Monetary Policy from 1914 to 1980s

This series of posts is based on a single lecture (Lecture 13 of Advanced Macro II) exploring the evolving functions of Central Banks through time. It goes through a vast amount of material in a very short time, and hence is a very sketchy treatment. This is the 3rd post,  which deals with the period from the world wars to the 1980s. The 15m segment dealing with this time period is linked below. The writeup which follows the video is more detailed, and provides more clarification and explanation. A slightly edited and abbreviated version of the writeup is on WEA Pedagogy Blog: Central Banks 3/5 – 1914 to 1980s


The first post Origins of Central Banking (1/5) shows how the Bank of England was created to provide war financing, and was very successful in doing this. A second post on  Monetization, Maturity Transformation, and MMT provides a deeper understanding of how banks actually function (credit creation & maturity transformation) and how this differs from the popular beliefs (financial intermediation). Looking at the history shows a very strong association between wars and finance. The creation of money creates the power to finance wars. Money is actually a promise to pay in the future, and what makes the promise credible is power – the assurance that the creator will be there to redeem the promise.

The third post discussed the Hundred Years’ Peace, when direct warfare between the Great European Powers on the European continent was avoided because the transnational Central Bankers had a strong interest in maintaining peace. During this period, the globe was an open frontier and Europeans colonized nearly 85% of the planet. Capitalism has a built in dynamic of expansion, and financial expansion was accomplished by investments and colonial wars. This historical context is essential to understand how the role and function of Central Banks evolved over the nineteenth century. This is discussed in Central Banking (2/5) The Hundred Years’ Peace from 1814 to 1914.

How did World War 1 end the 100 years of peace (within Europe)? Global colonization diverted the war energies until the abut 85% of the globe came under European control by the early 20th Century. Exhaustion of the opportunities for exploitation of global resources led to  “the dissolution of the existing forms of world economy—colonial rivalry and competition for exotic markets” (Polanyi). The second factor which led to the first world war was the breakdown of the system of balance of powers, which relies on the existence of three or more major players. Whenever any players threaten to become too powerful, the others combine against it to prevent this outcome. The formation of the Triple Entente, and the Triple Alliance created two hostile groups, with no major third party which could maintain balance. The structural change in the underlying world economy, combined with the breakdown of balance of powers, led to the first world war. For a deeper and more detailed discussion of the Gold Standard in this historical context, see “The Vital Importance of Understanding Global Financial Architecture”.

The Gold Standard is inherently a zero-sum, adversarial system of trade.  I can get gold by taking it from you or vice versa – we cannot both have it. In a world with open borders, we can extract increasing amounts of gold and resources from expanding colonies, but once this prospect is exhausted, then benefits of war can exceed benefits of trade. The standard economic theories of comparative advantage are based on a world of barter without any politics or war. Money is just a means used to trade commodities, and does not matter for the real economy. Karl Marx clarified the matter with the C-M-C’ and the M-C-M’ notation. In a barter economy, one sells commodities for money, and uses money to buy more commodities. Here, international trade can be win-win when both parties sell their less desired surplus commodities to purchase those which they need or desire more. However, if the goal of trade is to make money – gold – than the entire calculus changes. Now trading is a hostile, zero-sum game, because only one of the two parties will end up with more gold. Gold is the key to finance, and to the power to make wars. So, acquiring gold, keeping pace with other countries in terms of acquisition of gold, and preventing enemies from acquiring gold, is an existential problem. This is the key to understanding both Mercantilism and the decline of mercantilism in the nineteenth century, when peace temporarily became more profitable than war.

The Interregnum: 1914 to 1944

The Interregnum refers to the Inter-War period 1914 to 1944. The heavy expenses of war incurred by all European powers led to a massive drain of gold from the Central Banks. This made it necessary to abandon the gold standard, since Central could not redeem their currencies for gold at the promised parity. Post-War there was a massive effort made to restore the gold standard. The nineteenth century had been one of massive increases in prosperity in Europe, due to the massive amount of surplus made available by colonization and exploitation of the resources of the entire globe. It was mistakenly thought by all that this prosperity was due to the free international trade enabled by the gold standard. Polanyi describes the effort to restore the gold standard after the WW1 in poetic terms as follows:

Indeed, the essentiality of the gold standard to the functioning of the international economic system of the time was the one and only tenet common to men of all nations and all classes, religious denominations, and social philosophies. … mankind braced itself to the task of restoring its crumbling existence. The effort, which failed, was the most comprehensive the world had ever seen. The stabilization of the all-but-destroyed currencies in Austria, Hungary, Bulgaria, Finland, Roumania, or Greece was not only an act of faith on the part of these small and weak countries, which literally starved themselves to reach the golden shores.

