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He argues that there is evidence that banks have made consistent profits from specu-lation and that such speculation has resulted in a stabilization of ex-change rates over time in compa

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A Publication of the Egon-Sohmen-Foundation

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Herbert Giersch (Ed.)

for the Egon-Sohmen-Foundation

Berlin Heidelberg New York

London Paris Tokyo

Hong Kong Barcelona

Budapest

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Prof Dr Herbert Giersch

© Springer-Verlag Berlin· Heidelberg 1992

Softcoverreprint of the hardcover 1st edition 1992

The use of registered names, trademarks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use

214217130-543210- Printed on acid-free paper

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by many in the economics profession on both sides of the Atlantic In extrapolating his great achievements as a scholar and teacher beyond the time of his death, one is inclined to suppose that Egon Sohmen's name would figure high on many a list of candidates for honors and awards in the field of international economics

For the reconstruction of economics in the German language area Egon Sohmen was invaluable Born in Linz (Austria), he studied in Vienna at the

Business School (Hochschule fUr Welthandel, now Wirtscha!tsuniversitiit),

then went to the US as a Fulbright scholar (1953), returned to Europe to take his doctorate in Tiibingen, Germany, (1954) and crossed the Atlantic again to teach at MIT (1955-58) where he obtained a Ph.D (1958) under Charlie Kindleberger He might have stayed permanently in the US, con-tinuing a career that he started as Assistant Professor at Yale University

(1958-61), if the US visa provisions had been applied in a more liberal fashion

Fortunately for quite a few people in Germany, Egon was offered a chair

at the young Saar University in 1961, after the faculty had been persuaded

to waive the traditional Habilitation requirement We were glad that he

accepted It gave us new opportunities to strengthen our ties with MIT and Yale, with Austrian economists like Gottfried Haberler and Fritz Machlup, who had become Egon's friends and mentors, with Willy Fellner, and with the international economists of Egon's age cohort Many stu-dents at the Saar University were deeply impressed by his teachings, including his later wife, our best female student, and quite a few who now hold prestigious posts in economics and public life I can frankly say without hesitation that Egon's influence was particularly strong among

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Egon was not afraid of controversy; perhaps he even liked it Great controversies developed in Saarbriicken over the exchange rate issue, with Wolfgang Stiitzel defending fixed rates, Egon propagating flexibility, and some -like myself - pondering for a while until circumstances demanded

a system switch in the interest of domestic price level stability In May

1969, when action was needed, Egon and I drafted a memorandum that

we sent to the government When we went to the public it aroused a political turmoil when more than a hundred economics professors in Ger-many openly joined forces with us A few months later, exchange rates became the main issue in the general elections

In stormy periods, one needs friends with a strong character Egon was

a true friend He had an instinctive sense of the needs of others, notably his family Without his good advice and the generous financial support he diverted from his salary as a young professor in his early thirties, much of the scope for productive human capital formation in the Sohmen family would have remained unexploited, as I gather from remarks by his sister From his brother, Helmut, Egon quickly received high intellectual returns Those who have read the preface to the first edition of "Flexible Exchange Rates" will remember that he thanked his brother for having acted as Dr Wong, meaning Jacob Viner's Chinese draftsman who turned out to be an excellent amateur economist by discovering a mistake in Viner's reasoning about "Cost Curves and Supply Curves."

It so happened that Helmut Sohmen, as if Egon's reference had had predictive power, made his way to the top of the world business commu-nity in the Chinese cultural and ethnic environment of Hong Kong with such success that he acquired the means for creating the Egon-Sohmen-Foundation Should sociologists have doubts about the viability of the family in a cosmopolitan environment, they would become more confident

by looking at this example Egon surely was a father figure, and economics

is now benefiting from it in a roundabout way

The papers for this memorial conference cover the main areas of Egon's interest and research during the largest part of his academic life, i.e, ex-change rates and adjustment problems; welfare economics and allocation theory; trade and factor movements; competition and economic growth The perspective is international, except for the paper on German monetary unification, a subject which Egon would have found fascinating

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There was no planning behind the allocation of subjects to participants

It just worked out this way by my calling upon persons who were known

to have been influenced by Egon's teachings and writings in one way

or another and vice versa No jawboning was necessary to support the invisible hand What was left for correction and coordination was mostly achieved in the free discussion during two pleasant conference days at Tegernsee in the Bavarian Alps

The participants enjoyed the presence of the Sohmen family: Egon's wife and brother, his sister, and sister-in-law A verbatim record of the discus-sion would have shown that their intellectual contribution was not minor Bob Mundell had unanimous support when he recognized this at the end

of the conference, after having expressed his opinion on the future role of the Egon-Sohmen-Foundation in the field of international economics The Egon Sohmen Memorial Conference was the second symposium organized by the Egon-Sohmen-Foundation The first one had taken place half a year before in Laxenburg, Austria, on "The Economic Transforma-tion of Central and Eastern Europe." The papers were published in 1991 under the title "Towards a Market Economy in Central and Eastern Europe," edited by Herbert Giersch for the Egon-Sohmen-Foundation (Berlin: Springer-Verlag) The third symposium was held on "Economic Evolution and Environmental Concerns" in late summer 1991 in Linz, Austria, Egon Sohmen's hometown

Herbert Giersch

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A Reexamination

Joachim Fels 39

An Institutional-Economic Analysis of the Louvre Accord

Rudolf Richter and Udo Schmidt-Mohr 59 The German Monetary Union

Harmen Lehment 87 Financial Liberalization in Developing Countries

Bela Balassa 105

Part II: International Trade

Fiscal Policy and the Theory of International Trade

Robert Mundell 125 Wage Agreements and Optimal International Factor Flows

Stephen T Easton and Ronald W Jones 151

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Protection and Exchange Rates

John S Chipman 167 Aggressi ve U nila teralism

Jagdish Bhagwati 201 Theory and Practice of Commercial Policy: 1945-1990

Anne O Krueger 233

Part III: Competition

Welfare Economics, Economic Order, and Competition

Manfred E Streit 255 Competition and Economic Growth: The Lessons of East Asia

Wolfgang Kasper 279 List of Contributors 305

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Introduction

Friedrich Schneider

The thirteen papers in this conference volume cover a wide range of topics They can be broadly categorized into three groups Six of the papers deal with money and exchange rates Five of them tackle problems of interna-tional trade theory and commercial policy The remaining two papers examine the relationship between competition and economic growth, as well as the issues of welfare economics, economic order, and competition Many of the ideas developed in this volume have already been treated in Egon Sohmen's works This demonstrates that his basic concepts and ideas are still very much alive and, moreover, can provide useful insights into the problems that economists face nowadays Sohmen was truly a leader in the field and has inspired many economists to continue his work Therefore, this volume can be seen not only as an attempt to apply Egon Sohmen's most important ideas and theories to current economic issues but also as encouragement to direct additional research towards develop-ing these ideas further In the remainder of this introduction I will briefly summarize the different contributions to this volume

Part I: Money and Exchange Rates

The first paper by Charles Kindleberger adds to the current debate on free banking Kindleberger has written a historical piece on the seventeenth century experience with free minting He provides evidence on the spread

of currency debasement in the so-called Kipper- und Wipperzeit in many and infers that free minting in a world of small states was - and by analogy, free banking unrestrained by regulation would be - a disaster Kindleberger concludes that the seventeenth century experience with free minting clearly points out the need to have some sort of public control of the money supply; a view that is opposed by the advocates offree banking (for example, Peter Bernholz and Roland Vaubel) While admitting that even under an installed public control inflationary bubbles might occur as the market monetizes credit beyond that decreed by government, Kindleberger

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Ger-argues that under unregulated free banking, short-term profit seeking will

go much further to destabilize the financial system

Herbert Grubel's paper with the provocative title "Profitable Currency Speculation: Service to Users or Destabilizing?" takes up another hotly debated issue Grubel critically examines the view of some influential econo-mists that the large variance of exchange rates in the post-Bretton Woods era can be attributed to widespread destabilizing speculation He argues that there is evidence that banks have made consistent profits from specu-lation and that such speculation has resulted in a stabilization of ex-change rates over time in comparison to a situation in which the banks would not have earned such profits Grubel admits that some new theories have generated examples of destabilizing, profitable currency speculation, but stresses that so far neither direct empirical tests are available nor are valid empirical results obtainable The evidence cited in support of the thesis that speculation is destabilizing is, according to Grubel, not undisputed in the literature Therefore, one cannot make a clear case for speculation leading to destabilizing effects Grubel mentions another problem that arises in this context, namely, that up to now no general model explaining the fluctuations of exchange rates has been developed If a model of this type were available, it would then be possible to investigate whether or not one could observe destabilizing effects However, Grubel's final conclusion that currency speCUlation will stabilize exchange rates over time is also an assumption (made by him) that has not been empirically verified

