as possible to persuade nonmembers to pay at par. During the period from early 1919 through 1923, the Reserve
Banks resorted to a number of costly collection techniques, such as sending
Reserve Bank employees to present over the counter or hiring local agents to
make direct presentation. These were characterized in litigation as outside the
bounds of customary banking practice; in many cases the expenditures on such
techniques exceeded the presentment fees that were avoided and thus would
not have been undertaken by private sector collecting banks.71 The list of
banks accepting par presentment was naturally largest in the presence of such
measures. When court decisions struck them down, Reserve Bank leverage was
commensurately reduced and the par list shrank.

68 “The

Hardwick Amendment” (1917, p. 40). See also Tippetts (1929, pp. 272–74).
that costs were shifted to taxpayers as well, since the Fed stopped recovering its
costs when collection fees were eliminated in June 1918 (Spahr 1926, pp. 192–93).
70 Federal Reserve Bulletin (1918, pp. 367–70).
71 Spahr (1926); Tippetts (1929).
69 Note

Lacker, Walker, Weinberg: Check Clearing Reconsidered

8.

27

CONCLUSION

The Reserve Banks were able to achieve what reformers had been unable to
bring about—a more centralized clearing of interregional checks. Although
early reform-minded writers, like Cannon (1900) and Hallock (1903), had argued that the cost savings from eliminating what they saw as inefficiencies in
clearing irregular interregional checks would exceed the cost of setting up a
more centralized arrangement, no such schemes had emerged. The Fed succeeded where earlier efforts failed, under our alternative view, because the
Board arrogated the right to present at par on member banks. No such unilateral
ability to reallocate property rights was available to private sector collecting
banks. Reallocating property rights had the effect of shifting the common costs
of check collection away from collecting banks that used the Reserve Bank
system, toward member banks and, after fees were eliminated in 1918, toward
federal taxpayers.
The par presentment right granted to the Reserve Banks by the Board
in Circular No. 1, Series of 1916 (now Regulation J), is essentially a barrier
to competition in the sense that it allows the Reserve Banks to offer check
collection services at lower costs than competitors. Other banks could obtain
the right to present at par, but they would have to offer paying banks material
compensation in order to do so. The Reserve Banks did not need to offer any
compensation. Note that this barrier to competition persists today in the form
of differential presentment times (Lacker and Weinberg 1998). Private sector
collecting banks must present by 8:00 a.m. in order to obtain same-day funds
(at par), while Reserve Banks can present until 2:00 p.m. for same-day funds;
the Reserve Banks have a “six-hour monopoly.” Interestingly, the Board of
Governors recently revisited the presentment time differential.72 The statement
announcing the Board’s decision to retain the competitive advantage notes that
any equalization would reallocate costs in a way that would be disadvantageous
to some segment of the industry. Moving the private presentment time later,
for example, would make collecting banks better off and paying banks worse
off.73 Ironically, the Fed’s original entry into check collection appears to have
been accomplished by reallocating the common costs of check collection in
just this fashion.

72 Board
73 Board

of Governors of the Federal Reserve System (1998).
of Governors of the Federal Reserve System (1998, p. 12).

28

Federal Reserve Bank of Richmond Economic Quarterly

REFERENCES
Baxter, William F. “Bank Interchange of Transactional Paper,” Journal of Law
and Economics, vol. 26 (October 1983), pp. 541–88.
Benston, George J., and David B. Humphrey. “The Case for Downsizing the
Fed,” Banking Strategies (January/February 1997), pp. 30–37.
Board of Governors of the Federal Reserve System. “Collection of Checks
and Other Items by Federal Reserve Banks and Availability of Funds
and Collection of Checks” (Docket No. R–1009). Available:
http://www.bog.frb.fed.us/boarddocs/press/BoardActs/1998/19981209/R-1009.pdf [March 3, 1999].
. Regulations. “Regulation J, Collection of Checks and Other
Items by the Federal Reserve Banks and Funds Transfers through
Fedwire,” as amended 1998.
. “The Federal Reserve in the Payments System,” Federal Reserve
Bulletin, vol. 76 (May 1990), pp. 293–98.
. Seventh Annual Report, 1920. Washington: Government Printing
Office, 1921.
. Annual Report of the Federal Reserve Board, 1914. Washington:
Government Printing Office, 1915.
Cannon, James G. Clearing-Houses: Their History, Methods and Administration. London: Smith, Elder, & Co., 1900.
Congressional Record. Washington, D.C., 1917.
Conway, Thomas, Jr., and Ernest M. Patterson. The Operation of the New
Bank Act. Philadelphia: J. B. Lippencott Co., 1914.
Corrigan, E. Gerald. “Background Materials to the Statement of E. Gerald
Corrigan,” in The Role of the Federal Reserve in Check Clearing and
the Nation’s Payments System. Finance and Urban Affairs, U.S. Congress,
House of Representatives. Subcommittee on Domestic Monetary Policy
of the Committee on Banking, and the Subcommittee on Commerce,
Consumer, and Monetary Affairs of the Committee on Government
Operations. Hearing, 98 Cong. 1 Sess. Washington: Government Printing
Office, 1983.
Duprey, James N., and Clarence W. Nelson. “A Visible Hand: The Fed’s
Involvement in the Check Payments System,” Federal Reserve Bank of
Minneapolis Quarterly Review, vol. 10 (Spring 1986), pp. 18–29.

Lacker, Walker, Weinberg: Check Clearing Reconsidered

29

Federal Reserve Bank of Richmond. “The Development of Par Collections
by Federal Reserve Banks,” Letters to College Classes in Economics and
Banking Discussing The Practical Operations of the Federal Reserve
System, no. 6 (May 1922). Fellows, E. G. The Exchange Charge on
Checks. Dissertation, Rutgers University, 1940.
Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the
United States: 1867–1960. Princeton: Princeton University Press, 1963.
Gidney, Ray. “Notes: Federal Reserve Clearings and Collections,” Journal of
Political Economy, vol. 24 (June 1916), pp. 606–08.
Gilbert, R. Alton. “Did the Fed’s Founding Improve the Efficiency of the U.S.
Payments System?” Federal Reserve Bank of St. Louis Review, vol. 80
(May/June 1998), pp. 121–42.
Gorton, Gary. “Clearinghouses and the Origin of Central Banking in the United
States,” Journal of Economic History, vol. 45 (June 1985), pp. 277–83.
, and Donald J. Mullineaux. “The Joint Production of Confidence:
Endogenous Regulation and Nineteenth Century Commercial-Bank Clearinghouses,” Journal of Money, Credit, and Banking, vol. 19 (November
1987), pp. 457–68.
Hallock, James C. Clearing Out-of-Town Checks. St. Louis: Author, 1903.
Harding, W. P. G. “Reply to Senate Resolution Relative to Check Clearing,”
in Board of Governors of the Federal Reserve System, Seventh Annual
Report, 1920. Washington: Government Printing Office, 1921, pp. 335–57.
“The Hardwick Amendment,” Journal of the American Bankers Association
(July 1917), pp. 40–41.
James, John A. “Commentary,” Federal Reserve Bank of St. Louis Review,
vol. 80 (May/June 1998), pp. 143–50.
Jessup, Paul F. The Theory and Practice of Nonpar Banking. Evanston, Ill.:
Northwestern University Press, 1967.
Kemmerer, Edwin W. The ABCs of the Federal Reserve System. Princeton:
Princeton University Press, 1928.
Lacker, Jeffrey M., and John A. Weinberg. “Can the Fed be a Payment System
Innovator?” Federal Reserve Bank of Richmond Economic Quarterly, vol.
84 (Spring 1998), pp. 1–25.
Langston, L. H. Practical Bank Operations. New York: Ronald Press Co.,
1921.
Martin, Wm. McC., Frederic H. Curtiss, and Pierre Jay. “Report of the Federal
Reserve Agents’ Committee on Clearings,” Federal Reserve Bulletin, vol.
1 (November 1915), pp. 369–72.
McAndrews, James J. “Commentary,” Federal Reserve Bank of St. Louis
Review, vol. 77 (November/December 1995), pp. 55–59.

