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central to the theoretical issue of w hat gives the quantity theory validity. A nd to retu rn to F riedm ans well-known quantity theory article, the quantity theory has life as long as th ere is a stable dem and function for m oney. D ep artu res from o u r regulated systems of p ro vision of m edium of exchange and the identity of the existing m edium of exchange with the unit of account could underm ine the dem and for m oney. No m atter how you look at it, the stability of the dem and for money still looks as though it is under attack, both theoretically and empirically.

4 The Evolution of the Banking System and the Theory of Monetary Pohcy
Victoria Chick
4.1 IN T R O D U C T IO N

Notes
1. Studies in the Quantity Theory o f Money ^ edited by Milton Friedman (Chicago: University of Chicago Press, 1956). 2. One of the severest critics of our standard econometric methodology has been Edward A. Learner. See Explaining your results as access biased memory, Journal o f the American Statistical Association^ 1975; and L ets take the con out of econometrics, The American Economic Review, March 1983. A n important criticism of the literature on empirical money demand equations is contained in T. F. Cooley and S. F. LeRoy, Identi fication and estimation of money dem and, The American Economic Review, Decem ber 1981. As these references display, a lot of the con remains in the econometrics of money demand. 3. See Benjamin M. Friedm an, M onetary policy without quantity vari ables, American Economic Review^ Papers and Proceedings, May 1988. 4. In reference to Milton Friedm ans preference for money growth rate rules, David Laidler states, money growth targets should be regarded as simple devices for ensuring that monetary policy does not do more harm than good in its attem pt to stabilise the economy, p. 103, in Monetary Targeting and Velocity: Conference Proceedings, Federal Reserve Bank of San Francisco, 1983. 5. See Don Patinkin, Money, Interest and Prices, 2nd edn (H arper & Row, 1965) pp. 42 and 617 The separability of money as a unit of account 3 8. and money as a medium of exchange, anticipating some of the work of Black and Fam a, can be seen in Luigi Einaudi, The theory of imaginary money from Charlemagne to the French Revolution (translated from the 1936 article appearing in Revista di storia economica) in Enterprise and Secular Change: Readings in Economic History, by F. C. Lane and J. C. Riemersma, (George Allen & Unwin, 1953). My thanks to Victoria Chick for reminding me of the Einaudi article.

Reference
Gpldfeld, S. M. (1973) The Dem and for Money Revisited, Brookings Papers on Economic Activity, vol. 4, pp. 577-638.

Stephen Frow en has set a m ost difficult task for this book: to predict the scope, m ethod and m eans of operation of m onetary policy in the 1990s. The E uropean C om m unity (E C ) faces a m ost uncertain dec ade: the 1990s prom ise the integration of m arkets and there is much talk of a com m on currency. W hat m ight these developm ents presage for m onetary policy? Som etim es it helps, w hen trying to see around corners, to look at ,the way a system has developed in th e past. T he object of this chapter, therefore, is to trace certain developm ents in the co evolution of the English banking system and the theory and m ethods of m onetary policy, w ith occasional asides on A m erican develop m ents, and to try to draw from this history some lessons for the 1990s, conscious all the while th at 1992 m ight change everything. T he theory of m onetary policy has until recently been form ulated in and for specific m onetary institutions and a particular international m ilieu, even though the th eo ry s institutional roots may not always be acknowledged. There is a reason for this in the sociology of knowl edge: following a (now ra th e r old-fashioned) notion of physics, institution-free theory tends to be valued as scientific and an institutional approach is seen as anti-theoretical, although it has been argued th at, particularly in the m onetary field, it is necessary to connect theory w ith history (H icks, 1967) and rational expectations theory has rem inded us of th e im portance of a change of regime. By contrast, the practice of m onetary policy is forced by its nature to take account of m onetary institutions. M onetary practice in turn changes m onetary institutions. Some of these changes should force a reconsideration of th e theory of m onetary policy, but it seem s to the