Another topic relating to flexible exchange rate theory is tackled by Joachim Fels in his paper "Flexible Exchange Rates and Insulation: A Reexamination." The author argues that, contrary to conventional wis-dom, the early proponents of flexible exchange rates (such as Milton Friedman, Egon Sohmen, and Harry Johnson) never believed in the ability

of the system of flexible exchange rates to provide complete and automatic insulation from all foreign disturbances However, they stressed that do-mestic monetary policies would be free to pursue domestic goals under flexible exchange rates and could, in some circumstances, be employed

to neutralize undesired macroeconomic influences from abroad After orating on the work of the early proponents of flexible exchange rates, Fels confronts the hypotheses of the early advocates with data from the post-1973 period of flexible exchange rates Summarizing his empirical results, he arrives at two conclusions First, in the flexible exchange rate period countries have been able to set their price levels independently

elab-of foreign inflationary or deflationary trends, as was predicted by Milton Friedman and others Second, business cycles have been much more syn-chronized under flexible exchange rates than they were under fixed ex-change rates This result is not in line with the argumentation of the

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It is not only important to analyze the consequences offlexible exchange rate regimes but also to go a step further and to subject the institu-tional arrangements themselves, and in particular the contractual relations that characterize them, to economic analysis Rudolf Richter and Udo Schmidt-Mohr provide such an analysis in their paper "An Institutional-Economic Analysis of the Louvre Accord." They undertake their analysis

of exchange rate regimes from the contractual viewpoint of institutional and especially transaction costs economics, which allows them to examine reality as it is observed, without the usual claim that reality does not fit into the economic model The authors find that the transaction cost approach provides economic rationales for the observation that a world currency exists under an international paper standard together with flexi-ble exchange rates and for the apparent "invalidity" of the purchasing power parity theory as indicated by long periods of over- and under-shooting in exchange rates As the approach of this paper takes into account the actual policy measures in the given institutional frame, it permits a rational basis to be provided for a relationship that seems "very dirty, when viewed through neoclassical spectacles" (quoted from Richter and Schmidt-Mohr) and it permits this relationship to be discussed The advantage of the analytical style of the institutional economics is that such

an approach makes it possible to discuss complex organizational forms using concepts such as bounded rationality, ex post opportunism, and transaction costs

The next paper, "The German Monetary Union" by Harmen Lehment, deals with the introduction of the West German Deutsche mark as the single German currency Lehment begins with a short description of the main events, discussions, and decisions accompanying the path towards the German monetary union, and then analyzes the basic issues of the German currency unification and its main implications The author con-cludes that the German montary, economic, and social union can be seen

as a historically unique event because it aimed at transforming a socialist economy into a market economy within a period of only a few months A monetary union of this kind is unlikely to increase the DM inflation risk because the uncertainty about the East German money demand is rela-tively small due to the fact that the economic and monetary weight of East Germany is only roughly 10 percent of the West German level Further-

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more, the author points out that the German monetary union did not come about as the result of economic reasoning, but rather as the result

of a specific German political and economic situation Lehment's paper provides a set of economic facts and some preliminary conclusions about the functioning of a suddenly installed monetary union, and hence can

be seen as describing a "field experiment" for the planned West European monetary union

In the last paper in Part I, Bela Belassa provides an analysis of the financial liberalization in developing countries The author starts with the McKinnon-Shaw analysis McKinnon and Shaw argue that higher interest rates will lead to increased savings and financial intermediation as well as improvements in the efficiency of using savings The authors present this model, criticizes it, makes various extensions, and finally summarizes the available empirical evidence indicating that higher real interest rates in-crease the extent of financial intermediation, whereas increased financial intermediation raises the rate of economic growth in developing countries Furthermore, he presents evidence on the effects of interest rates on invest-ment and economic growth, but he also points out that excessively high interest rates will have negative economic effects (e.g., for private investors) Such a situation could be avoided if a liberalization of the banking system were to take place under certain conditions

Part II: International Trade

In his paper "Fiscal Policy and the Theory ofInternational Trade," Robert Mundell integrates major aspects of fiscal policy into the theory of interna-tional trade, employing classical assumptions such as that the purchasing power parity theory is valid and that fiscal policy is perfectly anticipated

by the economic agents Mundell reaches the conclusion that the effect

of fiscal policy on interest rates and on the exchange rate is much more strongly determined by the decision of a government to spend now or in future periods than it is by the way government spending is financed Moreover, the author presents the result that a country can put the entire burden of domestic government spending on the rest of the world and that retaliation from the affected country(ies) might only be able to counteract such a result if it (they) at least has (have) the same economic power Then the author drops the assumption that the rest of the world acts in a monolithic way and divides the rest of the world into partner and rival countries The author derives the result that usually some countries are positively affected by a country's fiscal policy, whereas other countries are hurt An example for such a situation is the fiscal policy of the United States (a net borrower since 1975), which increased government spending

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Introduction 5

in the eighties and worsened its financial terms of trade, thereby benefiting some trading partners However, as pointed out by Mundell, it harmed other borrowers, such as the less developed countries and some European countries Mundell further stresses that even though the benefits to the lenders, i.e., Japan and Germany, were larger in a narrow sense than the losses to the borrowers, it could not be argued that the rest of the world was better off in a wider sense unless compensatory transfers from the lending countries to the others had in fact been made In his paper, Mundell not only demonstrates how closely fiscal policy is currently re-lated to international trade, he also states that the more countries are linked to each other by trade flows, the more severe the consequences of the fiscal policy of a major country are on other countries

The next paper, "Wage Agreements and Optimal International Factor Flows," is by Stephen Easton and Ronald Jones They investigate the nature of the response of the home demand for foreign labor to the level

of the minimum wages stipulated by the source country when capital is more or less immobile between countries Additionally, the authors con-sider the case that capitalists invest abroad, and the possibility that capital might flow towards the low-rate-of-return home country as a part of a buyout strategy offoreign factors Further, the authors consider the impact

of various wage agreements on real incomes at home as well as in foreign countries Easton and Jones stress the argument that in the theory of international trade one should analyze not only the gains that goods trade allows when relative prices differ among countries but also the gains from factor movements in response to differences in factor payments that are not merely a reflection of asymmetric skill levels This paper provides some theoretical insight into the effects of the large-scale migration we are observing, especially within Europe

In the paper entitled "Protection and Exchange Rates," John Chipman focuses on the relation between exchange rates and trade restrictions Chipman begins with a critical survey of the literature on the relationship between protection and exchange rates He then develops two models to study the effect on the exchange rate of a change in a tariff or export tax (or subsidy), obtaining the result that both an import tariff and an export subsidy will bring about a currency appreciation Chipman admits that the trouble with this approach is the difficulty in interpreting the meaning of strictly separable trade preferences He chooses an alternative approach and uses more direct trade-demand functions He differenciates between two states of the world: one in which two countries produce all three commodities (two tradable and one nontradable) with only two factors of production, and one in which all three commodities are produced with three or more factors of production While the results for Case 1 are

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straightforward, the results for Case 2 are more interesting and here the author is not able to detect reasonably sufficient conditions that ensure that both a tariff and an export subsidy will cause a country's exchange rate to appreciate

The next paper by Jagdish Bhagwati is entitled "Aggressive alism." He discusses the various measures the United States has taken against countries like Brazil, Japan, and India because it feels that these countries conduct unfair trade The US attempts to deal with the effects of unfair trade by arguing that these trading partners more or less secretly subsidize industries in their countries by using various measures These measures result in lower prices than the prices that would have resulted

Unilater-in a perfectly competitive situation The US then exerts massive pressure

on these countries in order to force them to either abolish this type of subsidy (in a very broad sense) or to come to "voluntary agreements" about trade restrictions Bhagwati provides an analysis of the various stages in this highly interactive game He is critical of the actions of the US and he concludes that agressive unilateralism has no place in a world trading regime reflecting the rule of law and the necessary symmetry of rights and obligations, such as the GAIT

Anne Krueger's survey paper, "Theory and Practice of Commercial Policy: 1945-1990," concludes Part II of this volume Krueger begins by describing a few "realities." One such reality is that most economists, on the one hand, believe that free trade is optimal, while politicians, on the other hand, quite often act in accordance with the opposite belief These realities have resulted in new ideas like the political economy of commer-cial policy, which is still in a developing stage Krueger argues that earlier theories of commercial policy assumed that governments attempt to maxi-mize a social welfare function and that politicians understand the principle

of comparative advantage Using a political economic framework, public choice economists seek to explain government behavior in a positive way, whereby the motives and outcomes of commercial policy may significantly diverge from those that would result from policies adopted to maximize a social welfare function Krueger briefly reviews the GATT Agreements and the evolution of trade policies among developed countries She concludes that decision makers (governments) apparently have not attempted to maximize social welfare and that research should focus on the political determinants of levels of protection This leads to the approach of the political economy of protectionism, which argues that under certain condi-tions protection may be favorable for a government (e.g., to win an election

by guaranteeing high employment due to protectionist short-term policy) Krueger also analyzes the theories underlying commercial policy in de-veloping countries She shows that here, too, a political economy approach