Despite massive efforts, the gold standard could not be restored because it was inherently flawed as a basis for global trade. Use of the gold standard creates a strong conflict between the needs of the domestic economy and the stability of exchange rates required for international trade. In the pre-war era, Central Banks had ignored the needs of the domestic economy, and set stability of exchange rates as their goal. In the inter-war era, with European economies lying in ruins, this was no longer possible. An expansionary monetary policy was required to rebuild economies, but this was not compatible with the stringency required for restoring the gold standard. Eichengreen provides a detailed analysis on how Central Bank policies, and their effects, underwent a radical change in the inter-war period, because of the necessity of emphasizing the domestic economy. For a detailed discussion, see “International Financial Architecture: Part II”.

The Great Depression of 1929

The destruction of the European economies, and the isolation of the USA, led to the emergence of USA as the financial center of the world in the post-war era. The creation of the Federal Reserve Bank in 1914 substantially strengthened the ability of banking sector of the USA to create credit. See “Completing the Circle: GD ’29 to GFC ‘07” for a brief discussion of how this led to a spree of credit creation which financed the roaring 20’s in the USA. The speculative boom led to a spectacular crash famous as the Great Depression of 1929. It was widely realized that this was due to irresponsible behavior by banks, and massive regulations on banking were enacted. The Glass-Steagall act prohibited banks from speculative activities. Competition among banks for creating highest yields led to risky behavior. This was prevented by putting a ceiling on the maximum interest rates offered on deposits. To prevent them from growing too large, banks were prohibited from expanding beyond state boundaries. Federal Deposit Insurance Corporation was introduced to insure deposits. One important restriction known as the Chicago Plan, was however defeated by the financial lobby. The Chicago Plan would have taken away the power to create credit from banks, and given it to the government. This failure did not have immediate impact, but did lay the seeds for the long run disaster of the Global Financial Crisis. For more details and discussion, see “The Battle for the Control of Money”.

As a result of heavy regulations, Banking became the most boring profession on the planet! Bankers followed the 3:6:3 rule, i.e. borrow at 3%, lend at 6% and on the golf course at 3 p.m.  But, a boring System is also a SAFE System. There were no systemic banking crises for about fifty years, and hence also, no efforts by Central Banks to control crises. During this period, experience led to clearer understanding of the Role of Central Bank Versus Treasury. Central Banks were assigned the responsibilities of managing the foreign exchange rate, and reserves. They were given the job of implementing banking regulations. In addition, Central Banks were in charge of debt management, liquidity management, and management of the financial markets.

Creation of Keynesian Economics

Apart from regulation of the financial industry, another major revolution caused by the Great Depression was the inventions of Keynesian Economics. Whereas classical economics held that money was neutral, Keynes argued that expansionary monetary and fiscal policy was required to lift economies out of recession. This created another set of tasks for the Central Bank – maintenance of full employment, in addition to guarding against inflation. In some countries, this task was given to The Treasury, to handle Monetary Policy as well as Budget & Fiscal Policy.

From the earliest times, Central Banks have been closely connected with financing for wars. The next major development occurred when the Bretton-Woods Conference was held in June 1944, a little before the end of World War II. It was clear that the efforts to restore the Gold Standard had failed in the inter-war period, and the second World War had put the gold standard permanently out of reach. There was a need to design a new system for international trade, which would not be based on gold. Although Keynes came to the conference prepared with a sensible, well-designed, symmetric system, this was shunted aside in favor of a system based on the dollar, backed by gold. This was called a gold-exchange standard, in the sense that at the core was a currency which could be exchanged for gold, since US had gold reserves which had not been affected much by World War II. This use of dollar created an asymmetric system with huge benefits for the center currency and huge disadvantages for all others; see “A Lopsided System”.