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present author th at we econom ists are still using theoretical struc tures developed in the 1930s o r earlier, having lost track of the assumptions that gave validity to our theories; or we have given assent to ideas that do not m atch reality at all. In this chapter trace the evolution of English banking and de velopm ents in the theory and practice of m onetary policy which went along with changes in banking institutions and their behaviour. It is my belief that th ere are general principles to be uncovered by this approach - enough, I hope, to excuse the p a p e rs A nglocentricity. Regrettably, I do not claim to have a new, relevant theory of m onet ary policy, ready for presentation in this chapter. 1 wish only to expose hidden assum ptions of existing theories, codify the insti tutional context, and ask readers to turn their minds to the form ula tion of a new approach. In an earlier article (Chick, 1986) I exam ined the im plications of stages of banking developm ent for the theory of saving, investm ent and interest. I will use the same approach to evaluate the relevance of theories of m onetary policy.^ Five stages of banking are identified in the 1986 paper, to w'hich it now seems appropriate to add a sixth. These stages cannot be associated easily w ith particular dates, not least because it is often a quantitative change th at signals a qualitative difference, and one cannot say definitely w hat quantitative change is sufficient. O ne m ust be a bit impressionistic. O ne must also be rather drastically incom plete. M any aspects of change - some of them crucial - m ust be left o u t to keep th e paper m anageable and m aintain its focus: the parallel developm ent of m oney and capital m arkets, the developm ent of o th er financial in stitutions, and - m ost im portant of all - international aspects. T he plan of the chapter is first to outline the stylised stages of banking developm ent, then to rem ark on the developm ent of the theory and practice of m onetary policy as they have changed to reflect events - or not reflect them , as may be.

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4.2

ST A G ES O F B A N K IN G D E V E L O P M E N T

in th e first stage of banking developm ent, m oney is deposited in the banks as a relatively safe w'ay to save, but claims on the banks are not widely used in transactions: bank liabilities are not yet a generallyacceptable m eans of paym ent.^ In this stage, th erefore, banks act purely as interm ediaries betw een savers and the investors who bor

row from them . E ven though their lending exceeds their lioldings of high-pow ered m oney (gold or cash, depending on the pcriotl) their lending is lim ited by the flow of new deposits and their existing depositors willingness to continue to hold deposits rath er than cxci cise their right to high-pow ered money. This stage o f banking may be said to have continued from the beginnings of banking to som e tim e early in the Industrial R evolu tion, surviving drastic changes in the fo r m of reserves and of liab ilities. W hen deposits began to be used m uch m ore widely as a m eans of paym ent, rath er than as a vehicle for saving, banking en tered stage two. T he B ank A ct of 1844 m uch accelerated the use of cheques as m eans of paym ent and could be regarded as a w atershed. In the second stage, claims on deposits are widely used as a jn e a n s of paym ent. This is, historically, a new role for deposits, with a far-reaching'im plication. lioldings of bank liabilities now represent m oney used to support consum ption as well as representing saving. Mainly for that reason, the redeposit ratio from bank lending will be high. R eserves, rath er than the acquisition of savings held as d e posits, have becom e the constraint on lending. G iven an addition to reserves, w hether from a deposit new to the banking system (called in old money-and-banking texts a primary deposit), from capital inflows or througli open m arket operations, banks taken as a whole can lend out a m ultiple of this am ount, creating secondary deposits as they do so. This is the stage to which the deposit m ultiplier begins to apply, though the theory cam e about sixty years after th e banks had developed to this stage. T he greater lending pow er of the banks in this stage has its dark side: the banks becom e m ore vulnerable to liquidity crises and col lapses of confidence. G iven the new role o f deposits as m eans of paym ent, there was no guarantee th at secondary deposits, once cre ated, would rem ain with the individual bank, or even with th e bank ing system. T hus th e willingness of an individual bank to lend beyond its reserves-in-hand depended on its forecast liquidity position: the prospect of new reserves from the three exogenous sources m en tioned above and its estim ated redeposit ratio. This ratio, portrayed in theory as depending on individuals portfolio preference for cash as against deposits, depends at the m acro level on the degree of integra tion of the banking system and the size of an individual b an k s m arket share. It is also in this stage th at th e B agehot Principle (that th e central bank should act as lender of last resort in tim es of crisis) becom es

