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John Garrett Gold Monetary Policy, Expectations and the BOE

John Garrett Gold Monetary Policy, Expectations and the BOE

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MonetaryPolicyandExpectations:Market-ControlTechniques and theBank ofEngland, 1 925-1 931
JOHN R. GARRETT
TheBankof England depleted itsopen-market portfolio by secretly sterilizinglarge gold inflows. Thereafter interest rates wereinfluenced by manipulatingreported gold flows. Expectationsmanipulation as a monetary policy channel ismodeled and estimated. A gold flowfalsification wasovertwo-thirds as effectiveas anopen-market operation.Theseresults contradictacceptednew classicalmodelsandsuggest that credibility benefits from new classical policy are small,despite current popularity amongcentral bankers.Theepisode supportsPeterTemin'sviewof interwar centralbankersas nonstabilizers and enforcersofadysfunctionalclassicalorthodoxy.
M
arket controlrefersto"maintainingtheeffectivenessof BankRate:theproblemofforcingthemarkettokeepits ratesreason-ably closetoBank Rate'."'Inhis 1976 book,writtenas an officialhistorywithfull access to confidentialBankofEngland archives,R.S.Sayersclaimsthatmaintainingmarketcontrolwasamajor policyconcernduringthe interwargold standard. Sayers's revelations,how-ever,havereceived scantattentionin thevoluminous literature oninterwarmonetary policy,perhapsbecause heattemptednoquantita-tiveanalysis of market-control problems nor proffered an explanation ofhowtheywere overcome. Forexample, Barry Eichengreenrefers tomarket control only briefly in hisextensive writingson interwarmonetary and exchange policies. Inamodelexplaining changesin BankRate, theBankof England'sdiscountrate,he writes: "sincethe BankofEngland apparentlywasconcerned with therelationshipof BankRateto market interestrates,we enter BR
-
ias aseparatevariable."2Thequalifier "apparently" serves notice thattheconcernis doubted-as
The Journal of Economic History,Vol. 55,No.3, (Sept., 1995). The Economic History Association. All rights reserved. ISSN0022-0507.John R. Garrett is Associate Professor ofEconomics attheUniversityofTennessee atChattanooga, Chattanooga,TN37403.This work owes its existence to the lateLeonardA.Rapping, my doktorvater, who is sorelymissed. The author thanks ClaudiaDziobek, Charles Kindleberger, Martin Klein, Alan Rabin,Carl-Ludwig Holtfrerich, ManfredNeuman, Peter Lindert, and two anonymous referees of this
JOURNAL
for insightful comments, withoutimplicating them for my errors. The Research SeminaratUTC and Das Institut fur InternationaleWirtschaftswissenschaft at Bonn University providedconstructive, stimulating environments. Financialsupportfrom theUniversityofTennessee, the Fulbright Kommission of Germany, andthe UC Foundationisgratefully acknowledged. 'Sayers, Bank, p.297.
2
Eichengreen, Watson,andGrossman,"Bank RatePolicy," p.733.
612
 
