An important key to Thornton’s analysis is the distinction between the demand for bank credit (indebtedness to the banking system) and the demand for money. At the start of an (unanticipated) inflation, the demand for bank credit and the demand for money move in opposite directions. These movements reflect a common cause, changed anticipations of the return to real assets and the rate of change of prices. Increases in the stock of money, resulting from an issue of paper or a gold inflow, increase the demand for goods, raising the prices of the goods demanded and encouraging borrowing by businessmen, whose sales and prospective profits rise. Velocity increases—the demand for money falls—not only because (some) businessmen are for a time more optimistic and velocity depends on “confidence” (ibid., 96), and thus on anticipations of the future, but also because inventories decline (237). These are short-term cyclical effects, but for a time they persist and generate additional increases in the demand for credit and in velocity. One reason the demands persist is that not all prices adjust at the same rate. Some are fixed by contract in nominal terms and rise or fall more slowly than others. Thornton used money wages as an example of a price that was fixed in nominal amount and argued that, as a result, real profits rise and real wages fall in periods of (unanticipated) inflation. Once real balances adjust to their desired level, total wealth is “nearly the same,” but there has been a once and for all redistribution from workers and other creditors to debtors (189–90).11
Thornton saw that short-term monetary disturbances had no lasting real effect. Money is neutral in the long run. One of his main reasons for short-run nonneutrality is that it is difficult to distinguish between permanent and transitory changes when they occur.12
In contrast to Ricardo, Thornton argued that replacing a convertible currency with inconvertible paper causes the market price of gold to rise above the mint price even if the nominal amount of paper money remains unchanged. His reasoning is that if money holders anticipate a decline in the purchasing power of money, they attempt to shift out of money. This argument makes the demand for money and short-run price changes depend on the anticipated rate of price change.13
Thornton’s fifth contribution to the theory of central banking is a part of his theory of money and in this respect also stands in marked contrast to much of the literature on monetary theory and policy that followed. By combining short-run and long-run adjustment, he was able to deal with issues that Ricardo neglected or dismissed. In all important respects, his analysis of the long-run consequences fully anticipated Ricardo’s.14
Neglect of Thornton’s work and reliance on Ricardo’s meant that the directors of the Bank of England, after periodically facing large changes in gold stocks and several threats to convertibility at the fixed exchange rate, concluded that Ricardian theory was inapplicable or useless. They therefore abandoned monetary theory as a basis for monetary policy and substituted ad hoc notions about money markets. These notions are at their best in the brilliant essays of Walter Bagehot and perhaps at their worst in the writings of central bankers during and after the depression of the 1930s. But either at their best or at their worst, the principles and practices of monetary policy became divorced from any analysis of the mechanism linking changes in money to short- and long-run changes in output and employment.
11. On the following pages, 97–100, Thornton offers as one example the panic of 1793 when “many country banks failed. The stock of Bank of England notes, at the start, were not fewer than usual,” but the number became “insufficient for giving punctuality to the payments.” The effect was “to lessen the rapidity of the circulation of notes on the whole, and thus to increase the number of notes wanted.” The remedy was found in issuing Exchequer bills discountable at the Bank of England. Thornton points out as a “fact worthy of serious attention” that the crisis was started by a demand to convert country notes into gold but was brought to an end by an issue of paper (Exchequer bills) that could be turned into banknotes or gold and that “created an idea of general solvency.” In this passage Thornton anticipated Bagehot’s 1962 work on the lender of last resort.
12. See also Thornton 1965, 236–41, where he traces the consequences of an injection of new money for the borrower and for the community. See especially 239 for a brief statement relating the fall in real wages during inflation to forced saving.
13. The idea appears several times. He discusses (1965, 119) the greater variance of nominal prices than of nominal wages that leads agents to regard a fall in price as temporary. The same misperception of a permanent change is used to explain the real effect of currency depreciation. In this case Thornton also invokes misperception of relative and aggregate changes (340).
14. See Viner 1965, 134, for a comparison of Thornton’s views and those of his contemporaries. Keynes was apparently unaware of the extent to which Thornton anticipated his discussion of the demand for money.
As part of his development of the price-specie flow mechanism, Thornton analyzed the effects of price changes on the gold stock of the Bank of England under convertible and inconvertible paper standards. Although he recognized the short-term effects of anticipations on the demand for money, he placed responsibility on the Bank of England for long-run inflation and any permanent divergence of the market from the mint price of gold. In a lengthy discussion of the relation of the country banks to the Bank of England, he argued persuasively that the expansion of country banknotes depended on expansion by the Bank of England and that the expansion of money was a necessary condition for inflation. But unlike the currency school, he emphasized that neither the total stock of notes in circulation nor the price level rose and fell in direct proportion to the note issue of the Bank of England (Thornton 1965, 219–29). If some resources are idle, the Bank of England can increase their employment by increasing the note issue, but “the increase of industry will by no means keep pace with the augmentation of paper,” and inflation results (239).