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Introduction 7

may be quite valuable for explaining the behavior of the governments in these countries Krueger's contribution sheds some light on normative theories of international trade and their implied results on the one hand and on the actually observed policies on the other hand She concludes that more and more economists are realizing that there is a huge discrep-ancy between what the outcomes should be according to the normative international trade policy and what they are if actual government behavior

is analyzed

Part III: Competition

The paper "Welfare Economics, Economic Order, and Competition" by Manfred Streit is a normative one Streit begins by discussing some of the basic concepts of welfare economics, of the role of competition, and of a free market economy in order to guarantee economic prosperity, freedom, and stable democracies Another goal of his paper is to demonstrate what steps have to be taken (from a theoretical perspective) in order to sucess-fully assist the process of the transformation of the former planned economies into market economies Finally, he discusses efficiency prob-lems in centrally planned economies and the interdependence between economic order and the political system Streit's paper elaborates on the basic essentials (from a theoretical perspective) that are necessary to ensure that a market economy in a democratic system functions

Wolfgang Kasper, in his paper entitled "Competition and Economic Growth: The Lessons of East Asia," analyzes whether some basic eco-nomic concepts about the nexus between competition and growth, which worked quite well in postwar Germany, could be applied to the remark-able growth of some East Asian countries Kasper provides an analysis of the driving forces behind the fast economic growth in the Asian countries and reaches the conclusion that their fast output growth and "excellent income distribution" (quoted from Kasper) were the result of functional policies that made the supply of production factors elastic On the other hand, the author argues that there was relatively little government policy intervention in allocation Moreover, in these countries, openness to trade combined with a stable economic order established a market rivalry that promoted sustained growth over thirty years The author provides further arguments according to which the establishment of a market economy with openness to trade and international factor mobility may be one ofthe key elements for developing countries to reach a stable growth pattern Finally, he argues that it may be easier to establish a stable economy in East Asian countries because of their underlying "neo-Confucian order."

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Part I

Money and Exchange Rates

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Free Minting

Charles P Kindleberger*

It is tempting as we honor the memory of Egon Sohmen to speculate

on how he would have reacted to the current interest in "free banking."

He was, of course, Austrian by birth, and the advocates of free banking are sometimes lumped together as the "Austrian School." He was, more-over, a fierce proponent of flexible exchange rates, and an opponent of fixed rates, strongly believing that exchange rates unaffected by interven-tion of monetary authorities would work smoothly - a view he might have modified had he lived to observe the rise of the dollar in the free market from 1982 to February 1985, its decline in the two subsequent years, and the gyrations since If one had any faith in revealed preference, there would seem to have developed a revealed preference in governments for interven-tion after the disenchantment with free floating - not successful interven-tion perhaps, but some modest stability preferred to chaotic over- and undershooting

It is possible to advocate flexible exchange rates but hold back from free banking, as does Milton Friedman Egon Sohmen was in that camp, rather than an adherent of the Austrian school, which advocates both flexible exchange rates and free banking Like Friedman, he may have wanted to abolish central banks, to be sure, while insisting on strict control of the money supply that requires some sort of government intervention or regu-lation Friedman differed, as it happened, from Henry Simons, a Chicago monetarist, who would enforce 100 percent reserve money by making all capital apart from money take the form of equity in an effort to restrict the issue of private debt that could be used as money substitutes (1967) To

go as far as Simons in restricting the money supply, would go too far in Friedman's view in government intervention in private behavior Sadly we

do not know Egon Sohmen's view on this further point

• I am grateful for leads to the literature on free banking to Eugene N White, and on the

Kipper- und Wipperzeit to Christopher Friedrichs, Geoffrey Parker, and to Wolfram Fischer, who generously provided me with xerox copies of a great many articles in local German state historical periodicals impossible to obtain in Cambridge, Massachusetts

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Free banking in developed countries is difficult to judge by rary experience, since there is none Its advocates resort either to theory,

contempo-as Friedrich A Hayek (1976) and Roland Vaubel (1984) do, to economic history in the cases of Lawrence White (1984) and Eugene White (1990), or both (especially Selgin 1988) The theory rests on the belief that banks will work to gain acceptance for the (note or) deposit liabilities they issue, and will themselves restrict their amount Banks that overissue will find their deposits discounted in the market In this view, good money drives out bad, the opposite of the widely believed version of Gresham's law Vaubel defends his position by claiming that Gresham's law in the ordinary view depends on fixed rates of conversion between different forms of money, whereas his model allows for the money of one bank to vary in price against the monies of others But money is the one asset with a fixed price

in terms of itself, and when the deposits of Bank A vary in price with those

of Bank B, there is a problem whether one can call either of them money

in a true sense, as opposed to non-interest- or interest-bearing securities Under the 1860 National Bank Act in the United States, with no central bank, and on those occasions when the Treasury did not take over the role

of lender of last resort, panics gave rise to the issuance of certificates

by local clearinghouses - a system that Friedman has defended Selgin, moreover, makes the clearinghouse a central institution for restraining banks from overissue (1988, pp 28-9, 136, 137, etc.) During monetary troubles under the National Bank Act, the notes issued by the separate clearinghouses went to premia and discounts as wide as $10, $15, and $20

per $1,000 against New York, and of course possibly wider premia and discounts against one another (Sprague 1910, pp 203 ff, 291 ff) In these circumstances it can be said that there was local money, but no national money A system of free banking in a single country would appear to represent a flexible exchange network rather than a currency area

It may happen theoretically that good money drives out bad, and as noted below this has occurred on occasion when the debasement of an existing money has gone so far that no one is willing to accept it and some new medium of exchange is required I have hypothesized that normally bad money drives out good because the buyer chooses what money he

or she will spend; in ordinary times buyers' markets prevail and buyers choose the currency in which the purchase is made In this view, in sellers' markets, when goods are scarce, the seller could claim and gain the right

to determine the currency of the bargain But this is theory, with no historical agreement on when buyers' markets become sellers' markets and vice versa A book on minting in parts of France and Spain in medieval times notes that many contracts specified the kind of currency to be used

in fairly general terms: "best coin," "good coin," "money of legitimate

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Free Minting 13

weight," or mancuses (a coin) "of the best gold," "alternative payment in fine silver." In one area at a given time, it was exceptional "to designate payment in unspecified deniers or sous" (Bisson 1979, pp 63-4, 67, 73-4,

79, 83) The history in which these phrases appear is largely devoted to minting as a service to the public, when debasement was rife and money was "conserved" or "confirmed" as good coin mainly by public payments

to the King, prince, lord, or other minter to dissuade him from debasing his coinage, as was the general practice

I offer a few paragraphs on modern history before turning to an episode

in the currency disorders of early modern times in the German states, an episode that I find illuminating

The history of so-called "free banking" in the United States is not relevant to the present discussion, since while there was free entry into banking, banking itself was regulated From the Free Banking law of New York State of 1838 until the National Bank Act of 1860, many states adopted laws providing for "free banking." In all of them, however, the group starting a bank had to deposit specified securities with the state treasury up to the amount of the notes issued, dollar for dollar (Ng 1988)

Wildcat banking occurred in Indiana and New Jersey under their laws because of mistakes made in the lists of securities eligible for deposit (Rockoff 1975, pp 141-68) Ng claims on the basis of a great deal of evidence that this free-banking era failed to lower bank profits signifi-cantly, so that the freedom did not greatly increase entry

I disregard this US experience and turn to other historical episodes involving Scottish banking between 1772 and 1845 (L White 1984), and

the caisses patriotiques of the French revolution (E.N White 1990)

The L White book on free banking in Scotland between 1772 and 1845

has evoked a considerable literature The basic question is whether it was

in fact entirely free, or whether there were some limitations on banks in issuing notes For one thing, three major banks exercised an informal control akin to central-bank surveillance in collecting the notes of each other and of smaller banks, and presenting them for conversion into coin or Bank of England notes when it was suspected that a particular bank was leaning toward overissue (Checkland 1975) The Second Bank of the United States behaved in the same fashion from its establishment until

1836, when President Andrew Jackson vetoed the renewal of its charter (Hammond 1957), ushering in the brief period of wildcat banking in Michi-gan before the "free-banking" period from 1838 to 1860 Secondly, with respect to the Scottish experience, the success of free banking is disputed

on the ground that unlimited liability of the owners of banks exercised a restraining influence on overissue Lawrence White's study starts after the failure of the Ayr bank in 1772, which ruined its stockholders, many of

