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History of Political Economy Annual Supplement to Volume 33 (2001) 162-189
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Quantity Theory and Needs-of-Trade Measurements and Indicators for Monetary Policymakers in the 1920s
Thomas M. Humphrey
It is no accident that the age of measurement in economics coincides with the rise of central banking, for that epoch produced the statistical indicators that central bankers employ in conducting monetary and credit policy. So plentiful did the indicators become that officials were often forced to choose among them. At other times, however, choice was hardly an option. Instead, legal, institutional, or analytical considerations dictated which indicators policymakers would use. These considerations became especially important in the 1920s and early 1930s when U.S. gold holdings were sufficiently large to relax the constraint of the international gold standard and permit domestic control of the money stock and price level. At that time, two rival sets of indicators clamored for acceptance by Federal Reserve System (Fed) policymakers.
One set of indicators, consisting of the money stock, the price level, and the real rate of interest, was appropriate for an activist, ambitious central bank that endeavored to stabilize the price level and smooth the business cycle. The other set consisted of measures of aggregate output, type and amount of commercial paper in bank portfolios, levels of [End Page 162] short-term nominal rates of interest, and volume of member bank borrowing at the discount window. This set was appropriate for a passive, decentralized, noninterventionist system of autonomous regional reserve banks serving local commercial banks and their borrowers by accommodating automatically all productive demands for loans over the cycle while preventing credit from flowing into speculative uses. In other words the second set of indicators was appropriate for the type of banking system mandated by the 1913 Federal Reserve Act.
Fed policymakers accepted the latter set of indicators because they had little choice in the matter. The 1913 Federal Reserve Act required them to do so. The act established a system of twelve independent but cooperating regional reserve banks whose job was to “accommodate commerce and business” by “furnishing an elastic currency” and “affording a means of rediscounting commercial paper.” Accommodation and regional autonomy were the watchwords. The act said nothing about stabilization as a policy goal or about a single central agency charged with the duty of achieving that goal.
Nevertheless, by the mid-1920s there were voices—some within, but most without, the Federal Reserve System—claiming that the Fed should have learned that stabilization, not accommodation, was its overriding responsibility and that certain statistical measurements were available to help it accomplish that task. Accordingly, these same voices advocated that the Federal Reserve Act be amended to make stabilization the chief responsibility of the system, with power given to a single central authority to unify, coordinate, and synchronize the policy actions of the individual reserve banks.
But the Fed rejected these suggestions and clung to the notion that accommodation, not stabilization, was its duty and that the proffered measures were irrelevant to the discharge of that duty. The result was that the Fed spurned those measures and the quantity theoretic or monetary-approach-to-the-business-cycle framework that featured them in favor of an entirely different framework. Composed of the real bills or needs-of-trade doctrine (also known as the commercial loan theory of banking), that latter framework had nonmonetary forces driving the price level just as it had output and the needs of commerce determining the money stock.
Since the doctrine taught that (1) money created by loans to finance real production rather than speculation has no influence on prices, (2) causality runs from prices and output to money (rather than vice versa, [End Page 163] as in the quantity theory), and (3) the central bank in no way possesses control over money, there was no reason for the Fed to accept a theory asserting the opposite.1 Indeed, as previously noted, throughout the 1920s officials and economists located at the Federal Reserve Board and certain...