30

Federal Reserve Bank of Richmond Economic Quarterly

Miller, Melvin C. The Par Check Collection and Absorption of Exchange
Controversies. Cambridge: The Bankers Publishing Co., 1949.
Moore, Carl H. The Federal Reserve System. London: McFarland & Co., 1990.
Preliminary Committee on Organization. Report to the Reserve Bank Organizing Committee. New York: Reserve Bank Organizing Committee, June 1,
1914.
Preston, Howard H. “The Federal Reserve Banks’ System of Par Collection,”
Journal of Political Economy, (July 1920), pp. 565–90.
Spahr, Walter Earl. The Clearing and Collection of Checks. New York: Bankers
Publishing Co., 1926.
Sprague, Oliver M. History of Crises under the National Banking System, U.S.
National Monetary Commission, Senate Document No. 538, 61 Cong. 2
Sess. Washington: Government Printing Office, 1910.
Stevens, Ed. “Non-Par Banking: Competition and Monopoly in Markets for
Payments Services,” Working Paper 9817. Cleveland: Federal Reserve
Bank of Cleveland, November 1998.
. “The Founders’ Intentions: Sources of the Payments Services
Franchise of the Federal Reserve Banks,” Working Paper 03–96. Cleveland:
Federal Reserve Bank of Cleveland, Financial Services Working Paper
Series, December 1996.
Summers, Bruce J., and R. Alton Gilbert. “Clearing and Settlement of U.S.
Dollar Payments: Back to the Future?” Federal Reserve Bank of St. Louis
Review, vol. 78 (September/October 1996), pp. 3–27.
Timberlake, Richard H. The Origins of Central Banking in the United States.
Cambridge, Mass.: Harvard University Press, 1978.
Tippetts, Charles S. State Banks and the Federal Reserve System. New York:
D. Van Nostrand Co., 1929.
. “The Par Remittance Controversy,” American Economic Review,
vol. 14 (December 1924), pp.629–48.
U.S. Congress, House of Representatives, House Report 69, 63 Cong. 1 Sess.
Washington: Government Printing Office, 1913.
U.S. Congress, Senate, Senate Committee on Banking and Currency, Hearings
on H. R. 7837 (S. 2639), 63 Cong. 1 Sess., November 6, 1913. Washington:
Government Printing Office, 1913, pp. 512–13.
U.S. Treasury, Office of the Comptroller of the Currency. Annual Report, 1914.
Washington: Government Printing Office, 1915.
. Annual Report, 1902. Washington: Government Printing Office,
1903.

Lacker, Walker, Weinberg: Check Clearing Reconsidered

31

Walter, John R. An Examination of the Factors Motivating the Federal Reserve
System’s Entrance into the Provision of Check Collection Services.
Dissertation, University of Delaware, 1988.
Watkins, Leonard L. Banker’s Balances. Chicago: A. W. Shaw, 1929.
Weinberg, John A. “The Organization of Private Payment Networks,” Federal
Reserve Bank of Richmond Economic Quarterly, vol. 83 (Spring 1997),
pp. 25–43.
White, Eugene Nelson. The Regulation and Reform of the American Banking
System, 1900–1929. Princeton: Princeton University Press, 1983.
Williams, Charles R. The Bankers Encyclopedia. Chicago: The Bankers
Encyclopedia Co., 1901.
Willis, Henry P. “The Federal Reserve Act,” American Economic Review,
vol. 4 (March 1914), pp. 1–24.
Willis, Henry Parker. The Federal Reserve System: Legislation, Organization
and Operation. New York: The Ronald Press Co., 1923.
Willis, H. Parker, John M. Chapman, and Ralph West Robey. Contemporary
Banking. New York: Harper & Brothers Publishers, 1933.
Wyatt, Walter. “The Par Clearance Controversy,” Virginia Law Review, vol. 30
(June 1944), pp. 361–97.

A Forward-Looking Monetary
Policy Reaction Function
Yash P. Mehra

T

he Federal Reserve’s reaction function, which summarizes how the
Federal Reserve (Fed) alters monetary policy in response to economic
developments, plays an important role in macroeconomic and policy
analyses. It can be helpful in predicting actual policy actions, thereby serving
as a benchmark for assessing the current stance and the future direction of
monetary policy. Also, in macro models, the reaction function is central in
evaluating Fed policy and determining effects of other macro policies or economic shocks, implying macroeconomic performance may itself depend upon
the conduct of monetary policy. Consequently, there is considerable interest
in identifying the nature of actual policy pursued by the Fed and determining
whether the estimated reaction function fostered or hindered macroeconomic
stability.1
Although numerous monetary policy reaction functions have been estimated, in this article I estimate one that sheds new evidence on the nature of
Fed policy since 1979. In particular, I present and estimate a forward-looking

The views expressed are the author’s and not necessarily those of the Federal Reserve Bank
of Richmond or the Federal Reserve System.
1 See,

for example, Clarida, Gali, and Gertler (1998b) and Taylor (1998). Clarida, Gali,
and Gertler estimate a forward-looking version of the Taylor rule for the post–World War II
U.S. economy and find that the interest rate policy in the Volcker-Greenspan period was more
responsive to changes in expected inflation than it had been in the pre-Volcker period. They
then embody these estimated policy rules within a standard business cycle model and analyze the
statistical properties of inflation and output. They show that the estimated pre-Volcker rule permits
larger fluctuations in inflation and real output (and therefore greater macroeconomic instability)
than does the Volcker-Greenspan rule. Similarly, Taylor (1998) argues that U.S. interest rate policy
during the period 1986 to 1997 is well predicted by the Taylor rule and that this period in U.S.
monetary policy had the greatest degree of economic stability. Both inflation and real output had
smaller fluctuations during this period. He then identifies two other periods, 1879 to 1914 and
1960 to 1979, when policy deviated significantly from the Taylor rule in that the nominal interest
rate was not very responsive to both inflation and real output fluctuations. During those periods
macroeconomic performance was not as good.

Federal Reserve Bank of Richmond Economic Quarterly Volume 85/2 Spring 1999

33

34

Federal Reserve Bank of Richmond Economic Quarterly

monetary policy reaction function that predicts the actual path of the funds rate
during most of the period from 1979 to 1997. The distinguishing characteristic
of this policy reaction function is that policy responds to movements in longterm inflationary expectations as evidenced by the behavior of the bond rate, an
issue discussed first in Goodfriend (1993) but ignored in the recent empirical
work on estimated monetary policy rules.2 I also examine whether the policy
reaction function has changed significantly during the 1990s, especially during
Alan Greenspan’s tenure as Fed Chairman. Finally, since this reaction function
predicts actual policy actions fairly well, I discuss whether policy during the
most recent period 1997Q1 to 1998Q2 is consistent with prior Fed behavior.
This period is of interest because during this period the Fed did not adjust the
funds rate in response to above-trend real growth.
The policy reaction function that I consider here has both backward- and
forward-looking components. It assumes that the funds rate responds to actual
inflation, increases in expected future inflation, expected output gap, and the
bond rate. The funds rate response to the bond rate captures the influence of
long-term inflationary expectations on policy. The empirical work here, which
focuses on the behavior of the funds rate over two sample periods, 1960Q2
to 1979Q2 and 1979Q3 to 1998Q2, broadly supports this specification. However, policy responses differ across these sample periods. The most significant
difference is that the funds rate has responded to movements in the bond rate
after 1979 but not before. This indicates that since 1979 the Fed has been
very sensitive to long-term expected inflation; so much so that for most of this
period the nominal funds rate has moved more than one-for-one with actual
inflation. Hence the real as well as the nominal funds rate increased in response
to inflation. That is not the case in the pre-1979 period, when the nominal funds
rate did not adjust one-for-one with actual inflation. In that period the real funds
rate declined in response to actual inflation.
The policy reaction function given here tracks the actual behavior of the
funds rate more closely since 1979 than it does in the period before. The
sample period 1979Q3 to 1998Q2 spans the tenures of Paul Volcker and Alan
Greenspan as Fed Chairmen. The results, however, indicate that the policy
reaction function has not changed much between the Volcker and Greenspan
periods. Finally, policy during the most recent subperiod 1997Q1 to 1998Q2
is consistent with prior Fed behavior. While the U.S. economy has grown at
a very strong rate during this period, actual inflation has fallen steadily and

2 Clarida,

Gali, and Gertler (1998a) and Clarida, Gali, and Gertler (1998b) estimate forwardlooking versions of the Taylor rule for G7 countries including the United States, but they do not
examine the role of the bond rate. Nor do they examine issues relating to the stability of the
reaction function and the ability to predict actual policy. Mehra (1997), on the other hand, does
consider the response of policy to the bond rate and finds that the bond rate is significant in the
reaction function.

Y. P. Mehra: Monetary Policy Reaction

35

long-term inflationary expectations as measured by the behavior of the bond
rate have remained well behaved. Furthermore, there is also some evidence
that the economy’s underlying trend growth rate may have increased somewhat during the ’90s. Once we consider together the influences of all these
economic factors on the funds rate target, then the actual funds rate, which
hovered around 5.5 percent during this subperiod, is not too different from the
value predicted by the policy reaction function. On a more intuitive level, the
surprisingly good performance of the economy on the inflation front combined
with well-behaved long-term inflationary expectations and higher estimates of
trend growth worked to neutralize the tighter policy response indicated by
above-trend growth. Accordingly, the absence of any policy move during this
subperiod is not out of line with prior Fed behavior.

1.

