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EXCHANGE RATES Fixed or Floating? Depression Scrip in Georgia Inflation and the Dollar Index Economic Review President Robert P. Forrestal S e n i o r Vice President a n d Director of Research Sheila L. Tschinkel Vice President a n d Associate Director of Research B. Frank King Research Officers W i l l i a m Curt Hunter, Basic Research Mary S u s a n R o s e n b a u m , M a c r o p o l i c y G e n e D. S u l l i v a n , R e g i o n a l Larry D. Wall, Financial D a v i d D. W h i t e h e a d , R e g i o n a l Public Information Officer B o b b i e H. McCrackin Publications l o y c e l y n T. W o o l f o l k , P u b l i c a t i o n s C o o r d i n a t o r Lynn H. Foley, P r o d u c t i o n C a r o l e Starkey, G r a p h i c s The Economic Review seeks t o inform the public about Federal Reserve policies and the economic environment and. in particular, to narrow the gap between specialists and concerned laypersons Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System Material may be reprinted or abstracted if the Review and author are credited Please provide the Banks Public I n f o r m a t i o n Department w i t h a copy of any p u b l i c a t i o n containing reprinted material Free s u b s c r i p t i o n s and l i m i t e d a d d i t i o n a l copies are available from the Public Information Department, Federal Reserve Bank of Atlanta. 104 Marietta Street. N W . Atlanta. Georgia 30303-2713 (404/521-8788) Change-of-address notices and subscription cancellat i o n s s h o u l d be sent d i r e c t l y t o t h e Public I n f o r m a t i o n Department Please include the current m a i l i n g label as well as any new information ISSN 0732-1813 V O L U M E LXXV, N O . 5, S E P T E M B E R / O C T O B E R 1990, E C O N O M I C R E V I E W ! 2 Flexible Exchange Rates: An Idea Whose Time Has Passed? The author looks at the pros a n d cons of the flexible exchange rate system in place since 1973. Joseph A. Whitt, Jr. 16 Lenders of the Next-to-Last Resort: Scrip Issue in Georgia during the Great Depression William R o b e r d s 32 F.Y.I. 44 Book Review This u n i q u e study of Georgia's depression scrip issues provides lessons concerning the usefulness of certain forms of private money, such as money market accounts. Inflation a n d the Dollar Index Karen R. H u n t e r William R o b e r d s I FEDERAL RESERVE BANK O F ATLANTA The Making of an Economist by Arjo Klamer a n d David Colander Flexible Exchange Rates: An Idea Whose Time Has Passed? Joseph A. Whitt, Jr. Given the current flexible exchange rate system's disappointing performance, especially during recent years, the debate over whether major industrialized nations should return to a fixed rate system has intensified. After a brief description of various episodes of fixed and floating exchange rates during the past century, the author discusses the arguments for and against a return to fixed rates. He concludes that limits on exchange rate movements are feasible in principle but that fixing exchange rates would probably require governments to give up some of their economic autonomy. h o u l d the major industrialized countries s u p p o r t a return t o fixed exc h a n g e r a t e s ? This q u e s t i o n h a s garnered increased attention in the past few years as large fluctuations in key exchange rates have led s o m e observers to c o n c l u d e that t h e current floating exchange rate system, which arose more by default than design in t h e early 1970s, has failed. Critics argue t h a t f l o a t i n g e x c h a n g e rates h a v e a l l o w e d large, u n p r e d i c t a b l e m o v e m e n t s that h a v e d e p r e s s e d international trade a n d at t i m e s resulted in massive j o b losses in particular industries. R o n a l d I. McKinnon (1974, 1988) has a d v o c a t e d a return to fixed rates since t h e e a r l y d a y s of f l o a t i n g , w h i l e J o h n Williamson (1983) prefers a system of target zones that w o u l d allow l i m i t e d flexibility of exchange rates. More recently, Arthur J. Rolnick and Warren E. W e b e r (1990) of the Fede r a l R e s e r v e B a n k of M i n n e a p o l i s h a v e favored fixing e x c h a n g e rates, a n d The Economist (1990) magazine, which a d v o c a t e d S 2 t h e m o v e t o flexible exchange rates d u r i n g the early 1970s, has editorialized that the exp e r i m e n t with flexible rates has b e e n a failure. However, supporters argue that floating rates h e l p e c o n o m i e s a d j u s t t o policy a n d other shocks a n d that fixing exchange rates would only m a k e things worse. To give s o m e background on how t h e current system arose, this article includes a brief historical review of t h e experience with exc h a n g e rates d u r i n g t h e p a s t century. That discussion l e a d s to t h e main arguments for a n d against a return to fixed exchange rates in light of recent experience. Changes in the Exchange Rate System during the Past Century During t h e past century, the exchange rate s y s t e m h a s o s c i l l a t e d b e t w e e n fixed a n d floating rates several times. 1 In the late nine- E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 ¿ 4 teenth century, exchange rates between the currencies of the major industrialized countries were fixed b e c a u s e each country was on the gold standard. Each currency was red e e m a b l e for a fixed a m o u n t of g o l d ; for e x a m p l e , U.S. d o l l a r s c o u l d b e freely red e e m e d at the rate of $20.67 per ounce. Because gold could b e transferred from o n e country to another with little cost or regulatory restriction, arbitrage in the gold market kept e x c h a n g e rates b e t w e e n c u r r e n c i e s fixed. Even so, the size of gold flows prior to 1914 was modest for two reasons. Most international t r a d e was f i n a n c e d using British pounds, even when the trade was between third c o u n t r i e s (for i n s t a n c e , Mexican exports to France). In addition, there was considerable c o n f i d e n c e that the existing pattern of exchange rates w o u l d b e maintained. As a result, when capital flowed from one country to another, as was common because g o v e r n m e n t restrictions on c a p i t a l flows were rare, settlement usually was d o n e F E D E R A L R E S E R V E B A N K O F ATLANTA Ä ^ f e through the banking system, without requiring physical movements of gold. The gold standard came to an abrupt end in 1914 with t h e o u t b r e a k of World War I. During the war the combatant governments i m p o s e d n u m e r o u s restrictions on international trade and on citizens' seeking to convert paper money into gold; these governments also printed large amounts of m o n e y to h e l p pay wartime expenditures. When the conflict finally e n d e d , various governments, including Great Britain and France, proclaimed their int e n t i o n to return e v e n t u a l l y to prewar exchange rates. In the meantime, however, they allowed their currencies to float. Because prewar exchange rates were no longer consistent with e c o n o m i c equilibrium, the decision to return to them was a dubious one. As argued at the time by Swedish The author is an economist in the macropolicy lanta Fed's research department. section of the At- 3 e c o n o m i s t G u s t a v C a s s e l , t h e c o n c e p t of purchasing p o w e r parity i m p l i e s that if t h e price level rises more in o n e country than in a n o t h e r , t h e first c o u n t r y ' s e x c h a n g e rate s h o u l d d e p r e c i a t e . 2 Because wartime inflation varied considerably, restoration of prewar exchange rates on a lasting basis would have required either substantial deflation by countries that h a d e x p e r i e n c e d t h e largest price rises during t h e war or substantial additional inflation by countries that had experie n c e d t h e s m a l l e s t . In a d d i t i o n , s o m e c o u n t r i e s , n o t a b l y G r e a t B r i t a i n , s o l d off many foreign assets to finance the war effort, t h e r e b y r e d u c i n g t h e i r f u t u r e s t r e a m of d i v i d e n d a n d interest rate remittances from abroad. As a result their exchange rates may have n e e d e d to b e d e v a l u e d b e l o w prewar levels, even aside from t h e effects of differential inflation. However, t h e gold standard was a rigid system that m a d e no provisions for changing exchange rates in response t o economic circumstances. After a few years of t u r m o i l , Britain succ e e d e d in fixing the p o u n d at its prewar rate. France p e g g e d its currency at a new, muchd e p r e c i a t e d rate. The U n i t e d States maint a i n e d its prewar p e g to gold. However, t h e new pattern of exchange rates was probably n o t c o n s i s t e n t with long-run e q u i l i b r i u m ; Britain maintained t h e p o u n d only by shortterm borrowing from foreigners, while France eventually d e v e l o p e d balance of p a y m e n t s surpluses that swelled French gold reserves. In any event, the restored system of fixed exchange rates only lasted a few years before t h e G r e a t D e p r e s s i o n d i s r u p t e d it. In res p o n s e t o mass u n e m p l o y m e n t , many governments b o o s t e d tariffs and some i m p o s e d quotas on imports in h o p e s of stimulating dem a n d for d o m e s t i c a l l y p r o d u c e d g o o d s . In a d d i t i o n , s o m e governments apparently devalued their currencies in an attempt to boost exports a n d cut i m p o r t s . Such tactics may b o o s t e m p l o y m e n t in o n e country, b u t they d o so at t h e e x p e n s e of e m p l o y m e n t elsew h e r e ; h e n c e t h e y c a m e t o b e k n o w n as "beggar-thy-neighbor" policies. Also during this p e r i o d , g o v e r n m e n t - p e g g e d exchange rates s o m e t i m e s came under severe pressure as a result of private capital flows from o n e country to another. The governments regard- 4 e d these capital flows as a constraint on their f r e e d o m of action, t h o u g h t h e p e r s o n s who were transferring capital may have been merely trying to protect their wealth from the effects of anticipated devaluations. At the outbreak of World War II, the exchange rate system again went under tight government control. The Bretton Woods Period When the end of t h e Second World War was in sight, deleg a t e s from m a n y n a t i o n s m e t at B r e t t o n Woods, New Hampshire, to plan postwar economic arrangements. The international leaders generally recognized that the economic problems of the interwar years had contributed to the tensions that resulted in the war and shared a desire to avoid repeating past mistakes. The industrialized nations agreed to set u p a system in which government intervention would fix ex- "When the end of the Second World War was in sight, delegates from many nations met at Bretton Woods. . . . The industrialized nations agreed to set up a system in which government intervention would fix exchange rates." change rates. Unlike under the gold standard, if a nation were running a continual balance of payments surplus or deficit, its exchange rates would b e altered to bring an end to the payments imbalance; however, the change in exc h a n g e rates c o u l d only b e m a d e with t h e agreement of the nation's major trading partners. This condition was intended to prevent beggar-thy-neighbor policies. In addition, restrictions on international capital flows were maintained; otherwise, it was feared, private currency speculators w o u l d p u t u n b e a r a b l e pressure on the exchange rate pegs, forcing exchange rate changes inconsistent with economic fundamentals (see Ragner Nurkse 1945). The early postwar years were d o m i n a t e d by the problems of reconstruction, but in the 1950s t h e Bretton W o o d s system c a m e into full operation. Exchange controls on trade in goods and services were largely eliminated in E C O N O M I C REVIEW, SEPTEMBER/OCTOBER 1990 the advanced industrial countries, a n d late in t h e d e c a d e controls on c a p i t a l flows were loosened substantially in some countries. Under t h e Bretton W o o d s system, governments pegged their currencies by intervening in the foreign exchange markets, b u y i n g or selling their own currencies in exchange for international reserves to k e e p the market exchange rate in a narrow target range. While gold was one international reserve asset, U.S. dollars were used more often as reserves, in part because during most of the Bretton Woods period t h e U.S. g o v e r n m e n t was c o m m i t t e d to redeeming dollars in gold for foreign central banks at the rate of $35 per ounce. Under this system, if a nation experienced a continuing deficit in its balance of payments, its government would b e continually s p e n d i n g reserves stable source of a d d i t i o n a l international reserves to finance the growing v o l u m e of intern a t i o n a l transactions. With t h e world g o l d stock growing slowly, central banks gradually relied more a n d m o r e on U.S. dollars as reserves. However, Robert Triffin (1960) pointed out that as foreign central b a n k holdings of dollars got larger and larger, the U.S. p l e d g e that it would b e willing to redeem dollars for gold at $35 an ounce was b e c o m i n g increasingly untenable. 3 to maintain the currency peg. As its reserves dwindled, t h e government would eventually face a dilemma: either impose unpopular austerity measures to stop the deficit; borrow reserves from o t h e r g o v e r n m e n t s , t h e r e b y b e c o m i n g subject to various c o n d i t i o n s imp o s e d b y t h e l e n d e r s ; or a b a n d o n t h e exchange rate peg and devalue. A third issue was the growing policy conflict b e t w e e n t h e U n i t e d States a n d o t h e r countries, especially West G e r m a n y . In t h e late 1960s, U.S. inflation rose substantially, f u e l e d in p a r t b y t h e V i e t n a m W a r . T h e u n i q u e role of t h e dollar as the main international reserve currency in a system of p e g g e d exchange rates caused part of the inflationary pressure t o b e exported to other countries. For e x a m p l e , in m a i n t a i n i n g t h e exchange rate p e g for t h e D e u t s c h e m a r k , W e s t Germ a n y f o u n d it necessary t o b u y m o r e a n d more dollars in exchange for Deutschemarks in t h e foreign exchange market. This action kept excess s u p p l i e s of dollars off t h e market, but it also a d d e d Deutschemarks to t h e G e r m a n m o n e y s u p p l y . The increase in t h e German m o n e y supply eventually h e l p e d to fuel u n w a n t e d inflationary pressures there. The conflict b e c a m e acute in the s u m m e r of 1971. At that t i m e t h e U.S. b a l a n c e of payments was worsening, suggesting a n e e d for economic austerity to preserve the exchange v a l u e of t h e d o l l a r . However, t h e n a t i o n ' s economy was recovering slowly from the mild recession of 1970, a n d t h e a d m i n i s t r a t i o n wanted to take stimulative measures, in part b e c a u s e t h e p r e s i d e n t i a l e l e c t i o n year of 1972 was rapidly approaching. As the 1960s wore on, the system was more and more strained. A significant issue was the adjustment problem, the tendency of governments to resist either changing their monetary and fiscal policies to preserve exchange rate pegs or changing the exchange rate to make it c o n s i s t e n t with given m o n e t a r y a n d fiscal policies. For example, the British government p o s t p o n e d changing its exchange rate for several years in the mid-1960s, before finally dev a l u i n g in 1967. A n o t h e r c o n c e r n was t h e liquidity problem stemming from the lack of a nation of policies a n n o u n c e d on August 15, 1971, resolved the policy d i l e m m a . Domestically, the Nixon administration took stimulative actions c o m b i n e d with wage a n d price controls in an a t t e m p t to reduce inflation. In t h e international sphere, t h e administration i m p o s e d a t e m p o r a r y 10 percent surcharge (tax) on imports t o pressure other countries into agreeing on a devaluation of the dollar, d e s i g n e d t o i m p r o v e t h e b a l a n c e of payments. At t h e s a m e time, the "gold window" "As the 1960s wore on, . . . a significant issue was the adjustment problem, the tendency of governments to resist either changing their monetary and fiscal policies to preserve exchange rate pegs or changing the exchange rate to make it consistent with given monetary and fiscal policies." F E D E R A L R E S E R V E B A N K O F ATLANTA The Breakup of Bretton Woods. A combi- 5 was closed, m e a n i n g that t h e United States r e p u d i a t e d its c o m m i t m e n t t o convert dollars into gold for foreign central banks; this a c t i o n p r e e m p t e d a n y t h r e a t t h a t foreign central banks might b u y u p all t h e U.S. gold stockpile with their dollar reserves, b u t it also e l i m i n a t e d t h e o n l y c o n s t r a i n t on U.S. monetary policy i m p o s e d by t h e Bretton W o o d s system. During the next several m o n t h s the United States and the other major industrialized countries negotiated feverishly. Foreign gove r n m e n t s were anxious to h a v e t h e United States abolish t h e special import surcharge, while t h e U n i t e d States wanted t h e foreign governments to realign exchange rate parities to d e v a l u e the dollar. Agreement on both issues was reached in D e c e m b e r 1971, during a m e e t i n g at t h e S m i t h s o n i a n in Washington, D.C. As a result, t h e d o l l a r was d e v a l u e d an a v e r a g e of a b o u t 10 p e r c e n t versus o t h e r m a j o r c u r r e n c i e s ; t h e d e v a l u a t i o n was l a r g e r vis-a-vis t h e J a p a n e s e yen a n d t h e D e u t s c h e m a r k , s m a l l e r versus t h e British p o u n d , the French franc, and the Italian lire. As part of the agreement, and largely at the insistence of France, t h e official price of gold was raised from $35 to $38 per ounce; however, the gold window remained closed. In add i t i o n , t h e U n i t e d States agreed t o abolish the import surcharge. 4 D e s p i t e t h e agreement at the Smithsonian, foreign exchange markets c o n t i n u e d t o b e turbulent. Even at the t i m e of t h e agreem e n t , s o m e estimates i m p l i e d that a larger devaluation was n e e d e d if t h e U.S. external deficit was going to b e corrected (see Robert S o l o m o n 1977, 210). Moreover, considerable skepticism c o n t i n u e d a m o n g market particip a n t s a b o u t w h e t h e r t h e U n i t e d States or m a n y other g o v e r n m e n t s were p r e p a r e d t o take u n p o p u l a r measures to d e f e n d t h e new parities, lust six m o n t h s after t h e Smithsonian agreement, t h e British p o u n d came u n d e r p r e s s u r e , a n d t h e British g o v e r n m e n t res p o n d e d by a b a n d o n i n g its fixed parity a n d allowing it to float downward. The Bretton W o o d s system came to a definitive e n d in early 1973, when various key g o v e r n m e n t s (notably West Germany) gave u p trying to k e e p their exchange rates with the dollar pegged in t h e face of massive capi6 tal flows. At t h e t i m e s o m e h o p e r e m a i n e d that the system could soon b e brought back to life in a modified form, but other economic e v e n t s — n o t a b l y t h e oil price shock of late 1973 a n d t h e e n s u i n g recession throughout the industrialized world—quickly grabbed the attention of policymakers a n d p u s h e d reform of t h e exchange rate system to the back burner, where it has r e m a i n e d . As a result, t h e years since 1973 constitute t h e longest period of generalized floating exchange rates in m o d e r n history. The Recent Experience with Flexible Exchange Rates In assessing the pros a n d cons of flexible exchange rates, it is useful to compare flexible exchange rates' actual performance since they took hold in 1973 with their advocates' expectations during the last years of the Bretton W o o d s system. 