TWO VIEWS OF THE GOLDEN RULE FROM THE GOLDEN AGE
THE CUNLIFFE AND MACMILLAN COMMITTEES
M June Flanders
Tel Aviv University
University of Virginia
December 18, 1986
Two Views of the Golden Rule from the Golden Age
The Cunliffe and Macmillan Committees
Among the many Parliamentary Committees which were appointed to study various aspects of British financial and economic institutions, two are of particular interest to students of international monetary affairs. These are what are popularly called the Cunliffe Committee and the Macmillan Committee.
These are of interest in the development of ideas about international monetary economics first, because academic economists of distinction served on both committees and were influential (or more) in writing the reports.
Second, both committees and their reports are widely known and widely cited, in the academic and in the `journalistic' literature alike, as well as having been influential in the making, or justifying, of policy. The Cunliffe Report is frequently alluded to as the locus classicus of a statement of what the 19th century gold standard was, or was thought to have been.
The Cunliffe Committee, the "Committee on Currency and Foreign Exchanges after the War", was appointed by the Lords Commissioners of His Majesty's Treasury and the Minister of Reconstruction "... to consider the various problems which will arise in connection with currency and the foreign exchanges during the period of reconstruction and report upon the steps required to bring about the restoration of normal conditions in due course." Later the following words were added: "... and to consider the working of the Bank Act, 1844, and the constitution and functions of the Bank of England with a view to recommending any alterations which may appear to them to be necessary or desirable." The committee of fourteen members was headed by Lord Cunliffe, the Governor of the Bank of England, and was composed of a highly distinguished panel of bankers, plus the Secretary to the Treasury, Sir John Bradbury, and one academic economist, A.C.Pigou.
What has become known as the Cunliffe Report was their First Interim Report, published in August 1918. The final report, presented in 1919, added little.
The Committee on Finance and Industry was appointed on November 5, 1929, by the Chancellor of the Exchequer "... to inquire into banking, finance and credit, paying regard to the factors both internal and international which govern their operation, and to make recommendations calculated to enable these agencies to promote the development of trade and commerce and the employment of labour." (Macmillan 1931 vi) It thus had a much broader frame of reference than the Cunliffe Committe, and, of course, sat at a very different time in British (and world) history. It sat much longer than the Cunliffe Committee, and we have two large volumes of hearings and testimony, as well as a long and detailed Report, which was presented in June, 1931.
The Reports are separated by a period of 13 years, the return to gold, and the beginnings of the greatest depression the world had (and has) ever known. They are distinguished from one another by a number of other characteristics as well: their length (10 as compared with more than 300 pages), the breadth of their terms of reference, and hence the scope of their interest, their view of the world, of economic adjustments in general and of balance of payments adjustment in particular, their view of the actual and appropriate behavior of a central bank (or at least of a particular central bank, the Bank of England), and (only partly facetiously do I say this), by John Maynard Keynes.
Let us begin, chronologically, with the Cunliffe Report (hereafter simply Cunliffe). I shall concentrate on the famous Interim Report (1918).1 It is this which is known popularly as the Cunliffe Report. The view there presented of the pre war adjustment mechanism has been so often referred to and so much discussed that it is worth citing briefly:
When the exchanges were favourable, gold flowed freely into this country and an increase of legal tender money accompanied the development of trade. When the balance of trade was unfavourable and the exchanges were adverse, it became profitable to export gold. The would be exporter bought his gold from the Bank of England and paid for it by a cheque on his account. The Bank obtained the gold from the Issue Department in exchange for notes taken out of its banking reserve, with the result that its liabiities to depositors and its banking reserve were reduced by an equal amount, and the ratio of reserve to liabilities consequently fell. If the process was repeated sufficiently often to reduce the ratio in a degree considered dangerous, the Bank raised its rate of discount. The raising of the discount rate had the immediate effect of retaining money here which would otherwise have been remitted abroad and of attracting remittances from abroad to take advantage of the higher rate, thus checking the outflow of gold and even reversing the stream.