THE MODEL AND THE METHOD

A Forward-Looking Specification
The policy reaction function considered here builds upon the work in Taylor
(1993), Mehra (1997), and Clarida, Gali, and Gertler (1998b). The particular
specification estimated here can be derived using the following two equations:
FR∗t = rr + a11 INFLt−1 + a12 (INFLt−1 − INFL∗ ) + a21 (EINFLt+1 − INFLt−1 )
+ a31 (BRt − EINFLt+k ) + a41 EGAPt+k , and
FRt = (1 − ρ)FR∗t + ρFRt−1 + vt ; 0 ≤ ρ ≤ 1,

(1)
(2)

where FRt is the actual funds rate; FR∗t is the Fed’s nominal funds rate target
for period t; INFL is the inflation rate; INFL∗ is the Fed’s inflation target;
GAP is the output gap; BR is the bond rate; rr is the economy’s underlying
equilibrium real interest rate; vt is a stochastic disturbance term; and E is the
expectations operator. Equation (1) specifies the economic determinants of the
funds rate target. It assumes that the Fed has a target for inflation and a target
for the level of output. It also assumes that the Fed pays attention to actual
inflation as well as to the expected change in its future direction. Equation
(1) thus hypothesizes that the funds rate target each period is determined as a
function of the real rate of interest, actual inflation, and gaps between actual
inflation and expected output and their respective target levels. Since the Fed
is concerned with the expected future direction of inflation, equation (1) also
posits that the funds rate target depends upon the change in expected future
inflation and the bond rate. The other important assumption implicit in (1) is
that the economy’s underlying real rate of interest and the Fed’s short-term
target for inflation are constant in the short run.

36

Federal Reserve Bank of Richmond Economic Quarterly

Equation (2) specifies the actual funds rate as a weighted average of the
last-period funds rate and the current-period funds rate target. It assumes the
Fed smoothes short-run changes in interest rates and hence the actual funds rate
adjusts gradually to the target implied by economic fundamentals specified in
(1) (Goodfriend 1991). The magnitude of the parameter ρ measures the degree
of interest rate smoothing in Fed behavior. In equation (2) there is also a shock
term vt , indicating that the Fed may deviate transitorily from its systematic rule
in (1). I, however, assume these transitory deviations from the policy rule are
not serially correlated, as in true “policy shocks.” If we substitute (1) into (2),
we get (3), which is the policy reaction function investigated here.
FRt = (1 − ρ)(rr − a12 INFL∗ ) + ρFRt−1 + (a11 + a12 )(1 − ρ)INFLt−1
+ a21 (1 − ρ)(EINFLt+1 − INFLt−1 ) + a41 (1 − ρ)(EGAPt+1 )
+ a31 (1 − ρ)(BRt − EINFLt+1 ) + vt ,

(3)

where all variables are defined as before. Equation (3) is the short-run policy
reaction function where the funds rate in period t is determined in part by its
actual value in the previous period and in part by previous, current, and expected future values of economic factors. The reaction function indicates that
the funds rate rises if actual inflation increases, if future inflation is expected to
increase, if the bond rate moves relative to its value consistent with the Fed’s
current forecast of near-term expected future inflation, or if the expected future
output gap is positive. The parameters aij (1 − ρ), i = 2, 3, 4, j = 1, 2, measure
these short-run responses, their magnitudes being determined in part by the
degree of interest rate smoothing in Fed behavior. If the Fed does not smooth
interest rates, then ρ is zero and the funds rate adjusts each period in response to
changes in its economic determinants. The coefficients aij , i = 2, 3, 4, j = 1, 2,
then measure the responses of the funds rate target to economic fundamentals
within each period. Consequently, the period t responses are the long-term
responses.
The key feature of the short-run reaction function (3) is that the funds rate
is assumed to respond to long-term inflationary expectations imbedded in the
bond rate. Goodfriend (1993) has convincingly argued that in order to establish
and maintain credibility to low inflation, the Fed has reacted to the long bond
rate. However, since an expected future inflation variable is already included
in the reaction function, the bond rate should influence the funds rate only if
it contains information beyond that which is already imbedded in the Fed’s
current forecasts of the future inflation rate. As a result, the funds rate target
is assumed to respond to deviations of the bond rate as measured from the
expected future inflation rate.
We define the steady state as the one in which the Fed has achieved its
short-term objectives for inflation and real output and in which the public’s
expectations of inflation are stabilized whereby long-term expected inflation

Y. P. Mehra: Monetary Policy Reaction

37

equals the constant inflation target. Clearly the bond rate has no role in the
steady state because the long-term expected inflation also equals the constant
target inflation. Under this definition of the steady state (with EGAPt+1 = 0,
EINFLt+1 = INFLt−1 = INF∗ , a31 = 0, a11 = 1), the policy reaction function
(1) has the property that the nominal funds rate target equals the inflation rate
plus the economy’s underlying real rate of interest, i.e., rr + INFLt .3 The policy
reaction function (3) has thus embedded in it the Fisher relation as applied to
the nominal funds rate target, indicating that economic fundamentals such as
the inflation rate and the real rate of interest are the steady-state determinants
of the funds rate target.
The component rr + (a11 + a12 )INFL in (1) is of interest, however, for one
more reason. It provides information about the long-run response of the nominal
funds rate to inflation.4 In particular, the estimated coefficient (a11 + a12 ) that
appears on the level of actual inflation in (1) measures the net response of the
funds rate to three inflation variables.5 If its estimated value is above unity
during a given sample period, it indicates that, as a result of the Fed’s shortterm reactions to inflation indicators, both the nominal and real funds rate target
rose in response to inflation. On the other hand, if the estimated value is less
than unity, then it indicates the real funds rate target declined in response to
inflation. This information can be useful in assessing whether or not monetary
policy is neutral during a given sample period.
It is also worth pointing out that the short-term policy reaction function (3)
studied here is similar in some respects to the Taylor rule recently estimated
in Taylor (1998). The policy rule estimated there is given in (4):
FR∗t = rr + INFt + d1 (INFt − INF∗ ) + d2 GAPt ; FRt = FR∗t ,

(4)

where INF is measured by the average inflation rate over the past four quarters
and all other variables are defined as before. First note that the reaction function
(3) studied here collapses to the policy rule (4) if we substitute actual for expected output gap and set ρ = 0, a11 = 1.0, a12 = d1 , a21 = a31 = 0, a41 = d2 .
In other words, according to the policy rule (4), the Fed does not smooth interest rates, responds only to actual inflation and the output gap, and ignores
altogether the behavior of forward-looking inflation indicators in setting the
funds rate target. Therefore one can interpret the policy rule estimated here as
one that relaxes the restrictions implicit in the estimated Taylor rule.
3 I am implicitly assuming that the bond rate has been stripped of its assumed constant real
rate component. In the empirical work, the bond rate variable (BR − EINFLt+1 ) used has been
demeaned.
4 This is the long-run funds rate equation estimated in Mehra (1997) and is also the steadystate component of the Taylor rule (Taylor 1993).
5 To see this result, rewrite equation (1) so that all three inflation variables are in levels.
Then the coefficients that appear on levels of these three variables (INFL, EINFL, BR) sum to
(a11 + a12 ).

38

Federal Reserve Bank of Richmond Economic Quarterly

Estimating the Forward-Looking Reaction Function
The reaction function (3) contains unobserved expected values of inflation and
output gap. In estimating (3), I replace unobserved expected values with actual
values and assume that the Fed’s expectations of these variables are rational
and hence uncorrelated with time t − 1 information known to the central bank
as in (5):
INFLt+1 = E(INFLt+1 /It−1 ) + vpt+1
GAPt+1 = E(GAPt+1 /It−1 ) + vyt+1 ,

(5)

where vpt+1 and vyt+1 are forecast errors that are uncorrelated with t − 1 dated
information used by the central bank to forecast inflation and the output gap.
If we eliminate the unobserved expected values from (3), we can rewrite (3)
as (6):
FRt = (1 − ρ)(rr − a12 INF∗ ) + ρFRt−1 + (a11 + a12 )(1 − ρ)INFLt−1
+ a21 (1 − ρ)(INFLt+1 − INFLt−1 ) + a41 (1 − ρ)GAPt+1
+ a31 (1 − ρ)(BRt − INFLt+1 ) + vvt ,

(6)

where vvt+1 = vt − (a21 − a31 )(1 − ρ)vpt+1 − a41 (1 − ρ)vyt+1 . The composite
error term, vvt , is serially uncorrelated as both vpt+1 and vyt+1 are serially
uncorrelated. But it is correlated with period t + 1 values of actual inflation
and output gap. That is, the disturbance term in (5) is correlated with the righthand side explanatory variables. However, it can be verified that vv satisfies
orthogonality conditions expressed in (7):
E(vvt /It−1 ) = 0.