5 Flexible rates were expected to have several important advantages over fixed rates. G o v e r n m e n t s w o u l d h a v e greater freedom t o use monetary a n d fiscal policy to pursue d o m e s t i c objectives, propon e n t s m a i n t a i n e d , w i t h o u t having t o worry a b o u t international consequences or balance of p a y m e n t s p r o b l e m s . With t h e exchange rate adjusting automatically to achieve equilibrium in the external p a y m e n t s flows, gove r n m e n t s would no longer b e t e m p t e d to i m p o s e "temporary" import limitations, controls on capital outflows, or other such policies to stave off currency changes. Flexible exchange rates were also expecte d to insulate each national e c o n o m y from shocks originating elsewhere. For e x a m p l e , m a n y E u r o p e a n s c o m p l a i n e d that when inf l a t i o n a r y p r e s s u r e s in t h e U n i t e d S t a t e s rose in t h e late 1960s b e c a u s e of t h e Vietn a m War, part of t h e inflation was exported to E u r o p e through t h e workings of fixed exc h a n g e rates. If e x c h a n g e rates h a d b e e n flexible, it was argued, E u r o p e could h a v e r e m a i n e d unaffected by t h e inflation in t h e United States. Advocates of flexible exchange rates criticized t h e Bretton W o o d s system b e c a u s e in t h e i r v i e w its p e g g e d e x c h a n g e rates en- E C O N O M I C REVIEW, SEPTEMBER/OCTOBER 1990 a b l e d e c o n o m i e s to d e l a y a d j u s t i n g to changing international circumstances until a d i s e q u i l i b r i u m h a d r e a c h e d crisis proportions. Only then could an exchange rate b e changed, often by a large a n d economically disruptive a m o u n t . By contrast, they expected that u n d e r a system of flexible exchange rates, c r i s e s w o u l d b e rare b e c a u s e exc h a n g e rates w o u l d m o v e g r a d u a l l y u p or down in response t o changes in underlying e c o n o m i c c o n d i t i o n s or g o v e r n m e n t policies, t h e r e b y p r o d u c i n g t h e e c o n o m i c adj u s t m e n t s n e e d e d to p r e s e r v e b a l a n c e of payments e q u i l i b r i u m . Now that t h e m o d e r n system of generali z e d f l o a t i n g e x c h a n g e rates h a s b e e n in o p e r a t i o n for m o r e t h a n a d e c a d e a n d a half, it is p o s s i b l e t o c o m p a r e t h e a c t u a l p e r f o r m a n c e of a g e n e r a l i z e d flexible rate s y s t e m with t h e e x p e c t a t i o n s of its advocates. In several respects, t h e record of t h e years since 1973 i n d i c a t e s that flexible exchange rates h a v e fallen short in p r o v i d i n g e x p e c t e d b e n e f i t s . E x c h a n g e rates h a v e b e e n far m o r e v o l a t i l e t h a n a n t i c i p a t e d , a n d nations h a v e not e n j o y e d as much policy i n d e p e n d e n c e a n d i n s u l a t i o n from foreign shocks. Those w h o a d v o c a t e d flexible exchange rates p r i o r t o t h e b r e a k d o w n of B r e t t o n Woods d i d so largely on t h e theoretical g r o u n d s d i s c u s s e d a b o v e b e c a u s e at t h e time they had little historical experience on which to draw. A brief period of flexible exchange rates h a d occurred during t h e early 1920s—a t i m e of considerable e c o n o m i c a n d monetary disorder, including the famous German hyperinflation, as E u r o p e began t o rebuild after World War I. Observers at that time b e l i e v e d exchange markets to b e disorderly a n d s u b j e c t t o s p e c u l a t i v e frenzies, but with hindsight it is easy to argue that t h e exchange markets merely reflected t h e period's chaotic e c o n o m i c a n d political conditions. M o r e o v e r , it s e e m s l i k e l y t h a t t h e wide gap b e t w e e n t h e market's e s t i m a t e of e q u i l i b r i u m exchange rates consistent with postwar e c o n o m i c c o n d i t i o n s a n d governmental announcements that prewar exchange rates would sooner or later b e restored disrupted the exchange markets even more. With regard to policy i n d e p e n d e n c e , governments have continued to experience conflicts between d o m e s t i c policy objectives a n d exchange rate policy. For example, in the early and mid-1980s Europeans c o m p l a i n e d that they were having to run tighter monetary policy than was desirable in light of very high une m p l o y m e n t rates, b e c a u s e high i n t e r e s t rates in the United States were boosting dem a n d for t h e d o l l a r a n d causing its apprec i a t i o n , which in turn was c o n t r i b u t i n g t o inflationary pressures in E u r o p e . Since oil was priced in dollars, this problem was sometimes described as a second oil price shock. Importing countries such as France and West Germany experienced o n e inflationary shock when t h e price of oil soared in t h e 1979-80 period and then another when dollar apprecia t i o n s e n t t h e franc- o r D e u t s c h e m a r k d e n o m i n a t e d price even higher d u r i n g t h e next several years. Advocates of flexible exchange rates preferred to e m p h a s i z e the experience of Canada, which allowed its exchange rate to float from 1950 to 1962 while other industrialized c o u n t r i e s were p e g g e d u n d e r t h e Bretton Woods system. Canada's experience was fairly t r a n q u i l ; its exchange rate never m o v e d d r a m a t i c a l l y , a n d its e c o n o m y s h o w e d n o signs of t h e disastrous c o n s e q u e n c e s foreseen b y o p p o n e n t s of f l e x i b l e e x c h a n g e rates. Those who favored flexible exchange rates believed that if the Bretton Woods system were abolished, exchange rates between the major currencies would b e h a v e much like Canada's. 6 F E D E Rfor A L FRASER R E S E R V E BANK O F ATLANTA Digitized In a d d i t i o n , flexible exchange rates have clearly not succeeded in eliminating political pressure for trade restraints to protect particular i n d u s t r i e s . I n d e e d , as t h e U.S. t r a d e deficit soared in t h e mid-1980s, t h e U n i t e d States experienced its worst b o u t of protectionist fever in years. Import quotas, "voluntary" export restraints, or other restraints on imports of a variety of products, including autos, steel, motorcycles, textiles, and apparel, were maintained or tightened. P e r h a p s t h e m o s t d i s c u s s e d f e a t u r e of flexible exchange rates has b e e n their volatility. Chart 1 shows t h e exchange rate for t h e British p o u n d relative to t h e U.S. dollar since 1960. Clearly t h e 1960s experienced very little volatility; t h e only major j u m p was 7 Chart 1. The Dollar-Pound Exchange Rate Exchange Rate (1960-1989) associated with t h e p o u n d ' s 15 percent dev a l u a t i o n in 1967. 7 Those w h o a d v o c a t e d flexible exchange rates during t h e Bretton W o o d s years suggested that u n d e r flexible exchange rates day-to-day volatility might increase s o m e w h a t b u t large m o v e m e n t s w o u l d b e s m o o t h e d by t h e actions of private speculators; u n d e r flexible exchange rates t h e large a d j u s t m e n t that occurred overnight in 1967 might have occurred gradually over a period of several years, if not more. 8 In early 1973 the Bretton Woods system of pegged exchange rates collapsed, and since then the rates between the United States and o t h e r m a j o r i n d u s t r i a l i z e d countries have been flexible. A glance at Chart 1 shows that in contrast to expectations, during the flexible rate period rates have been volatile, with far more major m o v e s than u n d e r t h e Bretton W o o d s system. Other major exchange rates show similar patterns. Admittedly, no day-today moves by the pound have been as large as 1967's 15 percent devaluation; however, 8 n u m e r o u s large moves d o occur over fairly short periods of time. Table 1 gives the dates and sizes of large moves—defined as exceeding 10 percent over a period of six months—in the pound-dollar exchange rate since the breakup of Bretton Woods. The choice of size and the six-month time interval is somewhat arbitrary. The goal was to delineate relatively short periods during which the flexible exchange rate moved by an amount sufficient to create export and import adjustment problems comparable to those associated with the pound's 1967 devaluation. 9 When overlapping six-month periods showed more than one large change, only the largest was chosen for t h e t a b l e to avoid d o u b l e counting. To leave out all data for the Bretton Woods period, the earliest period considered for the table is June to December 1973. The last period considered is june to December 1989, resulting in a total of sixteen years of coverage. As the t a b l e indicates, during t h e years since the breakdown of Bretton W o o d s the dollar-pound rate has m o v e d more than 15 E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 than the p o u n d - d o l l a r rate. Although n o n e of Table 1. Large* Six-Month Percentage Changes in the Pound-Dollar Exchange Rate since the Breakup of Bretton Woods, Ranked by Size of Change Ending Date Size of Change' (Percent) July 1981 August 1985 February 1985 September 1975 May 1989 December 1987 October 1976 March 1983 July 1979 October 1978 May 1987 January 1978 September 1988 December 1973 25.1 -25.0 18.4 16.6 16.0 -15.1 13.8 13.5 -13.4 -13.2 -12.4 -11.6 10.9 10.6 t h e D e u t s c h e m a r k r e a l i g n m e n t s were q u i t e a s l a r g e as t h e 25.1 p e r c e n t m o v e b y t h e p o u n d - d o l l a r rate, t h e D e u t s c h e m a r k . d i d h a v e eight s e p a r a t e e p i s o d e s of m o v e m e n t greater t h a n 15 p e r c e n t in six m o n t h s , comp a r e d to four for t h e p o u n d ; in a d d i t i o n , t h e mark h a d eight other p e r i o d s when it m o v e d by m o r e than 10 percent. The y e n - d o l l a r rate had even more episodes—eleven—during which t h e rate m o v e d m o r e than 15 percent, a n d in three o t h e r cases it m o v e d m o r e t h a n 10 percent. In contrast, t h e D e u t s c h e m a r k a n d t h e yen s h o w e d e v e n less m o v e m e n t d u r i n g the 1950s a n d 1960s t h a n t h e British p o u n d . The D e u t s c h e m a r k h a d two n o t i c e a b l e c h a n g e s — revaluations of 4.88 percent in 1961 a n d 8.88 p e r c e n t in 1969; t h e y e n was v i r t u a l l y unc h a n g e d d u r i n g t h e s e two d e c a d e s . Clearly, exchange rate volatility has b e e n much greater u n d e r flexible rates t h a n u n d e r Bretton W o o d s . Large exchange rate changes, rare u n d e r B r e t t o n W o o d s — o c c u r r i n g less t h a n o n c e a d e c a d e o n a v e r a g e — b e c a m e comm o n , e v e n ordinary, u n d e r flexible rates. In- * Defined as exceeding 10 percent. " Positive values indicate depreciation of the pound; negative values indicate appreciation. End-of-month exchange rate data were used. Percentage changes were measured using logarithmic differences. Source: Calculated by the Federal Reserve Bank of Atlanta using data from the International Monetary Fund's IFS tapes. d e e d , since 1973 it has b e e n rare to h a v e a year t h a t d i d not c o n t a i n a m a j o r e x c h a n g e rate m o v e c o m p a r a b l e in size to t h e 1967 devaluation of t h e p o u n d . E x p l a i n i n g t h e V o l a t i l i t y . W h y h a v e exchange rates b o u n c e d a r o u n d so m u c h in recent years? Since t h e early years of floating, r e s e a r c h e r s h a v e a t t e m p t e d t o m o d e l exc h a n g e rate b e h a v i o r in terms of c h a n g e s in v a r i a b l e s that theory suggests m i g h t b e im- percent in a six-month period six times, in the p o r t a n t , such as m o n e y s u p p l i e s , i n t e r e s t two biggest moves, t h e rate c h a n g e d 25 per- rates, real ( i n f l a t i o n - a d j u s t e d ) G N P growth, cent. Moreover, in eight o t h e r e p i s o d e s t h e and current account balances. rate changed by more than 10 percent. By con- t h e s e m o d e l s h a v e p e r f o r m e d p o o r l y in ex- However, trast, u n d e r Bretton W o o d s t h e p o u n d - d o l l a r p l a i n i n g e x c h a n g e r a t e m o v e m e n t s of t h e rate h a d e x p e r i e n c e d o n l y t h e o n e l a r g e f l e x i b l e rate p e r i o d . M o r e o v e r , R i c h a r d A. change of slightly m o r e than 15 percent during M e e s e a n d K e n n e t h Rogoff (1983) show that a the d e c a d e s of t h e 1950s a n d 1960s. s i m p l e random-walk m o d e l of t h e e x c h a n g e Large exchange rate m o v e m e n t s h a v e also rate, which always predicts that t h e future ex- occurred for o t h e r currencies d u r i n g t h e peri- change rate will e q u a l today's prevailing rate, od of flexible exchange rates. Tables 2 a n d 3 o u t p e r f o r m s m o r e c o m p l e x m o d e l s t h a t in- give i n f o r m a t i o n on large m o v e m e n t s in t h e c l u d e other variables in forecasting exchange D e u t s c h e m a r k - d o l l a r a n d y e n - d o l l a r ex- rates. A c c o r d i n g l y , c o n v i n c i n g l y a t t r i b u t i n g change rates, respectively, s i n c e t h e break- t h e o b s e r v e d m o v e m e n t s of e x c h a n g e rates down of Bretton W o o d s . 1 0 In s o m e respects, to any particular c o m b i n a t i o n of variables has these rates h a v e shown e v e n m o r e volatility t h u s far b e e n i m p o s s i b l e . FEDER A L FRASER R E S E R V E BANK O F ATLANTA Digitized for 9 f l u c t u a t e d less t h a n s t o c k m a r k e t s d u r i n g Table 2. Large* Six-Month Percentage Changes in the DeutschemarkDollar Exchange Rate since the Breakup of Bretton Woods, Ranked by Size of Change this p e r i o d . They c o n c l u d e that g o v e r n m e n t s can b e s t r e d u c e t u r b u l e n c e in t h e exchange markets b y r e d u c i n g high a n d v a r i a b l e rates of m o n e t a r y e x p a n s i o n a n d generally reducing uncertainty a b o u t future e c o n o m i c policies. However, M c K i n n o n (1988) argues that turb u l e n c e is i n h e r e n t in t h e flexible exchange Ending Date Size of Change** (Percent) rate system b e c a u s e flexible e x c h a n g e rates are highly s e n s i t i v e to s m a l l c h a n g e s in exp e c t e d m o n e t a r y p o l i c i e s or a s s e t prefer- February 1986 J u n e 1981 August 1985 October 1978 January 1974 November 1986 September 1984 February 1975 December 1987 J u n e 1988 December 1989 May 1989 March 1978 September 1975 August 1983 March 1980 -22.6 19.9 -17.8 -17.4 16.8 -15.7 15.5 -15.4 -14.6 14.1 -14.0 13.5 -13.2 12.7 11.2 10.8 e n c e s , which are extremely uncertain in the current p o l i c y e n v i r o n m e n t . To r e d u c e t h e uncertainty, he advocates that t h e Federal Reserve, t h e Bank of j a p a n , a n d t h e G e r m a n B u n d e s b a n k agree to p e g t h e dollar-yen a n d d o l l a r - D e u t s c h e m a r k e x c h a n g e rates a n d to a d j u s t t h e i r d o m e s t i c m o n e t a r y p o l i c i e s to m a i n t a i n s i m i l a r inflation rates for prices of internationally t r a d e d goods. An alternative interpretation is that flexible e x c h a n g e rates are excessively v o l a t i l e bec a u s e of d e s t a b i l i z i n g s p e c u l a t i o n . 1 1 For instance, s u p p o s e monetary policy changes in a way that justifies a m o d e s t a p p r e c i a t i o n of the d o l l a r b u t m a r k e t p a r t i c i p a n t s are uncertain a b o u t how m u c h a p p r e c i a t i o n is justified. As * Defined as exceeding 10 percent. ** Positive values indicate depreciation of the Deutschemark; negative values indicate appreciation. End-of-month exchange rate data were used. Percentage changes were measured using logarithmic differences. Source: See Table 1. t h e dollar b e g i n s to appreciate, a speculative b a n d w a g o n may d e v e l o p if speculators react by shifting capital into dollar-denominated assets, thereby t e n d i n g to a p p r e c i a t e t h e dollar further. In principle, such b e h a v i o r could at least temporarily drive t h e dollar far a b o v e its long-run e q u i l i b r i u m . Paul R. Krugman (1985, 1989) a n d jeffrey A. Frankel a n d K e n n e t h Froot (1988) argue that part of t h e h u g e d o l l a r a p p r e c i a t i o n of t h e In this vacuum, various explanations of t h e early 1980s, e s p e c i a l l y t h e surge in t h e sec- l a r g e m o v e m e n t s of e x c h a n g e r a t e s h a v e o n d half of 1984 a n d t h e first few w e e k s of arisen. O n e possibility is that t h e large move- 1985, t o o k t h e d o l l a r far a b o v e a n y reason- m e n t s are rational a n d a p p r o p r i a t e responses a b l e e s t i m a t e of its long-run e q u i l i b r i u m ; the to an u n s t a b l e e n v i r o n m e n t characterized b y lack of a large i n t e r e s t d i f f e r e n t i a l favoring f r e q u e n t c h a n g e s in g o v e r n m e n t p o l i c y as t h e d o l l a r at t h a t t i m e l e a d s t h e m t o con- well as shocks to technology a n d oil prices. In c l u d e that t h e market was irrationally failing this view, a flexible exchange rate is an asset to forecast a sharp d o l l a r d e c l i n e of t h e sort price t h a t r e s p o n d s i n s t a n t a n e o u s l y to n e w that occurred subsequently.12 information, much like prices in t h e stock mar- (1989) c o n c l u d e s that an e v e n t u a l return to ket. Jacob A. Frenkel a n d M i c h a e l L. M u s s a fixed exchange rates is d e s i r a b l e to p r e v e n t (1980) q u e s t i o n w h e t h e r exchange rate fluctu- such speculative b u b b l e s . S u p p o r t e r s of flex- ations of t h e 1970s were in fact excessive, not- ible exchange rates c o u n t e r with ing that b y various m e a s u r e s exchange rates F r i e d m a n ' s (1953) a r g u m e n t t h a t destabiliz- 10 Krugman Milton E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 c h a n g e rates b u t a system of target z o n e s that Table 3. Large* Six-Month Percentage Changes in the Yen-Dollar Exchange Rate since the Breakup of Bretton Woods, Ranked by Size of Change w o u l d allow s o m e e x c h a n g e rate flexibility, within l i m i t s s u b s t a n t i a l l y b r o a d e r t h a n t h e very narrow o n e s t h e Bretton W o o d s agreem e n t allowed. Finally, Wallace (1979) argues that when fiat currencies are in u s e — t h a t is, currencies not b a c k e d b y g o l d or any o t h e r c o m m o d i t y — a s has b e e n t h e case since at least 1971, foreign Ending Date Size of Change : (Percent) exchange rates h a v e n o f u n d a m e n t a l equilibrium in t h e a b s e n c e of g o v e r n m e n t intervent i o n or certain t y p e s of legal restrictions. February 1986 October 1978 April 1979 March 1978 December 1987 October 1982 September 1980 May 1989 April 1983 July 1981 September 1986 April 1987 January 1974 February 1980 -27.8 -23.6 21.6 -17.7 -17.4 16.5 -16.3 15.9 -15.7 15.7 -15.6 -14.6 12.7 12.7 S u p p o r t e r s of f l e x i b l e rates a r g u e t h a t , left a l o n e , market forces can set exchange rates at a p p r o p r i a t e levels and that governments s h o u l d r e n o u n c e e x c h a n g e m a r k e t intervent i o n a n d c o n t r o l s on c a p i t a l flows or a s s e t h o l d i n g s ; h o w e v e r , W a l l a c e c l a i m s t h a t it is i m p o s s i b l e for g o v e r n m e n t s to d o b o t h . In his i n t e r p r e t a t i o n e x c h a n g e rate movements s i n c e 1973 reflect to a c o n s i d e r a b l e d e g r e e m a r k e t r e s p o n s e s to a c t u a l or a n t i c i p a t e d g o v e r n m e n t intervention. Market participants are c o n s t a n t l y trying t o g u e s s w h a t governm e n t s are going to d o , b u t t h e g o v e r n m e n t s rarely m a k e their intervention strategies pub- * Defined as exceeding 10 percent. " Positive values indicate depreciation of the yen; negative values indicate appreciation. End-ofmonth exchange rate data were used. Percentage changes were measured using logarithmic differences. Source: See Table 1. lic. In his view, volatility w o u l d b e r e d u c e d if g o v e r n m e n t s w o u l d c o o p e r a t i v e l y set p u b licly r e v e a l e d e x c h a n g e rate target z o n e s of s o m e k i n d a n d d e f e n d t h e m with intervention. In contrast, s u p p o r t e r s of flexible rates arg u e that given t h e differences in a t t i t u d e s tow a r d i n f l a t i o n a n d r e c e s s i o n in t h e m a j o r countries, fixed exchange rates or e v e n target z o n e s are n o t feasible; as soon as t h e y b e g a n ing s p e c u l a t o r s w o u l d s o o n e r or later l o s e to constrain g o v e r n m e n t policy significantly, m o n e y a n d b e driven o u t of business. t h e e x c h a n g e rate target w o u l d b e aban- Even if o b s e r v e d e x c h a n g e rate c h a n g e s are r a t i o n a l a n d a p p r o p r i a t e r e s p o n s e s to d o n e d . For i n s t a n c e , R u d i g e r Dornbusch (1988) claims that E u r o p e a n d Japan are m u c h policy i n s t a b i l i t y , W i l l i a m s o n (1983) a r g u e s m o r e o p p o s e d t o inflation t h a n t h e U n i t e d that greater fixity of exchange rates is also de- States is; in his view, they are willing to toler- sirable as a way of constraining g o v e r n m e n t s ate recession or d e p r e s s i o n to k e e p inflation from p u r s u i n g d e s t a b i l i z i n g p o l i c i e s , w h i c h low, whereas t h e U n i t e d States is not. Greater p r o b a b l y explain in part t h e large e x c h a n g e fixity of e x c h a n g e r a t e s w o u l d rate m o v e m e n t s of recent years. U n d e r fixed conflict with t h e s e preferences, forcing either exchange rates, a single g o v e r n m e n t ' s policy t h e U n i t e d States to tolerate m o r e u n e m p l o y - o p t i o n s w o u l d b e c o n s t r a i n e d by e i t h e r t h e m e n t or E u r o p e a n d Japan to t o l e r a t e m o r e n e e d to maintain t h e exchange rate p e g or to inflation than they w o u l d want. o b t a i n t h e a p p r o v a l of o t h e r g o v e r n m e n t s if an e x c h a n g e r a t e c h a n g e w e r e n e c e s s a r y . Williamson's preferred o p t i o n is not fixed ex- F E D E Rfor A L FRASER R E S E R V E B A N K O F ATLANTA Digitized sometimes Are Fixed Exchange Rates Feasible Tod a y ? Are t h e r e any e x a m p l e s of s u c c e s s f u l limits on exchange rate m o v e m e n t s in recent 11 years? Rolnick and W e b e r (1990) point to the United States under the Federal Reserve System, which ensures that a fixed, one-to-one e x c h a n g e rate p r e v a i l s b e t w e e n d o l l a r s in each of the twelve Federal Reserve districts. I n d e e d , this system has b e c o m e so s t a b l e that it is taken for granted, although earlier in U.S. history, currency from o n e region was treated as "foreign" m o n e y in other regions; that is, if you took an Atlanta dollar to Chicago and tried to exchange it for local Chicago money, you would get not a full dollar back, but perhaps 97 cents. 1 3 However, t h e example of the Federal Reserve is not entirely applicable to t h e group of major industrialized countries b e c a u s e , while all regions of t h e United States h a v e t h e s a m e national gove r n m e n t a n d i n d i v i d u a l states gave u p t h e power to print m o n e y decades ago, each ind u s t r i a l i z e d country is still a sovereign nation. The European Monetary System (EMS) is a better example, in t h e sense that the way it o p e r a t e s p r o b a b l y m o r e closely approximates what a new system of fixed or quasifixed e x c h a n g e rates w o u l d look l i k e t h a n d o e s t h e U.S. Federal Reserve System. Under t h e EMS, various European g o v e r n m e n t s agreed to k e e p their bilateral exchange rates within narrow target zones while continuing to have flexible rates with o u t s i d e currencies, such as t h e U.S. dollar, J a p a n e s e y e n , a n d British p o u n d . Accordingly, m o v e m e n t s of t h e French f r a n c - D e u t s c h e m a r k rate h a v e b e e n l i m i t e d , w h i l e m o v e m e n t s of t h e Deutschemark-dollar a n d franc-dollar rates have remained flexible. 14 The E M S was e s t a b l i s h e d in D e c e m b e r 1978 by t h e m e m b e r s of the European Econ o m i c C o m m u n i t y (EEC), which at that t i m e consisted of West Germany, France, Italy, the United Kingdom, Belgium, the Netherlands, L u x e m b o u r g , D e n m a r k , and Ireland. The h e a r t of t h e s y s t e m is t h e E x c h a n g e R a t e Mechanism, which was i n t e n d e d to k e e p bilateral exchange rates of m e m b e r countries within narrow b a n d s . Exchange rate targets (or parities) were set, and governments were o b l i g a t e d t o i n t e r v e n e in t h e foreign exchange markets to prevent market rates from moving more than 2.25 percent a b o v e or below t h e parity rates. 12 Although it was a m e m b e r of t h e EEC in 1978, t h e United Kingdom chose not to join the Exchange Rate Mechanism; hence it continued to have floating exchange rates for the p o u n d . 1 5 Italy insisted on somewhat greater flexibility for its exchange rate than the other countries w a n t e d ; t h e b a n d for t h e lira allowed it to m o v e as much as 6 percent above or below its target rate. Although t h e objectives of t h e EMS have always b e e n s o m e w h a t v a g u e , it is fairly clear that t h e m a i n goal was to r e d u c e the volatility of exchange rates within E u r o p e to p r o m o t e the EEC's e c o n o m i c integration and to p r o v i d e a stable unit of account for EECwide programs like t h e C o m m o n Agricultural Policy (see G e o r g Rich 1990). T h e system was not i n t e n d e d to b e completely rigid; the w i d t h of t h e target b a n d s p r o v i d e d s o m e flexibility, a n d in a d d i t i o n changing economic circumstances were e x p e c t e d to l e a d to occasional realignments in which t h e memb e r g o v e r n m e n t s w o u l d agree t o alter t h e parity rates. 1 6 T h e i m p e t u s for e s t a b l i s h i n g t h e EMS came largely from political leaders, especially Chancellor Helmut Schmidt of West Germany a n d President Valérie Giscard d ' E s t a i n g of France. M o s t e c o n o m i s t s were cool t o t h e i d e a , t h i n k i n g that t h e system w o u l d soon collapse because of differences between lowinflation W e s t G e r m a n y a n d high-inflation France and Italy. 