If the adverse condition of the exchanges was due not merely to seasonal fluctuations, but to circumstances tending to create a permanently adverse trade balance, it is obvious that the procedure above described would not have been sufficient. It would have resulted in the creation of a volume of short dated indebtedness to foreign countries which would have been in the end disastrous to our credit and the position of London as the financial centre of the world. But the raising of the Bank's discount rate and the steps taken to make it effective in the market2 necessarily led to a general rise of interest rates and a restriction of credit. New enterprises were therefore postponed and the demand for constructional materials and other capital goods was lessened. The consequent slackening of employment also diminished the demand for consumable goods, while holders of stocks of commodities carried largely with borrowed money, being confronted with an increase of interest charges, if not with actual difficulty in renewing loans, and with the prospect of falling prices, tended to press their goods on a weak market. The result was a decline in general prices in the home market which, by checking imports and stimulating exports, corrected the adverse trade balances which was the primary cause of the difficulty. (Cunliffe 1918 3 4 Italics mine)
A similar analysis demonstrates why excessive credit creation at home was automatically corrected: it leads to a rise in prices, hence an increased demand for cash and an equal reduction in the Bank of England's reserves and liabilities, that is, a shortfall in its reserves, forcing it to raise its discount rate "...and speculative trade activity was similarly restrained. There was therefore an automatic machinery by which the volume of purchasing power in this country was continuously adjusted to world prices of commodities in general." (Cunliffe 4 Italics mine)
This analysis fits into the category I have labelled elsewhere (Flanders 1986) neo classical: there is a banking system and an interest rate, both playing crucially prominent roles. There is even a central bank, but in this story it exercises virtually no discretion (except for the brief and vague mention of `other steps to make bank rate effective'). There is nothing here about the `rules of the game', which despite its name, implied some sort of discretionary activity on the part of the central bank. A reading of Cunliffe (unless, perhaps, one is actively looking for hints to the contrary) leaves one with the impression that a not very sophisticated computer could easily have been a Central Bank in this sense. Absence of discussion of a discretionary policy of any kind is consistent indeed with the concept of `rules'.3,4 The institutional framework, as the Cunliffe Committee interpreted it, at any rate, was that of the pre 1914 gold standard, dominated by the Bank Act of 1844. This involved a fixed absolute number of `fiduciary' notes issued by the Bank of England plus notes backed 100% by gold. While nothing forced the Bank of England to issue notes when it bought gold, it was not allowed to increase its note issue by more than an increase in its gold reserves. Since the reserves of the commercial banks took the form of gold or of Bank of England notes, the monetary base could change only with changes in the banking system's gold holdings.
The passage cited implies, and the rest of the report spells out explicitly, the view that the quantity of money is endogenous under fixed exchange rates, and to that extent there is a strong resemblance to the monetary theory of the balance of payments. Since the money supply is controlled by the gold reserves, and since the law of one price holds, any disequilibrium must operate temporarily on output and/or (some) prices (they are not entirely clear on this point) to affect the trade balance and restore equilibrium in the money market. This differs from the monetary theory of the balance of payments only (though crucially) in the importance it attaches to the rate of interest, both as a regulator of the total supply of credit and as an influence on output as well as on prices.
The automatic aspect of the adjustment is (almost) continuously stressed, and lauded. "Domestic prices were automatically regulated so as to prevent excessive imports; and the creation of banking credit was so controlled that banking could be safely permitted a freedom from State interference which would not have been possible under a less rigid currency system.5 (Cunliffe 4 Italics mine)
The automaticity implied that the Bank should (and did) respond when the gold outflow began, and not wait till it was forced by a lack of specie to contract its liabilities.
Whenever before the war the Bank's reserves were being depleted, the rate of discount was raised. This, as we have already explained, by reacting upon the rates for money generally, acted as a check which operated in two ways. On the one hand, raised money rates tended directly to attract gold to this country or to keep here gold that might have left. On the other hand, by lessening the demands for loans for business purposes, they tended to check expenditure and so to lower prices in this country, with the result that imports were discouraged and exports encouraged, and the exchanges thereby turned in our favour. ... When the exchanges are adverse and gold is being drawn away, it is essential that the rate of discount in this country should be raised relatively to the rates ruling in other countries. (Cunliffe 6 Italics mine)
There should, in short, be no attempt to interfere with the mechanism by which Bank Rate changes protected the gold reserves (while the real adjustment which resulted from the Bank Rate changes could take place). The prewar policy of adjusting Bank rate as soon as gold flows began needed defense, evidently, from those who were recommending continuation of a two tier interest rate system.