The Nixon Shock & Floating Exchange Rates

The next development in evolution of money was caused by the Vietnam War. Financing the war required printing dollars in quantities which made it impossible to back them with gold at the announced rate. The 1971 announcement that dollars would no longer be backed by gold has been termed the “Nixon Shock”.  Just as fixed exchange rates are natural in a gold-standard world, floating exchange rates are natural for a world of fiat currencies without any backing. However, this was a new experience for the world. There was substantial apprehension that wild gyrations of exchange rates would be a huge barrier to international trade and hence global prosperity. This has been called the “Fear of Floating”. One illustration of this fear was the attempt by the Hunt Brothers to acquire a monopoly on silver, under the belief that floating exchange rates were bound to fail, causing a return to gold and silver. Despite these fears, the world learned to live with floating exchange rates, and these are in fact an essential feature of Modern Monetary Theory as the right way to manage international trade.

From World War II until the 1970’s was a golden era for Western economies. It seemed that Keynesian economics had delivered the magic formula, and Central Banks were able to maintain full employment and price stability. However, this period of prosperity led to a rise in the wealth share of the laborers, and a corresponding decline in the wealth share of the top 1%; see The Power of Economic Theory: Graphically Illustrated. As Karl Marx noted, capitalism works by the willing consent of the laborers to their own exploitation. This consent is created by misleading and deceptive theories (see ET1%: Economic Theory of the top 1%) which promote policies which appear to be beneficial for all, but in fact strongly favor the rich and powerful. One of these theories is “Monetarism”.

The Monetarist Counter-Revolution

The first shot in the battle of the rich against the poor was fired when Milton Friedman wrote “A Re-statement of the Quantity Theory of Money” in 1956. This laid the theoretical foundations for the “Monetarist Counter-Revolution” against the Keynes. Keynesian theory gave great importance to the role of money – too little would lead to unemployment while too much would cause inflation. This meant that the Central Bank had to accurately target the money stock to be at just the right level. Friedman restored the pre-Keynesian view that money does not matter in the real economy. There are two fundamental misconceptions about money which are embodied in the quantity theory. The first is the idea that money is “exogenous” – that is, the government creates the stock of High-Powered Money, and the total amount of money in the economy is just a fixed multiple of this amount. This means that the government can control the amount of money in the economy. The second misconception is that money is neutral – that is, the money only effects prices, and has no other real effects on the economy. There is a massive amount of empirical and theoretical evidence against both of these myths. The Bank of England paper on “Money Creation in the Modern Economy”. Private banks create money when they give loans, so that money is not exogenous – demands of borrowers lead to creation of money. Similarly, extensive evidence on the wide-ranging effects of money throughout the economy (as opposed to neutrality) is available from “Market Power and Monetary Policy” as well as “The Trouble with Macro”.

Friedman’s re-instatement of the Quantity Theory of Money was based on a popular misinterpretation of Keynes which provided the basis for the neoclassical synthesis. According to this idea, money is neutral in the long run. Short run Keynesian effects arise because prices are fixed in the short run. Thus, when money supply increases, the real wage decreases, but laborers suffer from money illusion, and do not notice this, because the nominal wage is fixed. Thus, they become more willing to work, and the firms hire more labor, temporarily increasing employment. However, as prices rise, and everyone notices this, unemployment goes back to its “natural rate”. The lesson is that while expansionary monetary policy can have short run beneficial effects, in the long run it can only cause harm to the real economy by building in inflationary expectations. Also, monetary policy works by creating a “money illusion” because workers fail to distinguish between nominal wages and real wages, in the short run.

Paul Volcker and the Failure of the Friedman Rule

Based on this analysis (which is completely erroneous), Friedman came to the conclusion that monetary authorities should create and announce a target for monetary growth and stick to this target as the optimal form of monetary policy. This is the Friedman rule for monetary policy: Keep reserves growing at 6%. This will create a fixed and known rate for inflation, eliminating “money illusion”, and eliminating the harmful effects of unpredictable shifts in money supply. Since the real economy works best on its own without interference from government, the Friedman rule will lead to optimal economic results, creating Price Stability, Financial Stability and Growth.