MonetaryPolicy andExpectations613
well it shouldbe, if the Bank is assumed tohavehad anadequate open-marketportfolio.The failure to comprehendthecircumstancessurrounding the BankofEngland'smarket-controldifficulties has led toaseriouslydistortedview of British monetary policyduring the interwar gold standard.Theconsensusviewis thatanover-valuedpound resultedinchronicbalance-of-paymentpressures thatleftthe Bankwith toolittlegold,whichin turn forced monetary policytobe farmore restrictivethantheBank would haveliked.3Anexamination oftheassetside of theBankofEngland'sbalance sheet,correctedwithSayer's data,reveals a set ofproblems that vitiate the consensusview. For the first halfof the goldstandard,the Bank of England's problemwas toomuch gold,not toolittle.Nor was a lack of goldaconsistent policyconstraintinthe secondhalf ofthegoldstandard. FromSeptember1928 untiltheend,theprimary problemwas the unprecedentedinstability in internationalcapital flows,whichin twoseparatesix-month periods producedagoldflowgreaterthantheBank'sentireprewarstockofgold.MontaguNorman, the Governor ofthe Bank of England, consideredtheseproblems sograve that he engagedin alarge-scaledeceptionthat greatlyover-statedthe size of the effectiveopen-market portfolio,understatedthesizeof thegold stock,andmisstatedthe size andeven the directionofgoldflows.Hidingthestrengthofthepoundfromthepublic,thegovernment,theBank ofEngland's governingbodies,andthefinancialmarkets wasnecessary butnot sufficientfortheenactment ofNorman's policyscenario. To maintainhisgripon interestrates,MontaguNormantemporizedinanextraordinaryfashion:hedevelopedthefalsereportingofgoldflows intoanew channelofmonetary policy.Thenewpolicychannel wasanattempttomanipulatemarketexpectationsdirectly,withoutthe usual intermediary step of a changein a traditionalpolicyinstrument(bank reserves,BankRate,orthegold priceofthepound).Strongeconometric evidencereveals thatthefalsereportingofgoldflowswas apowerful policy instrument,deployedmainlytokeepmonetary policymore restrictivethan warrantedbythegold-standardrules ofthegame.4FollowingThomasSargent'swell-knownexample,thishistoricalepisode providesatestforacurrent controversyin macroeconomictheory.5Norman's activities producedauniquedata setthat can beused to isolatewithout ambiguityan"exogenous," policy-inducedchangein financial-marketexpectationsfrommovementsin bothreal
I
Seeforexample,Eichengreen,ElusiveStability, p. 9;and Sayers,"Return."
4
However,expectationsmanipulation wasfor short periodsused to exaggeratethe strengthofthe poundinorder to defendthe gold standardfacade that protected Norman's policy indepen-dence.
5
Sargent,Rational Expectations.
 
614Garrettand nominalvariables. Withthisdatatheexpectationsformationassumptions in the newclassical macroeconomics can beprobedwith asimplicity and robustness heretoforeimpossible.The new classical model of optimalmonetary policy(hereafterreferred to asthe credibility model) has generated a largeliterature.6Thecredibility model endorses what would have beena radical policynotioninthe 40years followingthe GreatDepression: thatitisinappropriatefor centralbanks to offset economic contractions. How-ever, somekey theoreticalassumptions necessary for this policyconclusion arecontradicted by the behavior of British financial marketsduring the interwar gold standard. Asthe credibility model influencescurrentmonetary policy and has received little empiricaltesting, this isanimportant result.This article describes thedifficulties of market control and thendetailsNorman's remedies. It then presents a model ofmarket controlcontaining both quantity-of-reserves andexpectations channels of mon-etary policy.The modelisthenestimated,andtheresults are inter-preted. Those results contradictthecredibility model.
MARKETCONTROL:THEPROBLEM
Contemporariesassumed thatthecontrol of marketinterest rateswasunproblematic, giventheofficial published balance sheetof theBankofEngland. A contractionary open-marketoperation-thesale of securi-ties from theBank's portfolio-could have drained bankreserves,drivingmarketinterest rates towards Bank Rate.7Duringtheperiodfrom1925to1931thereserves of the Londonclearing banks (till moneyand bankers'balances)seldomstrayedfromanarrow 180- to 200-millionpoundrange,with the total for allbanks about?40millionhigher.8TheBank ofEngland's reported portfolioofmarketablesecu-rities never fellbelow ?55 million, and was usuallyinthe65- to100-millionpound range, makingitappearthatbankreserves,andtherefore interestrates,werefirmlyinhand.9Theratio ofreserves to depositsdidnotexhibitsubstantial short-runvariation,with the exception ofbiannual episodes of window dressing.10Thereforeadecline inreservesof several millionpoundswas sufficientto snug marketrates upwards toward Bank Rate. TheBank's ownestimate,provided byErnest M.Harvey,theDeputy Governor,inevidence totheMacmillanCommittee,was thata drain offive million
6
Barroand Gordon, "Rules" and "PositiveTheory";andCanzoneri, "Monetary PolicyGames."
7
Themarket control problem isasymmetrical,ashigh ratesareprevented by recourse todiscountingat Bank Rate.
8
Capieand Webber, MonetaryHistory, p.464.9 Ibid.;and Brown, Gold Standard.
0
Onwindow dressing, see CapieandWebber, Monetary History,pp.266-69.

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