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them Glaswegian "tobacco lords" (merchants who had become rich from the Maryland tobacco trade) who were obliged to sell their vast estates to make good the liabilities to depositors for which they were jointly and severally liable (Carr, Glied, and Mathewson 1989) The three leading banks that acted informally as a central bank in checking note issue, among themselves and by others - the Bank of Scotland, Royal Bank of Scotland, and the British Linen Company (all chartered by the Scottish Parliament) - did have limited liability Others did not White is aware

of the limited-liability question but dismisses it as unimportant on the ground that when limited liability became available in 1862, the other banks did not adopt it immediately Ng argues the contrary The issue need not delay us, since both the note conversion practices of the three leading banks and unlimited liability make the case different from current proposals for free banking with no government regulation and only the general laws of limited liability

Public acceptance of the notes issued in the 1790s by the caisses

patriotiques of France fits my analysis of good money driving out bad

when the bad money - in this case the assignats - becomes completely

worthless This is really not good money driving out bad, but some kind

of money being sucked into the vacuum created by the collapse of existing money It is not currency competition so much as the tendency of any system without money to create one, for example, the cigarette money of Allied prisoner-of-war camps in World War II Another example is fur-nished by the rentenmark issued by the Rentenbank, which was created in Germany in the fall of 1923 when the mark became worthless This has been cited as evidence that good money can drive out bad, by Vaubel (in

a private letter), and by Bernholz (1989) The currency troubles of the early seventeenth century furnish more examples of new monies being created

to fill the void left by collapse of the bad, but I have difficulty in regarding these cases as upsetting the ordinary interpretation of Gresham's law

In this paper, I propose to examine another case, the so-called

Kipper-und Wipperzeit in Germany which spilled over into parts of Europe more widely, mainly in 1619-1623 at the outset of the Thirty Years' War Mint-ing in the Holy Roman Empire was not legally free A series of sixteenth-century ordinances laid down the numbers of mints allowed to each "Cir-cle," the weight and fineness of various coins, provisions for coin testing, oaths for mint masters, and the like They were widely disregarded One of the more authoritative historians of the period blames the depreciation and inflation on the weakness of the Imperial organization and control (Opel 1866) I shall start by sketching the institutional background The Holy Roman Empire was a "holding company" for a congeries

of political units varying in size from the substantial, like Austria,

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Branden-Free Minting 15

berg, and Bavaria, through principalities, duchies, states ruled by counts, bishoprics, imperial cities, and Hanseatic cities, down to small cities They were joined for monetary purposes with neighboring units into "Circles," often following ancient tribal boundaries like those of Swabia, Franconia, Westphalia, or such kingdoms as Burgundy The Holy Roman Empire laid down the rules for minting, and for testing to see that the rules were obeyed With the Reformation accomplished and the Counter-Reforma-tion that culminated in the Thirty Years' War (from 1618 to 1648) looming

on the horizon, the reigning authorities - nobility, church officials, city authorities, and even the Emperor - saw the need for more revenue to raise and equip their armies, largely of mercenaries, and to strengthen fortifica-tions Tax systems were rudimentary It was difficult to increase domain rents in periods of bad harvest One relatively easy means of acquiring revenue was to debase the currency, extracting greater seignorage

There are several interesting aspects to the debasement First, it was confined to subsidiary coins Gold coins and the silver thaler (reichsthaler) were not debased, although they disappeared into hoards The reichstaler functioned in effect as a unit of account, against which to measure the depreciation of the lesser coins, most of which were originally silver Mer-chants who used thalers and higher coins, and the mint owners or leasers, ended up with great fortunes in hoards, while the lower classes, using subsidiary coin, except for peasants living largely in the "natural" econ-omy, were ruined, along with those on fixed incomes, like government officials, clerics, teachers, creditors repaid in debased coins, and political units without mints that collected taxes in depreciated money Second, debasement in one political unit spread across state boundaries in "mosaic Germany," and over German borders into Poland and Denmark, indeed creating what was called a "commercial," as opposed to a monetary, crisis

in Britain (Supple 1959) The degree of debasement differed from Circle to Circle, although it was generally greater in the upper (southern) Circles, and less in the lower ones, including the Hanseatic cities (Opel 1866,

p 231) Third, the crisis built up slowly long before the outbreak of the Thirty Years' War - from at least 1600 - and rose to panic proportions in Upper Saxony before the war had reached its territory Moreover, stabili-zation was worked out with some difficulty in 1622 and achieved in 1623, decades before the end of the war, differing in this respect from the German inflations after World War I and II (Gaettens 1982, p 91)

The mechanism for the spread of debasement was Gresham's law, bad money driving out good, and involved the activities of princes, mints, exchangers, and the common people Adam Smith has described how small states are porous in monetary terms, with foreign coins circulating widely He may have exaggerated the ability of Britain and France to

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control their own money (certainly if the remarks were meant to apply

to the first half of the sixteenth century), but he understood exactly that juridical units with limited territory traded with their neighbors on an extensive scale and used foreign as well as domestic coins, without being exposed to the transactions costs of exchanging foreign for domestic money, or the converse, on every transaction One nineteenth-century writer referred to the "monetary pathology of border regions" (munzkranke Grenzlande) (Opel 1866, p 216) As late as 1816 at least seventy coins -

from Holland, France, Belgium, and various German states - circulated in the Rhineland, while Prussian coins were rarely seen (Tilly 1966, p 20)

"The shortage of small coin suitable for paying wages was perhaps the most serious problem of all Through the 1840s, at least, manufacturing areas in the Rhineland were supplying themselves with a motley collection

of small silver and copper coins from all over Western Europe" (ibid., p 22) Conversions were made from the coins of one country to another under these circumstances by means of a unit of account - often an

"imaginary money" in that it was not actually coined, but a unit that required some sophistication in handling (Einaudi 1936, pp 242-43) Even today, it is suspected that $180 billion in US currency issued in excess of estimated normal needs in the United States circulates largely abroad,

in the drug trade, other illegal traffic, and as parallel currency in countries with currency troubles (The New York Times, 1990)

It is difficult in the literature on the Kipper- und Wipperzeit to determine

exactly where the debasement of the wide variety of subsidiary coins originated On one showing, the bad money started pouring into southern Germany from Italy and Switzerland with the entry point at Lindau on Lake Constance (Schottle 1922-24, pp 70-80) The same account, how-ever, mentioned that the counterfeiting of the Upper Rhine Circle that included Strassburg, was particularly aggravating to the southern circles

of Bavaria, Swabia, and Franconia The important point, however, is that wherever it started it spread from one state or city to the adjoining territories

The mechanism ran as follows: a prince, elector, duke, count, abbot, bishop, or whoever needed more funds, would seek to increase his seignor-age by a slight debasement The numbers of mints grew, some officially owned by the state, some leased to private individuals against payment to the state authority or authorities With rentals, the mint operator added his profit to that of the seigneur Mter a time, counterfeiting added to the debasement Light coins would be taken abroad and exchanged for heavier coins, either at fairs or in exchange booths set up in cities and towns The good coins would be brought back to the original mint for recoinage into

a greater nominal value of debased coins In due course, the neighboring

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Free Minting 17

territory found it necessary to take steps to stop the loss of its circulating medium One such defense was to debase its own coins Thus the de-basement and counterfeiting spread from one state to another, crossing into Poland (Bogucka 1975) and elsewhere The debasement in Bohemia accelerated in 1622 after the Emperor leased minting rights for Bohemia, Moravia, and Lower Austria to a consortium for 6 million gulden a year

In the first two months before a great decline in confidence in the coins occurred, the consortium minted 30 million gulden of new coin, and in the next ten months twelve million gulden (Klima 1978) Klima insists that the Bohemian inflation of 1621-23 was unconnected (his emphasis) with the general European economic situation of the time, calling attention

to the particular features of the Czech situation, such as the uprising of the Protestant estates and their defeat and confiscation by the Catholic forces

It is difficult, however, to accept such a conclusion when everywhere else

on the Continent debasement was spreading, and, as Klima himself says (ibid., p 376), light foreign coins were penetrating Bohemia

Most ofthe literature on the Kipper- und Wipperzeit is restricted to given states and Circles, with the richest detail available for Upper and Lower Saxony (Redlich 1972; Wuttke 1916; Opel 1866) An attempt had been made by the Emperor in 1603 and 1604 to limit the number of mints to four to a Circle (except for states with silver mines), but the effort was opposed by the Lower Saxon Circle, in which there were six existing mints

in Bremen, Hamburg, Lubeck, Rostock, Brunswick, and Magdeburg This allowed other towns with minting privileges to establish further ones, and even encouraged those without privileges to follow suit (Gaettens 1982,

p 75) In Brunswick, where 17 mints had existed in 1620, there were 40 in all by 1623, including a converted convent with 300 to 400 workers (Langer

1978, p 80) The Duke of Weimar leased out 10 mints at 600-800 gulden weekly (Opel 1866, p 224)

The imperial ordinance providing for mint assayers in each Circle, and Coin Testing Days, fell by the wayside One General Assayer, Rentzsch, observed that the debasement was particularly acute in the Upper Saxon Circle and that some mints kept supplies of good groschen on hand to show the Assayer on his periodic visits (Wuttke 1916, p 136)

