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The Journal of Economic History, Vol. 55, No. 3, (Sept., 1995). The Economic History
Association. All rights reserved. ISSN 0022-0507.
John R. Garrett is Associate Professor of Economics at the University of Tennessee at
Chattanooga, Chattanooga, TN 37403.
This work owes its existence to the late Leonard A. Rapping, my doktorvater, who is sorely
missed. The author thanks Claudia Dziobek, Charles Kindleberger, Martin Klein, Alan Rabin,
Carl-Ludwig Holtfrerich, Manfred Neuman, Peter Lindert, and two anonymous referees of this
JOURNAL for insightful comments, without implicating them for my errors. The Research Seminar
at UTC and Das Institut fur Internationale Wirtschaftswissenschaft at Bonn University provided
constructive, stimulating environments. Financial support from the University of Tennessee, the
Fulbright Kommission of Germany, and the UC Foundation is gratefully acknowledged.
' Sayers, Bank, p. 297.
2 Eichengreen, Watson, and Grossman, "Bank Rate Policy," p. 733.
612
Monetary Policy and Expectations 613
well it should be, if the Bank is assumed to have had an adequate open-
market portfolio.
The failure to comprehend the circumstances surrounding the Bank of
England's market-control difficulties has led to a seriously distorted
view of British monetary policy during the interwar gold standard. The
consensus view is that an over-valued pound resulted in chronic
balance-of-payment pressures that left the Bank with too little gold,
which in turn forced monetary policy to be far more restrictive than the
Bank would have liked.3 An examination of the asset side of the Bank
of England's balance sheet, corrected with Sayer's data, reveals a set of
problems that vitiate the consensus view. For the first half of the gold
standard, the Bank of England's problem was too much gold, not too
little. Nor was a lack of gold a consistent policy constraint in the second
half of the gold standard. From September 1928 until the end, the
primary problem was the unprecedented instability in international
capital flows, which in two separate six-month periods produced a gold
flow greater than the Bank's entire prewar stock of gold. Montagu
Norman, the Governor of the Bank of England, considered these
problems so grave that he engaged in a large-scale deception that greatly
over-stated the size of the effective open-market portfolio, understated
the size of the gold stock, and misstated the size and even the direction
of gold flows.
Hiding the strength of the pound from the public, the government, the
Bank of England's governing bodies, and the financial markets was
necessary but not sufficient for the enactment of Norman's policy
scenario. To maintain his grip on interest rates, Montagu Norman
temporized in an extraordinary fashion: he developed the false reporting
of gold flows into a new channel of monetary policy. The new policy
channel was an attempt to manipulate market expectations directly,
without the usual intermediary step of a change in a traditional policy
instrument (bank reserves, Bank Rate, or the gold price of the pound).
Strong econometric evidence reveals that the false reporting of gold
flows was a powerful policy instrument, deployed mainly to keep
monetary policy more restrictive than warranted by the gold-standard
rules of the game.4
Following Thomas Sargent's well-known example, this historical
episode provides a test for a current controversy in macroeconomic
theory.5 Norman's activities produced a unique data set that can be
used to isolate without ambiguity an "exogenous," policy-induced
change in financial-market expectations from movements in both real
I
See for example, Eichengreen, Elusive Stability, p. 9; and Sayers, "Return."
4 However, expectations manipulation was for short periods used to exaggerate the strength of
the pound in order to defend the gold standard facade that protected Norman's policy indepen-
dence.
5 Sargent, Rational Expectations.
614 Garrett
16
The ruse was successful. W. A. Brown (Gold Standard, p. 721) describes the great
international effort among central bankers to rescue the weak pound in 1927, and this story has
been repeated in other classics, such as Clarke, Central Bank. Far from being weak, in the two-year
period from the spring of 1926 to the spring of 1928, the Bank was forced to accumulate 60 million
pounds of gold and hard currencies to keep the pound from rising, marking this as the pound's
strongest period in history.
17 Economic conditions in the worst prewar years were as good or better than those during the
interwar gold standard. In addition gold was far more plentiful during the interwar years. A prewar
616 Garrett
45I
40-
35 -
30 i
'25 -
o20-
15-
10- .
weak business demand, high nominal interest rates, mild deflation, and
plentiful short-term capital inflows, there was an incipient tendency for
market rates to sag under Bank Rate. Norman responded by large and
persistent open-market sales in excess of gold inflows (see Table 1). He
conducted ?66 million of net contractionary open-market operations
from the return to gold until 1928: 2, of which ?45 million were not
reported. Note in Table 1 the cumulative decline in the monetary base.