82 Evolution o f Banking System & Theory o f Monetary Policy

fully accepted (W alter B ag eh o ts L om bard Street appeared in 1873). Strange as it may seem , the two main theories of m onetary policy that still vie for attention, in various m anifestations, w ere developed to suit these first two stages of banking. In stage th re e the banks are forged into a coherent system. A lthough th e stages can be distinguished analytically, in B ritain the developm ent o f the third stage coincided with the em ergence of the second stage and is coterm inous with the early phase of th e fourth stage. In the third st^ge of banking developm ent, interbank lending arises. By this nieahs, reserve deficits o f som e banks are m ade goo^ by others in surplus. Individual banks now m ore readily lend in excess of the initial increase in reserves, on the expectation of being able to obtain reserves w ithout going to th e central bank. T he bank ing system increases in coherence: th ere is less excess liquidity in the system. Though the final total of credit creation is still dependent on the stock o f bank reserves available to the system as a w hole, bank expansion is m ore likely to reach the limits of the deposit m ultiplier, and the m ultiplier process is m ore rapid. O th er things being equal, this lowers the cost and increases the availability of credit, but the system is m ore vulnerable both to policy pressure and to overexpan sion: it is less liquid. In B ritain, stage th ree was accom plished by branching, consolida tion, and the banks relationship with the discount houses, and it happened very early. In th e U nited States the federal funds m arket did not develop until after the Second W orld W ar. B efore that, correction of an unequal distribution of reserves was effected, som e w hat im perfectly, chiefly by the netw ork of correspondent banks and by the Federal R eserve System. In the fourth stage, a central m onetary authority accepts the func tion of lender o f last resort w ithout waiting for a crisis to develop. In the U nited Kingdom this change was accom panied by a change in perception of the role of cash. It had been seen as the fulcrum of liquidity pressure on banks com m itted to honouring sight liabilities. From the late 1950s onw ards, the dem and for cash was seen purely in term s of the convenience of private individuals seasonal, reversible and harm less to supply on dem and. No one disputes the fact th at purely seasonal dem ands for cash ought autom atically to be supplied. B ut the dem and for cash may also stem from th e reserve needs of banks, caused by their lending poli

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cies. T he proportion of the total dem and for cash deriving from bank lending is not am enable to m easurem ent. The autom atic supply of cash reverses the causality inherent in bank behaviour, which in stages two and three had gone from exoge nous and scarce reserves to loans and then to deposits. In stage four, the stock of bank reserves becom es responsive to dem and from the banks. Banks collectively expanding credit can now do so w ithout risk of being caught short of reserves, for they will reliably be sup plied by the authorities. T he only question is their price. T he effect on banks willingness to lend is greatest, obviously, w hen the central bank has a stable interest rate policy and does not exact a penalty rate, as during the open back d o o r period of B ritish policy. In this latter set of circum stances the authorities can be said to be acting as lender of first resort. R eserves are endogenous to the banking system , the volum e of bank loans becom es fully dem and determ ined, and the supply of deposits simply follows. B ank balance sheets provide evidence of increasing confidence of being able to m eet their liquidity needs. B anks holdings of both liquid assets and cash declined steadily from the 1950s, until one could say that there was virtually no liquidity cushion left. In the 1970s, the cartel arrangem ents of B ritish banking were replaced by a policy of com petition, and the banks responded to the new clim ate with aggressive expansion of lending. M anagem ent of the liquidity structure of the asset side of the balance sheet gave way to liability m anagem ent, an active stance of attracting wholesale deposits to support the expansion. This is the fifth stage of banking developm ent. W ith banks practising liability m anagem ent, reserves are endogen ous for a different reason than that applicable in stage four. Stageiive banks m eet their dem ands for loans and then fund' them by actively bidding for deposits with higher interest rates. Some of these deposits will, indirectly, give rise to reserves. Banks may even be driven by com petitive forces to seek an increased share of overall lending by actively seeking both lending opportunities and deposits. Banks determ ined to expand may compete vnth securities for holders funds over the whole range of rates. (This contrasts with Keynesian theory, in which a strong preference for liquidity usually coincides w ith low interest rates.) This com petition cannot continue for long w ithout pushing up interest rates on both deposits and loans. O ne im plication of stage live is that m ost loan requests that are