Numerous measures were undertaken to halt the cross-border traffic in good and bad coin - good out and bad in, but to little effect Especially on market days, it was impossible to halt the carts and examine packages Some towns and principalities tried jawboning, warning the lower classes against the exchangers, who often included lawyers, doctors, Jews, and even women; forbidding transactions of money against money, as opposed

to money against goods (Opel 1866, p 224); and threatening the changers with punishment ranging from confiscation of the coins and all

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ex-the exchanges' goods to mutilation (cutting off a hand), death, and burning

at the stake At the height of the inflation set in motion by the debasement and the ultimate refusal of producers to sell for the debased money, riots broke out in various cities, involving several hundred participants and ending in deaths of some rioters The populace blamed the mint masters and the exchangers, especially the Jews, but most historians writing on the subject denounce the princes, dukes, counts, abbots, city authorities, and the like that sought to increase their incomes by further seignorage One account suggests, however, that the traffic of the period lacked suffi-cient means of exchange in the light of a protracted monetary famine and inadequate development of credit and banks (Opel 1866, p 222)

One defense against debased currency was the establishment of deposit banks These received deposits of coin that was assayed and weighed, and

a receipt was issued for a specific amount The system had developed slowly in Spain and Italy (Usher 1943), but made its way north when the Bank of Amsterdam was established in the early stages of the Kipper- und Wipperzeit The proposal was put forward in 1606 and the Bank opened its doors in 1609 A second Dutch bank was established along the same lines at Middleburg in Holland in 1616, two more at Hamburg and Venice

in 1619, and two further ones at Delft and Nuremberg in 1621, at the height of the debasement The Swabian Circle proposed the establishment

of a bank of deposit in the fall of 1619, but the project was altered to make

it a fund to buy silver in Genoa to induce the local mint to overcome the shortage in southern Germany (Schottle 1922-24, p 85) The Bank of Amsterdam started as a 100 percent reserve bank, with the costs defrayed

by a small charge on transactions, later took on the role of an exchange bank (wisselbank) to monopolize the discharge of bills of exchange in international trade over a certain sum, and ultimately, a century and a half later, made loans to the city of Amsterdam, which was making good the losses of the Dutch East India Company, and was bankrupted Its start, and that of those that followed up to 1621, was to provide an acceptable means of payment during the monetary disorders

On other than a local level, effective stabilization for distant trade, however, had to wait for acute inflation and a virtually complete break-down of trade and payments The working classes and others who had been exploited in the early stages of debasement, giving up their good coins for progressively worse ones, finally proved unwilling to accept them where they had any choice Goods stopped coming to the market, as in the spring of 1947 in the western zones of Germany Government accounts could no longer be kept (Friedrichs 1979) Children played with "tinsel money" in the street (Langer 1978, p 30) The reichstaler, which had risen

in price from 1 fl 12 kreuzer (out of 60 to a florin or gulden) in 1596 (on

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The stabilization process, during the early stages of the Thirty Years' War, as already noted, took place slowly and piecemeal It started in 1619,

as the northern cities, which centuries before had been linked in a Wendish monetary union, tried to organize to halt the debasement and restore the currency to its old basis Similar efforts were pursued in the South among the Swabian, Franconian, and Bavarian Circles A number of mints stopped producing debased coins in 1622 when it proved impossible to get the populace to accept them Gradually stabilization was achieved piece-meal, and spread When the process was well along, in June 1623, the Elector of Saxony appointed a commission to make recommendations on currency policy This commission furnished him a 26-page memorandum the next day, outlining a return to the Imperial Ordinance of 1559, a step taken shortly thereafter, including the reinstitution of the Mint Testing Days, which had been allowed to lapse for five years (Gaettens 1978,

pp 92-3) Shaw states that a great imperial deputation was convened in

1623 to establish the final return to the Augsburg Ordinance of 1559, but this is not treated in the German histories that I have seen Opel lists the various ordinances bringing back the standards of the Augsburg Ordi-nance, one in September 1621, 10 in 1622, 10 in 1623, and the last, the first action of the Emperor Ferdinand II, in February 1624 (Opel 1866, pp.261-2)

All accounts of the process emphasize that while there were safeguards that sought to prevent currency debasement -limitation of mints, oaths of mint masters, Coin Testing Days, prohibitions against coin traffic, official assayers, and the like - they were essentially unenforced and in the case of traffic unenforceable While most histories, moreover, lay the blame on the rulers of the states and cities, Opel (1866), whose account is said to

be "surprisingly reliable" (Redlich 1972, p 10, note), is virtually alone

in observing that growing trade created a shortage of coins - comparable

to the bullion famine of the fifteenth century (Day 1978) - and especially

in the "limitless domination of Territorialismus in trade" (schrankenlose Herrschaft des Territorialismus im Verkehrsleben) (1866, p 266) In a long passage he excoriates the battle of all against all, cities trying to increase their profits at the expense of their neighbors, the lack of territorial organi-zation and of strong central authority There was, he claimed, too much

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interest in short-run gains, and the old feudal territorial organization lacked strong ties of authority (ibid, pp 264-8) The same theme is echoed

in 1990 in a discussion ofthe unification in Europe:

"Centralism has never been a German strong point; it was never more than a Prussian forte Federalism is the German tradition, from the Hanseatic League via German Confed- eration to the Federal Republic of Germany" (Buschmann 1990)

The Austrian School of free banking believes that banks will restrict deposit growth in their long-run interest, seeking to build a strong money

to gain acceptance, to cultivate reputations for prudence and care The school, and especially Vaubel, deny that money as a unit of account is a public good that can be underproduced by free riders concerned primarily with short-run profits They ignore the record of economic innocence, especially of the laboring classes, which were taken advantage of by the unscrupulous, and the widely agreed necessity for government to establish standards in measuring goods sold at retail to protect the naive from venal traders Like many in the field of public choice, they believe that private choices are made with intelligence and after consideration of long-run benefits, while public choices are venal, in the interests of the officials themselves

One could perhaps argue that the disaster of the Kipper- und Wipperzeit,

which I have treated more generally in another paper, was the result of bad public choices by the authorities in the various states But the central authority was so weak that it was unable to look after the public good, and the large number of territories with minting privileges ensured that no one else but the Emperor was in charge The abundant free riders infected one another, like a security market in a bubble The inflation and debasement were halted when the stronger northern and southern states organized themselves to enforce established standards

Good money driving out bad did occur, but only as in 1792 and 1923 when the old good money had become so depreciated as to be worthless What works in crisis cannot be elevated into an algorithm for adoption on trend I conclude that free minting in a world of small states with no one

in charge was - and by analogy, free banking unrestrained by regulation would be - a disaster One could cite the experience of the Savings and Loan Associations in the United States following the deregulation of

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Free Minting 21

may still be inflationary bubbles under such a system, as the market monetizes credit beyond that decreed by government, but short-run profit making will go much further to destabilize the system under free minting

or unregulated free banking

Carr, Jack, Sherry Glied, and Frank Mathewson 1989 "Unlimited Liability and Free Banking

in Scotland: a Note." Journal of Economic History 49 (4~ 974-78

Checkland, S.G 1975 Scottish Banking: A History, 1695-1973 Glasgow: Collins

Day, John 1978 ''The Great Bullion Famine of the Fifteenth Century." Past and Present 79:

3-54

Einaudi, Luigi 1936 "The Theory of Imaginary Money from Charlemagne to the French Revolution." Reprinted in translation in F.C Lane and J.C Riersma, eds., Enterprise and Secular Change Homewood, Ill.: R.D Irwin, 1953, 229-61

Friedman, Milton 1967 "The Monetary Theory and Policy of Henry Simons." Journal of Law and Economics 10 (October~ 1-13

Friedrichs, Christopher R 1979 Urban Society in an Age of War: Nordlingen, 1580-1720

Princeton, N.J.: Princeton University Press

Gaettens, Richard 1982 Geschichte der l'!flationen 2nd ed Minden

Hammond, Bray 1957 Banks and Politics in America Princeton, N.J.: Princeton University Press

Hayek, Friedrich A 1976 Choice in Currency: A Way to Stop biflation London: Institute of Economic Affairs

Klima, A 1978 "Inflation in Bohemia in the Early Stages of the Seventeenth Century." In Michael Flinn, ed., collection of papers, Seventh International Economic History Congress,

Edinburgh

Langer, Herbert 1978 Kulturgeschichte des 30 Jiihrigen Krieges Leipzig

The New York Times 1990 "$180 Billion in U.S Currency Eludes Tally; Is it Abroad?" 20 February, p D.1, D.4

Ng, Kenneth 1988 "Free Banking Laws and Barriers to Entry, 1838-1860." Journal of Economic History 48/4 (December~ 877-90

Opel, J.O 1866 "Deutsche Finanznoth beim Beginn dreissigjiihrigen Krieges." Historische Zeitschr!/i 16: 213-68