The three duties of the Bank of England were to protect the gold reserve, function as lender of last resort, and control the note issue. These duties were best performed, Thornton thought, by keeping the market price of gold equal to the mint price, limiting the note issue by discount rate policy, except in periods of crisis when the bank must expand the note issue and lend more freely. Any attempt to limit the note issue by rules controlling the quality of credit as proposed in the real bills doctrine was to lend “countenance to the error. . . of imagining that a proper limitation of bank notes may be sufficiently secured by attending merely to the nature of the security for which they are given” (ibid., 244 and elsewhere in chap. 10).15 The appropriate policy for the bank was to change the discount rate so as to control the quantity of money. In Thornton’s words, the policy should be
15. The “real bills” notion, that credits advanced for productive purposes could not be a cause of inflation, had been proposed by several writers including James Stewart and had been used unsuccessfully to limit the note issue of the Bank of England before the Restriction. Mints (1945, 1) finds the real bills doctrine in writings during the 1770s. He notes (48) that even the earliest statements of the doctrine relate real bills to “elasticity” of the stocks of money or credit and to effective limitation of the note issue.
to limit the total amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction; in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits; to allow a slow and cautious extension of it, as the general trade of the kingdom enlarges itself; to allow of some special, though temporary, increase in the event of an extraordinary alarm or difficulty, as the best means of preventing a great demand at home for guineas; and to lean on the side of diminution, in the case of gold going abroad, and of the general exchanges continuing long unfavorable; this seems to be the true policy of the directors of an institution circumstanced like that of the Bank of England. To suffer the solicita
tions of the merchants, or the wishes of government, to determine the measure of the bank issues, is unquestionably to adopt a very false principle of conduct. (259; italics added)16
The bank did not accept Thornton’s prescriptions. From 1797 to 1815, the securities portfolio of the Bank of England increased threefold, and in the next seven years it declined as much as it had risen in the previous fifteen.17 At the end of the period as at the beginning, the Bank of England’s portfolio was approximately £15 million.18 Most of the increase in money during 1800 to 1810 resulted from the increase of commercial paper at the Bank of England. At its maximum of approximately £23 million in 1810, the bank’s portfolio of “private securities” was larger than at any time in the next hundred years. From 1810 to 1815, by far the largest part of the increase in money resulted from the bank’s acquisition of government securities to finance wars with France and the United States. The Gayer, Rostow, and Schwartz (1978) price index shows that the price level (December 1790 = 100) follows a similar course. Prices rose to 198 in May 1813, then fell to 94 in mid-1822.
16. Note Thornton’s careful distinction between credit (borrowing) and money. This distinction was neglected by most writers until Lauchlin Currie wrote in the early 1930s. Notable also in his monetary policy are the principles that the stock of money should grow as the economy expands and that the bank should make temporary advances when there are internal drains. The complete argument of his book makes clear that by the “general trade” he means real output, not “real bills.”
17. Suspension of convertibility came in 1797 following France’s attempt to land troops in Wales. See Dowd 1991.
18. Data in this and in the next several paragraphs are from Wood 1939, 191, and Viner 1965, 174. Viner uses price indexes developed in Silberling 1923, 232–33. I use the data from Gayer, Rostow, Schwartz 1978 instead.
There are several important developments for central banking theory and practice during the period.19 One is that bankers found, as Thornton had insisted, that the Bank of England had no effective means of limiting its portfolio and the rate of monetary expansion in a period of inflation. With prices doubling from 1790 to 1812, the average rate of inflation is 5 percent, but at times it was much higher.20 Since the usury law fixed the discount rate at 5 percent, the realized cost of borrowing was zero on average. There was no previous experience with managing a paper currency and, even neglecting the usury law, no tradition of limiting the volume of discounts and allowing the market to determine the rate on bills of exchange. The bank, in an early application of the “real bills” approach, attempted to control the quantity by controlling the “quality” and restricted commercial discounts to short and “sound” bills. The policy failed on this occasion, as on many future occasions.