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considered creditw orthy will be m et, irrespective of the will of the m onetary authorities. The availability of finance, for investm ent or any o th er purpose, has becom e alm ost exclusively a m arket phenom enon, d ep en d en t on the cost o f funds and on b an k ers ex pectations. The next, sixth, stage has now appeared: securitisation, the p ro cess of devising m arketable form s of lending, secured by assets that are them selves, of course, m arketable. In one sense this represents a com plete change in the traditional style of bank lending; but it can be seen as a logical developm ent of the paring down of liquidity th at has occurred steadily through stages one to four. Devising assets that can be sold if required but which are m ore profitable, perhaps, than the governm ent securities that used to play such a m ajor role in banks contingency plans, leaves the banks less vulnerable than they w ere when ultim ately com pletely reliant on the lender of last resort. Since the o u tb re a k of com petition in the 1970s and especially in the 1980s, th ere has been an hom ogenisation of functipo^am ongst financial interm ediaries. T he m ost im portant developm ent to watch from the point of view of this p ap er is the extent to which building societies liabilities have becom e m eans of paym ent.

D uring this period the m ain focus of the theory of m onetary policy was on international aspects: the external value of the currency and the m aintenance of an international m onetary ord er based on sterl ing. T h e j;a te of interest w as th e central instrum ent of a m onetary policy directed to these ends. T he reputation of B ritish banks was im portant in securing and m aintaining a central role for sterling, but ensuring it was not taken on as part of policy: since prudence was thought to be so m uch in the interest of the bankers them selves, the m anagem ent of the banks liquidity was largely left to them , in keeping with the general philosophy of laissez faire. Stages two and three T he change betw een stage one and stage two banking i^ perhaps the m ost fundam ental of all the changes. B anks are no longer m erely conduits for saving; the general acceptability of their liabilities has greatly enhanced their credit-creating capacity. This is th e beginning of w hat Hicks calls the overdraft econom y. A fter the experience of the financial crises of th e nineteenth century, it was clear th at deposit-m oney was not n eu tral and its regulation could not be left to the prudent b an k er ethic. T he lenderof-last-resort principle had staved off disaster, but prevention of crises would be preferable. So m onetary policy entered the m odern era, in which the dom estic banking system was a central concern, with its pair of (not always com patible) responsibilities, for m acroeconom ic stability (dynam ic policy) and for the m aintenance o f the fabric of the financial system (defensive policy). In the early phase of stage two, the attention of m onetary policy tu rn ed to the m anagem ent of dom estic credit, playing on the liquidity of banks balance sheets within the limits set by the need to defend both the banking system and the position of sterling. British m onetary policy continued to em phasise the interest rate. B ank rate was now: asked both to perform the international task traditionally assigned to it and to act a T t h e price at whiclTreserves would be available if the system needed to borrow them from the B ank of E ngland. This was not as im possible as it sounds, fo r^ ^ n k .. rate ^i^s backed u p ^ n j t^ d o m c ^ i^ ^ by a system of keeping the financial institutions the banks and ^he. discqunt^hQuses taken together - slightly short of T reasury bUls.Jrhis system ^mto the b an k and subject them to the higher cost of bank rateTflKey overlent. O pen m arket operations w ere used to m aintain the

4.3 IN S T IT U T IO N A L C H A N G E A N D T H E T H E O R Y A N D PR A C T IC E O F M O N E T A R Y PO L IC Y
f

Stage one in stage one of banking developm ent, th e econom y conform s to what Sir John Hicks called the autoeconom y, in which, on the w hole, expenditure is financed by incom e or the realisation of assets. T here is lending, of course, but not only does it play a rath er m inor role, it is also true at this stage that lending relies on saving - bank lending, for exam ple, depends on exogenously-given deposits, which at this stage are a form of saving. P ro p er m oney, th at is, cash, was understood to be im portant in the generation of cyclical fluctuations, especially in prices. But the role of credit-m oney was debated. T he prom inent view was that the need to ensure convertibility into p ro p e r m oney, that is, cash, will m ake bank m oney behave like p ro p e r m oney, and in so far as it does, no special problem s are created by bank money, rh is view m ade it possible to carry over the quantity theory from its com m odity-m oney origins to a w orld of bank m oney.