17 The German Bundesbank was so negative on the EMS that an unpreced e n t e d visit by C h a n c e l l o r S c h m i d t to the B u n d e s b a n k Council was necessary to overcome t h e o p p o s i t i o n (see Michele Fratianni a n d Juergen von Hagen 1990). The Bundesbank's position is ironic, considering that various observers recently have described the EMS as having b e c o m e a system by which the Bundesbank controls monetary policy in the other m e m b e r countries. 1 8 Despite the skepticism, the EMS has now survived for more than a d e c a d e . How have exchange rates b e t w e e n m e m b e r countries b e h a v e d ? C o m p u t a t i o n s of six-month percentage changes as were d o n e for Tables 1-3 show that the franc-Deutschemark exchange rate h a d t h r e e e p i s o d e s d u r i n g t h e 1970s w h e n it m o v e d m o r e t h a n 10 p e r c e n t b u t n o n e since the EMS was established. Indeed, E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 since the major realignment of EMS currencies in 1982, the franc-Deutschemark rate has rarely m o v e d m o r e t h a n 6 p e r c e n t in six m o n t h s . 1 9 C l e a r l y , its v o l a t i l i t y h a s b e e n much less in recent years than t h e p o u n d d o l l a r ' s , D e u t s c h e m a r k - d o l l a r ' s , or y e n dollar's, and it is reasonable to attribute that lower volatility at least partially to t h e effectiveness of the EMS. a b o u t whether t h e EMS could survive given the differences in policy preferences a m o n g France, W e s t G e r m a n y , a n d Italy was expressed in t h e early days of the EMS, yet it s e e m s to b e thriving after more than a d e c a d e of existence. Critics of t h e EMS e m p h a s i z e the disruptions caused by realignments of the EMS currencies, as well as the costs of capital controls that France a n d Italy have e m p l o y e d to h e l p maintain their currencies within the EMS target zones. In addition, Fratianni and von Hagen (1990) a r g u e t h a t w h i l e t h e E M S h a s m a d e s i g n i f i c a n t p r o g r e s s in r e d u c i n g exchange rate uncertainty a m o n g m e m b e r currencies, it may h a v e increased uncertainty about rates between m e m b e r s and nonmembers, such as t h e Deutschemark-U.S. dollar rate. Even so, t h e costs are a p p a r e n t l y not too great—the original m e m b e r s have chosen to remain members, a n d additional countries have joined as well. Conclusion C o u l d t h e U n i t e d States, Japan, a n d Europe work together to form an EMS-style exc h a n g e rate s y s t e m for t h e e n t i r e g r o u p ? Skeptics like Dornbusch (1986) a n d Stanley Fischer (1986) think not, arguing that the differences in policy preferences are too great, and that in any e v e n t t h e U.S. g o v e r n m e n t would never accept the constraints on its fiscal policy that would b e necessary to m a k e the system work. However, similar skepticism As the p r o b l e m s of t h e Bretton W o o d s system m o u n t e d in the 1960s and early 1970s, a m o v e to flexible exchange rates was widely t o u t e d as a s i m p l e a n d e l e g a n t solution to those problems. The experience with flexible rates since 1973 indicates, however, that t h e present system has its own problems, including high volatility of exchange rates, little ins u l a t i o n from foreign shocks, a n d little pressure on g o v e r n m e n t s to p u r s u e s o u n d long-term policies. As a result, t h e r e is renewed interest in proposals to i m p o s e limits on exchange rate m o v e m e n t s . The European Monetary System's experience indicates that limits on exchange rate movements are feasible in principle but that such limits imply that participating g o v e r n m e n t s give u p s o m e of their a u t o n o m y with respect to economic policy. Whether the governments of the United States, Japan, a n d t h e major nations of Europe would b e willing to accept such limits on their freedom of action in order to reduce exchange rate volatility remains an o p e n question. Notes 1 For a m o r e e x t e n s i v e d i s c u s s i o n of c h a n g e s in t h e in- p r o b a b l y f i n d it a d v a n t a g e o u s t o p e g its c u r r e n c y to ternational m o n e t a r y s y s t e m from t h e g o l d s t a n d a r d of t h a t of a large country, s u c h as its m a i n t r a d i n g partner, the late n i n e t e e n t h century t o t h e Bretton W o o d s sys- t h e r e b y s t a b i l i z i n g t h e p u r c h a s i n g p o w e r of t h e s m a l l tem of t h e 1950s a n d 1960s, s e e Y e a g e r (1966). country's currency in t e r m s of t h e w i d e array of g o o d s , 2 T h e h u g e l i t e r a t u r e on p u r c h a s i n g p o w e r parity is re- services, a n d assets a v a i l a b l e in t h e large country. S e e 3 A u s e f u l c o n t e m p o r a r y d i s c u s s i o n of t h e p r o b l e m s of v i e w e d in Officer (1976). J o h n s o n (1972, 206). 7 the Bretton W o o d s s y s t e m is c o n t a i n e d in M u n d e l l a n d using the dollar-pound rate. 8 P r i o r to t h e c h a n g e in 1967, t h e d o l l a r - p o u n d e x c h a n g e q F o r e x a m p l e , British i m p o r t e r s w h o h a d s i g n e d con- in J o h n s o n (1972, 353-61) a n d S o l o m o n (1977, 176-215). ' A d v o c a t e s of flexible rates i n c l u d e d F r i e d m a n (1953), 6 is m e a s u r e d c h a n g e in t h e n a t u r a l l o g a r i t h m of t h e S w o b o d a (1969). 'The i n t e r n a t i o n a l m o n e t a r y crisis of 1971 is d i s c u s s e d S o h m e n (1969), H a b e r l e r (1970), a n d J o h n s o n T h e s i z e of t h e d e v a l u a t i o n rate h a d b e e n e s s e n t i a l l y u n c h a n g e d since 1949. (1972, tracts d e n o m i n a t e d in d o l l a r s suffered an u n e x p e c t e d 198-222). loss w h e n Britain d e v a l u e d b e c a u s e t h e cost of t h e im- T h e a d v o c a t e s of f l e x i b l e e x c h a n g e r a t e s r e c o g n i z e d ports in t e r m s of British p o u n d s s u d d e n l y w e n t u p as a that a s m a l l a n d narrowly s p e c i a l i z e d e c o n o m y w o u l d c o n s e q u e n c e of t h e d e v a l u a t i o n , e v e n t h o u g h t h e price F E D E R A L R E S E R V E B A N K O F ATLANTA 13 in d o l l a r s was u n c h a n g e d . As a result, s o m e d e a l s exp e c t e d to b e profitable s u d d e n l y b e c a m e l4 F r a t i a n n i a n d von H a g e n (1990) review t h e first d e c a d e l5 A f t e r years of d e b a t e t h e British g o v e r n m e n t b r o u g h t unprof- i t a b l e . At t h e s a m e t i m e , British e x p o r t e r s w h o h a d of o p e r a t i o n s by t h e E M S . s i g n e d contracts d e n o m i n a t e d in d o l l a r s e x p e r i e n c e d t h e p o u n d sterling i n t o t h e E M S b u t with w i d e , 6 per- w i n d f a l l gains. 10 The dates c e n t b a n d s , o n O c t o b e r 8, 1990. and sizes of large changes the l6 D e u t s c h e m a r k - d o l l a r a n d y e n - d o l l a r e x c h a n g e rates w e r e e l e v e n r e a l i g n m e n t s d u r i n g t h e first d e c a d e of t h e E M S ; t h e d a t e s were S e p t e m b e r 24, 1979; Novemb e r 30, 1979; March 23, 1981; O c t o b e r 5, 1981; Febru- 1, ary 22, 1982; ) u n e 'This a r g u m e n t was p r e v a l e n t at t h e t i m e of t h e Bretton 12 A c c o r d i n g t o F r a t i a n n i a n d v o n H a g e n (1990), t h e r e were f o u n d u s i n g t h e s a m e p r o c e d u r e s t h a t were u s e d in a n a l y z i n g t h e p o u n d - d o l l a r rate for T a b l e 1 in 14, 1982; M a r c h 1985; A p r i l b e e n r e v i v e d by W i l l i a m s o n (1983), Marris (1985), a n d 1987. In a d d i t i o n , t h e r e was a m i n i - r e a l i g n m e n t t h a t in- K r u g m a n (1985, 1989). v o l v e d a d e v a l u a t i o n of t h e I t a l i a n lira's p a r i t y rate By contrast, M u s s a (1985) a r g u e s t h a t u n d e r p l a u s i b l e 7, 1986; A u g u s t 21, 1983; July 22, W o o d s a g r e e m e n t ; s e e N u r k s e (1945). It has r e c e n t l y 4, 1986; a n d J a n u a r y 12, a g a i n s t t h e D e u t s c h e m a r k o n l a n u a r y 5, 1990. l7 a s s u m p t i o n s t h e dollar's v a l u e in 1985 was n o t at a lev- S e e t h e c o m m e n t s by B r y a n t , C o h e n , a n d F e l l n e r in Trezise (1979), as well as K o r t e w e g (1980) a n d V a u b e l el t h a t i m p l i e d m a r k e t irrationality. (1980). ' ^ S u c h d i s c o u n t s on n o n l o c a l d o l l a r bills w e r e c o m m o n d u r i n g t h e free b a n k i n g era prior t o t h e Civil War; s e e 18 Rockoff (1975). T h e r e w e r e d i s c o u n t s or p r e m i u m s on l9 S e e , for e x a m p l e , D o r n b u s c h (1986) a n d Fischer (1987). A c t u a l l y , t h e r e w e r e t w o r e a l i g n m e n t s d u r i n g t h e first n o n l o c a l f u n d s d u r i n g t h e n a t i o n a l b a n k i n g era as well. half of 1982; as a result, d u r i n g t h e six-month p e r i o d T h e s i z e of t h e d i s c o u n t or p r e m i u m c o u l d e n d i n g in A u g u s t 1982 t h e f r a n c - D e u t s c h e m a r k become rate large d u r i n g financial crises such as t h e Panic of 1907; m o v e d a b o u t 9.8 p e r c e n t , t h e largest six-month c h a n g e s e e N a t i o n a l M o n e t a r y C o m m i s s i o n (1911, 209-28). since t h e E M S was e s t a b l i s h e d . References D o r n b u s c h , R u d i g e r . " F l e x i b l e E x c h a n g e R a t e s a n d Excess C a p i t a l M o b i l i t y . " tivity Brookings Papers on Economic Ac- 1 (1986): 209-26. . " D o u b t s a b o u t t h e M c K i n n o n S t a n d a r d . " journal of Economic Perspectives 2 ( W i n t e r 1988): 105-12. The Economist, l a n u a r y 6, 1990, 15-16. Fischer, S t a n l e y . " C o m m e n t . " Brookings Papers on Economic Activity 1 (1986): 227-32. . " I n t e r n a t i o n a l M a c r o e c o n o m i c Policy C o o r d i n a - K r u g m a n , Paul R. "Is t h e S t r o n g D o l l a r S u s t a i n a b l e ? " In The U.S. Dollar—Recent Developments, Outlook, and Policy Options, 103-32. K a n s a s C i t y , M o . : F e d e r a l R e s e r v e B a n k of K a n s a s City, 1985. . Exchange-Rate instability. C a m b r i d g e , Mass.: The MIT Press, 1985. Marris, S t e p h e n N. Deficits and the Dollar. W a s h i n g t o n , D.C.: I n s t i t u t e for I n t e r n a t i o n a l E c o n o m i c s , 1985. M c K i n n o n , R o n a l d I. "A N e w Tripartite M o n e t a r y Agree- tion." N a t i o n a l B u r e a u of E c o n o m i c Research W o r k i n g m e n t or a L i m p i n g D o l l a r S t a n d a r d ? " Essays in Inter- P a p e r 2244, 1987. n a t i o n a l F i n a n c e , n o . 106. P r i n c e t o n , N.J.: P r i n c e t o n Frankel, )effrey A., a n d K e n n e t h Froot. "Chartists, Funda- Greek Eco- m e n t a l i s t s a n d t h e D e m a n d for D o l l a r s . " nomic Review 10 (1988): 49-102. Series on Public Policy M e e s e , R i c h a r d A., a n d K e n n e t h Rogoff. " E m p i r i c a l Exc h a n g e R a t e M o d e l s of t h e S e v e n t i e s : D o T h e y Fit O u t of S a m p l e ? " Frenkel, J a c o b A., a n d M i c h a e l L. M u s s a . "The Efficiency of Foreign E x c h a n g e M a r k e t s a n d M e a s u r e s of Turbu- American Economic Review Papers and Proceedings 70 (May 1980): 374-81. Exchange Readings in International Eco- e d i t e d by Richard E. C a v e s a n d Harry G. John- s o n . H o m e w o o d , 111.: Richard D. Irwin, Inc., 1968. S o m e R e c e n t D e v e l o p m e n t s a n d Discussions." In proaches to Greater Flexibility of Exchange Rates, Ap- e d i t e d by G e o r g e N. H a l m . Princeton, N.J.: Princeton University Press, 1970. Further Essays in Monetary Economics. Lon- d o n : G e o r g e Allen a n d Unwin, 1972. Korteweg, Pieter. " T h e E u r o p e a n M o n e t a r y S y s t e m — W i l l It Really Bring M o r e M o n e t a r y S t a b i l i t y t o E u r o p e ? " 14 Economics M u n d e l l , R o b e r t A., a n d A l e x a n d e r K. S w o b o d a , Monetary Problems of the International Economy. 14 eds. Chicago: M u s s a , M i c h a e l L. " C o m m e n t a r y on 'Is t h e S t r o n g Dollar The U.S. Dollar—Recent Developments, Outlook, and Policy Options, 133-55. K a n s a s C i t y , Mo.: S u s t a i n a b l e ? ' " In National Monetary Commission. States, Great Washington, Britain, Germany Statistics for the United and France, vol. 21. D.C.: G o v e r n m e n t Printing 128 (1980): 15-49. Office, 1911. N u r k s e , R a g n e r . " C o n d i t i o n s of I n t e r n a t i o n a l J o h n s o n , Harry G. Economist of International F e d e r a l R e s e r v e B a n k of K a n s a s City, 1985. H a b e r l e r , G o t t f r i e d . "The I n t e r n a t i o n a l M o n e t a r y S y s t e m : De journal ( F e b r u a r y 1983): 3-24, University of C h i c a g o Press, 1969. F r i e d m a n , M i l t o n . " T h e C a s e for F l e x i b l e Rates." 1953. R e p r i n t e d in )ournal of Eco- 2 ( W i n t e r 1988): 83-103. Carnegie- 173-242. nomics, nomic Perspectives 32 (1990): p e a n M o n e t a r y S y s t e m Ten Years After." lence." • " M o n e t a r y a n d E x c h a n g e Rate Policies for Internat i o n a l F i n a n c i a l Stability.- A P r o p o s a l . " F r a t i a n n i , M i c h e l e , a n d ) u e r g e n v o n H a g e n . " T h e Euro- Rochester Conference University, 1974. E q u i l i b r i u m . " Essays in International Princeton University, 1945. R e p r i n t e d Theory of International Trade, Monetary Finance, n o . 4, in Readings in the e d i t e d b y H o w a r d S. Ellis a n d L l o y d A. Metzler. H o m e w o o d , III.: Richard D. Ir- win, Inc., 1950. E C O N O M I C REVIEW, SEPTEMBER/OCTOBER 1990 Officer, L a w r e n c e H. "The Purchasing-Power Parity Theory of Exchange Rates: A R e v i e w Article." I n t e r n a t i o n a l Staff Papers 23 (March 1976): 1-60. Carnegie-Rochester Conference ries on Public Policy 32 (1990): 243-50. Rockoff, H u g h . The Free Banking Era: A Re-Examination. Monetary Fund Rich, G e o r g . " C o m m e n t . " port. Gold and the Dollar Crisis. N e w H a v e n , Ct.: Y a l e University Press, 1960. V a u b e l , R o l a n d . " T h e Return t o t h e N e w E u r o p e a n Mon- Se- etary S y s t e m : O b j e c t i v e s , I n c e n t i v e s , In New York: Arno Press, 1975. Monetary Institutions Perspectives." and the Policy Process, edited Karl B r u n n e r a n d Allan H. M e i t z e r , 173-221. Rochester Conference Series on Public Policy by Carnegie- 13 (1980). Re- W a l l a c e , Neil. " W h y M a r k e t s in Foreign E x c h a n g e a r e Dif- M i n n e a p o l i s , M i n n . : F e d e r a l R e s e r v e B a n k of ferent from O t h e r M a r k e t s . " F e d e r a l R e s e r v e B a n k of Rolnick, Arthur J„ a n d Warren E. W e b e r . 1989 Annual Triffin, R o b e r t . M i n n e a p o l i s , 1990. Sohmen, Egon. Minneapolis Flexible Exchange Rates. Rev. e d . Chicago: University of C h i c a g o Press, 1969. Solomon, Robert. The International D.C.: I n s t i t u t e for I n t e r n a t i o n a l E c o n o m i c s , 1983. Monetary System, 1945- 1976. N e w York: H a r p e r a n d Row, 1977. Trezise, P h i l l i p H., e d . Promise and Prospects. The European Quarterly Review 3 (Fall 1979): 1-7. The Exchange Rate System. W a s h i n g t o n , W i l l i a m s o n , John. Monetary Y e a g e r , L e l a n d B. International Monetary Relations. New York: H a r p e r a n d Row, 1966. System. Its W a s h i n g t o n , D.C.: T h e B r o o k i n g s Institution, 1979. F E D E R A L R E S E R V E B A N K O F ATLANTA 15 Lenders of the Next-to-Last Resort: Scrip Issue in Georgia during the Great Depression The most recent scrip issue in the Reserve System, which technically scrip issues in Georgia during the the country's financial history with United States occurred during the 1930s, after the establishment of the Federal was the lender of last resort. The author reports on his ongoing project to describe Great Depression. Hi's account provides a detailed look at a transitional period in possible implications for private moneylike instruments in today's economy. William Roberds oday, t h e term cash money means exactly o n e thing to residents of t h e United States: Federal Reserve notes. These notes constitute a type of currency known as fiat money, the d o m i n a n t if n o t sole t y p e of currency circulating in t h e world today. O n e reasonable definition describes fiat m o n e y as "a form of credit where the issuing party is the state and the recourse of an individual creditor is negligible against the state, b u t by the law of the state the fiat m o n e y must b e accepted in p a y m e n t to extinguish other d e b t s " (John Eatwell, Murray M i l g a t e , a n d Peter N e w m a n 1987, 317). In s h o r t , f i a t m o n e y is m o n e y b e c a u s e a sovereign government d e e m s it so. T T h r o u g h o u t m o s t of o u r n a t i o n ' s history other forms of cash have circulated either in place of or alongside fiat currency. Until 1933 t h e U n i t e d S t a t e s was ( m o r e or less) on a 16 gold standard, meaning that the value of the U.S. dollar was legally d e f i n e d as a certain weight in gold. 1 While the gold standard was in effect, both gold a n d silver coins circulate d as m e a n s of cash payment. In addition to coinage, bank notes, which promised to pay a specified a m o u n t in coin on d e m a n d , were widely used as m o n e y during t h e gold standard era. To guard against overissue of such notes, their issuance was generally restricted by law to banks chartered by t h e federal or various state governments. Notes were also issued by the federal government itself. D u r i n g m u c h of t h e g o l d s t a n d a r d era, m o n e y for everyday transactions was often in short s u p p l y . This shortage was particularly acute in the rural South a n d West. Studies by Richard H. Timberlake (1978, 1981) attribute the currency shortage to a n u m b e r of factors, a m o n g these the natural scarcity of gold and E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 the official valuation of monetary silver below its market price. But the most important factor c o n t r i b u t i n g to t h e m o n e y shortage was t h e stringency of legal restrictions on the issue of p a p e r money. A congressional act of 1865 i m p o s e d a prohibitive 10 percent tax on bank notes by state-chartered banks and practically e n d e d their issue (A.T. Huntington and Robert J. Mawhinney 1910, 362). The same act required that national banks m a i n t a i n strict reserve a n d collateral req u i r e m e n t s against their n o t e issue. Congressional acts of 1873 a n d 1875 e x t e n d e d the 10 p e r c e n t tax on circulating notes to those issued by n o n b a n k entities. 2 The most onerous restrictions were reserved for smalld e n o m i n a t i o n currency, reflecting t h e curio u s n i n e t e e n t h - c e n t u r y v i e w t h a t strict control over the issue of notes in small denominations was necessary for a sound currency. U n f o r t u n a t e l y , s m a l l - d e n o m i n a t i o n currency was sorely n e e d e d in a c o u n t r y where per capita annual income was well below $1,000. were printed in smaller d e n o m i n a t i o n s and circulated generally as a form of emergency currency. In Georgia alone, the 1908 report of the U.S. Comptroller of the Currency estimated that roughly $2.5 million in certificates was issued by clearinghouse associations in Atlanta, Augusta, M a c o n , a n d S a v a n n a h a n d n o t e d that m a n y of t h e s e certificates were given general circulation. Ironically, the very stringency of these restrictions on private money created a powerful incentive to d i s o b e y t h e m . The chronic shortage of circulating cash offered a tremendous profit opportunity to anyone who could convince others to take his own manufactured currency in return for goods and services. In the nineteenth century, such issue of unauthorized currency by private firms, towns, and, in some cases, even states was a common practice. These unauthorized notes, often known as "scrip" or "shinplasters," took the form of tokens, railroad tickets, "tax redemption certificates," and so forth. 3 These scrip issues merit serious study for at least three reasons. The first is that the depression scrip represented a form of privately issued m o n e y that received relatively w i d e use. In this sense, many forms of depression scrip resemble more modern forms of money such as money market mutual funds. The second reason is that the depression issues represent the most recent examples of scrip in the United States. Depression scrip does not seem as remote from t h e m o d e r n world as nineteenth-century issues or those associated with the 1907 panic. The third reason for studying the depression scrip issues is that little d e t a i l e d information is available concerning scrip issues during this period. Scrip issues during the Great Depression t e n d e d to b e very localized and short-term in nature Historical evidence suggests that the use of scrip declined as both coin and official paper money became more widely available toward t h e e n d of t h e n i n e t e e n t h c e n t u r y . During the 1907 panic, there was a brief but important resurgence of scrip issue, particularly in the form of "clearinghouse loan certificates." At t h a t t i m e , f e d e r a l b a n k i n g law allowed clearinghouse associations of banks in a given city to issue such certificates for purposes of interbank settlements or settlements between a clearinghouse association and a given bank. During the 1907 crisis, however, a large n u m b e r of t h e s e certificates FEDERAL R E S E R V E B A N K O F ATLANTA The last major occasion of scrip issue in t h e United States occurred during the Great D e p r e s s i o n of t h e 1930s. This p e r i o d presents o n e of the most unusual e p i s o d e s of scrip issue in our nation's monetary history, particularly because it took place after t h e founding of the Federal Reserve System. In its role as a l e n d e r of last resort t h e Fed c o u l d have, given congressional a p p r o v a l , theoretically m e t all emergency n e e d s for currency ( a n d d i d e v e n t u a l l y m e e t m o s t such n e e d s ) . N o n e t h e l e s s , n u m e r o u s issues of "depression scrip" circulated locally as money, especially during the 1932-35 period. The author is a senior economist in the macropolicy section of the Atlanta Fed's research department. He is grateful to many people for their help in this project, including Carl Anderson, Anne Bourne, Charles Downey, Doug Fleming, Clifford Kuhn, Shira Lewin, and Roy Luttrell, jr., as well as the staffs of the libraries of Atlanta-Fulton County, the Atlanta Historical Society, Emory University, Georgia State University, and the University of Georgia. The author claims full responsibility for any errors. 