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C H A P T E R 3 MONETARY DOWNTURN COMPOUNDS TRADE WOES May–June 1982 Between 1980 and 1982 the developed world experienced two back-to-back recessions, with the US having recessions from January 1980 to July 1980, followed by another from July 1981 to November 1982 according to the National Bureau of Economic Research. Not surprisingly this led to a sharp downturn in Hong Kong’s external trade, as reflected in the original title of this next article. Of more significance, perhaps, from the standpoint of elucidating the monetary mechanism at work in Hong Kong was that the trade downturn was accompanied by an abrupt slowdown in monetary growth. If previous articles had given the impression that Hong Kong’s monetary system had a tendency to generate excess money growth, here was an opportunity to test that idea, or alternatively to devise a more robust hypothesis that was consistent with the empirical data. The hypothesis I proposed (“A Hypothesis for the Hong Kong Trade Cycle”) in the face of this new situation was essentially an application of the real bills doctrine. This is the proposition advanced in the eighteenth century by Adam Smith (among others) that money and credit should expand and contract to meet the needs of trade. It featured prominently in the bullionist controversy of the early nineteenth century, when it was repudiated by Henry Thornton and David Ricardo, who argued that controlling the volume of bills discounted (i.e. the quantity of high-powered money) was more important to overall economic stability than allowing flexibility of supply since there was no other limit to the depreciation of the currency “than the will of the issuers” (David Ricardo, see The New Palgrave: A Dictionary of Economics, 1987). The real bills doctrine appeared again in the Federal Reserve Act of 1913 and in the deliberations of the Fed in its first two decades. It was one of intellectual factors contributing to the Great Depression of 1931–33 (see Allan Meltzer, A History of the Federal Reserve System, 2003). It should be recalled that I was continuously grappling with the problem of how, in the absence of a central bank in Hong Kong, one could explain the accelerations and decelerations of the money supply. In view of the global economic slowdowns of 1980–82 it was natural for Hong Kong’s external trade to slow down, and this could be extended to explain the behaviour of money and credit. The additional twist to the hypothesis was the idea that, since the banks in Hong Kong set their deposit rates through the Hong 38 Hong Kong’s Link to the US Dollar Kong Association of Banks (HKAB) and lending rates were derived from these regulated rates, money growth and bank credit growth could in turn be viewed as a result of whether interest rates were set too high or too low by the HKAB cartel. If rates were set too low, or lower than equilibrium levels, this would generate excess money growth, whereas if rates were set too high this would generate inadequate money growth. A global recession and the downturn in Hong Kong’s trade, together with the delayed adjustments in HKAB interest rates, produced exactly the set of conditions that could explain the sharp downswing in Hong Kong’s money growth in 1982. Moreover, the temporary stabilization of the exchange rate during the global recession would also be consistent with the idea that Hong Kong’s monetary system was subject to a real bills mechanism. Although nothing can ever be conclusively proved in the real world from economic theory, it would be hard to replicate a situation that more closely conformed to a textbook case of the real bills doctrine than that in Hong Kong between 1974 and 1983. The analysis places strong emphasis on the desirability of monetary base control, or at least a quantitative approach to monetary control. In part this approach was designed to highlight the defects of the Hong Kong monetary framework in an era when the authorities had no direct means of managing expansions or contractions in the system; in part it reflected the academic spirit of the times which featured Paul Volcker at the Federal Reserve System attempting to implement monetary base control, and Margaret Thatcher’s first government in the UK attempting to control the broader monetary aggregates. An updated analysis would be more sympathetic to the use of interest rates as a means of indirectly...

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