(7)

That is, the composite error term vvt is uncorrelated with t−1 dated information
used by the central bank to forecast one-period-ahead inflation and the output
gap. That suggests equation (5) can be estimated by instrumental variables, using variables in the information set It−1 as instruments. In particular, I follow
Clarida, Gali, and Gertler (1998b) and estimate (5) using Hansen’s (1982) generalized method of moments estimator. Under the identifying assumptions (7),
this procedure produces efficient instrumental variables estimates. Furthermore,
the procedure generates a test of identifying restrictions (7) used to estimate
the model parameters.6
6 I performed the generalized method of moments (GMM) estimation using the statistical
package Regression Analysis for Time Series (version 4). The GMM is an efficient instrumental
variables estimator. If we specify the list of instruments that are assumed to be uncorrelated with
the disturbance term (vvt in [7]) and if we know exactly the covariance matrix of this disturbance
term, then the GMM estimator is in fact the generalized instrumental variables estimator of the
form given below:

β = [(X0 Z)(Z0 ΩZ)−1 (Z0 X)]−1 (X0 Z)(Z0 ΩZ)−1 Z0 y,

(a)

Y. P. Mehra: Monetary Policy Reaction

39

Data, Definition of Economic Variables, and Empirical
Specifications of the Funds Rate Equation
The empirical work here estimates the reaction function over two sample periods, 1960Q2 to 1979Q2 and 1979Q3 to 1998Q2. It is widely believed that in
the second subperiod the Fed made serious efforts to reduce the trend rate of
inflation and contain inflationary expectations and that this deflationary policy
was set in motion when Paul Volcker became Fed Chairman in late 1979. It is
also believed that such policy has continued through the current regime of Alan
Greenspan. Hence the estimated monetary policy reaction function is likely to
differ between pre- and post-1979 periods.7
With regard to data and definitions, the funds rate variable (FR) is the average quarterly value of the effective funds rate. Inflation (INFL) is measured
by the behavior of the (chain-weighted) GDP deflator. The output gap variable
(GAP) is measured as the excess of actual over potential GDP. I consider two
alternatives about the Fed’s estimate of potential GDP. In one I follow the
evidence in Hodrick and Prescott (1997) that potential GDP has a smoothly
varying trend and that this trend is well approximated by passing real GDP
through the Hodrick-Prescott (HP) filter with the smoothness parameter λ set
at 1600.8 Taylor (1998) also estimates policy rules with series on the potential
output generated with the HP filter. Alternatively, following Clarida, Gali, and
Gertler (1998b), I also consider results using potential GDP estimated from a
fitted quadratic function of time. This specification assumes that trend GDP is
where X is the matrix of observations on the explanatory variables, Z is the matrix of observations
on instruments, Ω is the covariance matrix of the disturbance term, and y is the vector of observations on the dependent variable. In the special case where Ω = σ 2 I, so that the disturbance
term vvt is both homoscedastic and serially uncorrelated, the estimator (a) reduces to the simple
instrumental variables estimator. However, in practice we do not know the form of Ω. But as
Hansen (1982) shows, it is possible to compute consistent estimators using a procedure that
imposes little structure on the matrix Ω. In particular, the estimates here are generated using a
two-step procedure. In step one, the policy reaction function is estimated using the instrumental
variables with Ω = σ 2 I, and the residuals are computed. In step two, the matrix (Z0 ΩZ) is
estimated using residuals as suggested in Hansen (1982) and the GMM estimator is computed
replacing the component (Z0 ΩZ)−1 in (a) by its estimated value. In addition to specifying the list
of instruments, one has to specify the length of lags on the instruments. Moreover, if the model
suggests the presence of serial correlation, then one can take that into account in specifying the
matrix Ω. The empirical work here is performed using four lags of instruments. Since the policy
reaction function focuses on one-step-ahead expected values, the disturbance term under that
assumption is serially uncorrelated.
7 The empirical work in previous research also indicates that policy responses differ significantly across these two sample periods (Mehra 1997; Clarida, Gali, and Gertler 1998b; and
Taylor 1998).
8 The magnitude of the smoothness parameter λ determines the variability of the trend
component. The larger the value of λ, the smaller the variability of its trend component. If λ is
chosen to be infinity, then the filtered series approaches the least squares fit of a linear trend model.
Hodrick and Prescott (1997), however, show that small changes in the value of the smoothness
parameter chosen (λ = 1600) do not much alter the business cycle properties of real GDP.

40

Federal Reserve Bank of Richmond Economic Quarterly

deterministic as opposed to being stochastic. The long-term bond rate (BR) is
measured here by the nominal yield on ten-year U.S. Treasury bonds.
In some previous studies, including Mehra (1997), lagged money growth
is significant when included in the reaction function. In order to investigate
this issue, I also include money growth in the policy reaction function. As in
previous studies, money is defined by M1 until 1982Q3 and by M2 thereafter.
Moreover, as in previous studies, money growth for the period 1979Q3 to
1982Q3 is included interacting with a slope dummy variable that is defined to
be unity over this subperiod and zero otherwise. This formulation is consistent
with the popular view that the Fed’s “new operating procedures” paid considerable attention to M1, and consequently such procedures may have been
a source of movements in the funds rate target during this period. McCallum
and Nelson (1998) also report that the New Operating Procedure dummy is
generally significant when included in policy rules estimated there.9 Given
the above-noted considerations, the policy reaction function estimated here is
expressed in the following form:
FRt = (1 − ρ)a0 + ρFRt−1 + a1 (1 − ρ)INFLt−1 + a2 (INFLt+1 − INFLt−1 )
+ a3 (BRt − INFLt+1 ) + a4 GAPt+1 + a5 M1t−1 + vvt ,

(8)

where a0 = rr − a12 INFL∗ , a1 = (a11 + a12 ), a2 = a21 (1 − ρ), a3 = a31 (1 − ρ),
and a4 = a41 (1 − ρ). M1 in (8) is money growth measured by the behavior
of M1 nd all other variables are defined as before. The instrument list consists
of a constant and four lagged values of the funds rate (FR), the inflation rate
(INFL), the output gap (GAP), the bond rate (BR), and the growth rate of real
GDP. For the subperiod 1960Q2 to 1979Q2, the instrument list also included
four lagged values of M1 growth. For the other sample period the instrument
list includes money growth interacting with a slope dummy that is defined to
be 1 over 1979Q3 to 1982Q3 and zero otherwise.10

2.

EMPIRICAL RESULTS

Estimates of the Forward-Looking Reaction Function
Table 1 presents GMM estimates of the short-run monetary policy reaction
function (8) for two sample periods, 1960Q2 to 1979Q2 and 1979Q3 to 1998Q2.
9 In their empirical work, the New Operating Procedure dummy is simply an intercept
dummy, defined to be unity over 1979Q3 to 1982Q3 and zero otherwise. Here, the New Operating
Procedure dummy is a slope dummy on M1 growth.
10 The choice of instruments is motivated by the view that the Fed’s forecast of expected
inflation and the output gap depends upon the past history of inflation, the output gap, real growth,
monetary growth, and the bond rate. In addition, the history of policy actions measured by the
past behavior of the funds rate is also relevant. As is clear, many of the economic variables
included in the Fed’s information set are consistent with the Phillips curve and monetarist views
of the inflation process.

Y. P. Mehra: Monetary Policy Reaction

41

Table 1 GMM Estimates of the Forward-Looking Reaction Function
Panel A: HP Trend
a1

a2

a3

a4

a5

ρ

a0

x21

J

1960Q2–1979Q2

0.71
(3.8)

0.34
(3.3)

−0.11
(1.0)

0.20
(3.6)

−0.04
(1.0)

0.76
(9.6)

2.6
(2.9)

2.3
(0.13)

24.0
(0.15)

1979Q3–1998Q1

0.64
(4.2)

0.26
(2.2)

0.27
(7.4)

0.41
(4.8)

0.28
(7.5)

0.69
(13.5)

4.6
(11.7)

5.3
(0.02)

17.9
(0.27)

Sample Period

Panel B: Quadratic Time Trend
1960Q2–1979Q2

0.70
(3.2)

0.32
(2.6)

−0.06
(0.5)

0.12
(4.1)

−0.05
(1.0)

0.77
(8.5)

2.5
(2.5)

1.8
(0.17)

22.4
(0.21)

1979Q3–1998Q1

1.2
(8.7)

0.40
(4.2)

0.46
(7.1)

0.26
(7.2)

0.26
(6.9)

0.59
(12.1)

2.9
(7.4)

2.8
(0.09)

13.1
(0.60)

Notes: The coefficients (t-values in parentheses below) reported above are from the funds rate equation
(8) of the text:
FRt = (1 − ρ)a0 + ρFRt−1 + (1 − ρ)a1 INFLt−1 + a2 (INFLt+1 − INFLt−1 )
+ a3 (BRt − INFLt+1 ) + a4 GAPt+1 + a5 M1t−1 ,
where FR is the federal funds rate; INFL is the inflation rate; M1 is M1 growth; GAP is the output gap; and
BR is the bond rate. For the sample period 1979Q3–1998Q1, money growth is included interacting with
a slope dummy variable D∗ M1, where D is a dummy that is 1 over 1979Q3–1982Q3 and 0 otherwise.
The instrument set consists of a constant, four lagged values of the funds rate, inflation, the bond rate,
money growth, output gap, and real GDP growth. J is the test of overidentifying restrictions and is
distributed Chi-squared. x12 is the Chi-squared statistic that tests the null hypothesis a1 = 1. Significance
levels of these statistics are reported in parentheses below. The constant term a0 is (rr − a12 INF∗ ), where
rr is the real rate of interest and INF∗ is the Fed’s inflation target.