17 a n d were often found in rural areas. For various reasons, these issues were until recently seen as s o m e t h i n g of an embarrassment for everyone involved. It is rare to find any mention of depression scrip in local c h a m b e r of commerce-type histories, a n d monetary hist o r i e s of t h e G r e a t D e p r e s s i o n g e n e r a l l y mention scrip only briefly if at all. A fortunate exception is Joel W. Harper's (1948) nationwide survey of depression scrip. More recently, an excellent numismatic survey has been c o n d u c t e d b y R a l p h A. M i t c h e l l a n d N e i l Shafer (1984). With t h e goal of augmenting knowledge of the depression scrip episode, this author has undertaken a project to identify a n d describe scrip issues in Georgia during the Great Depression. In t h e case of each scrip issue, the research begins with identifying a particular issue, the total a m o u n t of its circulation, and its duration. The second s t e p is to ascertain the "moneyness" of t h e issue by considering historical evidence on market valuation of the scrip relative to its face value, t h e general acc e p t a b i l i t y of t h e s c r i p as a t r a n s a c t i o n s m e d i u m , a n d t h e v e l o c i t y or rate of t h e scrip's turnover. The third a n d final step is to relate each scrip issue's "moneyness" to the circumstances associated with its issue. The present article is a progress report on this ongoing research project. It contains a brief history of t h e s c r i p i s s u e s t h a t h a v e b e e n studied thus far and a summary of the conclusions that might b e drawn from the depression scrip e p i s o d e a p p l i c a b l e to present-day or future monetary institutions. The Banking Holiday of 1933 and the Issuance of Clearinghouse Scrip O n e of the most important causes of scrip issue in Georgia during t h e early 1930s was t h e s e q u e n c e of events leading u p to the nat i o n w i d e b a n k i n g h o l i d a y of March 1933. In fact, t h e period from the stock market crash of 1929 through t h e first half of 1933 was t h e most turbulent in the nation's banking history. The n u m b e r of banks nationwide d r o p p e d from about 24,500 at midyear 1929 to roughly 15,000 by midyear 1934. During the same pe- 18 riod deposits fell from $58 billion to $46.5 billion (Board of Governors of t h e Federal Res e r v e S y s t e m 1943, 24-25). T h e b a n k i n g situation in Georgia mirrored the nation's, as the n u m b e r of b a n k s operating in t h e state fell from 420 in 1929 to 322 in 1934 and deposits fell from $342 million to $300 million (Board of Governors of t h e Federal Reserve System 1943, 26-27). As e m p h a s i z e d in S u s a n E. K e n n e d y ' s (1973) study, the banking crisis of 1933 was a complex s e q u e n c e of events that cannot b e u n a m b i g u o u s l y attributed t o a single cause. What is clear, however, is that the culmination of the crisis was the national banking holiday of March 6-12. President Franklin D. Roosevelt ordered this one-week closing of all banks on Monday, March 6, u n d e r t h e doubtful authority of t h e T r a d i n g w i t h t h e E n e m y Act, a wartime emergency measure dating from the First World War. Roosevelt's first term h a d begun only two days earlier, and the closing of the banks was his administration's first significant act. Such an e x t r e m e m e a s u r e was necessitated by a banking crisis that had begun to take on the character of a nationwide bank run. A c h a i n r e a c t i o n of s t a t e w i d e b a n k i n g moratoriums h a d b e e n set in m o t i o n when, on February 14, the governor of Michigan declared a s t a t e w i d e b a n k i n g h o l i d a y t o prevent t h e total collapse of the state's largest b a n k s . 4 T h i s m o r a t o r i u m s e t off m o r e statewide banking holidays as depositors, ant i c i p a t i n g t h e s p r e a d of t h e b a n k closings, frantically tried to withdraw their deposits at banks that were still o p e n . By Friday, March 3, more than 5,000 banks had closed their doors a n d thirty-six states h a d d e c l a r e d at least p a r t i a l r e s t r i c t i o n s on b a n k w i t h d r a w a l s ( K e n n e d y 1973, 147). In Georgia b a n k holid a y s in n e i g h b o r i n g s t a t e s f o r c e d n e w l y e l e c t e d G o v e r n o r E u g e n e T a l m a d g e t o declare a bank holiday on March 3.5 Roosevelt's closing of the banks was a bold and well-conceived gesture that did much to break the panic that had gripped the nation's banking system. However, in his proclamation declaring t h e bank holiday Roosevelt did not p r o p o s e any detailed plan for e n d i n g the crisis a n d reopening the banks—apparently because no detailed plan existed at the time of E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 the a n n o u n c e m e n t (Helen M. Burns 1974, 4249; Kennedy 1973, 173-75). Instead, t h e bank holiday declaration touched off a furious debate a m o n g t h e new administration's members a b o u t how to best deal with the crisis. Amazingly, o n e of t h e p r o p o s a l s Roosevelt considered called for instantaneous monetization of all U.S. government b o n d s then outs t a n d i n g , in t h e a m o u n t of $21 b i l l i o n . Fortunately for the nation, this plan raised as many eyebrows then as a similar plan might now, a n d t h e p r e s i d e n t was p e r s u a d e d t o abandon it (Kennedy 1973, 173-74). A n o t h e r p l a n , g e n e r a l l y f a v o r e d by t h e larger city banks, called for t h e issuance of clearinghouse scrip on a n a t i o n w i d e basis. 6 The p l a n finally a g r e e d on was historically significant in that it gave broad powers t o t h e Federal Reserve b a n k s t o a d v a n c e cash to m e m b e r banks on virtually any collateral and a l l o w e d cash a d v a n c e s t o a n y i n d i v i d u a l , partnership, or corporation against collateral of U.S. government securities. This plan was written into law by the passage of the Emergency B a n k i n g Act on March 9, 1933, a n d banks furnished with new infusions of Federal Reserve notes began to reopen in t h e twelve Federal Reserve cities, including Atlanta, on Monday, March 13 (Kennedy 1973, 180).7 For many Georgians, however, t h e reopening of the banks u n d e r the Emergency Banking Act came too late. Cash had b e e n scarce to nonexistent in most communities since the imposition of the statewide banking moratorium on March 3. The imposition of t h e nationwide moratorium a n d t h e s u b s e q u e n t delay in t h e r e o p e n i n g of t h e b a n k s m e a n t that even the reserve city of Atlanta was virtually without cash for ten days, a n d towns in t h e southern part of t h e state went without cash for two weeks or longer. The economic hardship caused by the loss of p a p e r currency was m u c h g r e a t e r t h a n might result from a similar event today. Georgia in 1933 was a poor state by both modern and contemporary standards. Per capita personal income in Georgia in 1929 has b e e n estimated at about $350, e q u a l to about half the U.S. average at the t i m e and a b o u t ten times that a m o u n t in 1990 dollars. 8 Although checks did circulate during the bank holiday, checking accounts were much less c o m m o n than toDigitized F E D for E R AFRASER L R E S E R V E BANK O F ATLANTA day. Particularly hard hit by t h e cash shortage were workers in t h e cotton mills a n d o t h e r blue-collar workers in u r b a n c e n t e r s , w h o were a c c u s t o m e d to receiving their weekly pay in the form of cash. O n e factor that mitigated t h e economic impact of the bank closings in Georgia was that a significant portion of the state economy was accustomed to operating without cash, even in 1933. In rural areas, tenant farming for store credit was a c o m m o n practice if not t h e norm (see, for example, Michael S. H o l m e s 1974). A n d according to oral accounts recorded by C l i f f o r d M . K u h n , H a r l o n E. J o y e , a n d E. Bernard West (1990), it was still not uncomm o n for mill workers to b e p a i d in c o m p a n y scrip, store credit, or c o m m o d i t i e s . In these sectors of t h e e c o n o m y , it s e e m s d o u b t f u l that the bank holiday would have caused any significant disruption of normal activity. In 1990 it would b e difficult for most of us to imagine a financial crisis such as occurred in early 1933 not b e i n g m e t with i m m e d i a t e federal government intervention. In 1933 the equally common presumption appears to have b e e n that t h e cash shortage would b e dealt with by issuance of clearinghouse scrip. As m e n t i o n e d in t h e i n t r o d u c t i o n , Georgia h a d a strong tradition of scrip issue d u r i n g the latter half of the nineteenth century, a tradition reinforced by t h e w i d e s p r e a d use of c l e a r i n g h o u s e scrip d u r i n g t h e 1907 p a n i c . The p r o s p e c t of c l e a r i n g h o u s e scrip i s s u e during t h e 1933 b a n k h o l i d a y was generally seen as a retreat by banks to a conservative, time-tested solution to the m o n e y shortage. 9 At the onset of the bank holiday, even federal a n d state officials s e e m e d resigned t o t h e l i k e l i h o o d of scrip issue. T h e p r e s i d e n t i a l proclamation e s t a b l i s h i n g t h e b a n k h o l i d a y e m p o w e r e d t h e secretary of t h e treasury to "permit issuance of clearing house certificates or other evidences of claims against assets of b a n k i n g i n s t i t u t i o n s . " 1 0 In Atlanta, Federal Reserve Bank Governor Eugene R. Black declared that t h e bank holiday was "a fine and constructive measure a n d will h e l p to bring a b o u t normal business conditions through the issuance of scrip." 11 O n e of the most ent h u s i a s t i c p r o p o n e n t s of s c r i p i s s u e was Georgia's G o v e r n o r T a l m a d g e , w h o v i e w e d scrip issue as a useful means of increasing the 19 circulation of funds. On March 14, Talmadge vetoed an emergency banking measure hastily passed by t h e Georgia legislature at least partly because, in his words, it "would annul Iscrip] issues already m a d e in the state." 12 Clearinghouse associations in Atlanta, Augusta, C o l u m b u s , Macon, a n d Savannah began p r e p a r a t i o n s for scrip issues a l m o s t as soon as t h e n a t i o n a l b a n k h o l i d a y was ann o u n c e d . In Atlanta, an u n p r e c e d e n t e d $20 million issue of clearinghouse certificates was p l a n n e d by the Atlanta Clearing House Association. S o m e i d e a of t h e m a g n i t u d e of this issue can b e o b t a i n e d by n o t i n g that total January 1933 d e p o s i t s of A t l a n t a C l e a r i n g H o u s e b a n k s a m o u n t e d t o o n l y $104 million. 1 3 Upon receiving authorization from the secretary of the treasury, t h e association began stockpiling the scrip for use by its member banks. At least $3 million in $1 notes had b e e n printed a n d delivered by the time t h e plan was called off on March 9. 14 The reopening of t h e Atlanta Clearing H o u s e banks on March 13, a n d the s u b s e q u e n t reopening of other "licensed" banks, seems to have eliminated the n e e d for clearinghouse scrip in Atlanta and in nearby communities in northern Georgia. 1 5 However, clearinghouse scrip d i d find its way i n t o circulation in t h e southern part of the state. Below are specific instances of clearinghouse scrip issue a n d t h e scrip's impact on the communities in which it circulated. Clearinghouse Scrip Issue during the National Bank Holiday, by City A u g u s t a . As soon as President Roosevelt o r d e r e d t h e national b a n k holiday, t h e Augusta C l e a r i n g H o u s e A s s o c i a t i o n (January 1933 deposits of $9 million) announced plans to print a n d circulate clearinghouse certificates. 1 6 interestingly, t h e story in the Augusta Chronicle carrying t h e a n n o u n c e m e n t of t h e scrip issue also p o i n t e d out that in the opinion of o n e local banker, t h e scrip notes were subject to a 10 percent federal tax. This mention of the bank note tax is the only o n e (that this author is aware of) in contemporary accounts of clearinghouse scrip issue. 20 By March 10, a $5 million scrip issue had b e e n authorized a n d delivered to t h e cleari n g h o u s e b a n k s . O n M a r c h 11, r o u g h l y $200,000 of scrip was paid out by t h e clearinghouse banks, much of it for t h e p u r p o s e of allowing manufacturers t o m e e t their weekly payrolls. This scrip constituted the only circulating m o n e y in the city until the banks were r e o p e n e d on March 14. N e w s p a p e r reports suggest that the scrip generally circulated at p a r a n d was a c c e p t e d by a l m o s t all retail merchants other than national chain stores. The par valuation of t h e scrip was n o d o u b t encouraged by threats from the city solicitor t o p r o s e c u t e any p e r s o n s f o u n d t o b e discounting the scrip. 17 The Augusta Clearing H o u s e scrip issue was short-lived. By March 16, two days after normal banking activity resumed in the city, Augusta banks were recalling the scrip. Of the $5 million in scrip printed, less than $300,000 ever circulated. 1 8 Still, the arrival of even this small a m o u n t of scrip c a m e at a timely mom e n t in t h e banking crisis. The circulation of scrip on March 11 meant that manufacturers' employees, who had already missed one week's pay b e c a u s e of t h e banking holiday, could receive their weekly wages a n d that local m e r c h a n t s c o u l d carry o u t b u s i n e s s on something resembling normal terms. C o l u m b u s . T h e i s s u e of c l e a r i n g h o u s e scrip in C o l u m b u s in m a n y respects paralleled the Augusta issue. Shortly following the a n n o u n c e m e n t of the national b a n k holiday, t h e C o l u m b u s C l e a r i n g H o u s e Association (January 1933 deposits of $11 million) sought and received permission for a $1 million scrip issue. "Over $100,000" of t h e scrip was paid out on March 10 to m e e t manufacturers' payrolls, a n d , according to Mitchell a n d Shafer (1984, 64), t h e e n t i r e $1 m i l l i o n issue was eventually circulated. As was t h e case with Augusta, scrip apparently was t h e only money circulating in t h e city until March 14. Welc o m e d by most merchants, t h e scrip generally circulated at par. There is even o n e report of a m e r c h a n t o f f e r i n g a p r e m i u m for t h e clearinghouse scrip. 19 Two unusual aspects of the C o l u m b u s scrip experience bear mention. The first is that the scrip a p p a r e n t l y c o n t i n u e d t o circulate for s o m e t i m e after t h e b a n k i n g crisis had E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 p a s s e d , a l t h o u g h exactly h o w l o n g is n o t clear. In the weeks i m m e d i a t e l y following the b a n k h o l i d a y , t h e b a n k s in t h e C o l u m b u s Clearing H o u s e Association d i d not p u b l i s h any notice that the scrip was being withdrawn from circulation. Mitchell a n d Shafer (1984, 64) p u t t h e d u r a t i o n of t h e scrip i s s u e at t w e n t y - s e v e n d a y s , b u t t h e m e m o i r s of an e m p l o y e e of t h e clearinghouse, W. Roy Luttrell, Sr., suggest that the scrip continued to circulate locally for a period of a b o u t three months. 2 0 The second unusual feature of the C o l u m b u s scrip was that it circulated concurrently with a n o t h e r t y p e of scrip, t h a t is, scrip printed a n d circulated by Phenix City, Alabama. The Phenix City scrip and other municipal scrip issues will b e discussed in a later section. M a c o n . The experience with clearinghouse scrip in Macon was also very similar t o t h e Augusta e p i s o d e , although less d e t a i l e d information concerning the scrip issue is availa b l e in c o n t e m p o r a r y n e w s p a p e r accounts. Scrip i s s u e d by t h e Macon Clearing H o u s e Association (January 1933 deposits of $7 million) began circulating in t h e city on March 10. Approximately $100,000 in scrip was issued on March 10 a n d 11 t o m e e t manufacturing payrolls. The clearinghouse banks r e o p e n e d their doors for normal operations on March 14, and much of the scrip was immediately withdrawn from circulation. Newspaper accounts indicate that the scrip was welcomed by city merchants and largely circulated at par. 21 Savannah a n d Valdosta. Savannah, the second largest b a n k i n g center in t h e state, did not escape having to use clearinghouse scrip during the bank holiday. Contemporary newspaper accounts indicate that the Savannah Clearing House Association (January 1933 deposits of $66 million) printed at least $1.5 million in scrip, though probably only a fract i o n of t h i s a m o u n t a c t u a l l y c i r c u l a t e d . Mitchell a n d Shafer (1984, 65) p u t t h e total amount of the issue at $1 million, of which only $535,000 is s u p p o s e d to have circulated. The scrip began circulating on March 10 a n d apparently circulated at par. Local banks began r e o p e n i n g on March 14, a n d t h e p u b l i c was urged by t h e p r e s i d e n t of t h e clearinghouse association to r e d e e m t h e scrip promptly. 2 2 F E D E R A L R E S E R V E B A N K O F ATLANTA An unusual feature of t h e Savannah scrip issue is that s o m e of the scrip printed by the S a v a n n a h c l e a r i n g h o u s e a l s o c i r c u l a t e d in V a l d o s t a . A l t h o u g h V a l d o s t a h a d its own c l e a r i n g h o u s e a s s o c i a t i o n at t h e t i m e , t h e small size of its banking market (January 1933 d e p o s i t s of $1.9 million) m a d e it more conv e n i e n t t o use t h e S a v a n n a h scrip t h a n to print a separate issue. Issue of the Savannah scrip in Valdosta was no d o u b t facilitated by the presence of branches of the Citizens a n d S o u t h e r n National Bank ( h e a d q u a r t e r e d in Atlanta) in b o t h cities. The S a v a n n a h scrip was first issued in Valdosta on March 11 a n d apparently circulated until at least March 29, when a general a n n o u n c e m e n t withdrawing t h e scrip was p u b l i s h e d . As was the case with t h e C o l u m b u s scrip issue, the clearinghouse scrip apparently continued to circulate after t h e Valdosta banks' r e o p e n i n g on March 14 and also circulated alongside scrip issued by the city of Valdosta. Research has uncovered n o mention of t h e clearinghouse scrip's being circulated at par in Valdosta, though the lack of evidence to the contrary and the par valuation of t h e s a m e scrip in S a v a n n a h suggest that it d i d circulate at face value. 2 3 Other Cities. In addition to the cities listed a b o v e , a n u m b e r of others in G e o r g i a h a d clearinghouse associations in 1933. The Rand McNally Bankers Directory for 1933 lists clearinghouse associations at Albany, Brunswick, Elberton, Griffin, Newnan, and Rome. Reflecting t h e p o p u l a t i o n of t h e c o m m u n i t i e s they s e r v e d , t h e s e a s s o c i a t i o n s were relatively small in size, each having c o m b i n e d deposits of its m e m b e r banks totaling less than $4 million. Of these associations, only Brunswick's has b e e n investigated at this point; the possibility of scrip issue by t h e o t h e r associations remains to b e investigated. C o n t e m p o r a r y n e w s p a p e r accounts indicate that c l e a r i n g h o u s e scrip c i r c u l a t e d in Brunswick beginning on March 11, 1933. The exact a m o u n t of t h e scrip issue is not ment i o n e d . N u m e r o u s accounts report the scrip circulating at par and, in o n e case, even at a 10 p e r c e n t p r e m i u m , s u g g e s t i n g t h a t t h e Brunswick clearinghouse scrip was as readily accepted as were similar issues in the cities listed above. A general call for redemption of the scrip was p u b l i s h e d on March 23. 24 21 On the whole, contemporary accounts indicate that the March 1933 clearinghouse scrip issues in Georgia were highly successful as emergency local currency. Apparently these issues e n j o y e d t h e full s u p p o r t of t h e local business establishments (perhaps in part because of the reluctance of chain stores to acc e p t t h e scrip) a n d were by m o s t accounts circulated at or a b o v e par. Two important factors reinforced t h e success of t h e clearinghouse scrip issues. The first of these was the virtual certainty, t h a n k s to t h e E m e r g e n c y Banking Act passed on March 9, of b e i n g able t o exchange t h e scrip for F e d e r a l Reserve notes in the near future. The second was the positive experience with clearinghouse scrip issues following the Panic of 1907. Any positive assessment of these scrip issues must b e t e m p e r e d , h o w e v e r , b y t h e fact that m o s t contemporary accounts reflect the opinions of c o m m u n i t y leaders a n d not the mill workers a n d small merchants who were the most likely recipients of the scrip. Scrip Issues by Local Governments Clearinghouse associations by n o m e a n s h a d a m o n o p o l y on scrip issue d u r i n g t h e Great Depression. In n a t i o n w i d e surveys of depression scrip, Harper (1948) and Mitchell and Shafer (1984) list issues m a d e by private businesses, self-help groups, business g r o u p s , a n d local g o v e r n m e n t s . To t h e author's k n o w l e d g e , in G e o r g i a only t h e last t y p e of s c r i p w a s i s s u e d in s i g n i f i c a n t amounts. Harper's survey lists seven issues of d e p r e s s i o n scrip b y local g o v e r n m e n t s in Georgia. Since the scrip issued by the city of Valdosta (see below) is not listed by Harper, it seems safe to conclude that this list is not c o m p l e t e . Mitchell a n d Shafer's survey only lists issues by t h e city of Atlanta. O n e factor that makes t h e municipal scrip issues difficult t o identify is that t h e reasons for i s s u i n g t h e scrip t e n d e d t o vary from c o m m u n i t y to c o m m u n i t y rather than b e i n g tied t o a single national e v e n t such as t h e national banking holiday. The most c o m m o n reason for issuing scrip, according t o Harper, s e e m s t o h a v e b e e n a c o m b i n a t i o n of rev- 22 e n u e shortfalls a n d t h e inability of the local g o v e r n m e n t s t o o b t a i n f i n a n c i n g by m o r e conventional means. But other m o t i v e s d i d influence the decision by municipalities to issue scrip. The general shortage of circulating cash d u r i n g t h e early d e p r e s s i o n years led many community leaders to feel that issuing scrip would provide their communities with a much-needed circulating currency. As shown in Timberlake (1981), the widespread use of m u n i c i p a l scrip in t h e n i n e t e e n t h century p r o v i d e d a m p l e p r e c e d e n t for t h i s sentiment. At least o n e scrip issue in the state was m a d e for the explicit p u r p o s e of putting the u n e m p l o y e d b a c k t o work. B e l o w are described the experiences of a n u m b e r of Georgia c o m m u n i t i e s with scrip i s s u e d b y local governments during the 1932-35 period. Local Government Scrip Issues, by City or County City of Atlanta. The most prolific issuer of depression scrip in t h e state appears to have b e e n t h e city of Atlanta. Although no exact e s t i m a t e is c u r r e n t l y a v a i l a b l e , t h e t o t a l a m o u n t of scrip issued by the city from 1930 through 1936 can b e placed at more than $2.5 million, only a fraction of which circulated as m o n e y . A t o t a l of f o u r t e e n i s s u e s w e r e p l a n n e d , and at least eight of t h e m were dist r i b u t e d to m u n i c i p a l e m p l o y e e s . W h a t is currently known about these issues is summarized in Table 1. The cause of t h e Atlanta scrip issues can b e traced directly t o t h e city's rapid population growth during t h e 1920s. Between 1920 a n d 1930 t h e p o p u l a t i o n of A t l a n t a grew from a b o u t 212,000 to roughly 270,000, a n d t h e city's school p o p u l a t i o n grew from 33,000 t o 6 5 , 0 0 0 . 