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desired am ount of financial pressure at th e level of interest rates the bank wished to see. In addition, especially later in this stage, direct controls on credit w ere also u sed ;_ ^ As an aside, one m ight m ake a com parison with m onetary practice in the U SA . T h e crises of the nineteenth century convinced US banks of the need for a central b an k , and the F ederal R eserve System was bo m in 1913. B ritain and the U SA took very different approaches to th e control o f dom estic banking, each deriving from th e history of their institutions. In the U nited States, although the rediscount rate the equivalent of B ank R ate - was a policy variable, the m ain instru ment of control was rationing of reserves. This policy, along with the stratification of reserve requirem ents to suit the degree of vulner ability of different classes o f bank, was tailored to the diversity and geographical specificity of US banks. R ationing was an extra degree o f discretion which th e B an k o f E ngland, dealing w ith a relatively small num ber o f banks, each with a wide netw ork of branching, did not need, and probably, given the highly developed m arkets in liquid assets such as Treasury bills, could not use effectively, either. This contrast of quantitative control with control by price is of interest in view of the d ebate over m oney base control in B ritain in the early 1980s. M y conclusion is that the suggestion cam e from the A m erican p a st, w here it had w orked very well, b u t th a t it was irrelevant in B ritain and th a t it no longer had a role even in the A m erican present. Later in Stages two and three: Keynes and monetary policy Keynes (1936) provided an alternative to the quantity-theory outlook th a t rem ains w ith us to this day, though in grotesquely altered form and despite w hat countless textbooks say: th at he stated that m onet ary policy was ineffective. (T hat is not true: w hat he did say was that m onetary policy could not force down interest rates w hen they are already very low .) Keynes changed the focus of m onetary policy from bank credit to th e ra te of in terest itself, which now h ad a role to play beyond its p art in the m anagem ent of bank liquidity. T he job of the rate of in terest was to affect investm ent; changes in th e volum e of investm ent w ere the cause of cycles and o f grow th. K eynes om itted to m ake the point th at it is the existence of stage-two banking that allows investm ent to play the role of autonom ous variable - in stage o n e, investm ent is in thrall to the volum e of saving. It is well know n that th ere is no quantity-theoretic direct effect

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from m oney to incom e in Keynes. It is less well know n why it is not there. H e does not suppose th a t m oney has no effect on expenditure: it is just that w hen m oney com es into the system as the counterpart of an incom e-creating expenditure, w hether investm ent o r governm ent expenditure (and these days we w ould have to add credit-financed consum ption), any subsequent increase in expenditure is attributed to the rise in incom e ra th e r than to the increase in m oney supply. T he transactions dem and for m oney is passive, increasing to support incom e-induced expenditure plans, n o t initiating those plans. K eynesian theory lost track of the source of m onetary increases Keynes had in m ind - open-m arket operations - and proposed an interest-rate consequence o f all m onetary changes. T he proposition th at m onetary increases do not change expenditure directly, but rath er w ork through the rate of interest, follows straightforw ardly from the mechanism of open m arket operations. To carry out an open m arket operation, m oney is exchanged for o th er existing assets. A change in th e rate o f interest is an integral p a rt of th e operation, and such a change in the rate of interest is ju st enough to ensure th at the increase in the m oney supply will be held idle as speculative balances, at least in th e first instance. T h at is a very particular theory, suitable to a rath er narrow range of interest rates and to a m oderate rate of increase in the m oney supply. Crucial to it is th a t, to K eynes, m onet ary policy m eant open-m arket operations, and bank rate. Stage four D uring stage th ree, excess liquidity is gradually squeezed out of the banking system as a whole. T he banks portfolios are gradually shifted away from m arketable securities into advances while by var ious devices reserves are m oved efficiently to the banks which need them . A fter these changes, the banking system is com pletely depen dent on the central bank for additional reserves, but far from giving the m onetary authorities enhanced pow er, their need to protect the stability of the system m eans th at they cannot deny access to cash. M onetary policy in this fourth stage, if it is to affect bank credit at all, m ust play on the profitability of the banks balance sheets rath er than on their liquidity. O nce the banking system reaches stage four of its developm ent, credit expansion is no longer necessarily constrained by a reserve base even at th e level of the system as a whole: the central bank stands ready to m eet reserve needs, at a price it sets. T he only limit to