Redlich, Fritz 1972 Die deutsche biflation des frUhen 17 Jahrhundert in der zeitgenossischen Literatur: Die Kipper und Wipper Cologne: Bohlau Verlag

Rockoff, Hugh 1975 The Free Banking Era: A Re-examination Salem, N.H.: Ayer SchOttle, Gustav 1922-24 "Munz- und Geldgeschichte von Ulm im ihren Zusammenhang mit derjenigen Schwabens." Wrirtembergische Viertelsjahreshefte for Landesgeschichte,

Neue Folge, no 31, 54-128

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Selgin, George A 1988 The Theory of Free Banking: Money Supply under Competitive Note Issue Totowas, N.J.: Roman and Littlefield

Shaw, William A 1895 The Monetary Movements of 1600-1621 in Holland and Germany

Transactions ofthe Royal Historical Society, new series, vol 9 London: Longmans, Green, 189-213

Smith, Adam 1776 An Inquiry into the Nature and Causes of the Wealth of Nations Cannan

ed New York (1937): Modern Library

Sprague,O.M.W 1910 History of Crises under the National Banking System New York

(1968): Kelley

Supple, Barry E 1959 Commercial Crisis and Change in England 1600-1642, Cambridge:

Cambridge University Press

Tilly, Richard 1966 Financial Institutions and Industrialization in the Rhineland, 1815-1870

Madison, Wisc.: University of Wisconsin Press

Usher, A.P 1943 The Early History of Deposit Banking in Mediterranean Europe

Cam-bridge, Mass.: Harvard University Press

Vaubel, Roland 1984 "The Government's Money Monopoly: Externalities or Natural Monopoly." Kyklos 37 (fasc I): 27-58

White, Eugene N 1990 "Free Banking during the French Revolution." Explorations in Economic History 27: 251-276

White, Lawrence H 1984 Free Banking in Britain: Theory, Experience and Debate,

1800-1845 Cambridge: Cambridge University Press

Wuttke, Robert 1916 "Zur Kipper- und Wipperzeit in Kursachsen." Neues Archiv fUr Siichsische Geschichte und Altertumskunde 15: 119-56

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Profitable Currency Speculation:

Service to Users or Destabilizing?

Herbert G Grubel·

Introduction

The publications by Milton Friedman (1953) and Egon Sohmen (1961/ 1969) present to this day two of the most articulate and comprehensive statements of the case for flexible exchange rates A part of this case is the proposition that in the absence of government intervention, speculators may be expected to stabilize exchange rates

This proposition rests on two simple but powerful theorems from price theory First, only persistently profitable speculators survive competition; persistent losers run out of equity and disappear from the market Second, persistently profitable speculation results in the stabilization of the ex-change rate, since profits can only be made by buying when the prices are low, which raises them, and selling when prices are high, which lowers them Towards the end of the 1950s, a number of economists challenged the general validity of the theorem that persistent profits from speculation necessarily imply stabilization The most notable of the contributors to this literature were Baumol (1957), Telser (1959), Stein (1961), and Kemp (1963) Sohmen (1969) critically analyzed the merit of these studies In the careful manner of a good theorist, Sohmen concluded that, in the end, the issue could not be resolved theoretically, but required real world observa-tions Nevertheless, he found that the models used in the counterexamples

to the basic proposition were based on highly restrictive assumptions about dynamic processes and could not be considered to represent a significant argument against the presumptively stabilizing influence of persistently profitable speculation

The currency upheavals of the 1970s that took place in the wake of the first oil-price shock elicited a number of studies that attributed the large exchange rate fluctuations to excessive speculation Contributors to this debate were Bell (1974), who quotes a survey of the Group of Thirty

• I acknowledge the receipt of useful comments on an earlier draft of this paper by Heinz Arndt, Stephan Schulmeister, Wolfgang Kasper, and participants at the Egon Sohmen Memorial Conference

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Economists, and Kindleberger (1976) These studies are reviewed by Baillie and MacMahon (1989) These authors also endorse the view that the fluc-tuations have been caused by speculators However, none of the authors

in this 1970s literature discuss evidence on consistent profits earned by identifiable groups of speculators

During the late 1980s the same topic that had been treated by men was raised again directly by Schulmeister (1988) and indirectly by Dornbusch and Frankel (1988), Frankel and Froot (1986,1988,1990), and DeLong et al (1987).1 Ironically, of course, this new challenge to the standard theorems about the stabilizing influence of profitable speculation

Soh-is aimed critically at the experience with flexible exchange rates, the duction and merit of which Sohmen had advocated so effectively.2

intro-Interestingly, none of the authors in the new literature recommend a return to fixed exchange rates Instead, they discuss corrective policies proposed by others, like the taxation of international capital flows or the introduction of dual exchange rates, only to reject them as not practical in the technologically sophisticated world of today Nevertheless, the impli-cations of their findings are of some importance Schulmeister claims that the speculative profits are directly at the expense of real trade in goods and assets and that the unstable rates themselves result in costly externalities These kinds of arguments support the army of ideological detractors from the free market system and may be expected to lay the groundwork for future interventionist reorganization of the international monetary system

In this study I consider the merit of these new challenges to the old orthodoxy I reach the uncomfortable conclusion that, in spite of the

1 Incidentally, this new literature has no references to Sohmen's work However, the rapid decay of citations of the work of retired or deceased economists like Paul Samuelson and Harry Johnson suggests that the explosion of knowledge has made for rapid obsolescence

of past work generally and that the absence of citations to Sohmen's treatment should not

be considered to be a negative reflection on its scientific merit Rather, in my view, it reflects negatively on the new generation of economists, whose lack of historic and doctrinal perspectives often reduces the social value or their work

2 There are other prominent economists who advocate the adoption of exchange rate systems other than a free float One of the most prominent and vocal of these is John Williamson (1981, 1985), who, in a number of publications, has argued for global agreements on the adoption of targets and crawling pegs MeKinnon (1988) recommends global agreement on the coordination of national monetary policies

The recommendations for these policies are based on the perception that exchange rates are unduly unstable because there is too much speculation, according to Williamson, and too little speCUlation according to McKinnon These authors have not presented detailed evidence on excess exchange rate variability, the role of speculators, and their profits and losses For this reason I do not deal with their arguments here However, it is worth noting this literature as evidence of the widespread perception that speculators unduly destabilized exchange rates during the 1970s and 1980s

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Profitable Currency Speculation: Service to Users or Destabilizing? 25

availability of substantial data, empirical work did not resolve the basic issue, as Sohmen had hoped The profession remains with assessments that

in the 1990s still have to rely on the principles that underpinned the views

of Friedman and Sohmen in the earlier debates

1 The New Challenges

The clearest and most unambiguous challenge to the conventional wisdom

on the stabilizing effect of persistently profitable speculation in foreign exchange markets is found in Schulmeister (1987, 1988, 1990) He notes that the foreign exchange trading departments of the major international banks are known to have made large profits from foreign currency specula-tion In support of this proposition he cites profit levels found in public bank reports In 1985, twelve large US banks earned income in their foreign exchange trading department amounting to US $1,165 million Similar profits were reported for a large number of years He argues that the speculation by banks has increased the volatility of exchange rates and that the profits have been earned "at the expense" of importers and ex-porters of goods and services

The arguments made by Dornbusch and Frankel (1988) and Frankel and Froot (1986,1988,1990) are summarized most conveniently in Dorn-busch and Frankel (1988, p 165) in a section entitled: "It appears that little

of the speculation that takes place is stabilising." At the same time that Dornbusch, Frankel, and Froot argue that speculation is destabilizing, they assert that banks make consistent profits, citing Schulmeister and Goodhart (1987) for supporting evidence They also report that there is a strong demand for the services of advisors selling foreign exchange rate forecasts, especially those of chartists, which they believe to be based on nonrational models Such firms could not be expected to prosper if they and the buyers of their services did not profit from the activities These authors, therefore, imply that speculation in recent years has been both destabilizing and profitable

The theoretical models and empirical evidence used by Dornbusch, Frankel, and Froot are presented and evaluated in later sections, after consideration of the possibility that speCUlation by banks is not consis-tently profitable

2 There are no Profits from Speculation

A critical analysis of the new challenges to the Friedman-Sohmen theorem must consider the possibility that some of the factual assertions of the

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literature are false One candidate for possible falsification is that banks do not make speculative profits Dornbusch and Frankel suggest that "the reported profits are not so large that, when divided by the volume of 'real' transactions for customers, they need necessarily lie outside the normal (relatively small) band of the bid-ask spread In other words, the profits represent the transactions costs for the outside customers" (1988, p 168) Dornbusch and Frankel leave this statement without further discussion However, there is strong evidence that the high profits by banks are due

to speculation Goodhart (1987) reports the results of a survey of banks in the London foreign exchange markets I have interviewed a foreign ex-change dealer working for a Canadian bank From these sources it appears that the foreign exchange trading departments generally follow the conser-vative regulations that were imposed after the failure of the Herrstatt and Franklin Banks during the 19708 The foreign exchange trading divi-sions of banks cover all exchange risks that arise from the provision of services to their nonbank customers and in arbitrage operations in the interbank market