This recommendation they opposed unequivocally. The idea had been to maintain low interest rates domestically to encourage domestic investment and high rates "for foreign money" to prevent gold outflows.6 They argue that evasion and arbitrage could be prevented, if at all, "... by the maintenance of such stringent restrictions upon the freedom of investment ... as would ... be most detrimental to the financial and industrial recovery of this country." And even if possible, it would be undesirable, since the high rate of domestic spending and prices would lead to current account deficits so that gold could be kept at home only at the cost of an ever increasing debt to foreigners. (Cunliffe 6)
All recommendations involving loosening the ties between gold and the money supply, by loosening restrictions on note issues, are rejected. They specifically, and in detail, reject also the proposal to allow the Bank of England to keep reserves of less than 100% against new note issues, providing the reserve ratio is fixed. (They are, however, willing to economize on the use of gold by permitting only the Bank of England to hold and to export gold.) Here the analysis is highly reminiscent of Hayek (1937). They argue that if the note issue is much less than the permitted level (if the Bank has excess reserves of gold, that is), then the reserve requirement is totally ineffective. If, on the other hand, the Bank of England is fully loaned up, then any loss of gold requires a multiple credit contraction, and "... would thus be likely to cause even greater apprehension than the limitations of the Act of 1844." (Cunliffe 8)
They emphasize the special position of Britain in the (pre war?) world economy and argue that other countries "... have not in practice maintained the absolutely free gold market which this country, by reason of the vital importance of its position in international finance, is bound to do. It has therefore been open to them to have recourse to devices to steady the rate of discount which, even if successful for this purpose, it would be inexpedient and dangerous for us to attempt." (Cunliffe 8) Noblesse oblige.
Finally, they come down firmly for maintenance and continuation of the Bank Act of 1844 and most of its basic requirements, particularly, as noted above, the fixed, one to one link between changes in gold reserves and in Bank of England note issues.7 Both the Act as a whole and this aspect of it were worth conserving even though it meant that occasional suspensions were necessary (though they note, with pride, that there had been no suspensions since 1866). They do not worry about the liquidity of the banking system, since they do recommend that gold be removed both from internal circulation and from the coffers of the commercial banks.8 (Cunliffe 9)
Though they do not, as the Macmillan Committee would, recommend widening the gold points, they are aware of the existence of this tool. There is a wry comment (Cunliffe 5) that it was the submarine danger which protected the gold stock during the war, by widening the gold points; this permitted a good deal of exchange depreciation without loss of gold. When the danger was over, gold exports continued to be restricted, this time by licensing (until 1925 and the famous Return to the gold standard).
A DIVERSION: THE FACTS ABOUT THE PREWAR ERA
Before treating the discussion of the Macmillan Report, let us examine the description given us by Sayers (, 1936) of the operations of the Bank of England during the High Noon of the Gold Standard, 1890 1914. Struck by the differences between the two reports (even in their descriptions of the way things had been in the past) I felt it desirable to look, however superficially, at the `facts'.9 The issues raised by Sayers are, essentially:
1) Whether the Bank of England tried to carry out the policy described by Cunliffe, of simply raising Bank Rate and thereby protecting its gold stock whenever the latter was threatened. This breaks down into the question of whether they were able to do this at all, and whether they were able to do it with the exclusive use of Bank Rate.
2) Whether they had any other goals, in addition to protecting their gold stock. Two additional goals that suggest themselves are first, protecting the earnings of their stockholders, and second, showing some concerned "tenderness" towards the home market, that is, towards `internal balance'.
Very briefly, the institutional setup was one of a very large and well developed market for bills and acceptances, the rate in which, called the `market rate', was that which primarily influenced international flows of funds. The banks went to the market for funds when they could, to the Bank of England when they must, and banks' lending policies were influenced, at the margin, primarily by Bank Rate, the Bank of England's lending or rediscounting rate. The Bank of England's rate was thus a penalty rate and had no influence on the bill market when the latter was easy. Tightening up on the money market enough to get the market and the market rate to respond to Bank Rate was, therefore, a major problem faced by the Bank of England. Doing this consistently with `being rich' and making money for its stockholders, exacerbated an already tricky problem.
It appears, then, that life was a good deal more complicated than a reading of Cunliffe would indicate. We find the barest hint of an awareness of one of these issues in the brief phrase (from the passage on pages 3 4 of the Interim Report which I cited above) about "... steps taken to make ... [Bank Rate] effective in the market." To the other issues Sayers raises, I can find no reference in Cunliffe.10 Bank Rate was, as noted, a penalty rate and the bill market rate might be for long periods considerably below it. Under these circumstances, changing Bank Rate would not directly affect either the bill brokers or the banks. International funds moved in response to the market rate; banks tended to respond in their domestic lending operations to Bank Rate. Unless these could be brought together, the simultaneous adjustment, described by Cunliffe, of the capital and current accounts would not take place.