2 5 By 1930 m u n i c i p a l finances were severely pressured by t h e obligation t o p r o v i d e city services, particularly schooling, to t h e swelling p o p u l a t i o n a n d by t h e loss of tax revenue caused by a faltering e c o n o m y . F i n d i n g itself short of f u n d s for D e c e m b e r 1930 salaries, t h e city e n t e r e d int o an a g r e e m e n t with R i c h ' s d e p a r t m e n t store to issue scrip to city schoolteachers in lieu of D e c e m b e r salaries. The scrip c o u l d E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 Table 1. City of Atlanta Scrip, 1930-36 Date of Resolution Interest Rate Date of Issue Amount of Issue Corporate Sponsorship Date of Redemption ? ? 12-18-30 $200-238K Rich's 01-01-31? 12-15-32 6% 12-20-32 $380-400K Rich's 3 01-27-33b 02-07-33 6% 02-15-33 $280-300K Rich's 05-20-33 04-03-33 4% ? ? ? "During 1933' 04-19-33 4% * * * "During 1933' 11-20-33 6% ? $260K ? 05-01-34 01-12-33 2% ? $500K Coca-Cola 05-19-34 11-05-34 4% 12-05-34 $200K Rich's 05-01-35 12-07-34 ? ? $400K Coca-Cola ? 02-04-35 4% ? ? ? ? 11-04-35 4% ? $800K Trust Co. 05-13-35b 01-20-36 3% ? ? ? "During 1936' 05-04-36 3% ? ? Trust Co.? 10-30-36?b 11-02-36 ? ? ? ? ? a Rich's offered to give half cash and half store credit for the notes of this issue. See text, page 25. b Actual payment dates from Mitchell and Shafer (1984). * Probably not issued because of early payment of property taxes by Atlanta Clearing House banks. See Atlanta Constitution, May 22, 1933, or Atlanta Clearing House Association (1950, 60). Source: Resolution dates and interest rates are from Atlanta City Council Minutes. Dates of issue, amounts, and corporate sponsors are from reports in the Atlanta newspapers or Mitchell and Shafer (1984). Redemption dates are either the dates cited in the enabling resolutions (scrip was callable before the indicated dates) or actual payment dates from Mitchell and Shafer. FEDERAL R E S E R V E BANK O F ATLANTA 23 t h e n b e r e d e e m e d at Rich's for its full face value. 2 6 A 1934 newspaper account reported t h a t Rich's a b s o r b e d a total of $238,000 in scrip. 2 7 A l t h o u g h little, if any, of t h e D e c e m b e r 1930 issue circulated as money, it is nonetheless of interest because it set t h e pattern for s u b s e q u e n t issues. As a m e a n s of borrowing m o n e y the issue of scrip seems unnecessarily costly a n d elaborate. An unresolved question is why t h e city d i d not borrow t h e m o n e y directly from Rich's or other firms in Atlanta's business community. Perhaps Rich's a n d other corporate "sponsors" of the city's scrip issues preferred t h e issue of scrip as a m e a n s of increasing p u b l i c awareness of their role in shoring u p the city's finances. Another possib l e explanation is that t h e city charter's restrictions may have led local leaders to prefer the issue of scrip. Chapter 12 of t h e 1924 Atlanta City Charter d i d not allow t h e "annual expense of the City . . . to exceed the annual income." Given the longstanding use of scrip as an emergency currency in the South, its issue may have s e e m e d less in contradiction t o that clause than a direct loan. A third possib i l i t y is t h a t t h e i s s u e of scrip m a y h a v e served as a m e a n s of effectively signaling to t h e business community that the city i n d e e d lacked t h e m e a n s to pay its employees. The city's fiscal situation continued to deteriorate in 1931 and 1932. The assessed value of t h e city's property tax rate rose b y a scant 2 percent in 1931 and fell by more than 10 percent in 1932.28 By February 1932 Mayor James L. Key a n d t h e city council h a d imp o s e d stringent economizing measures in an effort to bring t h e city's finances under control. Municipal e m p l o y e e s other than teachers were given pay cuts of 10 p e r c e n t a n d ordered to take payless vacations. The labor u n i o n r e p r e s e n t i n g m a n y Atlanta teachers, the Atlanta Public School Teachers Association, voted to accept even d e e p e r pay cuts, ranging u p t o 16 percent on a sliding scale. In spite of these measures, by N o v e m b e r 1932 t h e city found itself short of funds to m e e t its payroll. Negotiations between the city a n d local b a n k s t o o b t a i n e m e r g e n c y l o a n s were b r o k e n off w h e n t h e two p a r t i e s c o u l d n o t agree on t h e size of t h e city's 1933 b u d g e t (Melvin W. Ecke 1972, 236-37). 24 In 1932 t h e issue of scrip t o cover the city's payroll s e e m e d to b e t h e natural, though reluctantly a p p l i e d , solution to this d i l e m m a . City e m p l o y e e s d i d in fact receive their pay for N o v e m b e r a n d D e c e m b e r in t h e form of scrip. The N o v e m b e r payroll a m o u n t e d to s o m e $400,000, a n d scrip in this a m o u n t was i s s u e d o n D e c e m b e r 20, 1932. T h e scrip p r o m i s e d to pay to the bearer interest e q u i v a l e n t t o 6 percent p e r a n n u m u p o n red e m p t i o n on or before March 1, 1933. The D e c e m b e r 1932 payroll a m o u n t e d to $300,000 a n d was not issued until February 15, 1933. The smaller size of the latter issue was m a d e possible by imposing two-week payless vacations on city teachers a n d t h u s halving the size of t h e school system's payroll for that month. The February 1933 scrip issue was re- "The ICity of Atlanta] issue of scrip may have served as a means of effectively signaling to the business community that the city indeed lacked the means to pay its employees." d e e m a b l e o n M a y 20, 1933, a n d a g a i n promised to pay 6 percent annualized interest u p o n r e d e m p t i o n . 2 9 In contrast t o t h e clearinghouse scrip issues described above, t h e Atlanta city issue d i d not always circulate at par, d e s p i t e its rather generous interest rate. The city d i d not a n d could not legally require that t h e scrip b e accepted at par. Nor is there any evidence to suggest that Atlanta's b a n k s (which h a d their own set of p r o b l e m s at t h e time) were willing t o cash either the D e c e m b e r 1932 or February 1933 city scrip issues. Although contemporary newspaper accounts d o not mention any explicit discounting of t h e city scrip, newspaper statements by prominent Atlanta retailers suggest t h a t p a r v a l u a t i o n of t h e scrip was far from universal. For example, the Atlanta Retail Merchants' Association initially r e c o m m e n d e d to its m e m b e r s that n o more E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 than 25 percent of t h e scrip's face value b e given in change for any purchase m a d e with scrip. 30 Apparently Rich's d e p a r t m e n t store, which had offered to cash the 1930 scrip, was not in a position to absorb t h e entire December 1932 issue. It d i d offer m o r e g e n e r o u s terms than most merchants a n d promised to exchange t h e scrip for half cash and half store credit. Rich's also offered to cash t h e February 1933 issue outright. 31 Oral history accounts recorded by Kuhn, Joye, and West (1990, 144-45, 201) confirmed discounting of the Atlanta city scrip. O n e Atl a n t a t e a c h e r r e c a l l e d t h a t " m o s t of t h e stores, they w a n t e d a p e r c e n t a g e for it, for cashing that scrip." S o m e idea of the prevailing rate of d i s c o u n t is p r o v i d e d in t h e (unp u b l i s h e d ) r e c o l l e c t i o n s of a city f i r e m a n "Some idea of the prevailing rate of discount is provided in the (unpublished) recollections of a city fireman whose large savings allowed him to carry out a small Business in cashing scrip at 95 percent of face value." whose large savings allowed him to carry out a small business in cashing scrip at 95 percent of face value. This rate of discount would have p u t the annualized yield on the scrip at close to an unheard of rate of 27 percent, giving an idea of t h e public's lack of confidence in the city's finances. Even higher rates of discount a n d d o w n r i g h t n o n a c c e p t a n c e of t h e scrip were also c o m m o n , according to the oral history accounts. An Atlanta policeman curtly s u m m a r i z e d t h e situation in o n e s e n t e n c e : "Nobody wanted that scrip." 32 Fortunately for Atlanta municipal employees, the statement was not literally true. The city itself was willing to take t h e scrip at par for p a y m e n t of taxes and utility bills b u t refused t o give a n y c h a n g e for p a y m e n t s in scrip. 33 In oral history accounts, Rich's offers to redeem t h e scrip were recalled as crucial to t h e s c r i p i s s u e s ' s u c c e s s . O n e A t l a n t a F E D E R A L R E S E R V E B A N K O F ATLANTA teacher recalled, "You could go to Rich's and just put the scrip u p on the counter a n d say, 'I'd like to get this scrip cashed.' You d i d n ' t have to s p e n d anything." In the opinion of another teacher, Rich's acceptance of the scrip "saved our lives. It saved the p u b l i c school system." A school a d m i n i s t r a t o r n o t e d that b e c a u s e of its r e a d y a c c e p t a n c e of scrip, Rich's was heavily p a t r o n i z e d by t h e city's grateful teachers for years afterward (Kuhn, Joye, and West 1990, 144-45, 201). Atlanta's fiscal crisis of late 1932 was to b e r e p e a t e d , t o a s o m e w h a t lesser d e g r e e , in 1933, 1934, and 1935. The city's tax base fell by a b o u t 12 percent in 1933 from an already d e p r e s s e d 1932 level, a n d it c h a n g e d relatively little from 1933 to 1936 (see Douglas L. Fleming 1984, 203). Because the generally improved financial condition of Atlanta's corporate c o m m u n i t y somewhat offset t h e effects of the reduced tax base, it was easier for the city to find sponsors for its scrip issues than it had been in 1932. In N o v e m b e r 1933 t h e city f o u n d itself again u n a b l e to m e e t its payroll, and $260,000 in scrip bearing 6 percent interest was printe d . The N o v e m b e r 1933 scrip apparently was not backed by any corporate sponsor and may not have b e e n issued. 3 4 The remainder of the city's financing n e e d s for 1933 was covered by a s u b s e q u e n t $500,000 scrip issue. However, t h e latter issue p r o b a b l y d i d not circulate since it was r e d e e m a b l e , at par, at several of the larger Atlanta banks who in turn resold t h e scrip t o t h e Coca-Cola C o m p a n y under an agreement with t h e city. This scrip issue bore a much-reduced interest rate of 2 percent. In N o v e m b e r 1934 the city tried to negotiate a loan for its year-end cash n e e d s from a group consisting of the city's banks and CocaCola. When these negotiations broke off, the city p l a n n e d scrip issues to m e e t payrolls for the last half of N o v e m b e r and all of December. City e m p l o y e e s were paid the issue for the last half of N o v e m b e r 1934, amounting to $200,000, on D e c e m b e r 5. Rich's immediately offered to r e d e e m all t h e scrip in cash, a n d presumably most of this issue e n d e d u p with Rich's a n d d i d n o t circulate as m o n e y . An a g r e e m e n t b e t w e e n t h e city a n d t h e CocaCola C o m p a n y was a n n o u n c e d D e c e m b e r 7, 25 w h e r e b y Coca-Cola a g r e e d t o a b s o r b t h e $400,000 scrip i s s u e n e e d e d t o m e e t t h e city's D e c e m b e r payrolls. As in 1933, the scrip was still p a i d o u t t o city e m p l o y e e s , w h o were a b l e to cash t h e scrip at various local b a n k s . B e c a u s e of t h e s p o n s o r s h i p of t h e 1934 i s s u e s b y Rich's a n d Coca-Cola, it is doubtful that much, if any, of these issues circulated as cash. According to City of Atlanta records, and to Mitchell and Shafer (1984), five more scrip issues were authorized and printed in 1935 and 1936. At the present time it is unclear how many of t h e s e actually circulated. C o n t e m p o r a r y newspaper accounts indicate that Trust Company Bank of Georgia was willing to cash the entire $800,000 a m o u n t of t h e N o v e m b e r 1935 issue. 35 A photograph of a canceled May 1936 scrip note in Mitchell and Shafer (1984, 64) also bears the Trust Company Bank logo, implying that the issue was absorbed by that bank. Atlanta's experience with municipal scrip issue suggests that such issues worked better as vehicles for emergency municipal financing than they d i d as circulating money. The ina b i l i t y of A t l a n t a ' s g o v e r n m e n t t o o b t a i n emergency financing for its cash n e e d s d i d little to enhance the fungibility of its scrip. Individuals or firms who had accepted the scrip also h a d an incentive to hold on to the scrip t o receive t h e p r o m i s e d interest p a y m e n t . Little in the historical evidence suggests that the Atlanta city scrip was widely used for any more than a single transaction. Still, t h e scrip d i d prove useful in avoiding a c o m p l e t e shutdown of city services during the fiscal crises brought on by the Great Depression. The fact that the Atlanta scrip was often d i s c o u n t e d suggests that the interest rate paid by t h e city was probably lower than what t h e city w o u l d have p a i d for financing t h r o u g h m o r e t r a d i t i o n a l c h a n n e l s . In t h i s sense, t h e scrip issue may have served as a politically acceptable m e t h o d of i m p o s i n g a temporary pay cut on municipal employees; it forced t h e m to a b s o r b t h e difference between the nominal (that is, face) and market valuation of the scrip issue. Valdosta a n d Phenix City. Atlanta's experience with municipal scrip was repeated on a smaller scale in o t h e r cities in t h e state. T h e City of V a l d o s t a i s s u e d "less t h a n 2 6 $10,000" in scrip on March 7, 1933, to meet its payroll while the banks were closed. 3 6 Apparently the Valdosta scrip bore no interest and was r e d e e m a b l e on or before July 1, 1933, at t h e o p t i o n of t h e city. N e w s p a p e r accounts d o not indicate whether the city's scrip circulated at par, b u t n u m e r o u s exhortations by civic leaders to " k e e p t h e city scrip circulating" i n d i c a t e that t h e city's scrip was less p o p u l a r than t h e s i m u l t a n e o u s l y circulating Savannah Clearing House scrip. 3 7 L i k e w i s e u n p o p u l a r was t h e m u n i c i p a l scrip issued by Phenix City, Alabama, which circulated in C o l u m b u s , Georgia, during the b a n k i n g h o l i d a y a l o n g s i d e scrip i s s u e d by t h e C o l u m b u s Clearing House. A particularly unattractive feature of t h e Phenix City scrip was its " s t a m p i n g " or "self-liquidating" req u i r e m e n t . As originally issued, t h e Phenix City scrip notes required with each use the cancellation of a c o u p o n on t h e back of the note, each cancellation costing the note holder t h r e e cents. The scrip c o u l d n o t b e red e e m e d until thirty-five c a n c e l l a t i o n s had b e e n performed or, at the latest, on March 18, 1935. The self-liquidating scheme was a comm o n feature of depression-era scrip issues, according to Harper (1948), who traced its origins to t h e Freiwirtscfiaft m o v e m e n t of early twentieth-century Germany. Early versions of t h e stamping scheme required periodic cancellation of the scrip coupons, whether it had b e e n used in a transaction or not. The basic idea b e h i n d stamping was to stimulate business activity by i m p o s i n g a tax on h o l d i n g money. However n o b l e the scheme's original intentions may have b e e n , in practice it usually a m o u n t e d to little more than a backhanded way of imposing a tax on transactions. The unpopularity of t h e Phenix City scrip led to several attempts to weaken the stamping requirement, as well as early retirement of the scrip issue. 3 8 According to Harper's (1948) accounts, such experiences characterized scrip issues with the stamping requirement. Other Cities. In addition to the cities ment i o n e d a b o v e , Harper (1948) lists issues of d e p r e s s i o n scrip b y Americus, D u b l i n , Macon, Sparta, a n d T h o m a s v i l l e . 3 9 O t h e r than the fact that the last two cities' scrip required stamps, relatively little information is availa b l e at t h e current time about these scrip is- E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 sues. According to Mitchell and Shafer (1984), the A m e r i c u s i s s u e was a u t h o r i z e d on February 1, 1933, in an a m o u n t not to exceed $10,000. M u n i c i p a l e m p l o y e e s received 40 percent of their pay in scrip for an unspecified period of time. William B. Williford (1975) notes that t h e Americus m u n i c i p a l scrip served as an emergency currency during the 1933 bank holiday. Nancy B. Anderson (1979) states that Macon paid its e m p l o y e e s in scrip for a period of about o n e year. Though technically not a municipal issue, s o m e scrip was issued by t h e Sea Island C o m p a n y d u r i n g the 1933 b a n k holiday to serve residents of the resort as an emergency currency. 40 Details concerning the amounts, duration, and valuation of these issues are being investigated. Fulton County. Harper (1948) also lists a scrip issue by Fulton County. The scrip issue was small and of short duration, b u t a n u m b e r of interesting circumstances surrounded the county's d e c i s i o n to issue scrip. The proximate cause of the issue was a demonstration at the Fulton County courthouse on June 30, 1932, in which almost o n e t h o u s a n d p e o p l e participated. Local C o m m u n i s t s o r g a n i z e d the demonstration in response to the Fulton County commissioners' decision to cut relief e x p e n d i t u r e s in t h e face of falling tax revenues (Kuhn, Joye, and West 1990, 206).41 O n July 1 t h e c o m m i s s i o n e r s v o t e d t o spend $6,000 on a program "to support paupers." An additional $2,000 was voted to this program on July 29, a n d the program was continued until S e p t e m b e r 21, 1932.42 Contemporary newspaper accounts indicate that this relief effort largely c o n s i s t e d of e m p l o y i n g jobless m e n to h e l p maintain county parks. The m e n were p a i d in scrip, which was red e e m a b l e in food staples at a county commissary. W o m e n a n d d i s a b l e d m e n w e r e given t h e scrip w i t h o u t b e i n g r e q u i r e d t o work. 43 It is not known whether any of the Fulton County scrip ever circulated. Given that the scrip was issued in bearer form, it seems reasonable to assume that s o m e of it did. To the author's knowledge, Fulton County's was the only scrip issue in the state m a d e for the explicit purpose of providing relief to the une m p l o y e d , although Harper (1948) lists five municipalities in other states that had similar relief programs. FEDERAL R E S E R V E BANK O F ATLANTA Some Lessons from Georgia's Depression Scrip Experience M o n e t a r y systems h a v e historically consisted of a combination of private and p u b l i c money, s o m e t i m e s called "inside" a n d "outs i d e " m o n e y . The U.S. m o n e t a r y system in 1990 is no exception: outside m o n e y such as cash circulates alongside inside m o n e y such as m o n e y market mutual funds. This pattern is l i k e l y t o c o n t i n u e , a l t h o u g h some economists have considered the possibility of an entirely private monetary system (for example, Lawrence H. White 1989). In a quantitative sense, private or inside m o n e y has in recent years b e c o m e increasingly important in our economy. The impact of deregulation a n d technological innovation has been to create a large new set of financial instruments that possess s o m e degree of "moneyness." In such an e n v i r o n m e n t , t h e d e p r e s s i o n scrip experience in Georgia, a n d in the Unite d States more generally, provides s o m e int e r e s t i n g l e s s o n s as t o t h e u s e f u l n e s s of certain forms of private money. The depression scrip issues essentially represented att e m p t s t o c r e a t e forms of p r i v a t e m o n e y whose acceptability would match that of cash, at least in t h e community where they were issued. Given the current pace of technological change in the financial services industry, it is conceivable that private instruments of a similar nature c o u l d circulate s o m e t i m e in t h e foreseeable future. 44 T h e m o s t o b v i o u s i m p l i c a t i o n of t h e e p i s o d e s d e s c r i b e d a b o v e is that t h e real b i l l s d o c t r i n e was as a p p l i c a b l e in 1930s Georgia as anywhere else; that is, scrip notes issued in excess of the value of their backing were likely to b e d e e p l y discounted or simply not a c c e p t e d as p a y m e n t for g o o d s or services. The c l e a r i n g h o u s e scrip issues of 1933 largely circulated at par because of the virtual certainty of b e i n g a b l e to exchange t h e scrip for Federal Reserve notes, usually after a few days or weeks from the date of the scrip issue. The clearinghouse certificates were in e s s e n c e b a c k e d b y t h e p r o v i s i o n s of t h e Emergency Banking Act that drastically liberalized collateral r e q u i r e m e n t s for a d v a n c e s from t h e d i s c o u n t w i n d o w s at t h e district 27 Federal Reserve banks. By contrast, the municipal issues studied thus far were often discounted or simply not accepted as payment. The public's reluctance to accept the municipal scrip reflected the fact that these issues were backed only by the uncertain flow of fut u r e p r o p e r t y tax r e c e i p t s a n d w e r e red e e m a b l e only after a period of months or even years. The very issue of the municipal scrip, particularly in the case of Atlanta, signaled an unusual disruption in the flow of tax receipts. U n d e r such circumstances, s o m e discounting of the municipal issues would be expected to get p e o p l e to bear t h e risk of holding scrip that might not be promptly redeemed. A second lesson that can be gleaned from the municipal scrip issues is that their riskiness severely l i m i t e d t h e i r u s e f u l n e s s as transactions instruments. The risk associated with the municipal issues could and often d i d result in a high rate of return for those who accepted the scrip at a discount and held it until the promised date of redemption. The presence of such high returns effectively divided the public into those p e o p l e willing to accept the risk of holding the scrip at the going rate(s) of discount and those who were not willing to h o l d t h e scrip. O n c e an exchange took place between members of the two groups, further use of the scrip in transactions was unlikely. A third implication can be drawn from the experience with stamped or self-liquidating scrip issued by Phenix City, A l a b a m a , that was used in Columbus. The unpopularity of this issue, relative to the scrip issued by the C o l u m b u s Clearing House Association, suggests such self-liquidating instruments will not b e used when alternative means of payment are available. Given that the only real backing behind such an issue was a claim to tax receipts generated by its own use, it is not surprising that the public preferred to use scrip that did not require the payment of this tax. By using the clearinghouse scrip (or cash) instead of the stamped municipal scrip, residents of Columbus were able to avoid the tax on t r a n s a c t i o n s i m p o s e d by t h e s t a m p e d scrip as well as any uncertainty concerning redemption of the municipal issue. Research to this point has provided only a t h u m b n a i l sketch of Georgia's experience with scrip m o n e y during t h e Great Depression. Many more details are n e e d e d to better evaluate the success of the scrip issues described a b o v e , a n d no d o u b t other issues have not yet been discovered. O n e important area that needs to b e addressed is the legal status of the various scrip issues. The clearinghouse scrip issues of 1933 were issued under authority of the secretary of the treasury, b u t t h e c o n d i t i o n s u n d e r which t h e issues were approved are not known. It is also not known how or why the depression scrip issues were able to avoid the restrictions imposed by federal banking law on bank note issue. A n o t h e r area t h a t n e e d s t o b e addressed is the possible use of scrip issued by textile mills a n d other private firms during the 1933 banking holiday. Future research by the author in this area will aim to provide a m o r e c o m p l e t e p i c t u r e of this fascinating e p i s o d e in U.S. monetary history. 