However, increasingly since the initial institution of these rules, the trading departments have been given capital for the express purpose of exploiting profit opportunities from holding open foreign exchange posi-tions This capital is strictly limited, though rising, since it has yielded high rates of return Open positions overnight are restricted to the size of the allocated capital in order to limit the risk to the bank as a whole

Great pressures exist on the dealers, who are expected to earn a high rate

of return on the capital at their disposal Those who do not live up to expectations quickly lose their positions Those who succeed are able to earn high personal rewards in the form of bonuses linked to the profits The pressures of the job are such that few last for a long time

In Grubel (1990) I have argued that the speculative profits of these banks' dealers do not occur "at the expense" of their trading customers Instead, I have suggested that these profits are a return to the stabilization

of the exchange rate which is brought about by the speCUlative activities of the banks It is clear that this proposition is valid only if consistently profitable speculation is stabilizing

2.1 Unknown Population of Losers?

It is important to note in this context a fundamental idea contained in Friedman and Sohmen and addressed in the discussion by Baillie and McMahon (1989) It is perfectly possible for a certain group of speculators

to be destabilizing and lose money on average These speculators are

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Profitable Currency Speculation: Service to Users or Destabilizing? 27

drawn into the business by reports of large profit opportunities and often are kept in the activity by temporary successes Eventually, such specula-tors lose their equity and disappear from the market They are replaced by

a new set of optimists who destabilize exchange rates by engoging in speculation that is unprofitable on average

In the literature under discussion here, there is no mention of such a group of persistent losers in the markets of the 19808 The control systems

of banks appear to be so effective and competition among banks is so strong that no subgroup of banks can persistently lose from speculation without financial consequences and publicity in the media The same may

be said about the portfolio managers oftrusts, pensions, and mutual funds

At the same time, it cannot be ruled out that there exists a floating population of private speculators that loses regularly, destabilizes the exchange rate, and provides consistent profits for the banks, but is not known Human nature prevents the advertisement of such behavior and I know of no systematic research on the issue In the following I rule out this possibility not because I am confident that it is correct but because other-wise the alleged puzzle, which drives this analysis, ceases to exist More empirical research on this issue is warranted 3

3 New Theory

Dornbusch, Frankel, and Froot acknowledge that it is necessary to resolve the conflict between the alleged evidence on the existence of destabilizing speculation and on the consistent profitability of this activity by banks They attempt to do so essentially by citing theoretical articles that use mathematical constructs to generate examples of destabilizing, profitable

3 More research is also warranted into the question why the daily turnover of foreign exchange in the interbank markets of the world is so high and a large multiple of transac- tions with nonbanks Frankel (1988) reports that in March 1986 daily foreign exchange market transactions in the United States were $50 billion among banks and $34.4 billion among brokers and financial institutions, of which only 11.5 percent was with nonbank customers

One aspect of the activities is reasonably clear Not all of them involve speculative, open positions Much of them are explained by the act of covering open positions through swaps These swaps arise because in most centers of the world, cross rates tend to be quoted and transacted through the dollar For example, a bank in Frankfurt deals Italian lira to a German importer paying DM by buying dollars with the DM and using the dollars to buy the lira As a result, a transaction involving X lira tends to result in a turnover of 2X dollars in Frankfurt, all without any speculative motive

Other transactions are motivated by arbitrage and acting on news Someone has to make markets perfect This topic is discussed further in Section 4 below

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speculation They assert that "the modern theory of rational stochastic speculative bubbles has all but demolished Friedman's claim that investors who bet on destabilising expectations will lose money In a rational specu-lative bubble, investors lose money if they DON'T go along with the trend" (Dornbusch and Frankel 1988, p 165; emphasis in text).4 They note that DeLong et al (1987) construct a model in which there exists a class of traders who follow irrelevant noise, and "yet who prosper over time, contrary to Friedman's argument that destabilising speculators would be driven out of the market" (p 166)

Perhaps the most comprehensive expression of this position is found in Frankel and Froot (1990, p 184):

Since Milton Friedman (1963), the standard argument against the importance of stabilizing speculators is that they will on average lose money, and be driven out of the market in the long run An number of special counter-examples to the Friedman argument have been constructed over the years, most involving heterogeneous actors, (e.g., "suckers" who lose money and "sharpies" who win) The simplest counter-example would be based

de-on the theory of ratide-onal speculative bubbles, where each market participant loses mde-oney

if he DOESN'T go along with the herd (emphasis in text)S

It is not possible to disprove the validity of the theoretical, mathematical arguments by which these conclusions are reached This is so simply because these arguments involve sophisticated tautologies and the conclu-sions follow logically from the assumptions made The authors of these models have selected a small number of assumptions from a very large possible set capable of constituting a simplified picture of reality The authors of these articles, of course, typically are prepared to defend the realism of the assumptions that they have made But there are likely to be many other models that are based on similarly defensible assumptions and that do not produce the same conclusions at stake here 6

4However, the authors do not provide a precise reference to the source of this conclusion, which is presented in each of the papers in which Frankel is a co-author Presumably they assume that all readers are fully familiar with the literature on rational speculative bubbles, which mayor may not be appropriate Below I present some methodological criticism related to this issue

5 In the appendix I present a simple model that attempts to incorporate the essential features

of the speculative bubble and various other processes, in an attempt to shed light on the consistency of the various assertions found in the literature

6The best known of these is, of course, the Friedman "model" noted above In contrast to the new models, this one has the advantage of simplicity and use of assumptions the validity and central importance of which are disputed by few economists However, there is a puzzle why there are no articles that use sophisticated tautologies to prove that profitable specula- tion is stabilizing I think that the answer to this puzzle is found in the fact that rewards in economic science tend to favor research that is "news" in the sense that it proves market failure and sheds doubt on the efficiency of free markets

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Profitable Currency Speculation: Service to Users or Destabilizing? 29

These considerations leave me with the same conclusion reached by Sohmen during the 196Os The issue cannot be resolved theoretically Empirical evidence is needed This fact has been recognized by Dornbusch, Frankel, and Froot In the following sections I discuss the empirical evi-dence that they have introduced in support of the basic proposition that speculation has been destabilizing exchange rates It should be noted that this proposition is logically divorced from the question of whether it

is possible to have speculation that is simultaneously profitable and stabilizing, which was addressed in the preceding sections

de-The evidence produced by Dornbusch, Frankel, and Froot falls into the basic categories of macromodeling and tests of rational behavior in foreign exchange markets The literature in these fields is vast and it is not possible

to produce here a thorough, and no less a complete, review Instead, this analysis draws mainly on the propositions found in Dornbusch and Frankel (1988) and Frankel and Froot (1990)

4 Evidence from Macro Models

One of the most important sources of information about the destabilizing effect of speculation comes from the comparison of actual exchange rates with those generated by macroeconomic models Dornbusch and Frankel note that whereas "Exchange rates were supposed to be as stable as macroeconomic fundamentals" (p 152), in fact, "Exchange rates move inexplicably" (p 157) In a similar vein, Frankel and Froot report, "It is now widely accepted that standard observable macroeconomic variables are not capable of explaining, much less predicting ex ante, the majority of short-term changes in the exchange rate" (1990, p 81)

The basis for these findings is exchange rate forecasts produced with the help of sophisticated macroeconomic models resting on different theoreti-cal foundations like Keynesian, monetarist and rational and adaptive expectations

The problem of poor exchange rate forecasts must be seen in the light of the fact that these models have been equally unable to perform well in explaining or forecasting other economic variables, not just exchange rates The sources of these difficulties are well known and range from the Lucas critique and the natural instability of the estimated coefficients

to the complexity of multi-equation systems and econometric estimation techniques Perhaps most fundamentally, these models suffer from the need to estimate indirectly the non observable but crucial expectations held by economic agents

Given these difficulties with macroeconomic models, it is no surprise that "economists divide into two camps" (Frankel and Froot 1990, p 81)

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concerning the interpretation of the findings that exchange rates have been inconsistent with macroeconomic fundamentals

One camp finds no evidence of destabilizing speculation Some in this camp work with models in which exchange rates are well explained and predicted For example, Blundell-Wignall (1986) reports on published work (Masson and Blundell-Wignall 1985) according to which the 1984 increase in the value of the US dollar is not caused by speculation but by the correct anticipation of US fiscal policy Others in this camp work with poorly performing models According to Dornbusch and Froot, some of these analysts attribute their results to changes in tastes and technologies

in the economy which are not reflected in the models It is clear that such

a methodological stance comes close to making the theory non testable and

to assuming that the market is always right The other camp is satisfied that the models are correct and that their poor performance is evidence of destabilizing speculation