Panel A in Table 1 contains results that occur when potential output is measured
with the HP trend, and Panel B contains results that occur when instead the
quadratic trend is used. For all variables the coefficients reported are the shortrun coefficients, with the exception of the one for actual inflation. For that
variable the coefficient reported is the long-run coefficient a1 ; the short-run
coefficient can be recovered by multiplying the reported coefficient by (1 − ρ),
i.e., a1 (1−ρ) in (8).11 The J-statistic reported there tests the null hypothesis that
11 As noted before, the policy reaction function (8) is nonlinear in parameters, with ρ appearing in front of many variables including FRt−1 . One could estimate (8) with or without imposing
these nonlinear restrictions. If restrictions are imposed, then one gets estimates of the long-term
coefficients and the short-term smoothness parameter ρ. Given long-term estimates, the shortterm coefficients are recovered by multiplying the estimated long-term coefficients by (1 − ρ).
Alternatively, one may ignore these nonlinear restrictions and estimate directly the following
version of equation (8):

FRt = d0 + d1 FRt−1 + d2 INFLt−1 + d3 (INFLt+1 − INFLt−1 )
+ d4 (BRt − INFLt+1 ) + d5 GAPt+1 + d6 M1t−1 + vvt ,

42

Federal Reserve Bank of Richmond Economic Quarterly

orthogonality restrictions imposed under GMM estimation are consistent with
data. If this statistic is small, then it indicates the restrictions are not rejected
by the data; therefore GMM estimates are consistent.
If one focuses on post-1979 estimates, one can see that all estimated coefficients have expected signs and are generally statistically significant (see
t-values in parentheses below estimates in Panels A and B, Table 1). Those
estimates indicate that the funds rate rises if actual inflation rises, if future
inflation is expected to increase, if output is expected to be above trend, or if
the current-period bond rate moves relative to the expected future inflation rate.
The estimated short-run coefficients (a2 , a3 ) that appear on two future inflation
indicators are positive, indicating the funds rate target responded to expected
changes in the future direction of actual inflation. In particular, the estimated
short-run coefficient (a3 ) on the bond rate is 0.3 to 0.4, which indicates the
funds rate increases 30 to 40 basis points in response to 1 percentage point
increase in the bond rate.12 The M1 growth dummy is significant, which shows
the influence of “new operating procedures” on the funds rate. The pointestimate of the coefficient that appears on the lagged funds rate (ρ) is between
0.6 to 0.8, which indicates the presence of considerable interest rate smoothing
in Fed behavior. Finally, the reported J-statistic is small, which indicates the
restrictions imposed in deriving GMM estimates are consistent with data.13
The results do not change qualitatively between two alternative measures of
potential output used here. However, magnitudes of individual coefficients that
measure responses of the funds rate target to different economic fundamentals
are sensitive to the measure of trend used. The one difference to highlight
is the long-run, estimated coefficient (a1 ) that appears on the level of actual
inflation. This coefficient is greater than unity if output gap is estimated with
the quadratic trend, suggesting that in the post-1979 period, the real funds rate
target rose in response to inflation. However, the point estimate of a1 falls below
unity if output gap is estimated instead with the HP trend (compare estimates
of a1 in Panels A and B, Table 1). Nonetheless, as discussed later, the point

where all variables are defined as before. The estimated coefficients di , i = 0,1,2,3,4,5,6, are
then estimates of short-term coefficients. The long-term coefficients can then be recovered by
multiplying the short-term estimates by [1/(1 − d1 )]. Both these procedures yield qualitatively
similar results. The empirical work reported here is based mostly on estimates generated using
nonlinear restrictions.
12 Since the Fed smoothes interest rates in the short run, the long-term estimated response
measured by a3 /(1 − ρ) is stronger. In the HP trend case, the estimated long-run response is
0.26/(1 − 0.69), i.e., 0.87.
13 The overall fit of the regression as measured by the standard error of estimate is better
when four lagged values of the instruments are used in estimation than it is when two or three
lagged values are used. The results, however, do not change qualitatively if the policy reaction
function is instead estimated using two to three lagged values of the instruments. In particular,
the bond rate remains significant in the post-1979 period. The J-statistic continues to confirm the
condition in (7) that the error term is not correlated with instruments.

Y. P. Mehra: Monetary Policy Reaction

43

estimate of a1 has remained above unity in most other subperiods ending in the
’90s (see estimates of a1 in Tables 3 and 4 for various subperiods). Together
these estimates indicate that during most of the Volcker-Greenspan period the
real funds rate target increased in response to actual inflation.14
If one focuses on pre-1979 estimates, one can see that, like the post-1979
estimates, these estimates indicate that the funds rate target rises in response
to actual inflation, to increases in expected future inflation, and to the positive
expected output gap. But pre-1979 estimates differ significantly from post-1979
estimates in several ways. First, the bond rate is not significant, indicating that in
the pre-1979 period the Fed did not adjust the target in response to movements
in the bond rate. This result on the absence of long-term inflationary expectations on policy is robust to changes in the measure of trend used. Second,
money growth is also not significant.15 Third, the long-run, estimated coefficient
(a1 ) that measures the response of the funds rate to inflation is economically
less than unity, indicating that the funds rate did not adjust one-for-one with
inflation. That is, the real funds rate declined in response to actual inflation
prior to 1979. This decline occurred despite the evidence here that in the pre1979 period the funds rate is responsive to movements in near-term expected
future inflation (see estimates of a2 in Table1). The absence of response to the
bond rate may explain why the real funds rate target declined in response to
actual inflation during the pre-Volcker period.
Assessing the Predictive Content of the Policy Reaction Function:
Pre- and Post-1979
The key hypotheses posited about Fed behavior here are that the fund rate
responds to economic fundamentals specified in (3). The estimates discussed
above lend support to these hypotheses. In order to assess further the empirical plausibility of these hypotheses, I examine how well the policy reaction
function predicts the actual behavior of the funds rate during the two sample
periods. The predictive content is evaluated with the following regression:
FRt = c + dPFRt + eet ,

(9)

14 Table 1 also reports estimates of the constant term a = rr − a INFL∗ in (8). But, as
0
12
is obvious, it is not possible to recover estimates of the assumed constant real rate rr without
information about the Fed’s constant inflation target.
15 In the forward-looking reaction function estimated here, money growth, when included,
is generally not significant, with the exception of the brief “new operating procedures” period
1979Q3 to 1982Q3. This result is in contrast with the one reported in many previous studies,
where money growth is significant. One explanation of these different results is that the reaction
functions in these studies are backward-looking. Hence money growth may be significant in these
studies not because the funds rate responds to money growth but because past money is giving
information about future economic factors that are omitted from the reaction function.

44

Federal Reserve Bank of Richmond Economic Quarterly

where PFR is the funds rate predicted by the policy reaction function and
ee is the disturbance term. The predicted values used in (9) are the dynamic
within-sample simulated values of the policy reaction function (8), generated
using actual values of explanatory variables. However, in order to highlight the
importance of the effect of interest rate smoothing on the funds rate target, I
also generate predictions of the funds rate with the smoothing parameter ρ in
(8) set to zero. The predicted funds rate is an unbiased predictor of the actual
funds rate if c = 0 and d = 1.16
Table 2 reports estimates of the regression (9) for two sample periods,
1961Q1 to 1979Q2 and 1981Q1 to 1998Q1. The results are reported for both
measures of the output gap and with and without accounting for the effect
of interest rate smoothing (see Panels A and B). (Figures 1 through 4 chart
predicted and actual values of the funds rate for the HP filtered output gap.)
If one focuses on post-1979 sample results with smoothing, one can see that
the coefficient that appears on the predicted fund rate variable PFR in (9) is
close to unity. x12 is the Chi-squared statistic that tests the null hypothesis that
(c, d ) = (0, 1). This statistic is not significant at the 5 percent level, suggesting
the predicted funds rate is an unbiased predictor of the actual funds rate. The
result is not sensitive to the measure of trend used or to the presence of interest
rate smoothing in Fed behavior (compare results in Panels A and B, Table
2). Figures 2 and 4 tell the same story, which is that the funds rate moves
closely with the level determined by economic fundamentals as specified in
(1). The results, however, are different in the pre-1979 period. When the focus
is on results without smoothing, the coefficient that appears on the predicted
funds rate PFR is significantly below unity and this result is not sensitive to
the measure of the output gap. If one allows for the effect of interest rate
smoothing on the funds rate, the coefficient that appears on the predicted funds
rate does however move closer to unity (compare Figure 1 with Figure 3). But
the predicted funds rate is still a biased predictor of the actual funds rate in one
specification of the output gap (compare estimates in Panels A and B, Table
2). Hence the hypothesis that the funds rate target is a function of economic
variables as specified in the policy reaction function (1) is a better description
of Fed policy in the post-1979 period than it is in the previous period.