. f

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bank credit expansion now is the banks willingness to m eet the dem and for credit at an interest rate whose general level is set by the m onetary authorities. T he futility of p ru d en tial cash reserves was given formal recognition in the U K in the policy changes of 1981. These changes as far as I know the first o f their kind, but I expect o th er central banks to follow in due course abolished the cash reserve requirem ent as we know it and replaced it by two types of bankers deposits: a levy designed to provide the B ank of England with revenue, and operating balances for the clearing banks d e ter mined by consultation with the Bank. D uring the 1960s, the authorities pursued a policy of dam ping fluctuations in interest rates, on what was by th at tim e seen as the Keynesian principle of cheap m oney, the balance of paym ents per mitting. R eserves w ere often available at m arket rates. In a banking system now quite accustom ed to freedom from any exogenous con straints such as those the gold standard had im posed, and supplied with cheap reserves, the grow th of the m oney supply accelerated. I have elsew here (Chick, 1984) discussed the difficulty of sustaining the logic of K eyness outlook (as distinct from a K eynesian outlook) on m onetary policy w hen the m oney supply is changing rapidly. But rath er than stage four giving rise to a new and appropriate theory of m onetary policy, rapid grow th of m oney set the stage for the m onetarist-K eynesian d eb ate, even though the banking system had by this tim e changed to m ake both sides of the debate rath er irrelevant for policy purposes. T he debate was valuable for its salu tary effect on those K eynesians who thought that m oney doesnt m a tte r and for forcing aw areness of the interrelatedness of fiscal and monetary policy. The latter is now so much at the forefront of policy thinking, that it is difficult to rem em ber that those who tried to establish their interdependence in the 1960s were regarded as eccentrics. T he decade ended with the acceptance of targeting of dom estic credit expansion (D C E ), as a condition of an In tern ational M onetary F und loan. This thrust the counterparts of D C E , the public sector borrow ing requirem ent (P SB R ), debt m anagem ent and the broad m onetary aggregate M 3, into a limelight from which they have not, even now, retreated . H ow ever, while it is all very well to say th at m onetary, fiscal, interest rate and exchange rate policies are all interrelated, the truth of the statem ent derives from accounting ident ities, not econom ic theory. T he reason K eyness policy could b e come out of date is precisely th at it is based on a theory. M onetarist policy was devised long after the institutional fram ew ork th at gave it validity had disappeared. T hus it was never Hn d a te \ but at least it is a

theory. A ccounting does not go o u t of d ate, but it does not tell one m uch, either; it only prevents inconsistency. A ccounting identities also w arn against m isleading statem ents about policy. T he firming-up of m onetary targeting w hen the C on servatives cam e to pow er in 1979 was perceived, even p u t forw ard, as m onetarist. B ut recall th at w hen K eynes recom m ended public w orks, that is, governm ent expenditure, as a rem edy for unem ploy m ent, he specified that this was m ost likely to be effective if financed by m oney-creation. H e accepted that rising em ploym ent w ould cause prices to rise, because of increasing m arginal costs. R everse both the sides of the equation and the direction of policy and you have m onetary targeting engineered by control of the PSB R. T he ques tion o f w hether control of inflation or control of the labour force by creating unem ploym ent was the real objective of policy is an open one. W hatever the objectives, the theory is pure K eynes. (O n this m ost im portant m atter, see F forde, 1983, p. 207.) Stage five The fifth stage of banking developm ent is m arked by th e banks actively seeking both lending opportunities and the deposits to bal ance their loans. In effect, loans are determ ined by the dem and for them , subject to som e standard of creditw orthiness. Faced with rapid expansion on this basis in th e early 1970s, the authorities responded by dem anding additional deposits at the B ank against an excessive rate of grow th of interest-bearing eligible liabilities. T he policy played, once again, on the profitability of the banks balance sheet, though this tim e on the liability side. In effect, liabilities w ere being controlled to affect lending ra th e r than the reverse, as before, but the control was quantitative, rath er than working through interest rates. W hen the m ore traditional m ethod was attem p ted , w holesale d e posit rates rose high enough to m ake borrow ing to redeposit - roundtripping, as it was called - w orthw hile. This episode was quite enough to m ake the point th at the theory of m onetary policy was out of step with institutional developm ents. Eventually, I suppose, lending rates w ould have risen - it was surprising that the banks put up with the state of affairs as long as they did - but would higher interest rates have reduced lending? O ne of the problem s of m onetary control since the 1970s at least is th a t the dem and for loans appears to be interest-inelastic. A n o th er problem , the source of conflict betw een central bank and treasury in m any