Authors who believe they have found evidence of irrational speculation, but especially Frankel in all of the papers cited here, tend to argue that their case is strengthened by what is known as the theory of rational, speculative bubbles At one level of analysis this theory may be seen to be nothing more than a sophisticated way of describing or naming the devia-tion of actual exchange rates from those predicted by macroeconomic fundamentals in the model chosen by the author

Specifically, the theory postulates that a substantial number of market participants expect the exchange rate to move in a certain direction be-cause all other agents hold the same expectations.7 As a result, it is rational

to act in accordance with these expectations, and the market exchange rate

is driven from the level consistent with the macroeconomic fundamentals The theory is deficient as a simplified description of speculative episodes because it does not explain how such bubbles get started or what makes them burst More fundamentally, and at a methodological level, it is important to realize that such a theory cannot prove anything about the real world Empirical tests can find evidence consistent or inconsistent with such theories and thus suggest something about their merit as a descrip-tion of reality The theory of speculative bubbles has not been tested empirically At the same time it is not possible to use the existence of deviations of exchange rates from fundamentals as empirical evidence in support of the existence of bubbles The theory is supposed to explain the phenomenon, and not the other way around

7 Some readers may marvel at the fact that "the theory identifies speculative bubbles with the unstable paths in a rationai-expectations saddle-path problem" (Frankel and Froot 1990, p.84)

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Profitable Currency Speculation: Service to Users or Destabilizing? 31 4.1 Tests of Purcbasing Power Parity

Tests of purchasing power parity represent a variant of forecasting models based on macromodels, since they postulate that the spot exchange rate

is determined by relative price developments in the home country and abroad There probably exist now literally hundreds of empirical studies

of this theory, covering different exchange rates and time periods The tests involve ever-increasing levels of econometric sophistication

Some of the empirical studies of purchasing power parity are consistent with the goods arbitrage model of foreign exchange, some are not In general, the longer the time period covered by the studies, the more likely

it is that exchange rates conform to the development of relative price levels The results are also strongly dependent on the starting and ending period for the analysis

However, while there are no objective and universally accepted teria for accepting or rejecting the validity of the theory, Dornbusch and Frankel nevertheless conclude that "not only does purchasing power parity clearly fail in the short run, but it is difficult to disprove the claim that it also fails in the long run" (p 162).8

cri-I conclude from this review of the evidence from macroeconomic models and tests of purchasing power parity that they have failed to make a very strong case in support of the view that currency speculation has resulted in significant deviations of exchange rates from macroeconomic fundamentals

5 Nonrational Behavior

Dornbusch, Frankel, and Froot believe that there exists indirect evidence

on the destabilizing nature of speculation, based on three empirical

find-8 Dornbusch and Froot note that the theory of purchasing power parity was widely accepted during the 19708 and rejected during the 19808 One of the problems of all fast-moving sciences is the short memory of researchers and a lack of historical perspectives It is not clear from Dornbusch and Froot whether the disrepute of the theory is due to deviations that developed during the 19808 or whether new techniques of measurement and theoretical approaches have resulted in the need to revise evidence produced during the preceding centuries I suspect that the authors must mean the former If they do, they lack perspective

on the lengthy deviations that have been observed before and that the theory is much more complex than its simple statement in textbooks is During the early 196Os, Houthakker (1962) had used a simple purchasing power calculation to suggest that the dollar was overvalued The resultant furore was memorable and prompted P Samuelson (1964) to suggest that "every generation of economists needs to learn for itself the complexity of the theory."

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ings First, speculators are not rational This proposition is alleged to follow from the results of nearly all studies of forward and actual spot rates, as well as surveys of expectations Second, there is strong evidence that exchange rates follow random walks, which implies that the best guess about the future is that it equals the present spot rate and it makes no sense to speculate Yet, there are speculators Third, most market partici-pants pay scant attention to market fundamentals Instead, participants and especially banks, follow the advice of chartists and hold very short-term open positions

con-One camp views the results as reflecting a risk premium that forward exchange market participants are demanding for entering into contracts involving uncertain prices in the future The other camp views the results

as evidence of a systematic bias in the formation of speculative tions, which in turn results in excessive exchange rate fluctuations Frankel and Froot clearly belong to this camp

expecta-5.2 Speculation in Efficient Markets is Irrational

In a static world of unchanging fundamentals and expectations, it would indeed be irrational to speculate on future price changes, since prices embody all available information about the equilibrium value of assets However, in a dynamic and uncertain world, fundamentals and expecta-tions change continuously Speculators who specialize in the gathering and analysis of new information, and who act on them, make prices again consistent with the new environment In the process, such speculators under competition earn risk-adjusted normal rates of return on their ac-tivities Speculators who act only on the basis of past price developments,

of course, do not earn profits on a consistent basis These ideas have been worked out formally by Grossman and Stiglitz (1980) They have led Stiglitz (1983) to the conclusion that in such a dynamic world, markets

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Profitable Currency Speculation: Service to Users or Destabilizing? 33

cannot be completely efficient at every point in time.9 We may conclude that it is not irrational to speculate on the effects of new developments in the presence of evidence on the efficiency of foreign exchange markets 5.3 Acting on Chartists' Advice is Irrational

Frankel and Froot (1986, 1990) made ex post evaluations offorecasts made

by professional forecasting services These forecasts have a poor record of performance In addition, they found that increasingly such forecasts rely

on chartist principles rather than economic fundamentals The authors interpret both the poor forecasting record and increased preponderance

of chartists as evidence of destabilizing speculation According to the authors, this conclusion is not altered materially by the fact that the quality

of forecasts based on fundamentals is an increasing function of the length

of the forecast

The authors conclude that the advice of chartists leads to irrational and destabilizing speculation In my view, this conclusion is not warranted First, the buyers of chartist advice have at their disposal a wide range of models and forecasts From this supply they select that which they con-sider to be useful, especially in the light of experience and in combination with additional information.1O Second, the fact that chartists do not use rational economic models to justify their advice does not clinch the case What counts is the success of the forecast As someone once put it, it matters little whether the TV repairman believes that a component needs replacing because a little man who lives in the component has died All that matters is that he makes the TV work again

9 The idea that efficient markets leave no room for speculative profits has been poked fun at

by the following story Eugene Fama, the premier exponent of the efficient market model, was walking along the street with a visitor from another university who pointed to a 100 dollar bill on the sidewalk and suggested that Fama pick it up Fama answered that there could be no such bill on the ground, since someone would have picked it up already

10 Eugene Fama, who once was a very strong proponent of the view that past price tion contains no information useful for profitable trade in securities, now believes that it is possible for some trading rules to work for some time in generating excess profits Those with a special talent for discovering and using these rules will make profits until their activities destroy their usefulness by influencing the behavior of prices on which the rule was based, just as the theory of efficient markets implies This revisionist thinking is based

informa-on the recognitiinforma-on that efficient market outcomes are not instantaneous, but, in a world

in which information is uncertain and often verified only as a function of time, leaves opportunities for specialized and talented individuals to earn extraordinary profits I have made this argument in Grubel (1979)

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6 Summary and Conclusions

The large variance of exchange rates in the post-Bretton Woods era has been interpreted by some influential economists as evidence of wide-spread destabilizing speculation The view is shared by politicians and the general public The economists have supported their view by referring to theoretical models, deviations of market exchange rates from those pro-duced by econometric models, and empirical evidence concerning the efficiency of exchange markets

The validity of the empirical evidence on the existence of destabilizing speculation is not accepted by all specialists Because of the nature of the evidence, it is difficult to decide its validity on rigorous, scientific grounds and choose between the competing views However, there is strong evi-dence to suggest that banks have made consistent profits from speculation According to conventional wisdom, such profitable speculation should be stabilizing It is therefore in conflict with the evidence that there has been significant, destabilizing speCUlation

The economists who believe in the existence of destabilizing speculation argue that new theories have made obsolete the conventional wisdom about the stabilizing effect of profitable speculation The case they make is not persuasive It is possible to construct counterexamples and theories which prove their case However, theories by themselves can never prove such propositions in the absence of direct empirical tests Such direct tests

do not exist

The empirical evidence adduced in support of the proposition that speculation is destabilizing is not undisputed in the literature or, as in the case of the argument about the irrationality of speculation in efficient markets, is based on static assumptions

The examination of the evidence on the existence of destabilizing lation presented in this paper leads me to the following conclusions There

specu-is strong evidence that banks have consspecu-istently earned profits from change rate speculation and there is a strong presumption that this specu-lation has resulted in the stabilization of exchange rates over time, relative

ex-to the stability that would have prevailed otherwise As a result, the profits

of the banks are not earned at the expense of importers and exporters of goods and services Instead, the profits represent the return to the service

of exchange rate stabilization that the banks provided for their commercial customers

In terms of major policy issues, these conclusions suggest that there does not exist a strong case for the introduction of taxes on foreign exchange market transactions, of dual exchange rates, or of exchange rate target zones to reduce destabilizing speculation

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