16 The

result that the predicted funds rate may be a biased predictor of the actual funds rate
in (9) does not imply that the stochastic disturbance term in the estimated policy reaction function
(8) is biased and the estimation procedure used here is therefore invalid. The reason is that the
result above—that the predicted funds rate is a biased predictor—may arise because the predicted
values used in regression (9) are dynamic, not static. The policy reaction function (8) instead is
estimated using actual values of explanatory variables including the lagged funds rate. Hence the
disturbance term, though unbiased in (8), may appear biased in (9) if predicted values used are
dynamic.

Y. P. Mehra: Monetary Policy Reaction

45

Table 2 In-Sample Predictability of the Forward-Looking
Reaction Function
Panel A: Actual and Predicted Funds Rate, Without Smoothing
Sample Period

HP Trend
c

d

Quadratic Trend
x21 (2)

c

d

x21 (2)

1961Q1–1979Q2

2.7
(3.5)

0.46
(4.9)

38.5∗

2.2
(3.5)

0.53
(5.7)

25.9∗

1981Q1–1998Q1

1.0
(1.3)

0.89
(10.1)

1.8

0.64
(1.6)

0.93
(20.9)

2.6

Panel B: Actual and Predicted Funds Rate, With Smoothing
1961Q1–1979Q2

0.4
(1.2)

0.89
(18.9)

5.3∗∗

0.2
(0.2)

0.88
(8.2)

4.3

1981Q1–1998Q1

−0.27
(0.5)

1.0
(16.7)

0.5

0.2
(0.6)

0.96
(22.7)

0.8

*Significant at the 5 percent level.
**Significant at the 10 percent level.
Notes: The coefficients (t-values in parentheses below) reported above are from regressions of
the form FRt = c + dPFRt , where FR is the actual funds rate, and PFRt is the predicted funds
rate. The predicted values are generated using the policy rule (8) of the text, with ρ set to zero
(see Panel A) and with ρ set to its estimated value (see Panel B). The predicted values used in
Panel B regressions are within-sample but dynamic. x12 is the Chi-squared statistic that tests the
null hypothesis (c, d ) = (0, 1).

Has the Reaction Function Changed during the Greenspan Period?
It is commonly believed that the Fed under Alan Greenspan has maintained
an anti-inflationary stance set in motion when Paul Volcker became the Fed
Chairman. In fact, as discussed above, the forward-looking reaction function
(8) estimated here is consistent with the actual path of the funds rate over the
Volcker-Greenspan period, indicating the policy reaction function may not have
changed much over this period. Nevertheless, I investigate this issue further
by comparing the reaction function between Volcker and Greenspan periods,
1979Q4 to 1987Q3 and 1987Q3 to 1998Q2. The main problem with estimating separate reaction functions over the Volcker and Greenspan periods is that
those estimates may be subject to the small sample bias. In fact, during the
Greenspan period both the bond rate and inflation have not varied much. In view
of these considerations I estimate the reaction function using the technique of
rolling regressions, which generates somewhat larger subsamples. In particular,
I begin with estimating the reaction function over the Volcker period 1979Q4
to 1987Q3 and then continually reestimate it advancing the end date by four
quarters, keeping the start date fixed. The resulting estimates of key coefficients

46

Federal Reserve Bank of Richmond Economic Quarterly

Figure 1 Actual and Predicted Funds Rate, With Smoothing;
HP Trend Pre 1979

Figure 2 Actual and Predicted Funds Rate, With Smoothing;
HP Trend Post 1979

Y. P. Mehra: Monetary Policy Reaction
Figure 3 Actual and Predicted Funds Rate, Without Smoothing;
HP Trend Pre 1979

Figure 4 Actual and Predicted Funds Rate, Without Smoothing;
HP Trend Post 1979

47

48

Federal Reserve Bank of Richmond Economic Quarterly

are reported in Tables 3 and 4. Table 3 reports estimates using the HP filtered
output gap, and Table 4 gives estimates using the quadratic trend output gap.
If we focus on short-run estimated coefficients, ai , i = 2, 3, 4, they all
have theoretically expected signs in all subsamples considered here and are
generally statistically significant (t-values not reported). The estimated sizes of
the individual coefficients are relatively stable over different subsamples, with
few exceptions. Of particular interest is the long-run, estimated coefficient a1
that appears on the level of actual inflation. It is mostly above or close to unity
in all subsamples, with the exception of those ending in 1996 and 1997. In
those two subsamples the magnitude of the estimated coefficient is sensitive
to the measure of the output gap used: it falls below unity if the output gap
is estimated with the HP trend (compare estimates of a1 in Tables 3 and 4).
These estimates thus suggest that the Fed during most of the Greenspan period
has responded aggressively enough to expected inflation indicators that the real
funds rate has increased in response to actual inflation.
Predicting the Funds Rate during the Greenspan Period
The results discussed in the previous section indicate that estimates of the
individual coefficients that measure responses of the funds rate to economic
fundamentals do display considerable subsample variability during the VolckerGreenspan period. But despite such variability, a cursory look at Figure 2
indicates that the policy reaction function here tracks the actual behavior of the
funds rate fairly well in the ’80s and the ’90s. In this section I provide additional
evidence on this issue by examining the out-of-sample predictive performance
of the reaction function over the period 1988Q1 to 1998Q2, which for the most
part spans the current tenure of Alan Greenspan as the Fed Chairman.
Table 5 presents the predicted values of the funds rate. The predicted values
are the dynamic one-year-ahead forecasts of the funds rate that are conditional
on actual values of the economic fundamentals and are generated using rolling
regressions over the forecast period. Panel A in Table 5 presents the predicted
values generated with the HP trend and Panel B presents the predicted values
with the quadratic trend. (Figures 5 and 6 chart the quarterly values for this
period.) Actual values of the funds rate, prediction errors, and summary error
statistics are also presented. As shown, the reaction function tracks the actual
funds rate fairly well over the forecast period. The mean value of the prediction
error is very small and the root mean squared error is about 0.4 of a percentage
point. The average annual prediction errors are not statistically significant, with
the exception of the year 1995. In 1995 the prediction error is positive, and it
is more than twice the root mean squared error. During that year real growth
decelerated from its rapid pace of the previous year, but the Fed did not lower
the funds rate in response to such a slowdown. Nevertheless, since 1995 the
magnitude of the prediction error has steadily declined.

Y. P. Mehra: Monetary Policy Reaction

49

Table 3 Rolling Regression Estimates of the Reaction Function
during Volcker-Greenspan Periods,
GDP Deflator and HP Trend
Sample Period
Ends in

a1

a2

a3

a4

ρ

a0

1987Q4
1988Q4
1989Q4
1990Q4
1991Q4
1992Q4
1993Q4
1994Q4
1995Q4
1996Q4
1997Q4

1.0
1.0
1.1
1.2
1.2
1.2
1.4
1.5
1.1
0.8
0.7

0.6
0.6
0.5
0.6
0.6
0.6
0.7
0.7
0.5
0.4
0.4

0.48
0.45
0.37
0.35
0.35
0.35
0.39
0.39
0.33
0.29
0.28

0.25
0.28
0.40
0.32
0.36
0.41
0.39
0.38
0.38
0.41
0.32

0.42
0.43
0.50
0.50
0.51
0.56
0.57
0.59
0.61
0.64
0.66

3.6
3.4
3.5
3.1
3.1
2.7
1.9
1.6
3.2
4.1
4.5

17.4
21.6
19.3
16.0
14.1
15.0
16.1
15.5
14.7
16.1
17.1

1987Q3–1998Q1

0.7

0.1

0.28

0.35

0.81

4.7

17.8 (0.27)

J(sl)
(0.29)
(0.12)
(0.20)
(0.38)
(0.52)
(0.45)
(0.37)
(0.41)
(0.47)
(0.38)
(0.31)

Notes: The coefficients above are GMM estimates of the forward-looking reaction function given
in Table 1. Unless stated otherwise the estimation period for all regressions begins in 1979Q3
and ends in the year as shown in the first column above. All reported coefficients have significant
t-values (not reported), with one exception: a2 is not significant over 1987Q3–1998Q2.