At the end of the Napoleonic Wars, the government deficit declined from £35 million in 1814 and 1815 to £2 million in 1817. After 1816 the Treasury retired debt, and the bank’s holdings of public securities declined. The monetary base measured as the sum of gold and total securities appears to have fallen after 1815. At first the bank’s holdings of private securities continued to rise, presumably because the anticipated cost of borrowing remained far below the anticipated rate of return on real assets after fifteen years of inflation. But the anticipations probably changed quickly. From mid-1814 to late 1815, the price index fell about one-third, and the bank’s holdings of private securities dropped to the low levels of the early 1790s. By March 1816 the Treasury was able to issue exchequer bills below the 5 percent usury rate. In the severe postwar deflation, the bank accumulated gold and lost earning assets. Thus it came to recognize a second problem of monetary management, a problem that was in fact the mirror image of the first. As long as the discount rate remained above the market rate, the bank could not take action to expand its portfolio. It eventually resolved this problem. Under pressure from the prime minister, it lowered the discount rate to 4 percent in 1822, the first change in fifty years. For a time the bank’s holdings of private securities, the note issue, and the bank’s deposit liabilities expanded.21
The third main problem of monetary management that the bank faced during these years was the restoration of convertibility, or Resumption. As early as 1810, the Committee on the High Price of Bullion, under the influence of Thornton, who was a member of the committee, and of Ricardo, who was not, urged a resumption of cash payments at the price of gold that had prevailed in 1797. Since prices had increased, the market price of specie was above the former mint price. To resume specie payments at the old mint price, the Bank of England had to engineer a deflation. On May 1, 1821, Britain returned to the gold standard at the historical mint price.
19. For the developments of the theory of money see especially Viner 1965, chaps. 3 and 4.
20. The peak rate of inflation is 20 percent a year compounded from 1798 to 1800. Prices fell an astonishing 20 percent in 1801.
21. The reduction of bank rate was not the only action taken. The gold standard became the legal (de jure) standard in 1821. Also, the bank’s holdings of government securities expanded and the bank lengthened the maturity of eligible private bills from sixty-five to ninety-five days.
A century later, the Bank of England faced a similar problem and made a similar decision. Both decisions were followed within a few years by severe and prolonged depressions. The decision to resume specie payments (1819) allowed for a four-year delay and came after a deflationary policy had been in effect for six years. After the decision to resume cash payments was announced, gold flowed into the Bank of England. Much of the gold inflow occurred because the deflationary policy had pushed the price of silver and the exchange rate for the paper pound close to the mint price.22 Between 1821 and 1824, the bank’s holding of gold never fell below £10 million.
The years from 1820–24 are one of the more interesting episodes in early monetary history. The Bank of England’s holdings of bullion tripled in the brief span of seventeen months and reached £12 million, the highest level attained to that time. Prices continued to fall until 1822, then rose, on average, 8 percent a year for the next three years. Part of the rise was the result of an agreement between the bank and the Treasury calling for the bank to advance £13 million to the Treasury in exchange for a forty-four-year annuity, known as the Dead Weight debt. These and other special advances combined with the gold inflow to increase the bank’s deposit liabilities and note issue. Private borrowing expanded, and with bank rate reduced to 4 percent in 1822, the bank acquired bills and issued money.
Throughout the period, the government ran an almost constant budget surplus of £3 million to £4 million per year and used the surplus to retire debt. The net effect of the Treasury’s debt retirements and the special issues to the Bank of England was the same as would have occurred had the bank engaged in open market purchases. The expansive effect of the open market operation on the monetary base and the economy was not entirely unexpected. The prime minister, Lord Liverpool, informed the bank in 1822 that he wanted to increase the circulation, and it is likely that the bank’s purchases of Dead Weight debt were part of a plan to expand the stock of money and slow or stop the fall in (agricultural) prices. There is additional evidence that the idea of using open market operations to expand the note or monetary liabilities of the bank was understood, though the term open market operation was not used. At about the same time the bank purchased exchequer bills in the market at the request of the Treasury.23
Some indication of the effect on the bank of the changes in activity during these years is given by its income from discounts. Scammell (1968, 145) shows the following:
The figures are, of course, nominal values and therefore overstate the size of the changes in the bank’s real income.
22. See Viner 1965, chart 1 and table 1, 143–44. For Ricardo’s views on devaluation of the pound see Viner 1965, 204. The Gold Standard Act of 1816 repealed bimetallism in England.
Judging from the increase in the bank’s holdings of private securities
from 1822 to 1824 and particularly in the latter year, the economy expanded. The data are not sufficiently accurate to conclude that the expansion of the economy and the return of inflation can be attributed solely to the rise in the monetary base and the reduced discount rate at the Bank of England. However, the timing and direction of changes are consistent with the hypothesis that the deflationary policy before 1820 (1) induced a subsequent inflow of gold that increased spending, (2) thereby raising realized returns in agriculture and trade above previously anticipated rates, (3) stimulating additional borrowing, and (4) resulting in a further expansion of the monetary base. The reduction in bank rate and the open market purchases added to this process by increasing the growth rate of the base.
A History of the Federal Reserve, Volume 1 Page 5