The continued policy of deflation after the return to gold, and particu-
larly after the general strike of 1926, generated political controversy.'8
What support there was for continued deflation was predicated on the
need to defend the gold standard. 19Had it become public knowledge in
reaction function based on these two variables implies that Bank Rate would have been lower
interwar than the lowest prewar Bank Rate, had the Bank kept the same reaction function.
18 Note that pressure for easing in the 1920s came from all sides. Churchill as the Conservative
Party's Chancellor of the Exchequer threatened the Bank with a Parliamentary Inquiry when
Norman raised Bank Rate in 1925. Keynes was a prominent Liberal Party member, and, from 1922
on, was a tireless advocate for easier monetary policy. The Labour Party requested that monetary
policy be governed by a tripartite board with representatives from industry and unions, to blunt the
influence of the financial sector.
19 Keynes, Economic Consequences; and Hawtrey, Monetary Reconstruction, p. 171.
Monetary Policy and Expectations 617
TABLE 1
ESTIMATED SOURCES OF CHANGES IN THE MONETARY BASE
(millions of pounds)
Change in
Discounts Change Change
less in in Open-
Public Change Special Market Net Cumulative
Year Quarter Depositsa in Gold Deposits Portfolio Change Change
1925 2 -1.4 0.7 0.0 -7.4 -5.5 -5.5
3 -5.4 8.3 0.0 -3.1 -0.2 -5.7
4 13.0 -10.3 -3.6 -0.7 -0.6 -6.3
1926 1 -8.2 - 1.0 3.6 -2.1 -7.7 -14.0
2 2.1 5.6 0.0 -6.9 0.8 -13.2
3 -3.5 10.4 0.0 -9.0 -2.1 -15.3
4 2.1 2.6 0.0 -4.3 0.4 -14.9
1927 1 -1.3 3.3 0.0 -5.0 -3.0 -17.9
2 3.1 7.7 -1.9 -15.1 -6.2 -24.1
3 -5.2 2.0 1.2 -0.1 -2.1 -26.3
4 1.7 7.7 0.7 -5.3 4.6 -21.7
1928 1 -0.2 9.0 0.0 -10.6 - 1.8 -23.5
2 -7.9 6.6 0.0 -4.4 -6.7 -30.2
3 4.8 4.0 -3.0 -0.8 5.0 -25.2
4 6.6 -22.6 3.0 14.6 1.6 -23.6
1929 1 -3.2 -18.0 0.0 2.2 -19.0 -42.6
2 -2.0 10.0 0.0 -6.9 - 1.7 -44.3
3 0.0 -13.4 0.0 6.9 -6.5 -50.8
4 6.0 -9.6 0.0 10.3 6.7 -44.1
1930 1 -8.4 11.3 0.0 -12.1 -9.2 -53.3
2 0.8 6.0 0.0 3.1 9.9 -43.4
3 3.3 5.7 0.0 -3.3 5.7 -37.7
4 1.8 1.3 0.0 -3.2 -0.1 -37.8
1931 1 -2.0 -10.0 0.0 -8.1 -20.1 -57.9
2 2.1 11.0 0.0 -5.5 7.6 -50.3
3 -5.2 - 18.0 0.0 19.8 -3.4 -53.7
4 5.9 -24.0 0.0 31.7 13.6 -40.1
a Public deposits defined as public deposits less ways and means advances.
Notes: The table measures changes in Bank of England assets that reflect the sources of changes
in the central bank's liabilities, which provide for changes in the monetary base. Net public
deposits are not a Bank asset. Their inclusion is in effect a partial consolidation of Bank and
Treasury balance sheets necessary because, holding total assets fixed, an increase in Bank of
England liabilities to the Treasury necessarily means a decrease in Bank of England liabilities to the
public. Special deposits are also not an asset. Their inclusion does not lead to double counting because
the deposit was kept off the market and held as part of the asset category "reserve of notes and coin"
in the Banking Department. The table is derived using averaged monthly data, centered midquarter.
Sources: Sayers, Bank; Brown, Gold Standard; United Kingdom, Statistical Abstract; and
author's calculations.
the spring of 1928 that deflationary policy was three times as severe as
reported and concurrently that gold inflows and the gold stock were at
record levels, Norman would have been through.
Hiding the gold inflow contained political pressure for easing mone-
618 Garrett
tary policy, but required large open-market sales from a rapidly shrink-
ing portfolio. During 1927: 2 market rates sagged far below Bank Rate.