45 Notes 'To b e m e a n i n g f u l , this legal standard had to be 2 b a c k e d b y t h e w i l l i n g n e s s of t h e U.S. Treasury a n d pri- Article I, s e c t i o n 10 of t h e C o n s t i t u t i o n p r o h i b i t s t h e v a t e b a n k s to e x c h a n g e g o l d for p a p e r m o n e y . P e r i o d s w h e n h o l d e r s of e i t h e r g o v e r n m e n t or p r i v a t e b a n k s ' states t h e m s e l v e s from issuing p a p e r m o n e y . i n o t e s w e r e u n a b l e to carry o u t this e x c h a n g e w e r e gen- "soap wrappers" a n d "doololly." 4 convertibility that occurred u n d e r the gold standard h a v e b e e n i g n o r e d . Also, t h e " b i m e t a l l i c " s t a n d a r d of the late ninetenth century has b e e n ignored. See T h e r e w e r e a l m o s t as m a n y n a m e s for s c r i p as t h e r e w e r e issues. Two of t h e a u t h o r ' s p e r s o n a l favorites are erally referred to as " s u s p e n s i o n s of c o n v e r t i b i l i t y . " For p u r p o s e s of t h i s s u r v e y , t h e v a r i o u s s u s p e n s i o n s of S e e H u n t i n g t o n a n d M a w h i n n e y (1910, 379 a n d 424). S e e K e n n e d y (1973, c h a p t e r 4) for a d e t a i l e d a c c o u n t of t h e M i c h i g a n crisis. 5 6 Atlanta ¡ournal, March 3, 1933. S e e Burns (1974, 44-45). H a r p e r (1948, 90-92) n o t e s that F r i e d m a n a n d Schwartz (1963) o r T i m b e r l a k e (1978) for Professor Irving Fisher was a m o n g t h e m o s t enthusias- an i n t r o d u c t i o n to t h e s e topics. tic s u p p o r t e r s of a n a t i o n w i d e scrip issue. 2 8 E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 7 8 Atlanta journal, See also March 13, 1933. Atlanta Constitution, 2 6 F i g u r e s for 1929 a r e from U.S. B u r e a u of t h e C e n s u s (1975, 243). A d j u s t m e n t to 1990 d o l l a r s u s e s t h e Con- Atlanta 28 of inflation o v e r l o n g t i m e p e r i o d s . "Scrip M e a n s G o o d or 11, March 6, 1933. 3 1 For T a l m a d g e ' s f a v o r a b l e view of scrip, s e e Macon Tele- 32 M a r c h 13, 1933; a l s o L e m m o n (1952, 148). For T a l m a d g e ' s v e t o of t h e s t a t e b a n k i n g bill, s e e Constitution, S e e K u h n e t ai. (1990, 144-45 a n d 201); a l s o u n p u b - S e e A t l a n t a C l e a r i n g H o u s e A s s o c i a t i o n (1950, 36-47). 33 A l m o s t all of t h e e n a b l i n g r e s o l u t i o n s in T a b l e 1 h a v e a 34 S e e Atlanta City C o u n c i l M i n u t e s , N o v e m b e r 20, 1932, are from R a n d M c N a l l y (1933, 57-58). c l a u s e t o this effect. T h e A C H A c a l l e d off t h e s c r i p i s s u e w h e n it b e c a m e a n d M i t c h e l l a n d Shafer (1984, 62), T h e c l e a r t h a t c o n g r e s s i o n a l p a s s a g e of t h e tion, Emergency B a n k i n g Act w o u l d a l l o w all cash n e e d s to b e m e t in Atlanta Constitution on March 10 for p u r p o s e s of m e e t i n g p a y r o l l s a n d o t h e r s u c h " e m e r g e n c i e s . " J u d g i n g from t h e e x p e r i e n c e of G e o r g i a c o m m u n i t i e s w h e r e scrip was i s s u e d , t h e early a v a i l a b i l i t y of t h i s " e m e r g e n c y " currency was p r o b a b l y Valdosta Times, Valdosta Times, 36 3 7 Chronicle, March 7, 1933. Augusta Chronicle, March Columbus 38 Augusta Chronicle, March 22, 1933; April 5, 1933. Accord- H o l m e s (1974, 326) m e n t i o n s t h e u s e of m u n i c i p a l scrip Brunswick News, March 7, 1933. 41 S e e a l s o t h e m i n u t e s of t h e F u l t o n C o u n t y B o a r d of 42 M i n u t e s of t h e Fulton C o u n t y Board of C o m m i s s i o n e r s C o m m i s s i o n e r s , June 25, 1932. March 16, 1933, p u t s t h e circula- on t h e i n d i c a t e d d a t e s . tion at a r o u n d $200,000. M i t c h e l l a n d Shafer (1984) p u t 4 3 t h e circulation of t h e A u g u s t a issue at a b o u t $275,000. 44 Columbus Enquirer, Enquirer, in A m e r i c u s a n d T h o m a s v i l l e . t h e scrip m e a n s t h a t p r i c e s p a i d b y h o l d e r s of s c r i p The March 16, 1933; March 23, 1933; March 25, was retired b y J u n e 26, 1933. 4 0 were t h e s a m e as c u s t o m a r y cash prices. March 7, 1933; March 8, 1933. ing t o M i t c h e l l a n d S h a f e r (1984, 30), t h e e n t i r e issue Augusta 11-14, 1933. "Par" v a l u a t i o n of N o v e m b e r 5, 1935; N o v e m b e r 7, 1933. 39 "Local C l e a r i n g H o u s e Perfects Cash Program," Constitution, 1935. an i m p o r t a n t factor in t h e Atlanta b a n k s ' d e c i s i o n n o t to issue scrip. Constitu- b u t n o r e p o r t of its issue has b e e n f o u n d . indicated that the clearinghouse b a n k s were already o p e n Atlanta N o v e m b e r 21, 1933, m e n t i o n s p r i n t i n g of t h e scrip Atlanta Federal R e s e r v e n o t e s . A March 13 r e p o r t in t h e McDonald, cal Society. 14 l8 D e c e m b e r 20, 1932; F e b r u a r y 16, L i v i n g A t l a n t a Oral History C o l l e c t i o n , Atlanta Histori- March 14, 1933. January 1933 figures on t h e c l e a r i n g h o u s e a s s o c i a t i o n s 1 7 D e c e m b e r 16, 1932. l i s h e d p o r t i o n s of an i n t e r v i e w with H u g h Atlanta 13 16 Decem- 1933. graph, 15 Atlanta Constitution, F e b r u a r y 16-20, 1933. Atlanta Constitution, Atlanta Constitution, "Ibid. 12 19, 1932; J a n u a r y 2, 1933; F e b r u a r y 3, 1933; b e r 13-20, 1932; J a n u a r y 29, 1933; F e b r u a r y 7, 1933; 3 0 Atlanta Constitution, A t l a n t a City C o u n c i l M i n u t e s , D e c e m b e r 15, 1932; DeF e b r u a r y 6, 1933. S e e a l s o 1933. 1 0 16, F l e m i n g (1984, 203) p r e s e n t s f i g u r e s t h a t p u t t h e as- cember Atlanta journal, M a r c h 7, 1933, Business," Columbus Enquirer, March D e c e m b e r 20, 1932; F e b r u a r y 1930, $425 m i l l i o n for 1931, a n d $381 m i l l i o n for 1932. 29 S e e , for e x a m p l e , " B u s i n e s s Q u i c k l y R e s t o r e d b y Atl a n t a S c r i p in 1907," journal, s e s s e d v a l u e of t h e city's tax b a s e at $418 m i l l i o n for p r o b a b l y a b o v e t h e 1933 level, a n d t h e inflation of this 9 Atlanta 14, 1930; 1933; D e c e m b e r 5, 1934. of t h e u s e of t h e 1929 p e r s o n a l i n c o m e figure, w h i c h is figure u s i n g t h e CPI, which t e n d s to o v e r s t a t e t h e rate Constitution, 27 s u m e r Price I n d e x (CPI). T h e e s t i m a t e in 1990 d o l l a r s is p r o b a b l y b e s t t h o u g h t of as an u p p e r b o u n d b e c a u s e December D e c e m b e r 18-19, 1930. Atlanta Constitution, As noted July 12-14, 1932. in W h i t e (1989), t h e c r e a t i o n of par- 19 See 20 L u t t r e l l s e r v e d as secretary t o t h e C o l u m b u s C l e a r i n g lake (1978) n o t e s t h a t U.S. travelers c h e c k s o f t e n serve H o u s e A s s o c i a t i o n for t h e d u r a t i o n of t h e scrip issue. as a quasi-currency in foreign markets. M a r c h 7-14, 1933; a l s o L u t t r e l l a c c e p t a n c e a u t o m a t i c t e l l e r m a c h i n e (ATM) n e t w o r k s (no d a t e , 11). c o n s t i t u t e s a significant s t e p in t h i s d i r e c t i o n . T i m b e r - Macon Telegraph, March 7-15, 1933. Savannah Evening Press, March 8-14, 1933. Valdosta Times, M a r c h 7-29, 1933; Brunswick 45 2 1 22 23 2 4 25 News, The author would welcome any information concerning d e p r e s s i o n scrip i s s u e s in G e o r g i a a n d n e a r b y s t a t e s from p e o p l e w h o h a d p e r s o n a l e x p e r i e n c e with scrip. M a r c h 7-23, 1933. P l e a s e c o n t a c t t h e a u t h o r at: R e s e a r c h Brunswick F e d e r a l R e s e r v e B a n k of A t l a n t a , 104 M a r i e t t a Street, News, March 7-23, 1933. Department, P o p u l a t i o n a n d school e n r o l l m e n t e s t i m a t e s are t h o s e N.W., Atlanta, G e o r g i a 30303-2713; t e l e p h o n e 404/521- r e p o r t e d in R a c i n e (1969). 8970. Bibliography A n d e r s o n , N a n c y B. Macon. Virginia Beach: D o w n i n g Com- p a n y , 1979. 1930-December 1936. Association Atlanta Clearing House 1932-1949. P u b l i s h e r u n k n o w n , 1950. Digitized F E D for E R AFRASER L R E S E R V E B A N K O F ATLANTA D e c e m b e r 1 9 3 0 - D e c e m b e r 1935. Atlanta Historical Society. L i v i n g Atlanta Oral History Col- Atlanta City C o u n c i l M i n u t e s . N o v e m b e r Atlanta C l e a r i n g H o u s e Association. Atlanta Constitution, lection. Atlanta journal, D e c e m b e r 1 9 3 0 - D e c e m b e r Augusta Chronicle, March 1933. 1935. 29 Bank- B o a r d of G o v e r n o r s of t h e F e d e r a l R e s e r v e S y s t e m . ing and Monetary Statistics. W a s h i n g t o n , D.C.: N a t i o n a l pression Scrip of the United States, News, March 1933. Burns, H e l e n M. Deal Banking Tfie American Banking Community and New Reforms: 1933-1935. W e s t p o r t , Ct.: G r e e n - Atlanta City Charter. Columbus Enquirer, March 1933. Rand McNally a n d C o m p a n y . Palgrave-. A Dictionary of Economics. Vol. 2. L o n d o n : Ecke, M e l v i n W. From Ivy Street to Kennedy Center: A nial History of the Atlanta Public School System. Centen- Atlanta: At- F l e m i n g , D o u g l a s L. " A t l a n t a , t h e D e p r e s s i o n a n d t h e N e w D e a l . " Ph.D. d i s s e r t a t i o n , E m o r y University, 1984. F r i e d m a n , M i l t o n , a n d A n n a ). Schwartz. A Monetary History 1867-1960. P r i n c e t o n , N.).: Princeton Harper, )oel W. "Scrip a n d O t h e r F o r m s of Local M o n e y . " March 1933. about B a n k i n g Panics." Federal R e s e r v e B a n k of Atlanta Economic Review 73 ( N o v e m b e r / D e c e m b e r 1988): 2-21. United The Origins of Central Banking in the Stales. C a m b r i d g e , M a s s . : H a r v a r d University Press, 1978. . " T h e S i g n i f i c a n c e of U n a c c o u n t e d journal of Economic History ciations." Currencies." 41 ( D e c e m b e r 1981): 853-66. journal of Money, Credit, and Banking 16 (Febru- H o l m e s , M i c h a e l S. " F r o m E u p h o r i a t o Cataclysm: Georgia C o n f r o n t s t h e G r e a t D e p r e s s i o n . " Georgia Historical 58 (Fall 1974): 326. H u n t i n g t o n , A.T., a n d R o b e r t ). M a w h i n n e y . Laws of United States Concerning Money, Banking, the and Loans, 1778- 1909. N a t i o n a l M o n e t a r y C o m m i s s i o n . Washington, Crisis of 1933. L e x i n g t o n , History of the City of Money, U.S. B u r e a u of t h e C e n s u s . States, Colonial Times to 1914-1948. A t h e n s , Ga.: University of G e o r g i a Press, 1990. L e m m o n , S a r a h M . " T h e P u b l i c C a r e e r of E u g e n e Talmadge-. 1926-36." P h . D . d i s s e r t a t i o n , University of North Credit, and Banking 19 Historical Statistics of the United 1970. W a s h i n g t o n , D.C.: U.S. Gov- e r n m e n t Printing Office, 1975. Annual U.S. C o m p t r o l l e r of t h e Currency. Report. Washing- t o n , D.C.: U.S. G o v e r n m e n t Printing Office, 1908. March 1933. W h i t e , L a w r e n c e H. " W h a t K i n d s of M o n e t a r y I n s t i t u t i o n s W o u l d a Free Market D e l i v e r ? " Ky.: University of K e n t u c k y Press, 1973. K u h n , Clifford M., H a r l o n E. Joye, a n d E. B e r n a r d West. An Oral journal ( N o v e m b e r 1987): 437-47. Valdosta Times, D.C.: U.S. G o v e r n m e n t Printing Office, 1910. The Banking . "Private P r o d u c t i o n of S c r i p - M o n e y in t h e I s o l a t e d Community." Ph.D. d i s s e r t a t i o n , University of C h i c a g o , 1948. Atlanta: Evening Press, ary 1984): 1-15. S e p t e m b e r 1932. Living N e w York: . "The Central B a n k i n g R o l e of C l e a r i n g h o u s e Asso- University Press, 1963. F u l t o n C o u n t y B o a r d of C o m m i s s i o n e r s M i n u t e s , june- K e n n e d y , S u s a n E. Savannah T i m b e r l a k e , Richard H. l a n t a B o a r d of E d u c a t i o n , 1972. Quarterly Bankers Directory. R a n d M c N a l l y a n d Co., 1933. T a l l m a n , Ellis W . " S o m e U n a n s w e r e d Q u e s t i o n s M a c m i l l a n Press Ltd., 1987. of the United States-. c a t i o n s , 1984. Racine, P h i l i p N. "Atlanta's S c h o o l s : A History of t h e PubUniversity, 1969. 1924. Eatwell, ) o h n , Murray M i l g a t e , a n d Peter N e w m a n , e d s . New Standard Catalog of De- lola, Wise.: K r a u s e Publi- lic S c h o o l S y s t e m 1869-1955." P h . D . d i s s e r t a t i o n , Emory w o o d Press, 1974. City of Atlanta. The March 1933. M i t c h e l l , R a l p h A., a n d N e i l Shafer. C a p i t a l Press, 1943. Brunswick Luttrell, W. Roy, Sr. U n p u b l i s h e d m e m o i r s , n o d a t e . Macon Telegraph, Cato journal 9 (Fall 1989): 367-91. Wicker, E l m u s R. Federal Reserve Monetary Policy, 1917-1933. N e w York: R a n d o m H o u s e , 1966. W i l l i f o r d , W i l l i a m B. Americus through the Years. Atlanta: C h e r o k e e P u b l i s h i n g C o m p a n y , 1975. Carolina at C h a p e l Hill, 1952. 30 E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 Federal Reserve Bank of Atlanta, through its p u b l i c information d e p a r t m e n t , produces a variety of publications a n d other materials d e a l i n g with e c o n o m i c a n d financial topics. These materials a p p e a l to a wide audience, from s t u d e n t s a n d teachers of e c o n o m i c s to bankers, business p e o p l e , and professional economists. A recently p u b l i s h e d Publications brochure details t h e many types of information a v a i l a b l e from t h e Atlanta Fed, from p a m p h l e t s on electronic f u n d s transfer to videos on the evolution of money. All are offered free or at m i n i m a l cost. To order the Publications brochure write to the Public Information Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713, or call 404/521-8788. Inflation and the Dollar Index Karen R. Hunter n 1986 the Atlanta Fed first p u b l i s h e d its dollar index to provide an u p d a t e d summary measure of the dollar's global value. Recently, a few of the eighteen countries within t h e Atlanta Fed trade-weighted dollar index have been experiencing inflation that is higher than the U.S. rate, prompting concern that the Atlanta Fed dollar index may have become a less accurate measure of the dollar's real value. The Atlanta Fed dollar index, as well as a host of other new and existing indexes, was specified as an aggregate measure, a summary statistic of the dollar's average value against the currencies of the world. The recent proliferation of currency indexes may b e a product of the emergence of large bilateral trade imbalances since 1982.1 Because trade imbalances are often attributed to over- or undervalued currencies, a sin- I Ai the time this article was written, the author was an economic analyst in the macropolicy section of the Atlanta Fed's research department. She is grateful to Mary Rosenbaum, Sheila Tschinkel, Frank King, and Steve Feinstein for helpful comments and to Mike Chriszt and leff Watson for research assistance. 3 2 gle statistic c a p a b l e of tracking t h e dollar's value could b e helpful in exploring trade issues. The Atlanta Fed dollar index is constructed using nominal exchange rates weighted by a country's share of U.S. trade. Because each c o m p o n e n t country's exchange rate is not a d j u s t e d for inflation, o n e of the important criteria when considering whether to include a country in t h e i n d e x is that its inflation track U.S. inflation fairly closely. Otherwise, changes in exchange rates would reflect relat i v e price m o v e m e n t s b e t w e e n countries in a d d i t i o n to changes in real, or inflationadjusted, value. If all the countries in an index are nearly price-stable or are inflating at similar rates, then a nominal index such as the Atlanta Fed's index behaves like a real, or price-deflated, index. If inflation rates diverge a m o n g countries in an index, t h e n a nominal index may be distorted or biased in its representation of changes in real value among currencies. The purpose of this article is to examine whether or not the nominal Atlanta dollar index remains a reasonable proxy E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 for t h e d o l l a r ' s a v e r a g e real v a l u e , g i v e n changes in t h e rate of price change in several c o u n t r i e s i n c l u d e d in t h e i n d e x . This study is also an examination of t h e i m p a c t of inflation differentials on various regional s u b i n d e x e s into which t h e Atlanta F e d index is d i v i d e d . Japan have b e e n d e f i n e d . See Table 1 for a list of the eighteen countries, weights, and the c o m p o s i t i o n of t h e s u b i n d e x e s . Charts 1-5 show t h e m o v e m e n t of t h e n o m i n a l Atlanta F e d i n d e x a n d s u b i n d e x e s s i n c e 1981. It should be noted that the scale of the charts is not uniform. Currency Fluctuations Inflation Rates Since the 1973 conversion to a floating exchange rate system, currencies have not only f l u c t u a t e d w i d e l y in v a l u e b u t a l s o h a v e moved by disparate margins against the dollar. For example, the yen depreciated roughly 14.7 percent and the Deutschemark declined 43.8 percent in value versus t h e dollar from 1982 to 1985, while the Canadian dollar depreciated 16.1 percent against the dollar over the s a m e p e r i o d . Clearly, any o n e bilateral exchange rate is an unsuitable measure of the dollar's overall international value. It is, however, possible to c o m b i n e , or average, bilateral e x c h a n g e rates t o g e t an i d e a of t h e dollar's average m o v e m e n t . Giving each currency within this average equal weight w o u l d b e i m p r u d e n t since individual fluctuations in each exchange rate are n o t of e q u a l i m p o r t a n c e t o t h e U.S. economy. Within the Atlanta Fed index t h e currencies are weighted by their respective p r o p o r t i o n of t r a d e (exports p l u s i m p o r t s ) with the United States in 1984. For e x a m p l e , C a n a d a , t h e U n i t e d States' largest t r a d i n g partner, has t h e highest weight, 0.288, of t h e currencies in t h e index. Japan, t h e nation's second largest trading partner, has a weight of 0.213. W h e n t h e index shows that t h e dollar a p p r e c i a t e d 28.8 p e r c e n t a g a i n s t t h e eighteen currencies in t h e Atlanta Fed dollar index from 1982 to 1986, it is u n d e r s t o o d that t h e dollar d i d not rise uniformly against all currencies b u t that, on average, it appreciated by 28.8 percent. The Atlanta Fed dollar index is also divided into regional s u b i n d e x e s since countries within a particular region may h a v e similar trading patterns with a third country and their currencies often m o v e together. S u b i n d e x e s for Europe, Canada, Asia, and Asia excluding FEDERAL R E S E R V E BANK O F ATLANTA From the beginning, the countries included in the nominal Atlanta Fed trade-weighted index were chosen to cover the largest a m o u n t of U.S. trade p o s s i b l e (roughly 80.0 percent) while limiting the n u m b e r of currencies according to certain criteria. 2 Although an index might ideally encompass all U.S. trading partners, inclusion of either countries with high inflation relative to that of t h e United States or d e v e l o p i n g countries that e m p l o y m u l t i p l e exchange rates w o u l d i n t r o d u c e a bias. 3 A country such as Mexico, the United States' third-largest trading partner, has b e e n excluded from the index because of its historically high inflation rates a n d the tiered exc h a n g e rate in e f f e c t d u r i n g m u c h of t h e 1980s. Creating the Atlanta Fed index so that the average inflation rate of t h e countries in t h e index a p p r o x i m a t e d that of t h e U n i t e d States generated an index that could function as a r e a s o n a b l e proxy for a real aggregate d o l l a r index, with t h e a d d e d a d v a n t a g e of timeliness. Because nominal exchange rates, which are a v a i l a b l e daily a n d i m m e d i a t e l y , are e m p l o y e d in t h e index, it is p o s s i b l e to g e n e r a t e a d a i l y A t l a n t a Fed d o l l a r i n d e x . Timely, high-frequency price data necessary for a d e f l a t e d , or real dollar, index are less available. Several countries, primarily those included in the Asian subindex, have experienced accelerating inflation in the late 1980s. Although comparatively high, these inflation rates, with the exception of China's, have been generally in line with those found in other industrialized countries. For e x a m p l e , in 1989, prices increased 7.6 percent in Australia, 9.7 percent in Hong Kong, and 7.8 percent in the United Kingdom, compared with an inflation rate of a r o u n d 4.5 p e r c e n t for m o s t i n d u s t r i a l i z e d 33 Table 1. Atlanta Fed Trade-Weighted Currency Index and Subindexes* Country Exports Imports Sum Percent of Total Canada Japan United Kingdom West Germany Taiwan Korea France Italy Hong Kong Netherlands Saudi Arabia Belgium Singapore Australia China Switzerland Spain Sweden 46,524 23,575 12,210 9,084 4,775 5,983 6,037 4,375 3,062 7,554 5,564 5,301 3,675 4,793 3,004 2,563 2,561 1,542 66,911 60,371 15,044 17,810 14,772 10,027 8,516 8,504 8,899 4,329 4,009 3,287 4,121 2,899 3,381 3,199 2,628 3,427 113,435 83,946 27,254 26,894 19,547 16,010 14,553 12,879 11,961 11,883 9,573 8,588 7,796 7,692 6,385 5,762 5,189 4,969 28.768 21.289 6.912 6.820 4.957 4.060 3.691 3.266 3.033 3.014 2.428 2.178 1.977 1.951 1.619 1.461 1.316 1.260 152,182 242,134 394,316 Totals 100.00 European Subindex United Kingdom West Germany France Italy Netherlands Belgium Switzerland Spain Sweden 12,210 9,084 6,037 4,375 7,554 5,301 2,563 2,561 1,542 15,044 17,810 8,516 8,504 4,329 3,287 3,199 2,628 3,427 27,254 26,894 14,553 12,879 11,883 8,588 5,762 5,189 4,969 Totals 51,227 66,744 117,971 23.102 22.797 12.336 10.917 10.073 7.280 4.884 4.399 4.212 100.00 * Trade weights reflect total trade in 1984. Each weight is defined as a country's total trade with the United States (exports plus imports) divided by total trade of the United States with the eighteen countries. Exports and imports are given in millions of U.S. dollars. Source: Direction of Trade Statistics, International Monetary Fund, 1984; Federal Reserve Bank of Atlanta. 