US intervention in favor of Israel in the Yom Kipur War led to the oil embargo, and dramatically increased prices for oil in the USA. Cost-push inflation reached 9% in the late 1970’s when Paul Volcker was made the head of the Federal Reserve. Volcker announced that he follow the Friedman Rule, in order to bring down the inflation. Contrary to general expectations, he achieved this goal, bringing down inflation remarkably. However, huge real costs were inflicted upon the economy. The contractionary monetary policy followed by Volcker created the deepest recession seen since GD ’29. There is considerable controversy about Volcker. Friends praise him for controlling inflation, while enemies blame him for causing the recession. For example, see Goodfriend and King “The Incredible Volcker Disinflation” who argue that real costs of recession were low, and benefits of disinflation were high. Another article in praise of Volcker is about Volcker’s Rules.  A more global perspective on huge costs of the Volcker Recession of the early 1980s is provided in the Wikipedia article on the topic: the Early 1980s Recession.

Regardless of how one normatively evaluates this Volcker episode as good or bad, it had an extremely important influence on shaping Central Bank policy. Despite efforts by the Central Bank, it proved impossible to keep the money supply on target growth rates. This is because endogenous credit creation by private banks is not under central bank control. Thus, the Friedman rule is impossible to implement, simply because money supply is not exogenous. Since then, the instrument used for monetary policy has been the interest rate. In particular, the overnight discount rate offered by the Central Bank governs short term interest rates throughout the financial markets. Also, buy buying and selling short term bonds as required, the Central Bank can ensure that the policy determined interest rate prevails on the market. However, controlling interest rates means losing control of the money supply – sales and purchase of bonds will create or destroy money to ensure a match between demand and supply of credit at the policy rate. These are some of the key insights of Modern Monetary Theory, which is very different from conventional monetary and macro theory taught in standard textbooks.

Date posted: October 8, 2019
Categories: Blogs

Comments (6 responses)

  • Farhan Arif says:

    Nice overview Dr Asad.

    You mentioned that the Gold Standard was inherently flawed, because of the conflict between the needs of the domestic economy and the stability of exchange rates required for international trade, but isn’t that conclusion based on the premise that money supply expansion is required for prosperity? International exchange rates will be fixed under a gold standard world as you also have noted, so the only reason that will make it unsustainable would be domestic expansion of the money supply. When humanity has used hard money for the vast majority of recorded history and we know there were great achievements made by man in those times too and certainly there was not so much misery as it is know. I always question: Why should any organization, even the government, be given the right to create money out of nothing, when all others work, and the majority work very very hard to earn it.

  • asad says:

    As the economy expands, the monetary needs of the economy expand in proportion to the size of the economy. Gold expands at its own pace, NOT corresponding to the needs of the economy. If economy grows rapidly but gold supplies are fixed, this creates very strong brakes, preventing growth. If gold supplies expand faster than the economy, this creates inflationary pressures. Islam provides an answer to your question – MOney is a PUBLIC GOOD, beneficial for all – it should be created in the public interest.

    • Tahir Rafique Khan says:

      If Gold’s availability can not be comparable with respect to economic expansion then what I heard from an Islamic scholar, we may use any of the six commodities Wheat, Barley, dates, salt, (gold) and silver which according to a Hadith can only be traded with itself (Gold with gold, silver with silver and so on) in equal quantities and hand to hand meaning they may be used as currency. Further other commodities of various countries found in abundance and shelf life may also be used as currency.

      If Government issues paper currency then it should be backed by above said commodities which would made fiat currency valuable. While issuing new paper currency equivalent amount of backup goods will be sold in market so that supply remain adequate and inflation may not occur.

      • asad says:

        I do not know if there is any clear ruling about legitimacy, or otherwise, of fiat currency. It seems that scholars today are agreed on its permissiblity, because all currencies in the world in use for the past fifty years are without any backing by anything. No one has complained that this is haram

        • Tahir Rafique Khan says:

          The question is: Does backing fiat currency with commodities having shelf life as discussed above can prevent inflation and make economy stable because mere flow of fiat money and credit money without any backing results in high inflation.

          • Asad Zaman says:

            What you are saying is known (approximately) as the “Real Bills Doctrine” – difference being that currency can be issued if backed by business claims (bills). Backing by commmodities is rather complex and peculiar – who will STORE the commodities? would they go out of circulation because they are being used as “backing”? About 80% of gold backing does not circulate. So would we take real commodities out of circulation. There are many pragmatic problems which is why this system has never been used or proposed. Instead, commodities are DIRECTLY used for trade in barter systems. However abstract backing like LABOR POWER has some validity and possiblity.

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