Table 4 Rolling Regression Estimates of the Reaction Function
during Volcker-Greenspan Periods,
GDP Deflator and Quadratic Trend
Sample Period
Ends in

a1

a2

a3

a4

ρ

a0

1987Q4
1988Q4
1989Q4
1990Q4
1991Q4
1992Q4
1993Q4
1994Q4
1995Q4
1996Q4
1997Q4

1.2
1.2
1.1
1.3
1.3
1.4
1.5
1.5
1.3
1.2
1.3

0.7
0.7
0.6
0.6
0.7
0.7
0.7
0.7
0.5
0.5
0.5

0.54
0.54
0.47
0.47
0.49
0.48
0.49
0.49
0.43
0.44
0.45

0.17
0.17
0.25
0.23
0.26
0.29
0.30
0.29
0.30
0.31
0.28

0.39
0.39
0.50
0.48
0.50
0.54
0.54
0.54
0.59
0.59
0.57

3.3
3.1
3.6
3.2
3.0
2.6
2.3
2.2
3.1
3.3
2.9

14.6
15.4
14.3
14.5
14.1
15.3
14.3
14.1
13.7
12.6
12.1

1987Q3–1998Q1

1.4

0.2

0.28

0.20

0.73

2.5

17.5 (0.15)

Notes: See notes for Table 3.

J(sl)
(0.49)
(0.42)
(0.50)
(0.48)
(0.52)
(0.43)
(0.50)
(0.52)
(0.55)
(0.63)
(0.60)

50

Federal Reserve Bank of Richmond Economic Quarterly

Table 5 Actual and Predicted Funds Rate: 1988Q1–1998Q2
Panel A:
HP Trend

Panel B:
Quadratic Trend

Year

Actual
Funds Rate

Predicted

Error

Predicted

Error

1988
1989
1990
1991
1992
1993
1994
1995
1996
1997

7.6
9.2
8.1
5.7
3.5
3.0
4.2
5.8
5.3
5.5

7.8
8.7
8.2
6.0
4.3
3.1
4.2
4.9
5.1
5.4

−0.20
0.50
−0.01
−0.30
−0.80
−0.01
0.00
0.90∗
0.20
0.10

7.9
8.6
8.1
6.0
4.1
2.9
4.2
5.1
5.4
5.9

−0.30
0.60
0.00
−0.30
−0.60
0.10
0.00
0.70
−0.10
−0.40

1997Q1
1997Q2
1997Q3
1997Q4
1998Q1
1998Q2

5.3
5.5
5.5
5.5
5.5
5.5

5.3
5.3
5.5
5.6
5.3
5.2

0.0
0.2
0.0
−0.1
0.2
0.3

5.9
6.5
6.7
6.2
5.7
5.9

−0.60
−1.0
−1.2
−0.7
−0.2
−0.04

Mean Error (1988–1997)
Root Mean Squared Error

0.00
0.44

−0.02
0.41

*The prediction error is twice the root mean squared error.
Notes: The predicted values above are generated using the forward-looking reaction functions
reported in Tables 3 and 4. The predicted values are the dynamic, one-year-ahead forecasts,
generated using rolling regressions over sample periods that all begin in 1979Q3 but end in the
year before the forecast period.

Table 5 also presents the quarterly values of the predicted funds rate for the
most recent period 1997Q1 to 1998Q2. During this period the U.S. economy
has grown at an above-trend growth rate, while inflation has steadily declined.
The Fed, however, did not adjust the funds rate target during this subperiod,
which remained at 5.5 percent. The funds rate predicted by the reaction function
is 5.4 percent if the Fed’s estimate of trend GDP is generated with the HP filter,
and it is 6.2 percent if instead the quadratic trend is used. There is a difference
in prediction because in this subperiod the Fed’s estimate of trend GDP is
3.0 percent if the HP trend is used and 1.9 percent if instead the quadratic
trend is employed to estimate the output gap. Consequently, the magnitude of
the positive output gap is smaller with the HP trend than with the quadratic,
thereby suggesting a less tight response to observed above-trend growth. If
one believes the popular view that the economy’s underlying trend growth rate

Y. P. Mehra: Monetary Policy Reaction
Figure 5 Actual and Predicted Funds Rate, Out-of-Sample;
HP Trend

Figure 6 Actual and Predicted Funds Rate, Out-of-Sample;
Quadratic Trend

51

52

Federal Reserve Bank of Richmond Economic Quarterly

may have increased in the ’90s, then one may have more confidence in the
reaction function estimated with the HP filtered output gap than in the one
with the quadratic. Therefore, the absence of policy response to recent abovetrend growth is not inconsistent with prior Fed behavior if one takes seriously
the proposition that the economy’s trend growth in recent years may be higher
than 2 percent estimated using the quadratic trend.

3.

CONCLUDING OBSERVATIONS

In this article I estimate a forward-looking monetary policy reaction function that quite accurately predicts the actual behavior of the federal funds rate
since 1979. The key property of the estimated reaction function in the VolckerGreenspan period is that the funds rate target is responsive to movements in
long-term inflationary expectations evidenced by the behavior of the bond rate.
During this period the Fed has responded aggressively enough to future inflation
indicators that the real funds rate target increased in response to actual inflation.
Such is not the case in the pre-1979 period, when the real funds rate target
declined in response to inflation.
It has been suggested that the U.S. economy experienced macroeconomic
stability in the Volcker-Greenspan period because the interest rate policy pursued during this period was very responsive to expected inflation; so much so
that the real funds rate increased in response to inflation (Clarida, Gali, and
Gertler 1998b; Taylor 1998). The results here indicate that the Fed’s willingness to move the funds rate preemptively to react to movements in the bond
rate may explain why the funds rate was more responsive to inflation in the
Volcker-Greenspan period than it had been in the previous period.

REFERENCES
Clarida, Richard, Jordi Gali, and Mark Gertler. “Monetary Policy Rules in
Practice: Some International Evidence,” European Economic Review, vol.
42 (June 1998a), pp. 1033–67.
. “Monetary Policy Rules and Macroeconomic Stability: Evidence
and Some Theory,” NBER Working Paper 6442, March 1998b.
Goodfriend, Marvin. “Interest Rate Policy and the Inflation Scare Problem
1979–1992,” Federal Reserve Bank of Richmond Economic Quarterly,
vol. 79 (Winter 1993), pp. 1–24.
. “Interest Rates and the Conduct of Monetary Policy,” CarnegieRochester Conference Series on Public Policy, vol. 34 (Spring 1991), pp.
7–30.

Y. P. Mehra: Monetary Policy Reaction

53

Hansen, Lars Peter. “Large Sample Properties of Generalized Method of
Moments Estimators,” Econometrica, vol. 50 (July 1982), pp. 1029–54.
Hodrick, Robert J., and Edward C. Prescott. “Postwar U.S. Business Cycles:
An Empirical Investigation,” Journal of Money, Credit, and Banking, vol.
29 (February 1997), pp. 1–16.
McCallum, Bennett T., and Edward Nelson. “Nominal Income Targeting in
an Open-Economy Optimizing Model,” Mimeo. A paper prepared for the
Riksbank-IIES Conference on Monetary Policy Rules. June 1998.
Mehra, Yash P. “A Federal Funds Rate Equation,” Economic Inquiry, vol.
XXXV (July 1997), pp. 621–30.
Taylor, John B. “An Historical Analysis of Monetary Policy Rules,” National
Bureau of Economic Research conference on Monetary Policy Rules,
January 1998.
. “Discretion versus Policy Rules in Practice,” Carnegie-Rochester
Conference Series on Public Policy, vol. 39 (December 1993), pp. 195–
214.

Mercantilists and Classicals:
Insights from Doctrinal History
Thomas M. Humphrey

E

conomists 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 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” (Pearce 1978, p. 93).
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 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
Tom.Humphrey@rich.frb.org. An earlier version of this article appeared in this Bank’s 1998
Annual Report. For valuable comments the author is indebted to his Richmond Fed colleagues
Alice Felmlee, Marvin Goodfriend, Bob Hetzel, Rowena Johnson, Elaine Mandaleris, and
Ned Prescott. The views expressed do not necessarily reflect those of the Federal Reserve
System.

Federal Reserve Bank of Richmond Economic Quarterly Volume 85/2 Spring 1999

55

56

Federal Reserve Bank of Richmond Economic Quarterly

of a steady progression of new paradigms, we see 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 that 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.
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

T. M. Humphrey: Mercantilists and Classicals

57

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
Keynesian-monetarist 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.

1.

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
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).