3 4 E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 Table 1 (continued) Country Exports Imports Sum Percent of Total 54.746 12.748 10.441 7.800 5.084 5.016 4.164 Asian Subindex Japan Taiwan Korea Hong Kong Singapore Australia China 23,575 4,775 5,983 3,062 3,675 4,793 3,004 60,371 14,772 10,027 8,899 4,121 2,899 3,381 83,946 19,547 16,010 11,961 7,796 7,692 6,385 Totals 48,867 104,470 153,337 100.00 Asia-excluding-Japan Subindex Taiwan Korea Hong Kong Singapore Australia China Totals 4,775 5,983 3,062 3,675 4,793 3,004 14,772 10,027 8,899 4,121 2,899 3,381 19,547 16,010 11,961 7,796 7,692 6,385 25,292 44,099 69,391 28.169 23.072 17.237 11.235 11.085 9.201 100.00 countries. In China prices a d v a n c e d 16.3 per- Nominal-Real Differential cent last year. To m e a s u r e i n f l a t i o n ' s d i s t o r t i o n of t h e and T h e level of t h e real Atlanta Fed d o l l a r in- s u b i n d e x e s are c o n s t r u c t e d . M o r e specifi- n o m i n a l d o l l a r i n d e x , a real i n d e x dex i n d i c a t e s what t h e v a l u e of t h e n o m i n a l cally, t h e n o m i n a l d o l l a r i n d e x is d e f l a t e d index w o u l d b e w i t h o u t t h e p r e s e n c e of infla- by t h e r e l a t i v e rate of c o n s u m e r p r i c e in- tion. A p o s i t i v e difference b e t w e e n t h e nom- creases, a c a l c u l a t i o n t h a t g e n e r a t e s a real inal a n d t h e real d o l l a r i n d e x i n d i c a t e s t h a t dollar i n d e x . 4 The various exchange rates c u m u l a t i v e average inflation in t h e e i g h t e e n that c o n s t i t u t e t h e t r a d e - w e i g h t e d countries has b e e n a b o v e U.S. inflation a n d index a n d s u b i n d e x e s are d e f l a t e d b y t h e infla- that t h e n o m i n a l i n d e x has b e e n p u s h e d up- tion d i f f e r e n t i a l b e t w e e n t h e U n i t e d S t a t e s w a r d b y t h e p r e s e n c e o f i n f l a t i o n (in t h e a n d t h e c o u n t r y in t h e b i l a t e r a l c o m p a r i s o n . countries in t h e index) in excess of U.S. infla- These m e a s u r e s h a v e p r o d u c e d b o t h a tion. A negative nominal-real n o m i n a l a n d real i n d e x a n d s u b i n d e x for m e a n s t h a t c u m u l a t i v e a v e r a g e i n f l a t i o n in each p e r i o d c o v e r e d b y t h e o r i g i n a l nomi- t h e e i g h t e e n countries has b e e n b e l o w U.S. nal i n d e x a n d s u b i n d e x e s . inflation and that the nominal index F E D Efor R A LFRASER R E S E R V E B A N K O F ATLANTA Digitized differential has 35 b e e n p u l l e d d o w n by d i s p a r i t i e s in price pressures. Alternatively, if all the countries in t h e i n d e x h a d t h e s a m e i n f l a t i o n rate, even if it were not zero, t h e n o m i n a l a n d real indexes would b e identical and the correlation b e t w e e n t h e two measures w o u l d b e 1.0. Chart 1 shows that while the nominal and real indexes have moved together, the nominal i n d e x r e m a i n e d a b o v e t h e real i n d e x for much of the 1980s, when the weighted average of inflation for the eighteen currencies in the Atlanta Fed index exceeded that of the United States. Charts 2-5 show the experie n c e for t h e s u b i n d e x e s , which is m i x e d . Since both the real and nominal dollar indexes are averages of currency movements, it is to b e expected that the individual subindexes, b o t h real a n d n o m i n a l , will experience more variability than the aggregated indexes (see Charts 6 and 7). 1986 the greatest regional inflation outliers were in Europe. The chief culprits were Italy and France, where inflation averaged 9.4 perc e n t a n d 5.2 p e r c e n t , r e s p e c t i v e l y , well above that of West Germany (Economist Intelligence Unit 1989, 191). Since 1986 closer alignment of European economic policies has b e e n reflected in the uniformly lower inflation rates in these countries, a tendency reinforced by their continued participation in the Exchange Rate Mechanism of the European Monetary System (EMS). More recently, inflation in the United Kingdom has exceeded the EMS average by margins substantial enough to skew the European index. The average inflation rate for EMS countries is currently around 4.0 percent annually. 5 The largest differentials between the real and nominal subindexes occur in the Europ e a n subindex (see Chart 2). From 1982 to 3 6 Of t h e four s u b i n d e x e s , o n l y t h e real Asian subindex lies a b o v e its nominal counterpart, reflecting the large weight of Japan (roughly 55 percent of the total; see Chart 3), which has had very low inflation relative to t h e U n i t e d S t a t e s o v e r t h e p e r i o d . The Japanese influence on the Asian s u b i n d e x Chart 1. Atlanta Fed Dollar Index (1980=100) E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 Chart 2. Atlanta Fed Dollar European Subindex F E D E R Afor L RFRASER E S E R V E B A N K O F ATLANTA Digitized (1980=100) Chart 3. Atlanta Fed Dollar Asian Subindex (1980=100) 37 38 Chart 4. Atlanta Fed Dollar Asia-excluding-Japan Subindex (1980=100) Chart 5. Atlanta Fed Dollar Canadian Subindex (1980=100) E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 Chart 6. Atlanta Fed Dollar Canadian and European Subindexes (1980=100) Chart 7. Atlanta Fed Dollar Asian and Asia-excIuding-Japan Subindexes FEDE R AFRASER L R E S E R V E BANK O F ATLANTA Digitized for (1980=100) 39 is c l e a r w h e n t h e A s i a - e x c l u d i n g - J a p a n subindex is considered (see Chart 4). Unlike the Canadian and European averages in the past three years, the divergence of inflation d i f f e r e n t i a l s in t h e Asia-excluding-Japan subindex has widened, undoubtedly because of the increased inflationary pressures in Australia, Hong Kong, a n d China. According to the Asian and Asia-excluding-Japan subindexes, inflation rates in Japan have also b e e n substantially lower than inflation rates in other Asian countries. The n o m i n a l - r e a l g a p on t h e C a n a d i a n subindex is considerable since Canada has a large cumulative inflation differential against the United States (see Chart 5). This gap app e a r s in part b e c a u s e C a n a d a is t h e s o l e country within its subindex so that, unlike the other subindexes, no other countries balance out Canada's higher inflation. Of the four subindexes, three show large p o s i t i v e d i v e r g e n c e s from t h e U.S. retail price history. Over t h e p e r i o d as a whole, t h e E u r o p e a n , C a n a d i a n , a n d t h e Asiaexcluding-Japan prices d i d not always move p r o p o r t i o n a t e l y with U.S. price d e v e l o p m e n t s . The c u m u l a t i v e d i v e r g e n c e a b o v e t h e total U.S. c o n s u m e r price i n d e x from 1981 to 1989 is roughly 6.5 percent for the E u r o p e a n , 12.9 p e r c e n t for t h e C a n a d i a n , and 7.0 percent for the Asia-excluding-Japan countries. The cumulative inflation differential for the countries in t h e Asian subindex was actually 9.3 percent below total U.S. inflation for the period. The difference between the levels of the overall real and the nominal dollar index is the amount of aggregate bias introduced by using the nominal dollar index to approxim a t e a real dollar index. According to t h e real dollar index, the dollar's appreciation from January 1981 to t h e March 1985 peak a n d its s u b s e q u e n t d e s c e n t were n o t as large as p o r t r a y e d by t h e n o m i n a l index. Since mid-1986 the difference b e t w e e n these two indexes has decreased markedly, indicating that inflation rates in the eighteen countries covered by the index have t e n d e d to converge toward U.S. rates and have eliminated much of the cumulative inflation discrepancy reflected in the difference between the indexes. 4 0 Comovement of Indexes For the purposes of this study the comovem e n t of t h e real a n d n o m i n a l indexes and subindexes is of greater interest than the differences between levels of the nominal and real indexes (and subindexes) or the changes in the aggregate real index. The comovement, or correlation, of the indexes indicates the degree to which changes in the nominal index ( s u b i n d e x ) reflect c h a n g e s in real values. Since it is changes in the exchange value of the dollar that are thought to b e important in explaining movements in international trade, the correlation of the changes in the indexes are of particular interest, and the strength of that correlation is a measure of the nominal index's resilience to inflation differentials. The higher the correlation, the better is the nominal index at capturing real m o v e m e n t s and the smaller is the inflation distortion of the nominal index. U s i n g c o r r e l a t i o n s of first d i f f e r e n c e s (changes) of levels shows that t h e nominal d o l l a r i n d e x c l o s e l y s h a d o w s t h e real or price-deflated dollar index. (See Table 2 for Table 2. Correlation Coefficients between Changes in Nominal and Real Dollar Indexes (monthly data, January 1981 to December 1989) Index or Subindex Correlation Coefficient Nominal Atlanta Index, Real Atlanta Index 0.987 Nominal European, Real European 0.996 Nominal Asian, Real Asian 0.977 Nominal Asia-excluding-Japan, Real Asia-excluding-Japan 0.923 Real Canada, Nominal Canada 0.941 E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 correlations.) This result c o u l d b e inferred from reference to Chart 1, which shows close comovement during 1981 and from mid-1987 to D e c e m b e r 1989. The close correlation of the first differences over t h e entire s a m p l e p e r i o d (1981-89), 0.987, i n d i c a t e s t h a t t h e nominal index remains a reasonable proxy for the real dollar index. 6 Two inflation outliers serve as case studies for examining t h e sensitivity of the n o m i n a l Atlanta Fed dollar index to exceptions to the i d e a l criterion of u n i f o r m i n f l a t i o n a m o n g countries in the index. Canada, which has the single largest weight of any country in the index, experienced inflation that was moderately b u t persistently a b o v e the U n i t e d States' for most of the 1980s. China, which has a very small weight, showed a much larger inflation d i f f e r e n t i a l t h a n t h e U n i t e d S t a t e s over the s a m e period. T h e C a n a d i a n i n f l a t i o n rate p e a k e d in 1982 a n d since then has b e e n relatively stable, although consistently a b o v e U.S. rates. The level of t h e n o m i n a l C a n a d i a n s u b i n d e x diverged markedly from t h e level of t h e real Canadian s u b i n d e x starting in late 1983, a n d the divergence persisted a n d grew over the next t h r e e years, p e a k i n g in late 1986 a n d shrinking slightly thereafter. The n o m i n a l real s u b i n d e x differential has b e e n relatively steady since mid-1988. D e s p i t e t h e large a n d persistent differential in t h e s u b i n d e x levels, c h a n g e s in t h e real C a n a d i a n dollar s u b i n d e x a n d t h e nominal C a n a d i a n s u b i n d e x t e n d e d t o m o v e together. The c h a n g e s in t h e s e i n d e x e s are highly correlated from 1981 through 1989, at 0.941. This figure suggests that t h e change in t h e n o m i n a l i n d e x is a r e a s o n a b l y g o o d m e a s u r e of t h e c h a n g e in t h e real i n d e x , notwithstanding t h e difference in their levels. In t h e case of C a n a d a , a m o d e r a t e b u t l o n g - s t a n d i n g i n f l a t i o n d i f f e r e n t i a l in an important trading partner causes a w i d e n i n g gap b e t w e e n the n o m i n a l a n d real s u b i n d e x . The n o m i n a l a n d real s u b i n d e x e s c o n t i n u e to m o v e together, however, since t h e inflation g a p d o e s not worsen. In this way, t h e usefulness of t h e n o m i n a l i n d e x is not badly c o m p r o m i s e d b y t h e d i f f e r e n t i n f l a t i o n e x p e r i e n c e s of t h e U n i t e d S t a t e s a n d Canada. F E D Efor R A LFRASER R E S E R V E B A N K O F ATLANTA Digitized C h i n a is a c o n t r a s t i n g case. B e c a u s e its trade weight in the overall Atlanta Fed index in t h e A s i a n s u b i n d e x e s is q u i t e s m a l l (0.0162), a very large i n f l a t i o n d i f f e r e n t i a l w o u l d b e r e q u i r e d b e t w e e n China a n d t h e United States to drive t h e n o m i n a l a n d real i n d e x e s a n d s u b i n d e x e s apart. The C h i n a U.S. inflation differential has b e e n substantial over the last several years, although high inflation is relatively new to China. During t h e thirty years prior to 1980, the Chinese governm e n t was a b l e to hold inflation to a b o u t 3.0 percent per year, excluding a brief period in the 1960s.7 Stable inflation was achieved by regulating supply a n d d e m a n d through quotas, rationing, a n d price controls. In the late 1970s, t h e Chinese government d e c i d e d t h a t a slow m o v e t o w a r d a m o r e market-oriented economic system would help promote growth. In D e c e m b e r 1978 China began a program of e c o n o m i c liberalizations that raised real national income by an a n n u a l average of 9.9 percent in t h e 1980s (see Cheng 1988a, b and Bank of Japan 1989). The e c o n o m i c reform occurred in two segments: the rural liberalizations begun in 1978 a n d t h e urban industrial liberalizations imp l e m e n t e d in 1984. U n d e r t h e s e reforms, farms a n d b u s i n e s s e s were a l l o w e d to sell a n y t h i n g p r o d u c e d over-and-above official production q u o t a s at "market" prices, which were generally higher than state-set prices. Production increased dramatically, but at the s a m e t i m e t h e practice of allowing firms t o determine their own financing n e e d s kindled inflation. The result was a wave of d o m e s t i c borrowing that greatly increased t h e m o n e y supply. A by-product of reform has b e e n increased inflationary pressures. Retail prices s o a r e d , increasing 8.8 p e r c e n t in 1985, 6.0 percent in 1986, 7.3 percent in 1987, 18.5 percent in 1988, and around 16.0 percent in 1989, with even higher rates in urban centers. The rising inflationary pressures in China were of particular concern since the exchange rate was fixed for a l o n g p e r i o d after mid1986. 8 Unlike free-floating exchange rates, fixed exchange rates often d o not reflect domestic economic and political policies. Count r i e s fix e x c h a n g e r a t e s for a v a r i e t y of r e a s o n s such as c o u n t e r i n g t h e effects of high d o m e s t i c inflation, protecting nascent 41 m a n u f a c t u r i n g sectors, or d i s c o u r a g i n g imports. In a country with fixed rates, devaluation is often regarded as an indication of the government's inability to manage t h e economy effectively. As a result, governments frequently wait until exchange rates are grossly out of line before devaluing or revaluing, and they d o so in large strokes. Thus China develo p e d t h e characteristics—high inflation a n d use of unofficial exchange rates—that earlier h a d led to t h e exclusion of other important trading partners (Mexico, for e x a m p l e ) from the Atlanta Fed's dollar index. The exchange rate r e m a i n e d u n c h a n g e d at 3.341 yuan per dollar for roughly four years. This exchange rate was m a i n t a i n e d from mid-1986 through 1989 d e s p i t e accelerating price pressures, yielding an effective or "real" appreciation of the yuan. Much later, in D e c e m b e r 1989, a 21 percent devaluation was a n n o u n c e d . China is an example of a clear inflation outlier. However, its very slight w e i g h t in t h e weighted overall dollar index m i n i m i z e d the effect of its large d e v a l u a t i o n (after several years of high inflation) from having a large impact on the overall Atlanta Fed index or on t h e Asia and Asia-excluding-japan subindexes. The cumulative divergence in the real a n d nominal indexes is not large, a n d the correlation between changes in the nominal and real indexes is high—0.977 for t h e Asian subindex a n d 0.923 for t h e A s i a - e x c l u d i n g - j a p a n subindex. Conclusions Given that t h e average inflation rates for t h e e i g h t e e n c o u n t r i e s i n c l u d e d in t h e Atlanta Fed dollar index are still roughly in line with U.S. inflation rates a n d that t h e difference between the nominal and real dollar index is relatively modest, t h e nominal Atlanta Fed trade-weighted dollar i n d e x remains a reasonable proxy for a real or price-deflated dollar index. The i n c i d e n c e of substantially higher inflation in China a n d of a sustained moderate inflation differential in Canada, for example, has b e e n balanced by the inclusion of low-inflation countries within t h e Atlanta Fed d o l l a r i n d e x a n d b y China's relatively small weight in the index. It should b e noted, however, that there is no feature in the comp o s i t i o n of t h e i n d e x which ensures that it will remain free of distortions arising from inflation disparities in these or other countries. The presence of inflation outliers naturally has a larger impact on the subindexes because of the larger weight of individual countries in the subindexes. Within the Asia-excluding-japan subindex China has a weight of 10 percent. If a country's weight in b o t h t h e total a n d the subindex were relatively large a n d it continued to inflate excessively, it would b e reflecte d in a divergence of t h e real a n d n o m i n a l indexes and in a decline in the measures of comovement. Notes 1 For e x a m p l e , t h e M o r g a n i n d e x , t h e F e d e r a l Reserve 4 2 e a c h offer a different r e p r e s e n t a t i o n of t h e dollar's lev- exchange rates b e c a u s e s o m e n o n t r a d e d g o o d s that are el a n d variability. i n c l u d e d in c o n s u m e r or retail price i n d e x e s m a y skew a T h e m o s t i m p o r t a n t criterion is t h a t t h e a v e r a g e infla- real or d e f l a t e d d o l l a r index (Harberger 1986). However, tion rates of t h e c o u n t r i e s i n c l u d e d a p p r o x i m a t e t h a t c o n s u m e r price i n d e x e s were u s e d as t h e inflation mea- of t h e U n i t e d S t a t e s , s o t h a t t h e i n d e x will c o v e r t h e sure b e c a u s e t h e y are generally a v a i l a b l e a n d l a r g e s t p r o p o r t i o n of U . S . t r a d e p o s s i b l e closely c o m p a r a b l e a m o n g c o u n t r i e s . W h o l e s a l e p r i c e without s k e w i n g t h e i n d e x by i n c l u d i n g large inflation R o s e n s w e i g (1987). more m e a s u r e s were u n a v a i l a b l e for t w o of t h e countries with- out- in t h e i n d e x — S a u d i Arabia a n d H o n g Kong. l i e r s or c o u n t r i e s w i t h m u l t i p l e e x c h a n g e rates. S e e 3 It has b e e n s u g g e s t e d that a m e a s u r e of w h o l e s a l e prices rather than c o n s u m e r or retail prices b e u s e d to d e f l a t e B o a r d of G o v e r n o r s i n d e x , a n d t h e D a l l a s F e d i n d e x 5 C o u n t r i e s in t h e E M S b u t n o t in t h e d o l l a r i n d e x are An e x c h a n g e rate is t h e price of o n e currency in t e r m s D e n m a r k a n d Ireland. E u r o p e a n c o u n t r i e s in t h e d o l l a r of a n o t h e r currency. i n d e x b u t n o t in t h e E M S are t h e U n i t e d K i n g d o m , Swe- This relative price is d e t e r m i n e d n o t o n l y b y e c o n o m i c f u n d a m e n t a l s — i n f l a t i o n , growth, d e n , a n d S w i t z e r l a n d . S p a i n , which is a l s o in t h e index, a n d monetary p o l i c i e s — b u t also by political h a s o n l y recently b e c o m e an E M S m e m b e r . events a n d m a r k e t e x p e c t a t i o n s . In t h e c a s e of m u l t i p l e exc h a n g e rates it is difficult to c h o o s e t h e o n e m o s t repr e s e n t a t i v e of a f r e e m a r k e t r a t e . S e e (1987) a n d H e r v e y a n d Strauss (1987). 4 2 Rosensweig 6 O b j e c t i v e criteria for g o o d n e s s of fit in t h i s correlation h a v e n o t b e e n e s t a b l i s h e d . H o w e v e r , criteria for o t h e r e c o n o m i c t i m e s series s u g g e s t t h a t c o r r e l a t i o n s a b o v e 0.90 are c o n s i d e r e d strong. E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 7 LOW inflation is s e e n as o n e of t h e a c c o m p l i s h m e n t s of 8 A f t e r b e i n g i n c l u d e d in t h e A t l a n t a F e d d o l l a r i n d e x , the C o m m u n i s t g o v e r n m e n t s i n c e t h e h y p e r i n f l a t i o n of C h i n a s o o n b e g a n to fix t h e e x c h a n g e rate of t h e y u a n , the late 1940s c o n t r i b u t e d to t h e d o w n f a l l of t h e Nation- s e t t i n g it at a g i v e n n u m b e r to t h e dollar. alist g o v e r n m e n t ( H a r d i n g 1987, 279). References Bank of J a p a n . " R e c e n t D e v e l o p m e n t s in t h e C h i n e s e Hervey, lack L., a n d Strauss, W i l l i a m . " T h e N e w D o l l a r In- E c o n o m y : E c o n o m i c R e f o r m , Its S u c c e s s a n d Prob- d e x e s Are N o Different from t h e O l d O n e s . " F e d e r a l lems." S p e c i a l P a p e r no. 176, April 1989. R e s e r v e B a n k of C h i c a g o Cheng, H a n g - S h e n g . "Inflation in C h i n a . " F e d e r a l R e s e r v e B a n k of S a n F r a n c i s c o Weekly Letter, N o v e m b e r 4, Perspectives 11 International Monetary Fund. World Economic Outlook. W a s h i n g t o n , D C . : I n t e r n a t i o n a l M o n e t a r y F u n d , 1990. 