Thomas M. Humphrey

Classical Deflation Theory

Classical economists David Hume, Pehr Niclas Christiernin, Henry Thornton, David Ricardo, Thomas Attwood, and Robert Torrens looked beyond the redistributive (creditor-debtor) effects of deflationary monetary contraction to its adverse effects on output and employment. They attributed these effects to price-wage stickiness; to rises in real debt, tax, and cost burdens; to cash hoarding in anticipation of future price falls; and to other determinants. Addressing deflation associated with post-war resumption of gold convertibility at the old mint par, they advocated policies ranging from gradualism, to devaluation, and even to outright abandonment of the gold standard in order to avoid or mitigate deflation’s harm.

Monetary Policy Frameworks and Indicators for the Federal Reserve in the 1920s

The 1920s and 1930s saw the Fed reject a state-of-the-art empirical policy framework for a logically defective one. Consisting of a quantity theoretic analysis of the business cycle, the former framework featured the money stock, price level, and real interest rates as policy indicators. By contrast, the Fed’s procyclical needs-of-trade, or real bills, framework stressed such policy guides as market nominal interest rates, volume of member bank borrowing, and type and amount of commercial paper eligible for rediscount at the central bank. The start of the Great Depression put these rival sets of indicators to the test. The quantity theoretic set correctly signaled that money and credit were on sharply contractionary paths that would worsen the slump. By contrast, the real bills indicators incorrectly signaled that money and credit conditions were sufficiently easy and needed no correction. This experience shows that policy measures and measurement, no matter how accurate and precise, can lead policymakers astray when embodied in a theoretically flawed framework.

Dennis H. Robertson and the Monetary Approach to Exchange Rates

Prominent among competing explanations of exchange rate determination in a regime of floating exchange rates is the so-called monetary approach, which holds that the exchange rate between two national currencies is determined by current and prospective relative supplies of and demands for those national money stocks. This theory has a long tradition going back more than 300 years. As an integral part of pre-Keynesian international monetary theory, it formed the central analytical core of classical and neoclassical explanations of exchange rate behaviour. Although it was temporarily eclipsed by the rival elasticities and foreign trade multiplier or income-expenditure approaches that gained popularity with the domination of the Keynesian revolution, it has recently made a comeback and today is widely employed by academic and business economists to explain the behaviour of exchange rates in the post-Bretton Woods era of generalized floating. For example, such well-known economists as Robert Barro, John Bilson, Jacob Frenkel, and Michael Mussa1 have successfully employed the monetary approach to account for recent exchange rate experience, as have analysts at Citibank, Chase Manhattan, and other financial instituttions. Finally, it is worth noting that certain segments of the financial press, notably the editorial pages of the Wall Street Journal, regularly espouse the monetary approach.

Wicksell's Monetary Framework and Dynamic Stability

Traditionally, central banks seeking to stabilize general prices have followed policies similar to those advocated by Knut Wicksell: when prices are higher that desired, raise interest rates to exert downward pressure on prices, and conversely. Despite the historical predominance of interest rate-based monetary policies, analysts frequently focus on how prices are affected by control of the money stock (or its high-powered base). In those cases where they do examine the relationship between interest rates and prices, they mostly do so in a Keynesian framework rather than a Wicksellian one. For several reasons, Wicksells analysis deserves renewed attention. Here, we examine whether his interest rate-adjustment rule, coupled with his famous cumulative process mechanism of price level change, can stabilize prices (and interest rates). We find that if the interest rate rule is properly specified, it can.

Interest Rates, Expectations, and the Wicksellian Policy Rule

Prominent among older theories of inflation is the view that a rising price level stems from a divergence between two rates of interest.

Arresting financial crises: The fed versus the classicals

Nineteenth-century British economists Henry Thornton and Walter Bagehot established the classical rules of behavior for a central bank, acting as lender of last resort, seeking to avert panics and crises: Lend freely (to temporarily illiquid but solvent borrowers only) against the security of sound collateral and at above-market, penalty interest rates. Deny aid to unsound, insolvent borrowers. Preannounce your commitment to lend freely in all future panics. Also lend for short periods only, and have a clear, simple, certain exit strategy. The purpose is to prevent bank runs and money-stock collapses--collapses that, by reducing spending and prices, will, in the face of downward inflexibility of nominal wages, produce falls in output and employment. In the financial crisis of 2008-09 the Federal Reserve adhered to some of the classical rules--albeit using a credit-easing rather than a money stock–protection rationale--while deviating from others. Consistent with the classicals, the Fed filled the market with liquidity while lending to a wide variety of borrowers on an extended array of assets. But it departed from the classical prescription in charging subsidy rather than penalty rates, in lending against tarnished collateral and/or purchasing assets of questionable value, in bailing out insolvent borrowers, in extending its lending deadlines beyond intervals approved by classicals, and in failing both to precommit to avert all future crises and to articulate an unambiguous exit strategy. Given that classicals demonstrated that satiating panic-induced demands for cash are sufficient to end crises, the Fed might think of abandoning its costly and arguably inessential deviations from the classical model and, instead, return to it.

Alfred Marshall and the Quantity Theory of Money

Marshall made at least four contributions to the classical quantity theory. He endowed it with his Cambridge cash-balance money-supply-and-demand framework to explain how the nominal money supply relative to real money demand determines the price level. He combined it with the assumption of purchasing power parity to explain (i) the international distribution of world money under metallic standards and fixed exchange rates, and (ii) exchange rate determination under floating rates and inconvertible paper currencies. He paired it with the idea of money wage and/or interest rate stickiness in the face of price level changes to explain how money-stock fluctuations produce corresponding business-cycle oscillations in output and employment. He applied it to alternative policy regimes and monetary standards to determine their respective capabilities of delivering price-level and macroeconomic stability. In his hands the theory proved to be a powerful and flexible analytical tool.

James Pennington, (1777-1862): classical banking, monetary, and trade theorist and economic policy advisor

James Penningtons creativity as a scientific economist is matched only by his obscurity. He exemplifies the pioneering innovator who never gets his due recognition. Alone and with others he launched (1) the idea that checking deposits are money just like coin and notes, (2) the theory of the multiple expansion of bank deposits, (3) the currency principle according to which a mixed paper-metal currency can be made to behave as if it were entirely metallic, and (4) the notion that reciprocal demand fixes the terms of trade between the comparative cost ratios of two trading nations. Any one of these contributions should have made him famous. But they failed to do so and his name, neglected enough in his own time, is virtually unknown today.