The Bank frequently found its rate entirely out of touch with the market, and, since the foreign exchanges were influenced by the actual rate prevailing in the market and not by the official (and ineffective) rate, the Bank found itself powerless, in the ordinary course of events, to exercise control adequate for the protection of the gold reserve.11 (Sayers (1936) 4)
There were frequently times ... when the Bank wanted to enforce high rates in the City in order to deal with some temporary movement in the balance of international payments, but did not want to penalise home trade. In the early 'nineties all too frequently the Bank found that it was penalising home trade without having the desired short period effect on the balance of international payments. (Sayers (1936) 6 Italics mine)
One argument I find somewhat difficult to understand. Sayers notes that the Bank often kept its rate close to the market, because the joint stock banks tied their deposit rates to Bank Rate. If these rates were too high above the market rate (for bills and advances), the joint stock banks would lose money and might break off from Bank of England influence and "go off on their own". ((1936) 6 7) This would be bad because the functioning of London as the centre of the gold standard "... depended fundamentally upon the Bank's power to control interest rates in London." (1936 7) This argument is puzzling, since it seems to be saying that it was important for the bank to have control over the market, but it could keep this control only by not using it. (See Economist January 28 and February 11, 1893 and January 21, 1894.)
What does make sense is the possible implication that this is another explanation of the attempts on the part of the Bank to influence the market rate by other devices, such as open market operations of various sorts, making direct advances to the bill market, which Sayers discusses in some detail. Raising the market rate involved reducing the supply of funds available to the market "... just as an outflow of gold would reduce the market's funds." This was what was meant by "making Bank Rate `effective'.12 (Sayers (1936) 19)
Although the Bank did not in pre war days do as much `offsetting' of gold movements as it has done in post war days, it did far more, apart from regulating interest rates, to hinder gold movements than it has ever been able to do in the post war gold standard period. (1936 130)
Nevertheless, there were some important examples of offsetting. For instance, the period 1890-95 presented difficulties to the Bank, according to Sayers. Foreign investments fell and trade languished, so there was easy money. At the beginning of 1894 there occurred a tremendous inflow of gold because of a) South African gold coming in and b) United States Silver Purchase under the Sherman Act. Money became even easier, so the Bank had no control over the market because there was no need for rediscounts.
Had the Bank viewed this increase in its gold reserve as likely to be permanent, it might have considered being content with the situation, allowing cheap money to have its effect in stimulating trade and the eventual expansion of the credit structure, sending the market once more within its walls. Had it been content to follow the principles of 1844 this would have been the proper course; but in fact the Bank had moved far from these principles. The accession of gold, being more apparently due to the Sherman Act than to the development of the Rand, was regarded as ephemeral. ... It seemed desirable, therefore, to prevent the influx of gold from having its automatic effect in London. There was a prima facie case for "offsetting" operations. This course the Bank felt itself unable to afford. On the contrary, ... the Bank actually added to its investments very substantially, apparently for the purpose of increasing its income. ... This movement intensified and prolonged the cheap money of the middle 'nineties, and it did of course help the Bank of England's income. At the same time, by increasing the market's resources yet further, it made the Bank's control over the market more remote than ever. (1936 15 16 Italics mine)
To maintain at once its control and its income was to the Bank impossible in the short run. (1936 17 Italics his)
Had the Bank been prepared to follow the methods intended by the authors of the Act of 1844, none of these problems would have arisen. The Bank would, when the market was independent of it, simply wait until there was a sufficient efflux of gold to send the market into the Bank. The Bank would have been purely passive in its relations with the market. But in fact ... the Bank was not content to behave in that manner. It wished to take precautionaryaction very often, removing some purely ephemeral ease from the market. For this purpose it had to employ certain devices for acting directly on the open market discount rates, which, to the exclusion of the official Bank Rate, influenced the foreign exchanges. (1936 18 Italics his)
We have here an additional goal, or determinant of policy, for the Bank: not only `tenderness for the home market', not only technical problems of `getting control of the market', not only its own profits, but also anticipations and the need to take `precautionary action'. I can think of nothing in the Cunliffe Report to suggest that they were thinking of anything like this. Waiting for "a sufficient efflux of gold to send the market into the Bank" is precisely the type of action one would expect of the Bank based on reading that Report.
However, the Bank had to struggle for the power to take `precautionary' action, so that "... in the early nineteen hundreds, [it was] becoming fashionable to urge that there should be more co operation between the Old Lady, the commercial banks and the bill market. ... The Bank was, by tradition, permitted to take action to force the market to follow Bank Rate as a weapon for the protection of its Reserve; but it could not use these weapons to force an increase in its gold reserve." (1936 47 Italics mine) Convention, even "young" conventions, were very powerful controls on Bank action.
Sayers discusses the technical tools which the Bank had, and used regularly, though with varying frequency and at different times in the twenty year period. It is fascinating rading, but the major point of interest here is the continual reminder one gets of the non automatic nature of the processes.