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times and places, is th at higher interest rates raise the PSBR and create expansionary pressure on the m oney supply. T here is a similar ly perverse effect through international capital m ovem ents. With the liquidity cushion gone and bank lending rising rapidly, concern for the stability of the system shifted from the problem of liquidity to one of solvency and capital adequacy. C entral banks com m itted to the autom atic provision of reserves even outside a crisis were confronted by the prospect of having to bail out banks which had pursued misguided lending policies. T o the B ank o f E ngland this confrontation cam e soon after the encouragem ent to com pete em bodied in C om petition and C redit C ontrol, in the secondary bank ing crisis o f 1974 5. Stage six T he origin of the liquidity problem for th e banks has always been in m aturity mismatch: they hold assets of indeterm inate m aturity against sight liabilities. T he hallm ark of stage six, securitisation (see G ardener, 1988), is a way of alleviating the m ism atch after years of seeing it becom e ever m ore extrem e. Securitisation represents a return to banks* holding m arketable assets, and these fluctuate in m arket value w hen the rate of interest changes. If interest rates are raised, this will reduce the capital value o f banks assets. Will they react as US banks w ere said to do in the 1950s, and be unwilling to realise a capital loss (the locking-in effect), o r will they see the disparity betw een the value of their assets and the value of their liabilities (the latter, not being m arketable, having been unaffected) as an opportunity to expand their lending to fill the gap? If the latter, traditional m onetary policy will becom e perverse. G oodhart (1987) has proposed an alternative solution to the mis m atch problem : to construct banks like u n it trusts and allow the value of deposits to fluctuate with the m arket value of assets. Though this schem e challenges the inclusion of deposits in o n es concept of a m onetary stan d ard , in which different form s o f m oney exchange at p ar, deposits would presum ably retain o th er m onetary properties, such as general acceptability. Thus the value of deposits would vary inversely with m arket rates of interest, com pensated wholly or in part by any interest paid on deposits. If low interest rates are in general a G ood Thing, this schem e would have the advantage of adding the voices of depositors to those of m ortgagees in opposing upw ard m ovem ents in interest rates.

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The 1980s have also seen a revival of off-balance-sheet activity on the p art of the banks. This activity not only avoids th e liquidity problem s just discussed b u t also falls outside the purview of capitaladequacy guidelines and controls. Stage seven W ho knows w hat new developm ents there will be in banking in the 1990s? E uropean m onetary union, a cashless society? A serious problem for those thinking about the form er is th a t E uropean bank ing systems have not all gone through the sam e stages of developm ent as those described here - in particular, few central banks have been willing to supply reserves quite as readily as the B ank of England has been. The thought of abandoning reserve requirem ents as a useless anachronism w ould strike a G erm an or an Italian as quite mad. Will we have banks at all? C redij^cards m ust already have greatly reduced the num ber of payments bjTcheque and it has been suggested^ that computers may eventually make transfers of securities the preferred mode of payment - thus validating the new m onetary economics, which just about finds room for fiat money but not for deposits.

4.4

C O N C L U SIO N

If this chapter seems to p eter out, it is because the theory of m onetary policy has not developed to keep pace with institutional change and my im agination is not adequate to fill the gap I hope I have at least identified. T he annals of recent m onetary history are recounted endlessly, but w hat are the lessons of it for th e theory of m onetary policy? If the analysis of this chapter is correct, the last tim e the theory bore a relation to institutions was in stage two! This is a truly shocking state of affairs. R ecognition of the interrelatedness of m onetary and fiscal policy is a rich opportunity for m acroeconom ists. T extbooks, m eanw hile, are still rehashing th e m onetarist-K eynesian debate, adding the distinc tion betw een anticipated and unanticipated m oney and the im port ance of changes in regim e in deference to rational expectations. T h ere have indeed been changes in regime! It feels as if there is an innovation every w eek. Theory does not reflect them . W hat is to be done?