1988. . " M o n e t a r y Policy a n d Inflation in C h i n a . " In tary Policies in Pacific Basin Countries, 401-27. Mone- Boston: E c o n o m i s t I n t e l l i g e n c e Unit. Structure and Analysis. European Community-. Economic L o n d o n : T h e E c o n o m i s t Intelli- g e n c e Unit, 1989. Economic Adjustment in Developing Countries, e d i t e d b y and Exchange S a b a s t i a n Ed- w a r d s a n d L i a q u a t A h a m e d , 371-423. C h i c a g o : T h e University of C h i c a g o Press, 1986. H a r d i n g , Harry. M o r e G l o b a l P e r s p e c t i v e . " F e d e r a l R e s e r v e B a n k of Economic Review 71 (June/July 1986): 12-22. . " C o n s t r u c t i n g a n d Using Exchange R a t e I n d e x e s . " F e d e r a l R e s e r v e B a n k of A t l a n t a Economic Review 72 ( S u m m e r 1987): 4-16. Harberger, A r n o l d . " E c o n o m i c A d j u s t m e n t a n d t h e Real E x c h a n g e R a t e . " In R o s e n s w e i g , Jeffrey A. "A N e w D o l l a r Index: C a p t u r i n g a Atlanta Kulwer A c a d e m i c P u b l i s h e r s , 1988. Rates Economic d u l y / A u g u s t 1987): 3-22. W e i l , G o r d o n . " E x c h a n g e Rate R e g i m e S e l e c t i o n in Theory a n d Practice." M o n o g r a p h S e r i e s in F i n a n c e a n d E c o n o m i c s 1983-2. S o l o m o n Brothers C e n t e r for t h e S t u d y of F i n a n c i a l I n s t i t u t i o n s , G r a d u a t e S c h o o l of B u s i n e s s A d m i n i s t r a t i o n , N e w York University, 1983. China's Second Revolution: Reform after Mao. W a s h i n g t o n , D.C.: T h e B r o o k i n g s I n s t i t u t i o n , 1987, F E D E for R A LFRASER R E S E R V E B A N K O F ATLANTA Digitized 43 Book Review The Making of an Economist by Arjo Klamer and David Colander. Boulder, Colo.: Westview Press, Inc., 1990. 216 pages. $50.50 (cloth). $16.95 (paper). T he newly m i n t e d economist quickly discovers that his or her choice of profession can b e a social handicap. The four-word phrase "I am an economist" will in most cases bring a punch-bowl conversation to a predictable, a n d often s u d d e n , e n d . Those conversationalists not i m m e d i ately s i l e n c e d b y t h e m e n t i o n of t h e word " e c o n o m i s t " are a l m o s t always r e d u c e d t o such shopworn questions as "are you a Keynesian or a Monetarist?" or "just where d o you t h i n k t h e e c o n o m y is h e a d i n g ? " T h e ine v i t a b l y t h r e a d b a r e responses are, in turn, m e t by sullen stares or, more likely, furtive glances in search of t h e next r o u n d of hors d'oeuvres. It takes no more than a few such experiences for the novice economist to realize that, in the m i n d of the general public, the subject of economics enjoys a murky status akin to that of alchemy or druidism. G i v e n this l a m e n t a b l e i n f o r m a t i o n g a p , e c o n o m i s t s a n d n o n e c o n o m i s t s alike m u s t welcome t h e publication of The Making of an Economist, by Arjo Klamer a n d D a v i d Colander. The b o o k is a revealing snapshot of the a c a d e m i c segment of t h e economics profession in the late 1980s. This picture illustrates 44 what t h e a u t h o r s s e e as p r o b l e m s in their profession a n d provides a backdrop for their c o m m e n t a r y on h o w a c a d e m i c e c o n o m i c s should change. Even though t h e authors are economists, is written in a style that s h o u l d b e accessible t o the layperson. P e r h a p s m o r e i m p o r t a n t l y , t h e b o o k contains n o graphs or e q u a t i o n s . The authors d o afford themselves t h e frills of thirteen tables a n d six pages of e n d n o t e s , but these could b e b y p a s s e d without losing the book's message. M o s t of w h a t K l a m e r a n d C o l a n d e r have t o say is said in the main text, in plain English. The Making of an Economist The Making of an Economist is d i v i d e d into three major sections. The first offers a brief introduction to t h e economics profession of the "encyclopedia-entry" type and then presents t h e results of a survey d i s t r i b u t e d by t h e authors at six l e a d i n g graduate schools. The second section consists of e d i t e d transcripts of interviews with s o m e of the graduate students who c o m p l e t e d the survey. The last a n d most thought-provoking section offers an e s s a y b y e a c h of t h e c o a u t h o r s in which they interpret t h e survey results and E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 the interviews. Each of t h e book's three parts is fairly self-contained, and each has its own strengths a n d weaknesses. To a noneconomist, t h e most informative part of t h e b o o k may b e t h e first c h a p t e r , which reports such basics as w h o all t h e s e economists are, how much formal education they have, where they work, a n d how much m o n e y they make. To u p d a t e a few figures from the book, the latest statistics I can find suggest t h a t a b o u t 165,000 p e o p l e in t h e United States call t h e m s e l v e s e c o n o m i s t s , about 35,000 more than reported by Klamer and C o l a n d e r . 1 O f t h e s e 165,000, a b o u t 22 p e r c e n t h a v e d o c t o r a t e s . The m a j o r i t y of economists (62.5 percent) work in private ind u s t r y ; t h e r e m a i n d e r w o r k p r i m a r i l y in academia (20.5 percent) a n d the federal government (7.8 percent). This year, the 800-odd new Ph.D.'s in economics will find jobs paying on average about $45,000 a year, the majority of them at colleges and universities. The focus of The Making of an Economist is on a small s u b s e t of t h e s e P h . D . - e c o n o m i s t s - t o - b e , namely doctoral students at an elite group of u n i v e r s i t i e s — C h i c a g o , MIT, Harvard, Stanford, Columbia, and Yale. Many of these students will no d o u b t b e very influential in the academic e n d of t h e profession for years to come. They will b e hired by the elite schools and will publish extensively in academic journals. To b e t t e r g a u g e t h e a t t i t u d e s of t h e s e graduate students toward the economics profession a n d toward their g r a d u a t e training, the authors circulated a survey at the schools listed above. The survey results, which were first p u b l i s h e d several years ago in a professional journal, constitute most of t h e book's first section. The results of the survey probably would not surprise most economists but may b e of m o r e interest to readers o u t s i d e the profession. It came as no surprise to m e or any of m y c o l l e a g u e s , for e x a m p l e , that these doctoral s t u d e n t s find preparation in m a t h e m a t i c s m o r e i m p o r t a n t in m a s t e r i n g economics than preparation in sociology, nor did it c o m e as a shock that s t u d e n t s at t h e University of Chicago t e n d e d t o p u t m u c h more credence in the paradigms of classical economics than did the other students.2 These findings accord well with t h e folklore that e c o n o m i s t s h e a r r e p e a t e d c o n s t a n t l y F E D E R A L R E S E R V E B A N K O F ATLANTA over t h e lunch t a b l e or b e t w e e n presentations at professional meetings. Nonetheless, Klamer a n d Colander's survey was widely discussed in t h e profession when its results were first reported, since it offered t h e first publicly available data of this type. Of course, interpretation of the results varied according to the graduate school that the reader had attended. Following tribal loyalties, former students at Chicago and allied schools pointed to various results in the survey as evidence of the insincerity of students at the Ivy League institutions, while former Ivy League students found confirmation of their suspicions that Chicago t e n d s to p r o d u c e a group of ranting "free market" ideologues. The b o o k ' s authors are also m e m b e r s of t h e e c o n o m i c s profession a n d , as might b e expected, have pronounced views about the results of the survey. Professors Klamer (Ph.D., Duke) and Colander (Ph.D., Columbia) d o not approve of the current state of the economics profession, particularly at t h e University of Chicago, a n d much of this b o o k is m e a n t to support their opinions about how t h e profession should change. Although their arguments are not m a d e explicit until the third chapter, t h e book's critical t o n e is set early on. Acad e m i c economics at t h e graduate level, in t h e authors' view, has b e c o m e t o o s p e c i a l i z e d , too mathematical, too e n a m o r e d of computer simulations, too removed from the real world, and too disrespectful of other social sciences. As e v i d e n c e of t h e professional malaise ind u c e d by such overspecialization, o n e would expect to find considerable frustration a m o n g e v e n t h e brightest g r a d u a t e s t u d e n t s , a n d this is what the authors are looking for. No d o u b t there are many p e o p l e both ins i d e a n d o u t s i d e t h e e c o n o m i c s profession who share the authors' opinions on academic economics, and these p e o p l e will find in The Making of an Economist a well-articulated confirmation of their views. Yet even p e o p l e with differing ideas about the profession will find t h e b o o k interesting reading, particularly the s e c o n d s e c t i o n . This section p r e s e n t s t h e transcripts of interviews of graduate students c o n d u c t e d b y t h e a u t h o r s at f o u r of t h e schools—MIT, Harvard, Columbia, a n d Chicag o — t h a t were surveyed. While a n u m b e r of t h e interview questions are slanted in t h e di- 45 rection of t h e authors' biases ("How important is mathematics?" "Would you like to see m o r e e m p h a s i s on p o l i c y ? " a n d so forth), there are enough open-ended questions and answers t o g i v e v e r i s i m i l i t u d e t o t h e students' descriptions of their graduate school experiences. The s e c o n d s e c t i o n of The Making of an Economist is r e m i n i s c e n t of Klamer's earlier book, Conversations with Economists, for which he interviewed professors rather than students. In my opinion, the interviews in The Making of an Economist c o m p a r e very f a v o r a b l y with those in the earlier work. The students' views, while not articulated as fluently as their professors', are n o t i c e a b l y less o s s i f i e d a n d more frankly offered. O n e learns, for example, that at least two s t u d e n t s c h o s e Harvard's e c o n o m i c s g r a d u a t e school b e c a u s e "they wanted t o rule t h e world." And, 1 must confess, 1 felt more than a twinge of Schadenfreude upon reading that students still find my thesis advisor's lectures utterly incomprehensible. Although such juicy tidbits a b o u n d , there is m o r e t o t h e b o o k ' s s e c o n d section than academic gossip. The interviews are lengthy e n o u g h (about twenty pages each) to allow readers to get s o m e feel for t h e essence of economics graduate school, as well as for the different character of each graduate school. As was the case with the survey, the attitude of t h e students at Chicago is noticeably diff e r e n t from t h a t of s t u d e n t s at t h e o t h e r s c h o o l s . A l m o s t all of t h e s t u d e n t s interv i e w e d c o m p l a i n a b o u t t h e v o l u m e of t h e work load as well as the extremely technical n a t u r e of their classes. Except for t h o s e at Chicago, most of t h e s t u d e n t s seem to feel that much of this technical classwork bears little relevance to the real world. The Chicago students, by contrast, a p p e a r to b e very comfortable with the relevance of what they are taught, even though they complain about t h e difficulty of u n d e r s t a n d i n g t h e mathematics used in presenting the course material. The non-Chicago s t u d e n t s show a generally stronger interest in policy issues and seem t o regret that these issues are not d i s c u s s e d m o r e in their courses a n d seminars. On the other hand, the Chicago students feel that too much attention to policy issues 46 w o u l d b e distracting t o a serious economic theorist. The disparities between Chicago a n d the other g r a d u a t e p r o g r a m s are h i g h l i g h t e d even more sharply in the book's third and final section. In his summarizing essay, Klamer l a m e n t s t h e a p p a r e n t l y w i d e s p r e a d "cynicism" and "loss of intellectual vigor," particularly a m o n g t h e i n t e r v i e w e d g r a d u a t e s t u d e n t s o u t s i d e t h e University of Chicago. The Chicago program itself garners a mixed review. Even t h o u g h Klamer feels that the m e t h o d o l o g i c a l focus of Chicago's graduate program is inappropriate, he admires t h e fact that t h e program d o e s n o t foster cynicism a m o n g its students. C o l a n d e r , h o w e v e r , in his s u m m a r i z i n g essay, d e p r e c a t e s e v e n this marginally ad- "Almost all of the students interviewed complain about the volume of the work load as well as the extremely technical nature of their classes. . . . [M|ost of the students seem to feel that much of this technical classwork bears little relevance to the real world." m i r a b l e f e a t u r e of t h e C h i c a g o p r o g r a m . The p r o g r a m ' s u n d e r l y i n g p r o b l e m , as he s e e s it, is a c a d e m i c e c o n o m i c s ' positivist m e t h o d o l o g i c a l f o u n d a t i o n . This positivist orientation a s s u m e s that k n o w l e d g e in the field is " a d v a n c e d b y e m p i r i c a l t e s t i n g of well-specified p r o p o s i t i o n s . " In Colander's view, this a p p r o a c h has n o t b e e n fruitful. E c o n o m i c theorists h a v e not p r o v e d a d e p t at p r o d u c i n g u n a m b i g u o u s h y p o t h e s e s a b o u t e c o n o m i c behavior, nor have econom e t r i c i a n s i n s p i r e d m u c h c o n f i d e n c e in their ability t o sort o u t c o m p e t i n g hypotheses on t h e basis of statistical c o m p a t i b i l i t y with real-world d a t a . C o l a n d e r ' s a p p r a i s a l of t h e current situation in t h e field of economics, t h e n , is that " o n e is left with a wide range of r e a s o n a b l e h y p o t h e s e s from which o n e cannot select on t h e basis of empirical testing." E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 B e c a u s e of his v i e w s of a c a d e m i c economics' limitations, Colander is not surprised that so many of even t h e elite graduate students are discouraged a b o u t the profession. Their professors are in effect "telling t h e m to do what can't b e d o n e . " At Chicago, where this malaise is not prevalent, Colander sees students a n d faculty alike as engaging in a sort of mass delusion, in which empirical evid e n c e u n f a v o r a b l e t o e c o n o m i c t h e o r y is d e a l t with b y a c o n s p i r a c y of s i l e n c e . H e claims that t h e economics profession sorely needs a new set of methodological conventions, less w e d d e d t o m a t h e m a t i c a l constructs, m o r e oriented toward k n o w l e d g e of economic institutions, a n d less rigidly positivistic in its assertions a b o u t what constitutes " g o o d " economic research. . « • • • • • • ^ • • ^ • • • • • • • • • • • • • • H B i "Although the academic elite profiled in the book command a certain respect from other economists, the exclusive focus on this segment of the profession tends to give an exaggerated notion of these academics' influence on the profession as a whole." The criticisms a n d prescriptions set forth in Colander's essay constitute t h e most serious a n d a m b i t i o u s part of The Making of an Economist, a n d 1 b e l i e v e that Colander's crit i q u e n e e d s t o b e taken seriously. His antipathy towards abstract constructs is easy to u n d e r s t a n d . The p a r a d i g m s of e c o n o m i c s rival t h o s e of physics in t e r m s of abstract i o n , yet t h e y a r e m e a n t t o a p p l y n o t t o s u b a t o m i c particles b u t t o p a t t e r n s of behavior that most p e o p l e e n c o u n t e r in their daily lives. A n y o n e w h o has p u z z l e d over "indifference curves" a n d "the s u b s t i t u t i o n effect" in an introductory e c o n o m i c s course can testify that mastery of e v e n t h e m o s t basic e c o n o m i c p a r a d i g m s requires an ext e n s i v e c a p a c i t y for s u s p e n s i o n of o n e ' s d i s b e l i e f . But 1 also t h i n k t h a t C o l a n d e r ' s critique calls for s o m e i m p o r t a n t qualifications. F E D E R A L R E S E R V E B A N K O F ATLANTA The first of these is that the focus of Colander's essay, a n d The Making of an Economist generally, is unnecessarily narrow. Although t h e a c a d e m i c e l i t e p r o f i l e d in t h e b o o k c o m m a n d a certain r e s p e c t from o t h e r economists, the exclusive focus on this segm e n t of t h e profession t e n d s to give an exaggerated notion of these academics' influence on the profession as a whole. As n o t e d in t h e first chapter, the majority of economists currently working in t h e U n i t e d States d o n o t have doctorates and d o not teach at a college or university. The work d o n e by economists o u t s i d e a c a d e m i a is typically n o n t e c h n i c a l a n d institutional in nature. The s a m e might b e said for many a c a d e m i c economists outside the elite focus of this book. O n e cannot d e n y t h a t n o n m e m b e r s of t h e b o o k ' s socalled elite such as Paul Craig Roberts, Arthur Laffer, or Paul Volcker have had a powerful influence on all s u b c u l t u r e s of t h e e c o n o m i c p r o f e s s i o n . Still, t o say t h a t n o n f o r m a l i s t , real-world-oriented economics is widely pract i c e d in t h e U n i t e d S t a t e s t o d a y d o e s n o t confront C o l a n d e r ' s strong a r g u m e n t s that more of this type of analysis ought to find its way into t h e elite g r a d u a t e programs. I believe that to address this argument properly o n e m u s t h a v e s o m e i d e a of w h a t r o l e academia should play in t h e economics profession more generally; Colander's essay prov i d e s n o clues. His failure to a d d r e s s this issue u n d e r m i n e s the arguments in his essay a n d in t h e rest of t h e book. For a more specific i d e a of this concern, o n e may consider this example. After working a few years for the Federal Reserve System, many economists d e v e l o p a detailed knowle d g e of the Fed's o p e n market operations, of t h e c o m p o n e n t s of t h e various monetary aggregates, of t h e laws t h a t p e r t a i n t o b a n k h o l d i n g c o m p a n i e s , a n d so forth. Are t h e s e t h e sorts of topics these economists s h o u l d h a v e l e a r n e d m o r e a b o u t in g r a d u a t e s c h o o l ? To r e q u i r e t h a t n e w l y d e g r e e d e c o n o m i s t s have s o m e k n o w l e d g e in t h e s e areas s e e m s reasonable. Yet it seems doubtful that any academic training could provide a k n o w l e d g e of such institutional details as c o m p l e t e a n d as c u r r e n t as t h a t g l e a n e d during a year or two on t h e job in a setting that d e m a n d s such expertise. In a d d i t i o n , an 47 unpleasant insularity is i m p l i e d by the idea of i n s t i t u t i o n s o u t s i d e a c a d e m i a b e i n g s t a f f e d by e c o n o m i s t s w h o h a v e m o s t l y studied only the past behavior of such institutions. Certainly Klamer and Colander's concern for the relevance of academic economic research is a l e g i t i m a t e one. However, for this research to b e useful to the world outs i d e a c a d e m i a , its relevance n e e d s to b e balanced by a certain degree of detachment from t h e day-to-day m a n a g e m e n t of economic institutions. Otherwise, there may b e great difficulty in d i s t i n g u i s h i n g a professional viewpoint from a viewpoint motivated by financial or political gain. This t e n s i o n b e t w e e n t h e a p p l i c a b i l i t y a n d the integrity of intellectual pursuits is hardly a new concern. One of the best summaries of this issue is an essay by the historian Richard Hofstadter, in which he notes that t h e c o m p l e x i t y of m o d e r n s o c i e t y o f t e n presses academicians into positions where they wield considerable power. 3 That is, society often calls on "experts" to assist in making complex decisions, such as those faced by corporate executives or government policymakers. At the same time, academicians' close involvement in such decision-making processes tends to undermine the independence that led to their developing an "expert knowledge." There is an inherent conflict in any acad e m i c field b e t w e e n t h e roles of "expert" and "researcher," irrespective of the profession's methodology. Given that such conflict is virtually inevitable, it becomes difficult to e v a l u a t e t h e criticisms of a c a d e m i c economics voiced in Tfie Making of an Economist. Klamer a n d Colander effectively m a k e t h e p o i n t that e c o n o m i c researchers are often frustrated by the difficulty of applying their hard-won academic expertise to real-world situations. The authors fail to consider, however, that the profession may be well served by an academic elite who guard against intellectual stagnation—who are, in Hofstadter's words, "capable of stepping mentally outside their society and looking relentlessly at its assumptions, in sufficient n u m b e r and with sufficient freedom to make themselves felt." But there is also a danger in too much det a c h m e n t for d e t a c h m e n t ' s sake. The economics profession would not benefit should its elite members degenerate into what Hofstadter describes as a group of "willfully aliena t e d i n t e l l e c t u a l s m o r e c o n c e r n e d with maintaining their sense of their own purity than with making their ideas effective." Although reaching a m i d d l e ground on this issue clearly requires a fine balance, Klamer a n d C o l a n d e r s e e m t o a p p r o a c h t h e task wielding a single-bladed ax. P h i l o s o p h i c a l differences a s i d e , I think provides a readable a c c o u n t of w h a t a c a d e m i c e c o n o m i c s is currently all about, as well as s o m e thoughtprovoking ideas a b o u t what directions acad e m i c economics should b e taking. Nonetheless, if the authors are planning additional books profiling the economics profession, I h o p e they will consider branching out beyond this book's narrow focus. If economics' academic elite are not being trained to d o t h e i r j o b s , t h e n a b e t t e r d e f i n i t i o n must b e provided as to what their job is and how t h e i r r o l e as a c a d e m i c e c o n o m i s t s should differ from that of economists outside academia. The Making of an Economist William Roberds The reviewer is a senior economist in the macropolicy section of the Atlanta Fed's research department. Notes c e p t p e r h a p s N o b e l Prize a c c e p t a n c e s p e e c h e s ) h a v e 'U.S. D e p a r t m e n t of C o m m e r c e , B u r e a u of t h e C e n s u s , Statistical Abstract of the United States, 2 A q u i c k g l a n c e at recent i s s u e s of a n y " n o n m a t h e m a t i cal" e c o n o m i c s j o u r n a l , s u c h as The American Economic Review, will reveal t h a t a l m o s t all p u b l i s h e d articles (ex- 48 e q u a t i o n s in t h e m . 1989, s e c t i o n 20. 3 S e e Richard Hofstadter, "The Intellectual: Alienation a n d C o n f o r m i t y , " c h a p t e r 15 in American Life Anti-lntellectualism in (New York: R a n d o m H o u s e , 1962). E C O N O M I C R E V I E W , S E P T E M B E R / O C T O B E R 1990 M Economic Review Bulk Rate U.S. Postage FAID Atlanta, Ga. 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