Norman was losing control of market rates because his open-market
portfolio had become too small to counteract large gold inflows in a
timely fashion. Norman had a major market-control problem, though
this was known only to Norman and three senior officials at the Bank
who treated it as a "'secret matter."20 Sayers documents that the
Committee of Treasury, the Bank of England's day-to-day governing
body, was left in the dark, as was the Court, the Bank's de jure and,
before Norman, defacto policy body.21 Sayers expresses surprise at the
secrecy with which open-market operations were surrounded even
within the Bank's inner corridors. This extended to the point of
declining to keep in the Bank's confidential archives any written records
of policy decisions motivating transactions.22 However, for Norman's
policy model the utmost secrecy was essential.
TABLE 2
ESTIMATED EFFECTIVE OPEN-MARKET PORTFOLIO, 1924-1932
(millions of pounds)
Notes: The long-term securities holdings are conservatively set to 35 million pounds, the low end
of the 35-40 range given by Sayers. I also assumed that all foreign exchange was held in the
Banking Department, and small amounts, usually not more than 1-3 million pounds, were held in
the Issue Department. Therefore the accuracy bounds are +3 to -5. For explanation of negative
entries see the text.
Sources: Brown, Gold Standard, appendix 3A; Sayers, Bank, vol. 3, pp. 349-55; and author's
calculations. The table is derived using averaged monthly data, centered midquarter.
THE MODEL
This section will model the effectiveness of monetary policy con-
ducted through two separate channels: the traditional mechanism
through changes in the quantity of reserves and the expectations
channel. The model is based on the standard money-multiplier mone-
39 Sayers, Bank, p. 282.
4 Ibid., p. 282.
41 Capie and Webber, A Monetary History, pp. 313-14.
42 Sayers, Bank, p. 274.
624 Garrett
+ a3a4)la1)DG (5)
RDd is the d month difference in the reserve-to-deposit ratio. Equation
5 is suitably formulated to evaluate the channels through which mone-
tary policy maintains market control with a given Bank Rate. The
efficiency of open-market operations can be derived from the RDd
coefficient. The DG coefficient measures the impact of shifts in expec-
" A gold-flow model is formed implicitly by substituting equation 3 into equation 2 and solving
for DG. This is a sensible model only under restrictive assumptions, including, but not limited to
the special case that there is no expectation of a change in parity (meaning the gold standard will
be maintained forever), and foreign conditions are constant. The simplicity of the model should
erode its ability to track markets when either do not hold.
626 Garrett
TABLE 3
MARKET CONTROL REGRESSIONS
DEPENDENT VARIABLE: BR - BL, MAY 1925 TO AUGUST 1931
gold flows on market control.48 Both gold flow coefficients are highly
significant, even though substantial colinearity exerts a downward bias
on the reported t-statistics. The 12-month gold flow is a measure of
48 Two- and four-month gold inflows produced coefficients of similar magnitudes but slightly lower
t-statistics. One-month inflows were not significant, as is appropriate given their reduced information
content. Flows longer than four months had a steady decline in significance, as is appropriate, for, the
longer the flow, the less new information was added to that given by the 12-month flow.
628 Garrett
Interpretation
From regression 3 the coefficient on RD4 indicates that a ?1-million
open-market operation caused a 2.46 basis point change in market
rates.50 The GOLD coefficients show that purporting a one-million
pound gold flow produced a 1.82 basis point change in market rates. The
response of market rates to published gold alone, without any change in
the level of reserves, is remarkable, as it is almost as large as that
produced by an actual open-market operation of equivalent size. In
addition the high t-statistics on the gold flow coefficients indicate that
the market response was consistent and fairly precise.5' It could readily
be used as a channel for monetary policy.
I
For example, see Keynes, "Amalgamation."
50 For example a ?10 million open-market purchase will add ?10 million to both the numerator
and denominator of the RD ratio. This will increase RD4 by a maximum value of 0.001707 after four
months, using the average levels of reserves and deposits for the period.
s' See the note for Table 3.
Monetary Policy and Expectations 629
1.2
---
1 r BR- BL Regression 3
0.8-~~~~~~~~~~~~~~~~~~~~~~~.
4) A~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~A
0.8 |
4 -
O . .
-0.2~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~.
0.3-
i 0.2
0.1
-R .eserves
E tations
3
$21 0
V)~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~1
X o
-0. 1
-0.2-
0
-034
CONCLUSION
The role played by the interwar monetary policy system in the genesis
and propagation of the Great Depression is a source of controversy.
Charles Kindleberger writes:
I have failed to persuade large numbers of scholars that the depression was a
worldwide phenomenon in origin and interaction rather than an American
recession that, extended by policy errors on the part of the Federal Reserve
System into a U.S. depression, spilled abroad.65
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