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Evolution o f Banking System cfe Theory o f Monetary Policy

Notes

wish to thank Sheila Dow, Peter Earl, participants in the Geld und Whrung Seminar at the Johann Wolfgang G oethe University in Frankfurt, and an anonymous referee for their comments and suggestions, while not implicating them in the result. 1. For those interested in an application to regional developm ent, see Chick and Dow, 1988. 2. In this stage it is an open question w hether deposits count as money' at all. Tlis question was debated well into the 1930s, long after the accepta bility of deposits was widespread. 3. I owe this point to Peter Earl. References Bagehot, W. (1873) Lom bart Street: A Description o f the Money Market, 14th edn. (London: J. M urray, 1915). Chick, V. (1984) M onetary Increases and their Consequences: Streams, Backwaters and Floods, in A . Ingham and A . M, Ulph, (eds), Demand^ Equilibrium and Trade: Essays in Honour o f I. F. Pearce (London: Mac millan); reprinted in V. Chick, On Money, Method and Keynes: Selected Essays (edited by P. Arestis and S. C. Dow) (London; Macmillan, 1992) pp. 167-80. Chick, V. (1986) The Evolution of the Banking System and the Theory of Saving, investm ent, and Interest, Economies et Socits, Cahiers de lISM EA (Paris), Serie M onnaie et Production, no. 3; reprinted in V. Chick On Money, M ethod and Keynes, op. cit., pp. 193-205. Chick, V. and S. C. Dow (1988) A Post Keynesian Perspective on the Relation between Banking and Regional Developm ent, in P. Arestis (ed.), Post Keynesian Monetary Theory: New Directions in Financial M od elling (A ldershot, Hants: Edward Elgar). Fforde, J. S. (1983) Setting M onetary Objectives*, Bank o f England Quarterly Bulletin vol. 23, June, pp. 200-208. G ardener, E. P. M ., (1988), Innovation and New Structural Frontiers in Banking', in P. Arestis (ed.), Contemporary Issues in Money and Banking: Essays in Honour o f Stephen Frowen (London: Macmillan) pp. 7-29. G oodhart, C. (1987) Why D o Banks N eed a C entral B ank?, Oxford Econ omic Papers, vol. 39, pp. 79-89. Hicks, L R . (1967) M onetary Theory and History - A n A ttem pt at Perspec tive, in 3. R . Hicks, Critica Essays in Monetary Theory (Oxford: The Clarendon Press). Keynes, 3. M . (1936) The General Theory o f Employment, Interest and Money (London: Macmillan).

Comments on The Evolution of the Banking System and the Theory of Monetary Pohcy by Victoria Chick
G. M. Ambrosi
General comments From V ictoria C hicks interesting paper I tend to infer th a t in m onet ary econom ics the 1990s m ight well stand under the m otto W hatever the banking system consists of - it is very innovative. This certainly would be quite a change over the past decades which repeatedly seem to have stood under the m otto W hatever m oney is - it should grow at the appropriate ra te . B ut w ith additional m onetary innovations hav ing to be investigated alm ost every w eek, it may be small w onder that the theory of m onetary policy now has less to offer in the way of iron rules than seem ed to be the case in tim es of a w idespread belief in the long-term constancy of the incom e velocity of m oney. If we consider the extent of changes in econom ic and institutional conditions which have occurred over the recent past, for exam ple: the collapse of the B retton W oods System in 1973; the soaring volum es of transactions in E urodollar and o th e r xeno currency m arkets; the petrodollar problem s of the mid-1970s; the stock exchange crash on Black Friday in 1987; and the still-lingering T hird W orld debt crisis then one cannot but m arvel at the adaptability of the banking system in response to a series of rath er dram atic econom ic shocks. No doubt, the future developm ent of the institutional fram ew ork

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