58

Federal Reserve Bank of Richmond Economic Quarterly

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’contra-quantity 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 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 raising prices.4 His argument stemmed from his assumptions of (1) the
2 Because anti-quantity theory elements also characterize the fixed-exchange-rate, smallopen-economy case of the modern 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 closed-economy and inconvertible-paper floating-exchange-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-stimulates-trade doctrine.
3 On Law’s monetary theory, see Murphy (1997, Chs. 6 and 8) and Hutchison (1988, pp.
134–40). On Steuart’s theory, see Eltis (1986), Hutchison (1988, pp. 341–51), Meek (1967), and
Skinner (1981).
4 Law’s fear of monetary shortage 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

T. M. Humphrey: Mercantilists and Classicals

59

availability of idle resources at unchanged resource 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 employment. It likewise followed that money-induced 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-for-dollar 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 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.
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
two propositions, Law recognized the first but denied the second. He also argued, contrary to the
monetary approach, that expansion of the domestic stock of paper money would, by stimulating
production of goods for export, improve a country’s trade balance. See Murphy (1997, Ch. 8).
5 See Blaug (1996, p. 16).

60

Federal Reserve Bank of Richmond Economic Quarterly

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 markup component of individual and aggregate prices. In other words, he alleged
that the same real forces—market power and cost—that govern 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 equilibrium real output alters 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 active circulation and either hold it idle
so that velocity falls or melt it down into plate and ornaments such that the
money stock contracts. Conversely, if coin is deficient, the resulting 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.
6 On

Steuart’s cost-push theory, see Screpanti and Zamagni (1993, p. 53).
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).
7 Not

T. M. Humphrey: Mercantilists and Classicals

61

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, everactive, 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.
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.

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 all three
instruments 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. Bonds and stocks hardly
qualify as transactions media and thus 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.

62

Federal Reserve Bank of Richmond Economic Quarterly

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 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-specieflow mechanism to demonstrate the impossibility of the mercantilist goal of a
permanently favorable trade balance and corresponding persistent specie inflow.
Hume (pp. 62–63) 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. 62–63) 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.
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 costpush 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
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 changes in relative national price levels 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 (1951–1973, I, pp. 46, 61–63, 104–05, 126, 302–03, 307–08, 315).

T. M. Humphrey: Mercantilists and Classicals

63

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. Given a constant money stock, 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-stimulatestrade doctrine. Hume insisted that the doctrine holds in the short run but not
the long.16 At first, money-stock 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 price-setters 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

16 See

Hume ([1752] 1955, pp. 37–38, 47–48).
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 price 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 supernonneutrality. Being partly unanticipated (perhaps because agents formulate their expectations
adaptively 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.
17 Classicals

64

Federal Reserve Bank of Richmond Economic Quarterly

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
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.
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
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

T. M. Humphrey: Mercantilists and Classicals

65

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 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, or coin,
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 land-collateralized 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 whose elements are free
to expand or contract without limit. The result is 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
self-correcting through automatic wage, price, and interest-rate 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 (1951–1973, I, pp. 363–64; 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, 253–56) 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.

66

Federal Reserve Bank of Richmond Economic Quarterly

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 School-Banking 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.

2.

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 SchoolBanking School debate focused on whether the note component of such a
convertible, gold-standard currency required statutory 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
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.

T. M. Humphrey: Mercantilists and Classicals

67

much discretion in the management of their note issue. Banks, facing no minimum 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
precipitate financial panics. Such panics would be exacerbated if internal gold
drains coincided with external ones as domestic money holders, alarmed by
the possibility of imminent 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 note issue, reductions that
24 O’Brien

(1975, p. 153) credits Joplin, Drummond, Page, Pennington, and McCulloch with
the simultaneous enunciation of the metallic principle.

68

Federal Reserve Bank of Richmond Economic Quarterly

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 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 cost-push 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, costs that passed through into
higher prices.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
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).

T. M. Humphrey: Mercantilists and Classicals

69

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 inflation, (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 (sterilized) 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 circulation 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 be controlled through the latter alone. In short,
the total circulation was like an inverted pyramid resting on a gold and bank

70

Federal Reserve Bank of Richmond Economic Quarterly

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 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 corresponding nominal collateral backing
of—loans to finance the same level of real transactions. These 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.

3.

THE KEYNESIAN REVOLUTION AND MONETARIST
COUNTER-REVOLUTION (1936–1985)

Classicals won the Currency-Banking dispute. Their victory lasted until exclassical John Maynard Keynes, having defected to the opposite side, routed

T. M. Humphrey: Mercantilists and Classicals

71

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 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, individual and aggregate, 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, 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
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.

72

Federal Reserve Bank of Richmond Economic Quarterly

governed by nominal wage rates which autonomous forces—union wage-setting
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 (and so offsets) 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 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 any lower 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 interestinsensitive 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
29 On

324–30).

the cost-push pricing theories of Keynes and his followers, see Tavlas (1981, pp.

T. M. Humphrey: Mercantilists and Classicals

73

variable velocity absorbing the impact of money stock changes, 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 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.

30 On

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

74

Federal Reserve Bank of Richmond Economic Quarterly

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 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 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 caused or intensified 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 LawKeynes theory of interest rates as a policy guide. That theory claimed that

31 See

Haberler (1941, pp. 242, 389, 403), Pigou (1943, 1947), and Patinkin (1948, 1965).
Warburton (1966) for a collection of his relevant papers, many published between
1944 and 1953.
32 See

T. M. Humphrey: Mercantilists and Classicals

75

the interest rate, a purely monetary variable, accurately measures 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 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.33
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 spending to its long-run noninflationary full-employment 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 to smooth cyclical fluctuations in spending 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
33 As

did a related critique attributing high rates to the inflationary anticipations of the public.
Embodied in the inflation-premium component of interest rates and fueled by premonitions of
policy permissiveness, such anticipations would be realized if the central bank, in a misguided
attempt to lower rates, subsequently engineered rapid monetary expansion.

76

Federal Reserve Bank of Richmond Economic Quarterly

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 expectations-augmented Phillips curve. They
showed that when inflationary expectations are incorporated into the Phillips
curve, no permanent 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 ever-accelerating 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.34 Those versions embodied the assumption that agents revise their inflationary anticipations downward in mechanical, or adaptive, error-learning
fashion only when actual, reported inflation turns out to be lower than expected.
Accordingly, if the authorities sought to eradicate inflationary expectations—
an absolute 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.
34 See

Taylor (1997, pp. 278–79).

T. M. Humphrey: Mercantilists and Classicals

77

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 drawn-out 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
policymakers behaved in a nonhaphazard, 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.
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, fine-tuning 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 realize
that once they formulate and act upon such new price predictions, 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

78

Federal Reserve Bank of Richmond Economic Quarterly

precommitment binding it irrevocably to price stability.35 In demonstrating as
much, the time inconsistency argument reinforced the classical case for rules.36
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.

4.

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 nonnegligible 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 price-level
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 costpush theory, attributing the disinflation of the 1990s to such nonmonetary forces
as increased global competition, rapid technological progress, falling computer
and health-care 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
35 Alternatively,

an established reputation as a zealous inflation fighter would do.
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 holds that rules are good for commitment reasons even
when central bankers have full knowledge of the impact of their moves.
36 The

T. M. Humphrey: Mercantilists and Classicals

79

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 enduring 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, inflation-averse 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 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.

80

Federal Reserve Bank of Richmond Economic Quarterly

REFERENCES
Barro, Robert J., and David B. Gordon. “A Positive Theory of Monetary
Policy in a Natural Rate Model,” Journal of Political Economy, vol. 91
(August 1983a), pp. 589–610.
. “Rules, Discretion, and Reputation in a Model of Monetary
Policy,” Journal of Monetary Economics, vol. 12 (June 1983b), 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. “25 Years after the Rediscovery of Money: What Have We
Learned?” Discussion, American Economic Review, vol. 65 (May 1975),
pp. 176–79.
. “The Role of Monetary Policy,” American Economic Review, vol.
58 (March 1968), pp. 1–17.
. A Program for Monetary Stability. New York: Fordham University
Press, 1960.
, and Anna J. Schwartz. A Monetary History of the United States,
1867–1960. Princeton: Princeton University Press for the National Bureau
of Economic Research, 1963.
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.

T. M. Humphrey: Mercantilists and Classicals

81

. 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, 1662–1776. 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. Money, Interest, and Prices, 2d ed. New York: Harper and
Row, 1965.
. “Price Flexibility and Full Employment,” American Economic
Review, vol. 38 (September 1948), pp. 543–64.
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.

82

Federal Reserve Bank of Richmond Economic Quarterly

. “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 A Treatise 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: Twentieth-Century Opinion on the Banking
School-Currency School Controversy,” 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: George Allen & Unwin, 1939.
Viner, Jacob. Studies in the Theory of International Trade. New York: Harper
Brothers, 1937.
Warburton, Clark. Depression, Inflation and Monetary Policy, Selected Papers
1945–1953. Baltimore: Johns Hopkins University Press, 1966.